Last Updated: January 9, 2020
A new advertising campaign began in November, produced by Amazon Web Services1 (AWS), the highly successful division of Amazon that commercialized the concept of cloud storage of data. The campaign is built around the slogan: There is no Compression Algorithm for Experience. The first time I saw it, I immediately thought that I wished I had come up with that; it’s a great line. The second time I watched it, I laughed. Here is Amazon, a company considered to be the prime example of a “disruptor” in today’s economy, constantly challenging existing ways of doing business. Why is this company that brags of doing things its own new way making an appeal to the authority of “experience” of all things? Is the world turning upside down? Should we now expect cats to lie down with dogs?
It's not that it is wrong for AWS to trumpet that its experience in handling complex customer issues successfully is a competitive advantage. The cloud computing platforms have become increasingly competitive. Microsoft’s Azure service, for example, may present a highly competitive alternative. Can Amazon really claim “experience” – vs. Microsoft – as their competitive advantage? For our part, we have been doing much the same thing at SBH for over 25 years. The length of experience among our professional staff as well as their credentials (over 70% of our professional staff has a CFP® (Certified Financial Planner) or CFA (Chartered Financial Analyst) or other professional designation)2 are what “experience” looks like – a significant differentiating factor.
“I never let my schooling interfere with my education.” - Mark Twain
Readers may recall that back in 2017, we reported on an inquiry we had made to the CFA Institute in which we asked about the number of years of work experience for CFA® charterholders in the industry. We were using those with CFAs as a proxy for the professional investment community. In 2017, about 35% of charterholders had less than 8 years of experience. Back then, it meant that more than a third of CFAs had never lived through a bear market and had never experienced a bond market in which interest rates were held at zero percent (and lower!!!). Obviously, that percentage has grown higher in the last two years. It is going to be interesting to see how this group performs in the next substantive downturn without some “experience.” There really is no substitute for living through a market regime change.
All the rules of thumb you have acquired cease working. None of the indicators you have found reliable give you an accurate sense of where the market is or where it’s headed. As the AWS ad suggests, experience has value but there is no way to gain experience other than by living it. Experience teaches, but the tuition is high.
The Most Expensive Phrase in Finance
A counterargument can be proposed, suggesting that the experience of the past is not valuable because the current global financial and economic scene is unlike any we have faced before. Not only that but reading the old signposts through the prism of the present is not only a useless exercise; it could well be misleading because the meaning of the old signposts has changed. This could well be valid. Perhaps this time is different but, throughout financial history, that notion has always proven to be wrong. “This time is different,” is widely considered the most expensive phrase in finance.
Our Theme: “Good News for Main Street, Not So Sure About Wall Street”
At the end of each of the last two years, we have thought that the following year would be good for Main Street but not necessarily for Wall Street. We are 2-for-2 on the economy and 1-for-2 on the markets. What our phrase suggested was that the ingredients for a recession in the U.S. were not in place so the economy ought to chug along. There haven’t been – and there still are not – any excesses that we believe will lead to a recession. Keep in mind that a sector of the economy can experience a downturn, but if the problem doesn’t spread into the banking system, a recession is unlikely.
Think of a downturn in car sales, just for the purpose of illustration. If weak auto sales do not translate into repossessions and loan losses of a meaningful magnitude, the trouble will be confined to the auto sector. For the U.S. economy, the big concern today is risks created from a changing landscape in foreign trade. Rather than continuing to forge large multinational trading pacts, the trend is increasingly frequent use of tariffs in addition to regional and bilateral trade treaties. These uncertainties have caused considerable concern that current weakness in foreign trade will accelerate and trigger a recession. Some have suggested that weakness abroad, for example, in China or in Europe, could drag the U.S. down. The reality, however, is that the degree of U.S. exposure to trends in foreign economies is lower than any other developed economy. Our economy is much more insulated than others from trends in global trade based on our analysis.
Consider the chart above. While exports and imports account for 29% of the Gross Domestic Product (GDP) of the average member of the G20, the exposure of the U.S. to foreign trade (as defined by exports) is 12%. What this suggests is that even if China or Europe continues to experience weakness, the U.S. economy can likely just sail on, a tad slower perhaps but not falling into negative territory. The implications for this are favorable for the economy (up to a point, to be fair, but that’s another essay). The dollar should remain strong as capital flows from abroad (where in many cases interest rates are negative) to our relatively strong economy (where interest rates are positive). A stronger dollar will inhibit inflation and interest rates will not need to rise much, if at all.
From the point of view of the stock market, the implications of such a framework are a bit more mixed. Interest rates remaining low can underwrite high levels of price-earnings ratios so the market might not have to worry about a compression in multiples. That said, the bulk of the gains the market saw in 2019 was driven by multiple expansion (95% of it, according to SBH Research3) that in turn was driven by the Federal Reserve (Fed) reversing course during the year and lowering interest rates after having raised them in 2018 to early 2019.
The real question is what the growth in profits will look like. In the last five years, companies have been able to squeeze out costs and maintain positive operating leverage even in the face of sluggish revenue growth. It has been an impressive achievement, but one has to wonder with unemployment levels at 50-year lows and a considerable amount of political pressure to see wages rise, whether or not there remain enough efficiency rabbits to pull out of a hat in order to meet earnings expectations of Wall Street. Lower interest rates in 2019 may have masked this impact, but if rates don’t continue to decline, identifying the companies that can indeed grow profits will become an increasingly important element in investment success.
"The wind and the waves are always on the side of the ablest navigator.”
- Edmund Gibbon
In recent years, we have commented on the high degree of lockstep that existed in the ways stock prices behaved. We ascribed that to the (unintended – or not) consequences of quantitative easing (QE) moves by the global Central Banks to stimulate their economies. There are, as you might expect, a variety of ways to express lockstep: correlations of stocks in the S&P 500® Index to the price behavior of other members of the group; size of average daily price changes; degree of dispersion in the high-low range of stocks over the course of a year; the spread between the 10th and 90th percentiles of returns in the S&P 500 are but some of the ways this can be analyzed.
Whatever the metric, the degree of dispersion is notably higher today than the average shown in the period 2010- 2017, the era in which QE reigned supreme. A regime shift is coming, the timing of which is not knowable. But in a market in which there is greater volatility and uncertainty, “experience” will once again raise its hand and be accounted for. An experienced sailor who has been in both storms and placid seas will stand a better chance of steering his ship safely to its destination as opposed to one who has only sailed in tranquil waters. Even worse is a ship on auto pilot, sailing according to a fixed set of rules, heedless of the condition of the seas. We call such a ship, by the way, an index fund.
1 Source: https://aws.amazon.com/what-is-aws/ (As of 12/31/19) Amazon Web Services (AWS) is the world’s most comprehensive and broadly adopted cloud platform, offering over 175 fully featured services from data centers globally. Millions of customers—including the fastest-growing startups, largest enterprises, and leading government agencies—are using AWS to lower costs, become more agile, and innovate faster.
2 As of 12/31/19 CFP® and Certified Financial Planner® are registered marks of the Certified Financial Planner Board of Standards Inc. CFA® and Chartered Financial Analyst® are registered trademarks owned by CFA Institute.
3 As of 12/31/19, the market (S&P 500) was up +28.5% on a price-return basis. The market’s P/E multiple increased from 14.5x to 18.5x (using NTM forecasts; or +27%), meaning ~95% of the market’s return can be linked to valuation expansion. By our math, only 12% of S&P constituents experienced multiple compression. All of the largest 25 constituents in the index saw their multiple expand.
The information contained herein is for informational purposes only without regard to any particular reader’s investment objectives, risk tolerances or financial situation and does not constitute investment advice, nor should it be considered a solicitation or offering to investors.