Spectate or Speculate

This article has been excerpted and edited from our quarterly newsletter to clients dated February 18, 2021.

Many investors think there are only two options in a market where participants have become overly exuberant, either ‘I want in’ or ‘Get me out.’ Our strategies are more nuanced, and we believe fit better with what we expect to transpire.

It used to be that we consulted our favourite market prognosticator—the taxi driver—regarding market tops. When they were touting specific stocks, we knew the end was nigh, but the disruption from Uber and the pandemic has limited our access. Perhaps, in the not-too-distant future, robo-taxis will be equipped to provide stock tips.

From time to time, certain market participants treat the markets as a casino, speculating on outcomes. Others sell at the first sign of market froth as they prefer to be spectators rather than risk exposure to an overdone market. With the ability to perfectly forecast the timing of a recession, one would sell—stepping aside to watch until the bear market ended. Similarly, if one knew a bubble was brewing and could pick the top then aggressively selected positions would benefit most from exuberance. But these scenarios are obviously extraordinarily difficult to predict and fraught with risk. Thankfully, these are not the only options. The point in the cycle, the types of securities being impacted, relative valuations, and other factors play a role in the extent investors should be exposed to stocks when markets are frothy.

The Opposite of Panic

We aren’t sure whether the opposite of panic is complacency, euphoria, or otherwise, but we recognize it when we see it. And we’re witnessing it now. Outright speculation is occurring— IPO shares nearly doubling, on average, on their first day of trading. The IPO boom has now eclipsed that of the dot-com period and many more companies that are unprofitable have gone public than at any point in history. Penny stock trading volume is off-the-charts high too as speculators frantically seek out their next score. And securities trading over-the-counter is being conducted at higher volumes than on the exchanges, which has never before occurred. This certainly can’t end well because most of these companies are early stage, money-losing entities. Trading by individuals has far surpassed the volumes of the dot-com bubble. Margin debt— borrowing to invest—is at an all-time high relative to individuals’ net worth and GDP. So they’re betting using leverage; that’s rarely a good combination.

Meanwhile, short interest is at a record low. The heavily shorted stocks, which usually underperform, are the ones up the most in this recovery and as a group have exceeded any other period over the last 25 years. That has scared off those who typically hedge. Call option purchases have by far exceeded any period historically. Over 90% of market timing newsletters are bullish, invariably a negative sign, and leveraged ETFs are taking on record fund flows.

While we are waiting for herd immunity, the herd seems to be busy playing the stock market. Too many are buying stocks (or ‘stonks’ in Internet slang) indiscriminately, merely because they’re going up. Even worse, by using call options they are making short-term bets, which come at a premium, involve leverage, and expire worthless over 90% of the time.

While there have been specific pockets of speculation, such as electric and autonomous vehicles, anything green-energy related, SPACs, and cannabis stocks, share prices in general are expensive. Overwhelmingly positive sentiment has pushed market participants to overpay for many stocks. Apple’s market capitalization is now larger than the entire Canadian S&P/TSX Composite Index with its 221 constituents. Tesla’s market cap alone has surpassed the combined market cap of the top 10 global car manufacturers. Nearly 50% of S&P 500 stocks have forward P/Es above 20x, about twice as much as the average for the last 30 years. And it’s been relatively concentrated. The percentage of stocks in the S&P 500 exceeding the index return is near record lows, only approaching this level in 1973 and 2000, other periods marked by extraordinarily high valuations. Valuation is today’s primary risk.

And it’s not just the stock market. The world is awash in liquidity from stimulus which has flowed into assets of all kind. Mexico, a country that has a currency crisis every few years, issued 50-year bonds at an ultra-low interest rate and the issue was 3 times oversubscribed. The fine art market has had record sales. House bidding wars are the norm. Loose fiscal and monetary policies have propelled assets like gold and cryptocurrencies—bitcoin up 10-fold from its bottom in March last year. And collectibles, such as comic books and sports cards have been excessively bid up. These rises are occurring for the same reason toilet paper was selling out—excessive demand for items that the crowd is chasing.

Investor vs. Speculator

Since day-trading is back in vogue, let’s remind ourselves of the market statistics. Stock markets invariably outperform over multi-year periods with the probabilities, based on history, of gains rising toward 100% over 20-year time frames. But, on a daily basis, the odds of a gain are just over 50%. Day traders are clearly just tossing coins—some traders even behaving like boiler room brokers, essentially involving themselves in the unsavoury practice of pumping and dumping.

We consider purchases or sales based solely on price action to be speculations; whereas to be an investment, consideration must be given to fundamentals, including business operations, financials, valuation, and associated risks, including liquidity.

Investors should consider overall risk management too. Since the markets are at valuation extremes, we continue to hedge our long positions with short sales of the overall U.S. market (or inverse ETFs in registered or long-only accounts). Initially, we shorted in January 2020 because our Economic Composite suggested a recession could occur at any time. We covered our shorts a couple of days prior to the March market bottom because it appeared the markets had fallen too far too fast. We reinitiated those shorts after a significant rebound because we feared the risks associated with the pandemic (pre vaccines) and assumed the lows would be retested, which normally occurs, but the markets powered ahead. With valuations so high, and investor psychology so ebullient, we remain short because an outsized correction could start at any time. Insiders appear to agree as their selling is high and corporate buybacks have sunk to lows.

We don’t, however, foresee a new bear market. Those prolonged major declines occur during a recession. The current economic cycle is still in its onset and economies around the world are enjoying synchronized global growth which should continue to boost Fair Market Values (FMV).

Other than valuations there don’t appear to be any material excesses that should inhibit economic revival in the near term. Some worry about a double-dip recession. We don’t see it. Currently, supply cannot keep up with demand. We’re witnessing this in many areas including housing, semi-conductors, and industrials commodity prices which have shot straight up. The world has experienced a cyclical rebound and is now in a secular growth phase. Without major economic excesses in place, this cycle could last quite some time.

Most importantly, the stock market has a buffer. No competitive alternatives. Cash earns nothing. Government bonds and investment grade corporate bonds yield a pittance. Negative yielding bonds are now at a record $18 trillion. Inflation is muted, meaning these asset classes should continue to provide minimal competition for stocks, especially while earnings and FMVs are rising.

Unemployment in the U.S. has declined back to 6.3%, though there has been a material decline in the participation rate, leaving unemployment heavily understated. Another massive amount of stimulus is coming next month. And likely an infrastructure-spending bill soon too.

Once vaccinations are more pervasive, the back half of this year and well into next should be substantially boosted by pent-up demand and the unleashing of it. One cruise line recently sold out its 2023 around-the-world-in-180-days cruise in just one day. Perhaps those consumers are the same risk takers who were buying GameStop.

A cyclical uptick in inflation could be coming. Central banks are trying to engineer it. However, with such a massive amount of government debt overhanging economies around the world, growth rates and inflation should be restrained in the medium term. This too augers well for relatively high valuations.

Hedging Risks Not Risks of Hedging

Based on our models the markets are sufficiently overvalued to warrant hedging. It is unusual for the markets to be above FMV. The markets typically vacillate between undervalued and fair value. Since implied growth rates are now at all-time highs, these elevated expectations leave markets susceptible to any shock to the system which could take prices back to a discount. In these instances, short selling can be an effective hedge for an overall portfolio.

Most money managers don’t short. Others constantly short to be market neutral. In our view shorting isn’t for all seasons. The math works against shorting. You can theoretically lose an infinite amount and only make 100% if a position goes to zero. Those who don’t short either fear that math, have had poor experiences, or lack the mandate. We see short selling as a useful tool in extreme periods, normally at the onset of a recession. Or, as is the case today, when risk of an outsized correction is extremely high as a result of 100th percentile valuations and sentiment. And we don’t typically short individual stocks. First, because we are interested in hedging a market decline and second, because we fear an undue rise in a specific name (recent headlines have certainly drawn attention to this concern). Shorting individual stocks, as others have, using lots of leverage, where there was no immediate catalyst or potential fraud but simply concern regarding business erosion, where the short exposure was crowded (perhaps even conducted without securing a required borrow of shares to be sold short), made those positions susceptible to shorts being forced to cover as a result of margin calls or outsized losses as prices ran up.

While the overall market is elevated, growth stocks have grossly outperformed. They have been market darlings for an extended period causing most to be rather overvalued. These stocks are particularly vulnerable to a correction. Last year, the Russell 1000 Growth Index outperformed the Value Index by its widest margin on record. Value stocks are as cheap now on a relative basis to growth stocks as they were in 2000, before coming back into favour for many years. The differential between the most expensive stocks and the cheapest ones is rarely this wide.

Other risks should be noted too. The economic growth rate normally peaks 12 months after the bottom of recession, so growth rates could slow soon, especially if pent-up demand has yet to kick in. The virus could worsen but it’s already everywhere. In the U.S., there has been at least one case in every single one of the over 3,000 counties, even the furthest reaches of Hawaii and Alaska. Cases are dropping, and with vaccine distribution about to meaningfully pick up, there is finally an end in sight to the pandemic. Vaccine take-up should be a concern though. We were unnerved by the poll showing about 20% of Americans won’t get vaccinated while 35% were unsure.

Our Strategy

We are pleased to hold our long positions looking forward to continuing economic recovery but prefer to be hedged in case the market has an outsized correction. Even if our long positions sell off in unison, we believe they’ll only temporarily further detach from our rising FMV estimates. In a true bubble, markets can rise rapidly as a blow-off phase is often more dramatic than one can imagine. Monetary tightening bursts bubbles but that does not appear to be coming any time soon. If the market keeps rising, the near-term risk is that we would earn less on the upside as a result of our hedges. That’s a risk we’re prepared to take.

We don’t chase stocks. It’s not in our makeup to buy stocks at 52-week highs—that’s a game for others. Though, we are quite enamoured with buying stocks when they’re suffering from misconceptions, at a significant discount to our estimated appraisals, with economic tailwinds, when most appear to be overpaying for stocks in general.

Neither a Spectator Nor a Speculator Be

Investors should not take either of these extreme stances. Without a crystal ball, it’s extraordinarily difficult to time tops or bottoms. Speculation is accompanied by too much risk— outsized declines can arrive at any time. Sitting in cash and waiting for a better entry point can have the opposite effect as business valuations generally ascend with the march of time—so most returns are made from being fully invested to benefit from the lift in underlying security values.

Every so often the markets behave like the wild west. Normally animal spirits run wild at the end of cycles when excesses abound. So the markets’ run-up and the piling-in behaviour we are witnessing now, at the onset of an economic recovery, is unusual. Right now, the only material excess in the market to worry about is the market. Which is the reason we believe it will likely result in an outsized correction or lengthy consolidation phase rather than a prolonged market downturn, until value catches up.

It might be fun to guess at what the future may hold and postulate about extreme positioning. However, it makes more sense to us, especially during an economic recovery, to stick with our investments and continue to execute our process—buying undervalued out-of-favour companies, selling them when they reach FMV or our opinion changes, all while shorting the overheated market, just in case.