Dennis C. Butler, President
of all guest columns written by Dennis C. Butler, CFA
nother decade’s coming to a close brought to mind an essay we wrote for the Financial Times in the spring of 2009, near the end of a very different kind of ten-year period for thefinancial markets and investors. Entitled “Current valuations reward the long-term view,” it appeared just a couple of months after the great market crash of 2008-09 had reached its nadir. Ten year returns on equity investments had turned negative, and an overwhelmingly bearish attitude towards stock investments reflected the aftermath of the worst market rout since the Great Depression.
While much of the piece dealt with a debate between long-term, “buy and hold” investors and those who felt that short-term trading could save the day when markets turned south, we always felt the following sentence was of greater significance: “Negative returns over the course of a decade say more about the price of stocks ten years ago than they do about the wisdom of buying and holding.” Ten years prior (in 1999), enthusiastic buyers had paid very high prices (on average) for stocks. History and simple math indicate that one should expect poor results under such circumstances, so the negative figures realized ten years later were not really surprising. We wrote that given the depressed conditions and attractive valuations prevailing in early 2009, returns going forward could turn out well, as conditions were ripe for a rebound. As it turned out, our assessment was correct; what followed was a long rise in stock prices.
Now, once again, people have a growing faith in equities, following prices higher. Similar to the earlier period, stocks are the “only game in town,” but a “reversion-to-the-mean” would seem likely at some point, as stocks (adjusted for inflation) have returned approximately 11% annualized since 2009, above long-term averages. By some measures — the Shiller “CAPE” index — for example, valuations are in extreme ranges as well. Much like 1999, this is not an environment that bodes well for future equity returns.
What brings us to where we are now was another year of exceptional gains for U.S. stocks in 2019, with the popular indexes reaching a series of record highs, ending the year with the best returns since 2013. Including dividends, returns since 2009 reached 254% for the S&P 500, the most common benchmark used by investment professionals to gauge movements in the American markets. The market rise reflects, and likely has contributed to, an economic expansion that is now the longest on record.
Given the record of the last decade, it is remarkable that according to the results of a poll released in early December, two-thirds of Americans feel untouched by the great rise in aggregate corporate value. Furthermore, they are voting with their wallets, as record sums have been withdrawn from stock funds this year. This puzzling contradiction probably relates to the fact that individual ownership of equities is concentrated among the wealthy. Lesser mortals tend to have stock exposure through retirement plans investing in various kinds of equity funds, among other investments, so the direct impact of changes in equity values may not be as apparent. Positive consequences of higher stock prices — such as a stronger economy — certainly benefit everyone, but the direct connection with the stock market is muted. Also, in spite of the booming financial markets and strength in a few areas like technology, reports indicate that industrial sectors of our economy are experiencing slower growth or even a mild recession. Changes in the real economy would have a greater impact on most people’s lives than movements in the Dow Jones Industrial Average. This factor might explain some of the withdrawals, although politics and aging Baby Boomers probably played a role as well.
On December 9 we learned with some sadness of the passing of Paul Volcker, who had presided over the U.S. Federal Reserve Bank from 1979 until 1987. It was a traumatic period in financial history, one which we experienced first-hand when we entered the world of Wall Street in 1982. We have always considered Volcker to be the true master and hero of central banking during the latter decades of the twentieth century. Almost single-handedly, and in the face of much criticism, he used the blunt force of crushingly-high interest rates to subdue high rates of inflation, and, more importantly, to quash the expectation that prices would continue to rise rapidly. “Inflationary expectations” had become so firmly entrenched in the business community and among the public at large that business investment and consumption were distorted. In dealing forcefully with these problems, Volcker was blamed for the severe economic contraction and high levels of unemployment that ensued, but the bitter medicine worked. Inflation had been running at a 14%annual rate in the spring of 1980; after four years of rates as high as 20% on interbank loans (with bank CDs offering returns of over 13% for six months), the rate of price change dropped to 4% in 1984. There followed a long period of declining interest rates, subdued inflation, and robust economic growth. Lower inflation and steadily sinking interest rates eventually created their own problems, however, and in later years Volcker advocated stricter oversight of banks, and sought to reign in the casino-like behavior that had taken hold in many financial institutions.
It was with some irony that, on the same day as the Volcker announcement, there appeared in the Financial Times an article discussing steps being taken in some countries, including the U.S. and E.U., to ease some of the new banking regulations put in place following the financial crisis. These regulations subjected banks to tougher capital requirements in order to fortify them against a future crisis and reduce the incentive to speculate with bank (and, ultimately, taxpayer) funds. Many in the industry believe that these restrictions and “capital buffers” are excessive and inhibit profitability (bankers usually complain about regulations — until they need bailing out), and lobbying campaigns have sought to lift controls. Some of the new regulations should, perhaps, be reviewed (those impacting small banks, for example), but in general this seems a bad time to roll back bank oversight. Prices of financial assets — from stocks to real estate to private companies — have been pumped up by low interest rates and gobs of money flooding the system. Since banks are at the hub of this activity, and their excesses were key to the crisis a decade ago, it doesn’t seem wise to reduce their oversight. The “reach for yield” in the current low-return environment leads to more risktaking, and despite the regulations, the fundamental incentive schemes for banks — which tend to separate personal interests from institutional probity — still exist.
Over twenty years ago, we penned an article entitled “What Speculation?” in which we discussed how some supposedly-conservative mutual funds had been actually engaging in aggressive activities that were probably not what their customers had in mind for their savings. It’s happening again, and for the same reason: an attempt to goose returns to beat rivals for assets in a highly-competitive market. Although once again the focus is on technology stocks, in 1999, funds were taking oversized positions in young companies trading on public market places, whereas now fund managers are betting on companies before they even enter the public sphere. It has long been possible for certain “sophisticated” investment operations to buy shares in start-ups (companies which appear to hold promise though they may not yet have profits or even revenues). Now mutual funds are getting into this game, targeting so-called “pre-IPO unicorns.” “Unicorns” — a relatively new term — typically refers to certain heavily-hyped private companies with “disruptive” technology offerings in which early investors expect to make a killing when shares are eventually sold to the public. Some of the biggest mutual fund companies have poured billions of dollars into the best-known of the unicorn concepts.
This practice is objectionable for a couple of important reasons. First, speculating on new businesses is normally the province of venture capital or private equity firms whose personnel are accustomed to evaluating businesses that often have no earnings, and whose prospects are subject to a high degree of uncertainty. Mutual funds should have a more conservative orientation, investing in companies that have a history of earnings, and a “seasoned” public company status. Aside from the potential mismatch of skills, experience, and judgement, do mutual fund shareholders really expect their savings to go into speculative ventures? Probably not.
Secondly, the consequences of error could inappropriately fall on ordinary individuals putting away money for retirement or other purposes, and not professionals and institutional asset managers who presumably understand, and can handle, the risks. As is usually the case, if such commitments work out, then all is forgiven, and, in fact, most fund holders probably would be blithely unaware of what had gone into achieving their results. If things go wrong, then the funds risk a backlash that would probably reinforce the already strong trend to indexing. Negative experiences have indeed been piling up. A botched IPO of one “unicorn” resulted in write-offs of as much as 75% at some mutual funds; another’s problems led to valuation cuts of 50%. It could be that these “investments” remain so small at this time as to limit their impact, but it is not a good sign that retail funds are once again reaching for return in unusual places.
Speaking of IPOs, the biggest ever came to market in December when one of the national oil companies among the OPEC group raised over $25 billion for its state owner by selling shares to the public. The term “public” should be taken with a grain of salt in this case, since buyers were limited to local and regional financial markets, and many of them faced pressure from political authorities to commit their capital and help the company achieve a targeted market value of $2 trillion. (A valuation of $1.7 trillion was fixed on the offering, although it did touch the $2 trillion figure a couple of days after the shares started trading.) Foreign bankers, including large U.S. firms, were initially enlisted to sell shares internationally, but when they failed to drum up enough enthusiasm to back the sought-after $2 trillion value (figures as low as $1.2 trillion were reportedly discussed), they were ignominiously dismissed, and company and national leaders then turned to local markets where they could exercise more influence. In the past we have warned that IPOs are seldom suitable for investment purposes because they are accompanied by special promotional efforts on the part of enthusiastic sellers; this deal was a perfect example. When it comes to IPOs of any sort: buyer beware.. ________________________________
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 10, 2020 TAF
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