You know that adage, “stocks are sold, not bought”? What often drives stocks are simple, plausible stories. In fact, Nobel-winning economist Robert Shiller has made the case for how both financial markets and economies are heavily influenced by stories.
Investors often call these stories their “investment thesis.” We at Motif like to call them themes, ideas, trends, or motifs. We believe it is far more intuitive for investors to think this way rather than the traditional investment “style boxes” used by mutual funds or risk premium “factors” favored by academics. For example, “small cap value,” which combines academia’s two favorite factors into a mutual fund style box, doesn’t resonate with most investors.
While our themes at Motif are usually about relatively small groups of stocks, the market as a whole also needs good stories that are simple yet plausible to advance. Since markets are fueled by such stories, it is important to try to understand and articulate them if you want to try to stay ahead of the market.
The driving power of narratives
If you can’t explain your investment story very simply in just a sentence or two, it probably isn’t a very good story. Put another way, this is known as start-ups’ “elevator pitch” in the venture capital world. As for plausibility, the investment story may not necessarily turn out to be true, at least in the longer run. The thesis only needs to be widely credible in the shorter run by having some basis in reality.
For example, the market’s belief in the power of the Fed’s experiments with ultra-low interest rates and quantitative easing (QE) helped drive the S&P 500 much higher from 2010 to 2014, though those policies may ultimately prove disastrous in the long run, as market bears believe.
Right now, no one, including the Fed, knows the long-term impact of these actions. But much to the chagrin of market bears, until a bear market disaster finally hits, financial markets can and do move significantly higher than one may expect based on pure fundamentals, such as earnings growth, cash flows, price-earnings ratios, credit spreads, and yield curves.
For bears, “being early is the same as being wrong.” Conversely for bulls, the risk is overstaying their welcome too long, to keep on dancing even when the speculative music has stopped. The trick, and why market timing is so notoriously difficult, is guessing when to stop dancing before all the bulls attempt to stampede through the exits with very limited liquidity at the same time. Or in buying risk insurance before that happens, because you don’t know when it will.
Simple stories that dominated previous two bull markets
Shown below is the well-known Callan Periodic Table of Investment Returns, produced annually by Callan Associates.
Click to enlarge
Callan Periodic Tables of Investment Returns shows annual returns for key indices ranked in order of performance (1996-2015)
At first glance, there seems to be little order to the colorful chart, which is why this chart is usually used by investment professionals to try to make the point that asset class diversification is very important. But if you look closer, you will see the exact opposite to be true, that there is order and just a few key asset classes dominate during bull markets.
The most obvious example on this chart is that in the 2003-07 bull market, emerging markets (EEM) held sway each year. The simple, plausible story that propelled markets to new heights was the seemingly huge upside potential of the newly marketed BRICs, most especially China after its entering the WTO in 2001.
The other asset class that fueled the market before the Great Recession is surfaced by Prudential’s periodic chart in which the no.1 spot from 2004 to 2006 was held by global real estate. In the U.S. the simple story was that residential real estate prices could never see a sharp nationwide decline.
Obviously that fantasy bubble burst in 2007, when reality about sub-prime loans finally started to intercede, with hugely disastrous consequences in the equity and credit markets, taking with it the real economy in 2008.
In the prior tech bubble bull market, between 1996 to 1998 the S&P Growth index held the no.1 spot before dropping to third place in 1999, according to the Callan chart. The more technology heavy Nasdaq or Nasdaq 100 indices were not on the chart, otherwise they probably would have held the top spots each year during the tech bubble from 1996 to 1999.
The widely believed story back then was the seemingly unlimited upside potential of the Internet. The Internet has been one of the greatest inventions in history, but nothing grows to the sky in a straight line, so that fantasy bubble burst in 2000 when it dawned on investors that eyeballs can’t trump earnings and cash flows.
Memo to central bankers: bubbles do exist
A key point to be made about both of these previous bull markets is that the narratives that drove them were obvious and popularized–they had to be, in order to drive the market to such frothy, overvalued levels. You literally could read about the tech, real estate and emerging market bubbles every day in the financial media for years before they burst. Yet U.S. Fed Chairs Greenspan and Bernanke wouldn’t admit to them in public even though they strongly enabled them with their very easy monetary policies.
The bubbles in the bull market that began in March 2009 may seem less clear or dramatic than in the previous two bull markets. China’s real estate and excess industrial capacity, junk bonds, U.S. large cap stocks, private technology start-ups (unicorns), global debt especially in China, Japan and emerging markets, central bank assets, certain high-end real estate markets are all contenders for the bubble of this bull market, and the answer could be any and all of these and more. In any case, they are all ultimately driven by the incredibly easy policies of key central banks.
What is clear is that since the beginning of 2010, the S&P 500 has outperformed international stocks. According to the Callan chart, for the years between 2010 to 2015, the S&P 500 except in 2012 outperformed MSCI EAFE, which includes stocks in all developed economies except North America. That chart shows the S&P 500 outperformed emerging markets every year but two, namely 2010 and 2012.
Some market pundits now believe both Europe and emerging markets are far better value than U.S. equities, but whether that results in a change in these major price trends remains to be seen.
Prices reflect how supply and demand stories are aggregated in market economies and stock prices are no exception. That is why charts of price trends, especially relative strength charts can be useful in explaining the stories behind them, and how those stories might evolve.
Investing in securities involves risks, you should be aware of prior to making an investment decision, including the possible loss of principal. An investment in individual stocks, or a collection of stocks focused on a particular theme or idea, such as a motif, may be subject to increased risk of price fluctuation over more diversified holdings due to adverse developments which can affect a particular industry or sector. Investments in ETFs can include those with a narrow or targeted investment strategy and can be subject to similar sector risks than more broadly diversified investments. Motif makes no representation regarding the suitability of a particular investment or investment strategy. You are responsible for all investment decisions you make including understanding the risks involved with your investment strategy.