The 3rd quarter of 2020 saw a continuation of the rebound in stock prices as the US economy began to recover from its COVID-related lockdowns and restrictions. Much of the stock rally came in August, which saw leveraged buying by retail investors (individuals) of the usual mega-cap tech stocks and in speculative positions such as Tesla and Zoom. Treasury bonds were unchanged yielding 0.68% at both the beginning and end of the quarter, and gold prices rose 6%.
For the year to date, rising stock prices of the largest tech companies led indices higher while other stock prices, on average, declined. A notable divergence occurred between those large popular technology companies and the rest of the market. Large technology stocks dominate the so-called "growth" style of investing, as well as common indices such as the S&P 500. These are different than the ‘value’ companies, which tend to grow slower, be boring, out-of-favor, overlooked, and much less of an influence on the performance of the S&P 500 solely due to their smaller relative size.
One of the best characterizations of growth and value was made by Jim Grant, author of Grant’s Interest Rate Observer, who calls growth stocks “desirable because fast-growing, big, popular, world-beating and transformative”. Value stocks are “desirable because underpriced.” Growth stocks tend to trade at high prices relative to earnings and cash flow and value stocks at low prices.
To illustrate the recent divergence in price action, a large company growth index, the Russell 1000 Growth (40 percent of which is invested in six companies), rose 25% in the first 3 quarters of 2020. On the other hand, large company value stocks, as indicated by the Russell 1000 Value, declined 11%. Never before has there been such a difference in returns between styles of investing in nine months. And this is a continuation of the same divergence that has occurred for 13 years. For context, in the full year 1999, another time of huge popularity in the growth style (and the last year of growth’s 14-year dominance), the Russell 1000 Growth index rose 33% and the Russell 1000 Value was only up 7%.
We do not believe in a pure style of investing because it does not make sense to limit oneself. Fast-growing companies with higher multiples (price-to-earnings ratios, price-to-cash flow, etc.) can be great long-term investments. And slow companies that appear to be “cheap” (low price relative to earnings) can be terrible investments.
But we do note that, even including the last 13 years, value stocks have significantly outperformed growth stocks in the long run (see chart below). Why? Because on down days, value stocks tend to be down significantly less than growth stocks – enough so to make up for growth stocks’ outperformance on up days. Style statistics aside, successful investing comes down to the quality of analysis done, the price paid for the investment, and patience. Today, psychology, questionable beliefs, and short-termism are driving markets and causing many investors to pile money into poor long-term bets – poor because they have significant downsides if less-than-perfect results materialize.
Zero percent interest rates, zero-cost stock trading, abandoned bank reserve requirements, record-setting money supply growth, and the Federal Reserve’s open-ended commitments to “do whatever it takes” to support the stricken economy have had a huge effect. They have provided both the fuel and matches to ignite massive buying in the riskiest assets: tech stocks, private equity, and development stage companies. Options contracts, leveraged ETFs (exchange-traded funds that use leverage), and one-click mobile trading apps have facilitated the bidding. Emboldened by the herd, speculators threw caution to the wind and, despite already stretched valuations, bought the same stocks that they have been loving for five years: Apple, Amazon, Facebook, Google, Microsoft, and Netflix.
According to Bianco Research, those six stocks have accounted for over 100% of the year-to-date S&P 500 return of 5%. In other words, if you owned the S&P 500 without those six stocks you would be down. The equally-weighted S&P 500 is down 4% for the year. The median stock in the Value Line Index (1681 companies) is down 14% year-to-date. It is incredible that six stocks carried the S&P 500 return from negative territory to positive in nine months!
What does this mean?
It means that while the investment backdrop is favorable, price distortions from incentives, psychology, and behavior necessitate vigilance. When a narrow set of stocks drives the entire market upward, it is time to avoid them. When it is believed that prices don’t matter, it is time for caution. When there is euphoria and a sense of easy money, be on the lookout. Better long-term opportunities exist in quality overlooked stocks. This was true during the height of the Nifty Fifty in the late 1960s – early 1970s, true during the Japanese “miracle” in the late 1980s, true at the height of the tech bubble in 2000, true for real estate in the mid-2000s, and true today. When belief systems form and risks are ignored, it’s time to be discerning with your investment capital. As Warren Buffett quips, “Be fearful when others are greedy and greedy when others are fearful.”
Today, fueled by mass speculation, cheap credit, technological change, and COVID-19, new beliefs seem to be taking hold. Many people seem to believe that interest rates will be microscopic forever; technology will enable a new work-from-home world that eliminates the need for offices, business travel, and in-person interactions; inflation is dead; gas-powered cars’ days are numbered; the US economy will always dominate the rest of the world; and that the US government can operate through deficit into perpetuity. Many of those assumptions are questionable.
Much of today’s investment environment is enabled by Federal Reserve policies. Since 2008, the Fed has acted as a guarantor of questionable credits, conjured trillions of new money with a few keystrokes, and suppressed interest rates. The Fed states that it is focused on full employment and price stability (yet it deems a 2% annual decline in the value of dollars to be acceptable) and that it “is prepared to use its full range of tools” to achieve those two goals. But can the Fed really control market prices, economic growth, employment levels, inflation rates, and investor behavior by adding more and more debt? We will see.
What the Fed does not say is that the byproduct of deploying its tools (suppressing rates and printing money) is to facilitate overborrowing, incite speculation, cause capital misallocations, entrench incumbent businesses, create zombie companies, increase wealth and income disparities, increase the risk of financial instability and expose traders of momentum stocks (individuals in many US households) to large losses.
Inciting speculation is one of the reasons that growth stocks have outperformed value stocks over the last 13 years (a period of suppressed interest rates). That trend accelerated in the 3rd quarter. In a recent report by Bank of America, the three months ending September 30 have produced the biggest outperformance of growth style stocks for any period since 1932, the year that Herbert Hoover lost the presidential election to Franklin D. Roosevelt.
And as if to punctuate today’s popularity of growth stocks, Exxon Mobil was expelled from the Dow Jones Industrial Average in the 3rd quarter and replaced with Salesforce.com – the cloud computing phenomenon with a sporty $231 billion valuation. Salesforce.com has earned a cumulative total of $1.9 billion for its entire 19-year existence.
Will this trend in growth stocks’ outperformance continue going forward? Without getting too deep into the analysis (and in the spirit of keeping this letter brief) we will say that the case is very strong that it will not for five primary reasons:
- The winding down of lockdown measures as the pandemic abates (whether by nature or a vaccine) could shift consumer spending back to bricks-and-mortar from the online realm. Traveling will recommence and schools will go back to in-person;
- Interest rates are unlikely to fall further, falling rates being a primary tailwind fueling tech outperformance;
- Valuations in technology stocks are super-stretched;
- Large tech companies are so big that the laws of large numbers dictate that further market share gains will be difficult, if not impossible to achieve going forward in percentage terms; and
- Regulatory and tax policy changes could negatively affect a number of prominent tech companies going forward.
Tech insiders seem to agree with this assessment as they sold $10.4 billion worth of stock in the second quarter, a 171% increase over the second quarter of 2019 (the 3rd quarter data is not in yet). And they bought $35 million worth of shares in the second quarter, a 67% year-over-year decline. So, tech insiders are seeing something that speculators are not.
This presents a conundrum.
The combination of zero percent interest rates and a 2% inflation target forces people to take some kind of risk. Why? If one were to hold 100% cash at a zero return with a 2%annual inflation, that cash would have 81% of its purchasing power in ten years. Every day that one holds only cash is a loss of real wealth. As the number of people retiring increases, and more withdraw their portfolios to finance their living expenses, the negative compounding effect of inflation and withdrawals force risk-taking. The question then becomes, what types of long-term risks are prudent? With extremely high prices in tech stocks, it is a difficult question.
We continue to believe it will pay to be careful with investment dollars and to not chase returns in the popular stocks. Why? Because entry points matter. To illustrate this, in 2000 Microsoft changed hands at 65 times earnings and 20 times sales. This high multiple reflected expectations of high future earnings growth. And indeed, over the next 14 years, Microsoft’s earnings increased from $0.71 per share to $2.59. But the stock price declined 30% over those 14 years because the stock already reflected a rosy future at the beginning of the period. And not coincidentally that same 14-year period was one when overlooked and unloved (value) stocks of 1999 performed spectacularly.
The total U.S. stock market value today stands at $37 trillion, or 190% of GDP, which is higher than the peak in 2000 of 167% of GDP. Arguably stocks overall are richly priced. But that statistic is heavily skewed by the mega-cap tech companies that drove the overall market higher and are now insanely expensive. Value stocks are the cheapest they have been relative to growth stocks ever (higher than during the dotcom bubble – see chart below) so there are plenty of great long-term opportunities.
What will it take to get the underappreciated stocks to outperform? A re-opening of the economy, a whiff of inflation, rising interest rates, a weakening dollar, or a pickup in economic growth in the rest of the world. This is what began to happen in the 2000’s shift toward value. And, today as then, these are possibilities not priced in. If the slow growth, low inflation, and low-interest-rate world that we have seen for the last 13 years begins to reverse, it could cause investors to question their beliefs and dramatically change their positioning. If they don’t occur, the extreme price differentials and one-sided market psychology may all by themselves be enough to reverse it anyway.
The last time that growth stocks dominated value stocks for 13 years was the period 1987 – 2000. When that situation reversed, value stocks made back their entire 13-year underperformance in 13 months.