We enter the new year—and new decade—with more questions than usual. What has happened to democracy and the rule of law in the U.S.? Is the global alliance of liberal democracies kaput? Do truth and evidence still matter? Are historical norms in monetary policy, economies, and financial markets no longer relevant? Will Vermont ever have a normal winter again?
Given space constraints (and our lack of expertise), we will opine here only about financial markets and related economic and monetary considerations.
It’s understandable to conclude that, after a long period of a trend, a permanent change has occurred. After all, it’s human nature. Three historical examples come to mind. First, in the (“Roaring”) 1920s, rapid economic growth and technological breakthroughs (notably RCA’s radio) capped a euphoric decade that ended with record-high stock prices. Few were worried about the stock market’s future. In 1929, eminent economist Irving Fisher proclaimed that, “Stock prices have reached what looks like a permanently high plateau … I expect to see the stock market a good deal higher within a few months.” Yet stocks soon crashed, and the Great Depression ensued.
Second, the 1990s’ stock market boom also was boosted by technological breakthroughs, specifically the Internet. Some observers proclaimed a “New Era” of prosperity. Once again, after reaching extremely high valuations, the stock market plunged. It took until 2013 to surpass the market’s 2000 peak.
Third, in the early 2000s, soaring residential house prices reached levels that were far higher than historical norms, relative to household incomes. Yet again, the consensus view was ebullient, since residential house prices nationwide had never declined (at least not since the 1930s). When cracks in the housing market emerged, Federal Reserve Chair Ben Bernanke assured the financial markets that the financial collapse of the subprime mortgage market (which became the spark for the 2008 financial collapse and Great Recession) was “contained.”
Fast forward to today. After more than a decade of robust stock market gains and an absence of an economic recession, the prevailing view apparently is that despite having a lunatic in charge of the most powerful nation in the world, our Federal Reserve (“the Fed”) will prevent anything too bad from happening to the economy or the stock market.
After all, didn’t the Fed repeatedly stem declines in the stock market over the last decade by printing several trillion dollars to inject into financial markets? The Fed also has kept short-term interest rates near record lows, a decade into an economic expansion. Long-term interest rates also are near record lows despite federal budget deficits of more than $1 trillion and aggregate national debt of $22 trillion, which many had assumed would “crowd out” private borrowers in the demand for funds and drive up interest rates. And consumer price inflation has not jumped despite ten years of economic growth.
Do we think it really is different this time, that historical norms no longer matter? Emphatically not. We believe that humans still repeat errors in decision-making that result from overconfidence in good times and despair in bad times. This produces large mispricing of investment assets that provide opportunities for patient, value-oriented investors. This has been true time and time again in various asset classes, parts of the world, and historical eras. Over the long term, asset mispricing that is extremely high (overvaluation) results in future returns that are below average (and vice versa). That’s where we are today—with a stock market at extremely high valuations.
The key is long term. Investing is all about analysis and probabilities, and it is critical to avoid being swayed by the news of the day, short-term market swings, or most important, herd behavior. Forecasting is futile, because no one can accurately predict the future. We can, however, observe asset prices and infer what they reveal about the prevailing view of the future. It historically has been worth going against that prevailing view in seeking profitable investment opportunities.
Current stock market valuations reflect extremely high levels of investor confidence. Whether it’s outright greed or the recurring phenomenon of FOMO (fear of missing out), institutional and individual investors want in. Besides the major stock indexes holding at record highs, the economy is being supported by consumer spending, despite a recession in the manufacturing sector. Remember, though, that a strong economy does not precede large gains in the stock market. For example, housing starts recently hit the highest level since 1968. Stock prices, however, peaked in 1968 and took fourteen years to exceed that level.
In addition, Bloomberg reported recently that its index of confidence among American consumers had surged to the best level since October 2000. That’s actually bad. Stock prices fell by 45% from October 2000 to October 2002. There are many more examples that show that the economy is a contrary indicator for stock market prospects.
As we begin to consider what today’s asset pricing and survey expectations for interest rates and inflation suggest for investment conditions in the coming decade, we wonder whether conditions will be quite different from the decade just ended (as has been the case over much of the past century). If so, our contrarian approach that favors value stocks rather than growth stocks would have history on its side. (We’ll have more to say about the next paradigm in an upcoming essay.)
Again, we don’t make forecasts or guess what catalyst(s) might trigger financial distress. In setting our strategy, however, we remain convinced that the most responsible action is to emphasize capital preservation after a decade of stock market gains. Cash is at the high end of our target ranges (in anticipation of better buying opportunities later), and favored stock sectors are conservative, notably real estate investment trusts (REITs), communications services, consumer staples, and health care. Finally, we’re using put options on the S&P 500 index as a hedge against a historically large market decline (for clients who deem this appropriate).