The investing masses generally are notoriously
short-termed focused. Although the overall stock market notched another
gain this month, stock values are still down roughly -8% from the
January peak, which has caused some investor angst. Despite this
nervousness, stock prices have quadrupled and the bull market has
entered its 10th year after the March 2009 low (S&P 500: 666). Given
this remarkable accomplishment, we can now look back and ask, "Did
investors take advantage of this massive advance?" The short answer is
"No." For the most part, the fearful masses missed the decade-long, U.S.
bull market. We know this dynamic to be true because data regarding
stock ownership has gone down significantly, and hundreds of billions of
dollars have been pulled from U.S. equity funds over the duration. For
instance, Gallup, the survey and analytics company, annually polls the
average percentage of Americans who own stocks and they found ownership
has dropped from 62% of Americans in 2008 to 54% in 2017 (see chart below).
Much of the negativity that has dominated
investor behavior over the last decade can be explained by important
behavioral biases. As I describe in Controlling the Investment Lizard Brain,
evolution created an almond-sized tissue in the prefrontal cortex of
the brain (amygdala), which controls reasoning. Originally, the amygdala
triggered the instinctual survival flight response for lizards to avoid
hungry hawks and humans to flee ferocious lions. In today's modern
society, the probability of getting eaten by a lion is infinitesimal, so
rather than fretting over a potential lion slaughtering, humans now
worry about their finances getting eaten by financial crises, Federal
Reserve interest rate hikes, and/or geopolitical risks.
Even with the spectacular
+300% appreciation in stock values from early 2009, academic research
can help us understand how pessimism can outweigh optimism, even in the
wake of a raging bull market. Consider the important risk aversion
research conducted by Nobel Prize winner Daniel Kahneman and his partner
Amos Tversky (see Pleasure/Pain Principle).
Their research pointed out the pain of losses can be twice as painful
as the pleasure experienced through gains (see diagram below).
Given this backdrop, how can these
gargantuan gains be maintained (or improved upon) when investors are
continually draining money out of riskier stocks and pouring cash into
more conservative bonds? (see Fund Flows Paradox). There are several major factors that can explain the colossal gains in the face of a stock investor exodus:
- Share Buybacks: While investors might not be buying loads of stocks, corporations have purchased trillions of dollars in stocks since the financial crisis. As you can see from the chart below, the table is set for 2018 to be a record year in share buybacks ($842 billion estimate), thanks to record profits and tax legislation that is making it cheaper for corporations to bring back foreign profits abroad.
Source: Marketwatch
- Mergers & Acquisitions (M&A): Record profits, low interest rates, and high cash levels have led to trillions of dollars in U.S. M&A activity (almost $2 trillion in 2017) - see chart below. Not all of this was funded with cash and debt, but suffice it to say, enormous amounts of equity have been removed from the stock market.
Source: IMAA Institute
- Limited IPOs: Certainly, we have seen a few high-profile, stock deals hit the market in the form of initial public offerings (IPOs) over the last year. Some prominent IPOs over the last year, include Dropbox Inc. (NASDAQ:DBX), Spotify Technology (NYSE:SPOT), and Snap Inc. (NYSE:SNAP), however, this limited supply of new deals is a drop in the bucket. As you can see from the chart below, the number of IPOs is significantly below the 1999-2000 peak and the recent added supply pales in comparison to the latest supply-sucking share buybacks and acquisitions.
Source: Statista
Just as
important as these supply related issues are to the stock market,
demand related issues are important as well. While individual U.S.
investors have been scarred by the 2008-2009 financial crisis,
ultimately, over the long run, money does not care about behavioral
biases. Money goes where it is treated best. Theoretically, the best
treatment could be in U.S. stocks or U.S. bonds, or it could be in pork
bellies or the Thai baht currency, among many other asset classes (e.g.,
real estate, commodities, venture capital, Bitcoin, etc.). Much like a
trip to the grocery store, global money flows search for the best deals.
If beef prices spike by +30% and chicken prices drop by -20%, guess
what? Shoppers will now buy more chicken and less beef. Similarly, when
Japanese 10-year bonds are yielding 0.04%, German 10-year bonds 0.56%,
and U.K. 10-year bonds 1.42%, then U.S. 10-year Treasuries with a 2.96%
yield don't look so bad.
More importantly, as it
relates to stock prices, there has been a mass divergence between the
interest rate yields earned on Treasuries and the earnings yield (E/P or
the inverse P/E ratio) since this 10-year bull market began (Ed Yardeni
has a great chart of this Fed Valuation chart).
Stocks, as they are valued today, are effectively providing double the
yield of bonds (roughly a 6% yield vs 3% yield, respectively). As long
as this phenomenon remains intact over the medium term, stocks could
continue to significantly outperform bonds. Eventually, a spike in stock
prices and/or an earnings decline caused by a recession will lower the
earnings yield on stocks, but until then, nervous investors will likely
continue to underperform.
What the almost 10-year
bull market teaches us is that our behavioral shortcomings can be a drag
on performance and stock values, but the economic laws of supply and
demand can play an even more significant role in the direction of the
stock market. Learning how to control your lizard brain (amygdala), and
understand how the pain of losses (risk aversion) can distort decision
making processes can help you more clearly see how record profits (see chart below),
share buybacks, M&A activity, and limited stock issuance (i.e.
IPOs) will impact stock prices. Understanding these lessons will better
prepare the masses in navigating through future bull and bear markets.
Source: FACTSET
This article is an excerpt from a previously released Sidoxia Capital Management complimentary newsletter (May 1, 2018).
DISCLOSURE:
Sidoxia Capital Management (SCM) and some of its clients hold positions
in certain exchange traded funds (ETFs), but at the time of publishing
had no direct position in DBX, SPOT, SNAP, or any other security
referenced in this article. No information accessed through the
Investing Caffeine (IC) website constitutes investment, financial,
legal, tax or other advice nor is to be relied on in making an
investment or other decision. Please read disclosure language on IC Contact page.
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