Written by Tom Stanley, Investment Adviser, July 2023
This note taps into one of the Little Rules That Resonate I shared last year from Morgan Housel:
“Having no FOMO might be the most important investing skill.”
- Surprise! Investors were convinced stock markets would zig this year. So naturally they zagged.
- Returns year to date are concentrated in household tech names Nvidia up 214%, Apple up 50%, Microsoft up 39%, Meta up 165% – all retail investor favourites and beneficiaries of index investment flows.
- Markets always have and always will ‘swing’ around fair value. Valuations in many markets are stretched & expensive.
- Everyone gets greedy when markets are up 20% – Kiwis are no exception with ’Sharesies members looking bullish again’.
- On humility & FOMO: Any transaction needs both a willing buyer, and a willing seller – Remember if you are rushing to buy, there must be someone on the other side thinking ‘now is a good time to sell’.
- Lesson 1: Greed compels us to buy at the top, Fear pushes us to sell at the bottom – Consider your goals and plans before you act on emotions.
- Lesson 2: Having a strategy to combat FOMO is critical – Price is not the same as value, consider sentiment and expectation.
Inside out – Fear & Greed
I recently watched Pixar’s ‘Inside Out’, an animated movie that cleverly portrays how our emotions influence our actions and operate a control panel in our minds known as ‘Headquarters’.
In the movie the central character is Riley, an 11-year-old girl, who moves to a new city with her family. Moving cities turns Riley’s world upside down, her emotions (Joy, Sadness, Fear, Disgust and Anger) wrestle for control of Headquarters while digesting and responding to the changing world around her.
Inside Out is a must watch, and an emotional roller coaster we will all be familiar with – The speed with which Riley’s emotions can flip from Joy to Sadness, to Fear, to Anger is the inspiration for my note this month.
As investors, discipline and perspective are critical, maintaining both is difficult especially when it feels like the world has been turned upside down. Today I want to share with you some datapoints and perspective that may help you manage fear, greed and FOMO when stepping into markets.
Warning: This note is a little chewier than recent musings, but it is important. We are emotional beings, and central to our job as advisers is to help you through the emotional swings every investor experiences. With the 24-hour news cycle, we are constantly delivered new narratives. These narratives are designed to capture our attention, and play on greed and fear. As a numbers person, I try to observe and look through these narratives, seeking comfort in data – In this note I have sought to keep it simple and include charts and pictures where possible, but detail at times is necessary. If you have any questions or thoughts, please feel free to call, or book a time with me in the calendar links below – we are here to help.
New Bull Market, Time to Pile in Right?
Let’s give this market its due, it has been very strong. The US index known as the ‘S&P500’ is up 19% year to date, and up 28% since October lows. Many commentators have declared “the end of Bear market” and a “new Bull trend”.
It is true, the S&P has reclaimed over 76% of the ground it lost during the worst of last year’s decline. But the U.S. stock market rally has been limited in scope. Investor enthusiasm for breakthroughs in artificial intelligence (AI) sent some share prices and valuations soaring. NVIDIA, largely known for its video game chips, has led the way after making bullish comments in May about potential revenue from demand for its processors used in AI computing – note the word ‘potential’.
If you dig deeper, roughly 90% of returns for the S&P 500 have been concentrated among a small group of household names and technology companies, such as Microsoft, NVIDIA, Meta and Alphabet – What has driven that strength?
Are those companies earning more than ever? No.
Are those companies generating more earnings while other companies are struggling? No.
The rally this year has been largely driven by narratives (media hype) and FOMO (emotion).
The below chart from JP Morgan Asset Management looks at the top 10 companies in the S&P500, and shows 2 things:
- The top 10 stocks make up more of the S&P500 than they ever have – the big have gotten bigger.
- The top 10 companies have seen relative earnings declines – the big have gotten expensive.
While paying a high price for a Hermes bag may make sense from a luxury goods perspective, buying assets when they are expensive is not a great strategy for investors. But how do we determine whether something is cheap or expensive?
Analysts spend their lives in the pursuit of perfecting valuation models and trying to identify ‘value’, but getting a feel for whether a company (or investment) is ‘cheap’ or ‘expensive’ can be simplified.
Per Howard Marks in his note ‘Risk Revisited’:
“The return on a stock (or investment) will be a function of the relationship between the price today and the cash flows (earnings) it will produce in the future.”
Finding out the price of an investment is often straight forward, but how do you find out the cash flows produced in the future?
When companies talk to investors, they often state what they expect to earn. When looking at other investments like property, ‘earnings’ are the equivalent to your rental income (less costs) – While expectations may not turn into reality, this is a great place to start.
With ‘price’ and ‘earnings’ known; we can tap into a very effective valuation metric – the ‘P/E Ratio’.
The P/E Ratio is simply the price of an investment, divided by its annual earnings. Conceptually the P/E ratio tells us how many years’ worth of earnings it will take an investor to be paid back their initial purchase price. For example:
Occidental Petroleum (OXY.US) currently has a price of $62 USD per share and has generated earnings of $8.30 USD per share over the past 12 months – This equates to a 7.5x P/E Ratio ($62/$8.3) – a very reasonably priced stock that Warren Buffett has recently been buying into.
With the above context, it bears repeating, year to date valuations of the largest stocks have soared. The P/E ratio for the S&P500 technology sector was 27.4x as of June 30, compared with 19.5x for the broader S&P500 and 7.5x for ‘cheap & unattractive’ companies like Occidental Petroleum.
Other areas of the U.S. market and international markets may offer more compelling valuations, but generally valuations are high in the current market. In international markets, the valuation for the broader MSCI Europe Index, at 12.4x is below its 20-year average, even after recent strong returns. The below chart from Goldman Sachs outlines how stretched US and Global share markets remain.
These ‘box and whisker’ charts provide a great feel for how much markets can ‘swing’ around fair value, especially in the shorter term – But what drives these swings? There are many factors, but expectations, surprise, and sentiment are often the culprits.
On Expectations, Surprise & Sentiment
Markets have a history of surprising investors and showing resilience when circumstances appear bleak, and this year has been no exception. When I penned this note in September 2022 consumer sentiment in the US was the most negative it has been since the 1970’s, causing me to quote Warren Buffet’s famous one liner:
“It wise to be fearful when others are greedy and greedy when others are fearful.”
The above quote plays on the idea that the future often turns out ‘less bad’ than expected when everyone is negative – ‘Surprise’ data points often lead markets higher (or lower) and see valuations distort.
One of the most striking ‘surprises’ this year has been the ongoing strength of the labour market. The below chart from Bloomberg shows the extent of surprise in employment data in the US this year. Analysts have been expecting the labour market to be weaker than it has been for 13 consecutive months – The longest streak of positive employment surprises in the US since record keeping started in the 90’s!
With sentiment so negative in late 2022, and 2023 ‘being better than expected’ (so far), commentators and investors have played catch up. The below screenshot from Twitter offers good insight into how the cycle of fear and greed has played out in real time (note the date of each Youtube clip underlined in red):
This sort of sentiment shift is captured in a more systematic way by the CNN Business ‘Fear and Greed Index’.
This index is made up of 7 different indicators that provide insight into the emotion that is driving the market. 1 year ago, investors were fearful, as you may have guessed the index is currently flagging ‘extreme greed’.
Fear, Greed, Opportunity & Risk:
While investors are currently greedy, Could markets still march higher? Yes.
We could see reserve banks create the infamous ‘soft landing’ where they get inflation back to their targets, employment remains full, and economies continue to grow. Over the weekend, the Wall Street Journal, The Financial Times, and The Economist all published articles claiming that such a soft landing is a sure thing – But does this mean a “soft-landing” is now fully priced into markets?
If we consider the lessons learnt from September 2022 till now, where economies and markets were ‘less bad’ than expected – How much better can it get than a soft landing? Only time can answer that question, but now is the time to touch on risk.
The below chart and quote from Allan Gray Investment’s ‘Guide To Contrarian Investing’ focuses on investing in single stocks, but taps into how the swing of emotions create risk and opportunity for investors.
“we believe the point of maximum financial risk is actually that feeling of euphoria. That’s when the stock is priced for perfection, but it may well be the time to be worried about holding it, as even a small piece of bad news could cause the stock to fall. Conversely, the point of maximum financial opportunity – when the stock is priced to potentially rise the most – is exactly when you may feel most despairing of the stock. These are the points we are continually looking for when buying stocks – the points of negative sentiment and maximum financial opportunity. Psychologically it is very difficult to invest when market sentiment towards a stock is so negative.”
With valuations stretched, a ‘soft landing’ being priced in, positive surprises abundant, and investors exhibiting ‘extreme greed’, I believe we are at a point of elevated risk (in stock markets), just as retail participation in markets is picking back up.
Back to Inside out.
The past year (or three) have been on an emotional roller coaster like that of Riley from ‘Inside Out’. As investors we need to step back from the ride, consider our initial emotional response and maintain perspective.
Perspective allows us to be disciplined in both the short and long term. Outright ‘Fear’ and ‘Fear Of Missing Out’ (FOMO) are the most challenging emotions to manage as an investor – Right now FOMO is the name of the game. Like this note from Dec 2022, I believe it is wise to exercise caution:
- For clients with lump sums of new money to invest, we are weighing up returns in lower risk assets such as cash or bonds. If the client’s investment timeframe is sufficiently long, we are spreading out our buying over 6 to 12 month periods to reduce risk.
- For clients needing to free up cash, taking some of your gains in stocks is a good idea – per my May 2023 note cash returns are higher than they have been in 25 years!
To close out this note, I want to leave you with another quote, this time from famous actor Will Smith:
“Human beings are not creatures of logic; we are creatures of emotion. And we do not care what’s true. We care how it feels.”
Thank you again to all who have got this far – I appreciate you taking the time to tune in.
If you want to discuss your situation, or any of the above points – please book a meeting, or call in.
We are here to help.