Uncommon Sense

Three Surprises for 2020 that Deliberately Defy Logic

“Logic will get you from A to B. Imagination will take you everywhere.”

— Albert Einstein

Michael Arone, CFA
Chief Investment Strategist, State Street Global Advisors

New year. New decade. Exciting stuff. There is something fresh, new and invigorating about turning the page from one year to the next. It grants us the guiltless freedom to put our disappointments and unfinished goals firmly in the rearview mirror while looking forward to the untouched open road ahead. The start of the 2020s magnifies the excitement. A potentially pioneering decade filled with creative innovations and major breakthroughs across many fields. Something about it just feels good — hopeful.

Embracing these powerful start-of-the-new-year emotions, each January since 2016, I have reluctantly — and rather successfully— forecasted three surprises for investors. Over the past four years, I have accurately predicted 10 of 12 surprises. My two teenage kids would call that a humble brag. There will be plenty of time for gloating later. But first, let’s revisit my simple, disciplined and repeatable forecasting process, a seemingly foolproof formula.

Magic Formula: If It Ain’t Broke, Don’t Fix It
There’s really not that much to it. Forecasting a small number of surprises has helped my accuracy. Investors are repeatedly taught that having a larger number of positions in investment portfolios results in the welcomed benefits of diversification. However, when attempting to make accurate forecasts, concentration in a few predictions can lead to better overall results.

A short time horizon is important too. My forecast period is the calendar year. And when it comes to identifying surprises, unloved assets with compelling valuations where a lot of bad news is already priced in and investor sentiment is decidedly one-way produces a profitable environment with plenty of opportunities. That’s the simple formula that has yielded solid results over the past four calendar years.

However, in a classic sign of hubris and stupidity, for 2020, I’m adding a wrinkle to my formula. Run while you still can! With Christmas and New Year’s Day both falling on a Wednesday in 2019, the long holiday break provided ample time for some casual reading. I read two books that while quite different from one another shared a common theme about logic.

A friend recommended The Book of Why: The New Science of Cause and Effect by Judea Pearl and Dana Mackenzie. Pearl is a computer scientist, a recipient of the Turing Award ─ the highest distinction in the field ─ and a philosopher best known for championing the probabilistic approach to artificial intelligence (AI) and Bayesian networks. Mackenzie is a mathematician turned science writer. Admittedly, this book was tough to get through. It read like a college statistics textbook, and I cursed my friend for recommending it.

However, at least one theme stuck with me. At 83 years old, Pearl has dedicated his life to the development of artificial intelligence. He is an AI expert. When he and Mackenzie describe today’s shortcomings, they observe that the algorithms do as they are told. Computers, even smart ones, don’t break the rules of logic. But, here’s the thing: humans do. In fact, some of the greatest creations and innovations are the result of humans’ ability to dream and ultimately defy logic. The authors unexpectedly conclude that until we’re able to teach computers to break the rules of logic as humans do, advancements in AI may continue to be disappointingly gradual.

Speaking of breaking the rules, the second book I read over my holiday break was Rory Sutherland’s Alchemy: The Dark Art and Curious Science of Creating Magic in Brands, Business, and Life. Now, that’s a mouthful. Vice Chairman of Ogilvy Group UK, Sutherland is widely recognized as one of marketing and advertising’s most original thinkers. Thankfully, there weren’t any mathematical formulas in this book. Simply stated, Rory Sutherland is a rule breaker. In the opening pages, he lists “Rory’s Rules of Alchemy.” Here are just a few:

  • “It doesn’t pay to be logical if everyone is being logical.”
  • “The problem with logic is that it kills off magic.”
  • “Test counterintuitive things only because no one else will.”
  • “If there were a logical answer, we would have found it.”

Sutherland claims that modern society has turned its back on illogic, which at times can be uniquely powerful. Because reductionist logic has been so effective in the physical sciences, people now believe that it must be applied everywhere, including the messier field of human affairs. He writes, “The models that dominate all human decision-making today are duly heavy on simplistic logic, and light on magic ─ a spreadsheet leaves no room for miracles.”

On the surface, these books have nothing in common, but they remind me of a valuable investing lesson. Perhaps I will label it the “illogic premium.” If everyone is doing it — being logical — then it won't generate a profit for investors. So, in addition to the “magic formula” that I have successfully used over the past four years to forecast surprises, this year I will sprinkle in a little illogic for good measure. Here are my three surprises for 2020:

1. Missing Market Euphoria is Found
It has often been said that this is the least-loved bull market ever. Yet despite all the skepticism, like the Energizer Bunny, it just keeps going and going. Fast approaching 11 years old, this bull market is among the longest in modern history, and at its current trajectory, it’s on pace to be the best performing, too. And although market valuations are elevated, it feels far from the nosebleed levels observed at the turn of the century just prior to the Technology, Media & Telecom (TMT) bubble bursting. C’mon, people! Where is your excitement?

Most investor surveys and Wall Street market outlooks are forecasting modest, single-digit returns for the S&P 500 in 2020. The logic behind those expectations is solid. Last year’s outstanding returns were largely the result of multiple expansions. So it’s not likely that investors will continue to bid up stocks, unless underlying fundamentals begin to catch up to prices. Earnings growth plus dividends are likely to deliver single-digit returns this year. It all fits neatly together. Too neatly. Looking back at historical calendar year returns reveals that it is rare for the S&P 500 to deliver single-digit returns in any given year. Why should 2020 be any different?

Euphoria has been the missing link in the later stages of this long-running bull market, fueling investors’ growing confidence that stocks can continue rallying without it. Don’t be fooled, euphoria is required before the bull market can end. And it is coming in 2020. As a result, the next leg in the markets likely isn’t down, but up. And up considerably. Investors can put aside all those predictions for more modest returns in 2020, because my first big surprise for the year is that a massive market melt up is finally coming.

This prediction may fly in the face of logic, but a growing number of indicators suggest that a more euphoric investing environment is taking hold. The put-call ratio, a widely used gauge of investor sentiment, is signaling extreme bullishness. Technical indicators like the relative strength index (RSI) point out that stocks are likely overbought. There is excessive bullishness in S&P 500 futures positioning. Flows into equity mutual funds and ETFs are off to a hot start so far this year. Stocks are at all-time highs despite a persistent deterioration in fundamentals. And the American Association of Individual Investors (AAII) Investor Sentiment Survey from the week ending January 22 reports that just 24.8% of survey respondents are bearish about the market over the next six months, which is well below the historical average of 30.5%.

Investors may be ditching their skepticism and finally getting more euphoric about this bull market. Oddly, the surprise melt-up that I’m predicting this year may signal that the long-hibernating bear market is finally waking up from its slumber.

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Source: Bloomberg Finance, L.P., December 31, 2019. Past performance is not a guarantee of future results

2. Healthcare Beats the Broader Market

The healthcare sector has all the characteristics of a good surprise. It is unloved. Investors have withdrawn $4.7 billion from healthcare sector ETFs over the past 12 months, the second-highest figure among the 11 sectors. In a snap investor survey conducted by Strategas Research Partners at the end of December, just 11.2% of respondents expected healthcare to be the best-performing sector in 2020. The financials, energy and technology sectors all finished significantly ahead of healthcare in the survey.

In 2019, the healthcare sector trailed the S&P 500 Index return by 10.7%, making it the second-worst performing sector for the year. Only the hated energy sector performed worse. This has created a compelling valuation opportunity for healthcare. It is the second cheapest of the 11 economic sectors. Political and regulatory uncertainty in an election year have been strong headwinds for healthcare stocks.

Yet despite all the bad news and negative investor sentiment, the healthcare sector is reporting the strongest fourth-quarter year-over-year revenue growth of all the sectors, at 10.6%. Additionally, over the past three months, analysts have been ratcheting up their 2020 earnings-per-share (EPS) estimates for the sector. And over both the 1-month and 3-month periods, there have been far more analyst upgrades to 2020 EPS estimates than downgrades for healthcare stocks. A signal of strength. Not to mention the long-term tailwinds for the sector, such as aging demographics, longer lifespans, and R&D spending on fatal diseases and preventative care.

Logic might suggest waiting for further clarity on the sector’s prospects after the November election, but an unloved asset with attractive valuations, improving fundamentals and solid structural tailwinds is far too good to pass up. For my second surprise, I expect the healthcare sector to beat the broader market return in 2020.

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Source: Bloomberg Finance, L.P., December 31, 2019. Past performance is not a guarantee of future results

3. The Mighty US Dollar Still Stands Strong
After several years of unexpected strength, many market observers are predicting that the US dollar will weaken this year. In the same Strategas Research Partners snap investor survey mentioned earlier, roughly 79% of respondents said that the US dollar would be lower by the end of 2020. Again, the logic is sound. Skyrocketing twin deficits, much easier monetary policy conditions and a Trump administration committed to talking down the dollar could all lead to some softening of the currency. Now that both the US-China Phase One and USMCA trade agreements have been signed, trade tensions are finally cooling after two tumultuous years. As a result, economic growth outside the US is forecast to reaccelerate this year, putting further downward pressure on the dollar as other currencies gain in relative attractiveness.

However, the environment supporting dollar strength the past few years hasn’t changed all that much. Starting with interest rates, the US 10-year Treasury yield stands at 1.62%, considerably higher than 10-year sovereign bonds in Germany, Japan, UK and Australia. In fact, 10-year bond yields in both Germany and Japan remain negative. Many countries continue to have large amounts of bonds trading with negative yields. Investing in US 10-year Treasuries is an attractive option for many investors outside the US and should keep the US dollar well bid.

The International Monetary Fund (IMF) updated its World Economic Outlook in January. Overall, the global economic growth outlook got a little rosier this time around. Global economic growth is expected to rise by 3.3% in 2020, versus just 2.9% in 2019. Looking beyond the headline numbers, the IMF still forecasts stronger US economic growth compared with most other major advanced economies. For example, the IMF predicts that the US economy will moderate some year over year but still grow at 2% in 2020. Compare that with estimates of 1.3% for the euro area, 1.4% for the UK and 0.7% in Japan for this year. Similar to recent years, the US continues to be the best house in the bad neighborhood of underwhelming economic growth. This, too, should keep the demand for the US dollar elevated.

Cryptocurrency enthusiasts and conspiracy theorists also point to a shortage of US dollars; if that is true, it is likely to contribute to continued US dollar strength. As the US Federal Reserve (Fed) aggressively reduced its balance sheet in 2017 and 2018, it eventually pushed bank reserves down to their lowest levels since 2011. In September, the potential risks to the Fed’s actions started to bubble up in short-term funding markets like the repurchase (repo) market. The Fed quickly stepped in and pledged to keep reserves at higher levels, and its massive liquidity injection enabled markets to avoid pending disaster as 2019 came to a close. Additionally, the US government’s summer agreement to suspend the debt ceiling through July 2021 has also led to some US dollar scarcity concerns. The suspension of the debt ceiling enabled the US Treasury Department to borrow $433 billion in July and another $381 billion in October, further sucking liquidity from the banking system and exacerbating dollar-shortage fears.

Higher interest rate differentials, faster economic growth compared with other advanced economies and a potential shortage of US dollars mean that the world’s reserve currency still stands surprisingly strong in 2020.

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Source: Bloomberg Finance, L.P., December 31, 2019. Past performance is not a guarantee of future results

Keeping Score

Longtime Uncommon Sense readers know that I often describe myself as a reluctant investment strategist, specifically when it comes to making predictions about the markets. As a wise man once said, “It’s difficult to make predictions, especially about the future.” But, despite my warnings about the limitations of forecasts, weirdly, January’s three surprises article is often the most widely read Uncommon Sense each year. Investors want to believe that someone has investing figured out and that they are willing to share the secrets with everyone.

Last year, my three surprises mostly worked out. I predicted that financials would beat the broader market. And the financials sector returned a healthy 32.1% in 2019, besting the S&P 500 Index return by 0.6%. I also forecasted that despite the political discourse in Washington, elected officials would find a way to spend lots more money through fiscal spending before an important election year. In December, a $1.4 trillion spending agreement was reached to fund the federal government through fiscal year-end in September 2020. The agreement increased discretionary federal spending by $50 billion year over year.

The National Defense Authorization Act (NDAA) was also passed in December. This innocuous-sounding legislation establishes funding levels and sets policies for the Defense Department and the Energy Department’s national security programs. Cleverly, Congress used it to include all sorts of spending goodies, such as paid parental leave for federal employees and the creation of the US Space Force, the sixth branch of the nation’s military. My third surprise for 2019 was wrong. I expected high yield bonds to disappoint investors last year. Instead, so-called junk bonds rallied by about 16%.

As they say, two out of three ain’t bad. And for those keeping score at home, I have successfully forecasted 10 of 12 surprises since 2016. However, it’s not whether you win or lose that counts, but rather how you play the investing game that matters. Sure, when it comes to investing, winning is definitely a lot more fun than losing, but it’s the process that matters most. Outcomes are uncontrollable. A consistent, disciplined approach to identifying market surprises has been the key to my success over the past four years.

I keep the number of predictions small, the forecast horizon short, and look for unloved assets with compelling valuations where sentiment is decidedly one way. And this year, I was reminded that being logical may be safe, but if everyone is doing it – it may not be profitable. May all your surprises be rewarding in 2020!


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The total monetary or market value of all the finished goods and services produced within a country's borders in a specific time period. As a broad measure of overall domestic production, it functions as a comprehensive scorecard of the country’s economic health.


The views expressed in this material are the views of Michael Arone through the period ended January 26, 2020 and are subject to change based on market and other conditions. This document contains certain statements that
may be deemed forward looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.

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Past performance is no guarantee of future results.

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