May 19, 2021

Take yourself back to 2019 when the year was drawing to a close. Imagine being told:

2020 will be the year when our hospitals will be overwhelmed, offices will close indefinitely, scores of workers will be sent home and lose their jobs, and the developed world will be on sporadic lockdown.

Now, imagine also being told that the market would reach all-time highs with household savings reaching record levels.

For most of us, that outcome would have been unfathomable. Yet here we are, coming off a torrid 2020 with the S&P 500 Index ending the year up over 65% off pandemic lows. That momentum has extended well into 2021 with the market up about 10% through mid-May.

It is an incredible turn of events for a market that is now historically expensive on virtually any metric available. Renowned investor Charlie Munger might have said it best at the recent Berkshire Hathaway Annual Meeting in Los Angeles: “If you’re not a little confused by what’s going on, you don’t understand it.”

Like Mr. Munger, we have found ourselves scratching our heads more than once. And any attempt at explaining what’s happened needs to start with the massive economic experiment that we are now living under. Among the major developments:

  • To date, Congress has passed nearly $6 trillion of Covid-related stimulus, dwarfing anything we saw during the 2008 mortgage crisis—an event then considered the most devastating economic event since the Great Depression.
  • The Federal Reserve has created about $4 trillion of money supply as a result of efforts to calm the bond market and help absorb newly issued government debt.
  • Some of the major banks, flush with new cash, have asked their institutional clients to take their deposits elsewhere (who would have ever thought?).
  • The combination of near-zero rates, abundant liquidity, and prophetic narratives about our digital future have supercharged investors’ animal spirits.

Now, well over a year into the pandemic, the real economy is finally catching up to the stock market. The U.S. vaccine rollout has made it safer to socialize, dine out, and travel. Analysts are calling for 7% to 8% U.S. GDP growth in 2021, followed up by a still impressive 4% to 5% in 2022. Corporate executives are all too happy to report that earnings are on the mend. And that’s to say nothing of the new administration’s ambitious infrastructure spending agenda—with a bill numbering in the trillions—being debated in Washington.

Yet, even seeing a domestic expansion in plain sight, it would be a mistake to confidently assume that the market will continue higher. As far back as the data is available, there is actually very little correlation between the market and the economy in the short run1. In fact, if there’s any dependable relationship between the two, it’s that the market and the economy have a history of parting ways, sometimes for long stretches.

"...even seeing a domestic expansion in plain sight, it would be a mistake to confidently assume that the market will continue higher."

Which raises the all-important question: what’s the right course of action in a market that feels overdone but could conceivably head in any direction? How do we attain peace of mind when there’s no playbook for how to behave (massive stimulus heading into an expansion)?

Given the challenge of making near-term market predictions, which has been especially true of these unusual times, we think it best to speak to guiding principles.

We have long advised clients against tactically moving entire portfolios to cash (aside from unique personal circumstances) for the simple fact that corrections are notoriously difficult to time. In fact, the drag on long-term returns from going too soon and too heavily to cash can prove more costly than the downdraft itself.

At the other extreme, we have advised clients against aggressively deploying cash late in a cycle when the fear of missing out may feel overwhelming. There, the reminder is that long-term success is not built upon a short, incredible burst of performance but rather a disciplined plan that produces a lifetime of steady returns.

Durable companies compound value over time, even if the short term is littered with fits and starts. We recommend staying invested in the right businesses (more on this later) while having cash reserves on hand to capitalize on bargains as they appear.

In the face of a sell-off, taking action is undoubtedly difficult. But modern history has shown us that, without exception, we have overcome every crisis so far on our way to fresh new highs. We have also seen that a market dominated by emotion—whether it’s exuberance or panic—eventually reverts back to fundamentals.

This may sound like obvious advice. But rarely have we encountered a market so disconnected from business fundamentals.
Why is this important? Business fundamentals are the most reliable pricing mechanism available to investors, providing a figurative floor if the market goes awry. For a technology upstart lacking an operating history or even a single dollar of profit, a price correction may feel bottomless. For a time-tested company with staying power, that fall may feel more like a speed bump, and better yet, an opportunity to acquire more shares.

What does a durable business look like? We prefer companies that do not have to undergo constant reinvention. Consider the example of a mission critical service provider operating on a subscription model in contrast to a commodity hardware manufacturer needing to “re-earn” business every year against stiff competition. Durable companies tend to also have ample cash and credit available to help withstand industry shocks, which are almost always difficult to time. And once you’ve identified durable businesses, the advantage of owning them is that the best ones not only survive crises but use calamity to widen their lead over the competition.

"...once you’ve identified durable businesses, the advantage of owning them is that the best ones not only survive crises but use calamity to widen their lead over the competition."

To be sure, doing the right thing is often easier in theory than in practice. This will be the case for a market that has been filled with surprises and may bring many more. But remember that as much as markets change and companies come and go, our emotions remain a fixed part of the investment experience.

When faced with the unknown, emotions can hijack the decision-making machinery for many of us who are otherwise pragmatic and patient, prodding us to follow the crowds into mania and also towards the exits. And therein lies the power of guiding principles: to protect us from making lasting decisions based on fleeting factors. In a market that’s broken all the rules, guiding principles can make the difference between veering off course and staying firmly planted in the driver’s seat of our long-term plan.

1. Source: Rekenthaler, John. “The Stock Market Is Not the Economy.” 30 September 2020.

Download Article: A Playbook for Unprecedented Times

The above information is for educational purposes and should not be considered a recommendation or investment advice. Investing in securities can result in loss of capital. Past performance is no guarantee of future performance.

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