Let’s say that you found a time machine that can take you back to January 2010. Which five stocks should you buy?

Our Top Market Takeaways for the week ending February 21, 2020.

Markets in a minute

Market Roundup

Heat check. Following the best two-week stretch for the S&P 500 since last June (+4.8%), the S&P had a lackluster week heading into Friday (-0.2%). The Stoxx Europe 600 (-0.1%), Japan’s TOPIX (-1.7%), and MSCI EM (-0.3%) also sold off, while safe havens like gold (+2.1%) and Treasuries rallied. The trend is continuing so far Friday after the Markit Composite PMI for the United States showed one of its weakest readings in a decade. The S&P 500 is down another -1.0% today and 10-year Treasury yields are now at 1.46%.

Year-to-date, U.S. stocks and bonds are still up 4.7% and 2.2%. Investors could be having their cake and eating it too. However, fund flows suggest that many have flocked to bonds and have missed out on the equity upside. The chart below shows cumulative developed world stock and bond fund flows. From 2017 until the end of 2018, flows into each asset class were equal. Then flows diverged sharply. Since the start of 2019, bond inflows have been ~$600 billion while stock funds had outflows of over -$115 billion.

Line chart comparing bond fund flows and equity fund flows (cumulative weekly fund flows, in USD billions) from 2017 through 2020. The chart highlights that bond fund flows have increased significantly from 2019 to current day, while equity fund flows have decreased during that time period.

Whoops! While investors were flocking to bonds, the S&P 500 and MSCI World Equity Indices both returned over 25% in 2019, while the Barclays Global Agg. only returned 7%. While equity fund flows have rebounded in 2020, bond funds are making records. Last week, investors poured more money into bond funds than they ever have before.

Why are investors still infatuated with bonds with yields close to all-time lows? It seems like the wild cards that are in play have investors favoring the perceived safety that bonds provide.   

Wild card roundup:

  • U.S. presidential election update: Feeling the Bern. Mayor Michael Bloomberg participated in his first Democratic debate in Las Vegas on Wednesday night. Betting markets gave him a thumbs down. Bloomberg’s odds tumbled from 25% to 19%, while Bernie Sanders’s odds for the Democratic nomination rose to 56%. While we are still a long way away from the election, the markets will be closely watching to see how it all shakes out. Check out last week’s Top Market Takeaways for more. Next stop…the Nevada caucus on Saturday.
  • Coronavirus has spread from headlines to earnings reports and surveys. Companies such as Apple, Nvidia, Qualcomm and Disney all referenced the virus during their respective earnings calls and made revisions to their future quarterly guidance. Looking more broadly, almost half of the S&P 500 companies that held Q4 earnings calls cited the term “coronavirus”…and about a quarter of those included some impact or modified guidance. Further evidence of the disruption caused by the virus is apparent in the weak PMI data. Many U.S. technology companies rely on intermediate goods imported from China.

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Spotlight

Stock tub time machine

Ultimate hindsight…

Let’s say that you found a time machine that can take you back to January 2010. Before you go, you get to pick five S&P 500 stocks to buy when you get there. Which ones should you pick?

You’re more of a Biff from Back to the Future time traveler (not a Hermione Granger time traveler) and you want to maximize your returns. You find that over the last 10 years, the stocks with the highest returns in the S&P 500 were Netflix (NFLX), Nvidia (NVDA), United Rentals (URI), Old Dominion Freight (ODFL) and Amazon (AMZN).1

Point-to-point, you are a genius. An equal-weighted basket of those five stocks outperformed the S&P 500 by 1,983%. A $100 investment in Netflix 10 years ago is worth $4,346. A $100 investment in Amazon (the “laggard” of the bunch) is worth $1,705.

We use equities in portfolios to generate capital appreciation over the long term, and drawdowns are the price we pay along the way

But over those 10 years, would you have been able to stick with your stocks even though you knew what was going to happen? You may have (the time machine is a game changer here), but it probably would have been difficult for everyone else.

What is the cost of outperformance? Volatility. Faith-shaking volatility. In September 2012, Netflix was over 82% below previous highs. United Rentals has been down 60% twice, not to mention a 50% drawdown as recently as December 2018. Nvidia suffered a 50% drawdown, and Old Dominion and Amazon both had drawdowns in the mid-30% range. Throughout the investment period, an equal-weighted basket of your five stocks had twice the volatility of the index at large.

Line chart showing the percentage change in stock prices from their previous highs for two companies—Netflix and United Rentals—from 2010 to 2020. The chart highlights that since September 2012, Netflix has over 92% below previous highs and United Rentals has been down 60% twice during this time period.
This example illustrates the familiar concept of risk and return. In order to take outsized risk, investors need to be compensated with higher potential returns. One way to see this is the chart below. The light grey lines show the difference from previous highs for the five stocks, and the blue line is the market’s distance from its previous high. The market may not have provided the same astronomical returns, but investors also didn’t have to suffer the same drawdowns.

Line chart showing the percentage change from previous highs of the S&P 500 Index and a group of individual stocks (Netflix, United Rentals, Amazon, Old Dominion and Nvidia) from 2010 to 2020. The chart highlights that the S&P 500 Index did not experience changes as significant as the group of individuals stocks did during this time period.
This concept also relates to one of our Investing Principles charts: Don’t let volatility derail your plans. The chart shows the annual returns for the S&P 500 (grey bars) and the largest drawdown in that year (red dots). The average intra-year drawdown is almost 14%, even though most years generate a positive return. We use equities in portfolios to generate capital appreciation over the long term, and drawdowns are the price we pay along the way.

Bar chart showing annualized S&P 500 returns (grey bars) and their largest drawdown each year (red dots) from 1990 to 2020. The chart highlights that in 2019, the S&P Index had an annualized return of 29%, despite a maximum drawdown of -7%.

What really matters for long-term investors is understanding not only what magnitude of drawdown they would be comfortable with, but also what degree of risk may be necessary to achieve their goals.

 

1Also remember that you have perfect hindsight (foresight?). What if you wanted to concentrate without knowing what was going to happen? No one would have blinked twice in January 2010 if you had picked General Electric, Juniper Networks, Apache, Ford and Haliburton as your five. All of those companies lost value over the last 10 years.

 

All market and economic data as of February 2020 and sourced from Bloomberg, FactSet and Gavekal unless otherwise stated.

We believe the information contained in this material to be reliable but do not warrant its accuracy or completeness. Opinions, estimates, and investment strategies and views expressed in this document constitute our judgment based on current market conditions and are subject to change without notice.

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