Vaccines have been nothing short of a miracle; however, too many have been opting to not get them, endangering themselves and others, despite overwhelming evidence of the pro versus con.
The Olympics were delayed a full year yet still took place in a city amidst a state of emergency. The Russian team was a committee of athletes—look for them again at the winter Olympics in just 6 months.
Malicious cyber attacks are rampant, halting critical systems and demanding Bitcoin ransom, apparently perpetrated by state-sponsored actors—we wonder whether the Joker and the Riddler are real. Certain stocks, such as AMC and GameStop, have been caught up in a mania, those two jumping 38-fold and 119-times respectively from their 52-week lows before selling off dramatically.
Supply issues have been so constrained that one-year-old used car prices ascended to reach the same level as brand-new vehicles.
There are negative interest rates in many regions. That’ll always be weird, even though it’s persisted. And a spike in inflation while junk-bond yields declined has left real high-yield rates negative for the first time in history.
Some things are so bizarre they aren’t predictable. Such as a global pandemic accompanied by economic lockdowns everywhere. Despite these circumstances, we suffered the shortest recession ever—just two months—and the economy and markets are back to all-time highs. And, while not entirely peculiar, but certainly rare, stock prices for the indexes, particularly in North America, have risen well above Fair Market Value (FMV)—the S&P 500 now about 30% higher than its pre-Covid pre-recession high.
Keeping Your Head
Kipling’s poem “If—” starts with the concept, “If you can keep your head when all about you are losing theirs.” It’s not easy to zig when everyone seems to be zagging. It’s part of our job description though, to assess when the masses are losing it, to remain calm, and react appropriately. Often, it’s easy because there’s an obvious option. For example, when a security is being shunned—its price clearly overreacting to an innocuous temporary event. Other times, it’s harder, either because the options aren’t obvious, or because incredible fortitude is required to resist the pressures associated with markets that can remain irrational for longer than most can withstand. 2
Usually, we are dealing with the former—bottom-up decisions regarding a specific stock or bond whose price has fallen in relation to our estimate of underlying value. In those instances, a modicum of patience is required until clearer heads prevail, and others recognize what we have. Sometimes though, with broader macro-related events, pressures to hold our positions are much greater.
We are short the U.S. market for most clients. Easy for us given the fact that the market is at a ceiling in our work and more than 20% overvalued in our view. Not so easy for clients as the S&P 500 reaches its 45th new high of the year. And the markets’ reaction to our Chinese holdings is an example of all-of-the-above.
Shui Feng
If Feng Shui is synonymous with harmony and order, we seem to have experienced the opposite over the last couple of months with our holdings of Chinese companies. The stock prices were already trading well below our estimated FMVs when proposed government regulations began to impact specific companies, especially those within the Chinese tech sector. The culminating event appears to have been an outright ban of profiting from teaching core education subjects. This walloped the share price of for-profit education/tutoring companies, including our TAL Education holding, and the news cast a pall over the entire market.
Remarkably, China went from the best performing market in the world this year to one of the worst, primarily in response to regulatory changes. We held several Chinese companies that suffered. Investors tend to sell first and ask questions later for fear of losing their heads altogether. Since the Chinese state media have now started to provide reassuring messages, we could begin to see a reversal. The government specifically noted that shares do not face structural risk, that the recent declines were emotional reactions and misinterpretations of policies, and that the changes being imposed on the education sector were not intended to impact other areas. While the Communist party wants to protect its sovereignty and maintain control and power, it also realizes Chinese businesses need access to capital markets.
Other than the impact on the education sector, the regulatory changes are mostly benign and relate to consumer data protection, anti-monopoly laws, cybersecurity, and more equitable employee treatment. Interestingly, not too dissimilar to Western-world policy proposals. While initially destabilizing, these initiatives should ultimately act to enhance policy transparency.
There are certainly aspects of China that we do not favour: internment of and violence against Uyghurs, military overtures towards Taiwan, pollution, censorship, surveillance (China isn’t mirroring an Orwellian society, it is one), cyber warfare, disregard for intellectual property rights, and other rule-of-law issues. We clearly prefer democracy.
However, we remain attracted by China’s economic growth engine. The burgeoning middle-class should continue to have an unrelenting advance. The country’s power is undeniable, its economy expected to surpass the U.S. as the largest in the world by the end of this decade. And China has encouraged the growth and dominance of its businesses on the world stage. What kind of Communist country provides a 25% corporate tax rate? It’s even lower for tech companies. And most important, some of its businesses are amongst the best in the world, operating with competitive advantages, high returns on capital, and clean balance sheets. Their results show for it—they’ve compounded sales and earnings at high rates for years. 3
We have reevaluated our Chinese holdings and continue to have high conviction in the businesses and our estimated appraisals. Since FMVs are substantially higher than prevailing prices, this should also act as support against further erosion of prices. We don’t know exactly when the market will regain its senses but believe it’ll be worth the wait.
Strange Bedfellows
On rare occasions the market takes on a speculative bent as animal spirits run amok. For us value investors, during these periods, it’s always hard to believe that the others, whose behaviour is so odd to us, are competing in the same field. Why would anyone ignore fundamentals, buy purely on price, chase what’s already gone way up, use highly-speculative instruments, assume extreme leverage, or worst of all, purchase something that’s hugely popular—gone viral—a ‘meme’ stock?
Near zero interest rates, massive government stimulus, a surging economy, social media, a tech boom, zero commissions, and a speculative bent, not to mention a rising market lifting most stocks, have all conspired to create a mania in many U.S. stocks not seen since the 2000 bubble.
While this does not necessarily have to end badly for all stocks, it should spawn many losers whose valuations are unsustainable (a record high 60%+ of small caps are unprofitable) and could certainly lead to an outsized correction for the overall markets.
Expectations, in general, are too high. A recent investor survey suggested that U.S. investors expect returns of 17.5% in excess of inflation, compared to actual returns of about 7% historically and eclipsing the previous high in expectations seen just prior to the 2000 peak.
Individual investors’ equity allocations versus other asset classes are at an all-time high. And assets in levered ETFs are also at record highs.
And it’s not just the public markets. Unicorns, private companies whose valuation first exceeds $1 billion, have not been rare sightings. In the last 5 years there have been about 25 quarterly. In the most recent quarter alone there were about 130. Stock market sentiment remains elevated despite consumer confidence recently dropping significantly, attributed to surging inflation and a resurgence in Covid cases.
The stock market has run up in line with the growth of the Fed's balance sheet over the last 12 months, but this stimulus will abate at some point. And tax rates may rise too.
The economy is booming but wage pressures are setting in. And supply and demand imbalances continue. For example, semiconductor lead times hit a record high in July and have worsened each month this year—a shortage that caused GM to stop building pickup trucks and some SUVs.
Importantly, the number of companies surprising to the upside in the most recent quarter was a record high 87%. However, record high operating margins and rising costs could portend a mean reversion. Inflation is running hot, albeit off of easy comparisons last year.
The economic growth rate is bound to level off. Normally this occurs 12 months after the bottom of a recession. And it appears that the virus intends to linger until more individuals are vaccinated. 4
All that said, though we expect an outsized correction, markets could rise for years before the next recessionary induced bear market. Low growth should help. It keeps inflationary pressures under control as does ever-rising productivity, extraordinarily high government debt ratios, low velocity of money, and poor demographics. Speaking of weird, check out this demographic anomaly: in Japan last year, more diapers were sold to adults for incontinence than for babies. All of the foregoing should lead to relatively low growth rates, disinflationary pressures, and an extended business cycle. Compelling conditions for long-term equity investors.
