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Chairman’s Message: 2020 Hindsight?

BY
Tom McCullough
Perspective Newsletter

If I had told you in the Fall of 2016 – not even five years ago – that Elon Musk would be the richest man in the world, a global pandemic would virtually shut down the entire world, and a US president would be impeached (for the second time) for inciting an insurrection against his own country’s legislature, you would have questioned my sanity – or at least asked what I was smoking.Despite these and many other system shocks over the last half decade, the stock market seems to be powering through on its way to ‘infinity and beyond’ based on easy money from central banks around the world and recovering economies.

It’s always been said that ‘markets climb a wall of worry’ and that seems to be true again.My experience – and history, of course – tells me that natural consequences and mean reversion tend to correct excesses (in almost all areas of life, actually) over the long term. Unfortunately, these setbacks often come with pain, and there is always the risk that you miss the chance to make changes before it is too late.In his January 5, 2021 article "Waiting for the Last Dance: The Hazards of Asset Allocation in a Late-Stage Major Bubble", GMO founder Jeremy Grantham argues that markets are extremely frothy and on the verge of a drop. He is clearly on the bearish side of the continuum of prognosticators and has been negative for a while -- and is all too familiar with the old saying that ‘the market can often stay irrational longer than the investor can stay solvent.’He exited the Japanese market entirely in 1987 when the market was selling at a very ‘bubbly’ 40x earnings and accounted for 40% of the EAFE index (Europe, Australasia, Far East). Unfortunately for him, the Nikkei index kept going up for another three years to trade at 65x earnings and account for 60% of EAFE, before tumbling and then languishing for over 30 years. It still hasn’t recovered to its 1989-90 peak levels.The current market, he argues, particularly US growth stocks, is similarly in bubble territory.

One poster child, Tesla, has a market capitalization of $600 billion – or $1.25 million per car sold vs. $9,000 per car sold for GM; small retail buyers are back in the stock market with a vengeance, the Buffett indicator (market vs. GDP) is at new highs, and the IPO market is on fire again. The six FAANGM stocks [Facebook, Apple, Amazon, Netflix, Alphabet (Google), Microsoft,] now account for almost 25% of the market capitalization of the S&P 500 index and trade at 40.1x forward earnings vs. 19.8x for all of the other stocks in the index.1Who knows how long this will continue? Even if Tesla turns out to be a great and profitable business over the long term, how long will investors pay 130x earnings, except perhaps to sell it at a higher price to a ‘greater fool’ if the price keeps rising? The one thing we know is that excesses do ultimately get corrected, either by price drops or a long wait for earnings to catch up to the price you paid.As author Morgan Housel explains (in his excellent article, "The Three Sides of Risk" from August 2020), there are three components of risk that investors need to take into consideration:

"The first two are easy to grasp. It’s the third that’s hardest to learn and can often only be learned through experience."2So, what’s a person to do?The very long-term charts show that equities are the far and away best investment vs. bonds and cash. In round numbers, $100 invested in cash in 1926 would be worth about $2,500 today, $17,500 if invested in bonds, and almost $1,000,000 million if invested in equities.3One option is to stay in the equity markets and ride out the ups and downs hoping for a payoff in the very long term. Unfortunately, many people can’t withstand the volatility and end up changing horses at the wrong time.Another idea is to try to catch the market’s ups, but not its downs. In other words, you want to be there for the good times, get out before the bad times come, then get back in again for the inevitable market recovery. All sorts of historical and behavioral evidence suggest that correctly timing the market is very difficult to do successfully, even for the experts.I have found that the best approach is to find ways to soften the ride so you can stay in over the long term. Not all of these strategies are possible or even appropriate for every investor, but they can all help mitigate volatility of participating in equity markets and the risk of not having the funds when you need them.

No one has a crystal ball, so it is important to make sure you are focusing on the things you can control, both to participate in good markets and protect yourself from bad ones.

1 https://www.yardeni.com/pub/faangms.pdf

2 https://www.collaborativefund.com/blog/the-three-sides-of-risk/3 http://www.nylinvestments.com/polos/NYLIM_Chart_Ibbotson_SBBI_2019.pdf (Includes dividend re-investment)

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Tom McCullough

Tom McCullough is co-founder, chairman and CEO of Northwood Family Office. He is a frequent speaker on issues relevant to families of wealth and is the co-author of three books — Wealth of Wisdom: The Top 50 Questions Wealthy Families Ask, Wealth of Wisdom: Top Practices for Wealthy Families and Their Advisors, and Family Wealth Management: 7 Imperatives for Successful Investing. He is an adjunct professor and executive-in-residence at the University of Toronto’s Rotman School of Management, a member of the Editorial Board of the Journal of Wealth Management, and a member of the board and faculty of the Ultra High Net Worth Institute. He was awarded ‘Best Individual Contribution to Thought Leadership in the Wealth Management Industry (North America)’ at the 2020 Family Wealth Report Awards.

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