Season Investments


The Inexplicable Teflon Market

Posted on August 25, 2020

“When the Fed takes risk out of the equation this is the result." - Phil Ba, SecLenX Capital

teflon.jpgHeading into this year if you would have described everything that would transpire to this point, there is simply no way we would have thought it possible for the broad equity market indices to be in positive territory - let alone for the Nasdaq to be up over 30%! A section header in a recent Axios News email dubbed it The Inexplicable Teflon Market. We think that’s a decent way of framing it. Indeed, since the bottom in March bad news has been treated as good news, and good news has been treated as great news. This has been seen particularly in the headlines related to the virus, with some of the market's strongest days corresponding with hopeful developments related to a therapeutic or vaccine. And all of this, of course, is being driven heavily by the liquidity being injected into the economy and financial system by the Federal Reserve and Congress.

Looking beneath the surface, however, we see the stark reality that this crisis has created a few big winners and many small losers. Sector disparity has been dramatic, with the most glaring example being the outperformance of technology over energy by roughly 70% year to date. Large cap companies have also fared better than small caps by roughly 20%, and growth stocks have outperformed value stocks by 30%. Coincidentally, the “healthiest” companies from a balance sheet and liquidity standpoint have also been the ones that have benefited on some level from the COVID crisis. So perhaps it’s not surprising that these companies, predominantly in the “large cap growth/tech” category, have done the majority of the heavy lifting in this stock market rally.

The only problem is one of fundamental valuation, if that even matters anymore (legitimate question). What we’ve seen is that the most expensive stocks coming into the year have been those that have dramatically outperformed, meaning they have only gotten more expensive. The “smart money” investors have been calling this out as a reason to remain cautious. Legendary investor Stanley Druckenmiller recently indicated that the risk/reward calculation in stocks was the worst he has seen in his career, and billionaire hedge fund manager David Tepper said the market is the most overvalued he’s ever seen outside of 1999. Then of course there is Warren Buffett, who recently indicated that, “We have not done anything, because we don’t see anything that attractive to do.”

Historically, post-recession bull markets typically start from valuations 40-50% lower than where we are today. Add this to the fact that we may not be poised for breakout economic growth anytime soon, and well, it’s just hard to get excited about the long-term prospects for stocks at these levels. GMO’s Ben Inker stated it this way, "While many stocks appear to us to be overvalued today, overvalued stock markets are nothing new. What is new is the meaningful possibility of a disastrous economic outcome combined with a substantially overvalued stock market."

But What Does The Smart Money Know?

Perhaps the most interesting aspect of the stock market’s great comeback has been the way retail investors have absolutely dunked all over their professional counterparts. Ben Carlson called this out in a recent blog post,

This is the craziest market I’ve ever seen. Some of the smartest, most sophisticated investors on the planet have been caught off guard by the market surge in recent months. Not only have these titans of the investment industry watched as the market has passed them by, but the biggest beneficiaries of the rise seem to be tiny retail traders.

Day trading has skyrocketed in popularity...again. The stage was set given the trend towards $0 commissions from the major brokerage houses and the advent of user-friendly apps like Robinhood that have lowered the barriers and even “gamified” the process of investing. Add in copious amounts of free time with little to no televised sports and, well, what else is everyone going to do? The poster boy for this phenomenon seems to be Dave Portnoy, the brash and controversial founder of Barstool Sports. Dave recently decided that trading stocks is one of the easiest ways he’s ever seen to get rich, and he has accumulated a vast following of young traders online. Here are just a few of the nuggets of wisdom Dave has offered up on Twitter in recent weeks,

It took me a while to figure out that the stock market isn’t connected to the economy. I tell people there are two rules to investing: Stocks only go up, and if you have any problems, see rule No. 1.

This is the easiest game I have ever played.

I’m sure Warren Buffett is a great guy but when it comes to stocks he’s washed up. I’m the captain now.

And then there’s this…Dave encouraging investors to pick stocks by pulling letter tiles out of a scrabble bag:

As crazy as all this sounds, lately Dave has gotten the call right. After a decade of smooth, post-GFC bull market returns, the “buy the dip” mentality has proven itself to be fully ingrained in the minds of retail investors. These investors are predominantly the ones who took advantage of the COVID selloff to load up on beaten down equities, to include names in the most tenuous sectors: airlines, energy, cruise lines, etc. There was even significant interest in shares of bankrupt companies like Hertz and Chesapeake Energy, shares that are virtually guaranteed to end up worthless.

But is this really investing, or is it speculation? Robert Hagstrom, CFA penned a piece discussing the differences between the two concepts. In it he mentions a book that was written nearly a century ago, 

Philip Carret, who wrote The Art of Speculation (1930), believed “motive” was the test for determining the difference between investment and speculation. Carret connected the investor to the economics of the business and the speculator to price. ‘Speculation,’ wrote Carret, ‘may be defined as the purchase or sale of securities or commodities in expectation of profiting by fluctuations in their prices.’

Lately it seems like price momentum is all that matters, and the market has become disconnected from the reality of what’s happening in the world economy. This has confounded the “professionals” who anchor their investment decisions to underlying fundamental analysis, and benefited those who believe stocks only go up. The opening quote from Phil Ba pretty much sums it up, and the axiom “don’t fight the Fed” seems to carry more truth than ever. This begs the question, Who’s more disconnected from reality: those who speculate on stocks going up and get it right, or those who invest based on fundamentals and get it wrong? Over the last few months, at least, the smart money is looking pretty dumb, but over a longer time horizon we continue to believe that prudent investing will win out over blind speculation. After all, even Teflon starts to stick after a while.

david_headshot_bw.jpgAuthor David Houle, CFA is a founding member of Season Investments. He serves as the firm's Chief Compliance Officer as well as sitting on the investment committee overseeing the management of client assets. David spent nearly ten years in various roles primarily managing individual client assets prior to co-founding Season Investments. David graduated with a degree in Finance from Colorado University in Colorado Springs in 2003 and earned the Chartered Financial Analyst (CFA) designation in 2006. David and his wife Mandy have three children and spend most of their free time with friends and family.

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