An investor asked an important question on our April 28 quarterly conference call: How can anyone have a rigorous investment process when there are so many unknowns out there? I think that’s a very complicated question, and I want to go through it in more detail than I did on the call.
It’s certainly true that there are a lot of unknowns, with corporate and economic chaos, government intervention, Covid-19 and a race for its cure, and so on. I heard one comment I wish I’d been clever enough to think of: “At least in a casino you know what the rules are.” The rules keep changing as the Fed races to help asset prices and government tries to keep the economic balls in the air. What to do?
Things are changing by the day, whether it be prices, government plans, lockdowns, or hopes for a cure. Can you keep following a standard investment process in highly volatile times like these? I think it’s possible, but I’m not sure it’s the best idea. For instance, a lot of people love to follow trends. This has been a good idea for the majority of the last decade or so, but the whipsaw both up and down this year has been rough. Just look at some of the continued chaos in CTA (Commodity Trading Advisor) funds of late. That’s OK, all strategies have good times and bad times. Value investing was generally a great idea from 2000-2007, but not so much from 2012-2019. Times change.
I don’t generally like rigid strategies. Maybe it sounds good to have a very set investment process, but I don’t think it matches well with the constantly changing investment landscape. I tend to think ‘to everything there is a season.’ Sometimes one idea does well, sometimes other ideas do well. If you can recognize and understand those changing times, I think shifting to something better makes sense.
I’ve always liked the general idea that I think Ray Dalio first mentioned, which is the basic idea of taking an event and trying to find different events that are similar to it. So what is the current event like? To me the most similar event is the financial crisis from 2007-2009. Volatility got very high then, the only other time we had such high volatility. There was a tremendous amount of financial stress. Everything changed. Previously, financial stocks were a great place to be, until they became horrible destroyers of capital. It was a seminal change.
Given that, what should we expect? High volatility lasted a while during that period, and that seems likely now. Six-month volatility, for instance, has remained elevated even in this nice rally, so the market sure thinks volatility is here to stay for a while. During 2007-2009 we saw seven declines ranging from -10% to -36%. We also saw four moves higher of at least 10% (plus two more times that came pretty close). I don’t think we should be surprised to see similar action here. In fact, I expect it will be more dramatic, as our new market system seems to feature less liquidity, principally due to the increase in micro-second traders, and the decrease in the duty of market makers to provide liquidity.
In other ways, you can compare this to 2000, due to the top five names being such a huge portion of the market and growth stocks outperforming value by leaps and bounds. Goldman Sachs has noted this issue. In 2000, the top five stocks (MSFT, GE, CSCO, INTC, WMT) were at the highest aggregate level at least since 1990 at 18% of total market cap. Today, MSFT, AAPL, AMZN, GOOG, and FB represent 22% of market cap. Growth has also been outperforming value to an increasing degree, most obviously this year. Like then, this outperformance has helped make the overall market expensive vs. history. Goldman says that based on history, we need to see broader participation or risk a sharp decline. Either way, it seems unlikely that big tech stocks are the place to be going forward.
That’s the history, but how should we invest? First, comparative periods were dangerous, so we want to generally be conservative. Could we just get very defensive and sit tight? Sure, but as we’ve already seen, prices can be very volatile in these situations. My attitude is we can keep an eye on the market pillars of fundamentals, macro, sentiment, and technicals to see where we are and decide what to do. Done right, and with caution in mind, this should allow us to do better. With all the chaos, it’s also relatively hard to know how we want to be positioned in a year. Will a defensive position still be merited? That seems impossible to know.
Right now, for instance, fundamentals are poor, macro is poor (though there’s ample accommodation from the government), sentiment has soared short term, and technicals are pretty overbought. It’s hard for me to find reasons to be very bullish right now. Conversely, in late March federal accommodation came to support markets, sentiment was awful, and we were severely oversold. That seemed like a good time to be invested. From there, things changed quite a bit in a matter of weeks.
Looking at the economic landscape, I broadly agree with Hedgeye that the economic situation will continue to be volatile. Obviously the economy is crashing quickly, but there should be some amount of recovery as the world opens back up for business. As the year progresses, there is likely to be a time of further economic problems due to high unemployment, changes in consumer behavior, and the credit cycle, if nothing else, indicating a need for caution. Next year we’ll lap these hard times, making for easy comps, and that may create opportunities. You can stick with one rigid overarching investment process through that chaos, but I think that would be tough.
There are plenty of other questions to consider. Will government support totally insulate business and markets from problems? Investors largely seem to believe so, but we’ve already seen bankruptcies after the announcement. Considering municipal and state revenues are plunging, can the government cover all those messes? What does the coronavirus look like going forward? Could there be a cure or medicine soon? Would a vaccine work or is it something like the flu, where you need an annual shot that hopefully works? Can you get re-infected? Does it just burn out eventually? In general, what are the long-term ramifications of this mess?
I’m not willing to predict these things. All we can do, in my mind, is use what we know at each point in time and make reasonable judgments with them. What happens exactly, and when? Beats me. Will we see a V-shaped recovery or some other letter? I don’t really know. Will we see a big rally starting March 2021? Sounds a little too easy to me, but who knows? There are a lot of unknowns, and I don’t think it pays to be too firm on what exactly happens when. I’d rather see what’s in front of us and react to that.
Ultimately, we don’t control anything, all we can do is see what Warren Buffett’s Mr. Market offers us and decide what to do with it. As Buffett said, Mr. Market is pretty excitable, which should be obvious from recent market action that has seen the S&P 500 trade in a huge range. That can be used to our advantage, and that’s our basic investment process right now.
