What a crazy year this has been, and yet we are only two thirds of the way through it. With all that has transpired so far, it is a good time to check in and provide some investment perspective.
On September 2nd, the S&P 500 measure of US large company stock performance reached an all-time high, having increased in value by 60% (not a typo) from its March 23 lows and was actually positive for the year by 10%. A strongly positive return may seem startling, since we all know that this year has been anything but great. Just looking at the stock market’s return this year, you would have had no idea that we are still in middle of the first global pandemic in over 100 years, and with it, an associated high unemployment rate, questions of whether some businesses will ever fully recover, unprecedented government spending, and some of the worst levels of social unrest since the 1960s. With so much uncertainty still very much in play, what was going on? How could the stock market be so incredibly positive? Was it simply blind to the reality of present-day American life?
Optimism took a break though in the first week of September, and the downward trend we observed in the markets served as a good reminder that sentiment can change quickly, both positively or negatively. As an illustration of this fickle dynamic, let’s look at market darling Tesla which has been one of the strongest performing stocks this year. On August 11th, Tesla announced that it would split its stock: investors owning one share of stock at $2,213 per share would now own 5 shares at $442.6. If you do the math on this transaction, a stock split makes no actual difference to the value of the stock; however, for inexplicable reasons that have more to do with human psychology than rationality, investors almost always respond positively to such news. (When it comes to stocks, it’s like people would rather have five pennies than one nickel.) Tesla’s stock increased over 80% in the period between the announcement of the split and the actual split date. A week later though the tide had already turned and the stock price dropped by 21% in a single day. This was simply because Standard & Poor’s decided not to include Tesla in the S&P 500 benchmark, which many had viewed as a forgone conclusion for such an iconic and impactful company as Tesla. (It is somewhat ironic that on that same day that Tesla’s stock declined by 20%, the stock price of General Motors actually increased by 8% as it announced a significant joint venture with a company that has designed an electric truck that will compete with Tesla.)
Both the run-up in the market since the pandemic lows as well as the pullback we have seen in the first part of September can lead to anxiety and questions of whether the market might be headed for a bigger correction. As always, we don’t know what the market will do in the near term, but a discussion of market valuation levels may provide some perspective. There are competing perspectives of whether the market is presently overvalued and too optimistic, or simply being rational and looking forward to post-pandemic times where companies recover and growth returns to a normal path. The core assertion in the optimistic line of thinking is that present earnings are depressed by the pandemic but will recover once the economy fully reopens. After all, companies are valued on long term future earnings expectations, not just this year’s earnings (thank goodness). Even the optimist, though, must concede that markets are presently trading at relatively high valuation levels as compared to history. The question is: will businesses grow into their values by earning more as the economy recovers or will the market pull back a bit in a “correction” before that happens? No one knows, and in the end, it doesn’t truly matter since your portfolio is built for a lifetime rather than for just the crazy year at hand.
Market Evaluation: Is it too High or Not?
As is often the case, the question of whether “the market” is presently overvalued or undervalued is actually too general of a question because any market valuation level merely represents an average valuation of the constituent companies. There is always a very wide range of valuation amongst these companies, with some companies at extremely high valuations and others at extremely low valuations. The disparity has not been as great as it is currently since way back in 19991. To make matters even a bit more complicated, there is also currently a very large number of companies who are operating unprofitably. In part, this is due to the current economic situation, but it is also from having over 10 years of easy credit which has led to some poor decision making in deploying capital. When there is a large number of companies with negative earnings present in a market index, it can skew the averages and make it more difficult to gauge the reasonableness of valuation levels.
It is important to note that much of the market’s performance, as well as the increase in valuations, has been driven by just a small handful of extremely large companies, including Amazon, Google, Microsoft, Facebook, Apple, and Tesla. Investors have flocked to these amazing fast-growing businesses and have been willing to pay very large amounts to participate in their future growth. Many of these companies were already trading at high levels and their valuations expanded further during the pandemic since technology-oriented companies were considered the most obvious “winners” in a stay-at-home world.
Whether the current valuation levels of large innovative companies makes sense or not is a topic for a different article, but for purposes of the present conversation, suffice it to say that the average company has not performed as well as these large companies and is not presently valued as highly. The question is not really whether the market as a whole is overvalued, but whether an investor’s portfolio holds a reasonable mixture of companies that are priced appropriately relative to their prospects for future growth. This is why carefully balancing the portfolio by global geography, company size, sectors, industries, etc. is more important now than it has ever been. In fact, this is most true at times when such diversification seems to have made the least amount of difference.
Lessons from the Past: Is this Time Different?
The last time that we saw a market that favored large high-growth companies to this extreme was the Dot.com run up in the late ‘90s. Then, as now, large growth-oriented tech companies outperformed all other stocks to a degree that some investors (as well as some investment managers) started to question whether the economy had changed so much that all other industries are no longer as valuable as they once were. Many are unaware, though, that much of the late-stage price run-up in the ‘90s was attributed to unprecedented investment participation by small “retail” investors who flocked to participate in the market fearing that they were missing out. It is interesting to note that small retail investors’ ability to trade the markets increased dramatically in the late ‘90s thanks to the advent of online trading platforms such as E-Trade, as well as the creation of Exchange-Traded Funds that enabled investors to buy and sell throughout the day (“day trade”) like stocks, rather than once a day as is the case with traditional mutual funds. This widespread access to online trading capabilities were considered contributing factors to the run-up before the Dot.com crash, as well as to volatility as the market pulled back.
With this as context, it is extremely interesting to observe that much of this year’s trading in large high-growth companies has been driven by smaller investors, which contributed at least in part to the meteoric rise in tech stock prices since March. In fact, small investors have been flocking to trade speculative options on these large growth companies at record levels. But why now? In the past, small investors have had a difficult time trading in speculative options because trading such securities required filling out an application to demonstrate that one has sophisticated investment knowledge and is aware of the risks that they are taking. However, such hurdles have been rapidly diminishing through the “democratization” of investments via online trading platforms such as Robinhood. These platforms have enabled more small investors to trade in speculative securities that can be quite dangerous if they are used improperly. As was the case in the ‘90s, brand new platforms provided the capability for average investors to trade more aggressively than they had been able to trade in the past.
New investment capabilities can be a double-edged sword. While better access to investments and lower costs are good things, an increased ability to trade quickly and speculatively can be harmful. This is sad, but is not too surprising. Studies consistently show that the average investor performs much worse than the market does due to the emotional cycle of getting in and out of investments at the wrong times (i.e. buying after the market has run up and selling when it is going down). Easier and less expensive access to trade more sophisticated investment vehicles simply magnifies this already-existing dynamic, essentially enabling undisciplined investors to harm themselves even more.
What lessons can we learn from this? First, and most obvious, it can be dangerous to chase high-performing stocks after they have already performed extremely well. Second, when widespread investment market participation by smaller investors drives market returns up, we should also be ready for it to drive returns back down. The short-term mindset that often occurs at times like this comes with a tendency to both buy and sell things quickly. We saw hints of this in the first few trading days of September. Whether this dynamic will continue or not is difficult to say, but we should not be surprised if it does.
So far, we have discussed economics and valuations, which may bore half of you to tears (if you are still reading at all). But why is the market seemingly ignoring the fact that our country is so restless and seems to be coming apart? It turns out that this is not a new phenomenon, just most of us simply cannot remember anything quite like it in recent times. In fact, one must go back into the 1960s to find another time that was quite as unsettled as the present time from a social perspective. In that decade, JFK was assassinated, Martin Luther King Jr. was assassinated, there were massive riots in protest of racial and social inequalities, and there were widespread protests for our involvement in the Vietnam War. American values were rapidly changing and people were far from united. The simple reality is that there have been times in the past, as we are now, where we have been more focused on our differences than on the things that we have in common. What did the market do during the extremely unsettled decade of the 1960s? For the most part it went up.
Even apart from the extremely unusual year that 2020 has been, we also have an election coming up very soon. Normally we would have received a lot of questions by September of an election year, but this year there have been so many other things to think about that the election has just now finally started to feel front and center. Here again, history tells us that the markets will largely ignore the outcome of the election. Many sectors and industries have already begun to shift and adjust to the expected outcome, with industries like clean energy rising in anticipation of polls indicating that Biden is favored to win. But, as we learned in 2016, polls can change rapidly and they are not perfectly accurate. So what to do? Again, maintain balance and diversification. If you do not try to guess the winner, then you cannot lose. As the adage goes, never put all of your eggs in one basket.
Reflecting back, it is really quite interesting how quickly and suddenly the events of the year came upon us. We still recall having many upbeat conversations (in person!) with investment managers in February about how the year would likely be one that continued to be modestly positive and where nothing too anxiety-inducing was on the radar for the economy or the markets. What a difference a month made, and ironically, no one had “2020” vision ahead of time. The events of this year provide a very good example for why maintaining balance makes sense out of recognition of the fact that no one can see the future.
If you are anxious or unsettled, please let us know. This year has tested most of us mentally and emotionally in our own unique ways, and possibly more than we are even consciously aware of. We are always on the look-out for times when it makes sense to adjust your portfolio. However, if you are anxious about anything, whether it be COVID-19, the economy, societal tensions, the election, or anything else, we are always available to provide perspective. At times like this it can provide comfort to simply revisit your forecast to provide confidence that you are still on track and to evaluate if there is anything you might consider doing now to alleviate anxiety, such as trimming your exposure to stocks. We look forward to these conversations.