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I rarely find myself in a state of equilibrium. I’m either talking people up or bringing them down. When markets are weak and the tone is dismal, I’m reminding clients and readers that long-term returns will be higher – it’s a good time to invest. When things are going well and investors are euphoric, I’m dialling down oversized optimism.
Market extremes, when expectations are unrealistically bullish or bearish, are when the biggest mistakes are made. I’m not talking about buying a stock that doesn’t work out or a fund that underperforms, but rather crippling errors such as getting caught up in the news and diverging from your long-term plan. Going to cash because of what’s happening in Washington or chasing a theme to the point of being undiversified. Strategies that, if wrong, set you back years in terms of achieving your long-term goals.
Tom Bradley: A smart motto for investors in this sped-up world: Slow down
Today’s landscape is unusual in that I find myself playing both roles. For long-term investors who are freaked out about the state of the world, I’m reminding them of the positive factors (as I did in a recent column) and the benefits of owning a variety of companies from different industries and regions.
And then there is the other end of the spectrum: investors who are caught up in the speculative fervour. Those who are running hot and in need of a cold shower. I say that because animal spirits are running high. There are many indications that speculation and risk-taking are at extremes.
Head-scratchers
For instance, meme stocks are back. These heavily shorted stocks are rocketing higher even though company fundamentals are weak. In 2021, it was GameStop Corp. GME-N and AMC Entertainment Holdings Inc. AMC-N leading the way. This time around, it’s GoPro Inc. GPRO-Q and Kohls Corp. KSS-N
Special purpose acquisition companies are back in vogue. SPACs, which were also popular in 2021, are a type of initial public offering in which a well-known business or investment person is given a blank cheque to go out and make an acquisition. SPAC issuance is occurring despite a history of abysmal returns and an incentive structure that’s stacked heavily in the sponsors’ favour.
At Robinhood, a popular U.S. discount broker, options and crypto trading made up 84 per cent of transaction-based revenues in the first quarter. Yes, you read that right: 84 per cent. Stocks accounted for just 10 per cent.
What makes a meme stock? Online enthusiasm for a beaten down company with doubtful prospects
As for cryptocurrencies, people are making money with the rise of Bitcoin, but the risks in the digital ecosystem are also rising. There’s been a surge of companies abandoning their core business and becoming Bitcoin proxies (Strategy Inc., formerly known as MicroStrategy, is the model). This tactic has pumped up their stock prices because investors are valuing the Bitcoin holdings at double the market price. And if you find this perplexing, stay tuned because investment bankers are feverishly looking for other assets that might trade at a premium when held in a public vehicle.
As my former partner, Bob Hager, told me years ago, when something doesn’t seem to make sense, it usually doesn’t. These premiums will inevitably disappear and go to discounts, and for companies that are highly leveraged, the ride for shareholders will be painful.
No profits, no worries
As I’ve noted before, the hot sectors in the stock market are the ones that are unburdened by earnings expectations and price-to-earnings ratios. They don’t yet have earnings to value. Companies linked to crypto and artificial intelligence are being driven more by investor optimism than business fundamentals. A Goldman Sachs index of unprofitable tech companies is up more than 50 per cent since April 8 – its highest level since 2022 (a year when it halved in price).
For stocks that already have a P/E ratio, there are bargains to be found, but most risk assets are expensive relative to their history. Stock markets have been driven as much by rising P/E’s as expanding profits and dividends.
Similarly, corporate bond yields are low relative to more secure government issues. The extra yield they offer, called a spread, is the reward for accepting a higher chance of default. Today, the reward is near an all-time low across the risk spectrum (from investment-grade bonds to high-yield bonds and private loans).
Look in the mirror
With everything going so well, it’s a good time to ask yourself: Are you being greedy like investors around you, or are you using this time as a cue to be more cautious, like Warren Buffett counsels? Are you far off the plan you (and your adviser) laid out a few years ago? Are you taking more risk today than ever and using more leverage? Are you no longer well diversified? And if you’re wrong about a strategy or theme, will it wipe out years of returns?
If the answer to those questions is no, then stick to what you’re doing and remember the old adage “Markets climb a wall of worry.”
If you answered yes to some or all of those questions, you may be operating without a net. It’s time to hit the shower and turn on the cold water.
Tom Bradley is a portfolio manager with Purpose Investments, co-founder of Steadyhand Investment Management, a member of the Investment Industry Hall of Fame and a champion of timeless investment principles.