Rationality Amidst Uncertainty

June 30, 2020

The universe is under no obligation to make sense to you.

— Neil deGrasse Tyson

The first six months of this year brought on the worst global health crisis in more than a century. The result has been a lockdown of our economy that led to a recession, a spike in unemployment and a 34% decline in stocks in just 33 days… an event with no historical precedent. Add to this, racial inequality, social unrest and an upcoming presidential election that is sure to be as unpredictable as the previous one. Yet the S&P 500 Index just enjoyed its best quarter in more than 20 years and is up over 40% from its March 23 low— April alone was the best month for the S&P 500 in 30 years! This rally has some people wondering how equities could be so tone deaf to the pulse of world events. The truth is that this is not unusual. Historically, in the wake of political unrest, war or pandemics, the economic impact is relatively short-lived. Human intuition has shown itself to be a poor investor.

As investment managers, we do not attempt to time the market. The equity markets do not always share our views when things seemingly look darkest. When looking at long-term market trends, we can see that bear markets rarely destroy wealth, however, people’s reactions to them may. Over the last 20 years, half of the S&P 500’s strongest days have occurred during bear markets and another 30% of the best days took place in the first two months of a bull market—well before it was clear a new bull market had even begun. Missing the 10 best days over that 20-year period would yield a return of just half of what it would have been had one stayed fully invested the whole time; miss the best 20 days and that return goes to around one-third. Those who were sellers of their stocks in the last few months now have the daunting task of determining the “right” time to get back in. It turns out that the biggest risk isn’t being in the market when it declines, but being out of the market when it rises.

Psychologists Daniel Kahneman and Amos Tversky identified a behavior they call myopic loss aversion. This describes the tendency of investors who are loss-averse to evaluate their portfolios frequently, especially in times of stress. The study reveals that this may tempt them to abandon their long-term investment plan. We have written in previous communications that the prices of stocks tend to be much more volatile than the underlying values of companies themselves… perhaps that is only to be outdone by the volatility of people’s emotions. Annually, stocks are positive approximately 75% of the time, but on a daily basis, they are positive just slightly over 50%. And for those who check the stock market several times a day… bring your Dramamine! The average investor tends to feel the pain of a loss with twice the intensity they feel joy from an equal-sized gain. Therefore, the more often investors check the value of their portfolios, there is a strong likelihood that more net pain is felt and emotional decisions regarding their investments may be made. Warren Buffett has said,

It is almost impossible to do well in equities over time if you go to bed every night thinking about the price of them.

Since the Great Depression, the scary periods in the market share one common theme: they have been temporary. And while this time may, in fact, turn out to be different— chances are it will ultimately turn out to be the same, or at least similar. The average bull market has lasted approximately five times longer than the average bear market. One’s asset allocation between stocks, bonds (if applicable) and cash should be determined in a time of relative calm, with the assumption that every year there is likely to be a peak-to-trough decline in equities of around 15% and that every 6 years or so we will endure a bear market where stocks may fall twice that amount. The objective, of course, is to avoid being in a position where one needs to sell stocks in a depressed market. One’s investment mix should be re-evaluated when their goals change, not when the markets do. Over a 50-year investment horizon, one can expect to endure eight to nine bear markets— be (mentally) prepared!

For value investors, this has continued to be a frustrating environment and we know many of you feel the same way. This market has been driven largely by technology names— and just a handful of them, at that. To wit, the Nasdaq Composite is sitting at an all-time high, the only major U.S. equity index to enjoy that distinction. There hasn’t been a yearly performance gap this wide between growth and value stocks since the late 1990s during the dot-com boom. And on a price/earnings basis, the discrepancy is as wide as it’s ever been— as a whole, value stocks look very cheap right now. But why has value had such a difficult time keeping up with its growth counterpart? Value stocks tend to be sensitive to the ebbs and flows of economic activity. We have seen fits and starts of value outperforming growth in the last couple of months as investors became hopeful that a vaccine to the coronavirus was near and that economic activity was beginning to improve. But until there is more conviction about those trends persisting, economically sensitive names will likely continue to fluctuate. We feel that the names we own right now have the financial strength to survive this period and the potential to be in a stronger position once the economy returns to normal as some of their financially weaker competitors struggle. We continue to believe that buying companies that trade at a steep discount to our estimate of the company’s intrinsic value, are growing and have shareholder-oriented management teams will ultimately lead to compelling long-term results. While our overriding principles to investing have stayed consistent, our research process continuously evolves. We are not bashful about owning stocks from which many of our value peers may shy away— Alphabet (Google) being one example. Our analysis in determining a company’s investment merit goes well beyond simple metrics such as price/earnings or price/book ratios.

It is too early in this chapter to have any conviction as to what shape the economic recovery will take. We know that the 128-month expansion that began in 2009 officially ended in February. With a still elevated, but improving employment picture, the overall health of the consumer is much better than it was during the last downturn. In the 2007-2009 recession, consumers had their highest debt levels in history…now they are the lowest they have been in 40 years. Furthermore, home sales have begun to rebound as has consumer confidence. These are encouraging signs since consumers make up approximately 70% of U.S. economic activity. Some economists are forecasting that GDP will improve markedly in the second half of this year. We also know that there will likely be more monetary and fiscal stimulus, if needed, which should keep things humming along.

We understand how difficult and anxious these last five months have been for many of you. Our job is to remain objective and rational in times of calm as well as times of heightened uncertainty. The volatility we have experienced since February is likely to continue for the foreseeable future, but has provided us with the opportunity to upgrade our clients’ portfolios with names that we feel have been discounted well beyond what we believe to be reasonable. We will continue to do this as news flow and market dynamics dictate.

With regards to ongoing matters of inequality in our country, we are deeply disturbed and saddened by the inequities uncovered during the coronavirus pandemic, which have been compounded by recent racial injustices. At Harris, we embrace the diversity of our employees and strive to develop, promote, and integrate diversity and inclusion principles throughout the firm. As an organization, we are reflecting on how we can accelerate change for our employees, our clients and the community in which we live and serve.

As always, we thank you for entrusting us with your investment assets and your continued support. We hope you and your family stay safe and healthy.

Past performance is no guarantee of future results. Current performance may be lower or higher than the performance data quoted. The gross performance presented does not reflect the deduction of investment advisory fees. All returns reflect the reinvestment of dividends and capital gains and the deduction of transaction costs. The client’s return will be reduced by the advisory fees and other expenses it may incur in the management of its account.  The advisory fee, compounded over a period of years, will have an adverse effect on the value of the client’s portfolio.

The S&P 500 Total Return Index is a float-adjusted, capitalization-weighted index of 500 U.S. large-capitalization stocks representing all major industries. It is a widely recognized index of broad, U.S. equity market performance. Returns reflect the reinvestment of dividends. This index is unmanaged and investors cannot invest directly in this index.

The NASDAQ Composite Index is a broad-based market-capitalization weighted index of all common type stocks on the NASDAQ Stock Market, including common stocks, American depositary receipts, ordinary shares, shares of beneficial interest or limited partnership interests, and tracking stocks. The index includes all NASDAQ listed stocks that are not derivatives, preferred shares, funds, exchange-traded funds (ETFs) or debentures. This index is unmanaged and investors cannot invest directly in this index.

The information, data, analyses, and opinions presented herein (including current investment themes, the portfolio managers’ research and investment process, and portfolio characteristics) are for informational purposes only and represent the investments and views of the portfolio managers and Harris Associates L.P. as of the date written and are subject to change without notice. This content is not a recommendation of or an offer to buy or sell a security and is not warranted to be correct, complete or accurate.

Investing in value stocks presents the risk that value stocks may fall out of favor with investors and underperform growth stocks during given periods.

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