2020 was a year for the history books. A year of the unexpected and the unpredictable. A year that divided our country in some ways, and a year that united us against a cruel virus that has impacted every country in the world. And certainly a year we’re relieved to leave behind, as we move into 2021.

In the markets, we experienced the sharpest contraction followed by the fastest market recovery on record. For the year, the S&P 500 finished up 16.3% and the Dow Jones Industrial Average up 7.3% (both record highs), while the NASDAQ finished up 43.6%. Bonds also rallied, with the 10-year US Treasury yield finishing the year down nearly 1% from 1.92% to finish at 0.93%. (Remember that when yields decrease, bond prices increase.)

The virus-induced market downturn and subsequent recovery affected companies and industries very differently from an economic recession or even the ‘08 global financial crisis. As demand for their products and services spiked from the millions of Americans working and sheltering at home, companies in sectors like technology and consumer goods set record highs. At the same time, energy companies, restaurants, and firms involved with travel and leisure were forced to furlough or lay off thousands of employees as demand for their services plummeted.

The asymmetrical impact of the virus on the markets can be illustrated by the graph below, which looks at the 2020 performance of stocks in the S&P 500, an index that tracks the market capitalization of 500 large US companies. The red line shows the 2020 performance of the top five stocks — Apple, Microsoft, Amazon, Facebook and Google — which together comprise more than 20% of the index. (Note that Tesla was added to the S&P 500 index on December 21 and became the fifth-largest stock in the index last week.) The green line shows the other 495 stocks.

The comparison is particularly stunning during the third week in March, with the S&P 500 down more than 30% while the top five stocks were down less than 3%. This means that the bottom 495 stocks were collectively down more than 28%. The fact that the S&P 500 ended up more than 16% for the year means that its returns were primarily driven by the strength of these top five stocks.

The virus and the economy are not the only factors driving this dichotomy. As we saw from this week’s runoff election in Georgia, politics can also play a role. Stocks hardest hit by the pandemic rose on the election results, as a change of control in the Senate increases the possibility of more fiscal stimulus and spending. Meanwhile, large technology stocks that might be subject to tighter regulations with a Democratic White House took an initial hit.

While stocks are at record highs, interest rates are at historical lows, which affects the bond market. Bond yields are at record lows as we move into 2021. Just three years ago, in 2018, 3-month US Treasury bills yielded 2.5%; today, they yield less than 0.1%. Currently, the 10-year US Treasury note yields less than 1%. Historically (over the last 54 years), 10-year yields averaged 6% but almost reached 16% and did not dip below 4% over consecutive decades. At today’s lows, there is very little room for it to fall further, but plenty of possibility for it to rise.

With 2020 behind us, a new $900 billion stimulus bill with the possibility of larger stimulus checks, and almost six million Americans who have started the vaccination process, the markets are optimistic that the economy will come roaring back in due time. What isn’t so clear are the impacts that may be with us for a long time to come. Like jobs and businesses that won’t be coming back. Office space that will continue to be vacant. New routines that have become habits in our daily life. Despite an increase in permanent job losses, a decline in home sales, and a drop in spending and household incomes, most investment experts are optimistic that a strong economic recovery and continued fiscal stimulus will drive a continuation of the market’s rally into 2021, with double-digit gains for the S&P 500.

With the mixed bag of news, and with stocks at record highs and bond yields at record lows, what’s an investor to do? First and foremost, stay invested. Trying to time the highs and lows of the markets is a fool’s errand. There's a good reason for the adage: Time in the market beats timing the market.

But staying invested also doesn’t mean doing nothing. With stocks up 68% since their March lows, now is a great time to review your portfolio’s overall asset allocation, both your allocation to stocks, bonds, and alternatives, and your allocations within each of those asset classes. One thing is certain: 2021 will not be 2020, and what worked well before may not be the same going forward. Diversification should be a key focus.

Bonds vs stocks in 2021

Bonds have historically been a boring, reliable source of income and a safe haven when stocks are volatile. But with interest rates so low, income from bonds is scarce. It will likely stay that way for the next few years as the Federal Reserve pledges to keep interest rates lower for longer. Bonds still offer capital preservation and diversification benefits, but investors relying on bonds for income and / or appreciation will be disappointed as long as interest rates continue to stay low.

The chart below shows the relative yields of short- and medium-term US Treasuries versus the dividend yield for US large cap and value stocks. Just three years ago, the yields of all of these assets were within 0.60% of each other. Today, the dichotomy is stark: The dividend yields of large cap value stocks offer nearly three times the yield of medium-term US Treasuries. While the latter investment is risk-free, the point is this: On a relative basis, stocks don’t appear overly expensive when compared to bonds.

With that context in mind, investors may want to consider paring back on their bond allocation and adding to stocks, with a focus on value stocks that are currently generating dividends higher than corporate bond yields. Given the recent steep runup in large cap technology and growth stocks, it may also be prudent to think about pruning those positions and looking at other segments of the equity markets that have the potential to appreciate as the global economy recovers, such as value oriented, mid cap, and emerging market stocks. This is especially important for investors who hold concentrated positions in technology and other growth stocks. Taking capital gains (and paying the ensuing taxes) is always tough, but managing risk should be top of mind and having a plan is key.

Alternatives

While shifting allocations within your portfolio is one strategy to help diversify and mitigate investment risks, a more impactful strategy is to look beyond just stocks and bonds. Alternatives are investments that aren’t publicly traded stocks and bonds, but have risk and return characteristics that are truly differentiated from each. Including them can help lower your portfolio’s overall investment risk, replace income lost from low-yielding bonds, and offer the potential for enhanced returns. These are some of the reasons why we’ve been advising some of our clients to shift some portion of their bond allocations toward higher-income alternatives this year.

Yet not all alternatives are created equal. At Ellevest, we believe that the alternatives best positioned to offer risk-reducing, return-enhancing investment benefits are those that offer returns driven by factors unrelated to markets, how quickly or slowly the economy recovers, and / or the direction of interest rates. We actively seek alternatives that are resilient under varying market conditions, with investment strategies and characteristics designed to perform regardless of how public investment markets behave. You can learn more about building resilient portfolios and these types of investments here.

Including suitable alternatives can give more opportunities for your portfolio to earn returns while mitigating the impact of economic headwinds like we saw in 2020 and will almost certainly continue to see in 2021.

Of course, alternatives come with their own unique set of risks — things like illiquidity, limited transparency, long hold periods, higher fees, and risks unique to the strategy. But we believe the benefits of including alternatives in a portfolio may outweigh these risks, particularly in a market environment like today, where traditional assets are at record highs.

Even better: Many alternatives are designed to generate positive social and environmental impact for families, communities, and the planet. At Ellevest, we believe that impact investments like these, which range from renewable energy to affordable housing to private loans for enterprises owned by women and BIPOC people, can help position your portfolio well for whatever surprises 2021 may bring — and help others at the same time.

Sources and Disclosures