The Year of the Black Swans

12/23/20: 2020 is a year we don’t like to think about, but it will be a year we’ll never forget. 2020 was defined by the arrival of a bevy of black swans. The world suffered its first global pandemic in over 100 years, sending the economy to its most severe quarterly slide in history. The 10-year Treasury note yield plunged to its lowest level on record, 0.35 per cent. Crude oil prices cascaded into negative territory, an unfathomable concept, for the first time ever. The VIX, the market’s volatility index, spiked to its highest level in history. The S&P 500 posted its best November ever.

Economists’ predictions were so off base this year they made political pollsters look prescient. Part of the problem: economists like to use history as a guide and they had to dial back to the 1918 Spanish Flu pandemic to find the closest comparison. Their forecasts were overly optimistic leading into the pandemic, then turned sharply negative once the global pandemic was declared, overshooting reality on both sides. All told, the US economy shrank the most in modern history through H1, plunging more than 10 per cent year on year. While it rebounded in Q3, activity remained roughly in line with the bottom of the financial crisis. Growth is expected to continue through Q4, although the US economy is likely to usher in 2021 3.5 per cent smaller.

Spending, like just about everything else this year, was influenced by stay-at-home orders and other pandemic-related safety measures. Personal consumption flowed toward goods, which were up 8.6 per cent for the year through October, and away from services, which were 8.3 per cent lower. The biggest exception was community relief services: spending on social services rocketed 60 per cent this year to help support those suffering from unemployment. Demand for games, software and recreational vehicles surged more than 30 per cent as households found new ways to adjust to social distancing. Demand for exchange-listed equities surged as well; perhaps would-be sports gamblers, without spectator sports, turned their attention to day trading. Travel, unsurprisingly, plunged more than 90 per cent, while spending on spectator sports wasn’t far behind.

Strategists were probably as surprised as economists with the outcome of the 2020 equity markets.  Traditional market strategies didn’t work. The Dogs of the Dow, which selects the highest-yielding Dow stocks at the beginning of each year, had delivered admirable returns over the years. The Dogs were indeed dogs this year, though. They underperformed the Dow Industrials by more than 15 percentage points. The “Sell in May and go away” strategy would have missed out on the 13 per cent May through October gain.

Investors raced for the lifeboats when the global pandemic was declared. They clamored for large, high-quality companies. The highest-capitalization quintile of the S&P 500 outperformed the smallest cap quintile by nearly 32 percentage points for the year. Valuation as a metric in 2020 was as useless as concert tickets. The highest-priced stocks relative to cash flow outpaced their cheapest counterparts by over 40 percentage points. Dividends were similarly disregarded: the highest-yielding stocks in the S&P trailed the non-yielders by 42 percentage points.

Despite the fact that the cards were dealt from the bottom of the deck this year, the Cresset investment team played our hand pretty well. We kicked off 2020 with a 15 per cent cash cushion, thanks to the market’s rich valuation last year. Those proceeds were redeployed back into equities in March, when we recognized that the volatility-inspired plunge was overdone due to risk parity and other hedge fund sellers. Our team built the Cresset Quality 50 portfolio, a separate account of 50 high-quality companies insulated from the vagaries of the pandemic. Our strategy substantially outperformed US large caps.

2020 is a year for the history books – and that’s a good place for the year of the pandemic to stay. Here’s to 2021. Cheers!