Let’s take a look at our investment strategy for 2021. What’s in store for the global equity market and what are the risks? Should we expect the market to continue growing with minor corrections or will there be a collapse due to the ongoing pandemic? Let’s compare equity and bond investments.
The world has been living in a pandemic for over a year now. We’re not talking about a quick end to this story and a rapid economic recovery. COVID-19 will become a seasonal disease. In developed countries, it is probably realistic to reach a vaccination rate of 50% as early as summer. For other countries, especially those that do not have their own vaccines, the situation is ambiguous.
In February 2020, we entered uncharted territory. We didn’t know how the market would react to a pandemic, how it would recover from it. There seemed to be a consensus that we had strong growth ahead and cyclical stocks were the perfect way to get involved. Throughout the second half of 2020, the stock market was rewriting all-time highs. Not surprisingly, talk of a bubble has begun. How justified are they?
What’s in store for the global stock market in 2021?
- Among the signs of an imminent collapse are:
- Excessive optimism amid rising numbers of retail investors worldwide.
- Continued price increases in the market while core businesses haven’t even recovered yet.
- The high value of market P/E indicator relative to historical data.
- Record high level of “Buffett indicator”.
Growth companies – tech giants – have shown impressive growth in 2020. This does not mean that the technology sector is overvalued or that a lot of speculative money has come into the market. As with multiples (P/E), people are “comparing the warm with the soft”: current performance with historical values. This is incorrect. Not only do we continue to live in an “abnormal” pandemic situation, but the very business structure of technology companies has also changed.
The investment houses that give their forecasts are no longer looking at this year, in which profits will definitely be quite low, they are estimating next year – 2022. We live in the here and now, and the markets live in expectations. If we understand that things are going to grow in the future, the next six months don’t really matter.
It’s not right to compare companies in their current state in terms of multiples to companies that were 10 years ago. The world has changed a lot. If the structure of the S&P 500 Index had remained the same as it was in 2010, the 2020 result would have been 10% worse. Since 2010, the internet has taken the place of energy, and the technology sector has taken a few percent each from industry, consumer, and finance. That is, the share of cyclical companies in the index has declined.
It’s as if many technology companies were made for the current pandemic. The advantage of IT is not just technology, but also a special business model: software developers now provide their products and services on a subscription basis. Ten years ago Windows was sold on disk, so Microsoft’s revenue grew a lot after the upgrade and then stagnated until the release of the new version. Now, when you pay for license renewal every year, the company’s revenue has become more constant and predictable.
Iron manufacturers have refocused on the corporate market. If software sells, the server hardware vendors feel pretty good. The current multiples for such a market are not a bubble and not a disaster.
But corrections in the stock market will almost certainly happen: according to our forecasts, 2021 will be quite volatile. Small corrections were already evident in the first few months of this year. In the S&P 500 index, it was not so noticeable, because value stocks were rising and growth stocks were falling. The NASDAQ was more obvious as the index lost 10% from the highs of last year as technology stocks declined.
Should we wait for corrections of 5%-10% to enter the market or increase our position? Statistics show that mass investors do not go into the correction itself, even if they were waiting for it. And the levels to which the market corrects are still higher than those at which an investor could initially enter.
The number of investors on the Russian stock market grew 2.3 times to 9.9 million people (12% of the economically active population) in 2020. The total volume of exchange transactions added 19%. Despite the fact that the contribution of such investors in the total mass is small, they can increase market volatility, especially with respect to low-liquidity companies.
During market fluctuations, newcomers start to either exit en masse on corrections or enter on rises, reinforcing these trends. This year, it also became clear that retail investors, united through social networks, can “accelerate” individual companies. An example is a story of “couch investors” from Reddit and GameStop stock. In Russia, something similar happened in February with Beluga stock.
Shares vs. bonds
It is, to put it mildly, old-fashioned to consider shares as a knowingly risky instrument for investments. The main risk parameters are related to a short investment horizon. We believe that the collapse of the markets in 2020 is exactly what investors needed to understand the risks and further growth, that’s our argument:
The “record bull market” overhang is gone from the market. For the past five years, we’ve been reading about this all the time from all the investment strategists. The market was so sure of an imminent recession that it began to see its harbingers in every macroeconomic indicator. In 2016, a fall in industrial production was supposed to lead to a recession, in 2018, a straightening of the US Treasuries curve, and in 2019, trade wars.
It turns out that recessions are not that bad, even ones as sharp and deep as these years. Was it worth waiting so many years for the market to collapse to reach even the lowest point of three years ago (if we take the S&P 500 Index including dividends)?
The companies themselves have shown great flexibility in cost management. The first reports of cost-cutting began to appear before the end of the first quarter of 2020.
The market structure has changed dramatically over the past 10 years (since the previous crisis). Tech companies have become more resilient to crises.
Bonds as an investment instrument are still suitable for investors with a conservative risk profile. Bonds are more profitable than deposits in any case. Even OFZs offers a pretty good premium over most major banks’ rates in Russia.
Despite recent growth, bond yields remain very low. A significant portion of developed-country bonds offers negative real yields because of inflation. Therefore, people are increasingly investing in long-term securities and low-quality borrowers, taking on additional risk and extra duration.
The situation in the debt market is explosive. If the U.S. regulator, the Federal Reserve, even hints that it will start raising rates or rolling back its buyback program in 2022, people will run from these substandard bonds, which could bring down the debt market. In our view, it’s much safer to hold stocks. They are more interesting than corporate bonds.
The spread between stocks and corporate bonds is kept at 2.5%, which means that even with zero EPS (net income per common share) growth, stocks will provide a 2.5% higher yield than bonds. In addition, they provide an opportunity to participate in business growth.
In the context of individual sectors for equity investments, our favorites for this year are the financial sector, IT, and healthcare.
For ruble bonds, we should pay attention to second-tier issuers with a yield of 6-7% and BB-/BB+ rating. Sanctions risks are largely taken into account, but negative surprises cannot be ruled out.
In the next article, we will talk about specific investment ideas, what you can invest in now and whether you should only bet on growth companies or cyclical companies.