I was chatting with a friend about the markets yesterday and admitted I had a conundrum: I was looking to refinance one of my homes and was contemplating where to invest the proceeds. Both of us agreed the market is looking a bit frothy with the P/E of the S&P 500 at 37.5 and the index having returned 17.28% so far in a year when we are in a recession and a pandemic.
If you follow conventional wisdom or the “hot stock” crowd, there are a number of seemingly great choices: Bitcoin, Apple, Amazon, or pretty much any other tech stock you can get your hands on. My friend is a follower of YouTube trading channels and remarked on the explosion of new YouTube gurus who are giving tips on trading an investing. In a hot market, it seems everyone thinks they’re smart.
It’s an easy time to feel smart too. Many traders are scoffing at those who invest in the index or worse yet, an index outside the US or in emerging markets. These indexes have been losers, not only in the past year but in the past 10 years. The iShares MSCI Emerging Markets Index (EEM) has gained an annualized 2.96% over the past 10 years. The iShares EAFE Index ETF (EFA), which tracks stocks in other developed markets, gained 5.69% annually over the same period. Meanwhile the Invesco QQQ Trust (QQQ) which tracks the Nasdaq 100, has returned 20.33% annually over the past decade. This would have produced a 536% return over the same period, while the other markets still only returned something in the double digits.
Hindsight is 2020 though, my friend pointed out how Bitcoin is the perfect example. All of the sudden, Bitcoin is in the press as it hit the milestone valuation of $20,000, but Bitcoin has already been hot. 3 years ago, people were amazed that Bitcoin hit $5,000 or $7,000, but then Bitcoin crashed and everyone forgot about it. Bitcoin miners went bust and only the miners with the lowest electricity costs were able to survive. Now that it has jumped again, it’s back in the press and everyone wants in. Of course in such a market frenzy, the most outrageous predictions get the most press. Scott Minerd of Guggenheim says their research points to a valuation of $400,000 per Bitcoin. Of course details are scant because it’s completely made up. No one knows what Bitcoin is worth because it’s just a made up alternative currency. Its not tied to anything and only the blockchain backs its usability. It could be worth $400,000, but only to that person willing to pay $400,000 for it. To many it is worth nothing, I count myself in the latter camp.
Party Like it’s 1999
But let’s get back to the YouTube stock gurus. Their advice may be coming via a new media outlet like Tik Tok, YouTube or Instagram but the message is an old one: I will teach you how to get rich. They purport to show you which stocks to buy that will show gains quickly. They have even added a twist: many have incorporated options into their strategies. A high risk, shorter tenor derivative that can produce even greater gains in the short run. However this phenomenon owes more to the intuitive and easy to use layout of Robinhood than it does to any new technical skill. The YouTube gurus are just the latest iteration of day traders from the late 90’s. It helps to have some historical perspective to take a look at that bubble and it’s aftermath. I do this not to try to presage the future, but to try to take a more common sense approach towards our investing strategy to be able to prepare for a correction in the markets should they come.
Between 1990 and the year 2000, the S&P 500 returned 432.2%, this was especially surprising given that the return in the 80’s was 389.2%. The 90’s were also the best decade ever for price appreciation. The 2010’s saw a great recovery and a 256% return to the S&P so if you think things are growing too fast now, imagine that the 80’s and 90’s growth put the past 10 years to shame.
In an easy similarity, everyone was piling into tech while value languished.
Compare that with how value has been in the dumps for the past few years while many claim that “value is dead.”
I am old by internet standards, old enough to say that I started in an investing environment similar to the one we are in now: stories of regular guys getting rich with huge bets on new and exciting companies. IPO’s were doubling within a few days, just like they are now. Companies with seemingly no assets and small revenue were issuing shares and making people multimillionaires overnight. My older co-workers talk about how no one was working at the time, everyone spent the day day trading to get rich.
And yet all of it came to an end. Scandals like Enron shook up the corporate world, then 9/11 happened and the economy went into a mild recession. The S&P 500 went into a bear market that lasted for almost 3 years and lost over 40% of its value. Tech companies went bust. Amazon was just another tech company at the time but snazzier names disappeared: pets.com, groceries.com all ideas that eventually proved great business concepts but didn’t survive in their form at the time. We look back now and say it was easy to see the market was overvalued but on the way down it’s not so easy.
The “dead cat bounce” is a perfect example. This is a term used for a false rally in a bear market. Multiple times between 2000 and 2003, the market witnessed combacks that fizzled, breaking the spirits of any day traders who were left.
Everyone was in the market prior to the bear market of 2000-2003. High school kids, office workers, mechanics would give you stock tips, but most of these people stopped trading and got out of the market between 2000 and 2003. The YouTube gurus will meet the same fate when valuations become more reasonable.
Beating the Market
Something that is often heard in bubble times was that beating the market is easy. What is critical to understand if someone is beating the market however, is what time period they are looking at. If we are talking about beating an index like the S&P 500 over a 1 year period, for someone betting on a random company, especially one in a hot sector, this is relatively easy. The returns on the S&P 500 are dominated by the largest stocks in the index. As of 2020, the ten largest stocks in the S&P make up 29% of the index. Consequently, these stocks will account for most of the gains in the index, which means when you “beat the market” over a year, you are likely just beating a few large companies over a short span. If you are doing this with a stock like American Airlines or Carnival Cruises, which saw massive rallies in the latter half of the year, you aren’t comparing apples to apples. You are taking a small cap, high beta stock and comparing your return over a short period to massive companies, some of whom have trillion dollar valuations. Neither of them have much to do with each other.
It’s been shown that in bull markets, momentum plus a factor. What that means is that the market going up induces more investors to come in and push the market up further. Trading small cap, highly volatile stocks as an individual can help you ride this wave. The problem is these waves don’t last forever, it’s the downturns that prove who are the investors and who are the speculators and it’s much tougher to assess how a stock will act when it’s in a secular bear market than when it’s in a secular bull market.
7 years ago, DALBAR, which makes independent research reports, evaluated retail investors over a 30 year period from 1984 to 2013. Their results don’t speak well for the Robinhood crowd.
Underperforming for a year is ok and as we discussed, outperforming for year or even 2 isn’t unheard of. The challenge is when you look at horizons that are 10, 20 or 30 years. How will your single stock perform in a bear market? With increased competition? Or even with changing government regulations? It’s a tough call and that’s why it’s so difficult to beat the index over longer terms, despite being able to beat it over a year or two.
Diversification
On the other hand, how long could this bubble last? How much more can it go? We don’t know, no one does. This is why it pays to also stay in the market, even when you may be uneasy about valuations.
The solution is the diversification of your risk, especially if you are looking at the next 10-20 years of your money. Remember those charts of the S&P 500 falling 40% from 2000 to 2003? What did well during those difficult years were medium term bonds as well as the long time dog of them all: value investing.
From 2000 to the end of 2003 the Russell 2000 Value Index returned 81.3%, an annualized return of 16.0% over that 4 year period. Along with bonds, this would have at least partially offset big losses in tech and large cap stocks which caught most investors attention and were all the rage in the years prior. The reflection of the outperformance of value versus growth and other strategies can be seen in the ratio of the Russell 3000 Value performance versus the Russell 3000 Growth indexes over the period from 2000-2003.
So despite its lagging performance overall in recent years, there is an argument in terms of value for the years ahead when large cap and growth stocks may underperform. The hot single stocks of today may turn out to be some winners in the coming years but there are many pets.com and groceries.com in people’s portfolios. If you are investing for the long term, the easiest way to sleep at night and still become rich is to diversify across both the loved and unloved asset classes and rebalance among them as the market shifts. Hopefully a few more new age day traders learn these lessons this time around.
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