Against the constant barrage of tech stock news, the word “bubble” is often tossed around with recklessness. When you are in a financial euphoria episode, like the one we are currently experiencing with tech stocks, it is hard to visualize the impact it has when it breaks (or bursts). Everyone is confident they’ll know when it’s time to sell a soaring stock like Amazon or Tesla; but getting out before the crash is much harder than it looks. The intoxicating euphoria can go on longer than most investors can resist. People buying “bubble assets” will make money until they don’t. Hedgeye, Cartoon of the day June 5, 2018Most investors do not have a sell discipline – where they set a fixed exit strategy based on price or gain that they are “happy with” in order to say, “OK, enough already, I’m going to get out”. Without such a plan (and sticking to it) these investors are destined to get caught-up in the roller-coaster riding it all the way up and all the way down.The concern of a bubble comes after a stellar run for technology stocks this year, with the Nasdaq setting more than 25 record highs in 2020 (as of August 1, 2020), speculative trading sending the likes of bankruptcy stocks (i.e. Hertz) soaring and shares of Tesla surging nearly 300%. Comparisons of elements of 2020 to the dot-com days have grown louder. The concern is that today will end catastrophically as it did then, with a bubble eventually bursting, burning those who have enjoyed the historic rebound from the depths of the coronavirus bear-market. Some argue that unlike the dot-com crash where the tech darlings were unproven internet companies without a track record of success or the earnings to back up their lofty valuations, the tech companies today (i.e. Amazon, FaceBook, Apple, Netflix) are some of the most profitable companies in history. There is no argument that there are differences today versus the dot-com days, but looking at the big picture it is also very similar. Let’s look at Tesla as an example; from a market valuation, the electric-vehicle maker is now worth more than the entire U.S. auto industry combined (excluding Tesla) and is valued at more than twice the value of Toyota[i]. To justify this valuation, Tesla’s revenues would have to be comparable to sales of all those companies combined - a scenario that’s possible, but more than likely not plausible.Hedgeye, Cartoon of the day June 7, 2018Everyone is a genius in a bull market. If you have never been through the unwinding of financial euphoria before, there is no clear warning signal. It is not possible to time when a bubble starts or will end. The dot-come bubble lasted for several years, with the NASDAQ growing more than 500% from 1995 until the bubble burst in March 2000[ii]. A bubble is only classified as a bubble after the fact. And when it breaks it is like “a thief in the night.” Warren Buffett compares an asset bubble to Cinderella’s Ball, but in the case of the markets there are no clocks on the wall to tell you it is midnight. Remember, when it does hit midnight “everything turns to pumpkins and mice!” and it sure feels like the clock is about to strike midnight.We understand the temptation. We really do. You can only hear about your friends doubling or tripling their money for so long before you get sucked. If you want to take a small amount of money to have some fun and gamble, go for it – treat it as your “Vegas money”. If you’re lucky enough to hit your number on the roulette wheel, you beat the odds. However, this is not an investment strategy and more importantly this is probably not a risk you should be taking to preserve your family’s nest egg. You are not gambling; you are investing for a better future. This might end badly, but the best way to make sure you don’t lose is by playing a different game. Building wealth slowly over time is a reasonable objective - and often boring – which is what we like. Trying to get rich quick is the opposite. What do investors do now?As we have said countless times before, we firmly believe that long-term success in investing is about owning diversified quality investments at reasonable valuations, however, it is important to recognize that this does not always translate into success over the short-term. When markets returns are led by a very few concentrated group of stocks (i.e. FAANG), a diversified portfolio can sometimes lag. No better example than in the past year, where being in the right part of the stock market was critical and owing large-cap technology stocks (particularly in the U.S.) was key to finding success so far this year.From a geographical perspective, the U.S. has been the engine driving world stock market returns over the last year. Looking back from June 30 over the 12 preceding months, the U.S. stocks in the MSCI World Index delivered a return of 13.24%[iii] (all returns in Canadian dollars). This was not a world-beating return. Among developed countries, several others had higher returns; however, because the U.S. represented 64% of the MSCI World Index by market capitalization, U.S. stock returns were the biggest driver of the index’s overall return. If we look at the results in terms of contribution, multiplying the returns of countries by their average weight in the index over the 12 months, we get the following results: Source: FactSet (CDN Dollars) In other words, pretty much all the returns in world stocks last year came from owning U.S. companies. Collectively, stocks in the rest of the world were a drag on stock returns globally. This is not to say that there were not individual stocks that did well outside the U.S., but on average, non-U.S. companies contributed negatively to the return of the world stock index. Top 10 Contributors of the MSCI World Index as at June 30, 2020[iv] Stock Contribution to return (%) 12 Month Return (%) Apple Inc. 2.03 94 Microsoft Corporation 1.50 60 Amazon.com Inc. 1.13 52 Alphabet Inc. Class C 0.35 36 Alphabet Inc. Class A 0.31 37 NVIDIA Corporation 0.30 142 Telsa Inc. 0.29 404 Intel Corporation 0.28 33 Facebook Inc. Class A 0.22 23 ASML Holding N.V. 0.19 85 The above data displays just how heavily technology stocks contribute to global stock market returns. On the positive side, by way of diversification our clients with allocations to equity in their portfolios are invested in several of the top contributors, and these have had a positive impact on returns. With that said, the markets apparent fixation on technology and growth should be approached with caution as It appears that the market is underappreciating many strong businesses that from a valuation perspective look very attractive for long-term success. The biggest mistake investors make is that they tend to believe that when it comes to judging the performance of an investment strategy three years is a long time, five years is a very long time, and 10 years is an eternity. That belief leads them to ignore long-term evidence and abandon well-thought-out Financial Plans in order to chase performance. The result is that they end up buying high (after periods of outperformance) and selling low (after periods of poor performance). As we all know “buying high and selling low” is not a prescription for success. Yet, it is the path so many investors follow as they fail to pay attention to the lessons that history provides. The chart below demonstrates that while most think 10 years is an eternity, tell that to those invested in large-cap growth in 1999 – where after the dot-com crash growth stocks took almost 16 years to reach the levels of 1999. If we can expand our time horizon and look back at history, we have seen this movie before. To paraphrase Spanish philosopher Santayana: "Those who don't know their investment history are condemned to repeat it. Source: Bloomberg, WisdonTree, Dec 31, 1989-May 7, 2020. In USD We do not and will not make market calls. However, in light of the current circumstances we think it is important to emphasis what is going on in the markets to ensure investors do not lose focus. We cannot abandon sound and successfully tested logic, even if it may mean foregoing large (and apparently easy) gains, as this “strategy” could possibly lead to substantial and permanent losses. As many of our clients already know and as simple as it sounds, the best course of action an investor can take to protect their portfolios is to diversify. Reduce your exposure to “bubble assets” and resist chasing the best performing stock or fund. Rather, look to add exposure to “anti-bubbles”, where assets or markets offer value and asset prices are not egregiously above historical norms. Finally, we must be patient. Bubbles typically continue longer than expected, until they suddenly pop. [i] CNBC, July 1, 2020.[ii] CNBC, July 20, 2020.[iii] FactSet[iv] FactSet. In CDN Dollars
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Tony De Thomasis, BSc, CFP®
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