Quo Vadis: Where do we go from here?

“You’ve got to be very careful if you don’t know where you are going, because you might not get there.” Yogi Berra

The vaccine is here, but the economy still looks troubled with so much uncertainty ahead. This is accompanied by a sense of resignation that we are never going to fully go back to (pre-Covid) normal. And yet financial markets keep heading higher; we are now above the previous peak! So where do we go from here? This is the key question everybody is asking at the moment. We think it makes more sense to focus on the long term rather than try to get the short term right — because trying to get the short term right is an impossible task.

When faced with a difficult decision, especially during times of market volatility and uncertainty, the mind takes a shortcut. We rely on what is called recency bias—a cognitive bias that favours recent events over historic ones—in trying to predict the future. While this shortcut in our brain serves us well in other aspects of our lives, it can hurt us when making investment decisions. It prompts us to place undue importance on recent events. That is why it is important to look at the long term and know where markets are headed over our full investment horizon and not focus too much on the volatility in the short term.

We can be confident about where markets are headed in the long run

Source: Bloomberg, Endowus Analysis

As we begin another year, the so-called experts are rolling out their annual targets again—predicting whether markets will be up or down and where they will be at the end of the year. Whether value or growth or cyclicals or tech or this index or that currency will outperform the others. We forget how last year every single forecast was wrong, as nobody could have predicted the market moves we experienced.

But we won’t belabour the point, as we just published an article on the futility of forecasting in our monthly Science of Wealth column in the Business Times. Instead, we believe legendary investor Howard Marks put it best when he said, “recognising and dealing with risk and understanding where we are in the cycle are really the two keys to success.”

Markets fell and recovered faster than people expected

Source: Endowus, Bloomberg, MSCI ACWI net TR (SGD) and Bloomberg Barclays Global Aggregate net TR (SGD hedged)

A frequent question we get during an extended rally in equity markets is “is it okay to still go into the markets and invest?” or “how much longer do you think markets will go up?”. That is because the equity market is at an all-time high. Similarly, on the fixed income side, a common question is “why should we allocate anything in fixed income when yields are so low?” That is because the fixed income market is at an all-time high (remembering that interest rates and prices have an inverse relationship, so low yields mean high prices).

So what happens after the equity market hits a new high? The answer is not that they will fall, as most people assume. The mean reversion mentality that is so deeply ingrained in us prevents us from seeing the big picture. What is normal is different from what the majority expect. What happens, if you look at historical empirical data, is that more often the market goes on to reach another new high. Meaning that the market always tends to be upward sloping. This is because the market is a collection of the biggest and best companies globally. Even in a year like last year, markets still managed to hit new all-time record highs 20 times—and this is not atypical behaviour of markets!

Number of all-time highs achieved in a year

So what does it mean that bond and equity prices are at all-time highs? Does it mean they won’t go any higher? Does it mean we cannot generate returns from here? If we look at the table below, we find a rather surprising statistic. We can see the results of investments made on any given day 1, 3, and 5 years later. And we can compare those to the results of investments made only on a day that the market hit an all-time high. Counter-intuitively, the performance comparisons for all periods show that it would have been better to invest not only when markets are high, but when they are at their peak! The reason being that the market reached new peaks and typically generated an average of 15% after one year, 50% after 3 years and 79% after 5 years.

Average cumulative S&P 500 total returns (1988~2020)

Bubble? What bubble?

Talk of bubbles is everywhere: from stocks to bonds, and for a while it was gold, and then properties, of course Silicon Valley IPOs, and now Bitcoin. Nearly everything went down in value during the crash in March 2020, but now everything is back and more than recovered—with many having been caught off-guard both on the way down and on the way up. Anything with a continuous or sustained increase in value these days is labelled a bubble, and predictions abound that the bubble is just about to burst.

Bubbles are a curious thing, people talk about it all the time but it’s not a very common occurrence. Yet it is an inevitable occurrence in history. The big ones like the 1720 South Sea bubble, the “Roaring 20s” that burst with the Great Depression in 1929, the dot-com boom that burst in 1999 and finally the 2008 GFC bubble burst are all part and parcel of normal market cycles. Bubbles and bursts are largely driven by human nature—such as greed and fear—and human nature is impossible to predict in terms of when it’s going to turn. These days, one can argue that there are some signs that certain stocks, sectors or asset classes feel like bubbles right now, but it is difficult to say with any degree of certainty whether these or the entire stock market is about to burst from an extended bubble. In fact, maybe we are at the cusp of a new bubble still being formed from here. Is that so far-fetched an idea?

The historical performance of S&P 500 index during bull and bear markets

Source: Bloomberg, Endowus Analysis

A Year in Review

Somebody recently quipped that it feels more like Q5 of 2020 instead of a new quarter in a new year. Largely because of Covid-fatigue and the continued overhang that carries over people’s lives and the economy. However, what is also more of the same from last year is that the financial markets just power ahead. Let’s take a look back at the past year.

2020 Major equities & fixed income index movements and events

Source: Bloomberg, Endowus

For sure we had a truly unprecedented and eventful year. The chart above is very full because of the many issues we faced in society, politics, economy and financial markets. The below table shows the performance of different equity markets in each quarter of 2020 and the full year of 2020. The large drawdown in the first quarter was followed by a spectacular rebound in the next three quarters. All of the major markets ended 2020 in the positive territory, with US equity and emerging market equity leading the gain.

Quarterly breakdown of performance by major indexes

Source: Morningstar, Endowus. US equity market is proxied by S&P 500 index; World ex US developed equity market is proxied by MSCI World ex US index; Emerging market equity is proxied by MSCI emerging market index; Global bond market is proxied by Bloomberg Barclays global aggregate index; Emerging bond market is proxied by JPM EMBI global index, all in SGD, net dividend total return terms.

One seemingly puzzling thing about the stock market was the divergence we saw between the economy and the market. How could the stock market enter another bull run when the global economy was contracting? It was reported by OECD that in 2020 global GDP had negative growth of -4.2% (Source: https://www.oecd.org/economic-outlook/). One explanation is that financial markets are always forward-looking. Picture millions of investors around the world, both professional and amateur, almost instantaneously processing all of the information available—and their expectations for the future—to settle on a price. In 2020, the shock in the economy was followed by a tremendous amount of monetary and fiscal support, and also an improving economic outlook as different countries scrambled to get their acts together to contain the virus and restore economic activities. While the lingering uncertainty still subjected the market to heightened volatility, it was ultimately not that surprising to see the stock market being a leading indicator of the economy rather than the other way around.

Another observation of the market in 2020 was the dispersion in returns across time, countries and sectors. Firstly, the monthly return of the MSCI All Country World Index ranged from negative 12% loss to positive 10% gain, and two consecutive negative months were immediately followed by an outsized positive month. This meant that trying to time the market (while typically difficult to do) was especially hard last year.

Monthly return of MSCI All Country World Index

With regards to countries, the best and worst performing in terms of stock market returns had an almost 60% difference. South Korea, which is seen as one of the success cases in dealing with the Covid crisis and maintaining its economy and borders open, ended up having the best performing equity market in 2020 with returns of 37.9% (Source: morningstar country index). It was also helped by the country’s dominant tech companies and its defensive domestic economy. On the contrary, Brazil’s stock market lost almost 21%, due to its exposure to energy and commodity prices, both of which suffered during Covid.

Finally, the cost of the pandemic was not evenly distributed across sectors. While some sectors, such as aerospace and defense, airlines and retail real estate were severely damaged by the lockdowns and reduction in consumer spending, some other sectors such as technology software, internet retail and freight and logistics benefited hugely from changing demand and consumer behaviour during the pandemic. Zoom (NASDAQ:ZM), the video conferencing company that gained its fame through Covid, saw its stock price appreciate by almost 400% in 2020 alone, and Pinduoduo (NASDAQ: PDD), the Chinese online retailer that sells fresh farm produce directly from farmers to consumers, saw its stock price rise by about 330% in 2020.

2020 Major winners and losers by sector

Source: Bloomberg, Endowus. Each sector is proxied by the corresponding MSCI ACWI Indices. All in SGD, net dividend total return terms. 

The unpredictability and the divergence of markets in 2020 is a megaphone to investors to stay humble and principled. It is very easy to become fixated on short term movements and being obsessed with the latest market news, but markets price in this information almost instantly. Again, we don’t have visibility on the short term movements, but we know that in the long term, markets move up in tandem with an expansion of human productivity. 2020 might have felt so extraordinary in our lifetime, but remember we have also gone through the Spanish flu, the two World Wars and the Great Depression that followed suit, tech bubbles, and the 2008 Global Financial Crisis, and we came out of it all with continued strength and advancements.  In addition, the bet on individual countries, sectors, and stocks usually subject investors to heightened risk beyond one’s tolerance, and in the likely case that one makes the wrong bet, the opportunity cost of missing those winning countries, sectors and stocks is huge. Therefore, diversification across geography, sectors and asset classes (bonds in 2020 continued to cushion equity market volatility) remains crucial.

How policy affects markets

All About Policy Stimulus and Pump-priming

One of the most important consequences of the Covid crisis and the sharp drop-off in demand from consumers and corporates was that governments and central banks had to step in to fill the gap in demand and also loosen policy—both monetary and fiscal to support the economy and jobs. The level of government fiscal stimulus is truly unprecedented and the chart below shows how much bigger this round of fiscal stimulus has been compared to even the 2008~2009 Global Financial Crisis. These are unprecedented levels of fiscal stimulus that are backed by quantitative easing on the monetary policy side.

Massive and unprecedented size of stimulus (% of GDP)

Global policy rates dropped sharply to historical lows across the world

On the monetary policy side, interest rates have collapsed to historical lows again. But this too is backed by massive quantitative easing that is providing unprecedented levels of liquidity. The sharp drop in policy rates especially on the front end of the yield curve means that asset allocators and individual bank depositors are both scrambling to find yield. Bank deposits or even fixed deposits are actually going to give us negative returns in real terms (after taking away the impact of inflation and rising cost of living) so it makes little sense to keep money in deposits. Endowus launched the Cash Smart solution, the most intelligent way to manage your short term liquidity through the unique and varied offerings in cash management accounts.

Singapore is no exception: The new normal

Source: McKinsey, 2020

Evidence-based investing consistently delivers excess long-term returns

At Endowus, we help investors live out the time-tested and evidence-based principles of investing. As long-term investors, we should not be focusing too much on short term market moves. However, the reason for reviewing the portfolios on a regular basis is to (i) understand what is driving returns (positive or negative), (ii) be vigilant in checking whether the managers continue to deliver and do what they are supposed to do. With the above in mind, let’s take a look at how Endowus portfolios have done in 2020.

2020 Review of Endowus CPF advised portfolios

Endowus was approved as the first and only digital advisor during 4Q 2019 and launched its first CPF-advised portfolios at that time. While the fund choices for the CPF portfolio was restricted to the CPF-IS included fund list, Endowus worked hard to bring in the first Vanguard-managed passive index funds at the lowest cost achievable in order to enhance the choice and create a truly globally diversified, low-cost portfolio for CPF members.

During 2020, both the equity portfolio and the fixed income portfolio of the CPF advised portfolio generated good excess returns compared to their respective benchmarks. Due to the still limited options from CPF-IS investable funds, Endowus’ CPF portfolio is slightly overweight US, Asia and emerging market equity and underweight European equity relative to the benchmark (MSCI ACWI Index). As a result, the outperformance of the CPF equity portfolio in 2020 mainly came from our allocation to the US, Asia, and global emerging equity markets, which outperformed the overall global market in 2020. The fixed income funds are all actively managed and the managers that we chose were able to deliver superior returns relative to their peers in their respective mandates.

2020 Review of Endowus Cash/SRS advised portfolio

For our Cash/SRS advised portfolio, the underlying funds in the fixed income asset allocation did well to keep pace with the markets, generating great excess returns for our fixed income portfolios. However, our equities exposure slightly lagged the overall benchmarks.

Our advice has been and continues to be driven by geographic and sectorial diversification with overweights to company characteristics that have proven to drive excess returns  over the long run, of small size, low relative price (good value), and high profitability. This has led the Endowus Cash/SRS equities portfolio, which include the Dimensional Core Equity, Emerging Market Large Cap Core and Dimensional Small Cap Basin Equity, to continuously be underexposed to the growth factor, which has been the biggest driver of excess return in the last few years.

The Dimensional funds are in fact broadly diversified and passive in its exposure to the broad markets. It holds over 9500 securities and has one of the most diverse, broad, global market exposures to equities. It also employs a factor-based approach by tilting to equities with characteristics like smaller size, lower relative price, and higher profitability in a disciplined and methodical way. The funds’ factor exposure, in particular their exposure to lower relative price equities, has hindered it from outperforming the broad equity market. As shown in the below table, in 2020, the performance of companies with lower relative price as represented by the MSCI All Country World Value index returned -2.1% compared to 14.2% of the broad equity market.

Factor rotation: A year of two halves

Source: Endowus, Bloomberg. All returns in net dividend reinvested, total return terms.

However, Dimensional funds’ exposure to equity has generated excess returns over a longer period of time, and in a shorter time frame, the returns they generated are consistent with their philosophy and the market conditions. The last few years up to the first three quarters of 2020 was still largely a growth-chasing environment, rendering value stocks to underperform. One silver lining is that in Q4 the market started to see a rotation from growth stocks to value stocks. Regardless, the Dimensional funds are able to generate passive benchmark-like returns gross of fees, which is acceptable even when the factors have not reasserted themselves, due to its broad passive market exposure. The value, size and profitability premiums are time-tested and prevalent across regions: the below chart shows the annualised outperformance of each factor over a longer time horizon in the US, emerging markets and rest of the world. We believe that through the economic cycle, investors that remain overweight to the long-term risk premiums of small, value, and profitability will continue to enjoy the upside benefits and better downside protection during market weakness going forward.

Annualised returns of long-term risk premiums (USD)

Source: Dimensional Fund Advisors, Endowus

We held our first virtual conference entitled Endowus Insights 2021 with some amazing guest speakers. Four panels on four exciting topics and you can watch the replays here.

If you would like to hear more about the full 2020 review, the Endowus Investment Office held a webinar, which can be found here.

Endowus continues to make tremendous effort in improving financial literacy through these educational content and most of it can be found in our Endowus Insights landing page on our website here.

Don't know where to begin? Get a head start on financial literacy & general investing by watching our Investing 101 with Endowus 4-part series here.