2021 4th Quarter Market Commentary
Because I’m writing for a newly expanded readership, many of whom have never before seen our commentaries, I’m going to take a somewhat different approach in this issue. It is always advantageous to know the biases of a writer and, ideally, to know what he/she has identified previously as the factors likely to influence markets most significantly.
I will outline a number of issues that I consider most important for understanding markets and for increasing the odds of long-term investing success. While this should provide a helpful introduction for new readers, in a period of unprecedented market, economic and investor conditions, the following points should likewise help our longstanding readers to identify or confirm their own market expectations and risk tolerances.
Almost all investors who have been active market participants for over a decade or more have heard that through modern market history (over the last century or so), stocks have outperformed bonds, which in turn have provided a better return than risk-free cash equivalents. The long-term average annual returns have been about 10% for equities, about 5% for bonds, a bit above 3% for U.S. Treasury bills with inflation fractionally below Treasury bills. If we could count on such returns over any meaningful time period, investing would be an easy business. Unfortunately, a plethora of unpredictable factors can derail historically normal patterns for many years at a time, even decades.
Having personally been in the investment business for more than a half century, I have seen a great variety of economic conditions and market behavior. I have witnessed remarkable investor wisdom as well as astounding foolishness, unfortunately and tragically too much of the latter. The lessons learned have formed the basis for our own investment approach. What follows are a few important points upon which my investment understanding and expectations are based.
No One Knows
No matter how learned, experienced or persuasive-sounding, no one knows what will happen next to stocks, bonds, commodities or the economy. Some of the best and brightest have proceeded from great success to career-ending failure. Because so many in the investment industry are very bright, very articulate and speak with great conviction, it is not surprising that many develop large followings. In a tale played out innumerable times over the decades, a young investment manager hits a few home runs early in his/her career and new money pours in. Given the cyclical nature of investment markets, such managers invariably eventually stumble, usually with far more money under management than when leading the performance pack. Rather than seeking the latest hot manager or investment, it is far wiser to identify an investment process with lengthy historical success implemented by individuals committed to following the process through both weak and strong markets.
Very early in my career, I was struck by the spectacular performance collapse of Fred Carr’s Enterprise Fund. Having been one of the country’s most successful managers through the early-1960s, Carr was rewarded with a massive infusion of new money. From mid-1967 to early-1969, when I entered the investment business, Enterprise saw its asset base grow by more than 1,000%. When the bull market ended in early-1969, the fund suffered losses of more than 25% in each of the next two years. Because most of the fund’s shareholders bought after the fund’s earlier success, the vast majority of shareholders was deeply under water by 1970. Investors abandoned the sinking ship. This pattern is borne out repeatedly among both professional managers and individual investors, as most investors buy more aggressively into strength than weakness. As mutual fund industry statistics show, most investors do far worse than the funds they own because they tend to buy after the funds have already exhibited strong performance. They buy in time to experience the downside of most investment cycles.
Markets Move In Cycles
I can’t emphasize enough the importance of recognizing that investment markets move in cycles, some short, some long. Especially in long cycles, the weak side of the cycle typically serves to eliminate the market and economic excesses built up during the strong phase. The longer the upside of the cycle, the more excesses there typically are to eliminate and the deeper the corrections tend to be. In this country, the most severe decline from a market peak began in 1929 when equities plummeted 89% to a bottom in 1932. The long corrective phase was not over, however. Because the excesses built up in the Roaring 20s were so great, the Dow Jones Industrial Average did not exceed its 1929 peak until 1954, a quarter century later. Next sequentially, the excesses created in the post-World War II era into the mid-1960s took 16 years to fully correct. The 1966 Dow high was not permanently exceeded until 1982. Most recently, the excesses that developed in the run up to the dot.com bubble peak in 2000 led to two greater than 50% stock market crashes, the first from 2000 to 2002 followed by the real estate bubble and stock market collapse from 2007 to 2009. Major equity indexes in early 2009 were more than 50% below their year 2000 peaks.
With substantial portions of the U.S. banking system essentially bankrupt, the government began the biggest economic rescue in history. Though briefly interrupted by the waterfall market decline when the pandemic hit, the market continues its government-subsidized advance that has now lasted for almost 13 years.
Throughout history, stocks have risen more often than they have fallen, but the above mentioned examples of prolonged corrective periods have been sufficient to drive many investors from equity participation. A great many people reach a point beyond their pain tolerance when markets decline too far or for too long. For that reason, all investors should realistically assess their own financial and psychological willingness to endure occasionally long declines if they plan a buy and hold approach to investments. As the earlier described mutual fund data show, too many investors get driven out when declines get too painful, then wait to reinvest until confidence is rebuilt, usually after prices have risen considerably.
Avoid big losses. This sounds simplistic. Nobody deliberately seeks big losses, but many investors endure them because markets unfold in unexpected ways, and many investors are reluctant to exit a position at a loss even when the reason for buying it has changed. It has been well proven over the long span of market history that to achieve strong long-term results, one doesn’t have to be the best performer when markets are rising if the investor doesn’t give back big amounts when markets endure occasional big losses. It is especially important not to chase recent hot performance of a stock or sector. There are two sides to each cycle.
Absolute rather than relative returns. Largely because we have managed money over the decades primarily for not-for-profit institutions, retirees or others who could not easily replace lost assets, we have concentrated on producing positive returns, especially in high risk economic and market environments. There is an old saying in this business: “You can’t spend relative returns.” While we will always follow a client’s directions in terms of risk assumption, left to our personal preferences, we will work very hard to put a plus sign in front of each year’s return, even in the weakest market environments. This approach could be particularly important in the potentially volatile years ahead.
Excesses Mark Peaks and Troughs
The most dangerous excesses that tend to mark peaks in market cycles are overvaluation and overleverage. Both conditions tend to develop the longer a bull market runs. When price rises become persistent, an increasing number of people gain confidence and buy more stock, many employing leverage to increase their holdings. While no single level of overvaluation or overleverage is an automatic trigger to a market decline, there are good data going back for more than a century that identify the levels—especially of overvaluation—that have existed at every significant price peak. When data that cover the last 135 years are examined, it is an incontrovertible conclusion that stock market performance is strongest from levels of undervaluation and weakest from levels of overvaluation. While Mission honors the specific investment objectives of each client, our tendency is to become more aggressive when stocks are undervalued and more cautious when stocks are overvalued.
Although specific levels of debt don’t offer as clear a warning about dangerous market price levels as do levels of overvaluation, it is evident that some of stocks’ biggest declines begin in periods in which debt is near record highs. Most people have enough personal experience with debt to recognize that high levels of debt increase the vulnerability of individuals or businesses should other factors present a danger.
Perhaps the prime example in a modern industrialized country of simultaneous overvaluation and overleverage leading to a disastrous fall is Japan in the late-1980s. Mission and its predecessor firm Marathon Asset Management have conducted conferences around the country for clients for the past 40 years, but for a recent pandemic-based hiatus. At our 1987 conference, I remember well having confessed a very limited knowledge of the specifics of the Japanese stock market, but I professed a profound understanding of the history of equity valuations. I told our guests that Japanese valuations made absolutely no sense and that almost certainly equity prices would decline substantially. While prices did dip briefly later that year, they rose again and ended the year at new highs. Undaunted, I made the same assertion again in 1988. Once again, the Japanese market forged ahead. In 1989, admittedly with more doubters in the audience, I fearlessly made the same statement once more. The Japanese Nikkei index ignored all former valuation norms and rose to a record level around 39,000 on the final trading day of 1989. The Nikkei has never touched that level since. It began to decline precipitously and, with intermittent rallies, declined for 20 years reaching a point more than 80% below its 1989 high. Even later, the Nikkei’s 2009 price was at the level of that market in 1982, 27 years earlier. The Nikkei rallied from there but today remains about 27% below its 1989 peak almost a third of a century later. People are tempted to say, “But that’s Japan. That could never happen here.” Especially younger people who never knew, or others who may have forgotten, in the 1980s the Tokyo Stock Market, which the Nikkei measures, was the largest market in the world, bigger than New York. At the time, Japan dominated the electronics and automobile industries. The country was considered to have found the new industrial paradigm. So powerful had the Japanese market been, few believed that it could even suffer more than a brief, mild pullback. No one would have believed that the Nikkei could possibly be significantly lower more than three decades later. Relating this history is not a forecast for the United States, but rather a confirmation that extreme overvaluation, compounded by excessive indebtedness, has once before taken down the largest stock market that the world had ever known at the time.
Reversion to the Mean
Every major world stock market over the past century has invariably reverted to the mean when stock prices got sufficiently out of line with underlying fundamental conditions. When stocks are undervalued and prices well below normal levels relative to such factors as earnings, dividends, book values, sales or cash flows, prices ultimately rise. Conversely, when stocks are overvalued and prices well above normal relationships with such underlying fundamentals, prices ultimately fall. Theoretically, when stocks are overvalued, underlying fundamentals could rise sufficiently relative to prices to eliminate the overvaluation. Through all of U.S. history, however, that has never happened from a point of severe overvaluation. Price has always come down to meet fundamentals at a lower level.
Where Are We Now?
In most of our commentaries, that is the question we spend time addressing. Let me provide an abbreviated summary to this already long commentary and tie it to some of the points made earlier. The unprecedented amounts of money created by the Federal Reserve from the 2007-09 Financial Crisis to present, supplemented by Congress’s massive fiscal support, have loaded the economy with liquidity. Much of that money has found its way into stocks and bonds, driving each to all-time high valuation levels. Within the past few months stocks, bonds and real estate simultaneously reached their highest levels of extreme valuation ever.
At the same time, the money in consumers’ pockets, unspendable for many months because of the pandemic, has come gushing back into the economy producing strong economic growth in the year just ended. Economists expect a continuation of that growth at a reduced but still reasonably strong level this year as well. Forecasts for subsequent years fall off significantly.
The strongest support for the economy and the securities markets for the past few years has come from the Fed. They continue to create new money by buying Treasury and mortgage bonds each month, but that process is scheduled to stop in March. At its recent meetings, the Fed has expressed surprise and concern about the rapid increase in inflation, now at 7% year over year, the highest rate in 40 years. Interest rates have begun to rise fairly aggressively over the past few months in anticipation of probable Fed rate increases, possibly starting as soon as their March meeting. They have also recently spoken about starting to reduce their balance sheet that has risen to close to $9 trillion. In the Fed’s first 95 years, they accumulated balance sheet debt of a bit over $800 billion. In the 14 years since the Financial Crisis began, they have added about eleven times the amount it took 95 years to acquire. Rising interest rates and quantitative tightening (reducing the balance sheet) has in the past created a difficult environment for both stocks and bonds.
The Fed has for the past dozen years, however, been unwilling to allow stocks to decline very far or for very long. Many in the investment community believe that if stocks begin to decline in earnest, the Fed will abandon its inflation fight and will again commit its primary efforts to supporting the securities markets. In fact, one frequently televised investment manager commented last week that Fed Chair Jay Powell, as an ex-Wall Street veteran, knows how dangerous it could be if the Standard and Poor’s Index broke below its 200-day moving average. As I write, that average is less than 4% below current prices, so the manager expects Fed support to show up to limit any downside to that minimal amount.
This all sets up what we have been characterizing as the “bet” that all investors must make in an environment unlike any before in this country. As described earlier, markets in this country have always ultimately reverted to their fundamental averages. From the highest ever levels of overvaluation by many measures, reversion to the mean could imply a decline similar to the two 50% plus declines earlier in this 21st century.
On the other side of the “bet” is the Fed’s success in keeping equities from any lasting decline since the Financial Crisis. No country has ever succeeded in simply printing its way out of a debt crisis without serious inflation problems. If, however, inflation should ease and the Fed continue to provide support to the stock market, stocks could well climb to new highs.
Being aggressive toward equities will be the route to success if the Fed continues to follow the path that it has set for itself for the past dozen years. Being conservative toward equities will be the more prudent approach if reversion to the mean begins any time soon.
By Thomas J. Feeney, Managing Director, Chief Investment Officer
Mission’s market and investment commentaries reflect the analysis, interpretation and economic views and opinions of our investment team. They are not intended to provide investment advice for any individual situation. Please contact us if we can provide insight and advice for your specific needs.