Wash, Rinse, Repeat
Quarterly Commentary | Q1, 2024
Author: Jason Kirchhoff
The common directions on the back of a shampoo bottle are lather, rinse, repeat. I saw a stand-up comedian a few years ago who observed the dangers of following these directions literally—you would be stuck in a perpetual shower, not able to break free of the repeating cycle. Studying financial history highlights the same type of continuous and inevitable cycles. Financial cycles are the ups and downs of markets, companies, and economies that are driven by fundamentals (growth, innovation, liquidity, regulation) and human behavior (expectations, exuberance, fear, greed).
Because of the human behavior portion, each cycle differs in both its magnitude and duration. But historically, cycles typically have a few things in common: they start because of a strong/weak underlying fundamental story and then are reinforced by excessive optimism/pessimism.
Legendary value investor and founder of Baupost Capital, Seth Klarman underscores the importance of understanding the cyclical nature of markets.
"The stock market is the story of cycles and of the human behavior that is responsible for overreactions in both directions."
A short review of a few rather extreme historical cycles may be illustrative of how the combination of fundamentals and human emotion plays out.
Japan
In February the Nikkei 225, an index of the largest public companies in Japan, recaptured its all-time high that it had previously made 34 years earlier on December 29th of 1989. Investors who bought near the peak had to suffer a 90%+ drop and wait over three decades to break-even. The upturn in Japanese markets started with deregulation in the 1980s and an increased willingness of banks to lend. The growth trend was exasperated by investors pushing valuations to extreme with the assumption that the growth miracle would continue.
Nifty Fifty
In the early 1960’s investors became enamored with the largest “blue chip” companies in the U.S. These companies had strong and stable earnings and their brands represented high quality products. These companies included names like IBM, Kodak, Sears Roebuck, Polaroid and Avon. Many investors viewed these companies as unbeatable and bid up their valuations to extremes with the idea that their growth and popularity made them a value at any price. Unfortunately, while many of these companies continued to have good earnings their valuations were greatly reduced during the stock market crash of 1973 and remained low for the bear market through the 1970s.
Current Cycles
While we don’t think any of the current cycles are as extreme as the historical examples, one cycle we are watching carefully is the dominance of U.S. large-cap technology companies. The fundamental story is strong as these stocks have great balance sheets and fantastic earnings growth.
In addition, over the past 6-8 months the leap forward in artificial intelligence has increased expectations for future growth. Innovations can be very beneficial in improving efficiency, productivity, and our quality of life. However, the excitement around technology can generate strong early returns and a narrative of exponential future growth. The list of technologies over the past decade that have gone “full cycle” with quick valuation increases and decreases is lengthy…Autonomous Driving, Electric Vehicles, Robotics, 3D Printing, Genomics, Blockchain, Metaverse, Renewable Energy to name just a few. While all these technologies remain viable and have improved our lives, growth expectations and valuations got ahead of themselves and many investors that got in late were hurt by the outsized, lofty expectations.
How We Think About Cycles in Portfolio Construction
Unless we find a “solution” for the impact of human emotions (notably fear and greed) cycles will likely continue to repeat and we will be stuck in the shower forever (wash, rinse, repeat). However, by acknowledging their presence, we can potentially improve investor’s outcomes by occasionally taking contrarian positions to what have been the best/worst performers. When the market is extrapolating recent strong or weak performance and we start to see signs of excess exuberance (thematic ETF launches, magazine covers, “this time is different”, etc…) we will potentially underweight the strong performers with high relative valuations and overweight the weak performers with lower relative valuations. This can lead to short-term underperformance as picking tops and bottoms is a difficult task, but over the long run it should protect portfolios from larger pullbacks and lead to better long-term compounding of returns.
Howard Marks in his book Mastering the Market Cycle gives a good summary of our approach.
“Skepticism and pessimism aren’t synonymous. Skepticism calls for pessimism when optimism is excessive.
But it also calls for optimism when pessimism is excessive.”
The opinions expressed are those of McGill Junge Wealth Management as of the date stated on this communication and are subject to change. There is no guarantee that any forecasts made will come to pass. This material does not constitute investment advice and is not intended as an endorsement of any specific investment or security. Please remember that all investments carry some level of risk, including the potential loss of principal invested. Indexes and/or benchmarks are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance and are not indicative of any specific investment. Diversification and strategic asset allocation do not assure profit or protect against loss.
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