A mantra for 2021: “Let normal be the new normal.” (1Q21 Quarterly Newsletter)
January 15, 2021
A mantra for 2021: “Let normal be the new normal.”
The problem is, of course, that “normal” has always and forever entailed discomfort, failure, loss, and worse – for someone or ones, somewhere. Nature or God or Fate has seen to it that “just when you thought it was safe to go back into the water,” there is at least the risk the sharks will appear or reappear in one of their manifold guises (disease, war, famine, climate change, financial reverses, depression, poverty ... the list goes on).
Living with sharks (sometimes in your neighborhood, sometimes not) has been the lot of humans from the beginning. And the “progress of civilization” has involved, in large part, the construction of systems and processes (armies, laws, police forces, health systems and hundreds more) designed to keep the sharks at bay, or tamed, or somewhere else, or even eliminated.
If you thought this was going to be yet another discussion/analysis/critique of the impacts and consequences of the pandemic ... wrong. There has been more than enough of that and I have nothing new to add. What I do want to discuss is (are you ready for it?) the stock market – which I view as an (imperfect) example of a particular “system and process” developed, in this case, to rationalize (that is, discipline) the “sharks” of economic chaos and economic stasis.
And, in particular, I want to talk about the present state of the market and why, in the face of conditions that should, by any normal measure, have resulted in severe price declines, the opposite has occurred.
Recall that Warren Buffett once said that in the short-term, the stock market is a voting machine and in the long-term, a weighing machine.
One of the characteristics of a short-term voting machine is to translate votes into a supply-demand dynamic. In politics, the candidate who has the most votes wins (unless subject to the quirks of the electoral college). In the markets, the stock with a majority of votes (buyers) “wins” more demand and so a rising price. (Of course, election cycles are relatively long and stock transaction cycles are (or can be) relatively short – in many cases measured in seconds – but the principle is the same.)
Yes, and so what? Well, as investors, we must try to understand the causes of what may look like an irrational relationship between troubled economic/social conditions and generally rising stock prices. The crucial specific question for us now: to what extent do these causes, and the stock price levels into which they translate, serve as a fair proxy for the state of the economy in the next two to five years?
I will focus on four causes being discussed right now, though I think the jury is out on how well they explain what we are seeing.
Cause #1 is the Paycheck Protection Program (or “PPP”). At first blush, PPP would seem to be making a positive contribution to the economic well-being of the country, but it is not a significant contributor to the nation’s growth prospects. It is only a stand-in (albeit a critical one) for normal economic activity. The pandemic functions to debit normal economic activity and PPP functions to credit it. PPP is not additive (as, for example, product upgrades are), but functions somewhat like capital improvement expenditures. Capital improvements (as a generality) maintain asset values and so prevent or defer asset degradation. The same can be said for PPP: it is helping preserve the value of our human capital.
Cause #2 is the coronavirus vaccination. It is generally believed that the prospect of world-wide vaccinations will result, sooner rather than later, in a return to business as usual. Rising stock prices, so the explanation goes, reflect to some significant extent the prospective success of vaccinations.
I refer you to my comments about PPP. Before a widespread vaccination regime: unemployment, depressed consumer spending, recession. After a widespread vaccination regime: employment growth, increased consumer spending, recovery – all more or less to pre-pandemic levels. The pandemic is the debit, the vaccine is the credit. Great! A successful vaccination regime (and the successful implementation of PPP) will cause an economic reversion to the status quo ante – so, as is the case with PPP, no net gain (as measured, for example, by GDP). But shouldn’t rising stock prices today be the harbinger of future economic expansion rather than merely making up for lost ground?
Let me ask you this: In January 2020 and no pandemic in sight, how many thoughtful observers (even the most optimistic among them) would have predicted the actual twelve-month performance of the popular stock indices (for example, that the S&P 500 would follow a roughly 31% up year in 2019 with a still improbably robust roughly 18% return in 2020)? None. (The economic indicators we were all looking at in January were good, but not that good.) And if those same thoughtful observers in January 2020, had been able to foresee the pandemic and envision its consequences, would they have predicted the actual twelve-month performance of these same indices? Not a chance in a million.
And as a coda to my claim that neither PPP nor vaccines, however successful they may be on their own terms, will be additive to where we would have been in 2020 had there been no pandemic, there is also this. It may well be that, even if it has been brought under control, the pandemic will have the effect of moderating many people’s attitudes toward spending, saving and consuming. It is certainly possible that an extended period of enforced “austerity” may lead to a burst of excessive spending. But I suspect that, in this case, the burst may not happen. Many people have discovered a new appreciation for domesticity, home cooking, streaming media, making do with what they have ... and growing savings accounts.
If the advantages of PPP and vaccine availability were the only “contributors” to stock market performance in 2020, we should expect the stock market to return to levels approximating those of January 2020 as soon as investors generally awaken to this fact.
So, if, at best, these are faux (or short lived) “causes” then what constitutes the real thing(s)?
I think there are two other causes worth considering: one with a short term (voting) effect and one a long-term (weighing) effect. Taken together they explain the seeming disconnect between a really unsuccessful year in the economy and a really successful year in the markets. They may also give us a clue as to market prospects, as PPP and vaccines do not.
Cause #3 – the voting effect – arose as the result of a dramatic increase in the number of retail “investors” (in quotes because more correctly the word should be “speculators” or “gamblers”) who have discovered the joys of the stock market as a casino.
Think about it. A casino accessible from anywhere in the world. Open twenty-four hours a day, seven days a week. Little or no frictional costs (given the prevalence of commission-free trading). Decisions executed and confirmed in seconds. No limits (upside or downside) on amounts the willing speculator/gambler may commit. Government regulation of the “casinos” ... so no funny stuff. Endless amounts of easily accessible “what to bet on” opinions and recommendations. And a lengthy period of mass “involuntary confinement” causing tens of millions of people to seek out entertainment, action and, et voilà, the opportunity to get rich quick (or at least the opportunity to make some easy money) ... “all from the comfort of your own home.”
We have seen this phenomenon before. Think the Great Dotcom boom and its associated day-trading. But what we haven’t seen before is the number of people in the game (and “game” as in “gaming” is the right word) as well as the associated “efficiencies.”
In a period of generally rising stock prices, many folks (professionals and amateurs alike) employ a stock picking technique known as momentum investing. Over-simply (and recognizing that I am subject to criticism for ignoring the nuances) this technique consists of buying stocks that are going up and selling stocks that are going down. It is the favored technique of those millions of “investors” who are trading from the comfort of their own homes (or from their places of employment or from wherever they happen to be isolating).
Yes, there is a strong element of self-fulfilling prophecy about this technique. And yes, it fails when markets either stagnate or enter a period of generally declining stock prices. But it worked pretty well in 2020 and translated into significant demand, and so rising prices.
There is no way of telling how long the voting machine effect will endure, meaning how long the millions of “investors” will stay in the game, meaning how long before we enter into a period of market stagnation or generally declining stock prices. If I am right about Cause #4, it could be for a while yet.
And what is Cause #4, the fundamental economic weighing-machine circumstance that may be driving market advances? At some point in 2020, well into the pandemic experience, a number of professional investors realized that one of its longer-term consequences had to be either the weakening of the economic strength of some (many?) firms, public and private, or their elimination altogether.
From this realization one obvious (albeit brutal) fact emerged. Post pandemic, there would be a diminished number of competitors. Thus, firms that managed to survive and remained strong would enjoy increased market share and increased pricing power.
I conclude that in 2020 there really wasn’t the disconnect between the stock market and the “real” economy. PPP and the prospect of a vaccine gave (misplaced) hope to some that we would all be better off than before the pandemic. This did have a positive impact on the market, but an impact that diminished over time as investors and commentators realized these interventions would, even under the most optimistic scenarios, simply return the economy to January 2020. Not a bad place to be, but not a place from which to anticipate significant upside performance.
The fundamental reasons for the disconnect that “wasn’t” (or “may not have been”)? Millions of people, “enfranchised” by easy access to “casinos” and motivated by a combination of boredom and the prospects of easy money, created a ground swell of massive demand with, of course, predictable consequences. But with the voting came the weighing. Usually, weighing of value emerges over the long term. But in the case of 2020 the weighing began early as (primarily) sophisticated investors began to analyze the favorable economic consequences that will accrue to those companies who survive the pandemic and stay strong.
There is actually another “cause” for market performance, one whose impact is a mystery to me. It has to do with the policies of the Federal Reserve (low interest rates, debt market support particularly), and the extent to which such policies translated into positive investor attitude and behavior in 2020. I don’t know to what extent the belief that the Fed is your friend moved investors. So I note it ... and move on.
As a generality, our firm seeks to avoid investing in assets whose valuations are based on voting (unless we come across assets where large numbers of “no” votes have driven prices down to compelling levels), and stick with assets whose (favorable) valuations are based on weighing. With this said, it may be the case that between the voters and the weighers, stock prices can reach, at least in some famous cases, unjustified levels. (Note that “unjustified” almost always means that speculator/gamblers, who care nothing about fundamentals, have succumbed to some variation of the madness of crowds; or smart money has applied an overly optimistic assessment to future company prospects. Or both.)
Going forward, I think there may be a “contest” for influence in the stock markets between the voting forces and the weighing forces. If I had to bet – and, given our investment methodology, I don’t (see below) – I would come down on the side of the “weighers.”
P.S. A good year in the stock market makes everyone (or at least those who participate) happy. But from the point of view of WEIL a good or even great year is significant not for its “goodness” or “greatness” but because it tends to confirm our long-term investment thesis. By this I mean:
We expect to manage our own and client money forever.
We know that there will be “good” years, “bad” years and “indifferent” years during our tenure.
Generally, if you treat the equity markets as markets and not as casinos, if you buy quality assets at reasonable prices, if you diversify adequately, and you manage with a long-term (or in our case, infinite) horizon, then your total return (capital gains, dividends and interest, less capital losses and management fees) as measured during a reasonable holding period (say minimum five years of good, bad and indifferent market performance) will prove satisfactory. The good or great year, like the bad or indifferent year, is just one component in a lifetime of building and sustaining a foundation of assets which will be forever available to you and your heirs.
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