Earnings, valuation and rampant speculation have all played a role in the extraordinary bull market that began a year ago this week. The latest combination of the three has a troubling reliance on the speculative element.
A broad framework for thinking about stocks can be derived from the late economist Hyman Minsky’s three stages of debt. In the first stage, borrowers take on only what they can afford to repay in full from their earnings by the time the debt matures; a standard mortgage works like this. Earnings, valuation and rampant speculation have all played a role in the extraordinary bull market that began a year ago this week. The latest combination of the three has a troubling reliance on the speculative element.
The parallel in the stock market is stocks going up when earnings — or rather the expectation of earnings, since the market looks ahead — go up. There is a risk of course, just as there is with debt: The earnings might not appear, and the stock goes back down. But earnings offer the least risky form of gains, and one that we should welcome as obviously justified. From the low in the summer, 2020 earnings forecasts jumped more than 10%, and expectations for this year rose more than 8%. Stocks responded.
In Minsky’s second stage, borrowers plan only to repay the interest, and refinance when the main debt is due to be repaid; much company debt works like this. It is taken out with a plan to roll it over indefinitely. Interest rates matter a lot: If they go down when the company needs to refinance, it will pay less. The equity parallel is to gains in valuation due to lower long-term rates. As with corporate debt, this is entirely justified and sustainable so long as rates stay low, because future earnings are now more appealing. The danger is that rates rise, in which case the stock might be hit no matter how earnings pan out.
A big chunk of the gains in stocks in the past year came from the sharply lower rates in the first response to the pandemic when the Federal Reserve flooded the system with money. Price-to-forward-earnings multiples soared.
From the S&P 500’s low on March 23 to the end of June, the market went from 14 to more than 21 times estimated earnings 12 months ahead, even as those estimated earnings fell amid lockdown gloom. The yield on the 10-year Treasury, already down sharply from mid-February’s high, fell further as stocks rebounded.
In Minsky’s third phase, borrowers take loans where they can’t afford to pay either the interest or principal from income, in the hope of capital gains big enough to make up the gap. Land speculators are a prime example.
The parallel in the stock market is: the hunt for the greater fool . Sure, GameStop < shares bear no relation to the reality < of the company, but I can make money from buying an overpriced stock if I can find someone willing to pay even more because they “like the stock.”
Wild bets became obvious this year, as newcomers armed with stimulus, or “stimmy,” checks Wild bets became obvious this year, as newcomers armed with stimulus, or “stimmy,” checks Wild bets became obvious this year, as newcomers armed with stimulus, or “stimmy,” checks drove up the price of many tiny stocks, penny shares and those popular on Reddit discussion boards.
Speculative bets such as the solar and ARK ETFs rallied up until mid-February, long after growth stocks peaked in August Price performance.
The Concern for Investors
How much of the market’s gain is thanks to this pure speculation, and how much to the justifiable gains of the improving economy and low rates? If too much comes from speculation, the danger is that we run out of greater fools and prices quickly drop back.
A look at how stocks moved through the pandemic suggests earnings and bond yields are still much more important than the gambling element for the market as a whole, but is still troubling.
From the S&P peak in mid-February to the end of June, the story was of cratering earnings partly offset by higher valuations.
The S&P was down 8%.
Earnings forecasts for 12 months ahead fell 20%, while with 10-year yields down almost a full percentage point, valuations were up from a pre-crisis high of 19 times forecast earnings (itself the highest since the aftermath of the Dot-com bubble) to 21 times.
Growth stocks — based on the Russell 1000 index of larger companies — were slightly up, because they benefit most from falling bond yields, having more of their earnings far in the future.
Cheap value stocks, which benefit less, were down 18%.
Question: Can the typical investment adviser beat the S&P500?
If you work with an investment adviser, you’ve probably had a moment or two when you’ve lamented how much you’re paying in fees.
And it’s normal and healthy to regularly ask yourself — and your adviser — what you’re supposed to be getting in return for those fees.
If your adviser answers that they’re paid to “beat the market,” it may be time to re-evaluate the relationship. Because you might do better just using one of today’s popular investing appsand putting your money into an S&P 500 index fund.
The fact is, most people who are paid to deliver higher returns than the stock market as a whole can’t do it. Data from the S&P Dow Jones Indices shows 60% of large-cap equity fund managers underperformed the S&P 500 in 2020.
2020-2021 was the 11th straight year the majority of fund managers lost to the market.
There are plenty of good reasons to pay an adviser or certified financial planner to help handle your investments, but beating the S&P 500 isn’t one of them. The data says it probably won’t happen.
What Financial Pros Are Up Against
The S&P 500 has delivered inflation-adjusted returns of about 7% per year, on average, for the past 40 years.
So to beat the market, a financial adviser would need to design a portfolio that gets better returns than that.
Is it possible in a given year? Sure it is — plenty of investors and mutual fund managers do it.
But is it possible to predict who will do it? And does the possibility justify the fees charged by the most prestigious fund managers, many of which operate on a “two and 20” model (2% of the portfolio’s value plus 20% of profits)?
WARREN BUFFET BS
Warren Buffett, who’s justifiably famous for his sage money advice, has frequently argued that, for most people, a simple market-pegged portfolio is a smarter investment strategy than trying to pick winning stocks.
In January 2008, Buffett put this belief to the test: He bet a prominent hedge fund manager a million dollars that an S&P index fund would deliver better returns over 10 years than a fancy and expensive hedge fund portfolio consisting of actively selected stocks.
Buffett made this bet before the stock market collapsed during the financial crisis of that same year. But it didn’t matter — by 2015, the hedge fund manager had waved the white flag and admitted he’d lost.
Buffett’s index fund had made 7.1% per year; the hedge fund had made 2.2%. It wasn’t even close.
“There is a very fine line between loving life and being greedy for it.” – Maya Angelou
“I will tell you the secret to getting rich in the City of London or on Wall Street. Be greedy when others are fearful. And try to be fearful when others are greedy.” – Aldous Huxley