Market Commentary | The Twilight Zone - CAPTRUST

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Monday, April 12, 2021

Market Commentary | The Twilight Zone
As we enter the second quarter of 2021, CAPTRUST’s Nathan Erickson shares some
perspective as the landscape of investing continues to evolve in unique and sometimes
strange ways. Read on for a recap of the first quarter’s events, a look at the
development of new investments that sound like science fiction, and a few potential risks
and opportunities investors may want to carefully consider.

“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.

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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

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Source: Morningstar

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

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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.[1] 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.

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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

Source: FRED

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

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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.

[1] Reyburn, Scott, “JPG File Sells for $69 Million, as ‘NFT Mania’ Gathers Pace,” New York Times, 2021

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Author(s)

Nathan Erickson, CAIA, CFA®
https://www.captrust.com/people/nathan-erickson-caia-cfa/

Legal Notice
This document is intended to be informational only. CAPTRUST does not render legal, accounting, or tax advice.
Please consult the appropriate legal, accounting, or tax advisor if you require such advice. The opinions
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written permission of CAPTRUST: 919.870.6822.

© 2021 CAPTRUST Financial Advisors

© 2021 CAPTRUST Financial Advisors                               Market Commentary | The Twilight Zone | 7