26 Apr Bridge Perspective – What’s Your Investment Theme?
Well, we appear to be approaching the end of the pandemic tunnel. Perhaps it is better stated as the beginning of the end. The world as a whole is clearly not out of the woods yet but the United States and much of the developed world has made impressive progress in vaccinating their respective populations. Economic data, while still far from great is coming off the pandemic lows and some data points are producing their best readings on record (see ISM Non-manufacturing Index for March). There is a strong consensus that we will see a robust uptick in economic activity this year. How long it will last is a much more difficult question. The developed world has seen government debt balloon, has an aging population and the techonological frontier may disrupt long standing economic norms. When and how these forces may exert their influence is unknown but they must be acknowledged. The past five quarters have presented numerous events that underscore the foundation of our investment approach – whether it be taking advantage of tax-loss harvesting when opportunities present themselves or the importance of having a plan and a well diversified portfolio that will allow you to ride out times of market stress, much of our approach was tested and reaffirmed.
YOLO, Meme, and EMH: What’s Your Investment Approach?
You only live once (“YOLO”)! Social media investors have banded together on unconventional platforms to drive up the prices of a handful of “meme stocks,” seemingly without traditional evaluation of investing risks and rewards. They made headlines with their “short squeeze” of GameStop (GME), and, as they garnered media attention, their tactics continued. While it’s not the intended victim of the YOLO traders, will the efficient market hypothesis be a casualty of these events? The answer depends a lot on your definition of efficient markets. Perhaps long-term investors would be better served questioning the potential impact on their investment philosophy.
Nobel Laureate Eugene Fama (1970) defines the efficient market hypothesis (EMH) to be the simple statement that prices reflect all available information. The rub is that it doesn’t say how investors should use this information. EMH is silent on the “correct” ways investors should use information and prices should be set. To be testable, EMH needs a companion model: a hypothesis for how markets and investors should behave. This leaves a lot of room for interpretation. Should asset prices be set by rational investors whose only concerns are systematic risk and expected returns? It seems implausible to link recent meme-stock price movements to economic risks. Rather, they seem fueled by investor demand to be part of a social movement, hopes to strike it rich with a lucky stock pick, or plain old schadenfreude.
There is a vast ecosystem of investors, from individuals investing in their own accounts to governments and corporations who invest on behalf of thousands. Ask investors why they invest the way they do, and you’ll likely get a range of goals and approaches just as diverse. It’s this complex system that generates the demand for stocks. Another complex system fuels the supply of stocks. Supply and demand meet at the market price. People may contend that the market is not always efficient, or rational, but the stock market is always in equilibrium. Every trade has two sides, with a seller for every buyer and a profit for every loss.
There are plenty of well-studied examples that show supply and demand at work. The huge increase in demand for stocks added to a well-tracked index often creates a run-up in the stock price. Some of this price increase can be temporary and reversed once the tremendous liquidity demands at index reconstitution are met. Index reconstitution is just one example; instances of liquidity-driven price movements happen all the time. It is well documented that liquidity demands can produce temporary price movements. Investors may wonder if temporary price dislocations motivated by users of r/WallStreetBets differ from those caused by changes to an index. Lots of buying puts temporary upward pressure on prices, which later fall back to “fundamental value”–it sounds familiar. The more relevant observation may be that markets are complex systems well adapted to facilitate the supply and demand of numerous market participants.
There are numerous reasons people may be willing to hold different stocks at different expected returns. Can all those differences be explained by risks? Doubtful. To quote Professor Fama, “The point is not that markets are efficient. They’re not. It’s just a model.” EMH can be a very useful model to inform how investors should behave. We believe investing as if markets reflect fundamental value over the long-term is a good philosophy for building long-term wealth. Trying to time markets over the short-term might be a quick way to destroy wealth.
It’s true, you only live once. The good news is that investors can look to market prices and fundamentals, not internet fads, to implement a sound investment strategy. Theoretical and empirical research indicate higher expected future returns come from lower relative prices and higher future cash flows to investors. Long-run investors can be better served by using these tried and true methods, rather than chatrooms, to pursue a better investment experience.
Market Update – A Brief Around the World Tour of Markets
The first quarter of 2021 marked the one year anniversary of the pandemic infecting the markets and the aptly named COVID-crash. Market environments like we are living in provide no shortage of extraordinary statistics. We certainly saw our fair share last year and fast forward to the present we have a new one – through the end of March the S&P 500 had its best 12 month period since 1936! And has continued to notch new record highs as well. Overall, stock markets around the world were positive over the last 3 months. Bonds have had a much harder time after a stellar 2020. Why? The common refrain is that inflation fears and an improving economic outlook are driving interest rates higher, which is a negative for bond prices.
US Stocks lead global markets followed by non-US developed markets and emerging markets, earning 6.35%, 4.04% and 2.29%, respectively. Global real estate, one of the hardest hit sectors in the pandemic, experienced a strong quarter with a return just shy of 6.25%. From a sector perspective, the rotation into smaller companies and so-called value stocks continued – stocks categorized as small and value companies returned 21.17% while large growth stocks (think big tech) returned 0.94%. This trend was true across countries driven by investors renewed appetite for risk and the search for better valued opportunities after the significant run-up in large tech companies in 2020. Valuations (or price paid for some measure of cash flow or profitability) increased with the renewed economic optimism. However, they are at very high levels, especially in the US. Levels in some cases that have not been seen since the dot-com era.
Longer-term interest rates (rates for loans 5 yrs or greater) jumped higher throughout the developed world to begin the year which caused bonds prices to drop and thus returns fell as well. US bonds fared worse than the broad non-US bond market. The Barclays Bloomberg US Aggregate index dropped -3.37% and the Barclays Bloomberg Global Aggregate ex-US (hedged) index dropped -1.9%. The 10 year and 30 year US Treasury bond rate rose by 0.81% and 0.75%, respectively. Intermediate corporate bonds (those coming due in approximately 5-10 years) managed a slightly positive return of 2.19% as investors bought up the assets in a search for yield.
On the Economy
The global economy is on the mend and a rather quick recovery is expected for most of the developed world. The jury is still out for emerging markets given the lack of access to vaccines however many emerging markets have a better balance sheet than the developed markets. As mentioned in our opening, the economy is bouncing back from the pandemic lows and in some cases the data is showing incredible statistics. However, as most economists will tell you, data can be noisy in environments like this and some critical areas are not showing the same strength yet (e.g. unemployment in the US). Arguably the greatest question we face at the moment is whether inflation will increase? The answer is likely yes however determining whether it will be temporary or the start of a longer trend is what really matters. Most economists seem to be in the camp that there will be short-term increase in inflation that will then subside. Central bankers acted in unprecedented fashion in reaction to the economic destruction caused by pandemic related lock-downs and so far the results speak for themselves. And they are continuing their accommodative and simulative polices for the foreseeable future. These policies have certainly contributed to an excessive amount of liquidity (i. money) around the world but it seems as though the powers that be are accepting this side-effect as necessary to fend of greater economic damage in other areas.
 Adapted from “YOLO, Meme, and EMH: What’s Your Investment Style?” from Dimensional Fund Advisors LP.
 Systematic risk is the possibility of an investor experiencing losses due to factors that affect the overall performance of the financial markets in which he or she is involved.
 Reconstitution involves the re-evaluation of a market index. The process involves sorting, adding, and removing stocks to ensure that the index reflects up-to-date market capitalization and style.
 For example, see “Tesla’s Charge Reveals Weak Points of Indexing” (Dimensional, 2021)
 “Are markets efficient?” – Interview between Eugene Fama and Richard Thaler (June 30, 2016)