Investment Insights are written by Angeles' CIO Michael Rosen
Michael has more than 30 years experience as an institutional portfolio manager, investment strategist, trader and academic.
DISCONNECT: HOW CAN MARKETS BE AT ALL-TIME HIGHS WHEN THE WORLD AROUND US IS COLLAPSING?Published: 08-18-2020
Answer: Markets reflect the dynamism and adaptability of private companies, not geopolitical events or socioeconomic upheaval.
Many find this conclusion surprising, non-intuitive, but on our recent webinar (for those who missed it, or just want to watch it again, it can be found here: https://www.angelesinvestments.com/insights/videos/2020-webinar-how-can-markets-be-at-all-time-highs-when-the-world-is-collapsing), I presented historical data that I think supports this conclusion. Here, I offer a more succinct narrative.
Markets are a mystery to most people, perhaps more so today than ever before. Our economy contracted 9.5% last quarter, the largest decline since 1946. This was the fourth sharpest drop since the founding of our country. Thirty million people are receiving unemployment benefits, and five million have been infected with the COVID-19 virus. Normalization of the economy appears a long way off.
The state of political affairs is, if anything, worse than our economic morass. We are deeply polarized politically, unable to agree even on the facts, much less be able to have a constructive dialogue with our fellow citizens. Working-class families have seen their incomes stagnate for decades while a new class of elites garnered unfathomable wealth. Minority groups decry the ever-present repression of racism, demanding redress. We are fearful, anxious, worried. Three-quarters of Americans think the country is on the wrong track.
Amidst all the financial hardships, social turmoil and vicious political polarization, the stock market is near an all-time high! How can that be? Many assume that the market must be manic, driven by crazy or bored (those are not mutually exclusive) Robinhood-millennials soon to get their comeuppance. Hence the strongly bearish sentiment among most investors reflected in surveys (such as AAII) or the high cash balances held at banks.
Bearishness has been characteristic of this market since its bottom in March 2009. Not coincidentally, the market is up 400% in that time. Investor bearishness, or certainly skepticism about future prospects given all the troubles we see around us, misses a fundamental understanding of what the stock market is and what it reflects.
There is overwhelming historical evidence that the market quickly absorbs and adjusts to major geopolitical events. The bombing of Pearl Harbor was one of the most significant acts of the 20th century. The US stock market fell 20% in its aftermath, but was back above its pre-attack high within the year. Many see close parallels today with 1968, a year that began with the Tet offensive in Vietnam, saw two major political assassinations in Martin Luther King, Jr. and Robert F. Kennedy, and riots across the globe, from the occupation of Columbia University to the Democratic Convention in Chicago to the Mexico City Olympics. The market was up 7.7% that year.
Another year of political turmoil and social unrest was 1975. Puerto Rican terrorists (the FALN) began the year by bombing historic Fraunces Tavern in New York, killing four and injuring 53 people. A few days later, the Weather Underground set off bombs in Washington, D.C. and in Oakland, CA. The FALN was back in April with four bombs detonated simultaneously across Manhattan. In September, President Ford survived two separate assassination attempts, and at the end of the year, a bomb at LaGuardia Airport killed 11 people and injured 75. Croatian nationalists were suspected, but never caught. The market rose 37% that year.
So how to explain this disconnect between political, social, and economic upheavals and the stock market? If the market does not reflect the chaos and turmoil in our world, what does it reflect?
Part of the answer is technical: the market is not the economy. The five largest companies (Apple, Microsoft, Amazon, Facebook and Alphabet) make up more than 20% of the market capitalization, but employ only around 1.3 million people (mostly at Amazon), which is less than 1% of the total employment in the US.
The more important explanation is that markets reflect the dynamism and adaptability of the private sector to changing conditions, good or bad.
“Survival of the fittest” was not Charles Darwin’s phrase; it was Herbert Spencer’s summary after reading On the Origin of Species. A more accurate summary of Darwin’s work, although not as pithy, might be “survival of the most adaptable.” It is not the biggest, strongest species that survive, but the most adaptable to a changing environment (think of the dinosaurs that disappeared while horseshoe crabs, for example, survived). The same applies to companies, which is why we call large, lumbering companies “dinosaurs,” about to become extinct for failing to adapt to new technologies or threats to their businesses.
Companies fight for their survival every day, just as most species do, and those that successfully adapt to the changing political, social and economic environments will endure. Those that fail to adapt will die (go bankrupt or get bought by a nimbler company). This is what the market reflects: the adaptability of companies in the face of new challenges. This is what lies at the heart, and defines the success, of capitalism.
There is no question we face enormous challenges in our society. We may navigate these obstacles with skill, or we may manage them poorly. Some companies will adapt and thrive, others will stagnate and die. That is capitalism, and that is what the market reflects.