June 01, 2019
What, Me Worry?
There is an old saying that bull markets climb a “wall of worry”. I was prompted to think about this by the news that iconic MAD magazine will cease publishing after 67 years. No longer will we see the smiling face of Alfred E. Neuman. Like Alfred, investors do not seem worried as the market hits new highs in spite of ongoing trade disputes and signs of a global economic slowdown. The VIX, the so-called “fear index”, remains contained and heading back down toward lows. Meanwhile, stock valuations are high by historical standards. Should we worry?
I think about this often but always end up with the same conclusion. There is one overarching factor driving markets: easy credit conditions and low interest rates resulting from stimulative central bank policies in most major economies. It is a well-established fact that lower interest rates lead investors to pay more for stocks. So when the market expected the Fed to keep raising rates last fall, it sold off to December lows but then recovered quickly when the Fed reversed policy by indicating future rate cuts.
Now it seems we are in a positive Catch-22 situation. Stock prices are a function of earnings and the multiple investors decide to pay for those earnings. The global economy is weak enough that an outright trade war could push it into recession. That would cause earnings to decline, so bad for stock prices. But that same scenario would motivate central banks to provide further stimulus through even more monetary easing and lower interest rates. That would tend to push stock valuations higher, offsetting the negative effect of lower corporate profits.
So there is nothing to worry about, right? Yet one wonders how long this can go on given that debt levels are at record highs almost everywhere. Consider that we are seeing the most negative-yielding bonds in human history at $13 trillion US dollars (that is “trillion” with a “t”), according to Mark Grant of B. Riley FBR Inc. citing Bloomberg figures. So borrowers are being paid by lenders to take on $13 trillion of debt. There is no better indication of too much money sloshing around, a lot of which ends up in the stock market. But there is no reason to expect central bank policy to change any time soon, certainly not until after the American elections next year.
So I am not worried about central bank policy or interest rates running away to the upside any time soon, especially with inflation remaining tame. However, there are five characteristics of today’s equity markets that do give me some concern. They are interrelated and, together, could increase the risk and severity of a downturn.
First, extreme liquidity has resulted in large pools of professionally-managed “hot” money that accounts for most of the trading on exchanges, with a lot of it driven by computer algorithms. They focus only on momentum rather than any evaluation an issuer’s underlying business fundamentals. This contributes to the next characteristic, which is that the market is very focused on short-term performance judging by often extreme reactions to the latest quarterly earnings reports. Yet this seems to be in conflict with a third major market trend, which is the high premium being placed on “growth” with disregard for traditional “value” stocks or the rate of return on invested capital. The market will pay up for companies with high future growth expectations yet, at the same time, it wants immediate results. This can lead to over-valuation followed by sharp corrections when quarterly “guidance” falls below expectations (that are often unrealistic).
The remaining market factors I have written about before in “A New Era of Investing” and “ETFs and Market Timing”. Our industry has trained a whole generation of investors to assess the performance of their portfolios based only on comparisons with market index benchmarks. (Instead, you should be asking whether the returns you achieve are meeting your goals and whether your risk level is appropriate.) At the same time, the most significant trend in equity money flows has been out of actively managed portfolios and into passive ETFs. Instead of outperforming an index, investors are happy to simply own the index, minus a small fee. This means that no attempt is made to try to distinguish between good investments and bad, between businesses with a future and those with outdated business models that risk being overwhelmed by transformational technology.
So what to do? Alfred E. Neuman might say “stop worrying – do something”. Given the concerns just mentioned, I can see considerable advantages for an investor with two simple but powerful character traits: patience and the ability to work hard to find good businesses with excellent management to own for the long term. First, you need patience to wait for opportunities to acquire such businesses at reasonable valuations instead of chasing a rising market. Then you need patience to let those businesses grow over time, and to wait for the market to recognize their true value. None of this is easy, but nobody ever said investing was easy (even though passive investing might seem that way).
Finally, for those who can take the long view, I will relate a lesson from an great professor of mine, Prof. Tom Langan. The course was the philosophy of history focusing on Hellenic civilization. He taught that civilizations grow by focusing on a “fundamental project” that brings everyone together to co-operate in achieving some great idea. The Egyptians and Mayans built pyramids, for example. In America, the 19th century saw the construction of railroad networks to open up the West. In the early 20th century, there was the advent of the motor vehicle as well as electrification. Then we had the digital age and the internet. These fundamental projects attracted a lot of investment capital. I suggest there are two fundamental projects underway at present that should demand investor attention: the build-out of 5G networks and the boom underway in American natural gas from shale deposits. These two projects will go ahead regardless of central bank policy or whoever might win the next election.
In summary, you can keep from worrying if you own good businesses with a future that will do well regardless of trade wars, interest rates, or economic cycles.
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Markets Inc. 2020