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Starting the year off Right: 1st Quarter Market Update

  • Stocks advance during Q1 as the “Reopening Trade” gains steam
  • Changes in Washington dominate the headlines – how we’ve prepared portfolios
  • A weaker US Dollar has important macro-economic implications
  • Rising interest rates brought about a change in sector themes
  • Storm clouds on the horizon? What we should expect in the months ahead




As we noted in our last missive, elections usually create short-term volatility, and that often leads to opportunities for long-term investors. Equity markets rallied sharply from November last year through March. Investors anticipate superior 2021 US economic growth as many cities across the country emerge from social and economic restrictions. Immense fiscal stimulus from Congress and an easy-money policy from the Federal Reserve provide major support, too.

The Reopening Trade is found in many industries, but perhaps mostly in consumer travel, casual dining, and retail niches. Last year, in our 2020 Market Update, we discussed the headwinds these sectors faced from COVID-19. Now, as we recover from the pandemic, the headwind becomes a tailwind. The pandemic impacted the US economy much more than China’s since we are more services-based, so we felt the brunt of COVID but have also bounced back very well. We are finally starting to see economically-important cities and metro areas ease restrictions, leading to the aforementioned sectors to return to growth.

It’s hard to put in proper perspective the catastrophic GDP decline during the COVID-crash last year. Luckily, the economic collapse lasted only a month, but it still resulted in a 31.4% annualized fall in GDP during Q2 2020. For the year, our economy shrank 3.5% in 2020, while 2021 is expected to bounce back in a big way. The Bloomberg consensus forecast calls for 2021 GDP growth of 5.7% this year, but other forecasts are significantly higher. 2021 is poised to boast the strongest growth since 1984’s +7.2% climb.

Q1 2021 Equity Market Returns: Small and micro caps surge while Big Tech consolidates1

We positioned portfolios to capitalize on the market’s turn from caution to optimism. While we don’t want to publicly disclose our active stock positions, we are happy to report two reopening trades we initiated last November announced they were being acquired at higher prices. Since these positions have been closed, we can describe the trades. As a disclaimer, we do not recommend investors purchase these stocks today. The two positions were Michaels Companies (MIK) in our Microcap Strategy and Extended Stay America (STAY) in our Growth Strategy.

  • Last November, we initiated a position in MIK below $8 per share. On March 3, it was announced that Apollo Global Management would take MIK private at $22.
  • We bought STAY below $14 per share last November, and that too was acquired. On March 15, it was announced that Blackstone would purchase Extended Stay America for $19.50.

Both deals bolster the narrative that our economy is on the road to recovery.

Could there be roadblocks? Or at least some speedbumps? Of course. Maybe changes in DC have you unnerved right now. Higher taxes and increased annual budget deficits are of course a macro concern, but there is also opportunity. President Biden put forward a $2 trillion infrastructure investment bill late last month. While details are sketchy right now, there will be winners and losers.

We took action anticipating this policy change. One position we can discuss now is a concrete pipe manufacturing company – Forterra (FRTA). We initiated a position in FRTA last April in our Microcap Strategy under $7 per share. We were pleased when Quikrete Holdings, Inc. announced plans to acquire FRTA for $24 on February 22, resulting in a 250% return on our investment. We can describe the trade now that we have exited the position. As a disclaimer, we are not recommending investors buy it now. Again, to keep our compliance department happy, these positions have been exited, and we do not recommend investors buy the stocks today.

Many clients worry about budget deficits and our national debt’s major climb recently. We get it. The US government has spent more on COVID-19 relief than during World War II (adjusted for inflation). Last year, we believed this high deficit-spending trend would manifest itself in a weaker US Dollar. That thesis came to fruition.

The USD fell 8% from its lofty levels a year ago. Portfolio managers must understand the impact of a falling Dollar on security prices – certain sectors tend to outperform others in this environment. Among them are Energy and Materials. Commodities and Emerging Markets also usually rally when the Greenback drops. We positioned portfolios to be overweight these sectors, themes, and regions.

With a falling US Dollar usually comes a climb in inflation expectations and interest rates. The US 10-year Treasury rate moved from 0.9% at the end of last year to 1.75% in recent trading days – almost a doubling of the yield. While this is bad news for those looking to borrow money soon, it’s a fantastic development for the Financials sector.

Banks in particular love higher interest rates so long as near-term rates stay low. It’s essentially their profit margin. We positioned portfolios to be overweight the Financials sector as we expected rates to rise. Bond investors, on the other hand, do not like higher rates because it means the price of a bond goes down. If the year ended today, it would be the worst annual performance in the US Aggregate Bond Market in its history – all thanks to higher interest rates.

Q1 2021: 10yr yield rose from under 1% to 1.75% while the US Aggregate Bond Index suffered a massive decline2

The stock market has been up and down recently. Big picture though, the gains over the last several months and year-over-year are massive. It’s been a great time to be an aggressive investor as the stock market anticipated a robust economic recovery. Investors should always remind themselves that the stock market is a forward-looking indicator. There are concerns on the horizon.

GDP growth will likely peak during Q2, so the rate of change of growth will turn negative later this year. And the reopening is not without its challenges – we see this in the rising cost of goods and services. Higher costs could lead to lower corporate profits in the second half of 2021. Companies will attempt to pass on higher costs to consumers, too. Expect to see your bills and daily expenses go up as inflation rears its ugly head. Pent-up consumer demand and supply shortages following the pandemic is a bad combination for those concerned about inflation.

Conclusion

It’s been a great last 12 months for investors. We positioned our equity strategies aggressively and pounced on macro themes. Our individual stock positions performed well, too. While most of the market is excited right now, we are more cautious than we were a year ago. Last spring was a great time to be buying stocks, but the opportunities are fewer today. We must be more nimble and selective as portfolio managers. We thank you for your investment and trust. Be safe, and we’ll talk soon.


Sources:

1. https://www.wsj.com/market-data/quotes/index/DJIA/historical-prices

2. https://www.wsj.com/market-data/quotes/etf/AGG/historical-prices