January 4, 2018

Stock market investors have experienced quite a volatile ride over the last two decades. As measured by the S&P 500 Index, the stock market tripled from 1995 to 2000. The ensuing bear market from 2000 to 2003 saw a decline of about 50%. The market recovered completely from 2003 to 2007 and then fell again almost 60% from 2007 to 2009. The current bull market phase has lasted for over eight years and the S&P 500 Index has risen from 666 to 2640, another increase of 300%. While the markets have been eerily calm over the last year, pushing ahead to new highs, historically-informed investors are anticipating renewed volatility.

"Recent market action has taken on a more speculative tone." 

Why so? Recent market action has taken on a more speculative tone. Individual investors have a rehabilitated appetite for stocks, especially the stocks of technology companies. Stocks are expensive by historical standards, as indicated by the median price-to-sales ratio shown below. How does the current market dynamic compare to the Dot-Com bubble experienced in the later part of the 1990’s bull market? In 1996 our then Central Bank chief, Alan Greenspan, famously asserted that stock market investors were assuming an attitude of “irrational exuberance.” This warning landed upon deaf ears, as the market skyrocketed higher over the next three-plus years. It was a very demanding environment for those of us who were managing client portfolios during that period. While investors’ wealth increased at a fevered pace, we knew the risks of loss were increasing commensurately and required action. The conundrum was what to do with our investments in exceptional companies that were trading at very excessive valuations. Looking back from the current day, we can see that many outstanding franchises (the winners) proved to be sub-par investments over the ensuing period due to the high valuations being accorded in the late 1990’s. Many of the stocks have yet to eclipse or have just recently eclipsed the prices paid during that bubble.

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For the uninitiated, speculative market bursts are a joyful experience where easy money can be made and reputations burnished. The recent parabolic increases in the value of the crypto-currency Bitcoin and leading Chinese technology companies are good examples of just how “easy” it can be to manage money (sarcasm). For more disciplined investors, these speculative phases can cause existential crises, where our faith in investing as a rational enterprise is seriously tested. We find ourselves having to re-examine our foundational principles. A speculative market phase will not provide evidence that a disciplined approach to investment is valid or even worthwhile. We are obliged to look back to market history, spanning both bear and bull markets, to find successful demonstrations of our principles in action.

"As valuations get pushed to extremes in a more speculative phase, investors’ risk tolerances also change materially."

Over the years, in our letters and newsletter articles, we have often reiterated the truism that market volatility is the disciplined investors’ best friend. Amen. However, and quite frankly, upside volatility can be much more difficult to manage through. As valuations get pushed to extremes in a more speculative phase, investors’ risk tolerances also change materially. The fear of loss is replaced by the fear of missing out and envy begins to drive investors to take unnecessary risks. For the uninitiated, the speculative phase will end in a vale of tears. For the disciplined investor, it is the ride up the mountain that proves to be the most challenging stage.

"Bull and bear markets are caused by the interrelationship of two primary factors: business fundamentals and investor sentiment." 

What causes this cyclicality in the stock market? Human nature. Bull and bear markets are caused by the interrelationship of two primary factors: business fundamentals and investor sentiment. In a bull market, business fundamentals are usually healthy and profit growth is strong or at least consistent. As sales and profits grow, confidence in the business cycle increases and investors tend to extrapolate profitable growth trends well into the future. As the market advances, investors can become increasingly focused on the potential for growth, whether sales or profits. In addition to this, investor sentiment (risk tolerance) evolves as well. As profits increase and the trends seem persistent, investors become increasingly willing to pay more for the potential profit stream. Over time, the current level of profitability becomes less significant and future profit potential more so. The stock prices of those companies with the best perceived growth potential become the most popular. In addition, companies whose profit streams appear unassailable (blue chips) become increasingly popular as well. As the bull market progresses, stock prices become divorced from the business fundamentals and the sheer popularity of certain companies attract more and more investment. These stocks’ positive price momentum reinforces the trend and investors' confidence becomes increasingly tied to the price trend rather than the underlying business or the valuation of that business. Modern programmatic trading through the use of algorithms has added a new level of sophistication to momentum strategies. At this point, speculators are essentially just trading pieces of paper with the hope of selling that piece of paper to a greater fool. History shows that investing in these most popular stocks toward the end of a bull market turns out to be a sure path to wealth destruction. 

"History shows that investing in these most popular stocks toward the end of a bull market turns out to be a sure path to wealth destruction." 

Bear markets are the reversal of these trends. In many cases, the speculative advance in the stock market eventually has a negative effect on business fundamentals. Management teams feel increasingly pressured to justify the elevated stock prices of their respective companies and adopt riskier business strategies to drive profit growth. The increasing capital investment or acquisitive growth strategies tend to backfire, as the business cycle has nearly run its course. At this juncture, many companies’ stock prices are radically over-valued and the expectations for growth sadly misplaced. The business cycle turns negative (recession) and profits begin to shrink for many companies. And  just as in the bull market phase, investors tend to extrapolate the (in this case, negative) profit trend well into the future as confidence fades and the level of fear increases. Those companies without significant profits but with perceived growth potential begin to come under more scrutiny. The stocks lose the positive price momentum, which was the primary driver of appreciation to that point. Surprised momentum investors become more and more aware of the illusions on which their speculations subsist. 

Bear markets tend to be shorter-lived as stock prices become quickly aligned with business values, or even trade at a discount to fair value, and more disciplined investors reenter the market. Many of the companies that were bid up on the potential of future profits cease to exist.

We are currently in a bull market phase, and business fundamentals and investor sentiment are both positively aligned. Expectations are high and stock prices are, generally, reflecting the high expectations. Popular stocks, mostly technology companies, with well-established price trends and positive price momentum are leading the stock market higher. Investment strategies that are based on price momentum have been highly successful this year. More disciplined approaches that are based upon value-oriented principles are out of favor. The differential in investment returns of these two contrasting investment styles over the last twelve months are about as extreme as we have experienced since the Dot-Com bubble (see the chart below). Consequently, investment dollars are flowing toward momentum-oriented strategies and the more disciplined, value-oriented strategies are seeing redemptions. For now, these money flows have established a self-reinforcing cycle as is typical in the later stages of a bull market.

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At Clifford Swan we take a rational, disciplined approach to investment. As the stock market moves higher, valuations are extended, and popular stocks with positive price momentum take the floor, we continuously revisit our foundational investing principles. What are these principles? First, we invest for a long-term time horizon and believe that this orientation will help generate excess returns. Our advantage is derived from the argument that, as most investors are so focused on generating short-term returns, we have a better chance to harvest longer-term investment opportunities. In a sense, we are playing a different game, with less competition. Our conservatism is derived, in large part, from the universe of high quality securities in which we concentrate investment. The businesses we invest in are inherently less risky. We define high-quality as those companies that possess a competitive advantage which allows them to earn superior returns on invested capital for sustained time periods. These typically industry-leading companies compete in growing addressable markets with competent managements focused on growing the profits and intrinsic value of the businesses over the long term. These companies’ strong balance sheets and consistent, high levels of profitability allow them to self-finance any attractive growth opportunities. Second, but equally important, we take a valuation-driven approach to security selection. Clifford Swan has developed a specialized competence in assessing credits and pricing assets. We aim to generate excess returns by adhering to our valuation discipline and taking advantage of the shorter-term investment orientation of others. All of our investment decisions, whether to buy, sell or hold a security (common stocks) are made as long-term owners of the respective businesses. We assess risk on a security-by-security basis and attempt to balance risk through investment in a diversified portfolio of securities. Our ultimate goal is to construct portfolios to meet the specific investment objectives of our clients. We maintain an informed perspective toward the financial markets, including the potential risks as well as returns. A secondary goal is to communicate these sometimes complex ideas and circumstances clearly to our clients. 

"In a sense, we are playing a different game, with less competition." 

This disciplined approach allows us to earn competitive investment returns in upward trending markets as the companies that our clients own possess attractive growth characteristics. Importantly, the high quality characteristics of these businesses and the careful, valuation-driven approach to investment results in portfolios that tend to better hold their value in down markets. As the markets trend higher, we tend to lean against the wind somewhat, with an increasing focus on preserving capital. While the markets will again test our faith, we have conviction in the investing principles that have served our clients over the previous market cycles; we will continue to trust in the process.

“You would like to attain faith, and do not know the way; you would like to cure yourself of unbelief, and ask the remedy for it. Learn of those who have been bound like you, and who now stake all their possessions. These are people who know the way which you would follow, and who are cured of an ill of which you would be cured. Follow the way by which they began; by acting as if they believed…” —Blaise Pascal, Pensées, No. 233

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