The difficulty lies not so much in developing new ideas as in escaping from old ones.
John Maynard Keynes
Our insights, reflections and musings on the most timely topics relevant to managing your investments.
Right now there is a tug of war going on between people who believe that all this stimulus and the Fed keeping rates low will lead to wonderful economic growth, and those who believe that all this spending on top of easy money will lead to simultaneous high unemployment, high interest rates, and high inflation. What does this mean for the market? That is a good question. When things get uncertain and the market is not sure where to go, bottom-up investors tend to do best.
Lay investors buy the stock of really good companies and hold on to it. That is investing. GameStop is not such a company, and the people buying its stock have no intention of holding it and gifting it to their kids. This isn’t investing, it is trading, and there is a huge difference.
To the extent that what happened to Gamestop is a problem, it is all due to the fact that the SEC has allowed short sellers to run amuck for more than a decade now.
For what seems like years now, we have been talking about the market’s unhealthy skew toward large-growth companies. Some of our clients have even taken to making fun of me because of my insistence that this will pass. The season will change, value is coming.
We have a new ornament on our tree this year: a roll of toilet paper which simply says, “2020.” What a year it has been. It actually has been a positive year in the markets, although as we have said before, those gains are not equally distributed. However, even the unloved value stocks have made…
The Federal Open Market Committee of the Federal Reserve (Fed) met last week and while they did nothing, they said plenty. Fed Chairman Jerome Powell told us that the Fed now expects economic growth in 2021 of 6.5 percent, and that the Fed will still not raise rates even if inflation creeps up beyond their 2 percent target.
This rosy outlook on growth is partly due to the fact that Congress just promised to spend another $1.9 trillion dollars on top of what was already a rapidly recovering economy. The market has sold off; how could that be?
In a word, inflation. Right now there is a tug of war going on between people who believe that all this stimulus and the Fed keeping rates low will lead to wonderful economic growth, and those who believe that all this spending on top of easy money will lead to simultaneous high unemployment, high interest rates, and high inflation. Grow out your sideburns, flare out those pant legs and someone find us a disco ball, 1970’s here we come! Would “Billy Beer” be considered a micro-brew? (Now I’ve dated myself.)
Thus far the inflation worriers are winning. The short-term data is certainly helping them. The last reading for the Consumer Price Index came in at 1.7 percent, and the last reading for the Producer Price Index (or wholesale prices) came in at 2.8 percent. In the meantime, the Fed can keep the overnight borrowing rate low, but markets control other rates and the 10-year Treasury is yielding 1.74 percent as I write this article. That is up from 1.44 percent at the beginning of this month, or 0.93 percent at the beginning of this year. This does not bode well for the economy, and it comes as expectations are extremely high.
What does this mean for the market? That is a good question. It is times like this when prudent selection of individual investments really matters. When things get uncertain and the market is not sure where to go, bottom-up investors tend to do best. This flies in the face of the modern groupthink that index investing is the way to go.
Recently we took a look at our own institutional business, where we help retirement plan sponsors decide which money managers (through mutual funds or other institutional products) to include in their plans. Over the decade that ended December 31, 2020, we have 28 managers that we have held in client plans for that entire decade. Of these 28, 23 are outperforming their market benchmarks and five are not. That equates to 82.1 percent outperforming. The average amount of outperformance is 1.90 percent annualized over that decade, and the average amount of underperformance is 0.38 percent.
Keep in mind that one cannot actually invest in an index; one can only invest in a product that seeks to mimic the index, and by definition all of these products will underperform the index due to the real-world fees and expenses. These investors insist that outperforming is impossible. They proudly save a few basis point in fees and end up sacrificing, in this specific case, almost 2 percent in net return per year.
In fairness, there is the possibility of survivor bias, meaning we would have fired underperforming managers. There were four managers fired and replaced 9 years ago, all of the four new managers are outperforming, but we did not include them because we did not own them 10 years ago. The last replacement we made was three years ago, and we replaced two managers six years ago. The fact is, we have consistently done what the popular press says cannot be done: picked managers who outperform over the long haul after we pick them.
This is not an advertisement in any way. Perhaps it would be if I believed that what we do is unique, but I do not. I truly believe that there are many firms that can do what we have done. This is strictly for educational purposes. Intelligent managers who make prudent bottom-up investment decisions add significant value over time.
This is very important information when we are collectively heading for a very uncertain future. We will continue to discuss specific economic policies and their real-world results on our Perspective blog, but the big picture is that we seem to be heading for what Jimmy Carter called a malaise. We shall see, but if Jerome Powell’s 6.5 percent is an over/under bet, I will take the under, and still sleep well knowing that my investments have been selected prudently.
Chuck Osborne, CFA
~Tug of War
In our last Insight I made a prediction about this new day-trading phenomenon: “Trust me, there is nothing new, and nothing good, in this GameStop story. This will not end well for any who get involved.” This brings to light a question: Is there a place for the individual lay investor, or should investing be done only by trained professionals?
I want to be clear: I am a huge fan of the individual lay investor and believe strongly we should have more of them. Does that seem strange coming from someone who makes a living professionally managing other people’s money? Many of my clients have heard me use this analogy before, but I (and any service professional, for that matter) am no different than a plumber. If one has a leaky faucet and is handy with a wrench, then he can save himself some money and fix it himself. On the other hand, if he isn’t that handy, he would be better off in the long run calling in the professional.
Investing is no different. If one has the passion for research and the right temperament, then she can easily do what we would do for her and save some money along the way. Of course, real life isn’t black and white, not one way or the other.
Just this past weekend we had two plumbing issues in my house. The first was the sink in our guest bathroom, which was draining slowly. A clogged drain is pretty simple, so we had no issue tackling this ourselves. It became a little more complicated when the original (we think) 1940 pipe broke. Still, replacing a pipe for a bathroom sink is not hard. The hardest part is the tight working area, so I practiced my Yoga poses and grabbed a wrench. It probably took me longer than it would have a professional, but it cost a grand total of $30 at our local Ace Hardware store. It was also a cold, rainy day, so nothing lost there.
Two days later we had a major backup. This was a little more serious as one side of the house, including our clothes and dish washers, kitchen sink, half bath and two full baths were out of commission. The other side of the house with two full baths was still good, so we were able to isolate the problem. I do own a small household plumbing snake, so we gave it a go. We removed some gunk (I’m pretty sure that is a technical plumbing term) and got a little relief, but it wasn’t completely fixed. For our house, it was time to call in the professionals.
Some of our readers would have called long before then, and some would probably be in their basement replacing pipes as I write this. We all have a different moment when we say, “Call the plumber.” It depends on many factors. What is true in plumbing is true in investing.
The lay investor can do very well for herself if she sticks to investing – researching companies she is familiar with, buying their stock at a good price and holding it for the long term. I know Apple lovers who have owned Apple stock since the early days of the Mac. They have done very well.
Several years ago it would be common for us to meet a client who was retired and was holding onto some shares of Coca-Cola that their father had bought or had been given when he worked there. It had made their families rich. That generation has passed, unfortunately in my opinion. We have never, and I’ll bet my retirement that we won’t ever, have anyone come to us with an index fund that they inherited from their father that made their family rich. This, also unfortunately in my opinion, is what people think of in terms of investing today.
This is what lay investors used to do: buy the stock of really good companies and hold on to it. That is investing. GameStop is not such a company, and the people buying its stock have no intention of holding it and gifting it to their kids. This isn’t investing, it is trading, and there is a huge difference. Trading is a game and a form of gambling. Please do not read into that any kind of judgement; games can be fun, as can gambling, if done responsibly.
The problem is when lay investors fail to recognize the difference between investing and trading. The lay investor can do very well, if he has a good disciplined strategy and is truly investing. However, there is a saying in poker that if you have been in a game for 30 minutes and you cannot figure out who the sucker at the table is, then you’re the sucker. The lay trader is the sucker at the table. He is going to get cleaned out, it is only a matter of time.
If someone wants to take a few dollars that don’t really matter and play that game for entertainment’s sake, then more power to you. However, never mistake that for investing or one will end up gambling away far more then she can afford.
If one wants to invest on their own, follow our three rules: Invest from the bottom-up, be absolute return-oriented, and be risk-averse. If that seems like too much work, well that is why we are here. Know when it is time to call the plumber, and you can live comfortably in a nice dry house with working toilets.
Chuck Osborne, CFA
~When Do You Call The Plumber?
“The spectacle of modern investment markets has sometimes moved me towards the conclusion that to make the purchase of an investment permanent and indissoluble, like marriage, except by reason of death or other grave cause, might be a useful remedy for our contemporary evils. For this would force the investor to direct his mind to the long-term prospects and to those only.”
~ John Maynard Keynes, “The General Theory of Employment, Interest and Money”
I have to tell the truth: I wish I were writing about almost anything else. I find last week’s big story regarding Gamestop and the battle between young, inexperienced hedge fund traders and young, inexperienced day traders a boring distraction from real investing. I share this quote from Keynes as a testament to the fact that if one believes that this is somehow new or unprecedented, then he is gravely mistaken. In fact, I am going to go out on a limb here and say that regardless the subject, if one believes something is truly new, she is wrong. There have been approximately 4,000 years of human history. Whatever it is, it’s been done before. The only thing unprecedented about our era is that we now have too much free time to obsess on the trivial. But I digress.
The story of Gamestop is not complicated. Gamestop sells video games and gaming merchandise much the way Blockbuster used to rent movies. Its future, unless it can completely reinvent itself, is to follow the path of so many companies before into oblivion; to become an answer to trivia questions, and one day be highlighted in a movie where some kid goes back in time.
With this in mind it is certainly a company whose stock should be sold – and sold it was, by not only those who owned it, but also those who did not own it, the short sellers. Here is where a major regulatory disfunction becomes highlighted, once again I might add. To sell short (which is the term used to describe selling a stock one does not own), investors used to have to wait until some other investor bought the stock and caused the price to move higher. This was called the uptick rule, and was the way short selling worked from 1938 until 2007 when the SEC, in their infinite wisdom, removed the rule, and … well, do you remember 2008?
In 2010 the SEC wrote a new, watered down, far-too-complicated (which is another way of saying it’s easy to get around) version. Since then, short sellers have given us the flash bear market in 2018 and last year’s road to misery. The problem, in terms of fixing this, is that the impacts are short-lived and they actually create opportunities for longer term investors. We bounced back very well in both of those cases.
What is less noticeable to lay investors are the micro-disconnections that occur on individual stocks often. We see this almost all the time; there is a compounding effect whereby most hedge fund trading today is run by computer models and all the models are the same, so every professional trader is on the same side of all of these trades, and the daily volatility on individual stocks is hugely amplified.
Some day traders (that’s what we called them when I was their age, so that is what I’m going to call them) figured this out and saw an opportunity. The rest of the story is just color; this is the essence of what has happened. Is it a problem? Not really, but to the extent it is a problem, it is all due to the fact that the SEC has allowed short sellers to run amuck for more than a decade now. Bring back the uptick rule and this story goes away.
For the rest of us, times like this are a good reminder of why we invest prudently. We are owners of companies, not traders of stocks. These things do not happen to quality companies with solid futures. We are bottom-up investors; we invest in companies, not the “stock market.” The market is exactly what its name says, a market. I don’t care if they are price gouging on Captain Crunch, I’m buying eggs and bacon because we eat a real breakfast and the prices for eggs and bacon are fair.
We are absolute return-oriented. In other words, we do not participate in competitive investing. If some day trader made a lot of money on Gamestop, then good for her. That does not hurt me in the least. If some hedge fund rookie trader loses his boss a lot of money, well, welcome to Wall Street. These things do not impact us in the least, except that the time I spend thinking about this is time I can’t use finding actual investments.
We are risk-averse. While I put all the blame, if that is even the right word, for this fiasco on the short selling culture, this day trading trend will not end well. Those who make a lot fast, lose a lot fast. Las Vegas wasn’t built because gamblers are successful. There is a brass card holder and clock on my desk which I refer to as my “Purple Heart.” The last time we had a day trading craze, the technology required serious traders to come to offices where they could access trading terminals. One such place was down the hall from my office when I was a young team leader at what was then Aetna Retirement and is now part of Voya. One of those traders lost everything. In his desperation he took a gun, killed his wife and children, then came to our building. He killed several people that day, and my team members saved the life of one of his victims who was shot in the back. He eventually committed what they call suicide by cop, forcing the police to shoot him. Our bosses at Aetna Retirement came to Atlanta, took us to an expensive lunch, and gave us those card holders – our “Purple Hearts.”
Those who do not learn their history are doomed to repeat it. Trust me, there is nothing new, and nothing good, in this Gamestop story. This will not end well for any who get involved.
Chuck Osborne, CFA
~The Games Children Play
“To everything there is a season, and a time to every purpose under the heaven.” ~Ecclesiastes 3:1
Yes, that is right, this is not just a song by The Byrds, it is scriptural wisdom; whether one learned it in Sunday school or by singing along to the radio, it is just as true. For what seems like years now, we have been talking about the market’s unhealthy skew toward large-growth companies. Since the financial crisis the “market,” as judged by most, has gone up considerably, but this is really just the large U.S.-centric indices, like the S&P 500, which are dominated by technology firms. The rising tide has not lifted all boats, and investors who buy value stocks, or the stocks of smaller companies and those headquartered overseas, have seen little in the way of growth.
These trends happen in the market all the time. The decade of the aughts saw the exact opposite occur; the rationale was that we were coming off of the tech bubble. In response to the tech bubble and the economic downturn triggered by the 9/11 attacks, the Federal Reserve (Fed) lowered interest rates to levels that seemed very low back then. This had the effect of inflating a housing and commodity bubble, which brought on the financial crisis in 2008.
Since the financial crisis and the policy aftermath, we experienced an incredibly slow economic recovery with overall economic growth at almost half of historic U.S. levels. The result was that investors sought companies who could grow even if the economy did not. At some point in market behavior momentum takes over, and as always, the market overshoots. Recently, the unprecedented reaction to the COVID-19 pandemic exacerbated this already-entrenched trend, and the differential between growth stocks and value stocks approached record levels.
Some of our clients have even taken to making fun of me (to my face – they always make fun of me behind my back) because of my insistence that this will pass. The season will change, value is coming.
Not only has my tune not changed, but we may have already seen the change. In the fourth quarter of 2020, large-growth companies as represented by the Russell 1000 Growth index were up 11.39 percent while large value stocks as represented by the Russell 1000 Value were up 16.25 percent. Small-company stocks, as measured by the Russell 2000 index, were up 31.37 percent. The stocks of companies headquartered outside the U.S. also outperformed, as did companies from emerging-market countries.
In other words, diversification away from large U.S.-based technology companies worked for the first time in a long while. That trend has thus far continued into 2021. Through last Friday, January 15, our custom-blended global equity index, which is fully diversified in stocks of all shapes sizes and nationalities, was up 2.7 percent while “the market,” a.k.a. the S&P 500, was up 0.39 percent.
The trigger for this season of change appears to be Wall Street’s hope for stimulus. For what it is worth, the day of our new president’s inauguration, we had a reversal: the focus on the word stimulus was translated as economic growth, but then the reality of stopping pipelines, raising minimum wage, and regulating everything in sight momentarily put everything on hold. That is what happens in the market: Nothing happens in simple straight lines. There is always a trend and then a wait-a-minute moment.
We have seen false starts in this transition before, and it is possible that is all the last four months have been. These larger trends do, however, go on for years, and lately a decade seems to be the life span. “To everything there is a season…a time to plant, and a time to pluck up that which is planted.” We appear to be in the time to plant some diversification, while we pluck up those U.S. technology profits. To put it in terms of The Byrds, it may be time to “turn, turn, turn.”
Chuck Osborne, CFA
~Is It Value Season?
We have a new ornament on our tree this year: a roll of toilet paper which simply says, “2020.” What a year it has been. It actually has been a positive year in the markets, although as we have said before, those gains are not equally distributed. However, even the unloved value stocks have made a recent comeback and will at least finish the year where they started, if not a little ahead. How can that be?
Life is not really about the events or circumstances that impact us. No, life is about our reaction to those events and circumstances. Once upon a time, when children actually went to school and schools actually cared about education, we learned these lessons through classical literature. This time of year we would read “A Christmas Carol,” by Charles Dickens. Scrooge was a miserly old man, but we learned that he wasn’t always that way; the events of his life hardened him. One such event was the premature death of his sister.
His nephew Fred also experienced that same loss, but it did not affect him in the same way. He was full of love and happiness, especially during the Christmas season. His uncle treated him badly, but Fred’s response was to feel pity for his Uncle Scrooge. Two men, living in the same world and sharing many of the same events, but with two totally different reactions.
This is the story of 2020: same year, same pandemic, many different reactions. If you live in California or New York, then you have lost almost all of your freedom and ironically been ravaged by the virus anyway. On the other hand, if you live in Georgia or Alabama, your life has pretty much gone on with the exception of wearing masks and working more from home, and while the virus is here it has stayed relatively under control.
We see it as well with our friends. I have friends who sadly have lost parents to COVID-19, yet they maintain a positive outlook even while grieving their loss. I have others who have been spared, yet every word out of their mouths is gloom and doom and fear. It isn’t what happens, it is how we choose to react.
So why is the market finishing this year in positive territory? Because more people see the glass as half full than those who see it as half empty. 2020 has been hard, but life is hard. It is supposed to be hard; life tests us. Those tests make us stronger and more resilient, and help us have greater appreciation for the good times.
What will 2021 bring? I believe most of us are looking at 2021 with optimism. Although I did hear a joke recently, “Just wait until 2020 turns 21 and starts drinking.” While I admit that I laughed, I also have to admit to being firmly in the camp of optimism.
More importantly for my day job and your portfolio, I believe most market participants share that optimism. 2021 will likely be a good year for the market. The odds are that the gains next year will be heavily weighted toward the areas that were left behind this year, and that some highfliers will come back to earth. When all is said and done, it should be positive. Of course, those are just the probabilities. Ultimately, 2021 – like every year, even 2020 – will be what we decide to make of it.
As for the next few days, I know in my house, and I hope in yours, Santa is still coming. Merry Christmas and Happy New Year!
Chuck Osborne, CFA
~Santa Is Still Coming, Even in 2020