January 14, 2021
Written by Nathan Erickson, CFA®, CAIA, Principal, Financial Advisor
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There are a number of organizations that come up with a word of the year each year. According to Merriam-Webster, based upon a statistical analysis of words that are looked up in extremely high numbers, the word of the year for 2020 is pandemic.
One might have argued that unprecedented would be a good candidate for word of the year. The world and financial markets have experienced a number of events that have either never occurred before or haven’t occurred at the same time. We’ll make no attempt to cover them all, but there are several worth noting.
The onset of the COVID-19 pandemic in March (some suggest that the virus was in the U.S. as early as December 2019) is not unprecedented, but it may end up being the worst pandemic we have seen in 100 years once it is concluded. At nearly two million deaths worldwide so far, the death toll exceeds that of the H3N2 flu pandemic of 1968 and is similar to the number of deaths caused by the Asian flu pandemic of 1957-58. While there are no expectations that COVID-19 will rival the Spanish flu of 1918, which had a mortality rate of 10–25 percent and took more than 20 million lives, the COVID-19 pandemic will certainly be earmarked in history. As we look ahead to 2021, we expect COVID-19 to remain a topic of concern given the time it will take for vaccines to be distributed and the potential for mutations of the virus. However, we believe the worst of the pandemic may be behind us and 2021 should see its full resolution.
Shortest Bear Market in History
While there is no formal definition of a bear market, most market participants categorize it as a decline of 20 percent or more from recent highs. From the peak of the market on February 19, 2020, the market declined 30 percent in just 22 trading days (February 19–March 20), the fastest drop of 30 percent in history. The three events with the next-fastest declines all occurred during the Great Depression: in 1929, 1931, and 1934. 1987 saw a decline of 30 percent in 38 days. The next-shortest declines of 30 percent took at least one month more. As with most dramatic stock market declines, the catalyst in 2020 was uncertainty about the future: in this case, due to the COVID-19 pandemic. As we’ll discuss shortly, and as shown in Figure One, unprecedented fiscal and monetary support led to the fastest market recovery in history. In just 100 trading days (March 23–August 10) the S&P 500 Index gained 47 percent to get back to the highs in February, marking the fastest recovery in history, as well as the fastest sell-off and recovery cycle in history.
Figure One: Notable S&P 500 Index Drawdown and Recovery Cycles
Sources: Morningstar and BIMO Global Asset Management
Massive Fiscal and Monetary Stimulus
The economic disruption caused by the COVID-19 pandemic resulted in the largest monetary stimulus response in history. Initially, the Federal Reserve cut its benchmark interest rate by 1.50 percent in the course of a single month. This exceeded the 1.25 percent rate cut in January 2008 during the financial crisis. The Fed then expanded loan and asset purchase program, buying treasuries and mortgage-backed securities to maintain liquidity in markets. They also created lines of credit to financial institutions and provided credit to ensure money market funds would remain liquid. The Fed provided loans for small businesses and, for the first time, began buying corporate bonds. These are just some of the measures the Fed took to preserve the stability of markets. While they accomplished their mission, this unprecedented level of support and stimulus likely played a role in the market’s rapid recovery, as investors were all but assured that the Fed would not let markets fail. Couple this with the nearly $2.8 trillion in fiscal support from the government, and one can understand why the risk from a declining market was short-lived.
Some of the Worst Economic Data Points in History
As shown in Figure Two, 2020 saw some of the worst economic events in history. For example, the U.S. experienced two consecutive quarters of gross domestic product (GDP) decline, including its steepest quarterly drop in economic output on record, -9.1 percent in the second quarter. Historically, GDP had never experienced a drop greater than 3 percent since record keeping began in 1947. At an annualized rate, the second quarter’s GDP dropped 32.9 percent, which is worse than the Great Depression, when GDP declined an estimated 30 percent. Unlike the Great Depression, the GDP decline in 2020 was self-inflicted, a result of the first widespread economic shutdown in U.S. history, a measure enacted to attempt to slow the spread of COVID-19.
Figure Two: Percent Change in GDP Relative to Business Cycle Peak
Source: U.S. Bureau of Economic Analysis
As shown in Figure Three, the COVID-19 crisis also led to one of the fastest and steepest declines in unemployment in history, with total employment falling by 20.5 million jobs in April. The deepest decline of unemployment during the 2007-2009 recession or financial crisis occurred at around 24 months. We’re lower than the worst unemployment rate of the financial crisis, but the market doesn’t seem to care.
Figure Three: Percent Change in Employment Relative to Business Cycle Peak
Source: U.S. Bureau of Economic Analysis
If investors had the opportunity to read the headlines of 2020 prior to experiencing it, few would have predicted such a strong year in markets. Figure Four shows that, despite all that went on, domestic and emerging market equities were up 18–20 percent, international developed was up nearly 8 percent, and even bonds were up almost 8 percent (influenced heavily by the Fed lowering interest rates). Most investors with foresight into 2020 would have probably chosen to sit this year out, and in doing so, would have missed out on strong returns.
Figure Four: 2020 Asset Class Returns
Source: Morningstar Direct
Stick to the Plan
Unfortunately, we never have the benefit of foresight, and are often misled by hindsight. Looking back from this moment in January 2021, we can all feel pretty good about the market’s performance in 2020. In reality, the events described in this commentary were only part of the story, as illustrated in Figure Five.
Figure Five: S&P 500 Index Cumulative Total Return, Headlines, and Weekly Government Money Market Flows During 2020
Source: ICI, FactSet, Avantis Investors
We haven’t even mentioned anything related to international relations, racial unrest, the election, or many other events that occurred this year. It was an unprecedented year, and for investors, one that may have pushed risk tolerance in many directions. As shown in the bottom third of Figure Five, cash in government money funds increased by $400 billion at one point in March and then quickly retreated. Investors who didn’t act on their emotions when the market was down more than 30 percent very likely considered it.
Investors who didn’t change their stock exposure may have reconsidered their underlying allocation, particularly in light of the S&P 500 Index’s dominance over the past decade. For example, as shown in Figure Six, small-cap stocks were down far more than the S&P 500 Index at the depth of the decline. The S&P 500 Index was back to breaking even for the year by mid-August, at which point small-cap stocks were still down 4 percent for the year. That is meaningful underperformance for two markets that are highly correlated, and it may have led to a reduction in small cap and increase in large cap at possibly the worst time. By year-end, small cap outperformed large cap, up 20 percent for the year vs. 18.4 percent.
Figure Six: S&P 500 Index and Small-cap Stock Investment Growth, 2020
Source: Morningstar Direct
As we close on 2020 and enter 2021, we want to remind investors of the importance of planning ahead. No one could have predicted all that occurred in 2020, nor do we know what 2021 holds for us. As advisors, our job is to help clients develop an investment plan that can help them reach their goals. Most investment plans are long-term because predicting year-to-year movements in the market is next to impossible. Evaluating the success of a plan should look at the long-term outcomes. When evaluating over the short term, most investors will feel like they should be doing something else. 2020 was a great year to tempt investors with something else. Thankfully, most portfolios survived and are at higher levels than they were at the start of the year. With that in mind, and with the unprecedented 2020 behind us, now is a great time to reevaluate your plan. Are you comfortable with your portfolio mix? Are you comfortable with your level of diversification? 2020 primed us to evaluate many of these questions, and with markets in a relatively stable place, now is the time to reevaluate your plan, make changes if necessary, and prepare for the next downturn.