People often ask me this question. The short answer is that I have great confidence that the market will head higher over the long term. In the short term, I really have no idea and don’t really care. Keeping this “opinion” of mine in mind, I will expand on some of the things that I’m seeing and my corresponding thoughts.
This Time Is Might Be Different … But Stick to Your Plan
It is often said that the four most dangerous words in investing are “this time is different”. And, depending how the phrase is used, I do believe that it can be very dangerous indeed. I go back to the dot-com bubble top in 2000 when I heard one guy (a friend of a friend) willing to bet that the “market” would not go up less than 10% in any year for the next decade because the Internet had truly changed the economy into an ever advancing virtuous cycle of increasing growth (and continuing U.S. government budget surpluses)! He believed that even though several market valuation measures were at record extremes, they didn’t matter with the new paradigm taking hold. Oops, the NASDAQ fell roughly 80%, the S&P 500 fell just shy of 50%, and the market subsequently endured its worst decade since the 1930s (and, by the way, the budget surpluses of the 1990s morphed into the huge and growing deficits that we see today). That time was not different.
Anyway, most people don’t get caught up with such outlandish hyperbole but do often fall into the trap of extrapolating the current market conditions far into the future, believing something in the economy/world has changed market behavior so that prior market valuation metrics no longer matter. Unfortunately, the trap comes when the investors, expecting conditions to continue, abandon their plans (e.g. they stop rebalancing) and leverage up on the trend continuing. This doesn’t usually work out very well!
The key characteristic of past bubbles is when the belief that valuation metrics don’t matter anymore, or are outdated, becomes commonly accepted. Is that what we are experiencing right now? Dangerous, bubbly behavior? In some cases – Reddit options traders, etc. – maybe. On the other hand, it doesn’t seem like an epic, dangerous bubble to me because of truly unique circumstances.
Unprecedented Economic Extremes – Stay the Course
I could go through the litany of events over the past year-plus that have been so extraordinary in both good and bad ways. However, others have undoubtedly done a better job than I could at cataloging all that has made this period so unique. I thought I’d just highlight a few thoughts I have that I believe are particularly relevant to the current investing landscape. But first, I suggest keeping a sense of equanimity when looking at this market:
- Don’t get too excited and carried away with this strong market. The torrid pace, and lack of a corrective phase won’t continue forever. We will have a correction sooner or later.
- Don’t let this “bubble talk” scare you out of the market. There may be micro-bubbles in various market segments, but I can’t see the whole market being in bubble territory … at least not yet.
Why I Think This Time May Be Different and Why It Matters
Quite specifically, I believe that the extraordinary events and conditions of the past year-plus have skewed some of the traditional valuation metrics, rendering them less useful than in the past. There I said it. I’ve walked out on a limb. The key, in my opinion, is that we don’t really have all the information yet as the economic recovery continues to unfold.
- Economic Extremes in Both Directions. Last year’s economic shutdown was designed to limit or halt the spread of the virus but unfortunately sent many sectors of the economy to a screeching halt. It ended up being the steepest economic decline since the 1930s which was so bizarre because the economy had been performing well with no signs of being significantly out-of-balance before the pandemic hit. It was obviously an exogenous hit and not the result of an unhealthy economy.
- Prices collapsed in broad swathes of the economy. – e.g. oil prices going negative a year ago!
- Interest rates fell to zero and below worldwide, thus the value of discounted cashflows jumped seemingly overnight (with low interest rates, future cash flows become more valuable).
- The U.S. government has employed unprecedented (man, is that word being used in every other sentence since the pandemic began, or what?) fiscal and monetary stimulus.
- Many economists expect sharp reversals in 2021 – significant jumps in inflation, sharp acceleration in economic growth (some expect the strongest growth in nearly 60 years), and likely dramatic earnings growth. These accelerations will benefit from both the base effects (sharply lower 2020 prices, economic growth, and earnings as the base) and the impact of the immense fiscal and monetary stimulus on the economy.
- Many of the traditional valuation and economic metrics have been decisively impacted. Here are a couple examples and why they may be temporarily less meaningful:
- “Buffett Indicator”: the value of the stock market divided by the GDP (proxy for size of the economy) which is considered overvalued when stocks are valued higher than the economy.
- This indicator makes intuitive sense.
- However, it does not even factor in interest rates and their impact on valuations – lower interest rates should increase values.
- Stocks discount the future while GDP tends to be a snapshot of the past so there is somewhat of a mismatch especially with 2020 being economically so weak while 2021 is expected to be so strong.
- It definitely looks overvalued now by historical standards but if we get the fastest economic growth in decades, what will the GDP be worth?
- Price-to-Earnings (P/E ratio) or Price-to-Sales ratios
- These are also indicating an extraordinarily expensive market as well but some of the same caveats as with the Buffett indicator.
- Earnings and sales collapsed last year even virtually disappearing for the unfortunate companies most directly impacted such as travel, recreation, etc. Thus, any ratios based on trailing earnings/sales are going to be sky high since the denominators crashed.
- Again, stocks tend to discount the future and even looking at projected earnings/sales the ratios look high. Maybe they are but, again, these future cash-flows are being discounted by a lower discount factor making them automatically worth more. Also, I personally think that this current experience is so unprecedented (there’s that word again) nobody knows nor can anybody yet accurately predict the magnitude of this nascent economic recovery. It could be massive.
What to Do?
In sum, I would not try to “figure out” if this market is a big bubble about to burst, or a super-bull that can continue its unfettered advance. The reason I say not to worry, of course, is that the short-term is unknowable. And, if we have financial plans that match our long-term financial goals with the inevitable long-term growth in prices of great companies, then what happens today doesn’t matter much. All we have to do is to follow our plans, a big part of which is to periodically rebalance when our allocations get meaningfully out of alignment with our target allocations. For the last few months, this has generally meant selling some stocks (small caps, for example, a few months ago after their rocket advance) and buying bonds (at lower prices and higher yields). This is just an example of the kinds of adjustments we’ve recently made for some clients. The key is we don’t have to worry as we know that diligently following our investment strategies will allow us to achieve our financial goals. It’s a nice feeling not to have to worry about market swings. The key is not to ever lose faith in the inevitability of the long-term advance! That’s optimism but also realism.