Commentary | 4Q 2020
4Q 2020 Market Recap
In the fourth quarter of 2020, the stock market, as represented by the S&P 500 Index, produced a return of 12.2%. The market generated a return of 18.4% for all of 2020. The quarterly and full year returns were remarkably high given the challenges that confronted the market. The economy was buffeted by economic policies shaped by responses to a pandemic. In addition, a Presidential election brought on a new administration and the promise of significant revisions in economic policies. The prospective change in policies required market participants to anticipate a wider range of economic conditions than those of the recent past.
Throughout the year the market exhibited a high level of volatility as policy responses to the COVID-19 pandemic presented significant hurdles for economic growth. The VIX, a popular measure of the market’s volatility, finished the year at about 25, which was roughly double its level at the beginning of the year.
In the fourth quarter, the relative performance of market sectors experienced a reversal from trends that persisted for most of the year. Value stocks produced a higher return than growth stocks and small stocks returned more than large stocks. The S&P 500 Value Index generated a return of 14.5% while the S&P 500 Growth index returned 10.7% in the final quarter of the year. For the entire year, the Value Index experienced a return of 1.4% and the Growth Index returned 33.5% over the same period.
The S&P SmallCap Index showed a return of 31.3% for the last quarter, easily outpacing the 12.2% return produced by the S&P 500 Index. The SmallCap Index’s return of 11.3% for the full year was substantially less than the 18.4% produced by the S&P 500 Index.
COVID-19 Pandemic Impact
The poor economic environment was reflected in the behavior of corporate profits. The end of year estimates called for a roughly 12% decline in profits in the fourth quarter and a slight decline for the year. The decline in profits as stock prices rose led to a significant increase in the price earnings ratio for the S&P 500. At the end of the year, the ratio reached a level of approximately 38 on trailing twelve-month earnings. This level is significantly higher than the long-term average of 17 and higher than the beginning of the year level of 25.
The economic environment in 2020 was determined, in large part, by policy responses to the COVID-19 pandemic. As states required businesses to close to slow the spread of the virus, economic activity declined, and unemployment rose. An estimated twenty million workers became unemployed, and the rate of unemployment reached 14.6% when the constraints on economic activity were most widespread. By the end of the year, unemployment had fallen to 6.7% which, while down from the high, was still well above the beginning of the year level of 3.7%. The favorable trends in job growth reversed in December, and the number of jobs declined. The decline was the most severe in the food service and entertainment industries. These industries were the focus of efforts to reduce the spread of the virus by limiting the size and the frequency of gatherings.
As part of an effort to diminish the impact of increased poverty and high unemployment the Federal Government disbursed approximately three trillion dollars in the form of direct payments to individuals and institutions. This expenditure brought a temporary reduction in the poverty rate, while the overall Federal debt outstanding increased to over twenty-two trillion dollars.
At the end of the year, the stock market was near an all-time high, the price earnings ratio for the market was well above average, corporate profits were declining, job creation had halted, the COVID-19 pandemic had not ended, outstanding government debt stood at more than twenty-two trillion dollars, and a new administration promised to raise tax rates. The market continued to face high hurdles.
Economic policies will be constrained to a narrow path if further destabilization of the economy is to be avoided. The Fed’s balance sheet has increased steadily since the recession of 2008/2009. Assets now total approximately five trillion dollars up from less than nine hundred million dollars before the recession. Assets held by the Federal Reserve increased as the central bank bought assets to increase liquidity. During the COVID-19 pandemic, the Fed has been buying assets to help finance efforts to distribute money to those who are experiencing financial distress. Further rapid expansion of the Fed’s balance sheet raises the risk of increasing inflation and at the same time these policies restrict economic growth.
President Biden's Tax Plan
Mr. Biden, the President Elect, has stated he intends to raise tax rates while the unemployment rate is over 6%. There is little to prevent him from doing so now that his party controls both the House and the Senate. Presidents who have raised tax rates have faced rebukes in the past. When President Roosevelt raised tax rates prior to the 1938 election and drove the unemployment rate over 15% his party suffered the worst off-year election defeat in our country’s history to that point. President Bush increased tax rates before the 1992 Presidential election and lost his bid for re-election as the nation slipped into a recession.
President Clinton raised tax rates prior to the 1994 off-year election and the Democrats lost control of the Senate and the House. The Republicans had not had control of the House for 40 years. President Obama said he would raise tax rates after Democrats passed the Affordable Care Act and in the 2010 off year election the Democrats lost control of the House and the Senate. Mr. Biden may get lucky, but he will run the risk of slowing or reducing economic growth if he raises tax rates.
Mr. Biden plans to raise tax rates on capital gains, dividends, corporations, small businesses, and individuals. If he does so while the Fed is increasing the money supply at a rapid rate, there will be set in place economic policies like those of the 1970’s. The economic environment in the 1970’s included rising inflation, rising unemployment, rising interest rates, and ultimately, negative economic growth.
There is little evidence investors expect tax rates to increase or economic conditions similar to those of the 1970’s to develop. Interest rates remain low, but they did begin to drift upward in the fourth quarter. The price of gold has remained stable thus far. The price of oil has risen off its lows of below $20 per barrel to $52 by the end of 2020, but it remains below the $58 level of early in 2020. Commodity prices have bounced off their recent lows, but they remain well below levels reached less than two years ago. The price of Bitcoin, an electronic currency, has risen steeply in recent months. This behavior is consistent with expectations for increased taxes and higher inflation. The currency is thought to afford protection from scrutiny by taxing authorities, and therefore, it is expected to increase in value as tax rates increase.
The unfortunate economic circumstances of 2020 need not continue into 2021.At the end of last year, two COVID-19 vaccines were being distributed. If the threat presented by the virus diminishes, so might the restrictions on economic activity. If economic activity increases, and Mr. Biden postpones his promised tax rate increases, 2021 could see a return to the favorable economic circumstances that characterized early 2020.