Valuation, Not Stories, Ultimately Determines Investment Returns
- Richard Bernstein, CEO of Richard Bernstein Advisors (RBA) wrote an excellent article in the Financial Times this week with the title above. We can’t reproduce that article, but we found a more detailed RBA report that we’ll summarize here. If you are interested, we recommend the full report which can be found in the links in the next section.
- A fundamental rule of investing is that returns are highest when capital is scarce. In the long run, the supply and demand of capital will be the primary determinant of investors’ returns.
- Bubbles form when capital is abundant and is therefore misallocated. RBA identifies the anatomy of a bubble in the following graphic.
- US monetary growth, which has been on a historic run since the pandemic began, has generated tremendous liquidity of capital in the financial system, driving interest rates lower which in turn provides weak incentives for financial institutions to lend. The result is that this excess capital has been trapped within financial system and supported bubbles. Bubbles then grow based primarily on hype. Bernstein states: “Investors become very myopic during bubbles, and believe there is little in which to invest other than the bubble assets.” But history shows that valuation, not hype, determine investment returns.
- Although we have been taught these lessons before, as in the tech bubble of the late 1990’s, investors seem to have forgotten. During the tech bubble, innovation and disruptive technology themes dominated, and the promise of that period largely became reality. However, valuations were so high that if one bought the Nasdaq Index in December 1999, it took nearly 14 years to break even despite the widespread adoption of the technologies of the era.
- Bubbles create real economic damage because the financial markets grossly misallocate capital when bubbles exist. Too much capital flows into the bubble, but the rest of the economy is starved for capital on a relative basis. We believe the current global energy crisis is a prime example.
- Bernstein states that this misallocation of capital is reflected in sector performance over the past several years. Since the end of 2018, only three of the 11 global sectors have outperformed the MSCI All Country World Index: Technology, Communication Services (dominated by Facebook and Google) and Consumer Discretionary (dominated by Amazon and Tesla). This narrow performance suggests that opportunities are abundant in other sectors.
To Everything There is a Season
- Don’t let the temporary deal to extend the debt ceiling fool you. The deal on the debt ceiling will only last a few short months as Congress will have to re-address the issue by early December (current estimate is Dec. 3). By all appearances we will face another self-induced crisis around Thanksgiving.
- The extension of the debt ceiling allows the Democrats a short period to pursue the infrastructure and Build, Back, Better (BBB) legislation. The current thinking is that the $3.5 trillion price tag for BBB will have to be reduced.
- The key question is precisely how that will be done. Progressives do not want to eliminate anything and that could lead to a scenario where the full plan is laid on the table, but for a limited period of time, which of course, would reduce the price.
- That strategy is designed to force Congress to not renew the presumably popular programs at that time. That will be difficult to do, especially if timed to an election cycle.
- This could actually accelerate spending into an economy that is ill-equipped to handle it. The global economy, including the U.S., is spending at a level well above pre-pandemic levels. At the same time, production capacity is still restricted by the pandemic. This has created supply chain disruptions and numerous shortages. Any accelerant to spending could exacerbate that situation and make inflation a worsening problem. Inflation, of course, would hurt the little guy much more than the wealthy, and work against everything the Democrats are trying to achieve. This may not be the season for more spending.
What is the Fed Thinking?
- The poor employment headline on Friday could lead some to believe that the odds of the Fed tapering bond purchases sooner rather than later are diminished. But a closer look at the report indicates that the bulk of the shortfall was government workers, more specifically, teachers. Private payrolls increased by 317,00, which is pretty good number and leisure and hospitality added some 74,000 jobs. In addition, prior jobs data was revised upward. In short, the jobs data was not nearly as bad as the headline number suggested. We suspect the taper (Fed reducing bond purchases) remains on schedule.
- Ironically, a taper might be just what we need to dampen demand a bit (i.e. promote slower growth) and give the supply chain a chance to catch up.
What We’re Reading
Anatomy of a Bubble (Bernstein)
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All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such.Bubble, Congress, Debt Ceiling, Federal Reserve, Infrastructure, Interest Rates, Investment Return, Liquidity, Richard Bernstein, Tapering, Weekly Commentary