Friday, December 11th, 2020

Two Big Ideas for 2021

This is our last strategy note of the year, so we want to highlight two themes which we think will be important during 2021, or at least the early part of it.  Both ideas are supported by well-developed trends, with high-conviction lead indicators, which give us confidence that they may have a longer shelf-life than the standard 6-8 week horizon we cite for our process. They are:

  • Underweight US Equities in a global equity portfolio
  • Overweight Small Caps, mainly in Europe, but also the US.

Following several conversations with clients, the first idea is clearly more controversial than the second. Almost all of them seem to bear the scars of a previous period when they went underweight US Equities and got burned. We sympathise with their pain, but the simple truth is that we haven’t shared it. For the last ten years, our process has had a significant overweight on US equities. The average for the ten years from January 2011 to date is 30% and there was only one period, from May to November 2017, when we had an extended underweight.

Every year, a selection of strategists run with this idea, some of them perma-bears, some of them not, but for the last ten years, it is has never included us. That doesn’t necessarily mean that we are going to be right in 2021, but at least we haven’t made the same mistake year after year. When we have made this call, in previous periods, we have generally got it right. For the ten years from 2001-10, we had an average underweight of 13% and there were six periods of more than six months when we had a significant underweight – sometimes down to -75%. If we reduce our model to a binary choice between US and non-US equities, it has outperformed its benchmark by an average of 0.8% p.a. over the last 25 years, with a marginal increase in risk and no extended period of underperformance.

The model’s current recommendation is an underweight of -18%. Technically, this is still in neutral territory, so this note is more of a warm-up than a definitive call, but the view has suddenly deteriorated over the last month and we are now close to our two-year low. The lead indicator has also switched from stable to deteriorating and the quality of the signal has increased from no conviction to just below high-conviction. Stepping back from the detail, we have no difficulty in reconciling this change with the global rotation away from growth towards value and with forecasts for a weaker dollar. Our model was also underweight US equities in the recovery from the last two recessions – from May to November 2009 and from July 2003 to May 2005 (including a few weeks in neutral territory).

Our second idea is really simple. If you believe that the global economy is going to recover in 2021 and that the rotation towards value will continue, you should increase your exposure to Small Caps. Other parts of the equity universe may respond better to a recovery and others may do better from the rotation, but few will do as well from both. There is a sequencing problem in trying to play these themes purely via sector selection. Will Financials outperform before Energy? Can banks continue to outperform if yield curves don’t steepen. Is it sensible to be overweight Energy and Materials at the same time? If commodity prices start to rise, is it necessary to take profits from Industrials? What definition of value do you use to capture the recovery potential of the hospitality sector? Should we fund these positions via a big underweight in defensives like Consumer Staples and Telecom or from Technology? Is Healthcare already oversold?

All these questions drop away when investors commit to a broad exposure to Small Caps funded by a reduction in large caps, spread pro-rata across all sectors.

We have recently moved to overweight in European Small Caps and we expect to upgrade in the US in the very near future. In both regions we have high-conviction, improving lead indicators. Both charts are challenging long-term downtrends which have been in place since early 2017. This may require some short-term consolidation in January, but if they break these downtrends, there is the potential for the recommended weight of Small Caps to challenge its all-time high later in the year. For Europe, this would imply an overweight of 80%, versus 70% for the US. Just like the underweight in US Equities, the previous recoveries in 2003-04 and 2009 also featured a substantial overweight in Small Caps in both regions.

In conclusion: these ideas are not forecasts. They are just extrapolations of how we expect our process to behave. If it doesn’t behave like this, we will tell you. If we are right, we will do our best to keep you in the trade and to tell you when it is about to stop working.

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