THE OPTIMISTIC CONTRARIAN: Part I
PEOPLE & MARKETS ARE MORE RESILIENT THAN YOU THINK
In May of 1940, German panzers rolled through France's famed Maginot Line. A month later, the Nazis were marching through the streets of Paris. Only one thing stood between them and total victory -- Great Britain. As the Battle of Britain ensued and the Luftwaffe began bombing London, pessimism was at its nadir. Erik Larson describes this vividly in his recent best selling book, “The Splendid and the Vile: A Saga of Churchill, Family, and Defiance During the Blitz”,
“Civil defense experts feared that the first aerial attack on London would destroy much, if not all, of London and kill two hundred thousand civilians. It was widely believed that the city would be reduced to rubble within minutes of war being declared. Raids would cause such terror among the survivors that millions would go insane. ‘London for several days would be one vast raving bedlam,’ wrote JFC Fuller, a military theorist in 1923. ‘The hospitals will be stormed, traffic will cease, the homeless will shriek for help, the city will be in pandemonium.’ The Home Office estimated that casket makers would need twenty million square feet of ‘coffin wood’, which was an amount impossible to supply.”
So, how did these “expert" forecasts turn out? Did Londoners go insane? Were hospitals swarmed? Was the city in pandemonium? Not only did these forecasts prove to be wrong, they were not even close. While London certainly suffered, it was not destroyed. More importantly, the Blitz had a much different effect on the Brits than the experts expected. How so? As Ben Carlson highlighted in his post titled, “The Power of the Human Spirit”, the answer can be found in Malcolm Gladwell’s book David and Goliath:
“Why were Londoners so unfazed by the Blitz? Because forty thousand deaths and forty-six thousand injuries — spread across a metropolitan area of more than eight million people — means that there were many more ‘remote misses’ who were those emboldened by the experience of being bombed (due to not being impacted physically) than there were near misses who were traumatized by it (due to either seeing the bombings first hand or were directly impacted by them).”
Today, we are living through another era of extreme pessimism. In the last week alone, modern day “experts” have forecasted the country is doomed due to a lack of leadership, the economy is in trouble no matter who wins the election, the market will crash, equity returns will be anemic for the next decade, and small businesses are screwed. To wrap up my week, a neighbor posted a message on Nextdoor that an “attack helicopter with guns” was circling our houses, when in reality it was a department of energy helicopter performing a pre-announced routine flight over Rock Creek Park.
WE HAVE COLLECTIVELY LOST OUR MINDS!
On the surface, this extreme pessimism is disheartening. Beneath it though, there is a silver lining, at least for us optimistic investors out there --- we get to be contrarians at a moment usually reserved for the pessimists.
Taking a Step Back
Think back to March. The general public was just starting to wake up to COVID-19’s severity. Yet, the market had known this for weeks falling 25% in less than a month. In April, lockdowns began going into effect, remote working kicked in, many businesses shuttered their doors, and the economy contracted. Similar to the Battle of Britain, countless “experts” proclaimed that we were on the precipice of “the next Great Depression”. Forecasts grew increasingly pessimistic -- more than two million Americans would die, hospital systems would break, universities would not open in the fall and many would fail, and professional sports would have to cancel their seasons. Then something interesting happened. Deaths slowed as doctors learned how to better treat the virus, hospital systems were stretched but did not break, most universities opened for fall classes, and the NBA, MLB, NHL, and NFL all resumed their seasons. Even college football kicked off. What else happened? You guessed it. The market rallied in advance of all of these developments. Why? Because the market is a forward pricing mechanism. It recognized the virus's severity early, but when it saw the Fed inject liquidity, the healthcare sector pursuing treatments and vaccines, and businesses responding to the challenge, it began to stabilize. Most importantly, it recognized it was a matter or "when", not "if, we would get through it. See, while COVID-19 is certainly a daunting challenge, it will not leave the world controlled by the Axis powers or without a financial system. This is a BIG difference.
Are we out of the woods? Far from it. Is this election going to go smoothly? Unlikely. Are we going to have more unexpected events to overcome? Absolutely. But here is the thing. Pessimists act as if difficult events are irreversible and that society sits by idly as challenges arise. Optimists recognize that some of our greatest moments arise in response to challenges..
The Country is Devoid of Leaders
Pessimists
Pessimists believe we live in a world as divided as it has ever been and devoid of effective leaders. They also believe the country is too fractured, short-term focused, and politicized for future leaders to emerge. They don’t understand why leaders would want to step into the fray today.
Optimists
Optimists recognize that these are precisely the moments when great leaders emerge. The reason? Because leaders are “nice-to-haves” during good times, but necessities during difficult ones. From Lincoln maintaining the Union during the Civil War to FDR navigating the country through the Great Depression. From Dwight D. Eisenhower leading American forces on D-Day to Edward R. Murrow confronting Joseph McCarthy’s and his Red Scare tactics. From Steve Jobs’ returning Apple to prominence to Lee Iaccoca doing the same at Chrysler and Sataya Nadella at Microsoft. From Ben Bernanke and Hank Paulson handling the Great Financial Crisis to Paul Volcker defeating inflation. This is just the tip of the iceberg. Leaders emerge during challenge times because that is when leadership is most required and valued.
The Election
Pessimists
Pessimists on both sides of the aisle are convinced the economy and stock market are in serious trouble. Biden supporters believe that if Trump wins, the virus will continue to spread, the economic reopening will continue to be delayed, and his administration will undermine the faith in government. Trump voters believe that if Biden wins he will increase taxes, pursue a New Green Deal agenda, and re-impose regulations that Trump has cut. As the Financial Times said over the weekend, "Each side is convinced that the victory of the other spells the end of the republic." Therefore, the answer is to sell and move cash to the sidelines.
Optimists
Optimists focus on the facts, not biased opinions. The key is that this is not a partisan issues. If so, how should optimistic investors approach investing through this election? Charlie Munger said it best, “The first rule of compounding: do not interrupt it unnecessarily”. Pictures are worth a thousand words.
INVESTING UNDER REPUBLICANS OR DEMOCRATS vs. STAYING INVESTED
The fact is, the economy and markets have done well across presidents from both parties. In fact, often times policies are overwhelmed by underlying economic conditions. Look no further than the fact that the S&P 500 compounded by 16% under the Obama administration and roughly 15% under Trump. Even more notably, during Obama's term the best performing sectors were technology and consumer, while energy was the worst. Care to guess what the best and worst performing sectors were during the Trump presidency? The same exact ones...with very different policies.
100 YEARS OF STOCK MARKET PERFORMANCE UNDER U.S. PRESIDENTS
A Market Crash is Coming
Pessimism
Not only do pessimists think the market is in trouble, they think a crash is imminent. Yale professor Robert Shiller highlighted this view in an article last weekend in the NY Times titled, “People Fear a Market Crash More than They have in Years”. The gist of the article is that fears of a major market crash are at the highest levels in years. The source of this fear? The combination of high valuations and the fact that an overwhelming majority of investors believe that the probability of an imminent market crash is much higher than usual.
Optimism
Optimists like it when the level of pessimism in the market is high. Think about it. If you ascribe to the theory that markets turn when the "last buyer buys", then if there are a lot of "Casandras" in the market, it also means there are a lot of potential future buyers. I don’t know about you, but I would be much more worried about a market crash if valuations were high and investors were overly confident as opposed to overly pessimistic. This has been the most hated bull market in generations and continues to this day.
Ten Year Equity Returns
Pessimism
Pessimists look at the S&P 500's last ten years and current valuations and conclude that the market's outlook for the next ten years is very poor. Vanguard expects global equities to return less than 6% annually for the next decade on a nominal basis and ~4% on a real basis (inflation adjusted). GMO is even more dour as they expect real returns for U.S. Large Caps to be -5.8%, -3.9% for U.S. Small Caps, -1.0% for International Large Caps, +1.1% International Small Caps, and +0.4% Emerging Markets (yet, they expect “Emerging Value” to annualize at +8.7% annually...go figure). The reason? Strong trailing ten year returns, current valuations, the threat of rising rates, COVID-related issues, and potential policy headwinds are just the tip of their iceberg.
Optimism
Optimists acknowledge that the last ten years have been incredibly strong for U.S. equities (+15% annually for the S&P 500), but they also recognize that the trailing twenty years have seen a compounded return of just +6.6%, which is one of the worst twenty years on record. Are returns for the next decade going to match the +15% of the prior ten? Highly unlikely. Should we expect them to be less than half the long-term average? I would argue this is equally unlikely.
Such low forecasts for international equities are even more confounding. Over the past decade, the MSCI ACWI has annualized at just over 8%, while emerging markets have been even worse at sub 2%%. So after compounding at nearly half and a third of the long-term averages, they are going to get worse over the next decade?
I understand the case that fixed income returns will be materially lower going forward as long-term returns tend to closely reflect your starting yield. Equities though...I don’t get it.
Small Businesses
Pessimism
Small businesses are not going to make it. Up to 70% are going to fold. We just aren't as resilient as we once were and big business is going to dominate the future.
Optimism
This virus has been incredibly tough on small businesses. It is hard to get reliable data, but since the onset of the crisis, a number have folded, while many others are struggling to get by. This said, according to Shopify COO Harley Finkelstein, in Q3 2020 the United States had a record number of new business creations, the highest since 2004.
Speaking purely to personal experience, I have seen many cases of resilience and ingenuity. Our daycare provider adjusted, pivoted, and reopened. My barbershop closed, reopened with limited capacity, started taking reservations, invested in PPE, and raised their prices, which their loyal customers have been more than willing to pay. I saw our favorite local restaurant (Blue 44) stay afloat by building an online menu/delivery option from scratch. Each time we grab dinner there, the owner tells me that they’ve been stunned by the support from their “regulars”. I have seen countless other restaurants with no online presence pivot to be full blown catering operations. My neighbor who runs a great D.C. based restaurant (The Dabney) went from providing no delivery or take out options to becoming a full-service catering business, offering dine in/dine out options, selling multiple meals a day, and building a social media presence that was non existent prior to the crisis. I took my family down there last Sunday and there was a line around the corner just for breakfast. This is a list of four and anecdotal, but I have heard countless other stories from many other people about similar situations.
Are we as tough today as the Brits were in World War II? Maybe, maybe not, but let’s assume that we are not because sheltering-in-place is far from sheltering in bomb shelters and Tube Stations. But does that make us less resilient? This might be one of this crisis’s silver linings. Maybe technology has simply enabled people and their businesses to pivot faster and more effectively than ever before. Will the COVID-19 crisis end up leading to a scenario where those that survive do so because of a willingness to adopt new technologies and accelerate the current trends? Is that then the modern day resilience?
Outlook
Of all places, Matthew McConaughey recently had one of the best takes on the dynamic between optimism and pessimism in his recently best selling book “Greenlights”. He said,
“Days of prosperity make us forget days of adversity, while good times seem out of reach during the bad times. Both can seem like final destinations, the summation of our days. Then the cosmic joker plays with our ways. Yesterday’s condition no longer remains. All commas, no periods, all stops, no stays, the pleasure is for rent and so is the pain.”
Ordinarily, there is a very high correlation between the country's mood and the markets. Pessimism tends to be a byproduct of poor markets, while optimism tends to attach itself to strong markets. So, here we sit. Equities are near time highs, yet pessimism runs wide and deep. A conundrum for some, but for the few willing to look for the positives, this might be the rare opportunity to be an Optimistic Contrarian.
NEXT: The Optimistic Contrarian (Part II) -- History is the Antidote to Pessimism
Retirement & Benefits Specialist
3 年Ted, its good to read from someone that it's losing his mind to either the left or right. As I have always taught my kids, if someone wants your support for anything, its because they want money, power or influence. And point two, always look at the person's motivation as to why he/she would say or do something. As history has proven, the same story emerges every 4 years in this GREAT country. The republicans scream that our nation will never recover if (you name the person) is elected, and the democrats call everyone racist that isn't on their side. Pretty sure most of us with the ability to reason and see the trees through the forest realize both parties leave SO much to desire, and neither cares a lick about average joe/sally, they only care about power, influence and money. As you've pointed out, we've been here before, and will be again, so calm down, get a drink and popcorn, and watch as the juveniles that "lead" this country prove how dumb we are to vote them into office.
Partner | Client Advisor at Brown Advisory
4 年Love it Ted Lamade!