As the calendar has turned to a new year, COVID-19 is still very much with us, although the light at the end of the tunnel seems ever closer as vaccines roll out. Variant strands of the virus aside, the market appears to be carrying the momentum from Q4 2020 into the New Year. As we begin a new year of investing, let us take a look at where things stand.
Yield Curve Expanding
The 10-2 Treasury Yield Spread is the difference between the 10-year treasury rate and the 2-year treasury rate. A 10-2 Treasury Yield Spread that approaches zero signifies a “flattening” yield curve and is generally a negative for the economy, whereas a rising spread signifies a “steepening” yield curve and considered a positive for the economy. Since early August 2020, the spread has been steadily increasing, signaling future strength for the economy. The curve is suggesting that the worst of the economic downdraft has past and that the corporate profits cycle should continue to grow. The increase of the corporate profits cycle should produce a different batch of financial market winners as the market will expand to embrace many of the downtrodden industries of last year. An expanding yield curve and profits cycle historically has been favorable for:
- Smaller capitalization stocks
- Value Stocks
- High Yield Bonds
- Emerging Markets
Stock Market Valuation Rich
Based on several valuation metrics, the S&P 500 Index, which is a market-capitalization-weighted index of the 500 largest U.S. publicly traded companies, is overvalued. The table and chart below from Charles Schwab shows various metrics as of 12/31/2020. While stocks are expensive on many metrics, the most fervent counterpoint has been that because interest rates are historically so low, higher stock valuations are justified. On an absolute basis stocks may be expensive, but on a relative basis they are probably neutrally valued. Rising rates will need to be monitored, as this relative valuation advantage will vanish quickly if the current uptick in rates becomes more pronounced.
Rotation from Growth to Value
Coming into 2020, value stocks were historically cheap versus their growth counterparts. The virus and subsequent lockdowns created a Molotov cocktail that furthered the divide between value and growth companies, as the burden of quarantine was felt more deeply in cyclical and service industries. Work-from-home was a huge benefit to many companies in the tech and consumer discretionary sectors (e.g. Zoom, Peloton) and a detriment to value-oriented names in the retail and energy sectors (e.g. AT&T, Exxon) which tend to involve services that cannot be completed from a home office.
However, a rotation, as foreshadowed by the yield curve has begun. As seen in the chart below, with flashes starting in April, a rotation to value started to appear, which has significantly accelerated during the fourth quarter of last year.
The question is whether the acceleration in value stocks has further room to run or has gone too far, too fast. This move may have many more years as the economy heals, but the pace with which it has accelerated may need to cool down a bit over the medium term. Below is the percentage that the current price of the S&P 600 Small-cap Pure Value Index is above its 200-day moving average. The index is currently 42% above the 200-moving average, one of the highest readings in the history of the index. In the long run this is probably a sign of strength, but near term will need to be digested with consolidation of the gains.
As investors have gained confidence in the durability of the nascent recovery, no doubt aided by the Fed’s largess, the spread between high yield corporate bonds and Treasuries has continued to fall from the peak during the initial virus response in March 2020. They are now at levels consistent with no economic distress and no longer of exceptional value when compared to treasuries. However, as long as the economy continues to grow and remain stable, these spreads can remain tight for some time and high yield bonds can be reasonable investments going forward.
The vaccine rollout is proving more difficult than advertised, and normal life is a little further off than we would all like. Between today and when the virus is under control, there will be some bumps in the road. There will be occasional clashes between market expectations, earnings growth and the vaccine rollout. We will not be deterred, the destination is clear – within a year or so, we will have our lives back to normal, the economy will most likely be growing, and the markets will probably be higher than they are today. As 2021 progresses, the only prediction that we know will be correct is that it will be different from 2020.
General Disclosures: The content contained in this article represents the opinions and viewpoints of Cardan Capital Partners only. It is meant for educational purposes and not meant for consumer trading decisions. All expressions are as of its publishing date and are subject to change. There is no assurance that any of the trends mentioned will continue in the future. Market performance cannot be predicted, so nothing in our commentaries is ever meant to provide any kind of trading advice or guarantee of future results. Certain information contained herein has been obtained from third party sources and, although believed to be reliable, has not been independently verified and its accuracy or completeness cannot be guaranteed. Any reproduction or distribution of this presentation, as a whole or in part, or the disclosure of the contents thereof, without the prior consent of Cardan Capital Partners, LLC, is prohibited. Investments in securities entail risk and are not suitable for all investors. This is not a recommendation nor an offer to sell (or solicitation of an offer to buy) securities in the United States or in any other jurisdiction.