Resilient Market, Tempering Future Expectations
Resilient. That would be our response if asked to characterize 2020 U.S. equity market performance in a single word. The list of challenges markets overcame as prices moved to record levels is well known: the global pandemic, restrictive lockdowns, oil price wars, election uncertainty, etc. Investors experienced a full market cycle, which normally spans a 3 to 5-year period, in an incredibly short amount of time. The markets notched record highs in the start of the year before enduring a bear market decline over a matter of weeks in February and March. From there, prices moved higher and closed out the year by reaching new all-time highs during Q4. Overall, the S&P 500 produced an 18.4% total return for the year with 12.1% of that coming in the past three months.
With the S&P 500 (“the market”) around the 3,750 level, we have focused our recent discussions on the market’s valuation and what it may imply for future equity returns. One measure for examining valuation is the Price/Earnings (“P/E”) multiple. Historically, the next twelve months (“NTM”) P/E has been range bound between a minimum of 7 – 8x and a maximum of 20 – 22x. The market is currently trading at 22 – 23x NTM estimated operating earnings in the $160 – $165 range.
On a P/E multiple basis, this position is at the upper end of the historical range, suggesting the market is expensive. Given the overall financial environment investors are faced with today, there is a case to be made that the elevated multiple is reasonable. Benign inflation expectations and the low level of interest rates act in tandem to boost the present value of the future cash flows that accrue to equity investors. All else equal, this increase drives the P/E multiple higher. Concurrently, the paltry yields available in the bond market provide less competition for investor capital. This drives them to accept paying the higher multiple on equities in exchange for the opportunity at superior returns.
Today’s elevated multiple may be justified, but looking toward what lies ahead leads us to question the ability of current levels to be sustained. As we go to print, Democrats appear to have prevailed in both Senate run-off contests in Georgia. The consensus expectation is that this outcome results in additional COVID relief and economic stimulus spending. A more accommodative fiscal policy has the tendency to raise inflation expectations and push the level of interest rates higher. This would place downward pressure on the P/E multiple, as higher yields provide competition for investor capital and lower the present value of future cash flows via a higher discount rate.
A contracting P/E multiple presents a headwind to equity market total returns. The accompanying chart illustrates the historical relationship between the beginning P/E multiple and the market’s total return over the following ten years. Higher starting multiples tend to result in lower returns.
Recognizing this historical relationship and the potential for P/E multiple contraction, we expect near term market returns to be lower than historical annual total returns of ~10%.
Stock Market Split and Managing a Portfolio
In addition to being expensive, the market has also been quite divergent, with some companies having stellar returns while others languish. This is most clearly illustrated in the 38% return for the Russell 1000 Growth (R1G) vs. the 3% return for the Russell 1000 Value (R1V).
The result is an expensive market but one with some “cheap” stocks. As portfolio managers, we analyze the overall portfolio and could, in theory, pivot completely into value stocks, which look cheap, or growth stocks, which have been doing well. Our answer has been to stick to our process. We continue to look for companies with strong fundamentals and reasonable valuations. In turn, we have a high degree of confidence these companies will provide positive returns over the next few years.
Our portfolios hold “growth” stocks such as Microsoft, Alphabet, and the card processors. We hold these companies because we believe in the underlying businesses. Microsoft should continue to grow its cloud revenue, while its software products, such as Teams, have proven invaluable during these work from home times. Alphabet continues to dominate search, to the point where the Department of Justice and multiple states are filing antitrust suits. We understand this could be a lengthy process but also believe even a broken up Alphabet could prosper given the strength of its various properties, e.g., YouTube and Google Cloud. The card processors also continue to provide an investment in the move towards a cashless society, both in the US and abroad.
Our portfolios hold some “value” stocks such as banks or Intel. We do not hold these companies because we want value companies, but because we believe in the underlying businesses’ ability to generate cash. Low interest rates and an uncertain economy mean difficult times for a bank, but there is still a spread to be made between what banks pay depositors vs. current loan rates. And the banks are well capitalized, giving sufficient cushion for bad loans. Intel is out of favor as it struggles with its next generation chip (7nm) and whether to outsource its manufacturing. But the scale of its operations and still dominant share in server and PC chips enable the company to generate the cash needed to work through the tough times. Company management has acknowledged their failures and are looking to rectify. Outside pressure from activist investors will ensure this process continues.
Portfolios do not hold cheap companies in which we lack confidence in future earnings, such as some of the insurance companies. We believe these companies have underlying problems with their business model (too reliant on higher interest rates) and will not provide strong future returns. Portfolios also do not hold high-flyers such as Tesla or Twitter, with their either limited profitability or limited growth potential based upon our analysis.
Our process led us to a core portfolio with a mix of growth and value stocks. We believe a core portfolio will provide positive returns over the next few years, particularly in the current expensive market.
Behavioral Considerations: Get Rich Slowly
IPOs in the 4th quarter of 2020 (Airbnb, DoorDash, McAfee) continued to pique the interest of investors who sought sizable returns quickly. The quest for extraordinary capital gains is both intoxicating as well as reminiscent of the late 1990s, prompting renowned Fidelity Investment Manager Peter Lynch, to remark at the time: “Buying what’s ‘hot’ is not investing, it’s gambling!”
The allure of investing in “opportunities” we think will produce massive returns within a short time frame become more powerful as we read about individuals who have been successful investing modest sums and have converted them into six or seven figure outcomes. Perhaps we can relate to what these individuals have accomplished, believing we are equally talented and prescient. It is worth remembering, however, that headlines attract readers, but they don’t do a particularly sound job of helping us financially prepare for retirement or pay down debt. Most individuals are disappointed with the results from “get rich quick” ideas or, worse, lose a substantial portion of their original investment. Frequently, these unsatisfactory outcomes are the result of “herd mentality” and overconfidence bias approaches.
Today, cutting-edge financial plans assist clients by helping them identify and understand their financial biases and money scripts (unconscious beliefs about money), which can hinder attainment of long-term financial objectives. Financial psychology is an emerging as well as essential component of investing, personal finance goal setting, and attainment. A sound investment discipline, tempered with patience and the ability to envision each goal, has been shown by recent research to lead to more desirable, long-term results.
It is also worth remembering that, as individual investors, none of us escape the constraints of income taxation. Short-term transactions, brought about by rapid buying and selling to lock in gains, incur a maximum income tax penalty when compared against a more measured, long-term approach, making the timing and recognition of gains more voluntary and controllable in nature. In the end, it is what we get to keep that really matters. Keeping our eyes on the ball, for the benefit of our clients, is a major part of our investment discipline.
No Service Financial Services from the Big Banks and Brokers
Banks, brokerage firms, credit card companies, and insurance companies amongst others, are generally referred to as financial services companies. However, I (David Laidlaw) have recently found that any degree of customer service is lacking beyond automated do-it-yourself customer service. My experience is obviously anecdotal, but I believe it highlights the frustrations that many consumers experience when interacting with companies in this industry.
A few months ago, my wife, Moira, and I purchased a family home in Southeastern Connecticut. Since interest rates are so low, we decided to get a mortgage. We first discussed the issue with M&T Bank, since we have a relationship with a banker there. After several calls, our contact’s colleague in the mortgage department quoted a rate that was 0.5% higher than expected from my research. The banker also indicated that their group was very busy and that we wouldn’t be able to close on the property for a few months.
Next, we contacted Wells Fargo where we also have a relationship. Wells quoted and delivered a superior rate. However, obtaining the loan was the most difficult bureaucratic process that we have ever experienced. The closing took almost 4 months from start to finish, and I submitted over 120 separate financial documents to support the loan application. The bank requested monthly updates of our business financials, because the underwriters couldn’t review other documents in a timely fashion. The salesperson worked in tandem with the loan processor as a “good cop, bad cop” team. While the sales contact assured me that everything was going well and on schedule, the loan processor would call me in the early evening or send cryptic emails indicating problems or directing me to the bank’s website to upload additional documents. On the day of our closing, the salesperson called saying the underwriters needed proof that we made a mortgage payment on our primary home, even though we had already sent Wells Fargo information that the prior two mortgage payments were made in a timely manner. The whole ordeal was so excruciating that I hope we never apply for a mortgage again.
Just after we secured our mortgage, I received an email alert of a suspicious transaction from our Fidelity Visa card sponsored by Elan Financial Services. Old cards were cancelled, and new ones ordered. The new cards arrived within the week, but when I called to activate the cards, my call was not completed, and I was unable to activate. I then tried the customer service number on the card, which is also the only place to report problems or additional fraudulent transactions. No one answered, and I was kept on hold for over ½ an hour. I repeated this process a few times over the next couple of weeks and was never able to activate the cards or speak to anyone in customer service. At the same time, I was unable to link to the card’s website accessible through Fidelity’s portal. This experience was hard to understand, since we had used the card for 5 years without any problems.
Frustrated, I applied for a similar cash back Mastercard issued by Citibank. The Citi application process went smoothly, and the card was issued in about seven business days. However, the card was issued with a $3,000 credit limit. This level was lower than my son’s and niece’s credit limits, who are both full-time students with low incomes. When I called the customer service line to request a higher limit, I was told it was unavailable until we used the card for six months. I then called a few other credit card companies asking what credit limit I would receive if I applied for a card. None of the banks were able to provide an estimate without going through the full issuance process.
A month after this odyssey started, I was able to get through to customer service for the Fidelity Visa and activate that card. The representative informed me that call volumes have been very high since the start of the pandemic. More people are ordering online, and the fraud bureaus are shutting off credit, causing calls to skyrocket. She suggested I call between 7-8 am or 8:30-10 pm, since those are periods when one has the best odds of speaking to a human.
The above service issues are like those all of us experience at work daily. We are constantly advocating for our clients against the large custodian banks and brokers that hold the underlying accounts. These entities send us “Not in Good Order” (NIGO) notices, which delay vital tasks such as opening accounts or moving funds. The complaints are often the most miniscule details, such as messy date entries or PDFs with a crooked edge due to a scanning issue. More consequentially, TD Ameritrade changed account numbers for long-established accounts, causing a cascade of problems that took months to fix.
In a world where competitive forces compel organizations to constantly increase efficiencies, personal interaction and critical thinking are often subordinated to computer algorithms. Banks, brokers, and credit card companies have been extremely successful in automating processes through technology; however, these organizations have been hollowed out of people that can help or use common sense to solve problems. As the chart for JP Morgan’s employees per deposits highlights, the company has steadily reduced staffing levels which increases efficiency on their end but most likely does not enhance the customer experience.
As frustrating as this can be for the consumer, it is important to distinguish between the purchase of a commodity versus that of a value-added service. Whether we like it or not, financial products such as credit cards, mortgages, home equity loans etc., fall into the former. Conversely, the disciplines of trust and estate planning, financial planning, tax planning, and investment management require intimate knowledge, experience, and insight. I do not expect personal service for those products that have been commoditized will improve soon. Consolidation will continue, as larger organizations with scale acquire smaller ones. I do, however, expect consumers will find a balance between using automated services and those that require a hands-on professional to meet their unique needs.