Market Insight - February 2021
Over the past several years it has become apparent that our older son has inherited my poor eyesight, which was about 20/425 before I underwent LASIK eye surgery several years ago. He hasn’t gotten nearly that bad yet, perhaps partially benefiting from his mom’s superior 20/20 genes, but he’s almost to the point at which he needs glasses for most situations. I was a little older than he is now when I started wearing contacts while playing sports. He’s a hockey player and recently asked me whether it’s difficult to get used to wearing contacts.
I think he’s almost to the point where playing without glasses or anything to help with his vision is affecting his play. I had to think back to when I first started wearing contact lenses and I told him that the hardest part for me was putting them in and taking them out. I explained that our body instinctively wants to protect our eyes from foreign objects, so training the muscles around your eye to allow you to insert and later remove a foreign object took practice and patience.
For any of you that have worn contacts, you likely went through the same training process. Our tendency is to flinch or blink when we see something about to touch our eye. In most situations, this is obviously very useful in protecting our vision. That instinct is so difficult to overcome that we must practice repeatedly to allow that contact lens past our defenses, even though we know that what we’re doing is actually intended to help our vision not hurt it.
Like the instincts that engage the muscles that control my eyelids in a split-second are meant to protect my eyes, I am aware that I have instincts related to judging investment opportunities and risks. While we are born with certain self-protective impulses, investment instincts are generally formed over time and primarily by our experiences. An oversimplified scenario might be that an investment is made based on certain assumptions and it doesn’t go well. Another oversimplified scenario might be that an investment is made based on different assumptions and it goes very well. Over time these discreet experiences lead to the building of instincts or biases.
When I see a stock go from less than $20 per share to over $400 in a matter of days as GameStop did in January, my instincts scream from the rooftops that this stock isn’t an investment, but rather an irrational, foolhardy gamble that will invariably come crashing back down. Perhaps you had a similar initial reaction. While my instincts have been developed over time through experiences, so has my knowledge that choosing to invest (or not invest as in the case of GameStop stock) strictly on impulse is also typically an irrational and foolhardy gamble.
Check Your Impulses When Making Investment Decisions
It’s critical to check our impulses when making investment decisions. Even the most rational, prudent investors find the Siren song of exuberant capital markets, securities with seemingly endless prospects, and enabling central banks very difficult to ignore. Is it justifiable that an automobile manufacturer that sells fewer cars than eighteen of its competitors1 should be valued in the stock market higher than those eighteen competitors all added together as Tesla is2? Along the same vein, should an investor allocate to a hospitality industry disruptor like Airbnb even though the company has one-third of the sales of its strongest competitor3, but is valued 30-plus percent higher than that competitor in the stock market4?
Instincts might tell us that these relationships don’t make sense and are irrational, leading to an eventual reckoning. However, when we check the immediate impulse to write-off these two stocks as having irrational valuations, we can see that there’s more to the story for both. Tesla makes more than cars and Airbnb sells more than accommodations. Comparing Tesla to Toyota isn’t necessarily an appropriate or complete method for assessing the relative value of either automaker. Likewise, comparing Airbnb to Hilton or Marriot misses a big component of what makes Airbnb different than a traditional hotelier. After checking our impulse to discount Tesla and Airbnb as the temporary benefactors of irrational exuberance, how do we make sense of their recent ballooning valuations?
I don’t mean for this letter to be about the case for or against owning any particular stock, so please don’t infer that I am encouraging direct investment in any of the companies cited. I am not. I include these stocks as examples of investor behavior that is currently placing a higher than normal value on growth and especially the prospect of exponential growth. Instinct might tell you that this is a classic bubble forming. However, in a market environment characterized by exceptionally low interest rates and one that has become more democratized than ever before, it is plausible that growth and certainly the prospect of exponential growth does justify a higher than usual valuation. How high is too high though?
Checking Your Instincts Against the Current Environment
Investing is an incredibly humbling venture. Made up of varying degrees of skill and luck, investing has the capacity, but not the tendency, to bless imprudence and humiliate intelligence. The now legendary adage from Depression-era economist John Maynard Keynes, “the market can remain irrational longer than you can remain solvent” rings ever truer at certain points in the history of capital markets. An adaptation to that timeless quote to be more applicable to the current market environment could be that “the market can remain irrational longer than you can remain convinced it’s irrational”.
Instincts tell me that there is a fair amount of irrationality in the capital markets today. However, checking those instincts against the current environment is important. There is reason to believe that irrational behavior will persist, leading to a wide dispersion of investment outcomes from different parts of the capital market and a higher level of market volatility. As mentioned earlier, low interest rates continue to allow for inexpensive financing and leverage. Low rates also tempt investors to seek assets with higher potential returns, imposing a higher opportunity cost on lower risk investments like high-quality bonds. In addition, central banks around the globe have adopted a very accommodative stance to dealing with disruptions in the capital markets. In other words, if you know there’s a net under you, you’re more likely to leap before you look. Finally, the ability for nearly anyone, anywhere with a cell phone and access to a network to buy and sell securities in nearly any increment with no or very low trading costs has the propensity to fuel speculative behavior.
As you know, we certainly do not invest your portfolio on instinct or impulse. Built over the course of many different experiences, our instincts are important inputs to how we evaluate the capital markets but can’t be relied upon solely because circumstances always change. Our disciplined process of blending different types of investments with the goal of creating a portfolio consistent with your short-term and long-term goals accounts for periodic bouts of rationality and irrationality in the capital markets. We refrain from significant changes to your portfolio whether markets appear rational or irrational. Remember, the market can remain irrational longer than you can remain convinced it’s irrational. That doesn’t mean that you ignore what’s happening, but it also doesn’t mean that you overreact to it. It’s vitally important for your instincts to protect your eyes from foreign objects, but it’s equally if not more important to have the discipline to bypass those instincts if it can lead to better vision.
|Market Indices (As Of 12/31/20)||3rd Quarter||One Year|
|Dow Jones Industrial Average||+10.7%||+9.7%|
|S&P 500 Index||+12.2%||+18.4%|
|Bloomberg Barclays Capital Aggregate Bond Index||+0.7%||+7.5%|
|Small Cap Stock (Russell 2000 Index)||+31.4%||+20.0%|
|Non-US Stock (MSCI EAFE Index)||+16.1%||+7.8%|
I’d very much like to thank those of you that sent me book recommendations following my last letter. I’ve only read one of them so far and can honestly say that I share the same taste in books with at least one of you 😊. Please keep them coming as I’ve ventured into non-fiction now and will be excited to have some good fiction recommendations in the queue.
Last November was my thirteenth anniversary at Birchwood. Over those years I’ve been so fortunate to work with Ellen Johnson, our Chief Compliance Officer who is retiring at the end of this month. Among Ellen’s exceptional qualities is her meticulous attention to detail, unyielding work ethic and conviction in her beliefs. Ellen has continually instilled our core value of integrity with every new employee to join Birchwood. She is also a restless learner, broadening herself, and the rest of us over the years through her study of yoga, Feng Shui, mindfulness, meditation, and EFT tapping among other things. If you’ve had the opportunity to work with Ellen before, or even if you haven’t, I’d encourage you to drop her a note wishing her well (email@example.com). I can sincerely tell you that her priority in everything she’s done has been to do what’s best for each one of our clients.
I’d also like to introduce Jill Vilkama who joined Birchwood in November last year to succeed Ellen in the role of Chief Compliance Officer. Jill has over seventeen years of experience in the financial services industry and brings strong operational and compliance skills to Birchwood. In just a few short months we can see that Jill’s thoughtful, positive, and caring personality fits in very well with our culture. We are so pleased to have been able to lure Jill to our team and for her to have had several months to work alongside Ellen (virtually of course). We look forward to you getting to know Jill.
Be well and thank you for the trust that you’ve placed in us.
Steve Dixon, CFA CSRICTM, Investment Manager
Kay Kramer, CFP®, Dana Brewer, CFP®, Bridget Handke, CFP®,
Damian Winther, CFP® CSRICTM, Rachel Infante, CFP® CSRICTM
1 Source: Lu, Marcus. “Visualized: How Much Revenue Automakers Generate Every Second.” Visual Capitalist, 19 Aug. 2020, www.visualcapitalist.com/visualized-how-much-revenue-automakers-generate-every-second/. Accessed on 4 Feb. 2021.
2 Source: Ghosh, Iman. “The World's Top Car Manufacturers by Market Capitalization.” Visual Capitalist, 21 Jan. 2021, www.visualcapitalist.com/worlds-top-car-manufacturer-by-market-cap/. Accessed on 4 Feb. 2021.
3 Source: Action Based. “Steer Clear Of Airbnb And Add Booking On Weakness.” SeekingAlpha, 6 Jan. 2021, www.seekingalpha.com/article/4397531-steer-clear-of-airbnb-and-add-booking-on-weakness/. Accessed on 4 Feb. 2021.
“Airbnb, Inc. (ABNB) Stock Price, News, Quote & History.” Yahoo! Finance, Yahoo!, 9 Feb. 2021, www.finance.yahoo.com/quote/ABNB?p=ABNB. Market value on 8 Feb. 2021 was $119 billion.
“Booking Holdings Inc. (BKNG) Stock Price, News, Quote & History.” Yahoo! Finance, Yahoo!, 9 Feb. 2021, www.finance.yahoo.com/quote/BKNG?p=BKNG. Market value on 8 Feb. 2021 was $86 billion.
Table 1 Source: Morningstar. Market indexes are unmanaged, and investors cannot invest directly in indexes. However, these indexes are accurate reflections of the performance of the individual asset classes shown. All returns reflect past performance and should not be considered indicative of future results.