At any given time, there are at least four or five people (and often up to six or seven) working on our ETF trading accounts and strategies. We continually challenge each other as part of our investment process. We debate all points of view, and we freely express differences of opinion. We try to read the gamut of analytic literature and listen to diverse outlooks.
Matt McAleer, whom you meet for a few minutes every Friday via the Cumberland YouTube channel (https://www.YouTube.com/CumberlandAdvisors), is a veteran of nearly three decades of markets. He has long been and remains on the firing line as a money manager. He contributes to our ongoing discussion. He recently dropped a pearl of wisdom, and I asked him to put it in a written note.
Matt wrote:
“I found these two recent articles extremely interesting. Because I tend to lean pessimistically about the markets and risk – probably from trading through 2001/2 and 2008/9, when I started my own company – I purposely spend time reading/contemplating leanings opposite to mine. I have discovered outstanding traders that I enjoy reading because they trade real capital and thus must consider risk. Here are links to a couple interesting articles.”
“2020: What a Time to Be Alive,” by Morgan Housel
https://www.collaborativefund.com/blog/2020-what-a-time-to-be-alive/
“Investors Run from Stocks at Record Pace,” from Ciovacco Capital Management
https://www.ccmmarketmodel.com/short-takes/investors-run-from-stocks-at-record-pace
Matt’s point is well taken. We glean the biggest, most useful picture by seeking different viewpoints.
Punditry practitioners and analysts have a bias toward finding faults and risks. And the writers and talking heads who do not manage money as professionals are really just proffering opinions. It is different when you make your living having to decide what to buy-sell-hold and when to do it. And it is different when you have to determine if and when you are wrong and how and when to take losses.
A similar difficulty occurs when markets are setting new highs and the professional wonders where the top will be and how stretched valuations are. Think about this question when the 5 largest stocks are 1/5 of total market weight and are in the highest beta sector. Remember cash is zero beta: The S&P 500 index of all 500 stocks has a beta of 1; those 5 largest stocks have a beta above 1.5.
So far, this 2019–2020 stock market rally has been fierce. It started at the low point on Christmas Eve in 2018. Since then, the bias toward the large-cap tech sector has dominated the market. Consider that there are four companies with market caps above $1 trillion. They are Amazon, Apple, Microsoft, and Alphabet (Google). A fifth large-cap stock, Facebook, sits at a mere $700 billion. The total of the FAAMG stocks now equals about 19% of the market capitalization of the S&P 500 Index. The other 495 stocks make up 81% of that market cap. And the market cap-to-GDP ratio is the highest in the entire history of the American stock market while the profit share of that GDP is stagnant except for the benefit of the tax cuts.
The five FAAMG companies are all stellar business operations. They all have multidimensional and multinational business reach. They are all growing despite their enormous size.
So the question facing investors is not if these are viable companies, and not if they are making or losing money, and not if they have adequate capital. Those answers are “Yes!” The questions facing the investor are (1) how do I deal with momentum, and (2) how high is the price before it represents an extreme valuation.
Both questions are subject to robust debate. Please note that you could have had this debate months ago when the prices were lower. And also note that you may have it again months from now when prices may be higher. Pundits and analysts can talk and write all day long about risks and issues. They do not face the buy-sell-hold decisions that a professional money manager faces every single day.
In today’s world, the momentum issue is the most difficult one. We know momentum is powerful. We know it can continue for much longer than folks expect. We do not know when it will change, and we can only guess at the catalysts for change.
In today’s world a special factor is the policy of the world’s central banks. In the United States, the Federal Reserve has been expanding the size of its balance sheet and is maintaining interest rates at a very low level. The policy interest rate in the United States is below the various inflation rates, which means that the use of money (in real terms) is free. When that happens, asset price momentum is upward and will likely continue to be upward as long as money expands and the cost of money is next to zero.
In Europe and Japan, policy is expansive, and the cost of money is free or subsidized by negative interest rates. Remember, when the interest rate is negative, the theoretical asset price can go to infinity. With the usage of cross-currency interest-rate swaps, there is a clear transmission mechanism such that the negative rates in Europe and Japan end up raising asset prices in the United States.
In sum, this stock market is driven by momentum, and it is a force that must be respected. The market could go higher or much higher. It could stumble into a serious correction. We saw a 20% correction within the last two years. To be sure, this stock market could go both much higher and much lower in the coming year.
Meanwhile, we have some cash in reserve, and we are worried about the extended market behavior of FAAMG and its secondary effects on the broader indexes. Our ETF selection is defensive. Our quantitative strategies hold cash or defensive and lower-beta positions.
Twenty years ago, we faced a problem with the NASDAQ market top and the tech stock bubble. At that time (April 1, 2000), we wrote a piece entitled “Will the NASDAQ sell-off become a crash? A Value Perspective.” Here is a link to our archive. https://cumber.com/pdf/Cumberland-Advisors-April-2000-Will-the-NASDAQ-sell-off-become-a-crash.pdf. The circumstances today are different, and history never repeats itself exactly, though it often “rhymes.” We shall see.
For serious readers we offer three research papers. Here are the titles and links.
“Quantitative Easing and Exuberance in Stock Markets: Evidence from the euro area”; Tom Hudepont, Ryan van Lamoen and Nader de Vette; DNB Working Paper No. 660, De Nederlandsche Bank, December 2019.
https://www.dnb.nl/binaries/Working paper No. 660_tcm46-386407.pdf
“Asset Price Bubbles and Systemic Risk”; Markus Brunnermeier, Simon Rother, and Isabel Schnabel; NBER Working Paper No. w25775, April 1, 2019.
https://www.nber.org/papers/w25775.pdf
“The Long-Run Effects of Monetary Policy”; Oscar Jorda, Sanjay Singh, and Alan Taylor; Working Paper 2020–01, Federal Reserve Bank of San Francisco, January 2020. https://www.frbsf.org/economic-research/publications/working-papers/2020/01/
David R. Kotok
Chairman and Chief Investment Officer
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