Biggest Market Decline Ever?

That’s a title that gets attention and raises blood pressure, and it’s been the lead story for too many news outlets today. The stock market has experienced a lousy few days, without question. But the media talk is misleading, and the recent results warrant reframing. 

Many headlines cited today’s point drop in the Dow Jones Industrial Average, rather than its percentage drop. The Dow fell 1,175 points — a nasty outcome, and its largest point drop ever. But on a more meaningful percentage basis, the Dow was down 4.6% — a hardly comforting result, but only its 108th-largest percentage drop since 1900. That’s far-less-startling than “biggest market decline ever”. 

After today’s drop, the market is down 7% since mid-day Wednesday (1/31) — a terrible three-day run. But a glimpse at the last forty years of global stock market declines is instructive. As Figure 1 below shows, the largest decline within each year (represented by the orange dots) has been at least 12% in more than half of the years since 1979. And in 20 of the last 21 years, global stocks experienced intra-year declines of 7% or more, with 2017 being the sole exception. Interestingly, in most years with significant intra-year declines, the market still ended with a positive calendar-year return.

  Figure 1 — Significant Market Declines Are Common

Figure 1 — Significant Market Declines Are Common

Despite their definitive claims to the contrary, neither journalists nor analysts know why markets rise or fall. Today, counterintuitively, most point to an accelerating economy as the problem. They argue that such momentum could cause central banks to raise interest rates and, in turn, economic growth to slow. Such a view is not new or shocking, so we don’t find it sufficient as an explanation for the market drop.

More likely, a few mildly surprising news items were the proverbial straws that broke the camel’s back. Or maybe the period since the 2016 presidential election was a bit too perfect — with the U.S. market up over 30% in just 15 months, without a single month of market loss. Or maybe, with an even wider view, the period since the bottom of the global financial crisis in March 2009 was finally a bit too much — with the U.S. market up nearly five-fold since, or nearly 20% per year for nine years! But, who really knows. We certainly don’t.

We are not unconcerned, as you know. We worry about demographic trends, productivity woes, corporate-profit margins, stock-market valuations, inflation, the Euro, global debt levels, Chinese growth prospects, artificial intelligence, and asteroid strikes.

But neither our level of concern nor our outlook has changed from two months ago, when the current stock market level was last encountered. The last time around, way back in the first week of December, the current level of stocks was seen with exuberance — global growth was accelerating, tax reductions were to drive corporate profits higher, and tax incentives were to accelerate corporate investment and economic growth. Today, just 40 trading days later, this same level of stocks is seen with panic — economic growth may accelerate, and interest rates may increase. However, at both points, we have maintained the same market outlook for the same market level: 10-year expectations for global stocks well below historical-averages, but still above 10-year expectations of global bonds, which sit near 5,000-year-low yields. 

So, for anyone with a long time horizon, exposure to stocks is warranted, despite the anxieties we have discussed for several years. And since your bonds are liquid and your allocation to stocks is at or below normal levels, you are prepared to take advantage of attractive market levels, should they arrive. At the moment, while we are far from excited about stocks in general, we are aggressively considering several individual stocks that have recently piqued our interest. Stay tuned.

In the meantime, we recommend looking far out on the horizon. It’s calmer out there. 

No-Body

No one has successfully predicted stock-market results over the short term (any period less than a few years). No one. No investment legends from Omaha. No university endowments from Boston. No hedge funds from Greenwich. No prodigies, no sorcerers, no alchemists. No-body.

We have investigated. Lists of wealthiest Americans include no one magically inclined. Lists of top-performing funds show no one mystically gifted. Papers by idealistic academics and research by pragmatic practitioners find no one psychically skilled.

And yet, despite an absence of short-term fortunetellers, short-term forecasts remain prolific. In fact, we cannot find a single financial institution (of size) without a 2018 outlook on offer.

Morgan Stanley says global economies will “skate in sync”. RBC is feeling optimistic but vigilant. T. Rowe Price is simply optimistic. B of A Merrill knows we are toward the end of a bull market, but also knows such periods can provide great returns. Goldman predicts an impressively precise S&P 500 level of 2850. If you search on “stock market prediction 2018”, there are 8.56 million results.

All of these forecasts – all of them – lack evidence of predictive power. But they are also packed with elegant explanation. It is this combination – the futility of the forecasts and the intelligence of the forecasters – that makes one wonder why the forecasts persist.

A Freudian might argue that financial forecasters see in their mirrors market wizards. Most of them would, at least in private, acknowledge the difficulty of short-term market prediction. But (nearly) all of them still see themselves as especially skilled exceptions. After all, they are invariably well pedigreed: Well educated, well employed, well spoken. Some even write books, give speeches, appear on television. A presumption of special powers — by both investors and the forecasters themselves – seems reasonable.

A cynic might argue that financial firms wave their wands to enrich only themselves. Robert Proctor, Professor of the History of Science at Stanford, coined the term “agnogenesis” – the intentional cultivation of ignorance in order to sell a product. Proctor says that some industries and companies – think tobacco and Merck[1] – deliberately foster our confusion to enhance their profits. In the financial industry, the ever-complex, ever-changing clairvoyance of experts invokes much greed and more fear. In turn, billions in trading commissions and fees are generated. Suspicion is hardly unreasonable.

And investors are worried and overwhelmed. In the face of financial anxiety and complexity, the natural inclination is to swallow any plausible potion on offer. Our human brains demand order, and we attempt to satisfy this by relying on the experts.   

But when it comes to short-term market expertise, we find none. Any short-term advice, however mesmerizing, must be avoided, whatever the cause or motive.  It is difficult to acknowledge that the short term is random, but it is dangerous to deny reality.

J.K. Rowling says, in creating a fantasy world, the most important thing to decide is what your characters CAN’T do. In our perfectly un-fantastical world, short-term market results CAN’T be forecast, by anyone.

Instead, we advocate an unwavering focus on the long term. It doesn’t eliminate all worry or complication, and it doesn’t provide certainty. But while we find no evidence of market predictability in the short run, we see all sorts of evidence of solid predictability in the long run. And where one can find predictability, one can find investment success, and calm.

 

[1]Arenson, Karen. " What Organizations Don’t Want to Know Can Hurt." New York Times, August 22, 2006, Business Day

Amazon!

“How Amazon is Dismantling Retail” is a great video. It’s startling, even despite the self-evident trends in the retail sector.

Below are a few U.S. retail and Amazon notes (from the video and elsewhere):

  • The number of malls in the U.S. grew more than twice as fast as the population between 1970 and 2015.
     
  • The number of mall visits in the U.S. was 35 million in 2010. Just three years later, this dropped by more than 50%, to 17 million. It is likely that future mall-visit data will confirm that this trend has continued or even accelerated.
     
  • The combined stock market value of Wal-Mart, Target, Best Buy, Macy’s, Kohl’s, Nordstrom, JC Penney, and Sears is $307 billion. The stock market value of Amazon is $481 billion.
     
  • 49% of American households own a landline. 51% attend church monthly. 52% have an Amazon Prime subscription.
     
  • Amazon plans to open 418 fulfillment centers through 2020, on a base of approximately 50 U.S. centers now. Amazon fulfillment centers will create approximately 40,000 full-time U.S. jobs in 2017.
     
  • Amazon started with books, but its reach has obviously broadened dramatically. It is likely to become the largest apparel retailer in the U.S. this year. (Amazon bought Zappos in 2009.) It delivers random supplies to STUDIO within two hours, with no delivery charge. And there remain lots of retail (and distribution) segments in its path.
     
  • Amazon recently entered the $50 billion aftermarket auto-parts business, competing with AutoZone, O’Reilly’s, Advanced Auto Parts, and Genuine Parts. We always viewed this retailing niche as unusually attractive, due to its combination of retailing and wholesaling. But Amazon has made deals with the largest parts suppliers in the world in recent months, and it is coming!
     
  • We are usually skeptical of any company’s ability to enter an already-competitive space. In the case of Amazon’s entrances into new markets, we tend to be skeptical of the future of the incumbents. Jefferies reports that Amazon is now offering same-day delivery for auto parts in 40 major U.S. cities at prices that average 23% less than the incumbents, despite having entered the market just last year. We predict still more retail space coming available across America soon.
     
  • The even-larger industrial-supply market was newly added to the Amazon menu — beware W.W. Grainger, MSC Industrial, Fastenal, and lots of mom-and-pops. “Amazon Business,” just $1 billion in annual revenue a year ago, is reported to be growing 20% month-on-month. That is, the entire business is 20% larger each month, not each year. 
     
  • Many think of Amazon as only a web retailer, but it also has within it an incredibly valuable technology company. Amazon Web Services (AWS) provides cloud-based storage, networking, and other web services which allow customers to scale their technology more quickly and less expensively than they could on their own. AWS has over one million customers, including Netflix, NASA, and the CIA. AWS generated $3.1 billion in operating profit in 2016 — 75% of the operating profits of the entire company, despite representing just 10% of company revenue. 
     
  • Amazon had $136 billion in revenue, but just $2 billion in net profit, in 2016. However, the company is investing heavily in its business at the moment, preparing its already-enormous operations for a still-much-larger revenue level. If the company were content with its current revenue level, it could operate with a much smaller level of expenses. Under this scenario, we estimate that Amazon’s profits would be at least $10 billion, or five times the current level. This perspective allows a glimpse into Amazon’s long-term profit potential.
     
  • While Amazon’s financial outlook is phenomenal, the market is expecting phenomenal, or more. Amazon’s stock market value is $481 billion, which makes it the fifth most valuable company in the world. The stock trades for 203 times last year’s profit (or earnings) per share. For comparison, the S&P 500 (an index comprised of 500 large American companies) trades at 25 times last year’s earnings, a level well above its historic average. 
     
  • Amazon came public 20 years ago last week. Since its IPO, the stock has increased 65,000%. That is, a $10,000 investment would have become $6.5 million. Over the same period, an investment in the S&P 500 would have become $29,000.
     
  • It’s tempting to see Amazon’s progress as obvious in hindsight. But between 1999 and 2001, Amazon’s shares lost 95% of their value. Even the best investors with the longest horizons would have trouble holding the stock through such a period.
     
  • And despite a 15-fold increase in Amazon’s revenue from 1999 to 2009 ($1.6 billion to $24.5 billion), there was no increase in the Amazon share price over much of the same period. In 1999, the market had some wildly aggressive expectations for lots of companies. It is critical to remember that the market’s expectations for a stock ALWAYS matter, no matter how good the business.

In 1982, Sears was America’s largest retailer. Nine years later, its annual revenue was half of Wal-Mart’s. While we make no parallel prediction for Wal-Mart’s imminent demise, we did sell all our shares earlier this week. We no longer like the risk/reward ratio, mainly due to increases in the numerator, driven by Amazon.

We believe Amazon will be the most valuable company in the world, possibly by a large margin, at some point in the next decade. Unfortunately, the range of outcomes is so wide and the level of expectations so high that, at the current share price, we don’t like the stock as much as the business. We would love to be a shareholder, but, even with Amazon, the price still must be right.