A lot of people, investors included, took things month by month (or day by day) in 2020, but now that 2021 is upon us, it’s important to look at the opportunities this year presents. We posed our biggest investment-related questions for 2021 to Dodd Disler, CEO of Sagace Wealth Management, and his expert advice is below.
Where would you say we are in the process of recovery from the pandemic-related economic downturn?
From the stock market perspective, we have fully recovered the pandemic-related losses and realized substantial positive returns for the year, resulting in a V-shaped full stock market recovery. This isn’t to say everything is fantastic now, but that the market is looking forward and seeing significant growth in 2021 as the vaccine is distributed and the economy fully reopens.
However, the general economy has progressed in more of a “K” shape, with service sector businesses as well as the travel and hospitality industries still suffering and following the bottom of the “K.” Those segments will not recover until the vaccine is widely distributed and people feel safe to gather in groups, eat at restaurants, fly, and attend events.
At the top of the “K” are businesses catering to the work-from-home trend, technology, and home improvement. These industries have not only recovered, but have seen massive growth since the pandemic-related downturn.
Coming out of this economic downturn, is it better to invest in smaller companies or larger ones?
The key to any good portfolio is diversification, so you would always want some of both. That said, larger companies tend to generate more stable cash flows and include international operations in their revenue stream. As a result, large cap stocks generally outperformed small cap during the 2020 crisis.
Smaller companies tend to have more volatile cash flows but also offer greater opportunity for substantial growth. They are also typically more domestically focused. Heading into 2021, we expect small cap stocks to catch up to their large cap brethren and outperform them. We have applied this tactical overweight to our portfolio models.
How do debt and interest rates play into your 2021 forecasts?
The Federal Reserve has essentially guaranteed the current low interest rate environment through 2023, even explicitly stating they will tolerate an overshoot of inflation before considering interest rate hikes. This has massive implications for asset prices.
The typical investor has some mix of fixed income (bonds) and equity assets (stocks) in their portfolio. Let’s assume a 40/60 split. At current rates, the 40% in fixed income is only going to yield 1.5% with inflation at 2.0%, for a negative 0.5% real return. Many investors see this and start shifting the allocation away from bonds and into stocks, resulting in more demand for equities.
Additionally, the value of any asset can be determined by the discounted future cash flows it generates. When you discount those future cash flows at low or zero interest rates, the valuation increases dramatically. So, simultaneously we have an increased demand for equities and a willingness to pay higher valuations for those equities.
Companies are also taking advantage of the low interest rate environment to refinance debt and realize significant interest expense savings. This increases those future cash flow assumptions and further drives valuations higher. As I mentioned previously, the market tends to look forward and to price these events in 6 to 12 months before they are realized. That is why the stock market has significantly outperformed the general economy during the second half of 2020.
The key forecast question is this: How much of this future benefit has already been priced into equity markets? We believe there is still room for additional equity market upside in 2021, but that it will be more concentrated on the asset classes that lagged in 2020.
Is there anything folks should be doing to prepare for the new presidential administration?
From an estate planning perspective, the biggest concern is that the new administration will try to reduce the lifetime estate tax exemption.
The incoming Biden administration is likely to have more leeway to make tax changes because the Democrats now control the Senate in addition to the House. We expect significant tax changes, including higher rates for incomes above $400,000, increases to capital gains tax rates, and a possible lowering of the estate tax exemption.
However, we assume these changes will not necessarily be made retroactive to January 1, 2021, so there is likely still time for you to work with your wealth manager to make some key changes. We are advising clients with estate values of greater than $5 million to consult with their tax, estate and investment advisors to evaluate alternatives.
Not all countries are seeing a resurgence of COVID-19 right now. How does this play into your 2021 outlook?
Geographic diversification in your investment portfolio is so important. Not only are individual countries experiencing different rates of infection, their equity markets have experienced a wide disparity in performance compared to the U.S. stock market. We always broadly diversify our portfolios geographically, but as we head into 2021, we are making small tactical adjustments to our models towards foreign developed markets and emerging markets. This will position our clients for what we believe will be a period of catch-up for these markets, and protect against any one region having a significant second wave of infection.
What types of investments are you seeing folks have success with right now?
Anything related to the stay at home/work from home environment and the enabling technology stocks. While these have been favorites of the new stay-at-home day traders, our fundamental philosophy is long-term with a focus on efficiently managing return and risk.
It is true, a portfolio of these high-flying stocks would have delivered triple-digit returns this year, but they also expose the investor to a very high level of portfolio risk. Eventually, fundamentals win out, which is why we stay the course with our strategic asset allocation models and small tactical adjustments rather than placing large bets on individual stocks.
How will your advice for 2021 differ from that of previous years?
We see 2021 as a year of rotation, where the companies and regions that underperformed in 2020 start to catch up. Due to low interest rates, we underweight government bonds in the fixed income space. We are generally optimistic about overall returns next year as the vaccine becomes widely distributed and the economy is unleashed.
That said, there are risks of significant tax policy changes, vaccine distribution problems, and the fact that U.S. equity valuations are historically high. We remain committed to our strategic asset allocation, with the previously mentioned tactical adjustments, but may start to reduce risk in our models for the second half of the year.
Dodd Disler is the CEO of Sagace Wealth Management, a wealth management firm integrated with Spoor Bunch Franz CPA and Spoor Law to provide comprehensive investment, tax and estate planning expertise. Visit the website at sagacewealth.com for more information or to schedule an appointment to discuss your financial future.