Dennis C. Butler, President
of all guest columns written by Dennis C. Butler, CFA
n these missives, we have often emphasized (some might say ad nauseum) the importance of taking a long view when making investments. In particular, because they represent the ownership of businesses, equity commitments should not be entered into lightly or exited on a whim. Additionally, since we take the traditional view that the non-equity balance of a portfolio should provide stability and income (and serve as a source of capital for new investment opportunity), it should also be approached with a long-term perspective and change infrequently.
Events in 2020 proved to be extremely challenging to those who hold dear this fundamental principle, for underlying it is the assumption that despite the vicissitudes of history, things will mostly continue on as before, even after a traumatic interlude. While affirmed by history, such a stance has been difficult to defend and maintain during a seemingly never-ending public health emergency. A population of doomscrollers, confined to their homes and incapable of imagining an end to the crisis, nods in agreement with every pundit who foresees a future in which our lives will never be the same. Maintaining a stable investment policy in the face of such pessimism might seem to some as “putting principal at risk for the sake of principle.” Nevertheless, events over the course of 2020 demonstrated once again the value of patience (as well as experience) when dealing with daunting circumstances. We have been through depressions, wars, and financial crises before; from that perspective, 2020’s pandemic-induced economic heart attack is just another cataclysmic event from which we will eventually recover.
In fact, the final results for 2020, in the US and other equity markets, was quite “normal.” The numbers — 18.4% positive for the S&P 500 index — came in above long-term averages for the US (9-10%), and well within the usual range of fluctuation around the average. But as we all know, last year was far from being normal; over a timespan of about four weeks in late winter, stocks suffered their most violent sell-off in history (the S&P declined 34% in that brief period). Yet come November, equities enjoyed their greatest rise for that month on record. Flows of cash into equity funds exploded in the Fall as well. Last March, who would have thought we’d be discussing the dangers of market euphoria before year’s end?
Additionally, the arbitrary period of a calendar year, according to which we measure our financial affairs (and most everything else) introduces an element of artificiality into our measurements and prompts us to think about the granularity with which we view market fluctuations. 2020 is only one example of a year where a robust annual result glossed over a period of violent movement, despair, and euphoria. Similarly, the S&P’s respectable 5.2% gain in 1987 capped the year of Wall Street’s Black Monday. 1999’s 21% result came in defiance of declines in the broad market of stocks (like 2020, the index was boosted by a few technology issues). Going in the opposite direction, 2000’s negative 9.1% reflected the collapse of the Dot Com bubble, but thoroughly obscured the broad upswing in non-technology sectors that took place that year. One could point out many other examples in which a single end-of-year number belied the momentary passions that so enthrall the witnesses of events in real time. This fact itself speaks volumes for the value of a long-term view.
How closely should we pay attention to the fleeting moment, when even an annual figure — the net result of twelve months of market give and take — has in itself so little value beyond just summarizing the end result of that year? After all, did 1974’s negative 26% return for the S&P 500 tell us anything useful about subsequent results during the balance of that decade (the indexes were flat). Was 1981’s negative 5% predictive of the great bull market that began the following year? Was 2008’s negative 36% relevant to the relentless rise over the next twelve years? Many have expressed bafflement at how, despite the gloomy, uncertain future outlook this year, the market rose. The point is, as we have said before in many different ways and situations, over the long haul, businesses in the aggregate are indifferent to calendar years and to the constantly shifting winds of human emotions. Businesses and markets respond instead to underlying economic realities.
Far from being an academic exercise or idle speculation, these questions are important for investors. Financial markets were under no obligation to bounce back so quickly from their March lows; what if they had not done so? While the majority of market gains accrues to the wealthier elements of society, not all of it does; anyone owning mutual funds in a retirement plan benefits as well. Had securities entered an extended period of doldrums (such as occurred after the 1974 crash alluded to above), would less-sophisticated investors have been tempted to flee stocks and bonds entirely? In the late 1970s many turned fruitlessly to more exciting and exotic instruments such as commodity contracts and options (while ignoring cheap equities)
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History has repeatedly demonstrated the value of the long-term view. Keeping that perspective and acting rationally even when the rewards are not immediate, has consistently proven to be the wisest course.
Throughout 2020 financial observers looked on in disbelief at the markets’ relentless rise, even as a real-world catastrophe unfolded. The initial positive market moves came early on, in March and April, in response to aggressive actions by monetary authorities, followed by impressive fiscal measures as well. Such forceful responses tend to have a positive effect eventually, but many market participants at the time downplayed them, requiring good news about controlling the pandemic before committing themselves to any bullish view of the markets. The good news finally came in November in the form of promising results from vaccine trials, but by that time the market trough of March was rapidly receding in the rear-view mirror. The markets had risen with vigor since March, but it was the good news on vaccines that fueled a surge in November, turning that month’s results into the best for any November on record. The amount of cash flowing into equity funds also reached a record for the month. The surge was universal as an “everything rally” broke out on exchanges worldwide.
At year-end, many observers and the financial press were warning once again of dangers arising from enthusiasm. “A Speculative Frenzy is Sweeping Wall street,” blared a Bloomberg headline. “Market Heads Toward Euphoria,” claimed the New York Times. One observer said we were in a “raging mania,” while another (paraphrased by Bloomberg) said, “Sell U.S. stocks now to avoid an unprecedented bubble.”
While these fears may sooner or later prove to have been justified, we have found that acting on them is an exercise better left to professional traders, not investors, and certainly not the novices at online trading platforms who seem to hang on these pronouncements. However, we do believe it is useful to think about the future in general terms. For example, we believe that, for the foreseeable future, capitalism and private ownership will go on as before, people will invest in securities, and the economy will wax and wane. As difficult as it may be to imagine at present, people will live normal lives, though perhaps with some modifications as a result of the health emergency. We adapt; “twas ever thus.”
We also find more far-reaching and thoughtful analyses, such as the one presented by Martin Wolf of the Financial Times in a recent piece about the future direction of inflation and interest rates (FT, Nov 17, 2020), to be insightful. Wolf describes how developments of the last forty years — the opening up and growth of China, the expansion of world trade, the collapse of the USSR, demographic trends producing youthful populations — have served to favor capital over labor, suppress wage pressures, and create a savings glut. What has emerged is an era of falling inflation and interest rates that benefited the global economy, and fueled rising asset values, debt, and inequality. This state of affairs may be changing. Western nations face aging populations, meaning fewer younger workers to support their citizens, and China, too, is beginning to see this trend. Hence, the relative position of labor may strengthen, leading to upward pressure on remuneration. While a welcome development for left-behind segments of society, this could mean higher prices and inflation. Under those circumstances, the falling trend of interest rates we have experienced for decades may be coming to an end. If so, that could result in a future very different from the one that investors have experienced since the early 1980s.
Separately, with respect to the existence of a stock market bubble, Wolf maintains that current valuations are reasonable, given that interest rates are exceedingly low, even negative, in “real,” or inflation-adjusted terms. In financial terminology, when a company’s future earnings are “discounted” at a low rate of interest (the “discount rate”), a higher “present value” is calculated (think of a stock’s price as the market’s estimate of the value of all future cash flows, discounted to the present). In layman’s terms, when rates offered on earning assets are very low, stocks are “the only game in town.”
So the question of whether current stock prices are excessive boils down to whether current interest rates are reasonable. So far, market participants have concluded that they are, and that they will remain so for an indefinite period going forward, as high valuations indicate an equally high level of confidence in the status quo. If, as Wolf explains, there are forces afoot that may upend this happy state of affairs, a reassessment of the relative valuations of the equity and fixed-income markets could take place. Given the unpredictability of future rate movements, that reassessment could take place gradually, or with unexpected rapidity.___________________________
Dennis C. Butler, CFA, is president of Centre Street Cambridge Corporation, investment counsel. He has been a practitioner in the investment field for over 33 years and has been published in Barron’s. He holds an MBA from Wharton and a BA in History from Brown University. His quarterly newsletter can be found at www.businessforum.com/cscc.html.
“Current low valuations reward the long-term view”, an article by Dennis Butler, appears in the May 7, 2009 issue of the Financial Times (page 28). “Intelligent Individual Investor”, an article by Dennis Butler, appears in the December 2, 2008 issue of NYSSA News, a magazine published by the New Yorks Society of Security Analsysts, Inc. “Benjamin Graham in Perspective”, an article by Dennis Butler, appears in the Summer 2006 issue of Financial History, a magazine published by the Museum of American Finance in New York City. To correspond with him directly and /or to obtain a reprint of his featured articles, “Gold Coffin?” in Barron’s (March 23, 1998, Volume LXXVIII, No. 12, page 62) or “What Speculation?” in Barron’s (September 15, 1997, Volume LXXVII, No. 37, page 58), he may be contacted at:
Dennis C. Butler
Centre Street Cambridge Corporation
Post Office Box 390085
Cambridge, Massachusetts 02139
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Revised: January 18, 2021 TAF
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