The Answer is Blowing in the Wind - October 2018
How would you like to be locked into a room without windows? Your friends can join, but nobody gets out until you solve several mental puzzles. Oh, and you have to pay to play. In 2014 there were 22 such “escape rooms” in the U.S. By the summer of 2017, there were 2,000. (1) Crossword Puzzle recently celebrated its 100th birthday. Modern Sudoku debuted in 1979. Last year’s world championship attracted contestants from 34 different countries. This begs the question: Are we obsessed with problem solving? Anthropologist Peter Stromberg comments that although humans don’t innately like uncertainty, we do like figuring things out. (2) Mystery novels are the second most popular genre for books. (3) Meanwhile, estimates for the size of the sports betting industry reach as high as $150 billion. (4)
Our penchant for soothsaying transcends books, movies and sporting events. Historically the subject of considerable speculation, the stock market has garnered extra scrutiny recently, owing to the extended duration of the current bull market. The purpose of this note is to provide historical context to market cycles, profile the diviners of bold predictions and assess their accuracy. We will save our forecast for the market’s demise toward the end, just to build suspense.
Historical Context of Bull Market
On August 22, 2018 the current bull market (though subject to some debate, assumed to have begun on March 9, 2009) surpassed the previous record at 3,453 days. From the ashes of Bear Stearns and Lehman Brothers, the S & P 500 is up more than 300% and is approaching the longest bull market in history in terms of duration. (5)
Predictions and Promotions
Wall St. brokerage firms include giants such as JPMorgan, Goldman Sachs, Merrill Lynch, Morgan Stanley, Citi Group, Credit Suisse, Barclays and UBS. We will spare you the additional 3,717 others. (6) Fidelity, Vanguard, Schwab and Blackrock dominate the list of more than 400 institutional asset managers. How can any of these giants distinguish themselves, much less the smaller players? One approach to marketing involves the hiring of a “market strategist”. These typically highly credentialed individuals strive to speak at conferences or on television and opine on the financial landscape. If one of these “strategists” wants to establish a name, why not make a bold prediction? If it comes to fruition… a magical moment. If not, serve up a narrative about timing; the prediction will still come true, just later than expected.
We mean no disrespect but cannot shake the image of Johnny Carson playing “Carnac the Magnificent”.
Another group of vocal prognosticators consists of conflicted parties, with so called “predictions” attached to an agenda. Consider these two recent examples:
“Next Recession Ahead? Fixed Income Investing Ideas in an Aging Expansion” (7)
“Is Now the Time to Buy Gold?”
This sort of “reporting”, typical of Wall Street self-promotion, touts purchase of products these companies sell.
The Sohn Conference, hosted annually in N.Y. City, attracts street savvy players, despite the $5,000 price tag. Each attendee has an opportunity to glean investment ideas from the keynote speakers, typically hedge fund managers. On May 9, 2017 Bill Ackman used his allocated time to present a bullish case for the stock of Howard Hughes Corporation, his first such public mention of the company. After presenting the argument Ackman disclosed being the company’s single largest shareholder. (8) How convenient. Once again, this behavior is quite typical. It’s the messy truth.
How Good are the Predictions?
Nobody should confuse enjoyment and effectiveness. Who foresaw the Chief suffocating Jack Nicholson in One Flew Over the Cuckoo’s Nest? The amateur American hockey team prevailing over the battle tested Soviets? We challenge anyone to step forward and claim that they “knew” Kirk Gibson, who could barely walk on October 15, 1988, would hit the game-winning home run in the World Series. Odds makers lost money predicting Brexit wouldn’t happen.
Conflicts of interest combined with the mercurial nature of the markets keeps the litterbox of poor predictions about the stock market chock-full. Peter Schiff, Chairman of Euro Pacific Fund and SchiffGold, issued a report in March of 2009, warning investors that the massive Fed injection of liquidity into the financial markets would cause gold to reach $5,000 an ounce. (9) Gold trades at around $1,200 an ounce today, up from $1,100 in 2009. Fortune Magazine voted Enron “America’s Most Innovative Company” for six consecutive years ending in 2000 when the stock price peaked at $90 per share. (10) A year later they were exposed and out of business. James Cramer, Harvard educated and partner at Goldman Sachs assured his CNBC viewers, on March 11, 2008, “No! No! No! Bear Stearns is not in trouble. Don’t move your money from Bear.” (11) Three days later, they failed.
Then, consider the one and done heroes who have made successful predictions in a public forum. Elaine Garzarelli went on public television in August of 1987, warning of an imminent market correction. (12) Two months later, the S & P 500 fell a record 25% on a single day. The mutual fund she managed for Shearson/Lehman under- performed the S & P 500 for five years starting in 1987, despite the 25% head-start. How? By refusing to get back into the market. In May of 2008, as a more recent example, David Einhorn, a Cornell educated hedge fund manager, appeared at the Sohn Conference to challenge the accounting practices at Lehman Brothers. (13) Ultimately, he gained considerable fame and fortune by correctly shorting the stock. In 2017 his firm, Greenlight Capital, generated returns of 1.6% compared to the S & P’s 19.4%. Through the end of August this year, his fund is down 25%, despite an up market (14).
Now for our Forecast
When will this bull market end?
“Predictably”, we have no clue, but we share these sentiments from Barry Ritholtz, “Bull markets do not simply die of old age; they don’t reach a certain length, and then keel over.” (15) The Wall St. Journal recently poked fun at this topic by saying, “Talk is cheap in investing punditry and predicting a decline without saying when it will happen is cheapest of all.” (16)
What will be the catalyst for ending this bull market? Rising interest rates, the Fed’s shrinking balance sheet, rising debt, tariffs, geopolitical trouble, a spike in inflation? Some combination of these factors? We recognize that fear around these issues has deterred some investors from reaping the rewards of stock market participation over the past several years.
As stewards of your capital, we prefer data rather than conjecture. Factually, interest rates are rising. The 1-year Treasury Note yields more than 2% today, compared to less than 1% a year ago. The Federal Reserve Board has telegraphed their intentions to raise rates three times in 2019. (17) Several metrics suggest that the stock market is not cheap. (18) To understand the implications of this data, we reference the terrific metaphor recently published by Ben Inker of GMO.
“One draws an analogy to a leaf in a hurricane: You have no idea where the leaf will be a minute or an hour from now. But eventually gravity will win out, and it will land on the ground.” (19)
Academic research correlates higher valuations with lower expected returns. (20) The studies rely on math, not clairvoyance. The sequencing of those returns represents the bigger issue. Does the stock market simply buy time until earnings catch up with valuations, or do valuations adjust rapidly? Consider the two extremes. Internally, we refer to the first as “doing a Walmart”. The graph below shows the performance of Walmart stock for the 10-year period between 2000 and 2010. The stock bounced around but ended that decade close to where it started.
Was Walmart a bad company? On the contrary. Between 1997 and 2000 the stock appreciated from $10 a share to $50 per share; the elevated price reflecting investors’ optimism. It then took 10 more years for earnings to catch up to the stock price.
Conversely, return expectations might normalize from a rapid correction in prices, such as the event in October of 1987, depicted in the graph below.
Does it Matter?
Investing does not occur in a vacuum, but within the context of fueling your life journey. Empirically, we can demonstrate the reality that market volatility/downturns can improve the performance of a typical WCF portfolio, invested in stocks and bonds with regular rebalancing. (Present your nerd license and we will walk you through the math!)
Let’s consider two different portfolios in the context of 2008, what many would consider a “bad outcome” year. The first investor had all investments indexed in large cap U.S. stocks, losing 37% that year, before fees. Fear of experiencing that cliff dive remains at the core of many “itchy” trading fingers. Now consider the second investor, with a reasonably balanced portfolio - 70% in stocks and the other 30% in fixed income investments.
To illustrate our main point, consider the second investor, with the 70% equity portfolio heading into and out of 2008, who rebalanced back to 70% in stocks at the end of each year.
There were five different 5-year rolling periods that included 2008. It doesn’t matter if the investor started in 2004 and ended in 2008 or started in 2008 and ended in 2012, there were no five-year rolling periods that resulted in a loss. Again, no forecast involved.
Financial markets do not act rationally in the short run. Many predictions are made by conflicted parties and most are poor. We will not manage your money or ours based on crystal balls. Will the market soon experience a serious correction? We would not hazard a guess about that, but we do believe that long term future returns will be lower than the 10% historical performance of large cap U.S. stocks and probably closer to about 7% per year. In the future, we might see persistence of returns that are lower than the historical average, a serious correction, or anything in between.
Statistically, the quick correction to reset valuations produces superior results over steady but lower returns, for long term investors who maintain portfolios balanced between stocks, bonds and cash and regularly rebalance to a target allocation. Those with a five-year investment horizon should feel reasonably confident (under most asset allocation mixes) that they will end up with more money five years in the future. For those who think they need money for spending sooner than five years from now, we continue to recommend avoidance of exposure to the stock market for that portion of their savings and investments.
So, why does the prospect of a stock market correction, something that has occurred, on average, once every 20 months, stir such emotion? The facts suggest that a long-term, disciplined investor can use volatility to his/her advantage. Yet, “how many times can a man turn his head and pretend that he just doesn’t see?” The answer, like the leaf in the hurricane, is blowin’ in the wind. (21)
- “Why Escape Rooms Have a Lock on the U.S.” USA Today; May 7, 2018
- “The Mysteries of Suspense”; Peter G. Stromberg Ph D. Posted June 18, 2010
- “The Supreme Court decision in New Jersey’s sports gambling case could be worth billions around the country.” SBNation; June 28, 2017
- “The longest U.S. bull market? Depends on how you measure it.” Larry Berman. Bloomberg. September 17, 2018. Chart courtesy of our friends at Bessemer Trust and a few months dated now.
- Published by Pimco; September 18, 2018
- “Top Seven Investment Ideas from the Sohn Conference”, Wealth Management.com; May 9, 2017
- “U.S. Rally is Doomed. Gold will hit $5,000”. YouTube; November 14, 2009
- “The guiltiest guys in the room.” CNNMoney; July 5, 2006.
- “Bear Stearns is Fine”. YouTube; Jim Cramer; March 11, 2008
- “This Day In Market History: Elaine Garzarelli’s Infamous Bear Call”; Benzinga; July 23, 2018
- “This is the presentation David gave at Sohn”. www.greenlightcapital.com
- Most of the ‘big shorts,’ who thrived during the financial crisis, have faltered since 2008
- “What Does the Longest Bull Market Mean?” Nir Kaissar and Barry Ritholtz; Bloomberg; August 23, 2018
- “Triumph of the Pessimists”; Wall St. Journal; September 22, 2018
- “The Fed Tries to Engineer a Soft Landing for the Economy”. Barron’s; September 22, 2018
- Public’s allocation to stocks (56.3%) is the second highest ever recorded (2008 was highest) and Ned Davis Research thinks that the single best indicator of market valuation. Stock prices compared to book value, sales and earnings are all pointing toward high valuation. “The Eight Best Predictors of the Long-Term Market”, Wall St. Journal; September 22, 2018
- Multiple studies support this thesis though we are specifically referencing a presentation we attended entitled, “Probable Returns: Why the Next 5-10 Years Will Have an Unexpected Outcome” by Ed Easterling (Founder of Crestmont Research and teacher of Alternative Investments and Hedge Funds at SMU); May 1, 2017
- Lyrics to “Blowin’ in the Wind” by Bob Dylan; 1962