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Quarterly Commentary – Q4 2020

Deus ex machina

One of the few, albeit minor, benefits to an epically challenging 2020 was when blockbuster movies started being released straight to our homes. For example, the new Wonder Woman 1984 appeared on HBO on Christmas Day, offering two hours and thirty-five minutes of escape from reality. We won’t rate the movie in this commentary, but (spoiler alert!) we will say that we were not fans of them bringing back Chris Pine’s deceased character using some silly gimmick in the plot.

This gimmick is also known as a deus ex machina, a Latin term that dates back to the dramas of ancient Greece and Rome. Merriam-Webster defines deus ex machina as a “person or thing that appears or is introduced suddenly and unexpectedly and provides a contrived solution to an apparently insoluble difficulty.” In other words, if you have a problem for which there is no solution, you simply change the rules to fix it. When this device is used in literature or media, it is often unsatisfying and uncomfortable for the audience. We may willingly suspend our belief to enjoy a new world with new rules (e.g., one with a superhuman Amazon running around with a truth lasso), but once the rules have been created for this new world, they should not keep changing every five minutes.

If it is frustrating when this happens in the movies, it is even more disconcerting when it happens in real life. In many ways, it feels like this phenomenon keeps appearing in the modern world of finance as fiscal and monetary authorities keep changing the rules by which the game is played. Some examples include interest rates being held at zero or negative levels or trillions of dollars/euros/yen being printed globally under new monetary theory that fiscal solvency is irrelevant. The extremes of 2020 only exacerbated these distortions of reality and it is tempting to shut your eyes to the manipulations and hope that our government really has found a way to defy the truths of finance. Hope, however, is not a sound strategy. Instead, we need to keep our eyes wide open to the imbalances and risks that exist in our world today. If those in charge keep changing the rules, then we need to be willing to find a different game.

 

Stocks continue defying the laws of gravity and common sense

Most probably would have guessed that a global pandemic would have been negative for the stock market. Not so! Fiscal stimulus, in conjunction with early and sweeping monetary stimulus by the Federal Reserve (Fed), created the easiest financial conditions on record and flooded the market with liquidity, driving stocks higher in 2020. The fourth quarter also saw the introduction of two high-efficacy COVID-19 vaccines by Pfizer and Moderna, as well as prospects for additional stimulus, which propelled risk assets to new heights by the close of the year.

So not only has the market recovered the steep losses first suffered when the extent of the pandemic became apparent in early 2020, but it has since surpassed pre-pandemic levels to a meaningful degree. This is in the face of declining earnings and a great deal of uncertainty about when and to what extent those earnings will recover. To be sure, there have been some “winners” that came out of 2020. The pandemic shock has been transformational for the economy, bifurcating it into “haves” and “have-nots.” This bifurcation has benefited the so called “stay-at-home” sectors of the market, in particular technology, while decimating other sectors such as retail, travel and entertainment. While some of these shifts may prove to be temporary, others will be permanent, and still others have accelerated longer-term trends that were already in place.

At the end of 2020, markets seemed to be pricing in a degree of optimism and certainty regarding the path forward that did not appear to reflect the underlying challenges facing the U.S. economy. In our opinion, uncertainty still remains elevated with respect to both the short-term path of the recovery as well as the long-term transformation of the post-pandemic economy. The discrepancy between stock performance and earnings in 2020 served to only further exacerbate stretched valuations. Also, it is important not to forget about the revolutionary amounts of debt it took to keep things afloat, which we believe will reverberate through future generations. Is this really an environment where it is logical for stocks to be making new all-time highs?

 

Investor speculation adds fuel to the fire

While massive government stimulus has been a major driver of the recovery in stocks, investor behavior has also played a key role. Historically, two main indicators that point to how investors are engaging in more speculative behavior are heightened margin levels and abundant initial public offerings (IPOs). Starting with margin, this is simply debt that brokerages extend to their account holders, using their existing securities as collateral. Past market peaks have tended to coincide with high levels of margin debt. This is not surprising as it is human nature to become greedy when stocks go up and borrow to buy even more stock. Toward the end of 2020, margin debt topped $700 billion, a new high and well above levels that have been seen since the dot-com bubble.

Also consistent with previous market pinnacles, private companies are going public at a heightened rate. As you can see in the chart below, 2020 has had many more IPOs than in recent history.

In a year of a global pandemic, where our economy collapsed in terms of output and we lost 20 million jobs in just a few months, does it make sense that the IPO market was robust? Perhaps it would have been more prudent for companies to take a breather and wait until there was more certainty surrounding their near-term futures. After all, look at the middle of the chart in 2008 and 2009, where IPO activity collapsed. This makes a lot more sense in an economic downturn. But not this time, because despite all the uncertainty, in 2020 investors have been eager to take a chance on pretty much any and all IPOs. It is irrelevant if these companies have earnings; in fact, looking at the numbers you would think it was discouraged since about 80% of these 2020 IPOs had negative earnings.

Far from caring about earnings, speculative investors have pushed these stocks higher, to the point where their valuations often reach ridiculous levels very quickly. An example of a recent IPO in this category is QuantumScape, an up-and-coming entrant into the electronic vehicle battery space. With Elon Musk and Tesla making headlines, this is obviously a very hot area of the market, so it is no wonder that this company attracted investor interest. But despite the company’s exciting potential, THEY HAVE YET TO SELL A SINGLE BATTERY. The technology, while very promising, is not yet proven. So what valuation did investors give this pre-revenue company? Nearly $50 billion. To put that in context, that market cap is roughly double the size of Panasonic, which is the battery maker for Tesla cars. Panasonic has a number of other business lines as well and has been around for decades, but the market likes shiny new toys in this speculative environment, so QuantumScape reached a height of $50 billion before getting slashed back down to a meager $20 billion.

Another hot 2020 IPO was Airbnb, the popular company that allows you to rent a home or apartment online. This was a company that got hit pretty hard with the pandemic and its revenue in 2020 was down a good amount from the year before. Also, on $2.5 billion of sales, it lost an impressive $700 million. This is a company that has never made a profit in a calendar year. Yet it was rewarded with a $100 billion valuation when it went public. To put that in perspective, Starbucks, a truly global brand and moneymaker, has a valuation of a little more than $100 billion. FedEx, a massive company that has done well during this pandemic, is worth about $70 billion. These types of IPO valuations are completely disconnected from reality and reflect a speculative fervor that has seized market participants, not dissimilar from the tech frenzy that gripped markets prior to the dot-com bubble bursting.

 

If you don’t like the rules, then change the game

Most investors need to make their investments work for them over the long term to meet their financial goals. Even for those who have large cushions built-in, it is still prudent to make sure that you can stay ahead of inflation, which we see as being a meaningful risk in the years ahead. So what is the solution when we are faced with an investment landscape that includes massive debt imbalances from government intervention and frenzied investor speculation? Though the situation with traditional markets seems dire, we are not intimidated and instead feel increasingly confident in our approach to portfolio management. Three key aspects to our approach include:

1) With traditional stocks, focus on what you can control.

While our target stock allocations are at their lowest in our firm’s history, this does not mean that we do not own any stocks. There are a number of reasons why stocks are a prudent part of a long-term portfolio, not the least of which is that if the Fed continues pumping money into the system, we could continue to see stocks benefit from asset price inflation. At the end of the day, we do not believe that this is a long-term recipe for success. But the proverbial end of the day could potentially be far off and, in the meantime, stocks can continue to benefit from the tremendous liquidity in the system. One key is making sure that stocks are at an appropriate level in the portfolio given their potential for meaningful volatility. Another key is making sure you maintain diversification and do not allow FOMO (fear of missing out) to push you to overweight the hottest, most overvalued tech stock in the market. Finally, while we cannot control market valuations and performance, there are some attributes of this investment that we can control: namely, fees and tax efficiency. If we access our stock allocations using vehicles with relatively low fees and high levels of tax efficiency, this can help maximize returns for the long run.

2) Take advantage of speculative behavior (safely) when you can.

While we have no interest in being swept up in the speculative fervor of negative-earning IPOs, that does not mean that there aren’t ways to profit from the space. An increasing number of companies are choosing to go public through the use of special purpose acquisition companies (SPACs). SPACs, also known as blank-check companies, are pools of capital raised by a sponsor, such as a well-known businessman or asset manager, with the goal of finding a company to take public. At the onset, a SPAC is funded entirely with Treasuries. The manager that Morton Capital utilizes in this space looks to take advantage of a structural inefficiency that allows investors to participate in the initial jump up in SPAC prices following the announcement of a deal without actually having to own the stock and assume the downside risk. Thus, investors can participate in some of the upside from these SPAC IPOs with the downside being the yield on Treasury bonds. Needless to say, there are quite a few moving parts to this strategy, as well as logistical requirements and minimum sizes. If you are interested in learning more, please contact your Morton Capital wealth advisor.

3) Lend on assets, not to zombies.

The more debt that piles up in the system, the riskier it is to loan money to companies that may be challenged when paying back that debt. The stock market is currently plagued with the highest level of zombie companies in its history (representing around 20% of the largest U.S. companies according to a late 2020 study by Bloomberg). A zombie company is defined as a company that generates insufficient earnings to pay its debt service and has to continually borrow to stay in business. Instead of lending to companies that need a constant supply of cheap debt to survive, our focus has been on making loans on tangible assets. This includes making private loans to companies that are cash-strapped but have real assets that can be sold if the company does not survive. It also includes making loans to borrowers on assets such as real estate, including mortgage loans in both the private and public markets. The key to any strong asset-based loan is how conservatively the manager values the collateral assets that back the loan and what type of cushion the manager leaves to account for any changing values over time. Another preference of ours is to invest in managers that make short- term loans for periods where there is better clarity around the values of the assets. In an environment where traditional bonds offer little reward with plenty of risk, finding managers with expertise in asset- based lending can add meaningful downside protection as well as opportunities for heightened cash flow.

We recognize that these are trying times with a great deal of uncertainty pervading all aspects of life. Instead of being intimidated by the uncertainty in financial markets, we hope that our clients feel empowered by our willingness to look beyond the traditional game, where the rules keep changing, and instead find investments with fundamentals that still make sense. If you have any questions about your portfolio or financial plan, please do not hesitate to reach out to your Morton Capital wealth advisor. As always, we appreciate your continued confidence and support.

Best Regards,

 

Disclosures

This commentary is mailed quarterly to our clients and friends and is for information purposes only. This document should not be taken as a recommendation, offer or solicitation to buy or sell any individual security or asset class, and should not be considered investment advice. This memorandum expresses the views of the author and are subject to change without notice. All information contained herein is current only as of the earlier of the date hereof and the date on which it is delivered by Morton Capital (MC) to the intended recipient, or such other date indicated with respect to specific information. Certain information contained herein is based on or derived from information provided by independent third-party sources. The author believes that the sources from which such information has been obtained are reliable; however, it cannot guarantee the accuracy of such information. Any performance information contained herein is for illustrative purposes only.

Certain investment opportunities discussed herein may only be available to eligible clients. References to specific investments are for illustrative purposes only and should not be interpreted as recommendations to purchase/ sell such securities. This is not a representation that the investments described are suitable or appropriate for any person. It should not be assumed that MC will make investment recommendations in the future that are consistent with the views expressed herein. MC makes no representations as to the actual composition or performance of any security.

The indices referenced in this document are provided to allow for comparison to well-known and widely recognized asset classes and asset class categories. YTD returns shown are from 12-31-2019 through 12-31-2020 and Q4 returns are from 10-01-2020 through 12-31-2020. Index returns shown do not reflect the deduction of any fees or expenses. The volatility of the benchmarks may be materially different from the performance of MC. In addition, MC’s recommendations may differ significantly from the securities that comprise the benchmarks. Indices are unmanaged, and an investment cannot be made directly in an index.

Past performance is not indicative of future results. All investments involve risk including the loss of principal. Details on MC’s advisory services, fees and investment strategies, including a summary of risks surrounding the strategies, can be found in our Form ADV Part 2A. A copy may be obtained at www.adviserinfo.sec.gov.

New Year’s Wishes

As 2019—and this decade—comes to an end, we at Morton Capital would like to thank you for allowing us to continue to be part of your story. And for those of you who just joined our community this year, we are excited to start our story together. As we look forward to the year ahead, we would like to take a moment to share with you some highlights of what we’ve been working on over the past year.


MC TEAM AND GROWTH

In 2019, we continued to focus on making our team even better through initiatives around hiring, team structure, and firm growth.

  • We were named one of the Best Places to Work for Financial Advisors by Investment News. This list highlights the top 75 firms nationwide in the financial advice industry. We were chosen 2nd among firms our size and 16th overall.
  • We hired talented new people across several teams, including the advisory, financial planning, investment research and operations teams. New hires included:
    • Brian Standing, Esq. (Wealth Planner); Patrice Bening (Client Service Associate); Olivia Payne (Client Service Associate); Adam Bartkoski (Finance and HR Manager); Milan Pfeisinger (Research Analyst); Elana Yaffe (Paraplanner); Amber McBride (Paraplanner); Edward Garcia (Client Service Administrator); Chris Wahl (Client Service Administrator); Clarence Welton (Client Service Administrator); Austin Overholt (Private Investments Administrator); Benjamin Markman (Private Investments Administrator); and Kierstan Lewis (Administrative Assistant)
  • Two of our Wealth Advisors, Kevin Rex and Wade Calvert, became new partners in the firm.
  • We built out our internal team structure to create additional client support and to create new opportunities for team member career growth.
  • Through the hard work and dedication of our team, we were able to add just under 40 new client households to the MC community.
  • Two team members have welcomed beautiful baby girls Audriana (Kevin Rex) and Harlowe (Sarah Ellis) this year. Since sourcing young talent is always important, stay tuned for our 2041 year-end letter, as these girls’ names may appear amongst those hired!

EDUCATION AND ENHANCEMENT

Continuing to cultivate our team’s passion for education and to enhance our offering through technology, security, and leadership initiatives was also a focus over the past year.

  • Team members attended multiple conferences to stay at the forefront of our industry, network with thought leaders and enhance our financial planning and technological capabilities.
  • Our COO, Stacey McKinnon, spoke at 5 events this year, including at such leading conferences as Bob Veres’s Insider’s Forum in Nashville in September.

  • We worked to make our internal processes more efficient by introducing new CRM and workflow systems to improve your client experience
  • We continue to utilize multiple fraud prevention measures, such as verbal confirmations and dual-factor authentication when available, to protect our clients from increasingly sophisticated fraud attempts.
  • In August, we introduced our popular Financial Bites lunch series for clients in our downstairs suite, where advisors spoke about the basics of a number of financial planning topics to educate and empower attendees.

  • This year, Wealth Advisor and Senior Vice President Joe Seetoo earned his CEPA (Certified Exit Planning AdvisorTM) designation, and Associate Wealth Advisor Sarah Ellis passed her Series 65 exam.
    • As part of our focus on education, many other team members are in the process of obtaining additional certifications in such areas as financial planning, investment research, private wealth management, and insurance.

INVESTMENT RESEARCH AND FINANCIAL PLANNING

We work diligently behind the scenes to source great investment opportunities for our clients. To give you a peek behind the curtain, this year:

  • We screened hundreds of new investment opportunities and performed nearly 90 more in-depth reviews, which included meetings and/or phone calls with fund managers.
  • Out of those 90 opportunities, we introduced 6 new strategies for client portfolios.
  • In addition to numerous site visits around Southern California, we also performed due diligence on various groups in New York, Texas and Kentucky.
  • We made three new additions (see above) to our investment research and operations teams.
  • We continued to augment our internal research with outsourced research, both from larger, more institutional groups (e.g., Capital Economics, Bloomberg, Goldman Sachs, JP Morgan, Dimensional Funds, GMO, Elliott Management, Litman Gregory) and from more niche authors as well.

Over the past year, we have refined and expanded our financial planning offering by:

  • Adding wealth and legacy planning as an additional component of our financial planning service. This additional service has been spearheaded by Wealth Planner Brian Standing, who has 12 years of estate planning and wealth transfer experience.
  • Making three new additions (see above) to our financial planning and wealth and legacy planning teams.
  • Completing 180 financial plans for our clients.
  • Holding 50 education sessions for our advisors, with the goal of enhancing our ability to provide you with advice in estate planning, insurance, tax strategies, and retirement planning.
  • Collaborating with clients’ other professional advisors, including estate attorneys, CPAs and insurance agents.

 

Looking back on all that we’ve accomplished over the last year, we are excited to see how our constant pursuit of knowledge and growth has been better able to help you, our clients, get the most life out of your wealth. We truly appreciate your continued confidence and wish you and your family a very happy new year.

See you in 2020!

-Your Morton Team