If you’ve ever gone on a long car ride for vacation or out-of-town wedding, and then returned home, perhaps you’ve felt that the return journey felt drastically shorter than the initial expedition. While mathematically this is likely incorrect, from a psychological perspective it is a mental heuristic known as the “return trip” effect.
A study by a group of Japanese researchers published in the journal PLOS ONE in 2015, lends credence to this effect. The researchers studied two groups: one watched a film of a journey from point A to point B and the return trip; group two watched the journey from point A to B and then a trip from point C to D. While both groups were relatively accurate in determining three minute intervals along the trip, in retrospect, group 1 felt the entire journey to be shorter than group 2, even though the distance from C to D was equivalent to the delta between A and B.
The easiest explanation is that on the outbound trip, a traveler is focused on paying attention so as to not miss a turn, mile marker, taking in new sights, etc. On the return, we are comfortable and have greater familiarity leaving us much more at ease. The thought being that by focusing on every minute that passes in the immediacy, we can slow our perception of time and make the outbound journey feel relatively longer.
As this pertains to investing, the journey within a given month or quarter or year usually appears to be more dramatic than when we look back on the end result. The third quarter of this year was no different. The S&P 500 ended the quarter up 1.7%, for a total gain of just over 20% for the year. Given concerns such as the trade war with China, Brexit, the impact of the 2020 election, etc., etc., etc… the journey has not felt nearly that positive.
We often remark that the macroeconomic environment is exceedingly difficult to predict and that’s why our investment philosophy is rooted in fundamental, bottoms-up analysis of what a business is worth through the economic cycle. It’s a refrain we try to hammer home (perhaps to a fault) because first and foremost we believe it. But, we think it’s important to reiterate it, especially in volatile times such as these. When the market can literally turn on a tweet, it’s more important than ever to stay disciplined and see the forest through the trees.
Throughout the quarter, it seemed that the daily headlines in the financial press focused on the S&P 500 reaching an all-time high. And while that may be the case, it appeared as though investors were perpetually waiting for the other shoe to drop, as they have been since the recovery from the 2008 Financial Crisis. We saw a prime example of this towards the end of the quarter in the overnight repurchasing markets, or repo markets.
The repo markets serve as short-term sources of immediate capital for banks, hedge funds and other financial institutions which use their inventory as collateral. The rate of return for lenders in these often one-day arrangements is approximately the Federal Funds rate. Around the middle of the month, we saw a spike to twice the prior day’s levels. Practically speaking, the repo market is very important; it is the plumbing of the financial system. From a signaling perspective, this is small potatoes. The pace with which the financial media picked up the story, ostensibly indicates that we haven’t totally gotten over large unexpected swings in traditionally stable markets.
We have also seen this manifest itself in the trepidation of the broader stock market as it swings violently, especially as we draw nearer to the 2020 US Presidential election. A few weeks ago, Cornerstone Macro issued an entire piece about the segments of the market most at risk should a certain top candidate win. Just this week, Morgan Stanley created an entire basket index related to that same candidate. While a president’s policies can certainly impact what happens to a market or company, it is exceedingly difficult to accurately predict what the outcome will be.
In 2016, shortly after Donald Trump defeated Hillary Clinton, Barron’s published a long piece detailing how the Energy sector would be among the biggest winners from Trump’s unexpected win. Since that time, the S&P 500 has appreciated just under 50% and the worst segment of that index has been the Energy sector.
What we’re seeing now is akin to the concept of a Keynesian Beauty Content: the idea was developed by economist John Maynard Keynes in 1936. The thought experiment went something like this: entrants in a newspaper contest are charged with selecting the six most attractive faces from among 100 photographs. Those who select the most popular picture would be eligible to receive a prize. The thinking man’s strategy would be to select the most conventionally attractive face; this would maximize your probability of being eligible for the prize. The less sophisticated participant would select based on personal preference.
This looks to be the case with the broader market today. Whether it’s the aforementioned Cornerstone piece, Morgan Stanley’s basket or the broad selloff we have seen in healthcare given concerns about what a win from some of the Democrat candidates and the implication of “Medicare for All” might mean to these firms. Traders are attempting to guess who America will think is the most “conventionally attractive face” in 13 months and are placing their bets accordingly. The rise of ETFs and more passive investing has made this game easier to play. However, it’s not one we think is the most prudent for our clients.
As Joe Weisenthal from Bloomberg wrote, “Even if there’s no direct link between policy and outcome, traders will just bet one way or another on the expectation that others are playing the game.” It’s impossible to know at this point who will win, what policies would be enacted and what the impact would be to businesses or the stock market. In October 2016, the market traded off on fears of a Donald Trump presidency. For better or worse, upon his victory, after being limit down overnight, the market appreciated pretty steadily from that point until January 2018, when volatility returned. As we saw then, expectations do not always equal reality.
That said, the stock market is not based simply on the personal preference of people looking at pictures in a newspaper. Businesses are generating cash flows and the discounted value of those future cash flows is what they are worth today. While we can see short-term dislocation as market participants attempt to gain prize eligibility, eventually the real cash flows a business is generating will be recognized by the market and stock price performance should follow suit. We have seen this to some extent in 2019 with the “disappointing” IPOs of companies like Peloton, Uber and Lyft. Or the failure to launch of WeWork and Endeavor. That is why we are focused on valuation over a full economic cycle regardless of who is in the oval office.
This year has felt like a bit of a relatively arduous journey in the stock market, whether you’re looking quarter-to-quarter, month-to-month, or even day-to-day. Though hopefully not that last interval. While the voyage has seemingly been a tumultuous long ride, our focus will remain down the road on where we are headed. Our belief is that ultimately when we look back from our destination, the road traveled won’t appear so long and difficult in retrospect. As always, we thank you for entrusting us with your investment assets and your continued support. Lastly, the best compliment we can receive is a referral from a satisfied client. We appreciate your referrals and handle them with the utmost of care.
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