Anecdotes can be a crutch for writers because there’s always one that can be trotted out to prove any point. That said, several taken together can show the contours of a pattern. In that spirit, we share some recent incidents that highlight ways in which we are essentially re-living the dot-com bubble. First, take the recent coordinated behavior of a group of small investors buying individual stocks, including GameStop and AMC Theatres, causing a market rally based entirely on momentum. This activity is not a new phenomenon: in 1999, individual small investors were similarly trading hot tech stocks, such as Yahoo, CMGI, AOL, and Sun Microsystems. (Note the similarities between the two phenomena as recounted in a recent Wall Street Journal article about Keith Gill, the man behind the GameStop move, and the Journal article on the individual traders running up Yahoo and CMGI in December 1999.)

As in 1999, optimism has taken hold today that assumes the future is well defined and without complication. We are long-term optimists, but we do not see a future without hurdles. And we believe the aggressive ramp-up in growth expectations today is overly optimistic. The consensus outlook is for corporate earnings to grow almost 24% each year for the next 3 to 5 years—higher than the growth outlook in 1999 and 2000.

Although we sometimes have issues remembering what we had to eat last night, we have a crystal-clear memory of the dot-com bubble. Innovation was rapid; new companies brought new opportunities for growth; and profits were right in front of us, as scale promised market dominance. We have a feeling of déjà vu. Once again, heady optimism is being applied equally to many companies within the same space because it’s unclear who among the numerous competitors will dominate. The consequence of pricing all players as sole winners of their market, of course, is unrealistic valuations and outsized profit expectations. Not every company can win.

In the aftermath of the dot-com bubble, we saw a select few reaching critical mass, and excess capacity removing most of the others. The early years of this century were a period of recovering from past malinvestments. We fear the same is going to happen again.

Another similarity between the dot-com bubble and today is our central bank, the Federal Reserve. Remember, leading up to “Y2K” was a massive investment cycle into technology to prepare for the turning of the century. All knew it was coming, but few knew the ramifications. People feared that systems would think a person reaching their 100^th birthday would be seen as a newborn, flight control systems would fail to operate, computers would not turn on, and pay cycles would be missed. To protect from the possibility of the world shutting down, the central bank flooded the financial markets with liquidity. In the February 15, 1999, issue, Time presented the central bankers as saviors who prevented a world meltdown. Sound familiar?

Bubbles make it uncomfortable for those of us arguing for caution and patience. We find ourselves in that position now. Liquidity is plentiful, pandemic recovery is underway, and optimism is high. Some embrace a thesis that today’s activity, though similar in shape and form to 1999 and 2000, is somehow dramatically different. We do not.

We sit in a position of cautious participation. We are roughly 70% invested relative to our mandates. We are far from hiding under our desks, loading up on guns and butter, or honing our survival skills. We have seen times like this before, though, and now is not the time to be fully invested.

If you reflect on the fact that the best time to be fully invested is when markets are relatively boring, our approach might seem more intuitive. We see the times when the markets get riled up—via massive moves higher or lower—as times to walk slowly and guard against outsized moves that could cause regret. We refer to our approach as belly versus tails investing. The belly describes the bulk of financial history, in which market movements are routine (i.e., within one standard deviation of their long-term averages). The tails occur when the markets show extreme behavior, driving prices up or down.

We can show that if you avoid the market’s most extreme behavior, you can reap all of the market’s potential. As shown below, in an overly simplified view of this thesis, if we were to only be invested in the equity markets when they are considered boring (the belly of historical return distributions) and to be fully out of the market when it gets too exciting (the tails of return distributions), we can get to the same endpoint as the market without undue excitement.

We have discussed how current valuation levels are historically high, nearing the valuations witnessed in 1999 and 2000 and surpassing those seen in 1929. These valuations, combined with the exciting news of likely herd immunity in 2021, plus the high levels of stimulus being pumped into the world’s economies, mean no one is yawning with boredom. For those of us looking for calm, this signals we should move away from the trough. And on that note, we’ll end with this classic idiom: “Pigs get fat, hogs get slaughtered.”

One more flash from the past.

Benjamin Graham (father of value investing)

This is not a time for relatives. Don’t worry, Mom, we aren’t referring to family. We mean that justifying an investment based on its attractiveness relative to the prices of other assets is unwise. Over the last thirty years of our investing and experience during two asset bubbles (which we wish would not happen so often), a common perspective shift is apparent: market participants move from talking in absolute terms during market bottoms to speaking in relative terms at market tops. When investment markets are at depressed values, investors focus on the earnings capacity of a firm and how its current price could produce a robust return. Or investors focus on how you can purchase an asset for less than its replacement value, meaning you effectively get a productive asset on sale. During the market topping process, however, investors switch to thinking about how a certain asset class is valued more cheaply than another, without regard to the absolute price. Or investors focus on justifying a company’s valuation based on recent accelerated growth and extrapolating it to never-ending heights.

Today, we need only look as far as the words of Jerome Powell, the chairman of the Federal Reserve, for an example of this “relativity.” He said recently that equity markets are not overly expensive when compared to the high prices (i.e., low rates) of bonds. “Admittedly P/Es [current price divided by expected earnings] are high but that’s maybe not as relevant in a world where we think the 10-year Treasury [rate] is going to be lower than it’s been historically from a return perspective,” he stated during a December speech. He neglected to mention he set the interest rates artificially low and has aggressively bid up the prices of bonds in response to the pandemic and the recession it wrought. These forced actions are what pushed rates toward zero.

We have stated many times that market tops and bottoms should be viewed as processes rather than discrete points in time. This is especially true with the tops. We highlighted in our last newsletter, “Bubbles,” our experiences during past periods of blind faith. Significant cracks were showing in late 1999 and early 2000, yet the market held up for most of 2000—and then proceeded to decline for three years. Many analysts and publications from late 2000 asked, “Has the market bottomed?” It hadn’t. The NASDAQ proceeded to lose 80% of its value, and the S&P500 50% of its value, over the next three years.

We can also refer to the most recent bubble (the Great Financial Crisis) for evidence of this phenomenon of market tops being processes: mortgage defaults were rising throughout 2006. In May 2007, Bear Stearns attempted to save two of their large mortgage hedge funds, infusing them with more than $3 billion in new cash. The hedge funds failed within a month. The equity market did not respect even that signal and maintained its elevated position until late 2008, when the Lehman bankruptcy shocked investors into respecting financial risks. The bursting of the housing bubble resulted in a loss of more than $8 trillion of perceived housing value (as estimated by Jeremy Grantham of GMO). It is hard to comprehend how so many market experts and participants could have miscalculated the value of technology stocks in 2000, or of housing assets in 2007, to such an extent.

The explanation for these seemingly gross miscalculations likely lies in the way investors incrementally vote the market higher as relativism takes hold and short-term success bolsters confidence in long-term optimism. Yet, at some point, the greed eventually weighs heavy, resulting in collapsing prices—and then extreme fear—as we experienced in the bursting of past bubbles.

The problem with relativism when justifying investment decisions is its foundation falls away as other assets start declining. It is a key component in our philosophy that in times of duress, all assets are at risk, with few investments offering principal protection. In the case of Mr. Powell’s quote above, what if interest rates moved up, against the will of the Federal Reserve? (This is not the current consensus view, but it has happened repeatedly in our history.) Without any change in a company’s market positioning, earnings power, or defensibility, its equity value can be dramatically revalued. In other words, with unchanged business fundamentals, that equity will now look more expensive relative to safer fixed income instruments.

Investors become “trained” by short-term market movements. They change their analytical framework from one of assessing investment fundamentals to one of debating and trading on only macro factors (e.g., the expectation of monetary and fiscal stimuli, etc.) and the incremental change of those factors. They gradually shed their concern about the durability of a company’s business model and its future earnings stream’s ability to support its valuation.

And this is why we see the current environment as a fight between relatives and absolutes, with relativism currently on top. However, we tend to believe Mr. Graham that the weighing machine will kick in, and absolutes will win in the end. As momentum subsides, which it always has in the past, the weight of reality will take hold, and the foundational aspects of investing will once again become important.

One current example of market relativism: many think with the introduction of vaccines, a pro-cyclical approach should be taken as the world economy comes out of a very sharp, yet brief, recession. (Refer to our Fall 2020 newsletter, “Two Narratives.”) The typical game plan at the end of a recession is to close your eyes and invest in stocks, industries, and sectors that benefit from an economic recovery. We see a few issues with this line of thinking at this time.

During a recession, the economy sees a retraction in risk behavior that traditionally results in

• bad business models shutting down (yet the likes of Nikola rallied without any revenue or a durable business model),
• mergers occurring within weak industries to reduce capacity (yet airlines maintain their independence),
• companies’ inability to go public (yet the U.S. experienced more initial public offerings in 2020 than that experienced in 2000 internet bubble),
• deeply indebted companies working down excessive debt (yet 2020 was a record-setting year for all forms of debt issuance, with corporate debt levels rising to all-time highs),
• increasing pessimism around the likelihood of an earnings recovery (yet expectations are for a full recovery faster than experienced in any cycle over the past 50 years), and
• individual investors shying away from risky investments (yet we have experienced unprecedented activity in risky derivative markets).

Recessions act to clear out the weak and reinforce the good behavior of the strong. They have traditionally led to more sound investment opportunities. The evidence today suggests we are not experiencing the typical cleansing we are accustomed to. Is it different this time? Or, are we continuing to act in a relative manner, increasing the risks of a far greater and more painful event that drives us back to the absolutes?

Let’s look at some absolutes.

Valuations across almost all equity classes are at, or are very near, the highest levels experienced in recorded history (including the dot-com bubble). In our memory and reading of market history, robust and enduring investment cycles have not started from our current position.

There is no precise method of valuing a firm, so we use different perspectives to determine value. No matter the type, size, or region, almost all asset categories today are trading at their historical highs. Some might argue that depressed earnings prevent earnings-based valuation approaches from being a good predictor. However, the valuation process looks forward, at earnings expectations that assume a profit recovery happening in less than two years’ time. (This means that corporate earnings would surpass their pre-recession highs). A review of past recessions suggests that two years would be half the duration of prior profit recoveries. And two years is but a fraction of the time that the deepest economic contractions have taken to recover. It might be different this time… but it might not.

Let’s stay on the valuation train and look at how longer-term indicators are sometimes used to attempt to see past the earnings volatility driven by economic cycles. Like all valuation indicators, the Shiller Cyclically Adjusted PE (CAPE) measure has not been a good timing mechanism for determining when to buy or sell. However, it has been a strong indicator of the presence of bubbles. Please remember, at Auour, we do not look to valuation as a strong factor in timing future market movements. Instead, we see it as a risk factor, helping us ascertain the severity of any future correction. The farther from the historical average, the higher the concern that a future correction will be painful.

As the technology bubble of 2000 demonstrated, bursting doesn’t always happen quickly. The word bursting really calls up an inaccurate image altogether. The puncture might be dramatic, but it can take years for valuations to settle on a solid foundation. It is difficult to precisely time the bursting of a bubble. It is even more difficult, in our opinion, to determine the trajectory and length of the ensuing slackening. What we do know is that the more highly an equity is valued, the lower its future return potential. The risk of loss becomes high.

The chart below shows the equity market’s current valuation in a historical context. It reveals historical 10-year forward returns for different levels of the CAPE ratio. If history is to repeat itself, the current environment may offer a very unrewarding future.

As depicted in the S&P 500 CAPE Ratio graphic, valuations, as they present themselves today, are the highest since the 2000 internet bubble and, at least to us, the cause is clear: they have been created via the significant monetary liquidity the central banks facilitated. As expressed in the M1 Money Stock graphic, money supply growth is extreme by any measure.

We have discussed in the past how central banks possess a hammer and so see many problems as a nail —adding monetary stimuli no matter what issue the world is facing. Greed is the common element to all past bubbles and this one is no different. However, the central banks’ actions to suppress economic troubles are feeding speculators’ confidence that the greater risk is being out of the market rather than in it. The actions are a clear example of moral hazard.

As a sign of risk behavior of individual investors, new brokerage account growth hit records in 2020, and the use of options as a form of market-betting has been extreme. At Auour, we track the imbalance between call options (a form of buying stocks) and put options (a form of selling stocks). The graphic below shows the extremes in the imbalance, where we can think of red as indicating heightened greed and blue, fear.

We sit at a point of significant speculation in the options market and excessive growth in the money supply. The former is fleeting, and the latter has always resulted in inflation.

At some point, interest rates will rise no matter the intention of the Fed, and bond investors won’t care that the current equity market’s high levels are being justified on the expectation that rates won’t rise. In investing, we were taught to look for multiple “pros” to justify the purchase of an asset, knowing that having only one makes an unsteady justification. Right now, it appears that all investments are riding on only one pro: low rates.

Conclusion

William Sharpe, one of the fathers of modern investing, describes risk as unexpectedly losing a substantial amount of money over a short time. We see such risk being historically high.

Was the market correction (a 34% loss in 23 trading days) in the first quarter of 2020 the bear market, or was it the start of the bear market? Whichever you argue, it is hard not to see it as a tremor, a harbinger of what may be a new phase to this investment cycle. It is why we continue to stress a cautious tone. Our conservative positioning has allowed us to continue to participate in the market’s advances, yet it reduces the risk of extreme damage to our clients’ portfolios.

The quote at the beginning of this commentary was a comment about the struggle between short-term and long-term investing. Over short periods, the incremental investor votes with dollars (of which the central banks have provided many), pushing assets higher as success breeds confidence in continued success. Momentum takes hold as majority thinking drives ever higher pricing. However, at some point, the weight of the high valuation will need to be justified by the earnings of the asset.

Sometimes the results of a popularity vote can express current whims but have lasting ramifications. Just look at the early 2016 British Internet referendum where the public was asked to vote on a name for the lead boat of a new fleet of underwater vehicles. The overwhelming winner was Boaty McBoatface.

– Charlie Munger when discussing the current stock market environment.

There is a saying in the investment world, “You might know when you are in an investment bubble but still have no clue when or how it pops.” As we end 2020, we know we are in a bubble. We have no idea when it will pop, or what pin will pop it.

There is another saying, “The market tends to deliver the maximum amount of punishment to the greatest number of investors from time to time.” This is also called the pain trade. We see it when most market participants are already exposed to the same investments, and there is no one left to buy those securities if their price slides.

Deutsche Bank conducts an annual survey of the current positioning of their clients. The respondents are mutual fund companies, hedge funds and other large asset management clients. As the results below show, investors have determined that U.S. equities are the best option for 2021, and principal-protecting assets, such as cash and high-quality fixed income, is the worst. The U.S. equity markets are valued at levels not seen since 2000, the first bubble of this century. This brings up the question, “Why are investors feeling so confident in U.S. equities over the next year when their valuations suggest extreme overvaluation?” The answer?  We are in a bubble.

Bubbles begin when investors envision a new, untapped opportunity. The bubble continues to grow as short-term momentum builds. The justification for continued exposure is that the prices keep going up. Logic during a bubble relies on the premise, “If it worked yesterday, it should work tomorrow.” In bubbly times, then, momentum becomes a self-fulfilling prophecy. As it builds, one’s conviction in owning the asset increases. Assets become detached from fundamentals, and those signs that should signal caution are disregarded as no longer meaning anything since the assets’ values keep rising. The problem with momentum investing is that it works about two-thirds of the time, which is better than average, yet its adherents neglect to remember a much more important fact: momentum investors suffer the worst declines when the music stops.

Over the past 20 years, we have experienced the popping of two of the worst bubbles in modern times. These two bubbles have been ranked number two and number three, in terms of severity, of all the bubbles over the last 100 years. Only the crash of 1929 was worse. The characteristics of the two bubbles were very different, but there were warning signs in both cases that went back at least a year  prior to when the market decided to listen.

We think now is a time to reflect on those two bubbles.

Technology Bubble of 2000

The technology bubble can be attributed to two forces: 1) the general adoption of the internet, and all the potential it brought to the economy, and 2) the enormous investment in technology and telecom infrastructure required to update systems for the year 2000. For those not old enough to remember, “Y2K” was of great concern, and people thought the calendar flipping to January 1, 2000, might wreak havoc on the economy. As firms addressed the millennium calendar change, they also used Y2K as an opportunity to modernize their systems, paving the way for the already clearly imminent internet revolution. Leading up to the late 1990’s, Microsoft, Intel, Cisco, and Dell were considered the four horsemen. They were soon joined by Oracle, EMC, and Sun Microsystems (who put the “dot” in “dot com”). AOL, eBay, and Yahoo joined the wagon train as they became the de facto winners of the internet revolution. A company’s stock would jump after an announcement of a stock split, even though the split itself did nothing for the firm’s inherent value. 

This party continued throughout 1999 and deep into 2000, even as the Y2K investment cycle was ending. Warnings from Intel, IBM, and Lucent were some of the early indicators, but investors pushed those signals to the side, saying these companies were simply the old guard and their days to shine had passed. Although the market had gotten it mostly right on the winners, it took investors 15 years to get back to the valuations the “winners” experienced during the highs of 2000. The market picked the right horses, but there was no prize at the end.

Great Financial Crisis

After the bubble of 2000, an accommodating central bank and a desire to invest in real assets versus the stock market resulted in investors moving hard over several years into real estate and the mortgages tied to them. Real estate prices ramped to record high prices relative to household income. Interest rates were low, and investors were clamoring for securitized, fixed-income instruments as a means of obtaining a hard-asset-backed income stream. 

Cracks were showing themselves in 2006, as default rates were increasing. Many investors said it was not a big issue because the ability to blend different mortgages into one security allowed for diversification away from anyone real estate market. That turned out not to be true. In May 2007, Bear Stearns invested over $3 billion of new equity into two of their mortgage-based hedge funds, only to see them go bankrupt a month later. Housing prices and speculation remained high, with the party finally ending in late 2008, when Lehman’s bankruptcy forced the partygoers to realize the leverage in the system did not allow for any deterioration in real estate values. There was no longer punch in the punchbowl.

Pandemic Bubble?

We see several similarities today with both previous bubbles. Recent articles, such as the one above, echo past bubbles, implying a no-lose situation to investing. A very narrow stock market is being held up by a few very expensive companies. It would be hard to argue that just because many of these companies are category leaders—that is, the ones likely to dominate for a long time—they are safe bets. As the bursting of the 2000 bubble shows, that does not necessarily mean they will provide suitable returns.

Leverage within the government, municipal, and corporate areas has grown through the pandemic in hopes of softening the economic blow of the shutdown. As we saw in the Great Financial Crisis of 2008-09, excessive leverage has the chance of diminishing the equity left over for investors. 

Time will tell how the current bubble proceeds, but there can be no doubt that momentum is by far the biggest justification of most investors for continued participation.

When the self-fulfilling prophecy of momentum dies, the only reason for owning overvalued stocks goes away.

Holiday Reading

We look to the next few weeks to gather with family and friends, as well as a quieter time to sit back and reflect.  We offer some reading material that we think is pertinent to today.

Howard Marks’ January 2000 note bubble.com (pdf)

Warren Buffett’s November 1999 Fortune Magazine article (pdf)

To understate the obvious, we are in confusing times. One day, we are elated that a vaccine might be approved and distributed. Another day, we rue the escalating caseload and impending new lockdowns.  The global investment markets are reacting to both scenarios, depending on the day’s headlines. We live in a constant flux between two narratives.

The first narrative is optimistic, about a return to normalcy with an effective vaccine(s) and widespread distribution. After mass vaccination, herd immunity should allow for increased mobility, like in the good old days of 2019. People get back to work and consumption resumes. People no longer worry about their proximity to others. Large cities become attractive once again to employers, workers, and tourists. And, with this increased economic activity, a more normal monetary and fiscal environment comes into view.

The second narrative is one of continued disruption. Not only have so many lives been lost, but the economic toll also continues to increase. Unemployment stays high and becomes structural, as industries right-size their workforce and growth plans. People increasingly drain their savings. There is ongoing and increasing demand for government fiscal stimulus and central banks walking a fine line between supporting markets and constraining adverse risk behavior (a tightrope that even Houdini would not have attempted). 

These are crude descriptions of two opposing narratives, but they serve us for the purpose of discussion.  The uncertainty and increased volatility of the investment markets are the outcome of the tug of war between these two narratives. Investors tend to have firm beliefs on what the optimal investment positioning would be for each outcome. That’s not the hard part. The issue lies, rather, in knowing which narrative is more likely, and when we might transition to it. 

If we have a continued, pandemically-induced slowdown, growth will remain scarce, with only a few technology and healthcare companies benefiting. Monetary and fiscal stimuli will continue, keeping interest rates artificially low and indebtedness high. Inertia will take over, dampening investors’ enthusiasm for funding at-risk businesses on the strength of some nebulous future recovery. The search for secular growth will become harder, just as it did after the technology bubble of 2000 burst, resulting in a multi-year decay.

Could a vaccine bring us back to normal? An economic recovery would dramatically change the leadership of the stock market, or at least that is the expectation. Those companies that are most sensitive to economic cycles have been hardest hit in both their operations and in their valuation as the world experienced the worst decline in economic activity since at least 1961. Once the weight of the pandemic is lifted, investors will gravitate to those economically sensitive firms as they benefit from an economic recovery. The nine-year run of growth companies beating value companies will stop, and value companies (those most influenced by economic activity) will thrive.

Investors appear to have defined two portfolios, one for what we are calling the Normalcy Narrative, and one for the Lockdown Narrative. Of course, massive economic destruction has occurred, and the impact of measures taken to offset the destruction may be long-lasting. Being prepared to invest wisely for either narrative is important, but we think any investment scheme for either narrative has to reckon with the economic destruction wrought by the pandemic.

World GDP is expected to shrink by 4.4% in 2020. To put that into context, consider that world GDP shrank by less than 2% in 2009. The developed economies have been hit harder, shrinking by 6%. And yet, to many, shrinkingmerely 6% is a big win when you consider the magnitude of the global shutdown and what could have happened. That “win” wasn’t without large increases in debt that will need to be paid for in the future.

As we described in our last commentary, across the globe the response to the rapidly spreading virus was an almost complete shutdown—a blunt tool used on a finely textured economy. This brutal and abrupt cessation of so much industrial and consumer activity required, in many countries, extraordinary and massive fiscal and monetary stimulus accommodations. As shown in the chart above, stimulus responses ranged from pumping into its economy the equivalent of 15% of GDP in Australia to almost 40% in Germany. We mentioned in our last commentary our distaste for the word “unprecedented,” so we will just say “wow.” And such stimuli are not, in fact, unprecedented. We have seen government-based stimuli like this in the past. Unfortunately, they did not result in good political or economic outcomes.

It is not only governments borrowing from the future to maintain the present; private institutions and individuals have been using low current interest rates to make up for the economic destruction incurred from global lockdowns. Deutsche Bank has calculated the change in debt relative to the size of an individual country’s GDP over just the last nine months: Canada has almost doubled its debt. Japan and the U.S. are doing their best to keep up.  Government-backed debt (through stimulus action) make up about half of the debt load, but the private sector has also extended its indebtedness.

As one example of the consequences, we look to the number of firms unable to service their debt, via normal operating activities, let alone pay it off. Our past commentary, we referred to that cohort as zombies and highlighted the growing number of them. The number of such zombie firms was growing prior to Covid. With the pandemic, it has certainly grown. And while the sheer number of zombie companies is telling, the level of debt they carry is another metric worth following. According to Bloomberg, almost $1.5 trillion in debt obligations is attributable to companies that cannot currently pay the interest on that debt given their operating situation. This is three times the level of such debt seen during the Great Financial Crisis. And remember, one person’s debt is another person’s savings. Not a comforting thought.

Many are asking: Why would market participants continue to provide funds to firms when the economic climate is uncertain and the ability of those firms to pay back debt is not guaranteed and likely highly in doubt? We have the same question, and we have heard no good answers, other than that the Federal Reserve and other central banks continue to push rates so low that investors—savers—are forced to reach for anything with yield. These savers are more worried about the return on their capital than the return of their capital. Some think the government will bail out firms and the risk of capital not being returned is low. We do not share that opinion.

And neither do bankers, it appears. The growing uncertainty and the unclear path to recovery, plus the high levels of indebtedness, are causing bankers to become more conservative, which does not bode well for the Normalcy Narrative. 

Lending standards are still tightening, which has traditionally resulted in lower quality companies paying higher rates for debt. The Federal Reserve’s actions during the pandemic are distorting that cause and effect.  Something must give. We believe that the fundamentals of a company more reliably determine its ability to pay back its loans than the altruistic intentions of the Fed. The central bankers certainly wield a large weapon in the face of poor market liquidity, but history has shown that using it does not offset insolvency. 

A Sharpe Perspective to Investing

At Auour, we strive to approximately track the global markets in good times and to defend against their worst impacts in bad times. Outside of overall investment returns, we look to limit our experienced losses to half that of the market and to optimize our Sharpe Ratio. The Sharpe Ratio, named after William Sharpe, one of the fathers of modern portfolio theory, is a measure of the amount of return one can achieve for a given amount of risk being taken. Think of it as similar to a fuel efficiency measure. The more miles you can drive on a gallon of gas, the better. In investing, the more return we can provide at a lower level of risk, the better.

When discussing risk, most experts are mainly discussing volatility—the degree of fluctuation in value of a portfolio that one experiences over a period of time. At the present time, volatility is high. Uncertainty remains high as investors struggle with the two narratives—and everything in between. Over the past 14 months, we have maintained a high level of cash, expecting a period of high volatility with little overall return. We are keeping our powder dry, maintaining a defensive posture, and hoping for the best but expecting the worst. However you want to describe our current positioning, it is one of holding our investor’s assets dear and stewarding them through a period of fragility (we won’t say an unprecedented period) not seen in quite some time.

—Umberto Eco

False Heroes

Just a note: We have been quiet for the past two months not because we lacked things to say but because we felt everyone needed a break. We can’t be the only ones fatigued by the daily feed of dire narratives based on selective data. Rather than try to speak through the noise, we decided that reading, reflection and a little more reading was the better path. After that pause, it’s time to get back at it—and in front of what will likely be an eventful end of the year.

One more note: We are tired of the word “unprecedented” and think it a lazy way to view current events. Pandemics have occurred in the past. Recessions aren’t new. Politics have been this bad before. In other words, the world has seen worse scenarios, so to say this period is unprecedented is false. It also disrespects the trials and tribulations our ancestors experienced. OK, enough ranting. Back to previous programming.

We ended 2019 and began 2020 with a party analogy. We likened our move to increasingly high levels of cash in late 2019 to getting our coats and leaving the party before it got out of hand. In February and March, the spreading pandemic and government lockdowns abruptly stopped the party. The global lockdown was a blunt object used on the complex and fine texture of our economy. The hangover looked to be a doozie, but the U.S. Federal Reserve (also known as the lender of last resort) came to the rescue. (Our hero!) By the end of March, they promised to support the economy in every way possible—lowering rates; buying government, corporate, and municipal debt; even offering direct loans to businesses—thereby pushing liquidity into every pocket of the economy. In other words, they ramped up an after-party, with a refreshed band and bubbly flowing from the fountains.

The Federal Reserve’s efforts were no different than those taken by the central banks of other countries. They all promised to maintain low rates until inflation moved up past some subjective level. Though the intention was to mitigate discomfort in order to stimulate investment and economic activity, the result is not assured. And the unintended consequence might be increased instability.

The conventional thinking behind lowering rates is, and has been, that it stimulates greater investment, which leads to higher employment, which leads to greater income. And more income drives higher consumption, which heats up economic activity. The hotter economy then brings about higher prices. Once inflation picks up, central banks can raise rates to lower consumption, which brings on a modest economic contraction, which starts the cycle all over again. The central bankers, with the U.S. Federal Reserve being the leader among them, are perceived as regulating the fuel of the economy’s engine, thereby controlling the speed of its activity.

But what happens if the results of the Fed’s actions are not what they intend? Most people consider the inevitability of lower rates bringing on inflation to be firmly established. It is commonly perceived that low inflation is the result of money being “too tight.” However, when we look around at developed economies around the globe today, lowering rates has not caused inflation. Japan has negative interest rates—yet is struggling with deflation. Europe also has negative rates, yet it hasn’t come close to hitting its 2% inflation target. So, we have to ask: If it doesn’t look like a duck, doesn’t quack like a duck, maybe… it isn’t a duck?

To the minds of most central bankers and government officials, inflation is not necessarily a bad thing. Some inflation promotes the perception that wealth is growing, acting as an impulse to spend now rather than later. (To a cynic, it is just a silent tax.) However, for most of the population, inflation is not a panacea. Past episodes of higher inflation have shown a tendency to benefit the few at the expense of the many. 

Seeing lower rates not lead to higher inflation has stirred up interesting discussions. Some academics increasingly believe that lower rates bring about lower inflation—a spiral with potentially material consequences. It is not hard to imagine these academics are right when you examine how inflation is calculated:  The largest component of the inflation calculation is housing. Housing inflation is looked at as a change in the cost of shelter (be it either owned or rented). The calculation used to determine the growth in the cost of housing depends significantly on mortgage rates, which are tied to the interest rates set by the Federal Reserve. Lower rates lead to lower mortgage costs, which leads to lower inflation in the housing component, which makes up more than a third of the inflation measure. 

The old saw that low rates stimulate economic activity also might not be true. Instead, consider that lower rates stimulate significant debt, which acts as a deflationary weight on the economy. It is not hard to see example’s in your own experience: If you borrow money for current consumption, you need to either make more or spend less to pay off that earlier debt-driven consumption. Regardless, debt needs to be paid. Borrowing now means you must pay it back later, with interest. Without an influx of more money, debt for consumption brings on deflation.

When empirical results no longer follow theory, we are proponents of going back to fundamental principles to reset our thinking, just as we pull out a compass when lost.

Economics 101

Let’s reflect on the foundational principle of economics.

At the root of economics is the relationship between supply and demand. The price of any good or service will be the fulcrum point between the effort required to supply the good and the end consumer’s demand for that good or service. In the simplest illustration, if demand is greater than supply, more people will want product than is available, the price will trend higher, and inflation will follow. If supply is greater than demand, people have more competitive options and prices trend lower, as does inflation. The balance of supply and demand is the core pricing system of the economy and defines when an economy finds equilibrium.

A well-regarded economist, Hyman Minsky, evolved the thinking of an economy’s means of finding an equilibrium by speculating that economics must be viewed as having two pricing systems, not one. He says changing interest rates brings about different outcomes within economic systems. One pricing system is for goods and services consumed now, and another pricing system is for investments and savings.

To further this thought, Randall Wray, a professor of economics that studied under Minsky, writes, “Hyman Minsky’s financial theory of investment rests on a bifurcation of an economy’s price systems. On the one hand, there’s the price system for goods and services. And inflation here is what central banks look to hold in check. But at the same time, there is a wholly separate price system for assets. And it’s here where stability leads to asset price inflation, a buildup in debt, instability, and, eventually, crisis.”

If we believe these two pricing systems to be foundational, we can then explain our current and seemingly contradictory environment, in which lower rates have simultaneously produced lower inflation and higher asset prices.

Price System One: Goods and Services

Let’s look at inflation first. No surprises here. Lower rates on debt financings have allowed more companies to fund investments that drive up productivity (i.e., produce more goods at the same or lower cost, which is deflationary), or, if you are a cynic, to stay in business despite a poor business model, which can also produce excess supply and temporary deflation. Keep in mind that one person’s debt is another’s asset. Companies’ debt is purchased by investors, with the expectation that the debt will be paid back, thereby providing a reasonably safe method of earning income on their savings.

As central banks lower interest rates in an effort to help lower the cost of funding investments and consumption, those accustomed to earning a certain level of income on their savings must now accept less income, reducing the impulse to spend (lowering demand). Excessive supply, with the same or lower demand, will result in deflation.

The classically expected result of lowered interest rates—increased economic activity— sounds good, but it might be driving the pricing system out of equilibrium, as shown in the charts above. The percentage of U.S. companies unable to cover the costs of servicing their debt—as assessed when we were going into the pandemic, not now—was already approaching the percentage we saw in 2000. We can assume it has grown since. Another effect of the low rates has been that companies comprising the S&P 500, or its U.K. equivalent—the ones we think of as mature and stable—have taken advantage of the low interest rates to add more debt, all while they have had little growth in profits. Therefore, much of their future profits will have to go to maintaining and paying off this debt rather than to further investments and growth. We used to say, “People think about how much debt they can afford in the good times and how much debt they have in the bad ones.” It appears most people still think we are in the good times.

To summarize, lower rates have allowed companies to produce more goods (i.e., to increase supply) than they could have during periods of higher interest rates. Lower rates also mean investors are experiencing lower levels of income from their savings (i.e., lowering demand). High supply and low demand equate to lower prices and deflation, not inflation. And the newly added debt at the corporate level, without the corresponding increase in growth to cover it, is producing an unstable environment, as described by Minsky (and Wray).

Price System Two: Capital and Investment Assets

Now let’s look at the rise in the price of capital and investment assets. Increased levels of speculation are driving up the price of capital. Two types of assets, residential housing and the equity markets—both of which have leverage at their foundation—are at extreme highs. Housing within the U.S. is showing a material pick-up in prices. The pandemic has had an apparent impact on cities, rapidly driving urbanites to the suburbs.

If one believes that mortgages are debts that must be paid back, then The Buffett Indicator, which is defined as the ratio of the price of a house to the income the household makes, should be a good metric to discuss equilibrium in housing prices. When the price paid for a house is much higher than the income generated to support it, there is a good chance that you are in an unstable environment, and the purchaser is at risk of forfeiting the house, as we overwhelmingly saw in 2007 to 2010. Now may be another such time. As unemployment increases and household income falls in response, we are witnessing increasing housing prices unsupported by household income. We have not seen The Buffett Indicator this high since the housing bubble. Although the pandemic may be amplifying the effect, it was already quite high heading into 2020.

We just discussed how the largest asset of most people, their homes, have seen price increases without the income to support it. The second largest asset of most people, their investments in the public market, are also experiencing high prices not seen since the 2000 tech bubble. (Funny how that word “bubble” keeps coming up). We have always said the timing of market corrections of valuation extremes are hard to predict because the market can stay at elevated levels (or depressed levels) for a long time. However, valuation extremes are good predictors of the magnitude of pain one can expect to feel once the market moves into correction mode. At the time of this writing, the S&P 500 Index is valued (by looking at the ratio of price to forward expected earnings of the companies in the index) at a level that has only been higher than today 6% of the time during the 32-year history we track. The only time it has carried a higher value, based on earnings, was in 1999 and 2000. 

In that period, we saw mass speculation within a segment of the equity markets. We are witnessing a similar level of speculation today within that same segment: technology. Most technology companies have benefited from the pandemic because established trends in online purchasing and communication accelerated during the pandemic lockdown. There is little doubt this trend will continue. And “To what end?” is not a question most speculators are asking. 

We mentioned previously that individual investors have been opening retail brokerage accounts at a rate not seen before. We are witnessing a rise in speculation by new individual investors participating in securities trading, and we see it even more in options trading. We think this is an important observation. Options are a form of leverage—you can put down less money than you have in order to participate in a larger asset transaction by borrowing. The ease of purchasing options (particularly call options) has a material influence on asset prices within the public market. As call options are purchased, the assets underlying those options need to be purchased. The purchase of options acts as an amplification to the speculation. This is another example of instability.

“Individual investors” may be the wrong term to describe the new entrants to the market. “Speculators” might be better. Because the Federal Reserve has played a role in bailing out so many, particularly during the 2008 crisis, it might have promoted a moral hazard, in that speculators might assume profits will be kept by the individual, but losses can be socialized. This has not been a solid investment strategy for individuals in the past, and we do not think it will be one now or in the future.

Conclusion

We often see central banks as heroes because they lower rates and provide ample liquidity in times of economic duress. However, in many plays, the hero turns out to be an unwitting antagonist, hubristically perpetrating a dream that keeps us from adjusting to the present. Though we do not think that central bankers are evil, their role was originally conceived of as limited. It has grown throughout time, and the effect of their actions today is not always black and white. We see them, and they might see themselves, as saviors during economic calamity. But what if they abet that calamity?

The central bank’s mandate (at least for the U.S.) originally was limited to protecting the value and stability of our currency. They were the lender-of-last-resort so citizens could trust in the future purchasing power of their savings. The central bank’s mandate expanded to include an objective of full employment for the nation, which gave them a more active role in softening economic cycles. To some, their “heroic” efforts to save us from economic cycles are, ultimately, an overreach. There’s no saving us from economic pain and postponing it can amplify it.

Adam Smith, an eighteenth-century economist and philosopher, characterized the concept of the invisible hand. As described by Investopedia, “The invisible hand is a metaphor for the unseen forces that move the free market economy. Through individual self-interest and freedom of production, as well as consumption, the best interests of society, as a whole, are fulfilled. The constant interplay of individual pressures on market supply and demand causes the natural movement of prices and the flow of trade.”

This metaphor highlights how millions of small decisions made by individuals, out of self-interest, can have the unintended effect of being a widespread benefit to society. Referring back to the beginning quote, we believe the “real” hero is the collective force of billions of people acting in alignment with logic and their own interest, and that the centralized approach, as dictated by our world’s central banks, will be come to be viewed as a false hero.

Last year, we referenced a growing illiquidity in the investment markets. Now, we see growing instability as central banks push liquidity into the system, perverting the normal setting of prices. Today’s economy is far from a normal or true market environment, and we continue to tread very carefully with about 40-50% of our portfolios sitting in cash and cash equivalents.

—Claudius, in Hamlet

The Quarter in Review

The second quarter was almost a mirror image—the same, but in reverse—of the first. March ended with the world shut down, investment markets in disarray, significant layoffs, and people fearing infection. As June ended, the world was re-opening, investments had recovered most of what was lost since March, people were re-entering the workforce, and the frustration of confinement overwhelmed the fear of infection. The fast response to the virus’ spread was followed by hopes for an equally fast recovery.

The market recovery boosted all markets and regions, yet those in the growth-oriented space were alone in fully recovering. The economic impacts of the virus appear to be accelerating a trend towards a more digital world, as companies that facilitate a more digital life not only recover but make new highs in valuation and hoped-for market dominance. Time will tell whether the high valuations the anointed few reached in the second quarter can sustain themselves, or if they represent a phenomenon somewhat similar to the internet bubble in 2000.

The fixed income markets also recovered from what was a turbulent first quarter. Over the past one year, they have outperformed the equity markets, with a much lower level of risk. This was true in many of the subsegments of the fixed income world, helped by the U.S. Federal Reserve instituting a mandate to buy almost all forms of corporate and government debt. The Federal Reserve’s response was powerful and constructive, yet telling, in that it made crystal clear the magnitude of our monetary leaders’ fear concerning the global shutdown. Though the markets took the actions as positive, they also emphasize how significant the economic threats are that we might yet face.

A Million Monkeys

Emile Borel, a French mathematician, offered the following scenario to help us contemplate the event of something highly improbable occurring: given unlimited time, if a million monkeys typed at a million typewriters, they would eventually recreate Shakespeare’s works. In other words, no matter how unlikely or impossible seeming an event might be, it still has some chance of occurring, given infinite time and resources. It could be more probable than some other even more improbable event. We think this discussion is relevant to the current time, in which massive resources are being deployed to take us back to the improbable economic state that existed pre-pandemic. 

For ourselves—and we assume for most of our readers—the year 2020 has been filled with unlikely and unfortunate events: the massively destructive Australian fires, the Covid-19 pandemic, bubonic plague in Northern China, the worst locust swarms in 27 years, the loss of Hong Kong’s independence, the first combat deaths between two nuclear powers in more than 40 years, {taking a breath} a new swine flu outbreak in China, and dam breaks in the U.S. and China. And that is just in the first six months! We haven’t even hit hurricane season yet.

When you stand back from the myriad of unlikely events hitting the globe over a short period of time, it seems like we are living a Shakespearian tragicomedy. (We choose a tragicomedy, not a tragedy. Let us be optimists and assume current events will end positively, eventually.)

Act I – The Setup

As we wrote in the last half of 2019, and also in early 2020, the global economy was sitting in a precarious position. China was feeling the impact of the trade war, Europe was dealing with lower exports, and Japan was struggling with a deflationary environment. The lone bright spot was the U.S. consumer, who is also the world’s consumer. We highlighted, at the time, though, growing concerns with consumer strength, as the economic expansion showed high levels of strain. The low unemployment rate in the U.S. then was masking a weakening trend in job openings, as companies became more cautious and entered into a realignment phase.

The economic expansion, as depicted by the blue dot, above, was the longest on record, yet most people failed to experience a marked improvement in economic activity, which suggests the recovery from the 2008 crisis was built on a fragile foundation. From our perspective, the fragility was caused by elevated levels of leverage (debt) around the globe, specifically in the U.S. corporate sector, the key employer of the U.S. consumption engine. Corporations—not just in the U.S.—were taking on high levels of debt at a time when their health was weakening, which resulted in the vast majority of debt having lower credit ratings (i.e. lower chances of repayment) than in normal times.

We used the term fragility a lot last year, seeing gains in the markets juxtaposed against a wavering economic backdrop. In our January 2020 commentary, we stated, “How this all ends in the U.S. is anyone’s guess, but recent events suggest that when the end comes, as it already appears to be ending in some countries, it will not be pretty.” We did not know what might cause a downturn, but we saw that any economic downturn would likely be significant and the market’s reaction swift.

Act II – The Complication

Enter Covid-19, stage left. Identified in late 2019 in China, and then making its way to the West, the virus resulted in shutdowns and shelter-in-place requirements across the globe late in the first quarter. The global shutdown brought about the quickest and largest economic contraction in modern times. In our review of history, it is hard to find parallels for an event that acted on the economy like a light switch being flicked off. Uncertainty rose, and the world’s investment markets dropped dramatically.

During past economic contractions, the depth of the contraction and the number of unemployed were correlated with the length of the contraction. The deeper the contraction and the more people who were unemployed, the longer it would take to reach the bottom. The severity of the recent global shutdown would argue for a long and enduring period of adjustment.

Act III – The Rescue

The U.S. Federal Reserve (a.k.a. the Fed), our hero, comes to the rescue. The world runs on dollars much more than it does on Dunkin,’ and the Fed, keeper of the dollars, flooded the market with credit in an all-out effort to soften the anticipated blow from the shutdowns. Over $3 trillion was added to the economic engine in the Fed’s effort to make sure it could withstand the impact from lost jobs and income. The U.S. government, alongside other nations, pushed economic stimulus to ward off the darkness enveloping the world. 

The government, through the CARES Act, and the Fed, via easy money, aimed to maintain the animal (dare we say monkey?) spirits that had kept the economy moving forward even in its increasingly fragile state. Lower corporate tax rates in 2018, the resolution of the trade war in late 2019, and then trillions of dollars backed by government debt in 2020 have been geared to preserving and increasing animal spirits, all with the hopes of maintaining consumer demand and to ignite a reinvestment phase within the U.S. corporate world. 

These stimuli have partially worked, but not to such an extent that we sit on solid footing. Business investment has shrunk faster and farther due to virus-induced economic damage. And, although consumer demand for goods and services is down, animal spirits still reign in the investment markets. Perceived winners of an isolated economy (e.g., Amazon and Zoom) and new market entrants (e.g., Tesla and Nikola) are favored now, not only as survivors but as long-term winners. Mass speculation on low-priced stocks (mostly companies in bankruptcy with no equity value, such as Hertz and Chesapeake Energy) has energized some in the youngest generation of adults to think that markets only go up, not down. Short-term financial greed has overwhelmed long-term economic investment.

Act IV – The Reality

It is unclear when Act III will end and Act IV begin, but we can imagine how the narrative might play out.  The Fed and the U.S. government have taken considerable but temporary actions that lessen the impact of the economic freefall. But the drop is showing signs of being a long one—one where the negative economic effect could overwhelm the simulative impact of the government’s liquidity.

Although employment has bounced since the deep freeze of March and April, permanent losses have continued to rise. Recent employment gains should not be taken as a sign of a new and enduring base of economic activity.  The much-anticipated re-opening process started with a boom, but recently has stalled at a much lower level of consumer activity as virus cases increase and people’s fear surrounding it stay high. The recent ramp in new cases is having an impact on the recovery as we are seeing small business’ hours-worked (as presented in the chart below) turning lower.

The U.S. is not alone in experiencing a weak recovery as the pandemic is hitting all. Europe and Japan indicators anticipate a very tepid consumer. Even China – the first to be impacted – continues to feel the impact and appears to be masking economic weakness. As an aside, the communist party is acting in a way that authoritarian states act when internal troubles are mounting.  China’s heightened aggressiveness—in the form of breaking its two-systems-one-country approach with Hong Kong, poking Taiwan, having North Korea break off ties with South Korea, and allowing its conflict with India to grow—suggests something is afoot. The authoritarian playbook has been to escalate external conflicts when attempting to maintain internal control. The point we are attempting to make is that the pandemic started as a health issue, has quickly turned into an economic issue, and may lead to a political issue. We will give this more attention throughout the year because a destabilizing Pacific region would likely act as a falling domino.

Act IV seems somewhat predictable—the market will drop—although the timing is uncertain. Valuations can’t only go up when the economy is faltering.

Act V – The Finale

Act IV’s anticipated volatility makes predicting how Act V ends a lost cause. We will see a world with high levels of debt and a corporate sector rebuilding after an economic earthquake. It is hard to imaging tax rates staying at their current level, needing to rise as an offset to the increasing burdens of state and federal government budgets.  At the same time, we are seeing companies instituting changes to their supply chains, moving from just-in-time to just-in-case.  This will increase inventory levels and likely hurt corporate profitability as they become less efficient, planning for the next supply disruption.  Consumers will likely change past spending habits given uncertainty of another pandemic in the wings. And governments around the globe will be figuring out how to adjust to the unknown ramifications of a rising disgruntled populace.

The million monkey theorem is about respecting probability, suggesting that the most unlikely outcome still has a chance of happening.  Our models suggest market participants are overly confident that the massive resources pushed into the economy will lead to the unlikely outcome of a quick recession followed by an enduring expansion.  We will need to wait until closer to the end to see what plot twists the monkeys have in store.  So, at this time, our models have us defensively positioned and glued to our seats as (primarily) speculators.

Carrying on with this temperature analogy, we can, of course, quicken or slow the pace—or prevent—indoor-outdoor temperature equilibrium by adding heat or air conditioning. And, if you are a New Englander, you might find yourself doing both on the same day. (Don’t judge us. We have cause.)

The “outside temperature” of the investment markets has cooled rapidly (i.e., the shutdown of the global economy), but the government turned on the heat (i.e., through easy money and short-term stimulus). However, as can sometimes happen when you’re freezing, we turned up the dial on the thermostat too high and the “room” (yes, we mean the market) became too hot.

We need to keep in mind that heating a house during the coldest seasons can be very costly. And regardless of whatever the occupants do—wear sweaters, turn up the heat—within months, they will experience better weather. The economy has traditionally acted on a time scale of years, not months. So, we, as a society, need to be cognizant of the cost of keeping the investment markets at an unnaturally high level, if the economy stays soft for an extended period of time.

Currently, we are seeing the government’s furnace providing substantial heat to the investment markets.  Another heat source has been added, however, in the form of mass speculation. The shock the world’s economies were starting to experience in March explains the swift drop in the markets at that time. The initial market bounce in April can be traced to the government’s furnace kicking on when legislators and the fed attempted to offset some of the anticipated chill. The May “heat” appears to have been caused by the speculative accelerant.

One could comfortably conclude that speculation and gambling, not reasoned decision-making, took over the investment markets during May. As many experienced investors—ones who historically have offered considered and calculated opinions on investment opportunities and risk—moved overtly toward cautious and uncertain assessments, speculators new to the markets took over the pricing of assets.

From our readings, this speculation is best exemplified by the sports gambler and media mogul, Dave Portnoy, founder of Barstool Sports. He has amassed a large following on social media as he turned from gambling on sporting events to day-trading investment markets. In one of his many rants about how easy investing is, he stated, “I’m the new breed.  I’m the new generation. There’s nobody that can argue that Warren Buffett is better at the stock market than I am right now. I’m better than he is. That’s a fact.” And “I’m the captain now.”

One of Portnoy’s followers remarked, “I kind of make fun of some of these investors [referring to Buffett]. They just have a hard time understanding the new normal, the new business models.” This attitude—which in our perspective is a show of hubris and hubris’s corollary, not learning from the past—brings into greater relief the concerns about greed we shared in our last newsletter, The Arrogance of the Modern

We see this heightened greed in the above chart, which looks at the difference between two option (derivative) types: (1) call options, which bet that the underlying security rises, and (2) put options, which bet the underlying security falls. With any given security at any given time, one type of option might be more in favor than the other, but, typically, the volume of put options compared with call options are nearly balanced. There are usually close to as many investors protecting their holdings from falling as there are others expecting a rise. However, we know human behavior allows extremes to occur. We are in one of those extreme periods now. The red vertical lines in the chart above denote time periods when the volume of call options minus the volume of put options was so high as to be in the top 3% of historically observed deltas in those volumes. At these times of extreme imbalance, with speculators betting so dramatically that the markets only rise, the ultimate direction of the market is… the opposite. It falls. At least that is what the “old” generation of investors has learned through painful experience.

Think of the current imbalance in underlying option activity as an energy added to the heating system, which can easily be exhausted. Once it wears out, the heat diminishes, and the room temperature begins to drop into the range of the cold outside. Options and derivatives are a form of leverage; it doesn’t take betting too many dollars to significantly impact the price of the underlying asset. Trading options is like lighter fluid: efficient only at starting the fire; you need a substantial fuel source to keep it going.

To sustain the fire, the investment markets will want to see healthy corporate earnings. At present, it is hard to see that in the offing. The forward view on earnings has dropped and the increasing number of permanently unemployed could bring about a new Nor’easter.

As we’ve described, though, the market has held up, leading to the current investment market (as defined by the S&P 500 index) being extremely highly valued. The red line in the graph below shows the price-to-earnings ratio of the S&P 500. The blue line indicates where, along a historical continuum, that price-to-earnings ratio sits. At present, it sits at 95%. In other words, it’s at a level that has been exceeded only 5% of the time over the last 40 years.

The gravity of the economy today—that rather dramatic drop in outside temperature—will eventually, if not soon, impose a material cooling effect on the markets. The energy and cost of maintaining the hot-market–cool-economy delta will be high, too high for the small antes being placed on the table in the form of retail option trading.

We are seeing this play out already, as sellers overpower the trends and cause significant and violent market adjustments. And if those movements accelerate, or become broader, one can imagine the energy reversing itself, and quickly. (We can count on mass speculation to follow the imminent trend and amplify the move down.) Or destroying the wealth currently being thrown into this fire. Either way, the investment reality, be you a new entrant or an old participant like ourselves, will eventually converge with the economic reality.

Mass speculation is not a new phenomenon. We experienced it in 2000 with technology stocks and in 2007 with real estate.  It almost always brings about a confidence that things are different, and the old guard does not understand the new rules to the game. But as one of our clients pointed out just this weekend, the feeling of self-confidence is typically followed by shame. We sit in a period of heightened uncertainty. We see high confidence and complacency mixed with extreme and, likely fleeting, optimism. Our current cash positioning of over 50% acts as a thick blanket to lessen the impact of the cold, as it seeps inside.

-Yann LeCun, artificial intelligence pioneer

Earlier this month, Berkshire Hathaway held its annual meeting virtually. Warren Buffett’s statements were as poignant as ever. Most interesting to us were his repeated, “I don’t know,” responses. Buffett’s traditional long-term optimism was noticeably dampened this year, as demonstrated by his clear near-term caution. The firm sold stocks in the first quarter and now sits on more than $137 billion in cash.

Those that follow Buffett have always been fond of his buy-and-hold approach and his optimism in the face of global financial dangers. Some who attended the virtual annual meeting attribute his caution now to his age, wondering whether he’s lost his investment acumen. Let’s remember that Buffett’s caution was also treated with contempt at the end of the last century, when he was treated as out of touch when the internet bubble was ballooning. Once again, we think this disdain says more about the hubris of those who think, “This time is different,” which is to say those who too easily cast aside what history has taught us about economic turmoil.

We have long shared Buffett’s quotations in our writings because they are so simple, and yet they so powerfully capture immense knowledge and wisdom. And with the current level of uncertainty—and uncertainty on so many fronts—we think wisdom is needed, even when it takes the form of not claiming to know the answers.

“I don’t know,” will likely go down as a Covid-era catchphrase. We agree with Buffett that the near term is filled with uncertainty. “Our position will be to stay a Fort Knox,” Buffett soberingly said during the event. He reflected on the period 1929 through 1951—the 22-year period it took to bring the market back to 1929 levels—and in so doing hinted at the depth of his concern.

We think another time period worthy of looking back to is the Panic of 1907. In April 1906, San Francisco experienced a magnitude 7.9 earthquake. It reportedly lasted 42 seconds, yet the fires it caused continued for days, resulting in more than 3,000 deaths and 250,000 people becoming homeless, out of a city with 400,000 people. The destruction may have been localized to San Francisco, but the impact was felt around the globe. How? Although the banking sector was already showing signs of growing instability leading up to the Panic of 1907 (also called the Knickerbocker Panic), many economists think the match was lit by the large amount of gold (which backed most currencies at the time) being used to pay out insurance claims to rebuild San Francisco, starving the rest of the globe of liquidity.

Historians credit J. Pierpont Morgan with minimizing the panic’s blow by acting, in many ways, like a central bank. He loaned large sums to stave off runs on the banks. If you were a bank or a trust company back then, you went hat in hand to beg him for a lifeline. To some extent, Buffett played a similar role during the Great Financial Crisis of 2008, acting as a buyer of last resort. In effect, he was creating liquidity, but he was also strengthening the asset by expressing confidence in it, like J.P. Morgan in 1907. But unlike J.P. Morgan in 1907 or Buffett in 2008, Buffett in 2020 is not expressing confidence.

In less than a page, we managed to refer to the 1907 Panic, the Great Depression, and the Great Financial Crisis as reference points to help us interpret what we are seeing in front of us. To state the obvious, none of those were short or painless events.

Howard Marks of Oaktree Capital Management says, “We humans use our ability to recognize and understand patterns to make our decisions easier, increase benefits, and avoid pain.” We look upon past accomplishments, failures, and cause-and-effect cycles as lessons to help us understand and solve today’s problems. We know we have many options, each with the potential for many outcomes, yet only one of those will come to be, so we attempt to use pattern recognition to refine the options. Buffett’s I don’t knows are being echoed by many long-time and successful investors. We believe this is because no one or two past episodes mimic the current situation closely enough to provide examples that recommend a path.

We know others, generally those with less experience, are more confident about the course they think we should take, pointing to things we didn’t have in the past: today’s computing power, a deeper understanding of biology, and new types of “expertise” that will allow us to jump financial and medical  hurdles with ease. We couldn’t put our finger on what to call this specific mode of thinking until a client referred to it as the “arrogance of the modern,” the belief that past troubles would have been more easily solved with what we know today. To think, in any era, that we have evolved past the challenges we face reeks of smugness. Maybe because we are risk managers—or because we have seen that the result of over-confidence is often a fiery crash—we tend to err on the side of thinking we are not smarter than past generations. The tools get better, sure, but the problems also get more complex.  And human emotion is a constant.

So, back to pattern recognition: We see this virus much like an earthquake, a global earthquake. Instead of spending time trying to predict just where or when the next aftershock will hit or how big it will be, we need to accept that we do not know. We need to concentrate on what we already know, on what we can reasonably expect we will come to know, and on how we can control our adaptation based on what we know and might hope to learn.

What do we know about the virus? It spreads with greater ease than the flu and has a higher mortality rate than the flu. When infected, the elderly and the immunocompromised appear to be at the greatest risk of death or severe illness. Treatments will improve as researchers learn more about the virus and the illness it causes, so the mortality rate among those infected should fall with time. If we reflect on how long vaccines usually take, we have to assess the probability that we will have one soon as low. In other words, we need to learn to live with the virus.

What do we know about the economy? In modern times, we have never seen every economy in the world shutdown at almost the same time. What took the U.S. central bank almost a year to do in the Great Financial Crisis of 2008, they have done in less than five weeks in 2020, pumping $2.7 trillion into the financial markets and promising much more. The number of U.S. jobs lost in April equals the total number of jobs created over the last ten years. The U.S. federal government will borrow $3 trillion this quarter, which is nearly three times what it did in 2019, for the year. People are not paying rent, retailers are going bankrupt, and small business owners are increasingly wondering if they can reopen even once they are allowed to. Boeing, a symbol of American power, is at risk of losing its investment-grade bond status, and they are not alone. In other words, the speed and scope of this downturn is like nothing we have seen in modern times.

Yet, earnings estimates for public U.S. companies are estimated to grow in 2021 beyond earnings reported in 2019. We find that very optimistic. It took four years to recover levels of past profitability after the Great Financial Crisis. In other words, market participants are currently assuming a quick economic recovery is the base case, something we do not find likely.

This assessment of what we know or can know gets to the substance of the one graphic, above, we show in this letter. It illustrates the behavior cycle humans have exhibited throughout history but in the context of investing.

We have mentioned that we fear the intersection of immense greed and immense complacency. Although the volatility of the investment markets in the first quarter experienced significant volatility, to us it appears as if the markets were just oscillating between greed and fear, never making the jump to the lower half: uncertainty. We hope our concerns about a rough road to recovery are misplaced, but the level of confidence currently exhibited in the markets makes it hard to think so.

Conclusion

We apologize for the text density of this communication compared to past newsletters. We typically like to tell a story with graphs and charts, instead of words, because empirical data makes it easier to have an unemotional and rational discussion. However, at this time, all the graphs we might have used look the same—they show a swift and severe drop unlike anything we have seen in the past. All the graphs but one, that is: the equity market is closer to its recent top than its recent bottom.

We continue to be long-term optimists, believing that, with the freedom to act, the ingenuity of billions of individuals will propel us to a better time. This nation and its economy have survived wars, famines, pandemics, assassinations, political upheaval, civil unrest, and so many other hurdles, and, in all past episodes, we came out stronger. Today, we are comforted by our ability to be flexible and to walk gingerly into this unknown period.  We also take comfort in the empirical evidence that U.S. equity markets have produced respectable returns over their histories, which argues for not being too pessimistic about our current troubles. As we sit with 55% to 75% cash and short-term bonds, we believe we have preserved the ability to be nimble—to act as a Fort Knox—until “less unknowable” opportunities present themselves.

“We are pleased, once again, to be recognized for our performance, especially as the investment markets suffered the sixth largest drop experienced over the past 90 years.  Our strategies became more defensive late in 2019, moving to high levels of tactical cash” stated Joseph Hosler, managing principal of Auour.  The firm focuses on delivering ETF-based investment strategies that target nearly full participation in good times while mitigating the downside during times of market duress.

Through a combination of Informa Financial Intelligence’s proprietary performance screens, PSN Top Guns ranks products in six proprietary categories in over 50 universes. This is a well-respected quarterly ranking and is widely used by institutional asset managers and investors. Informa Financial Intelligence is part of Informa plc, a leading provider of critical decision-making solutions and custom services to financial institutions.

The following Auour strategies were recognized for having one of the top ten returns for the quarter in their respective universe:

Global Equity                            ETF Global Equity Universe
Gbl Eqty Levered                      ETF Global Equity Universe
Gbl Fixed Income                      ETF Global Fixed Income Universe
Multi-Asset Income                   ETF Global Balanced Universe
Multi-Asset Income                   Global / Intl Balanced Universe

The following Auour strategies were recognized for having one of the top ten returns for the one-year period in their respective universe:

Gbl Eqty Levered                      ETF Global Equity Universe
Gbl Fixed Income                      ETF Global Fixed Income Universe
Multi-Asset Income                   Global / Intl Balanced Universe

The following Auour strategies were recognized for having one of the top ten returns for the three-year period in their respective universe:

Gbl Eqty Levered                      ETF Global Equity Universe
Gbl Fixed Income                      ETF Global Fixed Income Universe

The Instinct Family of Downside Protection Strategies by Auour utilize the Auour Regime Model (ARM^©), a proprietary risk detection algorithm that aims to be proactive to a changing risk environment. The strategies can provide tactical, as well as, core functionality within a client’s investment needs, aiming to mitigate losses in down markets while capturing most of the market’s positive returns.

“Congratulations to Auour Investments for being recognized as a PSN Top Gun,” said Ryan Nauman, Market Strategist at Informa Financial Intelligence’s Zephyr. “This highly esteemed designation allows us to recognize success, excellence and performance of leading investment managers each quarter.”

The complete list of PSN Top Guns and an overview of the methodology can be located on https://psn.fi.informais.com/

For more details on the methodology behind the PSN Top Guns Rankings or to purchase PSN Top Guns Reports, contact Margaret Tobiasen at Margaret.tobiasen@informa.com

About Auour

Auour Investments (pronounced “our”), an SEC-registered investment advisor, is an innovator in regime-based investing and offers individuals, institutions, and financial advisors a range of investment strategies delivered through ETF-based portfolio construction techniques. Auour’s mission is to maximize Transparency, Trust, and Total Return by applying over six decades of collective experience within leading financial institutions. To learn more about Auour’s innovative approach to market risk detection, please go to http://www.auour.com.

About Informa Financial Intelligence’s Zephyr

Financial Intelligence, part of the Informa Intelligence Division of Informa plc, is a leading provider of products and services helping financial institutions around the world cut through the noise and take decisive action. Informa Financial Intelligence’s solutions provide unparalleled insight into market opportunity, competitive performance and customer segment behavioral patterns and performance through specialized industry research, intelligence, and insight. IFI’s Zephyr portfolio supports asset allocation, investment analysis, portfolio construction, and client communications that combine to help advisors and portfolio managers retain and grow client relationships. For more information about IFI, visit https://financialintelligence.informa.com. For more information about Zephyr’s PSN Separately Managed Accounts data, visit https://financialintelligence.informa.com/products-and-services/data-analysis-and-tools/psn-sma.