Letter To Partners: A Turning Point In The Fourth Quarter

Summary

• The general “risk off” environment of August to October gave way to drastic improvement in the market outlook starting in November.
• I believe that the landscape is now much more favorable to diversified investing, and I remain optimistic about 2021.
• The pillars of the investment strategy remain intact: broad diversification, sensible use of leverage, loss mitigation tactics, and long-term perspective.

A challenging 2020 has finally come to an end. As I do every three months, I would like to share with Seeking Alpha the "markets and the economy" piece of my two-page quarterly letter to DM Martins Multi-Asset Fund, L.P. limited partners. Maybe my observations and insights can help other investors navigate the first few months of 2021 in the markets.

As a reminder, for compliance reasons, I will omit specific information regarding the portfolio's past performance and return goals.

Source: Sophie Backes @ Unsplash

Markets and the economy

The fourth quarter of 2020 marked a turning point in the markets.

The “everything rally” that began with a V-shaped rebound in virtually all major risk assets – i.e., stocks (SPY)(QQQ)(DIA), treasuries (TLT)(IEF), gold (GLD), real estate (VNQ), commodities (DBC), etc. – off March lows had already showed signs of distress as early as August. Uncertainty over the COVID-19 crisis and the US election cycle led to further deterioration in September and October. The general “risk off” environment was particularly toxic for diversified strategies that rely on a balanced market dynamic, in which gains in certain asset classes help to offset losses elsewhere.

But the market outlook improved drastically in the first few days of November. Despite still being contested by the losing candidate, the US Presidential election turned out to be safe and secure. The markets seem to have welcomed the possibility of shared control of the executive and legislative branches by Republicans and Democrats. Almost at the same time, the announced success in Phase 3 trials of a few coronavirus vaccines helped to boost investors’ optimism.

Paired with the current environment of rock-bottom interest rates and the willingness of central banks to support the rebound in economic activity in 2021, these developments led to investors embracing risk more comfortably in the last six to eight weeks of the past year. The clear beneficiaries have been small cap (IWM) and cyclical stocks, which tend to perform best in the early innings of economic recoveries (see chart below, not included in the original letter to partners, depicting the outperformance of small cap in blue over large cap during rebounds) – like the one that is highly anticipated to unfold in the next few months.

Source: graph by Portfolio Visualizer

To be fair, the fundamentals of the global economy remain shaky. While the US unemployment rate continues to dip from a high of nearly 15% in April to less than 7% in November, the workforce participation rate has barely recovered from a sharp drop in the second quarter (chart below).

Consumer spending has declined progressively in the past three months, partly due to lack of additional fiscal aid. Worse yet, the service sector (e.g., restaurants, airlines, lodging) remains deep under water, with travel and entertainment spending estimated to be as much as 60% below 2019 levels.

Source: US Bureau of Labor Statistics

However, the markets tend to react several months in anticipation of turnarounds. The general tone seems to be one of optimism about the return to a post-pandemic normal in economic activity.

Risks continue to exist in the form of stretched asset valuations, justified in part by near-zero interest rates; the success of the vaccination efforts across the globe; and the transition of power in the US. But I believe that the landscape is now much more favorable to diversified investing than it had been through parts of the second half of last year.

Positioning for 2021

Regarding the fund’s strategy, despite a few minor adjustments and rebalances made at the start of the new year, nothing has changed substantially. I continue to believe in the main pillars of our investment thesis:

• broad diversification,
• sensible use of leverage,
• loss mitigation tactics, and
• long-term perspective.

While portfolio management will continue to be a challenge, I remain optimistic about 2021 and hopeful for another great year of performance ahead.