Roots of a Rally
January 3, 2021
Every day after the market closes, I take my dog Booker for a walk and think about how to best invest my clients' money. On these walks I have encountered two groups of people. The first group yells at me for not wearing a mask even though I am 20 feet away in the street (curiously those who yelled at me also weren't wearing masks) and the second group wants to give me their stock picks and investment advice. For most of my career people showed no interest in my profession, but now I am frequently receiving unsolicited advice on how to do my job better. We all know that COVID-19 can be a lung killer, but has there been a study of the impact the virus has on the brain? It caused people to hoard toilet paper, but did it also make people smarter? Where were they in March after a record sell-off?
With plenty of time on our hands lately, people have been watching at their 401K accounts grow and are hearing about their neighbor getting rich in the stock market. They in turn are thinking, well I can do this too. It becomes contagious and pushes the market even higher. It’s a lot like Cinderella, everything is wonderful while you are dancing at the ball, but eventually, if you don’t know what you are doing your investments will turn into pumpkins and mice.
Roots of the Current Rally
The remarkable market decline in March, followed by a rally to all-time highs by the end of the year has its roots in the Great Depression. During the Great Depression, there were numerous bank failures that resulted in a loss of confidence in the financial system. This led people to bury their savings in a coffee can in the backyard, which in turn caused even more banks to fail. The solution to this problem was the Federal Deposit Insurance Corporation (FDIC). The US government stepped in and guaranteed people's savings from a bank failure. The FDIC program was an enormous success in restoring faith in the financial system and we learned the economy runs on confidence. To date, it has not cost the taxpayers a dime as the insurance premiums paid by the banks have exceeded the cost of the program.
"If money isn't loosened up, this sucker could go down" George W. Bush
Losses on bad loans and mortgages in 2008-2009 again caused the financial system to seize up. This time people abandoned the stock and bond markets. Businesses accustomed to financing their operations with short-term loans found themselves unable to make payroll or pay suppliers and were pushed to the brink of bankruptcy. The solution was for the Federal Reserve and US Treasury to purchase securities in the market in order to increase the money supply. By increasing the supply of money, prices of financial assets rose while simultaneously lowering interest rates (i.e., the future return on investments). These programs were called Quantitative Easing (QE) and Troubled Asset Relief Program (TARP), they saved our economy from ruin and restored confidence in the economy. In total, the Federal Reserve pumped $3.6 trillion into the economy from 2009-2014. These programs were also highly controversial as they were seen as a bailout of Wall Street. Remember Occupy Wall Street? What is important, is that confidence in the market system was restored and the government earned a tidy profit along the way.
We learned from the Great Depression and financial crisis that when the economy seizes up, the faster we inject money, the faster it heals. Within a couple of weeks after realizing we have a serious pandemic on our hands, Congress and the Federal Reserve acted quickly with massive stimulus and quantitative easing measures. They deserve an “A+” for their actions in saving us from disaster. In order to keep money flowing, the Federal Reserve in a few months deployed $3.7 trillion to purchase the safest bonds, which forced investors to take the cash received from their safe bonds and purchase riskier investments. This is on top of the $3.1 trillion in stimulus provided by the US Treasury. This flood of money has driven the price of stocks and bonds higher and maintained confidence in the economy. This is how we end up with neighbors eager to dispense stock picks and advice to anyone who will listen rather than protesting Wall Street.
You may be thinking, what is wrong with this situation? Remember the bad loans and mortgages that started the financial crisis of 2008/09? They were the result of an easy money policy aimed at getting every American a home. Loose monetary policy eventually leads to people making bad investments. Today we are propping up our economy with lots of free money, and while much of it is necessary we must acknowledge we are also playing with fire. The amount of QE and stimulus is much larger this time around and we aren't finished. It is estimated the Fed will deploy another $2.5 trillion before it is done. The Fed isn't buying distressed assets on the cheap like 2008, they are paying the full price and the Paycheck Protection Plan (PPP) stimulus loans from the US Treasury do not have to be paid back. The tools are working, but it’s taking a lot more money to get the same effect as 2008 and this time there will be a bill waiting from the taxpayer. How much will we need next time and can we afford it?
"A Bird in Hand is Worth Two in the Bush" Aesop
The market only cares about one thing, and that is profits. The focus on profits is because an investment is only worth the money it returns to its owners. Aesop provided the formula for successful investing 2,600 years ago with his bird in hand maxim. Let's apply Aesop's formula to everyone's favorite stock Tesla. As I write this, Tesla is valued at $669 billion. Now before investing in Tesla at this price you should ask yourself, are there more than 669 billion birds (future profits) in the bush and if so, when will I get them out? Tesla is projected to earn a profit of about $5,000 per car in 2021, which is pretty good compared to Ford who is projected to earn $800 per car. At that rate Tesla will have to make 133.8 million cars to earn $669 billion in profits. Tesla sold 500,000 cars in 2020, with that volume it will take 267 years to get the birds out of the bush. Now Tesla is growing quickly so let’s assume they are able to scale up production to 5 million cars a year on par with Ford, then it will only take 27 years. Stock prices can do anything over short periods of time but eventually prices converge with the amount of money made by the company. So if there are more than $669 billion in future profits you will make money; if there are less then you will lose.
What Should You Do?
As the stock market rises, that means we need more birds (profits) in order to justify the higher price or face a lower future return on investment. But here is an interesting fact, aggregate corporate profits have only increased 0.4% per year since 2012 after adjusting for the change in tax code. So the actions of the Federal Reserve and Congress have raised the price of financial assets, increased risk, and decreased future returns. The market is running high on confidence and the underlying math is getting harder to justify the valuation. The famous investor Howard Marks has two rules for investing. Rule #1: Most things are cyclical. Rule #2: the most money is made or lost when people forget rule #1. It seems like some people have forgotten that stocks go up and down. Do you think there will be a corresponding increase in corporate profits after years of stagnation and a pandemic? Unlike the FDIC insurance program, there is no guarantee QE will be there to protect you from losses in the market. QE is there when needed and then is phased out to retain its effectiveness.
For those of you who I have been working with, depending on the situation we increased the allocation to equities somewhere between 70-100% back in March. We reduced the equity allocation modestly over the summer and now I think we should return to the 50-70% range held prior to the pandemic. This is not a prediction of an imminent downturn in the market, I just think we are not being adequately compensated for taking risk. By rebalancing in response to market conditions, it has forced us to buy low in March and to sell high over the past several months. I remain optimistic that America's best days are still ahead of us.
Reminder to stay the course, keep it simple and don't complicate the process.
With investing you don't have to do exceptional things to get exceptional results. I believe the following process is likely to produce satisfactory results over a long period of time by minimizing mistakes.
- Buy great businesses at reasonable prices. Stock valuations relative to interest rates remain the most attractive option
- If you do not know how to identify a great business or a reasonable valuation, buy the VOO (Vanguard S&P 500). Owning a piece of corporate America at low-costs will do well over the long run.
- Do not attempt to time the market
- Avoid active trading - Don’t let emotions drive decisions
- Have a clearly defined plan and stick to it. If you don't have one I can help you.
- Avoid asset classes that diminish returns - i.e. cash and gold
- Keep expenses to a minimum
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.
