As the stock market resumes its ascent, many are beginning to question the rationale for investor optimism in a time of widespread economic hardship. US unemployment levels remain elevated, the American consumer is nervous, and economic activity has plunged. Yet as of this writing, the Nasdaq Composite is up over 60% from its March lows, while the S&P 500 index and Dow Jones Industrial Average are up more than 50%. Main Street is struggling while Wall Street prospers.
Despite this investor excitement, the end appears nigh. The stock market appears more fragile by the day and the current love-affair with technology seems way ahead of itself. Investors should lower their expectations for future returns.
One of the most consistent indicators of bubbly dynamics is when investors panic-purchase stocks. Rather than dampening demand, higher prices drive greater interest, a dynamic resulting in even higher prices and even more demand. Fearful of missing out on further gains, investors chase rapidly rising asset prices. Many investors were caught off guard by the rapid ascent from the first quarter lows; they now feel compelled to join the party. Ironically, 20/20 hindsight appears to be driving the 2020 stock market. Investors may be using the rear-view mirror to chart their path forward.
Further, mis-priced money tends to be mis-used money. The Federal Reserve has printed an enormous amount of money and lowered rates dramatically. Investors now seek returns by assuming greater risk. Rather than worry about return of capital, many are now almost exclusively focused on returns on capital. Greed has trumped fear.
Investor (over)confidence is also running high. Fueled by strong demand for work-from-home, shop-from-home, learn-from-home, and entertainment-at-home technologies, the performance of the Nasdaq NDAQ points to a strong investor belief that “this time is different.” While there is no doubt that technology adoption is accelerating and there will be numerous winners, there will also be losers. Might the market be overpaying for companies offering the new new thing? In some cases, Wall Street is being forced to look a decade or further into an uncertain future to justify today’s stock prices. Let’s not forget that Amazon AMZN fell from $105/share to $6/share during the dotcom bust and took almost a decade to regain its triple-digit share price.
Many investors also believe the Fed and Congress will not allow markets to fall. As a result, a “heads I win, tails the government loses” logic grows stronger by the day. Investors have gone from hoping to expecting trillions of dollars of government stimulus. The need for budgetary sobriety amidst large deficits doesn’t seem to matter, a condition stemming from the status of the US dollar as the global reserve currency. How long America can retain this exorbitant privilege remains an open question, one that gold bugs and bitcoin devotees are keen to raise.
Finally, there are ubiquitous signs of everyday mom and pop investors flooding the market. Day-trading and a popular belief that “stocks only go up” have returned, in a haunting recollection of the 1990s internet bubble. Further, individuals at home who are bored are using the “free” money from government support to speculate in the market. The reduction in number of sporting events upon which to wager has led many fans to the stock market; Barstool Sports president David Portnoy proudly serves as the poster boy of this new era in which he notes the death of Wall Street “suits” and legendary investors such as Howard Marks and Warren Buffett.
As investors cheer the regular ascent of asset prices, it’s worth pausing to consider the sustainability of this performance. Equity markets have been driven by an investor love-affair with growth and technology stocks. Many large cap companies (AT&T T , ExxonMobil XOM , Pfizer PFE , Bank of America BAC , etc.) are meaningfully below their 52 week or all-time highs and the Nasdaq’s outperformance relative to broader indices is similar to the 1999-2000 period. The fragility of this performance is on full display when one considers the risks of an escalation in US-China relations, another round of COVID-related lockdowns, a plunge in US consumer confidence from persistent unemployment, intensifying race-related unrest, the potential for increased regulation or taxes, or a possible contested US election this November.
Market myopia is final factor to consider. The investment management industry is notoriously short-term oriented, with time frames in weeks, days, or possibly hours. With an increasing focus on incremental thinking, risks compound. By disproportionately focusing on marginal changes, one is more likely to miss an absolute effect. An allegory often used to describe this risk has to do with boiling frogs. Apparently (I haven’t tried), if a frog is put in a pot of lukewarm water on a lit stove, it will not notice the steadily rising temperature and boil to death. However, if placed in a pot of boiling water, it will jump out.
Daily gains in markets have obscured rising risks. It may be time for investors to take notice of the current temperature, not just the daily change.