The Mind of the Market

What is the stock market thinking? The world economy is nearly shut down, with no idea when it will get back to normal. Unemployment is the highest since the great depression. Few companies can predict next quarter’s earnings, much less next year’s. Still the stock market is barely in correction territory and pricing in business as usual for stocks like Tesla, Netflix, Facebook, Apple, Amazon, and Google. Take out these darlings and the market is in full correction territory.

The market’s judgement that these stocks are immune to the recession is debatable. So far, the economic pain has been almost entirely felt by people who don’t buy eighty thousand dollar cars while shopping on their new I-phones based on advertisements from their favorite social media influencer, but if this keeps up much longer the pain will be felt by everyone. Clearly, the market is thinking that the Fed and government spending will give us a bridge to a vaccine or treatments before this recession turns into a depression. If that is true, the fortunate 20% will be able to pay for those Amazon deliveries. If not, the recession will not spare anyone, and even the market darlings will fall from grace joining the rest of the field.

If you don’t want to pile into a handful of popular stocks, whose valuations were already stretched before the crisis, you have two alternatives. One is to go to cash. If you did that at the end of March you just locked in big losses and missed out on getting half that loss back in the last few weeks.

It seems to us that the better alternative is to continue to hold and buy the best of the other 90% of companies that have already priced in at least a recession, if not a depression. That eliminates the risk of the market running away from us if the bridge holds to the next recovery. More importantly, it eliminates the risk of blindly following the herd on the expectation that yesterday’s winners will make today’s best investments. What gives us the confidence that this is the best path forward for our clients when today’s market forecasts just the opposite?

THE MIND OF THE INVESTOR

Michael Lewis began his investigation of the Oakland Athletics into what later became the critically acclaimed book “Moneyball” wondering if pay discrepancy between star left fielders and after-thought right fielders created tension within teams. It turned out the players actually liked each other, but while interviewing them in the locker room he noticed many players were fat and “misshapen”. Lewis quickly realized the A’s were paying for value, not for a star’s appearance or headline numbers. This allowed them to compete with the big budget clubs when everything about their team predicted the opposite.

While it may feel great to dominate the headlines with mega contracts and star players, 9/10 times teams regret it. Why is that? The market, in this case team GM’s, recognize who is going to sell tickets, driving up compensation for overhyped players. But when reality sets in, as it usually does, the unanticipated risks of a player not living up to expectations can be a drag for years. The concept is no different in the stock market. Managing risk by holding beaten-up stocks with the greatest recovery potential and avoiding stocks that have held up the best may seem counterintuitive, but great investors embrace this paradox because they have perspective, patience, consistency and the confidence that the risk of overpaying for high expectations is dangerous.

Our clients have long-term objectives that require the same perspective. We develop asset allocations with our clients that anticipate protracted market corrections. Short-term performance means very little to someone investing for decades of retirement, but the temptation and comfort of riding a short-term trend is overwhelming. No problem with that as long as the trend holds up, but when it stops, the losses can be enough to set back plans for a very long time.

Patience is not just a virtue. It is necessity for a successful investor. Every company, even the great ones have setbacks, and nobody knows when they will come. Hopscotching from one stock to another based on short-term performance does not improve your odds of avoiding problems. If you own great companies with strong management they will likely fix their problems for you.

Just like moving from company to company in the mistaken belief that you can trade away risk is counterproductive, a lack of consistency in investment styles seldom improves performance. There is always something that worked better for the past year or two, the question is: will it work next year, and the year after that?

For twenty-three years Compass has had the same investment approach which gives us the confidence to weather this storm and we look forward to many more years.

THE MIND OF THE VALUE INVESTOR

That confidence comes from a long-held belief in value investing. Value investors seek to invest in good companies at reasonable prices based on expected future cash flows. They tend to avoid the hot stock of the day, and don’t get upset about missing the star player that everyone is talking about. They recognize that long-term investment success comes from independent thinking and the conviction to stick with it when it may not be popular. They understand that doing what feels comfortable or readily accepted by the market comes with significant unanticipated risk.

As the famed distressed investor Howard Marks says, “Bargain prices are most likely to be found among things that conventional wisdom dismisses, that make most investors uncomfortable, and whose merits

are hard to comprehend.” (272, Mastering the Market Cycle). It’s the investments that travel by momentum and that the market deems obvious winners that are often the least valuable investments.

When the market assumes the invincibility of a handful of companies or investment vehicles they are almost always let down. In fact, in just the last two months we’ve seen the false promises of safe “alternative assets” and their high yields. Trillions of dollars piled into leveraged loan funds, REITs, subprime mortgages, business loans, and MLPs; anything to get extra yield with the promise that they were somehow immune from bear markets. The results have been yet another confirmation of the fact that there is no such thing as a safe high yield. And that is just high yield, we won’t even get started on the “Unicorn” population that’s seen billions of dollars disappear behind growth at all cost mantras.

MAKING MONEY IN A BEAR MARKET

While we don’t like to see the value of our clients’ portfolios go down, we remind ourselves that great investment opportunities are most often the result of bear markets. That’s easy to say and easier than that to prove, but very difficult to execute. It requires looking over the abyss instead of into it. Not ignoring reality, but not letting fear overcome rational judgement.

This is not the first crisis we have managed. 1987, 1992, 1997, 2000 and 2008 were all different but here is what we found worked in each one. Stay calm. Let the market give you bargains and patiently buy the best of what the market is throwing away.

In 1997 it was energy stocks, 2000-02 it was tech stocks, 2008 it was financials. In each case if you bought the strongest companies in a detested industry you made money. Sure you could have made more if you were lucky enough to find a weak company that was able to survive, but for every company that survived, there are many that just didn’t make it.

The best companies not only survive the downturn, they pick up the pieces from the losers and gain cheap assets and market share. The big tech stocks, energy stocks and financials all got bigger after their industries got decimated. We believe the same will be true today. So, what can we buy today that will be worth a lot more when this crisis is over?

Consumer cyclical stocks are so called because they are exposed to economic cycles. It’s the first place to look for bargains in a recession. These stocks are most exposed to an economic downturn and they are especially hard hit in this pandemic. Retail, autos, airlines, housing and travel stocks take a beating in every downturn in consumer spending, but add a forced lockdown and you have unprecedented damage. All you have to do to make extraordinary returns during a recession is to buy or add to the survivors and wait for the recovery.

Industrials were once the heart of the economy but increasingly we have become a service economy more dependent on technology and finance than manufacturing. For investors looking for good dividends and stable businesses they are the epitome of value.

There has never been a recession that did not punish financial stocks. It’s just part of what you get when you buy a bank, insurance company or credit card processor. The good ones have gone through multiple recessions before, created reserves that will offset any losses they are likely to have and will come out the other end with fewer competitors. Not to mention the boost they will get from higher interest rates as the Fed and Treasury pump phantom money into the economy.

Natural resource stocks live and die with commodity prices that are beyond their control. Still, somebody has to supply the energy, minerals and building materials that are necessary for the world economy to subsist. Buy them when the cost of production is above the price of the commodity and one of two things have to happen. Either the price of the commodity goes up or enough of the producers go bankrupt to leave the market to the low-cost producers. If you own the most efficient producers, you don’t really care which way you make money.

THE COMPASS BUSINESS PLAN

We are doing just fine in the pandemic. Thankfully, all of us have avoided the virus. It helps to be located outside a major city where the infection rate is small and we can socially distance without much interruption in our daily routines. The changes we made over the past couple of years to our technology have been well worth the effort. Instead of putting a lot of money in fancy offices and unnecessary staff we have concentrated our investments in technology and vital personnel.

We are also happy that we aren’t market timers or traders. Portfolio managers and hedge funds that promised clients that they could predict the ups and downs in this market have sorely disappointed and underperformed a simple buy and hold strategy. Frankly, we have no idea how anyone could attempt to predict the markets short-term movements given its inexplicable bouts of pessimism and optimism.

The terrible thing about every recession, including this one, is that we do not know how bad it will be, or when it will be over. We do not know how deep or wide the abyss will be. Trying to predict what will happen in the short-term is futile and potentially hazardous, but we do know that there will be a resolution to the crises and that the market will anticipate the recovery long before it becomes a reality.

Our job is not to try to call the bottom of the market, it is to take advantage of the market’s preoccupation with short-term events and position our client’s assets to meet their long-term goals. Bear markets give us extraordinary opportunities to do just that.

_{Compass Wealth Management LLC is a SEC registered investment advisor, clearing transactions primarily through Pershing Advisor Solutions and Pershing LLC subsidiaries of Bank of New York Mellon Corp. This letter is written by Compass for the benefit of its clients and does not necessarily represent the opinions of its affiliated organizations. It is based on information believed to be reliable, but which is not guaranteed to be correct. Nothing herein shall be construed to be a solicitation to buy or sell securities, indicate that past performance is predictive of future returns, or recommend individual investments.}