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Strategy Update

Shades of 2000

The stock market closed 2020 on a high note, with the S&P 500 Index finishing at a new record on the final day of the year. In a year defined by sickness, death, and economic hardship, scores of companies saw their share prices double or more. We have previously outlined the rationale behind this seeming paradox. Extremely low interest rates, fiscal stimulus in the trillions of dollars, and a willingness to look through the pandemic to better times, are all reasons that investors decided to buy stocks. But the magnitude of the buying was somewhat astounding. It is easy to forget that the market was in a full meltdown as recently as last March, falling by about 35% in a matter of weeks. At first the recovery in stock prices was driven by more courageous bargain hunters willing to step into the breach. By year end that initial, cautious buying had turned into a full scale buying stampede that had pulled in a multitude of investors. Many astute market observers started to note the makings of an investment bubble. As 2020 concluded and we parsed through the closing price data, we concurred that an investment bubble was forming—perhaps not yet a completely inflated bubble, but certainly well underway.

There is no standard definition for what constitutes an investment bubble, but it is always an emotional phenomenon. Recent success in a given asset class, be it technology stocks, bitcoins, or tulips, attracts new investors eager to share in the gains they are witnessing. The entry of new investment money fuels further price appreciation, thus attracting even more momentum-driven investors. This cycle can continue so long as there is a supply of new investors willing to jump into the investment bubble and support higher prices. Eventually the cycle breaks when there is simply no more new money to lift asset prices higher. When the momentum breaks, all the momentum-driven investors are suddenly looking for an exit at the same time. In the dot-com bubble of 2000 it was not uncommon to see shares of technology companies fall by 80-90% as investors exited en masse. In our view, now is a time to be careful, as there may be shares similarly poised to punish investors in the near future.

When investors are caught up in the moment, it seems unlikely that many of the companies most touted and loved by investors and analysts will end up struggling or forgotten in short order. But that is what history and the benefit of hindsight shows to be true. The most popular winners of the tech bull market that ended in 2000 were companies such as Qualcomm, AOL, Sun Microsystems, and Lucent. Investors today hardly remember the name Lucent, even though it was the most widely owned company for a time in the 1999-2000 era. When it crashed from its bubble-high price it erased $250 billion dollars of wealth, about 2% of the entire Gross Domestic Product of the U.S. at the time. Many of the biggest winners of that bull market have disappeared, were forced to merge at a fraction of their former value, or have taken the better part of twenty years to claw back to the highs set in 2000. Does the same fate await the featured winners in this bull market, companies such as Zoom, Shopify, and Tesla? We think that is possible, even probable, which is why we have been taking some profits in companies carried higher by the same swelling wave of enthusiasm.

The past year contains plenty of anecdotes and warning signs that indicate a bubble is forming. Companies that profess to have an EV (electric vehicle) designed, but still far from production, have been accorded valuations that rival established companies such as GM or Honda. The shares of companies called SPAC’s (special acquisition companies) sprinted forward simply on the prospect of acquiring a company in a hot sector. The SPAC’s are not actual operating businesses, they are essentially blind investment pools, the popularity of which is another hallmark of extremely frothy markets. And the day traders are back in force, favoring controversial stocks with little in the way of a visible or viable business, but offering some linkage to a popular investment theme or perhaps a squeeze on short sellers. In bubbly markets mystery triumphs over reality. By our own assessment, at the end of 2020 nearly a third of the stock market could be described as part of this euphoric bubble. We now see enough statistical and anecdotal similarities to 2000 to make us cautious, which is reflected in the kind of stocks we are still willing to buy, and our strategy of locking in some profits on our big winners.

Current Strategy

The market bubble in 2000 created a bifurcated investment environment. Some stocks attracted so much investor attention that they sucked all the oxygen from other sectors, leaving pockets of undervaluation. We see the same phenomena in the current market, although the valuation gap is far less pronounced than in 2000. Our response is to avoid the very overheated part of the market, while picking up some shares in companies that have been shunted aside. When we buy what we perceive to be undervalued stocks in this high market, we are doing so with a multi-year horizon, accounting for possible declines in a near-term market correction.

We also recognize that, after a very successful year for many of our own investments, we now own stocks that could well be caught up in a late fit of buying. It is a rare thing to have an investment that doubles in a twelve-month period, and we feel fortunate to have found a number of companies that have done that, and more, in some cases. We have begun reducing some of these positions as valuations have become stretched after a tremendous run. Some of the stocks we are selling may continue higher, driven by their own momentum. This is typical during late stages in a market where trends seem cemented in place. It is nearly impossible to pinpoint the inflection point when trends shift, but our hope is that decisions we make today will bear fruit in the future when the pendulum swings back in the other direction.

There has been a small but perceptible change within the bond market after months of extremely low yields. Investors seem to be anticipating a recovering economy this year, further fiscal stimulus to aid this recovery, and the prospect of increased inflation as a result. This reflationary trade has begun to lift bond yields higher. It is our hope that this trend continues and that we can deploy cash into the bond market once again in the coming year.