We want to cover two things in this writing based on client questions we have been receiving: (1) Recent news flow related to short-term traders; (2) Our current market outlook.
- There have been nonstop headlines the past few weeks regarding the battle between the Reddit/Robinhood/millennial/day-traders vs. the short-sellers/hedge funds/Wall Streeters. What are our thoughts on this?
- This has not yet affected any company that GGS owns in the vast majority of client accounts. This is primarily happening in smaller companies like GameStop with less liquid shares that are easier for traders to cause significant moves in. GGS is not in the business of shorting companies.1
- There appear to be a large number of new traders in America that are short-term speculators/gamblers rather than long-term investors. There are several reasons for this, three of the most important: (1) The pandemic caused more people to try trading in their free-time since normal recreation is unavailable; (2) Trading costs (including option-trading costs) are zero now for most online brokerages, removing an obstacle to small frequent traders; (3) People getting their news straight from social media and the ease of forming large groups of like-minded thinkers on social media.
- Bottom line: There is a huge difference in the stock market between the short term and the long term. Our entire investing philosophy at GGS is predicated on our belief that in the long term, the price of each security will converge to its fair value. The fair value of a security relates to the present value of its estimated future cash flows. We invest in high quality companies where we can support the current share price with our discounted cash flow valuation. We are not attempting to own the companies that will have the best share price returns over the next week or month. Two types of traders seek to profit from short-term moves: (1) Sophisticated hedge funds, quantitative funds, market makers and high-frequency trading firms who have invested heavily in their business to build a speed, data, knowledge, and/or computing-power advantage versus their competitors; (2) Unsophisticated speculators/gamblers who think they have some sort of edge because they read a stock tip somewhere. It is group (2) that is driving this mania in stocks like GameStop. We acknowledge that it may be a viable strategy right now for a crowd to mass buy heavily-shorted firms thereby causing short-squeezes.2 However, over the long term (which may not be that long in this case) we would expect GameStop and the others to return to their fair value as justified by a realistic estimation of future cash flows. Anyone not lucky enough to get in on the ground floor and is now buying shares at an inflated price is playing a dangerous game that we at GGS will not participate in.
- Reasons to be positive/negative about the outlook for the market and where we stand on balance:
Let’s start with the positives:
- Corporate earnings have bounced back from 2020 trough levels and most now assume the aggregate 2021 earnings for the S&P 500 will exceed those of 2019, with 2022 estimates up another 15% vs. 2021.
- It is expected that the majority of Americans will be vaccinated against COVID-19 by the end of the summer, which, combined with those already infected, should allow herd immunity to start taking hold and drive down case numbers.
- Global monetary and fiscal stimulus remains at extraordinary levels and the amount of liquidity in the global financial system remains very high, with Central Banks again showing last Spring that they will step up support during any major downturn.
Reasons to be cautious (really the flip-side of the above points):
- Earnings growth expectations are already high so any disappointment on this front would be a negative event and more likely than things proceeding even better than the optimistic scenario already priced in.
- The current vaccines, while proven to work very well on the COVID strains that circulated in 2020, may not work as well against new mutant strains.
- The extraordinary levels of monetary and fiscal stimulus cannot last forever, and when they are taken away the market could react negatively, either in the form of lower growth expectations or higher interest rates. If they remain in place too long, they may stoke higher inflation.
Bottom line: There are a lot of reasons to be optimistic about the future as the world emerges from its 2020 COVID shell, but our number one concern at the moment is how much of this optimism is already reflected in companies’ share prices. Is the US stock market currently overvalued? Valuation metrics such as aggregate Price/Earnings, Price/Sales, Price/Book and Price/Cash Flow are well above historic averages. On the other hand, given today’s historically low interest rates, if you look at the expected return of the stock market vs. that of the bond market, the spread still appears attractive. That said, one should still expect future US equity returns to be below long-term historical averages because the higher spread vs. bond yields does not compensate for the low bond yield starting point. For example, using rough numbers, if the average 10-year US Treasury yield over the past 60 years was 6%, and the average annual return on the S&P 500 was 10%, you could say that stocks earned a 4% premium over Treasuries to compensate for the extra risk.3 The estimated spread right now is closer to 5%, implying that equities are more attractive vs. bonds than the historical average. But since the 10-year Treasury yield is only 1% right now, that means we should only expect a 6% average annual return for the S&P 500 in the coming years.
GGS continues to believe in the long-term reward for taking on equity risk; however, the reward is mainly due to the low current yields of high-quality bonds, not because we think equities can continue to post double-digit average annual gains from current valuations. We believe that bonds remain critical for maintaining the appropriate level of portfolio risk, and GGS recommends that clients choose and stick with the risk level that makes the most sense for their individual circumstances and risk tolerance.4
1 Short-sellers profit by borrowing the stock from existing owners and selling the stock with the belief that we will be able to return the stock later by buying it back at a lower price. A trader who shorts can make at most a 100% profit assuming the stock becomes a $0, whereas the potential loss can be much greater than 100%.
2 A trader who has borrowed shares of stock in order to sell it short must either post-more margin or buy back shares when the price of the stock rises significantly. A “short-squeeze” is caused when the price rises so much and so quickly that the short seller may have no choice but to buy back the position at the higher price.
3 See https://www.goodreads.com/author_blog_posts/20870834-data-update-2-for-2021-the-price-of-risk for more precise estimates of these values.
4 Please reach out to your advisor or client service representative if you wish to review your current risk profile.