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  • Chris Mueller

December 2020 Semi-Annual Commentary

Originally published January 16, 2021

Happy belated New Year! Personally, I don’t know if I am happier for a new year or for leaving the old one behind. Has it ever felt so good to say sayonara to a wretched year and just move on? From our family here at CM Financial Advisors to you and your family, here is to a better, healthier, more enjoyable, more sociable 2021.

With all the changes around us, now is a great time to briefly review a wild 2020 and look forward to 2021. Bob and I have shared our thoughts below, and we’re sure you will find this five-minute read well worth your time.

2020 Recap

It is too bad we could not have gone to sleep on January 1 and awoken on December 31. Despite all the noise in between, 2020 looks like a great year when simply comparing the beginning and the end:

In our June 30 commentary, we touched on the virtue of having patience and staying steady in the face of adversity. This graphic from JP Morgan[i], perhaps more than any, helps drive home that point. The low point for each year (red dot) represents how far the stock market fell at its lowest point during the year. The gray bar represents how much stocks gained over the course of the entire year. It is not unusual for stocks to be down double digits intra-year only to make respectable gains by year-end. What is unusual is the extremes in 2020. The disparity of 50% between the low point (-34%) and the annual return (+16%) is only eclipsed by the 51% difference is 2009!

Looking Forward to 2021 and Beyond

If we could summarize my thoughts in one sentence, it would simply be: Now is not the time to add risk; now is the time to reassess risk and prepare for what lies ahead. No one knows when the top of a market will occur. But it is prudent to heed the signs. Selling out of equities wholesale is not a viable strategy. Well-managed diversification with appropriate levels of risk is a great path forward. And now is a better time there ever – after back-to-back great years in the stock market – to reassess your risk and portfolio.

S&P 500 vs. S&P 500 Equal-Weight

Check out these two charts. We can glean a couple interesting insights from them. The first chart shows the performance of RSP (S&P 500 Equal-Weight index) vs. SPY (S&P 500 index) over the last five year. The second shows the performance over the last two years.

For context, the S&P 500 is comprised to 500 companies. Each company varies in size. Companies like Apple (AAPL) are worth almost $2.2 trillion, whereas companies like Colgate-Palmolive (CL) are worth $73.2 billion. The S&P 500 weights companies by size. If the index was only comprised of AAPL and CL, Apple would have a weighting of 96.8% and Colgate a weighting of 3.2%.

Thus, if Colgate was up 100% and Apple was up 3%, the index would be up 6.2% [3.2% would come from CL (3.2% * 100%) and 2.9% would come from AAPL (96.8% * 3%)]. It is clear the small guys have a hard time packing a punch. SPY tracks the S&P 500.

RSP tracks the S&P 500, but it assumes all companies are equal in size. So, if we go back to our example where Colgate is up 100% and Apple is up 3%, the index would be up 51.5%! Of this 51.5%, 50% would come from CL and 1.5% would come from AAPL. Quite a difference from SPY.

Through 2018, the S&P 500 (SPY) and the S&P 500 Equal-Weight (RSP) had been neck-and-neck. However, since then, and especially since COVID, the SPY has significantly outperformed. This outperformance can almost wholly be attributed to the top five holdings in the S&P 500 – Alphabet, Apple, Amazon, Facebook, and Microsoft.

The big 5 stocks make up a whopping 25% of the index, and their returns over 1- and 2-years dwarf those of the other 495 stocks. No wonder the RSP has trailed the SPY over the last two years: the big guys have even bigger returns. And the rest of the pack is not even close.

Moving forward, one of two things will happen: the big five will continue to outperform the rest of the market or the rest of the market will outperform the big five. Our money is on the rest of the market. Practically speaking, the big five would need to sustain impressive revenue growth to support their positions; this is certainly possible. But I would argue it is more likely that the big guys experience some mean reversion, thus teeing up the RSP for outperformance.

Valuations and Sentiment

A quick refresher on P/E ratios. If company XYZ earns $2 and its stock price is $14, its P/E ratio is 7 [14/2]. One way to think about this is that someone is willing to pay 7 years’ worth of earnings to own the stock. If company ABC earns $3 and trades at $300, its P/E is 100 [300/3]. A P/E is one way to compare the relative value of companies against each other and across time. All else equal, lower P/E means less expensive stock.

Per JP Morgan’s Guide to the Markets, the P/E of the stock market on December 31, 2020 was 22.3. By itself, this has little context. However, compared against the 25-year average, this P/E is rather high. In fact, it is approaching levels last seen in 2000.

High P/Es do not necessarily mean trouble is on the immediate horizon, but they do suggest it may be hard for the market to continue moving up. In fact, current P/E levels suggest that stock returns over the next five years will be relatively low.

One popular argument heard with increasingly frequency lately is that low Treasury yields are causing the P/E ratio to safely drift higher. In other words, whereas the 25-year average P/E ratio of 16.5 may be considered the old normal, perhaps the current 20+ P/E ratio is the new normal. And the reason it is the new normal is because interest rates are so low.

Put another way, imagine Jane Doe who makes $75,000 per year. If mortgage rates are at 5.00%, perhaps she can afford a house worth $250,000. But if rates are at 2.00%, she can afford a house worth $400,000. Now, when everyone is subject to the same rates, everyone can afford more expensive houses. That naturally pushes the prices of all homes up. But is the house at 123 Main Street worth more today simply because rates are lower? No. Jane Doe can now buy the $400,000 house because rates are low, but that house may be worth well less than $400,000. The price was artificially pumped up by low rates.

This may be the same effect seen in the stock market.

I disagree with the notion that low rats justify higher prices. If low Treasury yield supposedly justify higher stock prices – just as low mortgage rates supposedly justify higher home prices – then the red and blue lines above would be virtually identical. But they are not. And in plain English, that means the high stock prices right now may be artificially inflated from low yields, inflated above the true value of those stocks. And if that is the case, expect future stock returns to be lower.

The next chart below shows the Dow Jones Industrial Average since 1910. The upper blue line represents the long-term ceiling above which the index has not been able to move. That ceiling goes all the way back to the Great Depression. It was tested back in the late 1990s and again very recently. Is it possible the index keeps bouncing along the ceiling? Sure. Is it possible the index breaks through the ceiling? Sure. But what is most plausible? In the face of high valuations and high sentiment (see below), I would argue that bouncing along or breaking through is not most likely.

The next two charts complement each other. The top chart has two components: the black line represents the S&P 500 index, and the green & blue line represents the Q ratio (see definition below). Like the chart of the Dow Jones above, the S&P 500 is near its long-run ceiling. At the same time, the Q ratio is making all-time highs.

Very simplistically, the Q ratio measures the difference between the price the of stock index and the actual net equity of the underlying components. Its analogous to the mortgage example from earlier. If the true value of a home is $250,000 but the home is currently priced at $400,000 because prices are inflated, the Q ratio would be 1.60 [400,000 / 250,000]. Essentially, a high Q ratio is indicative of a frothy market. And we are at an all-time high Q ratio.

The bottom chart averages together four common market valuation metrics. The time series of the bottom chart aligns with the time series of the top chart. We can easily compare peaks in the valuation metrics on the bottom chart to peaks in the index on the top chart. Historically, when these four valuation metrics were at current levels, the stock market was nearing a cyclical high.

Finally, let’s look at margin debt. Just as you can take a loan to buy a house or car, you can take a loan to buy stocks. A stock loan is called margin debt. And it works like this: For every $100 of stock XYZ, you only need to commit $50 of your own money. You borrow the rest. If XYZ rises to $150, you have made 100% gain – the gain of $50 divided by your initial investment of $50. But, if the price falls to $75, you have lost 50% - the loss of $25 dividend by your investment of $50. Yes, it is very risky. And guess what, people take risks in greedy, overbought markets. The chart below shows the annual percentage increase in margin debt over time. There were massive spikes in margin debt preceding the 2000 and 2008 crashes; investors borrowed money to buy stocks leading up the crashes in 2000 and 2008 because they did not want to miss out on all the gains. Keep an eye on this.

A Very Quick Thought on Politics

One of my favorite research outfits is Bespoke Investment Group ( In its 2021 outlook, Bespoke very diplomatically stated:

“Republicans are typically considered a more business friendly party then Democrats, but the data doesn’t necessarily support the widely held notion that they are better for the stock market…the DIJA [Dow Jones Industrial Average] has averaged an annualized return of 4.9% under the 20 US Presidents since 1901. For the twelve GOP Presidents since 1900, the Dow’s average annualized return falls to 3.7%. Meanwhile, for Democratic Presidents, the average annualized gain is considerably higher at 6.7%.

…there is a caveat to consider. Because a President is elected more than two months before they take office, returns could be overstated or understated based on how stocks immediately react to the elections returns…We have provided a summary of the DIJA’s performance during each President’s Administration, but this time we based the start and end dates on the election dates instead of inauguration dates. Tracking Presidential performance under this method narrows the gap considerably. In fact, it eliminates the gap between the two parties in its entirely. For both Democratic and Republican Presidents alike, the median annualized return of the DIJA is the exact same – 6.6%!”

So be it red or blue the White House, the markets have reacted the same.


On a lighter note, here are some interesting trivia questions related to the markets in 2020. Answers are after our signature blocks [NO CHEATING 😊]:

1. In between launching astronauts into space on the first-ever private space mission via his SpaceX rockets, being named Forbes Businessman of the Year, becoming the world’s second wealthiest person, and finding time to sleep, Elon Musk helped lead Tesla stock to this percentage return in 2020?

2. If your idea of money is some computer program that “mines” for more money via a de-centralized computer network and where this digital money is stored in digital wallets, than bitcoin is your thing. While bitcoin couldn’t quite match Musk’s Tesla performance, it skyrocketed by this percentage in 2020.

3. If you found yourself dazed and confused after the March market chaos, you were not alone. Of the 20 days that make up the ten best single-day returns and ten worst single-day returns of the S&P 500 index, how many occurred in March?

4. The stock market opens at 9:30am each day and closes at 4:00pm. That leaves 16.5 hours each day where the markets are closed but news keeps breaking. Thus, it totally normal for the opening price on one day to be different than the closing price from the previous day. In 2020, if you had bought into the market at 9:30 each morning and sold out completely at 4:00 each afternoon, would you have done better or worse than had to bought into the market at 4:00pm on the prior day and sold at 9:30am on the current day? In other words, was holding stocks only overnight better or worse than only holding them intraday?

Thanks for reading. Bob and I sincerely appreciate your friendship and business. And we are always here to talk and work with you. Please call our office @ (610) 288-5800 or email us at at any time.


Answers to Opening Trivia:

1. Tesla shares soared 743% in 2020[i]!

2. Bitcoin crushed it in 2020 as it returned 403%[ii].

3. It is almost unbelievable: Of the 20 days that make up 10 best and 10 worst days ever for the S&P 500, four occurred in March 2020. The 9th and 10th best days ever occurred on March 24th and March 13th when the index was up 9.38% and 9.29%, respectively. The 3rd and 6th worst days ever occurred on March 16th and March 12th when the index was down 11.98% and 9.51%, respectively. Amazing, three of these four days were consecutive business days – March 12th, March 13th, and March 16th[iii]!

4. During 2020, had you bought the open and sold the close, your return would have been negative 0.002%! Had you bought the close and sold the open, your return would have been 16.3%. There are many lessons to be learned here, but let’s focus on two. First, it is almost always the case that most of the returns in the stock market come from overnight risk (in other words, price action outside of normal trading hours). And second, because most of the returns come during times when you cannot trade stocks, trading intraday in the hope of catching returns just right is very, very difficult to do. After tall the intraday return in 2020 was negative 0.002%.


[i] Returns derived from Morningstar. Return represents total return for calendar year 2020. [ii] Returns derived from 01/01/2020 opening price and 12/31/2020 closing price of Bitcoin futures per Yahoo Finance. [iii] Data derived from Securities and advisory services offered through LPL Financial, a registered investment advisor, Member FINRA/SIPC.

The information contained in this e-mail message is being transmitted to and is intended for the use of only the individual(s) to whom it is addressed. If the reader of this message is not the intended recipient, you are hereby advised that any dissemination, distribution or copying of this message is strictly prohibited. If you have received this message in error, please immediately delete.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk. Stock investing involves risk including loss of principal. No strategy assures success or protects against loss.

[i] Graphic derived from quarterly JP Morgan Guide to the Market dated December 31, 2020.

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