Zooming to Booming

This article has been excerpted and edited from our quarterly newsletter to clients dated May 19, 2021.

The pandemic forced us all to communicate via Zoom. While nobody wanted to attend a Christmas dinner or Passover seder on video, it was better than nothing. Thankfully, even though video communication is here to stay, vaccines are allowing us to return to normal. Meanwhile, the economy, now booming thanks to massive government stimulus and zero interest rates, should accelerate further in the near term as pent-up demand is unleashed.

Pedal to the Metal

Trillions of stimulus dollars have flooded into economies around the world. And it has stimulated beyond expectations. The global economy is flying. Economic stats in the U.S. are exhibiting record growth rates. Manufacturing and service sector expansion is surging. Commodity prices are soaring—industrial commodity prices have barely had down days since last July. Retail sales have spiked higher. Used car prices too. House inventories are at less than 2 months—a record low—and prices are up at a record year-over-year pace. Consumer confidence is at highs, despite the pandemic. There’s been record demand for mattresses and condoms—va va voom. And once everyone starts returning to the office, going to events, and vacationing, the economy should further strengthen.

The economic revival has returned corporate profit expectations to all-time highs too. Earnings per share results this quarter have exceeded expectations by a record level and forward guidance has been strong. Markets have taken note and stocks are at all-time highs. All this positive news caused speculation reminiscent of the dot-com bubble, though the frenzy isn’t as pronounced. The speculation now appears to be abating, with overdone stocks way off their highs. Even Zoom has declined about 50% from its high, though it’s still up 90% from its 52-week low.

Sentiment remains at the 100th percentile—most are bullish, which is bearish. Though sentiment has been unusually elevated since last November, an extremely long streak of such heightened investor optimism, one should not be complacent. Frenzies aren’t your friend. They always end with a separation of you and your money.

Despite a steep correction in high-flying stocks, overall market valuations in the U.S. are also at the 100^th percentile of historical valuation levels. Therefore, the indexes are ahead of themselves and a sizable correction could occur at any time. Importantly though, underlying intrinsic value should continue to rise along with economic growth, especially while central banks’ policies remain highly supportive. Valuations should ultimately catch up.

Our preference now is to be fully invested in undervalued positions in our Growth accounts while being partially hedged by shorting U.S. stock market ETFs (or holding inverse ETFs in registered or long-only accounts). We normally reserve shorting for recessions or the rare occasions when prices fall below our TRIM^TM line; however, with valuations and sentiment so elevated, we are comfortable maintaining hedges.

Long-Term Pain for Short-Term Gain

In the interest of boosting our returns, we just found an unbelievable stock. The company makes electric vehicles. Its lineup of cars is priced each day in 4,000 different cryptocurrencies. It has a fintech leasing arm that uses a massive cloud-based database to source customers. Each vehicle has solar embedded in the roof. The built-in dash infotainment system has a single button for placing a bet on your favourite sports team and another for locating the nearest cannabis retailer. A premium feature includes a small area for heating plant-based food. We were particularly attracted by the company’s celebrity board members. We haven’t bought shares yet because we are waiting for momentum to build and prices to return to a 52-week high. Despite its sky-high valuations and net losses, we are enamoured because the prospects looking out several years could be astounding. The ticker symbol is VROOM. Belated April Fools. Clearly this is the antithesis of our process.

We realize that investing is much like exercise and dieting, requiring discipline and often shortterm pain for long-term gain. Why is it then that individuals feel compelled to pursue quick-rich schemes when they invariably end badly? A combination of lack of discipline, succumbing to emotion, overconfidence, and unawareness of risks are the likely culprits. And it’s not just individuals. Government’s can be just as irresponsible—look at the misguided stimulus designed to spur spending rather than investment, enhancing short-term growth at the expense of long-run sustainability.

Sure, high speeds can get often get you there faster, but they also increase the danger factor. Embracing momentum, popular securities, and leverage are a means to enhancing short-term performance but each can materially elevate risk. And we have recently witnessed many examples—nutty things—social networks touting stocks, record levels of individuals buying penny stocks, blowups of hedge funds (Melvin, Greensill, Archegos) each with surreal stories, a staggering cryptocurrency run-up even though it was started as a joke, unbelievable prices for NFTs (digital collectibles), and a substantial return for equity holders of a bankrupt company, just to name a few.

The number of profitless companies in the S&P 1500 recently rose to a high last seen in the dotcom bubble. Newsletter writer, Berna Barshay, coined the term ‘profitless prosperity.’ The share prices of these companies have unusually benefited despite their lack of bottom line. And there’s still close to a near-record-high number of companies whose market caps exceed $10 billion trading above 10x sales. While these larger companies are holding in, unprofitable tech and Bitcoin stocks are down over 50% from their ’21 highs. The deflation of the bubble in speculative stocks seems to be already underway. Once the last buyer has placed an order and new issues abound, demand dries up while supply overwhelms. Then gloom sets in—a throwing in the towel effect—which drives former darlings even lower.

Value vs. Growth

In the last few months, there’s been a rotation from growth to value. Our kind of market. This rotation has kept the markets at highs in spite of the selloff in speculative stocks. Our favourite investment period was the 3 years that followed the dot-com peak. Our shorts fell (though our cuticles were in rough shape from the prior period as speculation persisted much longer than we thought possible), and our long positions rose, despite the indexes being dragged down as 3 speculation waned. The upcoming period could be similar. Today’s economy is still emerging from recession. Back then, the economic cycle was overdue for a downturn.

Over time, value has outperformed growth. But value relative to growth tends to go through long cycles of under- and out-performance. There were 7 fat years when value provided abundant returns versus growth from the bubble until ’07. Then the market went off-script and 14 lean years followed. The cycle has recently turned in favour of value, and we’re hoping it’s off-script again, allowing for more than 7 years of outperformance.

Lowering the Boom?

We have always taken issue with prognosticators concerned about markets at all-time highs. In theory, as the value of businesses grows, new Fair Market Value (FMV) highs should occur each day implying corresponding new market highs. Recessions are clearly disruptive as earnings and valuations decline. During booms, it is market psychology that brings an ebb and flow as markets rise and fall away from ascending FMV. The difference today is that market prices are ahead of valuations. While valuations will catch up, it could take some time. In the meantime, an outsized correction could ensue. There are plenty of examples of substantial market corrections during upcycles, even when the markets have yet to attain FMV.

There are notable concerns which could cause the markets to ebb—especially since stocks in general are priced for perfection.

Interest rates are likely headed higher, at least in the near term. Inflationary concerns have caused longer-term rates to be bid up. Soon, central banks should react to the brisk growth rates and begin reining in accommodative policies and lift short-term administered rates to stave off overheating. Most don’t expect the Fed to begin tapering and raising rates until next year or the following year. Any earlier moves will come as a surprise. Though rates would need to rise quite a bit before they constrain recovery, richly valued stocks do not react well to rising rates.

Because leverage abounds, higher interest rates won’t bode well. The growth rate of debt to purchase stocks is at a record high. Another sign of market froth. And supply of stocks could overwhelm temporarily if and when margin calls arrive. At the same time, U.S. corporate insiders, the ones who know their businesses and valuations best, are selling at a much higher than usual rate.

Government debt is unconscionably high too with all major developed countries at record-high debt/GDP. The debt loads should act to moderate growth over time. It could also be problematic if rates were to spike as it would propel interest burdens. Balancing budgets will not be an easy task. Where’s prudence? According to Herb, she hasn’t been seen since his grade-school days. Bada boom. And the U.S. Federal government is preparing for tax hikes. That will certainly impact corporate profits if enacted.

Some companies will struggle with higher costs from wages, raw materials (lumber prices ran up over 50% just this year), and interest rates if they rise too far. And parts shortages, such as with semiconductors, won’t help either. Small businesses are facing record level unfilled positions. Unbelievable, given the lockdowns we endured, and unfathomable to us Torontonians still stuck in lockdown, and leading the world now in duration.

Inflation expectations in the U.S. are higher than they’ve been in years—about double the 1.6% PCE rate. With the velocity of money finally rising, it could have inflationary implications, but will it be cyclical or secular (economist speak for short term versus long term)? While inflation should continue to lift cyclically, the secular trend is still disinflationary, in our view from massive debt levels, worsening demographics, and ongoing productivity enhancements. Births in the U.S. were the lowest in 41 years in ’20 and have been on the decline for years. Immigration, which can act as an offset, fell too. All of these factors ought to weigh on economic growth and inhibit longer-term inflation. Shorter-term supply chain bottlenecks will loosen. Even toilet paper hoarding has abated causing a poor quarter for Kimberly-Clark. Productivity enhancements won’t subside as the technological revolution seems to be at full tilt. This too is disinflationary.

We are also concerned in the near term because the economic growth rate should soon level off, which normally occurs 12 months after the bottom of recession. And the virus could worsen as a result of variants (particularly if vaccines aren’t effective for certain variants) or simply because a disturbingly large number of people are still refusing to get vaccinated.

Booming Beats Zooming

While Zooming is now a way of life, as economies reopen around the world the face-to-face interactions that we all crave will once again become the norm. Whether at work or play, we’re all missing in-person activities, camaraderie, collaboration, and even small talk.

Thanks to government intervention and the miracle of vaccines, the economy is now booming. The boom should not sustain itself at the current growth rates. However, we believe the upcycle should last for years to come. With valuations full and expectations uniformly high, we are concerned that even a slight negative shock could temporarily deflate the markets.

But we’re unusually relaxed because we’re able to build portfolios of high-quality undervalued securities while hedging an overvalued market, realizing that a robust economy should raise our holdings’ FMVs as we wait for the security prices to better reflect underlying values.

Even as the high market valuations continue to Loom, we’re looking forward to less Zoom, no Doom, and a continued Boom. Rah, rah, sis boom bah!