2021 Could Mark a Big Shift in Market Leadership

2020 was an incredibly turbulent year for the economy and markets. Fueled by the pandemic, stocks descended into a recession at the fastest clip in history, but a torrid recovery from March’s lows followed and pushed most asset classes back into the black by year’s end.

After a rollercoaster for investors, markets finished the year on familiar footing: U.S. Large-Cap stocks, just as they did in 2019, outperformed every major asset class in 2020. Could U.S. Large-Cap stocks outperform once again in 2021? It’s certainly possible. But history shows asset classes routinely go in and out of favor from one year to the next. Every year, there’s bound to be an asset class that surprises the investing world with its returns — or lack of returns. In 2018, for example, cash alternatives (represented by 3-month Treasurys) outperformed every single asset class. That’s only happened once in the past 15 years.

“It might come as a surprise, but since 2002, roughly two-thirds of the time the leading asset class on the quilt was either emerging market equities, commodities or real estate,” says Steve Bruce, a senior investment consultant at Northwestern Mutual. “There is a whole universe of investable assets outside of the S&P 500 or the Dow Jones, and a properly diversified portfolio should address that.”

Investors are simply better served focusing on long-term portfolio building rather than viewing markets as an asset-by-asset steeple chase. Typically, that means building a portfolio that has an allocation to every major asset class.

Asset classes never die, instead they go to “sleep” from time to time. It’s hard to say precisely when an asset class will wake up, but if your portfolio is diversified, you’ll already own some when it does. Professional portfolio managers know this well. Although they may tilt portfolios by overweighting and underweighting asset classes, they’ll never abandon an asset class altogether. It’s one reason professionals can avoid the big mistakes that trip up investors who abandon diversification to chase the latest trend.

THE QUILT

After every calendar year, we revisit a visual we call “the quilt” that clearly illustrates the unpredictable nature of markets, and why it’s so important to remain diversified for the long term.

The quilt is a color-coded chart that ranks, from highest to lowest, the total return of various asset classes each year. Mapping this over the span of 15 years produces a chart that looks something like the Periodic Table, or a quilt. Track a single “patch’s” position across the 15-year span, and your eyes will dart from the top of the page to the bottom and back again. There’s really no pattern or order to the squares. It’s a mess, and that’s precisely the point.

Now, because U.S. Large-Cap stocks claimed the top position in 2019 and 2020, there’s a tendency for investors to follow the trend and pile into that asset class at the expense of diversification. Why hold, say, Commodities or Real Estate when they clearly trailed leading asset classes for a few years?

We urge investors not to base their portfolios on this “what-have-you-done-for-me-lately” type of analysis. Successful investors focus on winning the intermediate- to long-term game, not the short-game, which is impossible to consistently win. Indeed, investors who avoid trend following, over time, participate in returns generated by various assets as they move in and out of favor.

“Long-term investors are building portfolios, not just collecting asset classes. Each asset class serves a purpose in a portfolio, and often acts as a hedge against the unknown,” says Northwestern Mutual Chief Investment Strategist Brent Schutte.  “This is a critical concept. Even though one asset class may finish on the bottom in terms of returns in a given year, it still serves a purpose.”

LOOKING FOR A CHANGE IN LEADERSHIP IN 2021

Indeed, U.S. Large-Cap stocks still ended up on top in 2020, but the gap was rapidly closed during the final months of the year. The fourth quarter was marked by a notable shift in market leadership as cyclical sectors and asset classes bested defensives and growth stocks. Economic growth is broadening as companies adapt to serve their clients, even as COVID-19 has intensified. Heading into the third quarter of 2020, U.S. Large-Cap stocks were in the black, largely driven by companies deemed virus resistant.

Conversely, economically sensitive U.S. Mid-Caps and U.S. Small-Caps declined 6 percent and 9 percent, respectively. However, during the final quarter of 2020, Mid- and Small-Cap stocks pushed ahead by a whopping 24 percent and 31 percent, respectively, to finish the year with gains. We’d also be remiss to not mention that International Developed and Emerging Markets experienced strong rallies that propelled them to yearly gains in the fourth quarter.

We think that trend could continue through the year. In 2021, the U.S. economy should experience strong tailwinds from additional fiscal and monetary stimulus coupled with an end to the pandemic’s impact on the economy (thanks to vaccines). Pent-up demand in industries impacted by COVID-19 should further spur job growth. All together, these are conditions for above-average economic growth and a more inclusive market. Ultimately, that could shake-up “the quilt” leadership in 2021.

DIVERSIFICATION IS THE KEY

Now, this is not to say that U.S. Large-Cap stocks aren’t good investments long-term. We’re are simply encouraging investors not to sacrifice diversification to follow a leader from one year to the next.

Take a little closer look at the quilt. You’ll notice there’s one square offering some semblance of consistency – it’s the white, "diversified portfolio" patch. Rather than a single asset class, the diversified portfolio is a melting pot containing every asset class on the quilt. It represents a portfolio with the following weightings: 23 percent U.S. Large-Cap; 6 percent U.S. Mid-Cap; 3 percent U.S. Small-Cap; 13 percent International Developed; 6 percent International Emerging; 4 percent Real Estate; 5 percent Commodities; 38 percent Fixed Income (bonds); and 2 percent Cash Alternatives.

It’s got a little bit of everything, which means it’ll hold the top-performing asset class and the worst-performing asset class at the same time. By its very design, a diversified portfolio will never take that top spot in returns, but it also won’t finish at the bottom. Rather, it has reliably produced middle-of-the-road returns relative to any single asset class and significantly diminished an investor’s exposure to risk and volatility. Over the course of decades, this consistency of returns, and relative safety, can go a long way toward growing a nest egg and helping mitigate your risk exposure to the ups and downs of any single investment in your portfolio.

Of course, more aggressive investors may be willing to accept more risk in search of more return. They may not allocate as much of their portfolio to Fixed Income, for example. Still, even an aggressive investor is well served by having some exposure across the spectrum of asset classes.

That’s the beauty of diversification, and those who stick with it will be in a stronger position especially if markets look much different in 2021 and beyond.

 

The opinions expressed are those of Northwestern Mutual as of the date stated on this material and are subject to change. There is no guarantee that the forecasts made will come to pass. This material does not constitute investment advice and is not intended as an endorsement of any investment or security. Information and opinions are derived from proprietary and non-proprietary sources. No investment strategy can guarantee a profit or protect against a loss.

 

Sources for asset class chart:

U.S. Large Cap: The S&P 500 Index is a capitalization-weighted index of 500 stocks. The S&P 500 Index is designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.

U.S. Mid Cap: The S&P MidCap 400 measures the performance of 400 mid-sized companies in the US, reflecting this market segment’s distinctive risk and return characteristics

U.S. Small Cap: The S&P Small Cap 600 Index is a market-value weighted index that consists of 600 small-cap U.S. stocks chosen for market size, liquidity and industry group representation.

Int’l Developed: The MSCI EAFE Index (Europe, Australasia and Far East) is a free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the U.S. and Canada. The MSCI EAFE Index consists of the following 21 developed market country indexes: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland and the United Kingdom.

Int’l Emerging: The MSCI Emerging Markets (EM) Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of the emerging market countries of Europe, the Middle East and Africa. The Index consists of the following emerging market country indexes: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Pakistan, Peru, Philippines, Poland, Russia, Qatar, South Africa, Taiwan, Thailand, Turkey and United Arab Emirates.

Real Estate: The Dow Jones U.S. Select REIT Index intends to measure the performance of publicly traded REITs and REIT-like securities. The index is a subset of the Dow Jones U.S. Select Real Estate Securities Index (RESI), which represents equity real estate investment trusts (REITs) and real estate operating companies (REOCs) traded in the U.S. The indices are designed to serve as proxies for direct real estate investment, in part by excluding companies whose performance may be driven by factors other than the value of real estate.

Commodities: The Bloomberg Commodity Index (BCOM), formerly the Dow Jones-UBS Commodity Index, is a highly liquid, diversified and transparent benchmark for the global commodities market. It is calculated on an excess return basis and reflects commodity futures price movements.

Fixed Income: The Barclays Capital U.S. Aggregate Bond Index (formerly the Lehman Brothers U.S. Aggregate Index) is an index of the U.S. investment-grade fixed-rate bond market, including both government and corporate bonds.

Cash Alternatives: Cash alternatives are represented by the Citigroup 3-month Treasury Bill Index, an unmanaged index representative of three-month Treasury bills.

Diversified Portfolio: A portfolio of all segments disclosed above, with the following weightings: 23% U.S. Large Cap; 6% U.S. Mid Cap; 3% U.S. Small Cap; 13% Int’l Developed; 6% Int’l Emerging; 4% Real Estate; 5% Commodities; 38% Fixed Income; 2% Cash Alternatives.