The Beatings Will Continue Until Morale Improves...

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June 6, 2022

Pop Quiz:  What follows below was taken from last week's Wall Street Journal:

A rich relative has left you $10,000 and you decide to invest in an S&P 500 index fund for 30 years in a tax-free account.  We'll pick five points in history to start and tell you what the news headlines were around that time.  Now write down how much your inherited $10,000 would be worth at the end of 30 years.  
 

1. It’s March 1991 and the U.S. is in a recession. The Savings & Loan crisis is raging, and unemployment is 6.8%—even higher than today. It won’t peak until the following June when an upstart third-party presidential candidate, Ross Perot, warns about the dangers of the national debt. The next 30 years would witness the dot-com crash, the 9/11 terrorist attacks, the global financial crisis and, most recently, a global pandemic. How much money do you think you had in March 2021?
    
2. It’s December 1969. The Vietnam War has years to run and there are big demonstrations against the draft lottery that began earlier that year. Inflation is on the rise and the U.S. dollar will be taken off the gold standard in a couple of years. The coming decade will bring Watergate, two energy crises, two recessions and—worst of all—disco. How much money do you think you had in December 1999?
    
3. It’s June 1932. Banks are failing all over the country, unemployment is over 20%, and Adolf Hitler is on his way to becoming Chancellor of Germany. He will invade Poland in seven years, triggering World War II. How much money do you think you had in June 1962?
    
4. It’s November 1957 and we like Ike. The U.S. economy dominates the world. The interstate highway construction program is beginning, the U.S. is investing in the space race with the Soviets, and the jet age is about to really take off with the first flight of the Boeing 707. How much money do you think you had in November 1987?
    
5. Okay, maybe this one is too easy. The stock market is booming, a wonder technology called radio is transforming the world and Herbert Hoover is getting high marks for his stewardship of the economy—but it’s August 1929. Cue ominous music before checking your account balance in August 1959.

 
Answers to the Wall Street Journal Quiz

1. Congratulations—you have $180,690! You can afford four Teslas. 
2. Not too shabby! You have $443,670 and can open that Blockbuster Video franchise you’ve had your eye on. 
3. Are you sure you’re not a market timing genius? You have $519,931. 
4. Ouch, that stock market crash sure stung. Even so, you have $179,343. 
5. Hey, that actually wasn’t so bad—you have $88,301. You can afford seven average U.S. homes with change left over to pick up a lightly used Edsel.

 
Ok, now let's get real.  The lesson above is an important one, but it's also the same lesson parroted by every lame-ass financial advisor on the planet.  I want to go a couple layers deeper into what is really going on in the market.  What follows is not a call on the market's near-term direction.  No one knows what is going to happen with inflation, interest rates, the war in Ukraine and oil prices.  There are too many factors to correctly predict the future.  I want to revisit an economics lesson I provided in my 2022 outlook to my partners that was later included in the January blog post https://www.tothefront.net/volatility.
 
Before I get to the portfolio, I want to provide a short lesson on economics.  From 1871 to 1997 the return on the stock market after removing the effects of inflation was 6.7% per year.  The corporate dividend yield plus the rate of earnings growth over that same period was also 6.7%; demonstrating overtime investment performance converges with business performance.  It is a simple concept; the value of the market can only reflect its output.  But that has not happened over the past few years.  Since the 2008 financial crisis, corporate profits have grown 5-6% per year on average.  Through the end of 2021, the S&P 500 grew at a 12% annual compound rate.  Why did this happen?  Low-interest rates have driven greedy behavior resulting in the strong market performance.  There are three ways the market can sustain this pace:
 
1. Rates can remain at historic lows 
2. Corporate profits claim a larger share of the economy 
3. The economy accelerates by a meaningful amount.  
 
I think all three are unlikely. The Federal Reserve has sent a strong message that it will be raising rates aggressively in the near future to combat inflation.  Corporate profits at the end of 2021 were already at the highest share of the economy in history.  Finally, inflation has dampened consumer sentiment because it is eating up discretionary income that would typically be spent on items outside of staples like food, energy and housing.  
 
"The beatings will continue until morale improves" Unknown
If we add inflation back to the figures I provided above, the average market return over the past 65 years is approximately 10%.  Now let's assume that a year where the market returns between 8 and 12% is "average."  How many times in the past 65 years do you think the return was average?  6 times.  Only 6 times did the market return produce and "average" result.  You may be wondering why the market seems to do anything but provide the "average."  It is because of human emotions and psychology, and they follow a consistent pattern.  The drawing below is an example of how the market cycle works.  The duration of each phase and the magnitude of the peak and trough differ throughout each cycle which make it particularly difficult to time with precision.  What we can do is have a process for an approximate understanding of where we are in the cycle and adjust our portfolios accordingly. 


 

1. Asset prices rise after a period of pessimism 
2. Greed grows as fear of losing money is replaced by fear of missing out
3. Risk aversion and caution disappear as investors assume things will get better forever
4. Eventually company fundamentals disappoint the market's lofty expectations
5. Prices decline and adjust towards fair value
6. Pessimism drives prices below fair value; a few investors realize things will get better
7. Everyone realizes things are getting better and prices rise
8. Rinse and repeat

 
The value of any investment is the sum of the future profits discounted by your required return rate back to a present value.  Think of this definition as a "fundamental law of physics" for investing.  If you had a time machine and told me future earnings of a business and the level of interest rates, I could value any company with precision.  Since we don't have a time machine, we must make estimates of future profitability and use them to help identify where we are in the cycle.  
 
We have so much variation in the market because large groups of investors all have differing views on future profits that are expressed in an open auction.  Stock and bond prices are set by the person who is willing to pay the most.  And by offering the highest price, they are also accepting the lowest future return compared to other bidders.  
 
We must be aware that open auctions are designed to turn your brain into mush.  You have all these people bidding creating social proof as well as FOMO (fear of missing out).  When these two psychological forces are combined, the market goes through periods of excess and corrections.  Unlike nature, the "fundamental laws of physics" for investing do not hold over shorter periods of time.  Think about your average person using the stock trading app Robinhood.  Over the past two years, we all have had the experience of suffering through their stories of how much they made in the market or trading crypto.  Do you think any of them sat down and thought about the future profitability of the underlying businesses whose stocks they were trading?  How do you place a value on something that will not produce anything like crypto?  It's FOMO, the participants in the auction were buying hoping a bigger fool would fear missing out on making money and pay an even higher price.  
 
The reason I am so fascinated by markets is because they are the intersection between the fundamental elements of nature and the irrationality of humans.  Only on Wall Street can you find a former concrete worker become the "Director of Hydrogen Production and Infrastructure" of an electric vehicle business or a "do it yourself" orthodontia company where both firms carry valuations in the billions.  What is your estimate of the future profits of these operations?  Mine is way less than zero.   
 
"The world is full of obvious things which nobody by any chance ever observes" Sherlock Holmes
In early 2021, Lucid Motors stock was selling with a market capitalization of $93 billion.  Now if you wanted to earn a 15% return on your investment, LCID would have to generate $14 billion in profits.  Since the company is not expected to earn a profit for several years, we must keep adding our desired return to the $93 billion market capitalization.  Five years from now to achieve a 15% return for investors, LCID would have to earn nearly $25 billion.  That $25 billion would amount to about 50% of all the profit earned on new auto sales in the US.  We should also keep in mind Lucid is only capable of producing 12,000 cars a year.  The numbers are staggering and are what happens when gullible investors get captivated by the notion of rising stock prices without paying any attention to underlying fundamentals.  
 
Thoughts on the Market 
The period of excess is over and has given way to the correction phase.  As I pointed out in the 2022 outlook, the pace of the market exceeded the profit growth of the underlying economy.  Knowing that pace could not sustain itself forever, I positioned my portfolio conservatively and remain so.  During the most recent earnings season, bellwether companies like Walmart, Costco and Target made it clear in response to inflation, consumers have shifted their purchasing behavior, prices will continue to rise, and the higher costs are eroding their profits.  Numerous companies also announced intentions to slow the pace of hiring or reduce headcount.  With the correction we have seen year to date in the market we are probably in stage 4 or 5 of the cycle.  Valuations in my opinion are still on the high side of fair but are now within a range I consider reasonable.  
 
I have been asked, "if you are so negative, why not sell everything now and buy it back later?"  It's a fair question but requires doing something extraordinarily difficult - correctly predict the future and time the market.  Because of the facts at the start of the letter, it would be foolish to completely abandon the market.  But while those facts support boiler plate advice from financial advisors to never change your investment allocation, that too is foolish when faced with numerous examples like Lucid Motors.  These mathematical impossibilities serve as a sign the market has become overheated and are an opportunity to adjust the level of risk in our portfolio.  It wasn’t just Robinhood traders who disregarded the "fundamental laws of physics" and chased the high-flying tech and meme stocks last year many professionals like Ark, Tiger Global and Melvin Capital are sitting on losses >50%.  The foundation for achieving above average long-term performance is to avoid disasters and can be accomplished by making decisions based on value rather than popularity.  It required giving up some of the upside last year but has mitigated much of the damage this year.   
 
I intend to incrementally shift my T-Bill holdings back into the market as valuations approach my opinion of fair value and will act aggressively should they overshoot to the downside.  The important take away is moderation, with investing you do not have to do extraordinary things to get extraordinary results.  Just doing a little better over a long period of time is enough.  Unfortunately, suffering through the agony of market declines is part of the process, but it will also provide the foundation of future success.  
 
Cautious Investing,
 
To The Front
 
 



This commentary is provided for general information purposes only and should not be construed as investment, tax, or legal advice.  Past performance of any market result is no assurance of future performance.  The information contained herein has been obtained from sources deemed reliable but is not guaranteed.