Dennis C. Butler, President
of all guest columns written by Dennis C. Butler, CFA
ccording to an Irish proverb, hindsight is the best insight into foresight. In fact, hindsight can be a wonderful teacher, helping us to overcome biases and providing a valuable perspective on past events. Take, for example, the action in the stock market since the beginning of the pandemic. Following the quickest sharp selloff in history, the market hit bottom on March 23 of 2020. In the year following, US stocks have enjoyed their biggest rebound since 1936, leaping 75%. Now, in hindsight, it is clear how this happened: massive central bank intervention, lots of public spending, and progress in fighting the pandemic contributed to an improving outlook for business and stocks. The economy is even poised to grow strongly this year, and perhaps enter a boom phase.
A year ago, however, at the end of March, we were barely beyond the panic-induced market rout. Further declines seemed plausible, as even a 30% loss only brought the averages back to where they had been at the end of 2018. There was talk about the possibility of an economic depression, and high debt loads across the economy and government stoked fears of banks’ exposure to losses. The emergence of breathtakingly bad economic data only served to deepen the gloom: from March to May 33 million Americans filed for unemployment assistance, and the unemployment rate rose to 14.7%, the highest in the post-war period, with some forecasts calling for the rate to ultimately reach 30%.
Despite the overwhelmingly negative sentiment at that time, a few observers offered more positive views, even during the middle of the crash. On March 12, 2020, Michael Mackenzie of the Financial Times wrote, “the case for buying equities over government bonds does look good.” On March 20, Merryn Somerset Webb, also of the Financial Times, said “an increasingly interesting number of stocks are cheap now and most will eventually recover.” In our own Commentary of April 2020, we maintained that “markets will recover in due course, as they always have.” If these remarks seem too tepid, let’s turn to Howard Marks of Oaktree Capital, an investment firm; in a note to clients of March 12 he stated, “all great investments begin in discomfort.” Subsequently, on March 19, he was more direct: “Given the price drops and selling we’ve seen so far, I believe this is a good time to invest… .”
By June 3, 2020, the S&P 500 had enjoyed its best 50-day upswing in its history, yet overall, sentiment remained cautious, even negative. Large investment funds “braced for second stock market plunge,” read a Financial Times headline. The rapidity of the surge had made many reluctant to make commitments, while others pointed to the markets’ narrow focus on big technology issues. Further dislocations were expected.
What one tends to overlook when markets succumb to an avalanche of selling (such as occurred last year) is that someone is buying those marked-down shares; Howard Marks and his like-minded brethren were among them. Those with the foresight to take advantage of what was, for most, a very bewildering situation clearly benefited. To quote Marks further: “there’s simply no room for certainty in investing.”
So, what insight does our hindsight give into the foresight that clearly existed a year ago? An answer is suggested by a recent piece in the New York Times entitled “Bad News Bias.” Researchers have found that “Human beings, particularly consumers of major media, like negativity in their stories.” And “We think the major media are responding to consumer demand.” It is probably safe to say that investment professionals, being human, also tend to subscribe to negative news and viewpoints and act accordingly. Overcoming this bias requires self-awareness, faith that difficulties will work themselves out in due course, and an ability to think long-term. Returning to Marks: “It’s not easy to buy when the news is terrible, prices are collapsing and it’s impossible to have an idea where the bottom lies. But doing so should be the investor’s greatest aspiration.”
He Who Sells What Isn’t His’n Must Buy it Back or Go to Pris’n.
This quaint nineteenth-century aphorism, attributed to Daniel (“Uncle Dan’l”) Drew, a Wall Street market operator of notoriety, succinctly describes the ancient and common practice of short selling. In a short sale involving a stock, the seller borrows shares from an owner and sells them at the current market price. Later, the seller purchases shares in the market in order to return the borrowed stock (the short position is “covered”). In the interval between sale and re-purchase, if the share price has fallen, the seller pockets the difference. If the price rises, the seller incurs losses, which can be unlimited. Hence the short sale is inherently a bet on the direction of prices, and while there are a few sound investment reasons for engaging in a short sale (hedging and arbitrage, for example), the preponderance of such transactions is associated with speculation.
Short selling figured prominently in one of the more colorful Wall Street blow-ups in recent memory. A retail chain called GameStop had attracted a large short interest (the percentage of a company’s outstanding shares that have been borrowed for short sales). GameStop sells video games and equipment and related merchandise through a brick-and-mortar network of over 4000 locations, plus online. Its business performance has been lackluster and some investment funds, believing the company to be ultimately doomed in an increasingly online world, had accumulated a short position of 141% by the beginning of 2021, an enormous bet on the company’s imminent demise. This large short interest became a ripe target for predatory traders interested in forcing a “short squeeze.” Squeezes can occur when an unexpected rise in the target company’s share price forces short sellers to buy shares at higher prices to cover their shorts, thereby losing money. Not doing so can subject the short seller to rapidly increasing losses, and margin calls (short selling requires a margin account). This is precisely what happened in the GameStop episode, on a grand scale.
The risk to short sellers of a squeeze in GameStop was especially high given the large number of shares in margin accounts, limiting the number available for trading. This fact was not lost on the predators, so-called “Trader Bros” — a group of mostly young men who seem to have nothing better to do than hang out in online stock tip forums and brag about their winnings. They collectively decided to stick it to hedge funds by buying GameStop shares, thereby forcing up the price (note that this would be illegal if practiced by investment firms). A rising price would in turn force short covering, driving the price still higher. It worked. The 52-week price range for GameStop shares — $2.57 to $483 — provides an idea of the extent of the carnage as some funds lost billions of dollars and at least one had to be bailed out. A few “Bros” made a lot of money, but since losers are disinclined to brag, we’ll probably never know how many were in the other camp.
Massive government spending and aggressive central bank activity over the past year undoubtedly saved the American and world economies from descending into a severe recession, or even depression. The enormous mutual aid program saved many lives and businesses, enabling individuals to retain skills otherwise lost through unemployment, and businesses to remain solvent until more normal times appear.
From an investor’s perspective, the recent injections of financial liquidity are exacerbating an environment already rife with risk due to years of low interest rate policies that have encouraged the use of debt and “reaching for yield” behavior. There are signs that speculative activity has reached an extreme that threatens a vast misallocation of capital, as well as the financial well-being of the participants. Just this year we learned how one private family office (an investment firm dedicated to serving one or more wealthy families) employed secretive speculative financial instruments that were not subject to regulatory reporting requirements in order to create breathtaking leverage. When its bets went sour, overwhelmed by margin calls, the firm self-destructed, leaving a few large banks with billions of dollars in losses, and stoking fears of yet another contagious banking crisis.
Another example of frothy markets is the “SPAC” (“Special purpose acquisition company”), essentially a blind investment pool in which “investors” buy shares of an entity that has no business, in the hope that the management finds one quickly. These speculative creations have appeared from time to time over the years, but in 2020 and 2021they attracted record sums (SPAC promoters grant themselves bonuses in the form of low-priced shares, a perk that enables them to potentially multiply their money many times. Buyer beware!). A few may do well, but the shares of many SPACS are now appearing in the “new lows” lists. Finally, there is the GameStop episode, fed by novice traders, some of whom used Economic Impact Payments as seed money. Of this we can only say that it is never a good sign when “Trader Bros” are being interviewed for evening news programs.
So what does our “insight into foresight” suggest now? The choices are not so clear-cut. A year ago it paid off handsomely to follow the foresight and advice offered by experienced observers and investors and take a highly contrarian approach: investing in equities (and some fixed-income) at often sharply discounted prices. This year those voices might counsel stepping back from the fray, as stock prices have risen considerably since March 2020. It is true that current massive government spending and monetary programs should have a positive impact on business going forward, but the big question is, how much of the good news has already been “discounted” by the markets — probably quite a lot. This makes finding attractive investments a lot harder, but we don’t advocate selling either, at least not in a formulaic fashion. As we said in April 2020 Commentary, “When skies are blue, the road ahead clear, all around the world is in bloom and markets are rocketing higher, that is the time to sell if you wish to do so; buy when no one sees hope for the future and prices are heading down.”___________________________
Dennis C. Butler, CFA, is president of Centre Street Cambridge Corporation, investment counsel. He has been a practitioner in the investment field for over 37 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: April 12, 2021 TAF
© Copyright 2021 Dennis C. Butler, All Rights Reserved