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January 7, 2021
To the friends and clients of the Harvey Investment Company:
“It is the subject in which nobody knows what one is talking about, nor whether what one is saying is true.” That’s how eminent British philosopher and mathematician Bertrand Russell described mathematical logic. Might not the same be said of stock market gurus trying to explain this year’s exuberant stock market? We will refrain from regurgitating the litany of difficulties the S&P 500 encountered on its way to a 18.4% gain in 2020. Nevertheless, it is fair to say that the notion of punditry as it relates to deciphering stock market behavior was dealt a serious blow in 2020.
We stand by our own explanation for the market’s robustness. Namely, if interest rates hover near zero for a lengthy period of time, human behavior, at least as regards to money, becomes quite bizarre. Recall that the Federal Reserve, in response to the Covid-19 pandemic, created massive liquidity, driving borrowing rates down to levels only seen in panics and wartime. In so doing, the Fed eliminated timing’s role in the consideration of purchasing stocks.
Why? Because timing becomes irrelevant when money can’t be deployed elsewhere profitably. Under such conditions, when an economic recovery occurs or a stock goes up ceases to matter to investors. All that matters is that someday it will. With so little to be gained by prudent waiting, prudence is abandoned. Stocks with values depending on profits expected in the distant future are deemed especially attractive since they are untethered from the dismal existing economy. Level headed analysis becomes, …… let’s just say that, for now, it’s a rather tenuous exercise.
At present, economic conditions are locked in a slow/no growth mode with rock bottom borrowing rates promised for years into the future. Until this construct is broken by some unexpected negative development, high stock valuations are likely to remain the rule. Pockets of reckless speculation have definitely developed and will continue to do so. High quality stocks or those seen building powerful competitive moats are likely to remain favored investments until…well, you name the next crisis.
Turning again to the subject of pundits, we note their propensity to label eras, even brief ones. It is forever one Age or another: the Age of Covid or the Age of Trump or the Digital Age. We consider this era the Age of Irritating Acronyms. Why must we refer to the President as POTUS or the august Supreme Court as SCOTUS or the First Lady as FLOTUS?
Catchy acronyms crop up all over the place. We recently read an article quoting Jamie Dimon, Chairman and CEO of JP Morgan Chase, describing the economic and financial terrain as fubar. Fubar is a military expression meaning “fouled up beyond all recognition.” (Often, however, a different word is substituted for “fouled”).
In financial accounting, abbreviations for long, cumbersome terms have always been employed. For example, the term EBIT stands for earnings before interest and taxes have been paid. It is intended to indicate the earnings a company generates to service its debts. To compare companies’ relative market popularity, analysts historically use net earnings after tax to calculate a multiple derived from the total market capitalization.
Today a relatively new financial term, EBITDA, is widely cited. This stands for Earnings Before Interest, Taxes, Depreciation and Amortization. It has become something of an all-purpose tool used to measure operating effectiveness, financial leverage, and to establish relative market valuations. We are careful with this one, as the amounts expensed for depreciation and amortization can vary widely depending on the scrupulousness of a company’s accounting team. Snap investment inferences using EBITDA can be costly. The point is acronyms and accounting abbreviations are no substitute for hard work and independent judgement.
Still, new acronyms are constantly popping up on Wall Street. FOMO, for example, describes the frenetic rush into certain stocks due to Fear Of Missing Out. Such acronyms are harmless as descriptive vehicles. But they are far from harmless when they become a mindless replacement for critical thinking. This type of mental laziness can be expensive. Take a term currently circulating, TINA. It stands for “there is no alternative.” This simplifies to four letters the argument that, given the plunge in interest rates, stocks are the only investment game worth playing.
Embracing this view relies, dangerously we believe, on embracing GFT---- Greater Fool Theory. The logic supporting GFT is that no matter what price one pays for a stock, an eager new speculator will soon come along and pay more. In short, for some companies, no price is too high to pay. It has been said that if one joins a poker game and can’t spot the sucker in ten minutes, he is the sucker. That’s worth remembering as this bumptious bull market rambles on.
Benjamin Graham opens his marvelous book, The Intelligent Investor, with this epigram from the Aeneid, “Through chances various, through all vicissitudes, we make our way…” And, so it was in 2020. We cannot let this year go down without telling you, our clients, how deeply we appreciate your loyalty and your trust in our approach. They are an invaluable ballast in stormy weather.
Have a great New Year!
Sincerely,Samuel C. Harvey