Category: Market Commentary

“Investing is a popularity contest, and the most dangerous thing is to buy something at the peak of its popularity. At that point, all favorable facts and opinions are already factored into its price, and no new buyers are left to emerge.” 

– Howard Marks

By John Goltermann, CFA, CGMA

Investors could really increase their chances for success by applying lessons from some of the best investors of all time. Howard Marks is one of them. Charlie Munger, Stan Druckenmiller, Warren Buffett and Seth Klarman are a few of the others. Two common themes emerge from their observations about successful investing:

1. The importance of temperament
2. The ability to be skeptical of what the “crowd” is doing.

Howard Marks stated it best when he said, “You can’t do the same things others do and expect to outperform.” Included at the end of this piece are more of Marks’ notable quotes.

It has been a quiet summer so far. Apart from Fitch’s downgrade of US government debt and Moody’s downgrade of a big chunk of the banking sector, it has been mostly drama-free. However, these developments do highlight more significant long-term issues. Stock prices have drifted higher over the last few months but during the month of June, the rally broadened out from its narrow leadership of mega-cap tech companies to include most stocks. The equally-weighted S&P 500 is now up around 9% since May 31.

Interestingly, this happened amidst rising interest rates. The 10-year treasury yields traded up from 3.65% on May 31 to 4.21% as of this writing (August 14). Ordinarily, rising rates are bad for stocks but financial conditions have eased,(see below and note: a declining line depicts easing conditions). Factors that can ease financial conditions include rising stock prices, rising home prices, declining interest rates, tightening bond spreads (yields over Treasuries), declining dollar, and declining energy prices.

Two beliefs on what’s ahead

Financial conditions are interesting for explanation but have limited predictive use. For the future, there are two primary schools of thought on how things will go. One is the belief that the economy currently has all the elements and signals to pull off a soft landing. This is what the consensus now believes and has mostly priced in. The other school believes that the soft-landing scenario is a lower probability than what is currently expected and that recessions are unpredictable. In fact, recessions and difficult markets tend to hit right at the moment the consensus believes they are not coming. This happens to be what I believe.

Look out, not down

There is no way to know for sure; everyone is out there guessing. Market prices do not move in a straight line. Traders react to headlines and those reactions cause follow-on reactions. What we do know is that debt levels are high and probably due to interest rates, (the cost of credit)being suppressed by the Fed for a long time. We know that interest rates has risen significantly. We know that COVID policies caused dislocations. We know that many institutional investors are restricted from investing in traditional energy sources. We know that technology stocks have dominated returns over the last 14 years and now comprise 38% of the S&P 500. We know that markets eventually revert to the mean. We also know that the same eight Wall Street darlings of the last 10 years, (Microsoft, Apple, Google, Amazon, Facebook, Tesla, Nvidia, and Netflix) have outperformed everything this year and trade at valuations that imply massive profit growth for a very long period of time. We can take these observations and begin to form an investment strategy using time to our advantage.

A late stage – not new – bull market

Because the same eight stocks skyrocketed this year using ‘AI’ as justification, it tells me that it is possible that we are still in the late stages of a 14-year bull market and last year’s decline was a simple correction. New bull markets usually see different leadership. Apple is now down 10% from its recent high, Nvidia is down 12% and Tesla is down 18%. Some of the froth seems to be coming off in the more speculative stocks. What never made sense to me was this year’s massive stock price rally because it did not tie to improving operating results. Revenues have been flat to down over the last few quarters. The runup in the Magnificent 8 was largely due to multiple expansion and “forward looking statements” not actual results. But lots of things in markets do not make sense.

Prioritize longer-term value over rapid growth

What does this mean? A cautious approach using a value-oriented investment process is still in order. Financial conditions can deteriorate quickly and rampant speculation by leveraged traders abates when they do. We do believe we are in the early stages of a long period when a value approach to stock investing will outperform a momentum based or growth-oriented approach simply because of mean reversion and the expectations implied by the prices of today’s tech stocks are overly optimistic.

It is important to remember that drama free periods are interrupted by drama filled periods. Low volatility predicts high volatility. This is not a reason to change tack or do something different – it is just to mentally prepare for times when conditions change, and if scary headlines start coming in. During those times it is important to take pause to consider what is happening, what it might mean and what to own on the other side of it. Owning good claims on valuable businesses that are well-priced is the best protection from having to do anything rash when conditions change. The people who own high-flying and popular stocks can worry about that.

Additional Investment Wisdom from Howard Marks

“The safest and most potentially profitable thing is to buy something when no one likes it.”

“To beat the market, you must hold an idiosyncratic and non-consensus view.”

“Not only should the lonely and uncomfortable position be tolerated, it should be celebrated.”

“Investment risk comes primarily from too high prices, and too high prices often come from excessive optimism and inadequate skepticism and risk aversion.”

“For investing to be reliably successful, an accurate estimate of intrinsic value is the indispensable starting point. Without it, any hope for consistent success as an investor is just that: hope.”

“The difference between successful people and really successful people is that really successful people say no to almost everything.”

“Investment success doesn’t come from ‘buying good things’, but rather from ‘buying things well’.”

“I like to say, ‘Experience is what you got when you didn’t get what you wanted’.”

“When you boil it all down, it’s the investor’s job to intelligently bear risk for profit. Doing it well is what separates the best from the rest.”

“Many of the great financial disaster we’ve seen have been failures to foresee and manage risk.”

The truth is, the herd is wrong about risk at least as often as it is about return.”

“The possibility of permanent loss is the risk I worry about.”

“Nothing goes in one direction forever. Cycles always prevail eventually. Just about everything is cyclical.”

Can a measurement of time be defined here? Is this true over the past 10 years?

By John Goltermann, CFA, CGMA

Relative to the S&P 500, the first 5 ½ months of the year have been rough for value investors. The S&P 500 is up 15% year-to-date (as of this writing), but value indexes are up 4% year to dateⁱ. The S&P 500 does not tell the real story with what is happening with stocks. The Dow Jones Industrial Average is also up 4%, the equally weighted S&P 500 is up 6%, and dividend-paying stocks (as measured by the iShares Core High Dividend ETF) are down 1%ⁱⁱ. In fact, the S&P 500 without the top 5 stocks (Apple, Microsoft, Google, Meta and Nvidia) is up 3%ⁱⁱⁱ.

Why the performance difference?

There has been a huge increase in the prices in technology stocks and the tech sector is 36% of the S&P 500^iv. Most other sectors are flat to down. The difference between growth indices (50% tech) and value indices has been enormous. Growth indices are up 28%, marking a 24% return difference to value stocks in 5 ½ months^v! I have never seen such large internal difference in returns between styles over such a short period of time.

It is one thing to make these observations, yet another thing to explain why. And even another to forecast this kind of price action and position for it. What is happening?

The vast majority of the daily trade is driven by algorithms, not people. As liquidity comes back into the market post-banking-crisis, much of it gets funneled automatically to the largest positions in the S&P 500 (Microsoft, Apple, Amazon, Google and Nvidia) simply because the largest weights are in those stocks. This happens without regard to risk or valuation. Two stocks alone, Microsoft and Apple, account for over 14% of the S&P 500^vi.

The chart below shows the relative resurgence of tech stocks in 2023. This is mostly led by artificial intelligence (AI) speculation/hype but is probably also largely due to levered speculators unwinding their short tech/long energy positions that they had on through 2022. Why? Because borrowing rates have increased significantly. Therefore, ironically, the tech rally is a form of de-risking. As a result, the S&P tech sector’s relative performance to the rest of the S&P 500 is now beyond where it was at the top of the tech bubble in 2000, and back above its peak in 2021. This is likely a short-term phenomenon, and there is high risk in those positions.

You can also see from the chart above what happened after 2000. There remains significant risk of permanent losses in tech positions as they trade very expensive (on metrics such as price-to-earnings and price-to-sales ratios). Because the algorithms that submit buy orders care very little about how much they pay for those stocks. But as Herb Stein (economist) says, “That which cannot continue forever will stop”.

This level of index concentration in technology strengthens the case for long-term investors to ignore the hype and continue to invest with a margin of safety. AI is the Wall Street hype du jour, so it’s attracting momentum players. But fundamentally the case to own them on a long term (valuation) basis is flimsy as their stock prices imply massive future growth rates that are not likely to materialize. This is the nature of today’s markets…hot money players swinging in and out of positions without regard to valuations.

As an example of extended valuations, according to the modeling work one of my friend’s, David Trainer of New Constructs performed, the $380 recent share price for Nvidia implies heroic future operating results for the company: a 20% revenue growth rate for 20 years, an improvement in operating profit from 27% to 44% and an increase in return on capital from 26% to 778%^vii. An unlikely future outcome to say the least, but very few care about the economic reality of these businesses — at the moment.

And what about dividend stocks? They have been disinvested because income seekers can earn 5% in cash. It’s that simple. But this is not a permanent state: Dividend stocks tend to outperform the market in inflationary times and carry much lower price volatility. Stocks that pay dividends tend to be of businesses that have a much greater ability to raise prices in inflationary times. And apart from that, their earnings tend to be high quality as they pay a portion of it out in cash.

What are we doing about all of this? Nothing. Apart from staying focused on the companies we own, and the companies we would like to own (but are too expensive), we have no plan to react to what is happening in markets. We will stick to our process and ignore the short-term noise. It does not pay to chase performance or get caught up in the ululations of Wall Street or the financial media. Our portfolio holds good stocks of good companies. Very little has changed fundamentally from 5 months ago. Just the prices, perceptions and investor preferences have changed.

Our goals are to earn you high returns without overpaying and without taking on risk of permanent losses. It is important to remember that market prices, and changes in those prices, reflect the mishmash of behavior of a bunch of actors (including the programmers of trading algorithms) that operate out of a fear of losing their jobs. It is that simple. For the time being, traders are in the mode of buying AI companies, and selling everything else. But as we see from experience, what happens in the most recent past in markets does not last as economic reality eventually sets in. Valuations and investment fundamentals win out in the long run.

Investing involves risk including the potential loss of principal. No investment strategy can guarantee a profit or protect against loss in periods of declining values. Past performance is no guarantee of future results. Please note that individual situations can vary.  Therefore, the information presented here should only be relied upon when coordinated with individual professional advice. The opinions expressed here are those of the author and do not necessarily represent the opinions of Securities America, Inc.

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[i]   S&P Global data as of June 15, 2023
[ii] S&P Global data as of June 15, 2023
[iii] S&P Global data as of June 15, 2023
[iv] S&P Global data as of June 15, 2023
[v] S&P Global data as of June 15, 2023
[vi] S&P Global data as of June 15, 2023
[vii] Fortune Magazine, May 25, 2023.

“There are only three ways to meet the unpaid bills of a nation. The first is taxation. The second is repudiation. The third is inflation.”

– Herbert Hoover

By John Goltermann, CFA, CGMA

Developments in markets have been moving so quickly that I have had to revise this piece several times since I started it last week.

Last week, some downward pressure came back into equities when Jerome Powell suggested in his Tuesday March 7 Congressional testimony that the pace of future rate hikes may increase. Specifically, he said, “If the totality of the data were to indicate that faster tightening is warranted, we would be prepared to increase the pace of rate hikes.”

Immediately after Powell’s comment, the probability (as measured by the CME FedWatcher tool) of a 0.50% (50 basis points) Fed rate hike at the upcoming March Fed meeting increased from 31% to 66%. One month ago, the probability of a 50 basis point hike in March was nearly 0%. Stocks, as measured by the S&P 500 fell 4%.

Then to pile on, Silicon Valley Bank’s (SVB) distress last week and bailout on Sunday created rumbles through markets and bank stocks declined broadly. Typically you don’t see bank blowups during strong economies and bull markets, so this hit the confidence of equity investors and volatility increased a bit.

After the SVB blowup and bailout, the probability of a 50% rate hike then declined to 0%, and the probability of no rate hike rose from 0% to 33%. Treasury bonds rallied as the 10-year bond yield fell from 4.0% to 3.5% in two sessions. This is a big move. An even bigger move was the 2-year Treasury yield declining from over 5% in one week to below 4% on Monday. That was the largest downward move in yield in the 2-year Treasury since the crash of 1987. The market is telling the Federal Reserve that it better be done raising rates or it risks a broadening financial crisis. The big question is when the Federal Reserve will admit this.

How quickly things change.

The Fed is now faced with two choices. Continue with rate hikes and risk breaking something bigger than SVB, or tolerate higher inflation for longer. We think it will be the latter, although the Fed will probably raise rates one more time next week to try to maintain a tiny bit of its shattered credibility.

These declines in interest rates have eased financial conditions, which could set us up for a bounce in equities and risk-on mode. Especially the highest risk investments, even though the broad environment carries higher risk than normal. Bitcoin, for example, is up 36% from last week as of this writing. Paradoxically, the SVB blowup,because of lower rates, could benefits equities broadly. If it would not have been bailed out it would be different.

Risk today is higher than normal because of the excesses, leverage and speculation wrought during the long period of suppressed interest rates and money printing since 2008. A lot of those excesses showed up in Silicon Valley. Especially in venture capital, startup tech companies and cryptocurrencies. So, it makes sense that Silicon Valley is the epicenter of trouble and that Signature evaporated. Signature was heavily involved in crypto lending just like Silvergate and other now-liquidated institutions. These were not traditional banks. But is this the beginning of something bigger? We shall see. It is a symptom of inflation, rapidly increasing interest rates and high amounts of debt.

When Bear Stearns collapsed in 2008, and its counterparties were rescued by an orchestrated merger with JP Morgan, the stock market rallied 14%. Thenstocks rolled over again due to a weak economy, rising rates, and the excessive speculation (too high prices) of the prior period. This is why we think it best to continue to stick with a value orientation instead of trying to re-position around what we believe other investors will do. Our stocks may underperform the lowest quality and riskier stocks for a bit. We may even underperform the S&P 500 because the S&P 500 is dominated by large cap tech. Speculators will speculate knowing that the Fed will backstop their failures and imprudence.

We could talk all day about the moral hazard of rescuing ultra-wealthy individuals, venture capitalists and tech companies that placed funds on deposit (in excess of FDIC insurance limits) with a mismanaged bank. Over 97% of SVB $151 billion deposit base was uninsured and upon bankruptcy depositors should have become unsecured creditors of the bank and gotten in line like everybody else. But instead, the Federal Reserve made sure they could get their money out by declaring the bank a “systemically important financial institution”. Changing the rules on the fly has broad and long-term effects.

In the near term it saved us from probably what would have been a nasty banking and credit market crisis, which would have negatively affected all asset prices. In the long term, it encourages speculation, recklessness and makes it more costly for those who play by the rules, and less costly for those who don’t. No punishment will be meted out to those who put the financial system in peril. What it means for markets is unclear, but for the time being participants are breathing a sign of relief as liquidity, credit and settlements go back to normal.

All these developments of the last week are very short term, and we don’t want to be myopic. During periods of stress like today’s the most recent event becomes top of mind and nearly all investment prices are affected. But these effects are short-lived, and we want to see the forest through the trees.

This is not to deny the fact that there are structural issues in the United States such as inflation, excessive debt, an aging demographic, etc., that matter to investors. With a longer-term view, what the Fed does or doesn’t do during this cycle has little bearing on overall investment strategy, positioning and avoiding bad risks.

As we have said in the past, our goal is to earn high average annual returns with low risk. Since we make investments in public markets, that means, sometimes, owning things that are out of favor or challenged, and avoiding what is popular or chasing returns. By owning public equities and bonds, we are occasionally subjected to large price swings driven by other investors, but if we own good investments, use time to our advantage, and stay focused on the big picture, we should have good results over the long run.

By John Goltermann, CFA, CGMA

We recently initiated some changes to your investment positions to 1) take advantage of long-term opportunities; and 2) reduce risk due to some concerning developments in the wider world unfolding. Our consistent goal is to earn you high average annual returns over time. To this end, we have shifted some of your investments to areas that we believe carry significant value and low risk of permanent losses — areas that did not participate in the speculative runup or tech bubble of the last few years. Investments that we believe present excellent long-term upside.

Where is the value today and what does not carry large downside risks? Almost by definition value tends to be in investments that are under-owned, under-appreciated and widely shunned for one reason or another. As such, we added positions to more US value stocks, foreign stocks (developed and emerging markets), energy and gold. In other words, value is usually seen in the unpopular investments that very few people talk about or get excited about – not in the popular investments. Value is in the investments where prices have not been run by media hype, performance chasing, reckless behavior, cheap borrowing or index flows. It is in investments that have underperformed or businesses that are challenged, and where those challenges are well-known and priced-in.

Why value investments today? As shown in the chart below, growth stocks have outperformed value stocks for a very long period (14 years) and in dramatic fashion. What are ‘growth’ stocks? They can best be described as newer businesses, new technology, high revenue growth companies that put market share over profit. What are ‘value’ stocks? They can best be described as “desirable because underpriced”. They tend to be overlooked, challenged, slow growth, profit-oriented and boring. Get-rich-quick types and speculators tend to love to chase growth-type stocks for fast returns. They don’t care so much about risk. The investment industry itself also loves growth stocks since most money managers are engaged in the short-term ‘performance derby’ (constantly trying to outperform their peers). And most disregard valuations and risk because it is not their money, and they have been enabled by cheap credit.

The truth about markets is that prices eventually revert to the mean. In other words, under the surface of the market itself, there are cycles that repeat — and the relative performance of growth vs. value stocks is one of them. Over the last 14 years, growth stocks dominated stock returns. Value stocks did not participate nearly as much in the Fed-sponsored runup. And, in our opinion, it is value stocks’ time. For long-term investors, one of the most critical factors for investment success is being positioned on the right side of mean reversion, not on the wrong side.

We also strongly believe that to earn high average annual returns means avoiding large price declines (to the extent possible). Why? Because the simple math of investment returns makes this true. For example, if somebody is down 33%, they need to be up 50% to break even. If one is down 50%, they need to be up 100% to break even. Large losses necessitate huge returns to make up for the losses. And to earn huge returns means carrying huge risks. Therefore, a sensible goal is to own investments that do not carry significant downside risk in the first place because then you don’t need to take big risks to try to earn the huge returns needed to make up for any large losses. You can hold a low-risk portfolio and still earn high average annual returns and not suffer huge swings in your balances.

What is concerning us today?

Large losses are more common in environments that occur after periods of excessive speculation (which we saw in 2019 – 2021): Environments characterized by high and rising credit costs, ebbing market liquidity (willing and able buyers), and without Fed support (interest rate suppression). These are also the environments where we tend to see dislocations such as the recent bankruptcy of FTX. As Warren Buffett says, “When the tide goes out, you find out who is swimming naked.” We don’t believe that large losses, at least permanent losses, will be likely in attractively priced stocks of strong stable companies.

When the Federal Reserve flooded the system with cash and easy credit (causing a credit bubble), it caused distortions. Distortions in pricing, distortions in perceptions and expectations, and distortions in behavior. We saw large scale capital misallocations. Periods during and after bubbles are periods, in our opinion, for long-term investors to be cautious. Because it takes time for the system (prices and behavior) to adjust and reflect economic reality.

In the late stages of the 2019 – 2021 credit bubble, many investment prices, such as tech stocks, cryptocurrencies, SPACs, private equity, meme stocks, etc., even residential real estate, became too expensive. Then, unexpectedly, inflation reared its ugly head. In response, interest rates went up and credit became more difficult and expensive to obtain. Investment markets and the economy are still adjusting to this new reality. Our belief is that due to the length and magnitude of the credit bubble being so large, it will take more time to rebalance the system. We have not seen any moments of panic or mass liquidations during this bear market and the ends of bear markets are often characterized by mass selling. We are not predicting a panic ahead, but we do believe it still makes sense to continue to invest with caution and that value stocks will outperform going forward.

As investors, there are always things to be concerned about. Besides the unwinding of the recent credit bubble, there are numerous challenges ahead and, as such, we want to avoid bad risks. The purpose is to avoid overpaying and avoid permanent losses. We want to put money in investments that have strong upside potential supported by a plausible investment case. And to use time to our advantage.