Date: January 20, 2021

***Q4 Client Update***

Many people like to read my very brief quarterly client update which I select excerpts. If you’re one of them, please read on. If not, feel free to stop reading here.

The year where time stood still and just wouldn’t end has finally come to a close. It was certainly a year that will live in infamy. Most importantly, I am grateful that you and our other clients survived. 2020 was one of those generational years that made an indelible mark on everyone, and not all of it was negative, thankfully. The country and the world learned new ways to live and accomplish things.

This report is about the fourth quarter of 2020 and not a rehashing of the year that was. So, let’s get into it. Obviously, COVID remained the dominant topic. And while medical experts have prepared us for a rather dark winter, there was absolutely incredible news on the vaccine front with both Pfizer and Moderna announcing almost unbelievable results from their clinical trials. 8 months ago, experts predicted it would take at least 12-18 months, best case, for a vaccine to be invented. The fact that the virus was sequenced in Q1 with a vaccine shortly thereafter and clinical trials beginning in Q2 was a medical miracle. I don’t know what to call two, independent clinical trials being 95% effective with several more on the way in early 2021. There is finally a light at the end of the tunnel.

The election was almost on par with the virus in Q4. I think I can speak for everyone when I say how glad I am that it is finally over, regardless of who won and lost. More than three months ago, I guaranteed that the 2020 election would set a precedent. I knew that because at least one piece of research that had never happened before would occur as a result of this election. While most of my research concluded that Donald Trump would be a one term president, there was also a piece that showed the original front-runner from the Democrats had not won an election in the modern era. Joe Biden was that person.

Working against Trump was the fact that no president had ever been reelected with recession or a bear market in the election year. Additionally, no president had ever been reelected with an approval rating of less than 47% on July 31. The last three elections in years ending in “0” all saw the incumbent lose. Finally, as I ran our own proprietary election model just before the big day, it indicated that Biden would win. That model has correctly called every election since 1996. It was wrong in 1992 along with two others decades earlier. With the election over, I am happy to mothball all my election research until 2024.

I can’t believe I am still writing about this, but BREXIT, the UK’s exit from the European Union originally voted for in June 2016, resurfaced yet again as the extension of the extension of the extension drew to a final deadline in late 2020. While global markets were roiled for two days in 2016, it’s hard to find any investor who even cares anymore. And staying on the topic of Europe, the European Central Bank (ECB) formally announced their decision to continue their money printing ways and kick it up a notch as Emeril Lagasse would say. This comes as a surprise to no one. As you may recall, I have long listed a breakup of Europe as a major concern of mine with a banking crisis setting off the final stage in its dissolution. As I continue to believe, countries like Italy, Spain and France are too big to fail and too big to save. The when is always the question. A key clue of Europe’s final demise will be a plummeting Euro currency below 100 against the U.S. dollar.

Surfing back to our shores, on the heels of a blistering +33% surge in Q3 economic growth after the Q2 collapse, Q4 is expected to be much more subdued around +4% which is still well above trend growth for this century. Given the plethora of unusual factors and the historically wide range of outcomes, forecasting the economy with any degree of certainty has become a fool’s errand until the country returns to some semblance of normalcy. I have said early on that I emphatically reject the notion of a “V” shaped recovery or anything that even remotely resembles that. There has been just too much systemic damage to the service sector, especially the real mom and pop businesses in the republic. While there has been an unprecedented number of special lending programs by the Treasury and Fed, I have heard countless times that the real small business people can’t survive by adding more debt to their balance sheets when they don’t even know if they will last another week, month or quarter. This epitomizes the real problem with the politicians and Fed. The group think is that debt is fixed with more debt and more debt. That is so beyond fundamentally flawed.

My own dry cleaner who built his successful small business with a handful of employees over decades bought a competitor who was retiring a year ago for a very fair price, if not a bargain. A few months later, with a 75% drop in revenue, debt service from his acquisition and an unsympathetic landlord, he is struggling every day and week to stay in business. Borrowing more money from the government doesn’t solve his problem. It only forestalls the inevitable with the added debt load. Think of all the dry cleaners, bar and club owners, caterers, party planners, entertainers and travel related small businesses. While Congress is busy celebrating another bailout by the billions in the airline industry, the true small businesses are devastated. It is shameful and embarrassing to watch the airline executives beg and plead for more money when they spent their free cash flow on stock buybacks and executive compensation, all legal, but certainly not prudent. Chapter 11 bankruptcy was created for situations exactly like this and when GM ran into trouble a decade earlier. 11 allows a company to get relief from creditors and operate while it negotiates and reorganizes as a leaner, meaner entity. That was where GM belonged in 2009 and where one or two airlines belong today.

Off my soapbox and back to business, the economy continues to recover and repair itself, but it is going to take a lot longer than the masses believe. Unemployment peaked in April at 14.7% and has been cut in half to 6.7%. While that is amazing progress in a very short period of time, it is still almost 100% above the generational low of 3.5% seen in February 2020. I continue to believe that 3.5% was nirvana and will not be seen again this decade.

The risk for Q4 2020 and Q1 2021 appear to be to the downside. The vast majority expect the vaccine to immediately return our economy to its pre-Corona days, something I do not expect to happen so quickly. Some things just take time and Americans have very little patience and acceptance for long-term solutions. Since July, Congress and the administration have been negotiating another round of stimulus. Nancy Pelosi was seeking a bill in excess of $2 trillion while Treasury Secretary, Steve Mnuchin, and his cadre was initially looking at $1 trillion. Over several months, Mnuchin raised his offer to $1.8 trillion, much to the disappointment of many in the GOP, but Pelosi banked on a November blue wave and held firm above $2 trillion. The bill that passed was barely $900 billion and it was sorely lacking in many areas. Most importantly, not every American making less than $75,000 is unemployed nor underemployed. There are millions of people in that category who are back to normal and do not need $600 or $2000 checks to survive. Americans in need require more and a blanket stimulus isn’t the way to address the problem.

The Fed has been keenly aware and very vocal when it comes to fiscal policy. Jay Powell et al believe they have gone to historic extremes on the monetary side and they have been tirelessly trying to throw the ball into Congress’ court. Let me be very clear on a popular misconception in the media. The Federal Reserve is not out of bullets. They aren’t now. They weren’t in 2009 and they won’t be anytime soon. Never fight the guy who owns the money printing press unless you control the ink. The Fed can always do something else, whether I agree with their involvement or not. Looking ahead in the new year, the Fed may begin to float trial balloons about pegging or manipulating the yield curve which is the difference between short-term and long-term interest rates. That would precede the Treasury issuing bonds without maturities. Think about that for a minute. You buy a bond that pays you X% a year in perpetuity. Talk about gumming up the credit markets with the government’s heavy hand.

Turning to the financial markets, Q4 wasn’t all that different from Q3. Stocks were up strongly, and bonds saw very modestly negative returns. As I mentioned three months ago and throughout Q3, I viewed any pre-election weakness as a screaming buying opportunity. In one of those rare occasions, all the data seemed to line up, resulting in a forecast of lower volatility and a post-election reversal of whatever we saw into the day. The late October decline was a gift. The media was adamant that the new surge in COVID cases, hospitalizations and deaths was weighing on the markets, a notion I immediately dismissed on the blog and during interviews. Rather, it was a classic case of pre-election jitters during an unsuccessful incumbent election bid. And in our case, it was one of those times to commit maximum money to equities and raise risk levels where appropriate. Since that low, both on the blog and in the media, I have been saying that the stock market is and has been looking well past COVID. It is behaving as if it is Q2 2021where the majority of the country has been vaccinated and is back to work. The hospitality industry is back to almost normal level and the country is traveling again.

Something seminally changed at the October 30 low and during the subsequent rally. Some will say it was leaked vaccine news, while others argue it was the anticipation of a Biden victory with split Congress. What I can definitively say is that for the first time since before the 2008 financial crisis, market leadership seems to have changed for more than just a quick trade. Small cap stocks have had an upside thrust over their large cap brethren. That lasted almost to year-end. After some pause to digest in Q1, I expect small caps to exert their leadership again over large caps. Additionally, banks, financials and energy also seem to have turned the corner leadership-wise. They may not need as much time as small caps to digest unusually large gains, but they will need some time. To a lesser extent, cyclical sectors like industrials and materials look a whole lot better than they have in some time.

With all of these positive developments, there has to be some areas of concern. If you have been reading the blog, you know that my worries continue to increase. Most notable, in a relatively short period of late March to November, stock market sentiment has gone from fear and despair to disbelief to acceptance and finally to giddy, greed and total euphoria. While it’s tough to compare sentiment levels from decade to decade, what we saw in Q4 has only been bested by the Dotcom era and 1929. Similar and more recent periods have been late 2019, January 2018, January 2017 and mid-2011. Although all resulted in some type of market decline, the magnitude was all over the spectrum. The biggest difference between now and the Dotcom period was that the stock market’s foundation was the strongest in Q2 1998 and proceeded to weaken straight to March 2000. Additionally, the worst Fed chair of the modern era, Alan Greenspan, was relentless in raising interest rates long after the bubble had popped in 2000.

I will be writing a full Street$marts in early 2021 about this historic sentiment, but here are a few examples of the greed and euphoria. We have seen a record amount of initial public offerings (IPOs) with companies losing money, highlighted by AirBnB, DoorDash and Snowflake. Investor demand saw these high profile IPOs soar on day one of trading. Surveys of both professional and amateur investors have shown extremely high levels of bullishness. Mom and pop options traders have been positioning for higher prices at levels not seen since the Dotcom era. And how could I not mention Bitcoin, the controversial cryptocurrency which always seem to elicit a response, good or bad. Just since September, Bitcoin has catapulted from roughly $10,000 to $29,000 as an alternative currency to the dollar. I could keep going, but I will save the rest for the newsletter and blog.

While I am concerned about stock market sentiment, it doesn’t automatically lead to a bear market or major decline. It all depends on the foundation of the stock market and the current one remains okay although weaker than it has been since the new bull market began in March. At a minimum there should be at least a short, sharp decline of 4-8% in Q1. That should remove some froth, but I can’t yet comment on the market’s foundation until stocks peak, if they peak. People always want to know what will cause such a decline. I wish I knew in advance, but the known catalysts are rarely the reason. In early January we have the two Senate seats up for grabs in Georgia. A blue sweep would certainly not be in the market’s best interest as that would likely result in corporate taxes being raised, individual income taxes being raised on high earners and capital gains taxes going up. However, that result would also likely lead to another massive stimulus bill which would juice earnings and the economy later in 2021. Earnings season begins shortly thereafter and that could be an opportunity to sell the news. The real catalyst is bound to be something else.

I am going to save details of my 2021 forecast for Fearless Forecast 2021 which will be out shortly, but a 30,000 view looks like this. Inflation remains a theme I began discussing last year. It’s here to anyone who buys food or building materials. Last year, I wrote that old fashioned agricultural inflation was on the way. I expect that to continue for several years with energy joining the party in 2021.

While Fed-driven short-term interest rates will not move in Q1 nor 2021, I do see longer-term interest rates rising throughout the first half of 2021 with the benchmark 10-year Treasury Note soaring from 0.92% to somewhere in the range of 1.30% to 1.45%.
In the stock market, Dow 33,000 is next for our forecasting model with the Dow being one of the leadership indices along with the Russell 2000 index of small companies. Sectors and stocks that are economically sensitive, like banks, energy and industrials have the best chance of leadership. To reiterate a call I first made in August, I continue to believe that the huge, widely popular technology companies have seen their relative peaks against the rest of the stock market. You know the names. The ones that everyone loves. Apple, Amazon, Facebook. Microsoft, Netflix, Google, Nvidia, Tesla, etc. It doesn’t mean they will necessarily decline, but I do believe that other stocks and sectors will perform better.

Before pivoting to our strategies, I want to reiterate a topic I have briefly written about before, but one I have discussed with many clients over the past few years. It’s the barbell approach to investing in our strategies. If you picture a barbell from the gym, there is a long, thin bar with big weights on both ends. Think of those weights as our conservative strategies and aggressive ones, the exact proportions do not matter yet.

In theory, your money would have higher weights to conservative and aggressive strategies, especially if you are in or very close to retirement, and lower allocations to the middle of the road strategies. Certainly, over the past few years, our conservative and aggressive strategies have performed better than the middle of the road ones. This barbell approach has also worked very well with monies being transferred in from 401K and 403b plans as those pre-packaged plans rely heavily on bonds for the more conservative approach and do not account for interest rates rising. Additionally, their aggressive choices do not usually reward the risk taken. If you would like to learn more about the barbell approach, we can set up a call, Skype or Zoom.

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2020 was certainly a year that no one will ever forget. It tested the mettle of humanity in a way that hasn’t been seen in more than 100 years and few thought it could ever happen. From unemployment at 50+ year lows (3.5%) and stocks at all-time highs to a global pandemic, 30%+ stock market crash, 30%+ GDP collapse, unemployment at almost 15% and an economic shutdown all in the span of basically one month. One thing that was strongly reinforced as the world rose from the ashes is that the U.S. economy and U.S. consumer is beyond resilient. Although naysayers love to bash and spew negativity with outrageously awful forecasts, we always come back. 9-11, The Great Financial Crisis, and COVID have all shaken us to our cores, but have also made us stronger.

Although I am not typically complimentary regarding the Federal Reserve and Congress, they each seemed to have learned their lessons from reacting barely at all during The Great Depression and too slowly during The Great Financial Crisis. With COVID, the Fed marshalled their forces immediately and although I believe they went way too far by buying junk bonds, they did provide what amounted to an unlimited tsunami of liquidity for the financial markets and economy. In a shockingly, but not impossible bipartisan fashion, Congress passed bill after bill aimed at helping individuals and business alike as well as almost endless support for the healthcare industry, especially with therapeutics, vaccines and PPE.

2020 was the first time I ever heard clients say they were less concerned about their money and more concerned about staying alive. Clearly, we all hope that never happens again. Although the financial markets bottomed on March 23rd and achieved the single most miraculous and dramatic recovery in history, there remains much work to be done in the economy, especially for the real mom and pop small businesses. I wish the Biden administration and new Congress nothing but success.

While we are always very appreciative of your support and loyalty, we are especially so right now. Although we can only meet via Skype, Zoom or the phone, we are happy to schedule meetings most days of the week. Please continue to share your feedback, positive and negative. Investing is a marathon not a sprint and the long-term future continues to look very, very bright. We look forward to sharing that with you over the coming years. Again, here is the link to my calendar to schedule a call, Zoom meeting or Skype.

Thank you for the privilege of serving as your investment adviser! Please stay healthy and sane!!


Paul Schatz, President, Heritage Capital