Although we don’t know what the future will ultimately look like, this is an extremely dangerous environment for gamblers, states Nell Sloane.
From everything we’re hearing from the financial media, the question of a V-shaped recovery versus a U-shaped, W-shaped or L-shaped recovery is settled.
The recovery is already done, with the S&P 500 now 1% higher than its previous high point in February, and the technology-heavy NASDAQ (Apple, Amazon, Microsoft, Facebook and Google make up 47.7% of the NASDAQ) currently 19.4% above its pre-COVID high point.
When you combine this with ultra-low interest rates, meaning there is practically no reason to own bonds, it makes sense that everyone is piling into stocks. The number of new retail accounts opened since April, has dwarfed the number from any previous period.
It's with this backdrop that I read an article recently from a big-name, respected commentator that articulated the current market situation better than I ever could. I thought what he said was extremely important, so I’m going to paraphrase and summarize it in this email.
We face incredible uncertainty in the financial world. Thousands of neighborhood businesses have closed for good. Unemployment is above 10%. Restaurants are hanging on by a thread. High-rise commercial office space may be a thing of the past, but the buildings aren’t going anywhere. Although COVID-19 infection curves have flattened, they don’t appear to be going away anytime soon, and there is a real risk of increasing levels again in the Fall when the regular flu season starts again.
The Federal Reserve has dumped more than $3 trillion into the economy, with more on the way if Congress can ever agree on anything, which has created a feeling of normalcy.
Those who have lost their job are still able to pay their rent and Netflix bill with stimulus checks, but the Fed can only carry the economy for a limited amount of time. Eventually, the economy will need to survive on its own, and probably sooner rather than later.
Throw in a presidential election with the potential (or eventual certainty) for higher taxes, continued shutdowns, and social unrest, and you end up with market uncertainty that is through the roof. And yet, the stock market continues to go higher.
James Montier, from GMO Investments, summarizes the current market this way: “Never before have I seen a market so highly-valued in the face of overwhelming uncertainty.” Said another way for those old enough to remember the Roadrunner cartoons, “The U.S. stock market looks increasingly like the hapless Wile E. Coyote, running off the edge of a cliff in pursuit of the pesky Roadrunner but not yet realizing the ground beneath his feet had run out some time ago.” The stock market is acting as if the best-case scenario in the best of all possible worlds will play itself out, and the market is pricing in this best of all cases with absolute certainty.
Over-optimism and over-confidence are a dangerous combination that tends to lead to the over-estimation of return and the under-estimation of risk. This is where the market is now, with a rather obvious lack of appreciation for risk.
Risk does not mean that bad things are certain to happen. The ultimate outcome of investing always involves uncertainty, but higher risk environments are defined by the odds of downside surprises being significantly higher than upside surprises.
One of the reasons that risk is difficult to understand is that the financial media is very good at isolating the upside surprises, especially when it involves high-profile stocks like Apple or Amazon.
Although Apple is up 69.4% for the year and Amazon is up 77.8%, some other well-known S&P stocks that don’t get as much attention are Chevron (-29.4%) (CVX), JPMorgan (-30.2%) (JPM), H&R Block (-37.7%) (HRB), Under Armour (-54.9%) (UA) and Carnival Corp (-71.2%) (CCL).
The financial media has a vested interest in encouraging investors to keep looking for the next stock that will behave like NVIDIA (up 115% for the year) (NVDA) and hoping they forget that they may end up with a stock that looks like Norwegian Cruise Lines (-73%) (NCLH).
What happens if an investor makes NVIDIA-type returns one year and Norwegian Cruise Lines the next? One return is 115% and one is -73%, so from an “average return” perspective, they should still be positive. Unfortunately, the math doesn’t work that way. $10,000 would grow to $21,500 in the first year, and then end up at $5,805 after the second year. This is why attention to risk is so important.
According to GMO’s 7-year Asset Class Forecast published last month, the estimated average return for U.S. Large Cap stocks is -3.4%. That’s a loss of 3.4% every year for the next 7 years. The estimate for U.S. Small Cap stocks is -1.7% per year.
With the possibility of inflation on the horizon, would Inflation-Protected bonds be a good idea? GMO’s estimated inflation-adjusted average return for U.S. Inflation-Protected Bonds is -3.8%.
The Shiller PE Ratio, which is a measure of how expensive stocks are, is currently 31.43. The average level over the last 100 years is about 16. The Schiller PE Ratio in 2008 just before the Great Recession was 27, so we’re over 16% above that now. By pretty much any measure, the stock market is very expensive in the face of incredible uncertainty. These two factors together equal a high degree of risk.
No investment decision is obvious looking forward, and all of them are obvious when looking backward. There are enough gamblers in the market that some number of them will always outperform everyone else for some length of time. Although we don’t know what the future will ultimately look like, this is an extremely dangerous environment for gamblers. Diversifying in non or low correlated assets and not sticking to the old formula of stocks and bonds alone appears a good bet at this point.
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