Q1 21 Market Review and Outlook

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The Bloodbath in Bonds

In my last market commentary at the end of 2020, I pointed out that it is natural but wrong for investors to simply extrapolate future returns from past returns. I specifically gave the example of the historical returns of the Vanguard Long-Term Treasury Fund. The following table shows the 1-year, 3-year, 5-year, and 10-year average annual returns of the fund as of 12/31/20.

These historical returns look fantastic but are completely irrelevant to estimating future returns. At the time, I noted that expected returns were low-single-digits at best and easily negative if interest rates increased.

What a difference a quarter makes! In Q1 2021, the Vanguard Long-Term Treasury Fund lost a whopping 13% in just three months. It is not every day that you see equity-like losses in a Treasury bond fund. The casual observer might have thought US Treasuries were “safe” investments. Although US Treasuries are backed by the full faith and credit of the US Government and are indeed “safe” from a default risk perspective, longer-term bonds have huge interest rate risk. This interest rate risk became very real in Q1 as the yield on the 10-year Treasury rose from 0.9% to 1.7%. Should interest rates continue to rise, significantly more losses would be instore for this fund.

This is what the historical return profile of the Vanguard Long-Term Treasury Fund looks like just three months later as of 3/31/21.

The Stock Market in Q1

The bullishness and optimism that characterized the market in the second half of 2020 became even more frenzied in 2021. Low-quality companies rushed to sell stock and to go public via SPACs. The total issuance of SPACs through just March 17, 2021 already exceeded all of 2020! Previous market peaks have been accompanied by booming IPO issuance. The current SPAC/IPO market is definitely booming.

Trading in extremely risky over-the-counter penny stocks also surged to new highs in 2021. These and other signs of irrational exuberance show that animal spirits are in full control and most people have thrown caution to the wind.

The stock of ViacomCBS (VIAC) serves as a warning of things to come when investors completely disregard risk. This previously sleepy media giant soared from ~$40 at the start of the year to $100 by mid-March on the rebranding of their Paramount+ streaming service. Such unbridled enthusiasm for yet another streaming service in a very competitive market which represented just a small portion of the total revenues of VIAC was clearly a case of the tail wagging the dog. VIAC stock soon imploded and declined back to $40 in a week (helped by the implosion of Archegos Capital). For VIAC to have such a spectacular flameout is scary in that it is not some fly-by-night penny stock but a media giant that owns trophy assets including the CBS TV Networks, BET, Nickelodeon, MTV, Comedy Central, Pluto TV, and Paramount Pictures.

The S&P 500 broke new highs in Q1 and returned 5.8% during Q1. However, higher rates weighed on growth stocks, which had a notable pull back in late February. With much of the value resting on future growth many years out, these high-flyer growth stocks are especially vulnerable to increasing interest rates. Rising inflation and interest rates pose the greatest risk to the stock market going forward.

ARKK: Genius or Bubble?

Cathie Wood is the hottest fund manager on Wall Street and her flagship ARK Innovation ETF (ARKK) has the track record to prove it. Thanks to its ownership of some of the most extreme technology growth stocks in the market, ARKK had gained 240% over two years ending in Feb 2021. The S&P 500 gained just 40% over the same period. Thus, ARKK outperformed the S&P by 200% over a two-year period! ARKK now owns a portfolio of fast growing, but also extremely expensive tech stocks (sporting some of the highest price to sales ratios in the market). Can ARKK’s stellar performance continue?

While impressive, ARKK’s rapid gains over a short time frame unfortunately also puts it into bubble territory as defined by Harvard researchers. In an article published in the Journal of Financial Economics, the researchers studied US market history from 1926 to 2012 to look for signs of predicting stock market bubbles (The article is titled “Bubbles for Fama”). They found that whenever a sector or industry gained 150% more than the market’s return over a period of two years, there was an 80% chance of a crash occurring in the subsequent two years. Whenever a crash did occur, the average decline from peak to trough was about 60%.

ARKK’s 200% outperformance over the market in the last two years puts it squarely in this bubble category. Will ARKK be the 20% that did not crash, or will it join the 80% that that suffer a peak to trough decline of 60%? Since peaking in Feb 2021, ARKK is down about 23%. The next two years will be very interesting to watch…

Disclosure:

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

The information in the article is provided for informational purposes only. It should not be construed as investment advice or advice on buying, selling, or other types of transactions relating to an investment in products or services, much less an invitation, an offer or a solicitation to invest.

The information in the article is provided solely by virtue of the fact that everyone will independently make their own investment decisions: the report does not take into account investment objectives, nor specific needs or financial situation. In addition, nothing in the article represents or is intended to express financial, legal, accounting or tax advice. You should consult your own investment or financial advisor before taking any actions.

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