Leaning In…

Welcome to 2025.  It’s still summer here in Australia, the year just passing its unofficial starting point being Australia Day.

My family and I had a busy, yet relaxing, Christmas period.  Lunches, drinks, dinners, more drinks…  There was the catch-ups with friends and acquaintances – several of which are home for a visit given their lives are now based in Europe and the U.S.  And more drinks…

I had a number of interesting discussions with people along with reading some of the various year-in-review/year-ahead forecasts that are plentiful this time of year. 

Covid remains a topic of discussion.  As I remarked during one such discussion, I don’t feel we collectively appreciate just how significant the Covid event was.  The world shut down.  Many people died.  I think it’s not till we’re reminiscing over it in many years to come – perhaps telling the story to our children – that we will truly appreciate what a significant event it was.

Of course, for investors, this Covid period has been remarkable with regards to markets.  We’ve literally invented new asset classes to speculate on (Crypto).  We’ve seen speculative bubbles inflate then burst (“NFT’s”, “SPAC’s”).  We’ve seen massive government stimulus and deficit spending only previously seen during wartime.  We’ve seen the highest rates of inflation in generations (coincidence?).  The swiftest interest rate hiking cycle for generations.  “Meme stock” frenzies.  Epic “short squeezes” etc.

And when it comes to the U.S. stock market, it’s largely shrugged everything aside in its march higher. 

Similar to Covid, I think it’s not till we’re looking back in years to come that many will realise just how amazing this period is.  “Caught up in the moment”, “unable to see the forest for the trees” and whatever other metaphors you choose to apply. 

Where should I look?

One discussion I had over a beer recently was with an acquaintance I’ve known for 10 years or so.  He’s what I’d refer to as an “intelligent layperson” – not from a finance background but a keen interest in investing.  He is clearly keen on Bitcoin.  He didn’t really have a response for me when I expressed my aversion to Crypto based on the reality that it has no real use, no real value, no real way of valuing it, no history and therefore essentially means exchanging real money for something you trust you will be able to flog on to someone else at a higher price in order to recoup your real money. 

Regarding the stock market, he accepted my opinion that we are witnessing a special period in history – U.S. market valuations are historically extreme and that virtually guarantees a period of low average returns is coming with a real possibility of a sizeable market drawdown at some point.

Then he asked “so where do you think I should be looking?  Are there any industries or sectors?”

I really didn’t have an answer for him…

This was somewhat of a wake-up call for me.  Whilst I’m comfortable with our market views and positioning, an inability to describe any compelling “down the track” opportunities did make me realise that I need to be more open-minded towards the opportunities that undoubtedly lay ahead. 

Lean into what’s working…

I really like this phrase – this concept.  It’s something I’ve been thinking a lot about over the past 6 months.  “Lean into what’s working”. 

In a sense, it’s a derivative of the old “the trend is your friend” principle.  But it’s deeper than that.  It’s about embracing what’s working for you based on your situation and goals.  For example, if term deposits are delivering you all the return you need, why chase other investments that pose a risk of capital loss?

Of course, “what’s working” can be very subjective.  Many investors – including us – have been focused on preserving capital over the past several years, for the reasons described below.  This has come at the expense of significantly under-performing the major market indices.  We’re somewhat content that we’ve been doing “what’s working” although many other investors will laugh at that. 

I do believe we have not been particularly good at “leaning into what’s working” over the past few years.  This is something we need to improve on in the future.

However, there’s another perspective that conflicts with “lean into what’s working”.  It’s this:

Some of the most profound money-making opportunities are the result of a shift in “what’s working”. 

There’s endless examples of this:

That fateful day in 1992 when the U.K. was forced to withdraw from the European Exchange Rate Mechanism, netting George Soros billions in profits from his short Sterling trade… 

March 2000 when “dot-com” stocks ceased going up, culminating in the NASDAQ falling 78% in the following 2 years… 

2007 when for the first time millions of Americans defaulted on their mortgages, spawning massive losses globally for investors that had participated in what turned out to be a bubble in mortgage-backed securities… 

Or that point during the 1981/1982 recession when the U.S. stock market stopped going down, valuations crushed, sentiment dire, leaving really only one way for the market to go – up!

Each of these events effectively came about because what had been working for quite some time ceased to work.  Being on the wrong side of the change resulted in significant losses.  Being on the right side was – with the benefit of hindsight – an incredible opportunity.

What’s working?

If we gaze around the global financial world, there’s one thing that sticks out as having been working – U.S. large capitalisation stocks, the most commonly tracked measuring stick being the Standard and Poors 500 index.

Whilst it certainly hasn’t been a straight line “up and right”, the S&P500 is up some 5,450 points from its low of 676 hit in March 2009.  That’s 800% over the course of 16 years.  A Compound Annual Growth Rate (CAGR) of 15%.  The last two years have been particularly impressive – back-to-back yearly gains exceeding 20% – in fact, 25%.  This is just the 5th time in history this has happened. 

Over this same period U.S. nominal GDP has gone from around 14.4 trillion to 29.4 trillion – a CAGR of just 4.6% per year.  Unsurprisingly, S&P 500 revenue growth during this period has closely resembled GDP growth.  The mere fact that the stock market has grown so much more than the economy for so long should give us reason to pause.

Now, of course its fallacious to suggest the market must go down simply because it has gone up too much.  But, with a nod to financial history, when we look at the S&P500 and market conditions today, there’s plenty of evidence to suggest “what’s working” probably won’t work for much longer.

Concentrate

We all know by now the story of the “magnificent 7” – those 7 mega-cap stocks that have been driving the market higher.  We surely also know that the market has become very “concentrated” – the largest stocks representing an outsized component of the total market.  Here’s a graphical illustration of the situation:

Okay so what.  What does that mean?  Well we’ve only got a few other data-points in terms of extreme concentration amongst a small cohort of large stocks.  But, with the benefit of hindsight, what did the previous examples have in common?

Well, we remember that other examples turned out to be, how do we say this politely, “periods of extreme optimism” – we have the “Nifty 50” during the early ‘70’s and the dot.com’s of the late-90’s.

Previous periods were characterised by extreme valuation. 

They were followed by long periods of “below-average returns”. 

During that subsequent period, the “concentration” abated – those most richly-valued stocks under-performed the broader market.  Many disappeared altogether – via merger or even bankruptcy.

Oh, and some of the “unwind” happened quite swiftly.  Said differently, the market fell hard.

In terms of broad market valuations, we truly are spoilt for choice at the moment.  Everywhere you look you seem to find another commentator referencing another valuation metric that tells the same story – valuations have never been higher. 

The one below looks at 8 different valuation metrics and plots the average of where each is relative to historical readings.  It shows that all these metrics are butting up against their “100th percentile” – the highest readings recorded.

Let’s talk about valuations in a slightly different way.  I’ve referred to Apple in previous commentary over recent months.  They are one of the greatest electronics retailers of all-time.  A dominant position in the mobile phone market that will unlikely be challenged any time soon.  Profits are huge and can be expected they will stay that way for a long time.

They are currently trading around 10 times sales and a P/E around 37.  Sales haven’t grown much for a few years.  Those valuation metrics have seldom been half of what they are now over the past 15 years – even when it was growing sales strongly. 

It’s a crazy market environment right now.  Maybe Apple will command a 45 P/E by year-end.  But that would simply make no sense – what’s the investment case for owning Apple? 

This same logic can be applied to most of those largest companies that have been driving the market.  You need a significant amount of profit growth to justify current valuations.  Not just another few quarters of stellar growth – that’s a “given” in the sense that if it doesn’t materialise there will be big trouble.  You need to be confident of stellar growth for years to come. 

Sentiment is very positive in this crazy market although not “universally” – whilst the S&P 500 posted an impressive 25% gain last year, a third of index components were down on the year.  From a historical perspective, this is an important observation – this market lacks the breadth generally seen in previous “durable” bull markets and better resembles the conditions seen around previous market peaks.  But once again, it’s a crazy market and anything can happen. 

Is a shift at-hand?

As a student of financial history, I am a believer in “reversion to mean”.  Whenever things have run ahead of themselves (or behind for that matter), they have tended to revert back towards some kind of “trend” growth. 

The U.S. market has been stretched well beyond “trend” for several years now.  This has resulted in us being cautious – “bearish” if you prefer. 

I’ve frequently expressed over the past several years that things are really hard at the moment.  Hopefully, it’s becoming abundantly clear what I mean.  Do we continue to “lean in to what’s working” – U.S. large-cap technology, U.S. dollar etc – or do we position for change?

There’s no “right” answer to this.  It depends on every individual’s investment philosophy and style. 

There’s one major problem with predicting change in financial markets.  In most fields, identifying something early on will often have you hailed a “visionary” or something similar.  In financial markets, being early is indistinguishable to being, well, plain wrong.

As I’ve frequently lamented, when it comes to investing there’s nothing wrong with being wrong provided you are wrong with everyone else.  This is really important to understand and the incentives embedded in it.

Let me explain this by telling a couple of stories – stories some of you may have heard from me before…

I was on the “front line” during and after the Global Financial Crisis of 2007/2008 – working as a stockbroker/derivatives dealer at several large firms. 

One day, in the lead-up to the GFC I overheard one of my colleagues, Les, on the phone to a client.  Les was in his 50’s and had been around the markets for decades – he’d lived a few market cycles.  It was a tense conversation.  “No… listen… it just feels different…” 

“What’s up with Les?” I asked my colleague.  “Oh he thinks the market is going to go to shit and his clients are pissed off because he sold them out and it keeps going up.” 

A couple of years later in the aftermath of the GFC I was working at a different firm.  One of the principals – a very “successful” broker in his 50’s – was inviting us to work on a project with him. 

[Digressing for a moment, I want to clarify what I mean by “successful” broker as it is very relevant to the story…  He was doing very well for himself.  Built a big client-base.  His personal income was well over $1M per year.  But it wasn’t the result of him being a shrewd investor – it was because he was a good salesman – successful at convincing others he was the guy to look after their money.  His income was sourced from brokerage and management fees.  To emphasise, he wasn’t a “bad” investor… just not special.]

The project he was working on was basically the development of an investment framework – a framework/philosophy for analysing and selecting stocks and assembling portfolios.

The key reason why he was doing this was because he was extremely disillusioned with the in-house research team.  All these analysts, strategists and economists – supposed “experts” telling all the brokers what to buy.  He felt extremely let down by them as none of them had offered any prescient warnings or strategy recommendations before or during the GFC.  Sure, they kept everyone updated throughout on why everything was going down the toilet, but there was no “sell” recommendation – only “buy”, “sit tight”…

Of course – seriously, what did you expect?  You see, when you’re in the business of selling investments it can never be a bad time.  “Bearishness” is bad for business. 

Referring back to Les and his prescient pre-GFC advice to clients, he had to fight hard to keep clients.  He wouldn’t have had that problem if he just kept encouraging them to stay invested.  Was it all worth it?

We’re in a world of “relative performance”.  All that matters to most is how you perform relative to your benchmark.  Straying too far from your benchmark equals career risk. 

And realise there’s nothing wrong at all with losing money.  For example, if (or I should say “when”) the Aussie market next falls 35%, if you’re overseeing an Aussie share portfolio and are only down 30% you can boast about your commendable out-performance. 

Evidently, we don’t think this way.  We have an “absolute return” mindset.  A loss of 30% is utterly unacceptable to us irrespective of how the market performs.  Our goal is to deliver attractive returns over the entire market cycle – and one of the best ways of boosting full-cycle returns is to do your best to exempt yourself from those periodical major market drawdowns.

But what about those opportunities?

To repeat, it’s really hard right now. 

Plenty of investors smarter than us have done some great research to guide us on where to look for opportunities.  As a starting point, the world is currently betting big on the U.S. – pushing valuations to the extreme.  It follows that the most compelling current opportunities are likely outside the U.S.

Much has been said about “value” stocks underperformance.  Stocks paying a decent dividend yield.  Much has been noted about the rather dismal market environment in areas like the U.K. and Europe.  Some emerging markets…

There’s a very compelling case being made for resources – things the world needs and where demand will keep growing.  Starved for capital and investment interest, there’s another meaningful resources bull market coming at some point.  Oil is in that category also.

The thing is… with an “absolute return” mindset, I’m wary we’re just too early. 

Cash provides optionality.  It’s like a continuous “at-the-money” call option over everything – it enables you to buy anything you like – any asset class, any jurisdiction – any time you like.  What’s more, there’s no premium attached to it! 

Of course, there is a cost – “opportunity cost”. 

“Lean into what’s working” or “position for a shift”?  I don’t know what the right answer is.  We’ll continue to savour this amazing juncture in financial markets history and try our best to make some sensible decisions guided by history. 

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