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The most damaging stock market event of this generation may have been the unprecedented 3-year collapse of the Internet Bubble. Technology stocks dominated the market with the highest valuations ever before witnessed – though, in the moment, these seemed entirely reasonable to most investors. A measure of the damage: the S&P 500 returned 14.7% a year in the last 10 years; but over the last 20, since December 1999, only 5.9% – that’s been the 2-decade return for someone invested at that time.
But what if the Internet Bubble never really ended? The number of people on the internet today is 18x greater than it was then. On the back of that extraordinary rise, the technology sector is again the highest weight in the S&P 500. But that doesn’t include mis-labelled companies whose premium (some would say unsupportable) growth rates and valuations depend on continued expansion of internet usage: Amazon.com is classified as a Consumer Discretionary company; Facebook and Google are in Communications; the country’s largest cell-tower and cloud server data centers are listed in Real Estate. Add it all up, and one-third of the value of the S&P 500 is now in internet beneficiary companies.
Seems normal enough, again, yes? Except for one thing. Internet usage growth is about to face limits that cannot be avoided. The early edges of those limits are already appearing. As that unfolds, the normalization of profit margins and valuation multiples of these market leaders, from Apple to Microsoft, even to a level well above that of the average company, will, for those who did not get to witness the first Internet Bubble collapse, provide a front row seat.
Indexation’s great argument is diversification of security-specific risk and the performance benefit of low (or even no) fees.
The performance debate has now been answered; you need wait no longer. With ETFs’ 20th anniversary upon us, which also encompasses a full market cycle, equity ETFs as a class — growth and value, domestic and international, developed market and emerging, biotech index funds to IT to financials — have under-performed bonds. Over these two decades, they haven’t even come close to the universally presumed 10% return. From here forward, they might not do even as well as that.
The risk debate continues. But it has now moved to a higher-stakes plane. Acceded: indexation is an excellent means to diversify into and across the important asset classes much or most of the time. Counter: by definition, indexation also exposes one’s capital into and across all the systemic risks that have destroyed investors’ savings during economic and political crisis and upheavals. Those feel like rare events only to those who don’t review the history — even modern history. It happens again and again, and today’s valuations and systemic risks are measured in extremes. There is a time and place for indexation. Now is a time to learn about upheaval investing: concentration as a method to diversify against systemic risk.
Falling stock prices, swings in stock prices, a December like this December. They hit all of our buttons. The big red buttons hard wired to the emergency exit centers in that part of our brain closest to the nape of the neck. It’s what we do when he have patterns (data and statistics to our forebrains, shapes moving in the dark to our hindbrains) instead of information (qualitative context, or a light in the hand). That’s when we react and make decisions as opposed to exercise judgment. We’ve seen it before, and we’ll see it again.
To help illumine the landscape before us, we’ll compare the events and reactions leading up to the Internet Bubble of 1999 and its aftermath (and how and why we positioned our portfolios to be so far away from that party) to the events and reactions leading up to today’s bubble (and how and why our portfolios are again so far away from the index benchmarks). The parallels are quite clear and, once seen, the path (or paths, for there are many alternatives) are much clearer.
As a prelude to this review, we revisit a theme that has long informed our research: cognitive limitations in investment analysis. Reasonable minds may differ on what is or is not a good investment, but exceedingly few of those minds study or are even aware of the many ways our brains deal — automatically and without our conscious permission — with an excess of data (which certainly defines the securities markets). The shortcuts we unknowingly take amidst this onslaught of information can lead to the most unfortunate conclusions.
Herein, some of our strategies for wading through the facts to address some client questions we received about inflation, U.S. debt levels, and the potential for continued corporate earnings growth. And a couple of new positions, CACI International and Science Applications International, that we believe add functional diversification to our portfolios.
A number of clients have been asking about inflation: are the recent numbers, 2%, benign? Encouraging? Cause for concern? Some of the answer depends on whether the reported inflation data are even real. The changes, over time, in the way that the sausage that is the Consumer Price Index is made seem, repeatedly, to have the effect of lowering it. Either way, it’s well neigh impossible to avoid earning a negative rate of return from the various bond ETFs, after taxes and inflation. We provide a brief survey.
Then there is the failure with, now, a 20-year record, of the equity ETFs to provide the expected 10% rate of return. To avoid a continuous loss of purchasing power, which adds up pretty quickly, investing has to take place differently and elsewhere.
The value of the entire stock market relative to GDP – perhaps the most fundamental valuation measure – is pretty much at an all-time high; interest rates aren’t much above their recent all-time lows; the Federal debt/GDP ratio, despite one of the lengthiest economic recoveries on record, is at a high exceeded only in the immediate aftermath of World War II. Yet, despite this traffic jam of systemic risks, and for whatever reason, investors feel sufficiently at ease that they don’t require a real interest rate above zero, or lower stock valuations, as if there financial markets rest in a comfortable equilibrium.
For the first time in quite a long while, clients have been asking about whether their portfolios contain any inflation beneficiaries, whether there’s much leverage. Really, these questions are about practical, functional diversification (as opposed to what the mind recognizes as ‘lip service’ diversification). There is a sense that all the investments are crowded into the same place and are more and more governed by a few shared risks. And perhaps there’s an unasked question, what happens when the music stops, whichever music it is that has made it all work so far.