The market over the last several days has me thinking about Soul II Soul, and their 1989 hit, “Back to Life.” For those who don’t remember, or who wisely blocked it out, I apologize in advance because it is one of those songs that gets into your head and you want to get it out, but can’t. It goes, “Back to life, back to reality…” I’m pretty sure those were the only lyrics but you can fact check me on that. (Again, sorry.)
Anyway, this is exactly what is happening in the market today. We went too far too fast, especially with the technology stocks, and they are simply coming back down to earth. This much, frankly, is not all that insightful; it is obvious. What may be less obvious is what is happening underneath the surface.
We have written about this before, but it bears repeating: This market rally has not been a tide that has lifted all ships; it has been decidedly unbalanced in favor of the technology firms that have benefitted from the Covid-19 world of virtual work, school, and social life. To put it in perspective, one can look at the Morningstar style boxes.
As a reminder, Morningstar breaks the world up into a grid consisting of large companies, small companies, and those in between. They also break the universe up into stock of companies that would be attractive to the average-growth investor, value investor, and in-between or blend investor. The index for the large-company growth box is the Russell 1000 Growth index, and it returned a positive 23.2 percent over the 12 months that ended June 30, 2020. Over that same period, the small-company value box represented by the Russell 2000 Value index returned a negative 17.4 percent. Yes, you read that correctly – there is a 40 percent difference over the last year between one category of stocks and another. No, that is not normal.
Not only is it not normal, it is historic. It is also completely unsustainable. The last time anything came close to this in the market was the dot-com bubble. The similarities between now and then are striking. Then, large-growth (aka technology) stocks had dominated the returns in the market for a decade. Today, large-growth (aka technology) stocks have dominated the returns for a decade. Twenty years ago that dominance accelerated toward the crash. Today, the dominance has certainly accelerated.
Here the stories differ a little bit. Twenty years ago there were many tech companies, lots of whom did not have a sensible business plan let alone things like revenue, and almost none of them had any profits. Today, that is not the case. These firms represent the core of our economy. They are the big blue chip companies. Coming back to reality twenty years ago meant industry consolidation and years of building actual businesses. Amazon was an online bookstore when the dot-com bubble burst. Today it is everywhere.
I’m not sure whether Mark Twain actually said it, however, “history does not repeat itself, but it often rhymes.” There is no force in investing stronger than what we call the reversion to the mean. That is a fancy way of saying stocks seem to find a way to do what they have always done on average. There should not be a 40 percent gap between one segment of the market and another, and that gap will disappear. It appears to have begun that process a few days ago, as technology stocks have been the biggest losers in this short selloff.
This doesn’t mean we have to go through a bear market as we did when the tech bubble burst twenty years ago. It does mean that there are many areas of the market that have been neglected over the last decade, and they will catch up. Diversification is likely to be much more important in the decade ahead of us then it has been.
One last thought. Nineteen years ago, terrorists from the other side of the world flew planes into the World Trade Center and the Pentagon. Heroes on another plane fought back against a fourth attempt, crashing into a field in western Pennsylvania. That day is burned into my memory like few other days. However, what I want to focus on right now is the days that followed. For a brief time, we came together as a nation, and it was the most beautiful thing. The goal of the terrorists was to split us apart, but the opposite happened.
Unfortunately that unity did not last long, but those of us who lived it can still remember that togetherness is possible. Hopefully my children will get to experience such a time, and hopefully it won’t take an enormous tragedy to make it happen.
Too many people died on that day. Don’t ever forget that with all of our flaws and how far we fall short from the scale of perfection, when graded on the curve of human history, the United States is the shining city on the hill. We are the light in the darkness. That is why we were a target then, and it is why we remain a target today for those who, at their core, are the enemies of freedom.
The markets get carried away as does society at large sometimes, but ultimately we have to come “back to life, back to reality.” (Sorry, I know it is a horrible song.)
Chuck Osborne, CFA