Morningstar Views: What to Do When the Market is Manic


Why doing a whole lot of nothing might be the ultimate contrarian approach.
By Ben Johnson, CFA.

On January 1, 2021, GameStop (GME) was a struggling brick-and-mortar retailer, trying to adapt an antiquated model to a world that’s been living online for much of the past year, and to serve customers who are consuming more Internet bandwidth and fewer video game cartridges. The company had lost money each of the past two years and was being pressured by investors–including Michael Burry of “The Big Short” fame–to get its act together.

Over the next few weeks, the company’s stock price spiked 2,484%, and it has subsequently plummeted nearly 90% from its January 28 intraday high of $483 per share. The story of what was briefly the world’s favourite “meme stock” has been spun every which way by the media. It was even fodder for a Saturday Night Live skit. It made for good theatre, but what are investors to make of this drama?

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There’s Nothing New Under the Sun

First, a history lesson is in order. What happened with GameStop and all the other stocks swept up in this nonsense (I have to admit that I didn’t know Tootsie Roll Industries (TR) was a public firm until I saw it on a short list of the market’s biggest daily gainers) has happened before, and it will happen again. GameStop has been added to a long list of short squeezes throughout history. Stocks with a large amount of short interest (the percentage of the companies’ shares that are being sold short by investors betting against it) are ripe for a squeeze. If these stocks’ prices rise, it puts pressure on short-sellers. As the stock price goes higher, shorts’ losses mount. Once the bears begin to cry uncle and buy back the stock to cover their short positions, their exodus pushes prices higher still. Short squeezes are at least as old as markets. Northern Pacific Railway (1901), Piggly Wiggly (1923), and Volkswagen (2008) are just a few examples of historical short squeezes.

While short squeezes aren’t anything new, in the case of GameStop, the actors and methods were uniquely modern. In this instance, a contingent of vocal GameStop bears were forced out of their short positions by a merry band of self-described “degenerates.” The latter group’s base of operations was the social media platform Reddit, specifically the “WallStreetBets” community. They used this platform to rally together and squeeze out the shorts—and it worked. But the gains were short-lived. After the shorts headed for the hills, the ragtag group turned on itself and ultimately disbanded. GameStop’s share price crashed.

Why Don’t Trees Grow to the Sky?

One theory as to why trees don’t grow to the sky suggests that gravity is the limiting factor. The taller trees grow, the harder they have to work to overcome gravity to pull water through their roots and distribute it to their extremities. Gravity has a similar effect in stock markets, though it goes by another name: fundamentals. Economic growth, earnings growth, inflation–these are the fundamental forces that shape markets. Markets will often defy fundamentals during shorter time frames, but over the long term there is no escaping them.

No amount of fervour from a swarming horde of “degenerates” would have been enough to push GameStop’s share price to escape velocity. While its stock has since come back to Earth, this episode is–in my opinion–symptomatic of a market that has likely decoupled from fundamentals, for now.

Exhibit 2 plots the cyclically adjusted total return price/earnings, or CAPE, ratio for U.S. stocks and long-term interest rates going back to 1881. Measured by CAPE, stock valuations have rarely been more stretched. Only at the height of the tech bubble and shortly before the 1929 market crash did the CAPE ratio register higher than its February 2021 reading. Looking at U.S. stocks through the lens of Morningstar’s price/fair value estimate yields a similar result. As of Feb. 8, Vanguard Total Stock Market ETF (VTI) was trading at a price/fair value ratio of 1.09, indicating that U.S. stocks were trading about 9% above what they’re worth.

Meanwhile, interest rates have never been lower. Though they’ve ticked up recently, 10-year Treasury yields were a measly 1.18% as of Feb. 9. Accounting for inflation, yields on government bonds are firmly negative.

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What’s an Investor to Do?

I think the market is in the middle of a manic episode. I see anecdotal evidence to support this everywhere I look: the hoopla about meme stocks, the boom in special purpose acquisition companies (or SPACs, the so-called blank-check companies), Tesla (TSLA) buying bitcoin, teenagers dispensing financial advice on TikTok, and more. But I think the strongest evidence is the growing chorus singing a familiar tune: “This time is different.” The fact of the matter is that it’s never different. Historically high stock valuations and historically low bond yields aren’t fertile ground for future growth. So, what is an investor to do?

Everyone knows the classic Warren Buffett-ism about being greedy when others are fearful and fearful when they’re greedy. I love the symmetry of this saying. It is the contrarian investor’s playbook distilled down to its essence.

Over the past year, investors had the opportunity to be both greedy and fearful. Greed might have done many investors some good in early 2020, when fears surrounding the global pandemic surged and markets plummeted. But it was a brief scare–at least for markets. In fact, it was the shortest bear market in history. One year later, as some people are still living under lockdown, many markets are at all-time highs. Now may be the time to be a bit fearful.

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I don’t think investors should try to time the market and call a top. I do suggest that now is a good time to take a close look at your portfolio and ask some simple questions. Are you comfortable with your asset allocation? After markets bounced back, stocks might represent a bigger piece of your portfolio. This might be an opportune time to rebalance. Have low yields pushed you into risky sectors of the bond market in search of income? With junk-bond yields recently touching all-time lows, I am sceptical that investors are being paid enough to take risks in that corner of the bond market, among others. It might be time to de-risk your fixed-income allocation, especially as credit risk tends to be positively correlated to equity risk and can diminish the diversification potential of your fixed-income allocation.

Once you’ve reacquainted yourself with your portfolio and gotten comfortable with your asset allocations, your best bet is probably to walk away from it for a while. Late Vanguard founder Jack Bogle said, “The stock market is a giant distraction from the business of investing.” These words have never rung truer. In recent weeks the stock market has been a major distraction. Its movements have been influenced by newly minted retail investors, who themselves are looking for a distraction after months of leading virtual lives. The platforms they’re using to engage with each other are themselves distractions. And they make use of these platforms on the world’s best-ever distraction device–the supercomputer phones we carry around in our pockets every day. If there’s ever been a moment to tune out all this noise and drop these distractions, I’d argue it is right now. If markets’ performance over the past year has taught us anything, it’s that inaction is often the best course of action.

If none of my suggestions seem exciting, that’s because they aren’t. For most of us, successful long-term investing is painfully boring, like watching paint dry and grass grow at the same time. But doing a whole lot of nothing might be the ultimate contrarian approach in a market that’s gone manic.

 


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Liontrust Insights: Building trust through integrity

By Harriett Parker, Partner, Investment Manager at Liontrust Asset Management

 

A ‘do no harm’ approach is always our aim as sustainable investors. But sometimes even the best managed companies make mistakes. How fund managers respond to these mistakes can give a good insight into the integrity of their investment processes. 

A core component of our role is to understand what best practice looks like and specifically what it does not look like when it comes to sustainability.  I’m sure most fund managers that run ESG or sustainability focused strategies at least mildly enjoy calling out corporate greenwash when they see it. But there is often a collective wince on our team when we hear a company begin a meeting by describing itself as having ‘sustainability in its DNA’. Such misappropriation of biological terminology can be somewhat forgiven, however, when it is backed up by hard data and accompanied by steady performance and progress on ESG impacts.  Asking the right questions and taking time to understand a business in its entirety helps to identify signals that indicate genuine integrity, and experienced fund managers will come to know over time whether sustainability is truly integrated.

Monitoring and engagement are an essential part of active stewardship, irrespective of whether funds are ESG or sustainability focused, although the bar will obviously be set that much higher for such strategies. While fund managers all have their own interpretations of what makes a portfolio sustainable, none can promise perfection; all companies continually make choices that balance the needs of many stakeholders, and, occasionally, even great businesses with the best of intentions, policies, governance and culture make mistakes.

When a company does find itself the subject of such shortcomings, the first response should be to analyse the facts.  Selling positions in companies as a knee-jerk response to a controversy is not the best course of action because it is through engagement that investors can help to ensure mistakes are resolved and prevented from happening again.

Responsible fund managers will look for a clear initial response from the company that includes details of the issue in question and the process for any internal or third-party investigations. This can take time, which can be used to go beyond the company line and any media hype; hearing views from other stakeholders and gathering wider perspectives can be critical to understanding the issue.

At the end of this process, we need to see a company take responsibility for any failings, along with swift, corrective action, to be confident that harm will not be repeated. The type of controversy, focusing on the severity as well as the likelihood for change, is key; issues concerning culture, for example, can be hard to rectify quickly. Being clear about what we need to see from a company in response to a mistake so we can continue to back them, as well as what would prompt us either to reduce the position or divest completely, assists engagement. 

The decision of whether to divest from a company subject to a controversy should come down to the lines already drawn by a fund manager’s investment process, such as where a company no longer adheres to stated investment criteria or the issue is material so that the initial investment thesis no longer stacks up. 

Clients might use these situations to assess the integrity of a fund manager’s investment process, checking how a company made it into funds and whether specific failings could have been predicted. Such events might also highlight the resilience of processes for escalating engagement, the extent to which fund managers leverage their stewardship position, and whether they are genuinely committed to fostering fundamental change with engagement informing investment decisions. 

Honest communication from fund managers to clients when these issues arise is also important and can help to build long-term trust. Fund managers with greater transparency, and who  explain the outcomes of engagement and the resulting investment decisions, would seem to warrant greater trust.  Investment teams who are open about where they might have got things wrong themselves, and are willing to learn from and improve their engagement, signal best practice: like the companies in which we invest, we are only human after all. No one has perfect foresight, so explaining how companies continue to deserve their place in sustainable funds, and how fund managers process and react to emerging controversies, is an important aspect of ‘being the change’, especially as interest and flows into sustainable strategies continue to grow. 

 


Liontrust Key risks and Disclaimers

Past performance is not a guide to future performance. Do remember that the value of an investment and the income generated from them can fall as well as rise and is not guaranteed, therefore, you may not get back the amount originally invested and potentially risk total loss of capital. The majority of the Liontrust Sustainable Future Funds have holdings which are denominated in currencies other than Sterling and may be affected by movements in exchange rates. Some of these funds invest in emerging markets which may involve a higher element of risk due to less well-regulated markets and political and economic instability. Consequently the value of an investment may rise or fall in line with the exchange rates. Liontrust UK Ethical Fund, Liontrust SF European Growth Fund and Liontrust SF UK Growth Fund invest geographically in a narrow range and has a concentrated portfolio of securities, there is an increased risk of volatility which may result in frequent rises and falls in the Fund’s share price. Liontrust SF Managed Fund, Liontrust SF Corporate Bond Fund, Liontrust SF Cautious Managed Fund, Liontrust SF Defensive Managed Fund and Liontrust Monthly Income Bond Fund invest in bonds and other fixed-interest securities – fluctuations in interest rates are likely to affect the value of these financial instruments. If long-term interest rates rise, the value of your shares is likely to fall. If you need to access your money quickly it is possible that, in difficult market conditions, it could be hard to sell holdings in corporate bond funds. This is because there is low trading activity in the markets for many of the bonds held by these funds. Mentioned above five funds can also invest in derivatives. Derivatives are used to protect against currencies, credit and interests rates move or for investment purposes. There is a risk that losses could be made on derivative positions or that the counterparties could fail to complete on transactions.

The information and opinions provided should not be construed as advice for investment in any product or security mentioned, an offer to buy or sell units/shares of Funds mentioned, or a solicitation to purchase securities in any company or investment product. Always research your own investments and (if you are not a professional or a financial adviser) consult suitability with a regulated financial adviser before investing.

Issued by Liontrust Fund Partners LLP (2 Savoy Court, London WC2R 0EZ), authorised and regulated in the UK by the Financial Conduct Authority (FRN 518165) to undertake regulated investment business.


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The financial instruments discussed in the document may not be suitable for all investors and investors must make their own informed decisions and seek their own advice regarding the appropriateness of investing in financial instruments or implementing strategies discussed herein.

If you invest in this product you may lose some or all of the money you invest. The value of your investment may go down as well as up. A commission or sales fee may be charged at the time of the initial purchase for an investment and may be deducted from the invested amount therefore lowering the size of your investment. Any income you get from this investment may go down as well as up. This product may be affected by changes in currency exchange rate movements thereby affecting your investment return therefrom. The performance figures quoted refer to the past and past performance is not a guarantee of future performance or a reliable guide to future performance. Any decision to invest should always be based upon the details contained in the Prospectus and Key Investor Information Document (KIID), which may be obtained from MeDirect Bank (Malta) plc.

 

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