“You unlock this door with the key of imagination. Beyond it is another dimension. A dimension of sound. A dimension of sight. A dimension of mind. You’re moving into a land of both shadow and substance, of things and ideas. You just crossed over into … The Twilight Zone.”
― Rod Serling, The Twilight Zone: Complete Stories
For those of you unfamiliar with The Twilight Zone, it was a TV show that ran for five seasons from 1959 to 1964. It was a strange mix of horror, science fiction, drama, comedy, and superstition, often concluding with an unexpected twist and a moral lesson. As we conclude the first quarter of 2021, the landscape of investing continues to evolve in unique and sometimes strange ways. Events in the first quarter as well as the development of new investments that sound like science fiction represent new risks and opportunities investors must carefully consider. As we recap the first months of the year, we’ll start with traditional markets and then discuss some of these new ideas that sound like they’re coming from another dimension.
In the first quarter, traditional markets appeared to continue the trend that started in the fourth quarter, with U.S. small-cap and international developed stocks outperforming U.S. large-cap stocks. This was true at the mid-point of the quarter; however, comments by Federal Reserve Chairman Jerome Powell in early March cooled international markets and led to higher bond yields for the rest of the quarter. Chairman Powell expressed concern that markets are a long way from the Federal Reserve’s goals, implying continued ease of monetary policy to push the economy back to full employment and potentially overshoot the inflation target of 2 percent.
As shown in Figure One, U.S. small-cap stocks maintained most of their early quarter gain and finished up 12.7 percent, U.S. large-cap stocks returned 6.2 percent, while international developed and emerging market stocks were up 3.6 percent and 2.3 percent, respectively. While returns were higher earlier in the quarter, these returns are remarkable for one quarter for all equities, particularly U.S. large-cap stocks, which are on pace for another double-digit return year. The U.S. aggregate bond index had a particularly bad quarter in the face of rising yields and is likely to struggle to deliver a positive return in 2021 unless yields decline at some point later in the year.
Figure One: Stocks and Bonds—Performance from January to March 2021
Sources: CAPTRUST Research
The Resurgence of Value
For at least the last seven years, growth stocks have substantially outperformed value stocks, particularly in U.S. markets. Whether this is due to a low interest rate environment or investor sentiment favoring growth stocks, value investors were giving up 6 to 10 percent in annualized returns to their growth counterparts. However, in the last quarter of 2020 and first quarter of 2021, that trend has reversed in dramatic fashion. As shown in Figure Two, U.S. large-cap value stocks are up nearly 30 percent in the last two quarters, relative to growth up 12.4 percent, while U.S. small-cap value is up more than 61 percent compared to U.S. small-cap growth up 36 percent. Historically, when leadership changes between value and growth it happens quickly and violently. While we won’t know if this is indeed the tipping point for value to reestablish leadership, we’ve certainly experienced a massive outperformance of value in the past two quarters.
Figure Two: Growth Stocks Versus Value Stocks
Wall Street Bets and Archegos
Perhaps the most notable event for traditional markets in the quarter was the price movement in GameStop stock due to what appeared to be organized trading in the stock by a number of investors who participated in a Reddit bulletin board group called wallstreetbets. Up until this point, a number of hedge funds had short positions in GameStop, basically betting that the stock price would continue to decline, due to repeated quarterly losses. On January 22, wallstreetbets investors initiated a short squeeze on GameStop, buying shares of the stock and causing the price to rise, which forced a number of the hedge funds to unwind their short position. As a result, the price increased more than 600 percent by January 26. While short squeezes have occurred on occasion historically, this appears to be the first short squeeze initiated by nonprofessional investors organized as a community. The price action was the talk of financial markets for several days and led to millions both made and lost in the process—by professionals and nonprofessionals alike.
Near the end of the quarter, stories surfaced about Archegos Capital Management, a family office that had $10 billion under management and defaulted on margin calls from several global investment banks in late March. Archegos used derivative instruments to establish positions, which meant they didn’t have to disclose many of their holdings to the banks they were borrowing from. They were able to leverage the portfolio much more than if they were trading in traditional stocks. As banks issued margin calls—likely due to learning their exposure was much greater due to derivatives—and Archegos failed to meet them, positions were liquidated to cover the margin debt. The Wall Street Journal reported that Archegos lost $8 billion over the course of 10 days, and Credit Suisse reported losses of $4.7 billion as a result of its involvement with Archegos.
Both the GameStop trading and Archegos collapse reveal material risk in markets that can impact the broader financial system. While Archegos’s losses were contained, it is fair to assume there are other large investors who may have similar leverage and derivative risk. While markets had a strong first quarter despite these events, it goes to show that the real risks portfolio diversification protects against are the ones you can’t anticipate, like extreme volatility in a concentrated stock position or broader financial system risks.
Special Purpose Acquisition Companies (SPAC)
While not a new invention, special purpose acquisition companies (SPACs) have seen a resurgence since 2014. A SPAC is essentially a shell corporation that is currently listed on a stock exchange but is then used to acquire a private company, thereby making it public without actually going through an initial public offering (IPO) process.
In a way SPACs circumvent private equity investors. The SPAC structure lists publicly through an IPO process, typically at $10 a share. Investor capital is then used to acquire an existing private company, taking that company public through a merger as opposed to its own IPO. In 2020, SPAC IPOs reached $83.3 billion of investment assets raised, more than six times the previous year. In 2021, SPAC IPOs have already exceeded 2020 numbers.
The popularity of SPACs has led to many investors speculating and buying these stocks in hopes of participating in the upside post-acquisition. While in both private equity and a SPAC the risk is borne by the investor, each structure attracts different types of investors at different time periods in the investment cycle. Unfortunately, SPACs are raising money easily because they are attracting investors who expect to make a quick, easy profit. In reality, academic analysis shows the investor returns on SPACs post-merger are almost uniformly heavily negative. Unless investment occurs at issuance of the SPAC—before you know what company they’re buying—investors are likely to lose money.
Fractional Ownership of Collectibles
There are several businesses created to offer investors access to collectibles and assets in fractional ownership form. These businesses—such as Rally Road or Collectible—purchase high-value items like classic cars, watches, or sports cards, and then essentially register them with the Securities and Exchange Commission (SEC) as limited liability companies and sell shares in the company. For the first time the average investor can easily own a few shares of a 1955 Porsche 356 Speedster or a Jackie Robinson rookie card—approximately $400,000 each—for $20 per share. While these investments offer limited liquidity and unique risks associated with the assets, they open another avenue of investment that not long ago was inaccessible to the average investor.
Cryptocurrency and Non-fungible Tokens
While cryptocurrency has been around for nearly a decade, it is making headlines again as the price of Bitcoin hovers near its all-time high price of over $60,000. The blockchain technology that most cryptocurrency is based on is now being used to create non-fungible tokens, or NFTs, which have also attracted investor capital.
The general concept of an NFT is that it represents a scarce asset. While the underlying digital file, such as art, audio, videos, or other forms of creative work, can often be seen or used by anyone, the NFTs representing them are unique and digitally linked to an original owner. Most recently, digital artwork created by Mike Winkelmann, the digital artist known as Beeple, was sold by Christie’s in an online auction for $69.3 million with fees. The price was a new high for an artwork that exists only digitally, beating auction records for physical paintings by museum-valorized greats like J.M.W. Turner, Georges Seurat, and Francisco Goya. Anyone can google the art and see it on a computer screen, similar to a picture of the Mona Lisa, but only one person owns the original NFT file.
One of the more popular platforms has been the National Basketball Association (NBA) Top Shot, a marketplace for digital video clips endorsed by the NBA. Investors can buy and sell clips of highlights from NBA games that each have their own identifier and level of scarcity. Anyone can see the same clip on YouTube or on the Top Shot marketplace, but investors and speculators are placing value in ownership of the NFT.
The continued evolution and recent explosion of strange investment ideas leads to two questions: Why is it happening, and should everyone participate? There isn’t a concrete answer to why it’s happening, but one cause may be the ever-growing supply of money coming from the Federal Reserve and fiscal stimulus programs. As shown in Figure Three, in the last two years the level of debt to gross domestic product (GDP) in the U.S. has increased drastically.
Figure Three: Ratio of Financial Assets to GDP
Half of the 2021 federal budget is projected to be funded by borrowing, resulting in a deficit to GDP of 15.6 percent in 2021. Whether one agrees or disagrees with the justification that fiscal stimulus is required to survive the global pandemic, it’s happening.
As stimulus flows into the economy, the top decile of consumers spends more than 60 percent of its income after tax. As shown in Figure Four, that leaves 36 percent to be saved or invested, which results in an ever-increasing ratio of financial assets to GDP. Simply put, there are a lot of people with excess cash willing to speculate on new and untested investments.
Figure Four: Spending as a Share of Income After Tax
Source: U.S. Bureau of Labor Statistics, Consumer Expenditure Survey, 2019
Should everyone participate? We don’t believe so. All of these investments have their own risk factors, which at times can be masked by ever-increasing returns. One could make a lot of money with a concentrated bet in a single stock like GameStop, but they could just as easily lose it as the price dropped 50 percent in a single day. One could increase returns through excessive leverage and derivatives like Archegos, but then see their portfolio move against them and be forced sellers at the worst time.
While SPACs, fractional collectibles, cryptocurrency, and NFTs may all have attractive returns relative to traditional assets, they are new and evolving ideas that haven’t experienced a true market dislocation. We want to be clear that we are not blindly dismissing these or any investment, but carefully considering the benefits and risks for clients in the context of their long-term objectives.
We will ask the same questions we do of any investment: Are the potential returns appropriate given the risk, and will this investment add value to an existing diversified portfolio? We think these are questions every investor should ask anytime they are considering committing capital to something new. For most investors, these Twilight Zone investments should represent very little of their overall portfolio, with the bulk of their portfolio in traditional assets that have stood the test of time.
 Reyburn, Scott, “JPG File Sells for $69 Million, as ‘NFT Mania’ Gathers Pace,” New York Times, 2021