Foxes and hedgehogs

However, from the March market low, there was a gradual transformation from hedgehog to fox culminating in Q4. Throughout this time, many stocks rallied significantly. Equity indices in the US hit all-time highs driven by a historic imbalance between a very small number of "mega-cap" technology stocks and the rest. Investors woke up from the pandemic being the only thing that mattered, to it being one of many factors.

Of those that we would highlight, three were general and should persist into 2021:

• Monetary and fiscal stimulus was of unprecedented scale and accompanied by clear "whatever it takes" commitments from authorities worldwide,
• The development of vaccines in record time meant it was possible to look through the disturbing short-term COVID data,
• Economic data began to recover and drove sentiment: showing investors arguably care less about current levels and more about changes of direction.

Source: Talaria, St Louis Federal Reserve

Source: Bloomberg, Talaria

The US election was a specific factor:

• Biden becoming President-elect eliminated one uncertainty, and markets hate uncertainty,
• While by the end of December there was no "blue sweep," the early January elections have now given the Democrats control of the Senate, which will likely be more stimulatory for the US economy.

Most importantly, for all the terrible consequences of the pandemic, it had a major positive effect in ending a long-running economic cycle while kicking off a new one. 

This means while an investor knows that growing inflation will reduce her real return from bonds, she might see an improvement in her return from shares if the companies the shares represent can grow cashflows in the inflationary environment. 

Which equities? 

One rule is to buy growth when growth is scarce, and to buy value when there is growth for all. A variation on this theme is to invest in value when there is a wide-spread between value and growth and invest in growth when that spread is narrow.

Source: Talaria, Bloomberg

This arbitrage lens provides a guide to which areas of the market are interesting. Strictly speaking, arbitrage is a value-based strategy but relative performance is useful shorthand, with areas that have been weak for an extended period worthy of consideration as the below charts demonstrate (all charts below are 10-year price relative): 

Source: S&P Dow Jones Indices

As the charts show, one class of shares can underperform another for years: in themselves these relationships are not timing tools, yet they are powerful indicators of when there are changes in economic and market cycles. In view of the reset, they are worth taking seriously.

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