EEP CALM and CARRY ON. The people who came up
with that slogan over eighty years ago arguably faced a more insidious
peril than mere investors did in early 2020 when the reality of the
Covid pandemic dawned on the markets. Yet wartime Britons persevered and
maintained their spirits. The same cannot be said of financial market
participants recently, who reacted in panic, triggering the most rapid
market collapse on record. Even today, after seeing the markets defy
doomsayers to reach new highs, investors remain nervous, and have
resorted to hedging strategies in record numbers to protect themselves
against a feared market reversal. Had investors maintained their
equanimity, and looked beyond the fears of the moment, they would
undoubtedly be better off today, having avoided unfavorable selling and
the anxiety of trying to second-guess the markets. This was the case in
all market crises in the last century, at least in the U.S., but it
could be argued that one day a crisis will come along which results in
lasting misery and extinguishes capitalism as we know it. Anything is
possible, but so far, the markets have always recovered from even the
worst downturns.
Signs of the times: easy money and high animal
spirits. Following a record year for tapping the markets in 2020,
corporate entities of various kinds took out loans and sold stock and
bonds to raise over $12 trillion in 2021, besting the prior period by
seventeen percent. Established issuers did their share of fundraising,
but it was the speculative sectors that made the difference in 2021.
“Special Purpose Acquisition Companies” (i.e., “SPACS,” corporations
that have no business, but hope to find one soon) found favor early in
the year although they fizzled out by summertime. Initial stock
offerings boomed, up twenty-four percent globally, and doubling in the
U.S. to a new record. In addition, massive loans funded hot merger and
acquisition activity. Such episodes of devil-may-care finance usually
end poorly for the buyers, and already there are indications of
potential weakness in poorly received IPOs; an index of the performance
of the U.S. market for newly public companies was down eight percent at
year-end. Likewise, an index of global bonds worth $68 trillion fell
nearly five percent, the worst year in over two decades, as rising
inflation and possible changes in central bank monetary policies led
some to fear an end to the forty-year bull market in fixed-income
instruments.
This turnaround from the situation in early
2020, when markets collapsed and economies ground to a halt in the face
of the pandemic, is extraordinary — a turn of events that few could have
imagined at the time. One statistic stands out: the U.S. stock market
staged its fastest ever recovery from a big plunge. Following its 35%
drop in March-April 2020 when the pandemic scare was getting underway,
it took only five months to recoup the losses. By way of contrast,
recovery from the Great Financial Crisis of 2008 took over four years
for the S&P 500 and NASDAQ indexes, and the latter did not scale its
dot-com bubble heights until late 2017. After the Great Crash of 1929,
markets required twenty-five years to get back to pre-crash levels. In
March-April 2020, commodities also saw incredible price volatility, but
after crashing to sub-zero dollar levels, crude oil futures returned to
pre-pandemic prices within a year and rose 55% in 2021, the biggest
annual increase since 2009. As in many facets of modern life, the
vicissitudes of finance happen at a much faster pace than ever
experienced before.
Reflecting the exuberant demand for financial
assets, prices for most rose strongly in 2021, building on their
recovery from the initial pandemic shock nearly two years ago, and
moving on to multiple records over the course of the year. The S&P 500
reached a record closing high on 70 occasions, the highest count since
1995. It should be noted, however, that much of the gain was
attributable to a small number of issues, as broad swaths of the stock
list remained below earlier highs. Nevertheless, for the third
consecutive year the major U.S. equity indexes sported double-digit
returns, rising 20% to 29%, depending on the index — remarkable results
given the ongoing and increasing complexity of the Covid crisis.
Fixed-income returns were modestly negative, but in fact they were the
worst results in forty years after accounting for inflation. Even so,
the poorest showing since Volcker was Fed Chair did not deter issuance
in the face of relentless yield-seeking in all corners of the bond
market.
It seems unlikely that 2022 will see yet another
year of gains that are well in excess of long-term equity averages.
Valuations are already very high by almost any standard, and rampant
speculation in such areas as “meme” stocks and options would indicate
that we are well along in the “greater fool” process. Yet the same could
have been (and was) said of market conditions a year ago, and the
markets rose strongly despite daunting challenges. Looking ahead, the
potential roadblocks seem formidable — rising geopolitical tensions,
inflation, and declining economic stimulus, to name a few. Much of the
market risk depends on the extent to which these concerns are already
“priced in” to stock valuations; we suspect that to a great extent they
are. Then there is the “unknown unknowns.” The surprises in 2021 turned
out to have been benign to markets. We will see what 2022 brings.
Behind the almost one-way rise in stock markets
since March 2020 has been an avalanche of money from “retail” investors,
or individuals. At least to some extent, this was fueled by government
stimulus programs. Success breeds success, and those riding an
upward-sloping curve can and do win big, attracting the attention of
others who have money burning a hole in their pockets, and there is a
lot of money in those pockets nowadays. In early December the
Financial
Times reported that cash inflows into retail-facing funds had reached a
record. Other reports showed that stock funds had taken in more cash in
2021 than in the last nineteen years combined. In addition to using
available cash, borrowing on margin has also been popular, sending
margin debt to near peaks. A significant amount of the torrent of cash
has been facilitated by new technology, including mobile telephone
trading apps intended to “democratize” share trading. We weren’t aware
than buying stocks is undemocratic (it’s called “free enterprise,” after
all), but we’ll concede this point to the trader bros, as long as they
don’t democratize gains and “socialize” losses, a game we have seen
practiced far too often by the entrenched hierarchy they supposedly aim
to unseat. When the slope of the curve turns negative, we’ll see how
strongly these “democratic principles” are held.
Public interest in markets has not been confined
to the U.S.; it has become a global pasttime. Retail trading in China
has been popular for years, but in India — China’s neighbor and sometimes
rival — participation by small players (some with only a few hundred
dollars equivalent) has recently soared. As reported by the Financial
Times in an article entitled “Millions of Indians join pandemic-fueled
rush into retail investing,” nearly twenty million Indian “investors”
have registered with the national stock exchange, where retail trading
now accounts for forty-five percent of share volume. As in the U.S.,
technology has fueled the increase by making markets easily accessible
to anyone with a smart phone. And as often happens in these frenzies (in
the beginning, at least), some novices make more money from trading than
they do at their jobs, enticing friends who hope to do the same.
The interest in stocks is not confined to retail
punters; professional investors are also keen participants. Here the
fear of missing out (“FOMO”) on future gains takes on a different
character. As we have often noted in the past, institutional investors
are motivated by competitive pressures, most notably the aim to
“outperform” other funds and benchmarks. To be fair, their position is
often complicated by poorly-timed inflows of customer money, usually
after markets have already risen appreciably and investment
opportunities have withered as a result. Still, institutional
imperatives require that all money be “put to work” — investment
principles be damned. This, too, is a worldwide phenomenon. In addition
to the onslaught of retail investors, Indian investment funds have also
grown strongly — up sixty-eight percent in the past year — providing an
additional boost to stock prices.
As is often the case, this sort of financial
folly will likely end badly for those caught up in the tail end of the
speculative rush. Professional investors should know better. Retail
enthusiasts for the “democratization” of investing may discover the
downside of “participatory democracy” when it comes to financial
markets.
Finally, the fourth quarter of 2021 marked the
twentieth anniversary of the collapse of Enron, an event that was little
noted, perhaps due to the press of current concerns. The infamous Texas
energy company, felled by management deceit and shady accounting
practices, took down a big accounting firm and left the investment
community nursing wounds. There are few better examples of poor business
and bad investment behavior and judgement; thus, the name “Enron” has
become synonymous with crooked corporate practices.
Investors who bothered to study the freely
available public information about Enron in its heyday could discover
that there was “no there there;” the business produced little in the way
of real cash flow. Nevertheless, investment funds were heavily committed
to its shares. This was due to the fact that only months prior to its
demise, Enron was one of the most valuable public companies in the
investment universe, figuring prominently in the stock indexes; failing
to own the stock, therefore, entailed a risk of negative “performance”
relative to an index. In the end, by ignoring investment facts and
principles, many investors suffered poor absolute performance instead.
Enron is a lesson that serious investors should
take to heart; it is particularly relevant today, when, once again, a
relatively small number of very large companies dominate a very
expensive stock market, thus skewing the indexes. Dealing with weak
relative results can be embarrassing and difficult to explain, but
suffering absolute losses is painful, made more so when the evidence for
avoiding them is readily at hand for those who take the trouble to look.
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