Introductory Note: A Distant Mirror is the title of a book by historian Barbara Tuchman about the Middle Ages, talking about how human nature doesn’t change and we can draw useful lessons from the past – if we would only pay attention. I believe the book is doubly interesting because you can both see that human nature doesn’t change, even over hundreds of years, nor do habits change in the short term despite clear reason to. Why in the world did the Hundred Years’ War keep going? A simplistic answer is that Britain and France kept engaging in the same basic practices – they didn’t pay attention to the lessons of history.
On to modern times, does this sound familiar? Are investors not paying attention to the lessons of stock market history? Stimulus drives stock market speculation centered on high growth technology. A new era is declared by some investors, and so they argue the old lessons of stock market history should be thrown out.
Am I talking about history being ignored in 2000 or 2018? Is the stock market excess Pets.com or Theranos? Corning or Bitcoin? Cisco or Tesla? If we keep doing the same basic things, we should expect the same basic results. Today – are investors repeating past mistakes – once again ignoring the lessons of stock market history?
How do we use and learn from stock market history? Why are our portfolios positioned the way they are – tilted toward safe stocks and away from high growth technology and the like? Generally we look for risks and opportunities, usually from a top-down, forward-looking perspective, and position accordingly. Often we’re just looking for where people strongly believe something that we think may not be true. The easiest time to do that is at transition points. For instance, let’s say we have a gentle, low volatility swing up in growth stock prices, and that looks likely to change. A lot of people will stick with an up move like that for a very long time as their continuing “all-is-well” look from the rearview mirror will cause them to miss a turn ahead. That approach took many investors over a cliff in 2000 and 2008.
Today, is something changing that you can’t see in the review mirror, but that you can see in the “Distant Mirror” of the lessons of stock market history that help you do a better job of pondering the future? In the back half of 2016 we exited a curve turning the market direction from safe to growth stocks, and the low volatility of 2017 created a long straightway to accelerate into. The rising volatility we started to see towards the end of January of this year is the sound of us hitting the rumble strip at the side of the road, and recent market performance and macro numbers is the sound of us starting to touch the gravel at the edge of the road. The road has started to turn again, but the bulk of people are blissfully unaware. That creates risks and opportunities.
I like to ask myself a lot of questions – I think it’s a good and useful practice. For instance, it’s generally agreed that recent data, whether you look at the economy or companies, has been pretty good, but stocks, after roaring out of the gate in 2018, have failed to follow through. Why?
One somewhat trite answer is that these things depend on capital flows. To push prices up, people have to be saying, ‘I want to own this, and I want it badly enough that I’ll pay more!’ We need more of those people than people thinking the opposite to drive prices up. To put it into a simple sentence, we need more marginal, motivated buyers than sellers, and apparently we don’t have that. OK, but why would that be?
One way I look at that is to figure out if things are getting better or worse. In the case of the economy, things have been getting a bit better for seven straight quarters, but that looks set to change. You can see this in a couple of ways. First is base rates, which is basically the question of where we’re coming from. Think of a deck of cards, where you’re trying to call out if the next card will be higher or lower than the last one. It’s much easier to say the next card will be higher if you’re looking at a 4 instead of a Jack. In this case, those base growth rates are going to continue to get tougher to beat, and eventually that comparable with a year ago will break lower. Another way to look at it is through momentum. Whether you look at ‘softer’ or ‘harder’ data, we saw some pretty good numbers over the last several quarters and months, and while that data is still generally pretty good, it’s less good – momentum is slowing down. A third way is to look around at the bigger picture. Last year saw what was hailed as ‘global synchronous growth.’ This year? A lot of economies are falling off the wagon and have slowed notably. In sum, it looks like things are still good, but not as good as they were, and I think that’s a concern.
It gets a little more complicated when you’re looking at companies, because the price is based on future expectations. If Tesla (TSLA) has the same financial profile going forward into perpetuity that it has now, it should be worth zero, because it’s actively losing money. People value it above zero because they believe in the future they will be able to sell shares at a higher price due to better prospects than we currently see. That’s true with all companies. Investors are, at least mostly, trying to game future expectations when they buy and sell stocks, and over the years it’s mostly worked fairly well. Thus, it’s interesting that the market has been unable to rise in what seems like a ‘clear blue sky’ market to many. Again, why could that be?
I think the most popular answer is that enough marginal buyers are nervous about the future that they’re unwilling to buy, and I’m broadly inclined to agree. Expectations of growth broadly got very high, to the point where it’s hard to see how we can price much better outcomes. Have investors learned anything from the “Distant Mirror” of what happened in 2000? To go back to our game of cards, do you want to bet on a higher card when you’re holding a King? You can look at this two ways. Yes, you’ve had great earnings, but do you expect great earnings numbers to get even greater? It seems enough investors are nervous about that to form a critical mass. Second, when mean-reverting series like margins are historically high, are you willing to bet they’ll get higher?
So what do you do? While the market as a whole has done quite well, there are segments that haven’t done as well. Generally, companies that have high potential to grow in growth environments, unsurprisingly, have done pretty well. That general basket is tech, financials, and industrials. Stocks that struggle to grow fast have done relatively poorly. That includes sectors like utilities, REITs, and staples. As we transition, those growth companies are starting to lose their luster while the steady value companies are starting to look like good bargains. Thus, I think the basic focus should be on a rotation from growth to value stocks. Looking at the card analogy again, the low interest rates, heavy stimulus environment created a very long period of growth outperformance over value. The cards showing have kept getting higher and higher. Now we see rates rising, monetary easing changing to monetary tightening, and year-over-year comps getting harder. That’s a pretty clear transition.
Is this bad? It sounds bad. But I don’t think it’s all that bad, at least not yet. Some people got overexcited and bid up some stocks too much, but the overall market never got all that crazy. In 2000 it was like we went off the road at 100MPH, but here we’re going 35MPH. We’ll take some damage, but nothing too bad. If I was forced to guess, and I am guessing, I’d predict something like a high single digit loss in the market for 2018. I do expect a rotation, though, where that which was last becomes first. Utilities, REITs, and eventually staples should do pretty well on low expectations and weak positioning while tech, financials, and to some extent industrials do poorly on high expectations and exuberant ownership.
In conclusion, looking at the market, I see a number of signs that the era of growth–at–any-price is over. While value stocks seem likely to take over, I’d add that high-quality stocks, which generally grow at a decent clip in most environments, are probably a good, broad place to look. Additionally, if there’s one thing in my thesis I’m most uncertain about, it’s the staples stocks. Because of the nature of their business, they tend to be more exposed to inflationary pressure than most companies, and that’s been a popular worry of late. While I can look at comps and see that inflation is quite likely to settle down in the back half of the year, that’s more likely to be clearer in a few months or so. So why have we been buying some more staples stocks? Because they’re good risk/reward setups and you never quite know when those will take off. In retrospect, I do think in 2017 we were carrying too many staples stocks, but it’s hard to let them go when the likelihood of them improving shortly is high. It shouldn’t be all that long before their headwinds turn into tailwinds. So, while it doesn’t make sense to be aggressive sellers, I wonder how bouncy the ride from here to there may be.
As George Santayana said, “those who cannot remember the past are condemned to repeat it.” “A Distant Mirror” teaches us to pay attention to potential turns in the road, so that, while the ride may unavoidably be bouncy, we don’t go off the road.