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Rekenthaler Report

3 Investment Lessons From the First Half of 2021

For the most part, the markets behaved in line with expectations.

Making Sense

The first half of 2021 reinforced three investment principles, two of which are long-standing, and one of which is quite new.

The first precept is that the financial markets are essentially rational. There are anomalies, which I will shortly discuss. However, the general pattern is clear: Most securities move logically. Their movements often puzzle contemporary investors, because background noise frequently obscures the essential facts. But when viewed in hindsight, investment behavior is usually scrutable.

Thus, although I (for one) struggled to understand the global stock market's spring 2020 rally, which began barely after COVID-19 arrived, the underlying reason was sound. Neighborhood businesses might declare bankruptcy, but publicly traded companies, which were better positioned to withstand downturns, would likely survive. Patient shareholders would therefore profit.

It quickly became apparent that even the impatient would prosper if they held shares in companies that eschewed bricks and mortar, such as e-retailers or social-media networks. Consequently, growth stocks, which typically use newer technologies, outlegged value stocks, which operate traditional businesses. For the eight months from April through November 2020, the Morningstar US Growth Index gained 63%. Meanwhile, the Morningstar US Value Index appreciated by 38%.

In 2021, the rally has continued, but their positions have switched. The Value Index finished the first half up 17%, with the Growth Index at 14%. Granted, not a huge difference--growth stocks remain the teacher's pet, as they have for several years now. But a modest shift has occurred, which makes sense given that global businesses have mostly returned to normal. The old-line businesses are no longer handicapped. Tellingly, the best-performing stock group this year has been the most vulnerable sector, small value. That Morningstar index has gained 28%.

Occasionally, mysteries occur. Nobody has satisfactorily accounted for 1987's Black Monday. On that date, the world's stocks fell by more than 20%, for no particularly good reason, then recovered. Less spectacularly, global bond yields spiked during 1994, causing large fixed-income losses. A scholarly postmortem left the authors shaking their heads. One is also hard-pressed to explain the extreme rise and fall of Japan's stock market. But such exceptions are rare.

Contrarian Success

Some might regard March 2020's stock performance as a more recent example of an anomaly. After all, global equities abruptly dropped, then rallied. That behavior strikes me as rational, though. Unlike with Black Monday or during 1994's bond sell-off, which occurred despite the lack of a single big event, March 2020's investors faced a huge and unprecedented question: How would a pandemic affect global economies? That the answer arrived tumultuously is not surprising.

Nonetheless, March 2020's downturn does provide the second lesson: From pain comes investment possibilities. As observers struggled to assess the economic impact of COVID-19, asset prices were roiled--most famously, that of oil. On April 20 of last year, the cost of a barrel of oil, as measured by futures contracts on the New York Mercantile Exchange, plunged to negative $37, meaning that those selling oil contracts paid buyers to take barrels out of their hands. Strange days indeed.

Oil prices quickly rebounded, as was inevitable. The temporarily negative price provided a buying opportunity for professionals but was immaterial for everyday investors, who don't monkey around with futures contracts. However, they might hold the shares of oil companies. If so, they would have profited handsomely. Per Morningstar's data, the U.S. equity energy group was the best-returning Morningstar Category during the first six months of 2021, gaining 44%.

Several other early 2020 disappointments have also shone so far this year, including funds that specialize in financials, natural resources, and real estate. It took several months for the hardest-hit industries to find their footing, but when they finally did, they rewarded shareholders.

The challenge then becomes how to seize such opportunities. Trading specialty funds usually fails. For one, when investors do purchase industry-specific funds, they tend to buy high rather than low; the most popular sectors are those that have recently performed well, not badly. For another, the tactic generates capital gains (assuming that the trades were successful) that punish taxable accounts. Finally, most specialty funds have high expense ratios.

A better idea than selling existing securities to buy a specialty fund is to be contrarian with new monies. Besides energy and real estate, which have sluggish five-year records even after their 2021 gains, utilities stocks have languished in recent years, along with infrastructure providers. Those who have cash at hand might wish to consider funds that emphasize such industries. As this year's results have demonstrated, most bottom-feeding investments eventually resurface.

Gold, Bitcoin … or Both?

In May, The Economist pointed out that although gold and cryptocurrencies seemingly occupy the same space, each being an alternative investment that will allegedly protect against currency inflation, the two assets don't necessarily move in tandem. Indeed, gold and cryptocurrencies are diverging more often than they converge. Thus, bitcoin appreciated by 22% during the first half of 2021, while the price of gold bullion (and precious-metals funds) has slightly declined.

The Economist posits that although cryptocurrencies are often viewed as "a walled garden unconnected with the rest of finance," their recent behavior suggests that, at least to some extent, they are inversely linked with gold prices. The theory being that the two assets attract similar buyers, who shift between each investment. Writes the magazine, "Viewed this way, the fall of bitcoin and the revival of gold [a trend that reversed in June, thereby supporting the claim] are a relative value trade within a broader set of inflation hedges."

In other words, bitcoin and gold will likely head in same long-term direction, since they both derive much of their value for their roles in serving as an inflation hedge, but over shorter periods the two assets appear to diversify each other. Their 2021 performances strengthen the tentative suggestion that I made earlier this year, that those "who are inclined to hedge with gold may wish to add bitcoin to their portfolios."

The Outlier

While it's comforting to find evidence that reconfirms one's beliefs, doing so is also dangerous. The researcher is apt to think that he has it all figured out, which is a prelude to stupidity. Fortunately, one aspect of the preliminary year-to-date returns confused me. It seems that most actively managed U.S. equity funds beat their relevant Morningstar index. I did not expect to see that, given that the active funds should have been slowed during the bull market by the drag of their cash.

I will double check those preliminary figures and think more about that subject.

 

John Rekenthaler (john.rekenthaler@morningstar.com) has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.

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