This year has been unlike any other, a year gripped by a pandemic, multiple lockdowns and a cessation of travelling across the globe. For many, investing, this year has been a challenge too. The market diverged into Pandemic Losers and Winners. The former suffered a brutal selloff as their business models collapsed while the latter thrived during lockdowns and brought owners of these stocks an abundance of riches.
Curiously, in 2020 the market has behaved in ways similar to previous cycles. Fear, greed, and in some sectors, even euphoric. Here are five lessons that we have learned over the past twelve months.
1. Always expect the unexpected
Markets are full of surprises. But for many years before 2020, investors did not consider the possibility of an epidemic. Why would they? A health-related Black Swan event has not happened in over a hundred years.
So when the coronavirus emerged out of nowhere, it caused panic and stoked fears. But Black Swans often leave clues, like ripples of waves in the water. We can use these clues to our advantage – only if we know where to look for.
In late January, for example, after the Chinese government shut parts of the country, many western stock markets continued to climb. There was a brief window of opportunity where investors could take precautionary action. Bill Ackman of Pershing Square did – and bagged a $2.6 billion profit in eight weeks.
Therefore, it pays to have a small fund reserved for ‘unexpected’ black swan events.
2. Don’t Fight the Fed
As many aspiring traders learn, one of the trading rules is: Don’t fight the Fed. What has the Fed been doing since March? Quantitative Easing, virtually non-stop.
Accordingly, it is no coincidence that the Dow, Nasdaq, and S&P 500 all managed to make fresh highs this year while the Fed’s balance sheet swells. Currently, the Fed’s balance sheet stands at an astronomical $7.2 trillion, an increase of $3 trillion since the start of the year (see below).
The decisive action by the Fed led to a V-shaped recovery in the US stock indices.
Going forward, the Fed will continue to buy $120 billion worth of fixed income securities. The sum equates to about $1.4 trillion per year. Therefore, it is fairly unlikely that the stock market will collapse as long as this program remains active.
3. A correction leads to a sector rotation
The once-in-century pandemic led to a new paradigm. This induced substantial market changes and a sector rotation.
Back in March when covid-19 first appeared, the market was utterly confused. Nobody had any idea what would happen next. Spooked investors adopt a ‘wait and see’ approach and dumped all asset indiscriminately. Prices slumped across the board. On March 12, for example, US stocks fall 10 percent in the biggest crash since 1987.
Only when investors realised that some sectors are still functioning – due to Work From Home – did they piled into these sectors. Technology communication stocks soared. The poster child of this shift is Zoom Communications (ZM), which soared 8x in ten months.
The massive shift into tech shares began in earnest. Any business that benefitted from WFH soared. Meanwhile, hospitality and travel stocks collapsed and stayed low.
Typically such a rotation happens during a correction. New leadership appears; former leaders become laggards.
In the UK, sectors that benefitted from a lockdown are home improvement, supermarkets, and online stores. Look at AO (AO). It was underperforming the market until March. Subsequent returns here rivalled that of Zoom’s.
4. Relative strength matters
The question is, how do we spot and pick these market leaders? Relative strength.
What does this mean? Relative strength means a stock is performing better the general market. For example if a stock stays the same while a benchmarked index like S&P 500 drops 5 percent, it is showing good relative strength.
Look at the chart of Zoom. Notice how its share price continued to make new highs in March even though the market was weakening. This is relative strength. As soon as the general bearish market atmosphere subsided in April, Zoom rocketed 500 percent.
Generally, we want to buy shares that are:
- Performing better than the market
- One of the first to make new long-term price highs after a correction
- Clean breakout on charts
- A leader in that niche sector
Note that, after a while, a stock’s outperformance can pause – or even reverse. This is because its uptrend has exhausted. No more buyers can be found. Demand tapers off, often at round-number levels. Zoom’s share price peaked at $600 and are now consolidating around the $400 mark.
5. Governance affects investment returns
Governance can significantly impact investment returns. Compare how Asian and western countries tackled covid-19 this year. The difference is stark.
Generally, Asian countries have lower infection rates and lower death rates. This means governments there were able to maintain some sort of economic normality. In turn, this translates into better market performance.
Japan, for example, has managed to cap the number of covid cases. Look at the Baillie Gifford Japan IT (BGFD). Prices broke out in September cleanly and have been soaring to new long-term highs ever since (see below).
Other countries like China, Singapore, Korea have also kept the infection rates generally low. This translates into stronger market performance. This enables Schroders Asia Pacific (SDP) to make new highs regularly since September.
Vietnam, a country that seldom make covid-related headlines, has been powering ahead quietly. Vinacapital Opportunities Fund (VOF), a £700 million investment fund listed in the London stock exchange, recently broke out to new highs (see below).
The pandemic year is unique. Seldom do we experience an event as scarring as this more than once, or twice, in our lifetime.
While the virus has created havoc at the societal level, in the market things have remained more or less the same. Fear, greed, and speculative euphoria.
Trillion-dollar tech stocks, soaring stock prices in some sectors, and a speculative boom in crypto-currencies are signs of a mad dash into risk assets. Heard of SPAC? Special Purpose Acquisition Companies are listed blank-cheque shell companies used to acquire other private companies. SPAC booms because they bypass the usual stringent conditions for listing. Another sign of a bubbly sentiment. Meanwhile, the Fed is pouring liquidity into the market via QE.
Observing these market conditions, these French words plus ça change sprang immediately to mind – the more things change, the more they stay the same.
Jackson has over 15 years experience as a financial analyst. Previously a director of Stockcube Research as head of Investors Intelligence providing market timing advice and research to some of the world’s largest institutions and hedge funds.
Expertise: Global macroeconomic investment strategy, statistical backtesting, asset allocation, and cross-asset research.
Jackson has a PhD in Finance from Durham University.