n these missives, we
have often emphasized (some might say
ad nauseum) the importance of taking a
long view when making investments. In particular, because they represent
the ownership of businesses, equity commitments should not be entered
into lightly or exited on a whim. Additionally, since we take the
traditional view that the non-equity balance of a portfolio should
provide stability and income (and serve as a source of capital for new
investment opportunity), it should also be approached with a long-term
perspective and change infrequently.
Events in 2020 proved to be extremely
challenging to those who hold dear this fundamental principle, for
underlying it is the assumption that despite the vicissitudes of
history, things will mostly continue on as before, even after a
traumatic interlude. While affirmed by history, such a stance has been
difficult to defend and maintain during a seemingly never-ending public
health emergency. A population of doomscrollers, confined to their homes
and incapable of imagining an end to the crisis, nods in agreement with
every pundit who foresees a future in which our lives will never be the
same. Maintaining a stable investment policy in the face of such
pessimism might seem to some as “putting principal at risk for the sake
of principle.” Nevertheless, events over the course of 2020 demonstrated
once again the value of patience (as well as experience) when dealing
with daunting circumstances. We have been through depressions, wars, and
financial crises before; from that perspective, 2020’s pandemic-induced
economic heart attack is just another cataclysmic event from which we
will eventually recover.
In fact, the final results for 2020, in the US
and other equity markets, was quite “normal.” The numbers — 18.4% positive
for the S&P 500 index — came in above long-term averages for the US
(9-10%), and well within the usual range of fluctuation around the
average. But as we all know, last year was far from being normal; over a
timespan of about four weeks in late winter, stocks suffered their most
violent sell-off in history (the S&P declined 34% in that brief period).
Yet come November, equities enjoyed their greatest rise for that month
on record. Flows of cash into equity funds exploded in the Fall as well.
Last March, who would have thought we’d be discussing the dangers of
market euphoria before year’s end?
Additionally, the arbitrary period of a calendar
year, according to which we measure our financial affairs (and most
everything else) introduces an element of artificiality into our
measurements and prompts us to think about the granularity with which we
view market fluctuations. 2020 is only one example of a year where a
robust annual result glossed over a period of violent movement, despair,
and euphoria. Similarly, the S&P’s respectable 5.2% gain in 1987 capped
the year of Wall Street’s Black Monday. 1999’s 21% result came in
defiance of declines in the broad market of stocks (like 2020, the index
was boosted by a few technology issues). Going in the opposite
direction, 2000’s negative 9.1% reflected the collapse of the Dot Com
bubble, but thoroughly obscured the broad upswing in non-technology
sectors that took place that year. One could point out many other
examples in which a single end-of-year number belied the momentary
passions that so enthrall the witnesses of events in real time. This
fact itself speaks volumes for the value of a long-term view.
How closely should we pay attention to the
fleeting moment, when even an annual figure — the net result of twelve
months of market give and take — has in itself so little value beyond just
summarizing the end result of that year? After all, did 1974’s negative
26% return for the S&P 500 tell us anything useful about subsequent
results during the balance of that decade (the indexes were flat). Was
1981’s negative 5% predictive of the great bull market that began the
following year? Was 2008’s negative 36% relevant to the relentless rise
over the next twelve years? Many have expressed bafflement at how,
despite the gloomy, uncertain future outlook this year, the market rose.
The point is, as we have said before in many different ways and
situations, over the long haul, businesses in the aggregate are
indifferent to calendar years and to the constantly shifting winds of
human emotions. Businesses and markets respond instead to underlying
economic realities.
Far from being an academic exercise or idle
speculation, these questions are important for investors. Financial
markets were under no obligation to bounce back so quickly from their
March lows; what if they had not done so? While the majority of market
gains accrues to the wealthier elements of society, not all of it does;
anyone owning mutual funds in a retirement plan benefits as well. Had
securities entered an extended period of doldrums (such as occurred
after the 1974 crash alluded to above), would less-sophisticated
investors have been tempted to flee stocks and bonds entirely? In the
late 1970s many turned fruitlessly to more exciting and exotic
instruments such as commodity contracts and options (while ignoring
cheap equities) — Bitcoin anyone?
History has repeatedly demonstrated the value of
the long-term view. Keeping that perspective and acting rationally even
when the rewards are not immediate, has consistently proven to be the
wisest course.
Throughout 2020 financial observers looked on in
disbelief at the markets’ relentless rise, even as a real-world
catastrophe unfolded. The initial positive market moves came early on,
in March and April, in response to aggressive actions by monetary
authorities, followed by impressive fiscal measures as well. Such
forceful responses tend to have a positive effect eventually, but many
market participants at the time downplayed them, requiring good news
about controlling the pandemic before committing themselves to any
bullish view of the markets. The good news finally came in November in
the form of promising results from vaccine trials, but by that time the
market trough of March was rapidly receding in the rear-view mirror. The
markets had risen with vigor since March, but it was the good news on
vaccines that fueled a surge in November, turning that month’s results
into the best for any November on record. The amount of cash flowing
into equity funds also reached a record for the month. The surge was
universal as an “everything rally” broke out on exchanges worldwide.
At year-end, many
observers and the financial press were warning once again of dangers
arising from enthusiasm. “A Speculative Frenzy is Sweeping Wall street,” blared a Bloomberg
headline. “Market Heads Toward Euphoria,” claimed the
New York Times.
One observer said we were in a “raging mania,” while another
(paraphrased by Bloomberg)
said, “Sell U.S. stocks now to avoid an unprecedented bubble.”
While these fears may sooner or later prove to
have been justified, we have found that acting on them is an exercise
better left to professional traders, not investors, and certainly not
the novices at online trading platforms who seem to hang on these
pronouncements. However, we do believe it is useful to think about the
future in general terms. For example, we believe that, for the
foreseeable future, capitalism and private ownership will go on as
before, people will invest in securities, and the economy will wax and
wane. As difficult as it may be to imagine at present, people will live
normal lives, though perhaps with some modifications as a result of the
health emergency. We adapt; “twas ever thus.”
We also find more
far-reaching and thoughtful analyses, such as the one presented by
Martin Wolf of the Financial Times
in a recent piece about the future direction of inflation and interest
rates (FT, Nov 17, 2020), to be insightful. Wolf describes how
developments of the last forty years — the opening up and growth of China,
the expansion of world trade, the collapse of the USSR, demographic
trends producing youthful populations — have served to favor capital over
labor, suppress wage pressures, and create a savings glut. What has
emerged is an era of falling inflation and interest rates that benefited
the global economy, and fueled rising asset values, debt, and
inequality. This state of affairs may be changing. Western nations face
aging populations, meaning fewer younger workers to support their
citizens, and China, too, is beginning to see this trend. Hence, the
relative position of labor may strengthen, leading to upward pressure on
remuneration. While a welcome development for left-behind segments of
society, this could mean higher prices and inflation. Under those
circumstances, the falling trend of interest rates we have experienced
for decades may be coming to an end. If so, that could result in a
future very different from the one that investors have experienced since
the early 1980s.
Separately, with respect to the existence of a
stock market bubble, Wolf maintains that current valuations are
reasonable, given that interest rates are exceedingly low, even
negative, in “real,” or inflation-adjusted terms. In financial
terminology, when a company’s future earnings are “discounted” at a low
rate of interest (the “discount rate”), a higher “present value” is
calculated (think of a stock’s price as the market’s estimate of the
value of all future cash flows, discounted to the present). In layman’s
terms, when rates offered on earning assets are very low, stocks are
“the only game in town.”
So the question of whether current stock prices
are excessive boils down to whether current interest rates are
reasonable. So far, market participants have concluded that they are,
and that they will remain so for an indefinite period going forward, as
high valuations indicate an equally high level of confidence in the
status quo. If, as Wolf explains, there are forces afoot that may upend
this happy state of affairs, a reassessment of the relative valuations
of the equity and fixed-income markets could take place. Given the
unpredictability of future rate movements, that reassessment could take
place gradually, or with unexpected rapidity.
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