ccording to an Irish proverb, hindsight is the
best insight into foresight. In fact, hindsight can be a wonderful
teacher, helping us to overcome biases and providing a valuable
perspective on past events. Take, for example, the action in the stock
market since the beginning of the pandemic. Following the quickest sharp
selloff in history, the market hit bottom on March 23 of 2020. In the
year following, US stocks have enjoyed their biggest rebound since 1936,
leaping 75%. Now, in hindsight, it is clear how this happened: massive
central bank intervention, lots of public spending, and progress in
fighting the pandemic contributed to an improving outlook for business
and stocks. The economy is even poised to grow strongly this year, and
perhaps enter a boom phase.
A year ago, however, at the end of March, we
were barely beyond the panic-induced market rout. Further declines
seemed plausible, as even a 30% loss only brought the averages back to
where they had been at the end of 2018. There was talk about the
possibility of an economic depression, and high debt loads across the
economy and government stoked fears of banks’ exposure to losses. The
emergence of breathtakingly bad economic data only served to deepen the
gloom: from March to May 33 million Americans filed for unemployment
assistance, and the unemployment rate rose to 14.7%, the highest in the
post-war period, with some forecasts calling for the rate to ultimately
reach 30%.
Despite
the overwhelmingly negative sentiment at that time, a few observers
offered more positive views, even during the middle of the crash. On
March 12, 2020, Michael Mackenzie of the
Financial Times
wrote, “the case for buying equities over government bonds does
look good.” On March 20, Merryn Somerset Webb, also of the
Financial Times,
said “an increasingly interesting number of stocks are cheap now
and most will eventually recover.” In our own
Commentary
of April 2020, we maintained that “markets will recover in due
course, as they always have.” If these remarks seem too tepid,
let’s turn to Howard Marks of Oaktree Capital, an investment firm; in a
note to clients of March 12 he stated, “all great investments
begin in discomfort.” Subsequently, on March 19, he was more
direct: “Given the price drops and selling we’ve
seen so far, I believe this is a good time to invest… .”
By June 3, 2020, the S&P 500 had enjoyed its
best 50-day upswing in its history, yet overall, sentiment remained
cautious, even negative. Large investment funds “braced for second
stock market plunge,” read a
Financial Times headline. The rapidity
of the surge had made many reluctant to make commitments, while others
pointed to the markets’
narrow focus on big technology issues. Further
dislocations were expected.
What one tends to overlook when markets succumb
to an avalanche of selling (such as occurred last year) is that someone
is buying those marked-down shares; Howard Marks and his like-minded
brethren were among them. Those with the foresight to take advantage of
what was, for most, a very bewildering situation clearly benefited. To
quote Marks further: “there’s simply no room for certainty in
investing.”
So, what insight does our hindsight give into
the foresight that clearly existed a year ago? An answer is suggested by
a recent piece in the New York Times
entitled “Bad News Bias.” Researchers have found that “Human
beings, particularly consumers of major media, like negativity in their
stories.” And “We think the major media are responding to
consumer demand.” It is probably safe to say that investment
professionals, being human, also tend to subscribe to negative news and
viewpoints and act accordingly. Overcoming this bias requires
self-awareness, faith that difficulties will work themselves out in due
course, and an ability to think long-term. Returning to Marks: “It’s
not easy to buy when the news is terrible, prices are collapsing and
it’s impossible to have an idea where the bottom lies. But doing so
should be the investor’s greatest aspiration.”
He Who Sells What Isn’t His’n Must Buy
it Back or Go to Pris’n.
This quaint nineteenth-century aphorism,
attributed to Daniel (“Uncle Dan’l”) Drew, a Wall
Street market operator of notoriety, succinctly describes the ancient
and common practice of short selling. In a short sale involving a stock,
the seller borrows shares from an owner and sells them at the current
market price. Later, the seller purchases shares in the market in order
to return the borrowed stock (the short position is “covered”).
In the interval between sale and re-purchase, if the share price has
fallen, the seller pockets the difference. If the price rises, the
seller incurs losses, which can be unlimited. Hence the short sale is
inherently a bet on the direction of prices, and while there are a few
sound investment reasons for engaging in a short sale (hedging and
arbitrage, for example), the preponderance of such transactions is
associated with speculation.
Short selling figured prominently in one of
the more colorful Wall Street blow-ups in recent memory. A retail chain
called GameStop had attracted a large short interest (the percentage of
a company’s outstanding shares that have been borrowed for short sales).
GameStop sells video games and equipment and related merchandise through
a brick-and-mortar network of over 4000 locations, plus online. Its
business performance has been lackluster and some investment funds,
believing the company to be ultimately doomed in an increasingly online
world, had accumulated a short position of
141% by the
beginning of 2021, an enormous bet on the company’s imminent demise.
This large short interest became a ripe target for predatory traders
interested in forcing a “short squeeze.” Squeezes can occur
when an unexpected rise in the target company’s share price forces short
sellers to buy shares at higher prices to cover their shorts, thereby
losing money. Not doing so can subject the short seller to rapidly
increasing losses, and margin calls (short selling requires a margin
account). This is precisely what happened in the GameStop episode, on a
grand scale.
The risk to short sellers of a squeeze in
GameStop was especially high given the large number of shares in margin
accounts, limiting the number available for trading. This fact was not
lost on the predators, so-called “Trader Bros” — a
group of mostly young men who seem to have nothing better to do than
hang out in online stock tip forums and brag about their winnings. They
collectively decided to stick it to hedge funds by buying GameStop
shares, thereby forcing up the price (note that this would be illegal if
practiced by investment firms). A rising price would in turn force short
covering, driving the price still higher. It worked. The 52-week price
range for GameStop shares
—
$2.57 to $483
—
provides an idea of the extent of the carnage as some funds lost
billions of dollars and at least one had to be bailed out. A few “Bros”
made a lot of money, but since losers are disinclined to brag, we’ll
probably never know how many were in the other camp.
Massive government spending and aggressive
central bank activity over the past year undoubtedly saved the American
and world economies from descending into a severe recession, or even
depression. The enormous mutual aid program saved many lives and
businesses, enabling individuals to retain skills otherwise lost through
unemployment, and businesses to remain solvent until more normal times
appear.
From an investor’s perspective, the recent
injections of financial liquidity are exacerbating an environment
already rife with risk due to years of low interest rate policies that
have encouraged the use of debt and “reaching for yield”
behavior. There are signs that speculative activity has reached an
extreme that threatens a vast misallocation of capital, as well as the
financial well-being of the participants. Just this year we learned how
one private family office (an investment firm dedicated to serving one
or more wealthy families) employed secretive speculative financial
instruments that were not subject to regulatory reporting requirements
in order to create breathtaking leverage. When its bets went sour,
overwhelmed by margin calls, the firm self-destructed, leaving a few
large banks with billions of dollars in losses, and stoking fears of yet
another contagious banking crisis.
Another example of frothy markets is the “SPAC”
(“Special purpose acquisition company”), essentially a blind
investment pool in which “investors” buy shares of an entity
that has no business, in the hope that the management finds one quickly.
These speculative creations have appeared from time to time over the
years, but in 2020 and 2021they attracted record sums (SPAC promoters
grant themselves bonuses in the form of low-priced shares, a perk that
enables them to potentially multiply their money many times. Buyer
beware!). A few may do well, but the shares of many SPACS are now
appearing in the “new lows” lists. Finally, there is the
GameStop episode, fed by novice traders, some of whom used Economic
Impact Payments as seed money. Of this we can only say that it is never
a good sign when “Trader Bros” are being interviewed for
evening news programs.
So what does our “insight into
foresight” suggest now? The choices are not so clear-cut. A year
ago it paid off handsomely to follow the foresight and advice offered by
experienced observers and investors and take a highly contrarian
approach: investing in equities (and some fixed-income) at often sharply
discounted prices. This year those voices might counsel stepping back
from the fray, as stock prices have risen considerably since March 2020.
It is true that current massive government spending and monetary
programs should have a positive impact on business going forward, but
the big question is, how much of the good news has already been “discounted”
by the markets
—
probably quite a lot. This makes finding attractive investments a lot
harder, but we don’t
advocate selling either, at least not in a
formulaic fashion. As we said in April 2020
Commentary, “When
skies are blue, the road ahead clear, all around the world is in bloom
and markets are rocketing higher, that is the time to sell if you wish
to do so; buy when no one sees hope for the future and prices are
heading down.”
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