February 2020 Investment Insights

Of Bitcoin and Bubbles

As 2021 has begun, markets and asset prices have continued to march onward and upward. We’ve also seen some frenzied
activity in certain individual stocks (i.e. GameStop and AMC) and in cryptocurrency. This has led some to question if this activity
in the market periphery is something that they should be concerned about and/or participate in. The overall level of the
market is also being called into question by some as we have seen great performance in equity markets in spite of COVID
challenges and political unrest and division. In this month’s comments, we’ll explore the following themes and the
considerations for investors:

  1. Are markets in a bubble?
  2. What’s going on in cryptocurrency and should I own this asset class?
  3. What do I need to know about GameStop and does it impact me?
    Are Markets in a Bubble?
    Anytime we experience sharp and sustained increases in markets, individuals reasonably question if prices have risen too far
    too fast and if we are experiencing a market bubble. The implication of a bubble is that market valuations are not supported by
    underlying economic reality. In exploring whether or not markets are in a bubble, we need to first determine what drives stock
    prices. A friend and colleague has insightfully pointed out that over time, EARNINGS DRIVE STOCK PRICES. While we see short
    term spreads over time, in the long run, earnings drive stock prices:
    Stock prices may get disconnected from reality at times (look at the late 1990s), but they inevitably revert to the mean and the
    mean in this case is earnings growth.
    So how do stocks measure up today relative to earnings? A popular measure of how expensive or cheap markets are is price to
    earnings (P/E) ratio. This metric provides a multiple of how much investors are willing to pay for an equity interest in a
    company’s earnings stream. High multiples mean a company or index is expensive and potentially overvalued and low
    multiples indicate a comparative value and/or potential low-quality earnings (earnings stability and/or sustainability is in
    question). P/E ratios according to the Wall Street Journal stood at the following as of 2/12/2021:
    Current P/E Year Ago P/E
    Dow Jones Industrial Average 31.74 22.89
    NASDAQ 100 Index 40.12 29.15
    S&P 500 Index 44.94 25.74
    We can clearly see that the tech heavy Nasdaq is trading at very lofty levels as is the S&P 500 which is increasingly dominated
    by large tech names. The Dow Jones Industrial average has less growth and tech focus and trades at a comparative value, but
    note that all three indices are trading at much higher levels that they were a year ago (the year ago figure was pre-COVID, so
    the figures for last year are theoretically free of COVID-related distortions).
    Markets are clearly expensive right now (particularly on the growth side) but are they overvalued? Consider the following:
  4. We still see tremendous levels of investor cash sitting on the sidelines. Theoretically much of this will eventually
    make its way into financial markets which would push prices up further.
  5. The Fed continues to pursue historically easy money policies and the system is awash in liquidity which bids up the
    price of stock. Policy statements from the Fed do not suggest a change to this anytime soon. While optimism and
    liquidity reign, it will be hard for stocks to pull back significantly.
  6. Companies are making money. Apple recently reported an all-time record quarterly revenue figure of $111 billion.
    They have over $191 billion in cash. This is one company only and therefore anecdotal, but tech and growth
    companies are making staggering amounts of money. This contrasts sharply with the late 1990s when there was
    often more flash than substance and little in the way of earnings for many highly valued names. P/E ratios during the
    dotcom bubble were as high as 200x. We’re nowhere near that level today.
  7. While growth is expensive, value stocks and international stocks are comparatively cheaper. Market rallies over the
    past several years have disproportionately favored growth and there are bargains to be had in other market
    Conversely, there are significant causes for concern. Below are some key ones to consider:
  8. Unsustainable fiscal and monetary policy. US debt to GDP has risen to historic levels (higher than post WWII) and
    there does not appear to be any restraint in sight for either political party nor any plans to address this in serious
    ways. Significant economic growth is needed to rise out of this hole and the growth needed does not appear likely.
    This will be potentially be a serious albatross in the coming years. On the monetary front, the money supply
    increased from $15 trillion to $19 trillion over the course of 9 months and we expect this figure to increase in the
    coming year. As the economy eventually turns a corner from COVID, inflation will be a very real risk and the Fed will
    likely face some very unpalatable policy choices.
  9. Political stability and structural issues. Will the political temperature go down from here or will it continue to rise?
    The United States appears to be at an inflection point and where will we go from here? Will polarization continue or
    will there be increased national unity? Will the nation meet the rising challenge out of China and other parts of the
    globe and maintain its global financial, cultural, and military preeminence? The answers to these and other questions
    will be important drivers of future economic prosperity and growth.
  10. Mean reversion. Markets inevitably revert to the mean. If the average annual return of an index is 11% and we have
    a decade of 15% annual returns, we’d expect lower returns at some point in the coming years. The decade of the
    2000s was a disappointing one for markets and investors while the decade of the 2010s outperformed the average.
    Will the 2020s see more upside performance or will we take a step backwards?
    The market is unquestionably expensive, but the question as to whether or not we’re in a bubble is more nuanced and more
    uncertain. The portfolio prescription for markets like these is hedging one’s bets. Don’t abandon growth, but consider adding
    value and international. Carry cash for liquidity and for future opportunities, but beware of opportunity cost (markets go up
    while you’re on the sidelines) and inflation risk (inflation outpacing the rate of return your bank will pay). Fortune favors the
    bold, but successful investing favors the appropriately diversified.
    Cryptocurrency has elicited significant interest over the past several years and has provided a wild ride for those who’ve
    invested in it. It has made some overnight millionaires and devastated life savings for others. Consider the path over the past
    three years of Bitcoin, the most widely known cryptocurrency:
    The rapid increase in value, the sharp volatility, and the novel nature of the currency has garnered the interest of the financial
    and popular press and we have fielded questions from clients. Many main street investors are wondering if they should be
    owning cryptocurrency as part of their overall portfolio of financial assets.
    In order to address this question, we need to begin with a primer of what cryptocurrency is. Cryptocurrency is a decentralized,
    digital, fiat currency based on distributed ledger technology. This means the following:
     Cryptocurrency is decentralized which means that it is not tied to any government or political entity. There is no
    government backing or intervention in the price or issuance.
     Cryptocurrency is digital (transacted online) and is a fiat currency. Fiat currency is not backed by any physical asset and
    most currency today is fiat post the abandonment of the gold standard.
     Cryptocurrency is based on a distributed ledger technology called Blockchain. This technology provides a secure record of
    ownership that forms the backbone of cryptocurrency. This technology has broad application in finance and potentially in
    many areas where an accurate and immutable records are required.
    We have talked about what cryptocurrency is, let’s cover what it is not:
     It is not like a stock where ownership is tied to earnings nor is it tied to a physical asset or commodity.
     It is not an investment in Blockchain technology. Cryptocurrency runs on Blockchain, but broad adoption of Blockchain
    technology will benefit cryptocurrency holders no more than Goodyear tire owners will benefit if Goodyear stock goes up
    in value.
     It is not a proxy for investments or bank accounts.
     It is not yet widely accepted as a means of payment.
    Cryptocurrency’s success is predicated on broad adoption and theoretically benefits if the global currency order is upset or if
    traditional currencies are debased significantly. While adoption is expanding (Tesla recently indicated that they would accept
    Bitcoin for payment), we’d likely need to see very dystopian scenarios play out for cryptocurrencies to be a viable competitor
    for national currencies.
    For now, cryptocurrency remains extremely speculative and represents tremendous risk. The problem lies in modelling and
    valuation. How does one accurately predict the path of a cryptocurrency? With a stock or a bond there are underlying earnings
    and financials and relevant economic data. Right now, too much of cryptocurrency’s future is based on the “greater fool”
    theory (i.e., there’s a greater fool out there who will take this off of my hands for a greater price). In the coming years
    cryptocurrencies may become a more broadly used means of payment, but how this affects the underlying price is unclear.
    Would you for example, pay a premium to buy Bitcoin and transact if you could simply use dollars? Early adopters may be
    rewarded, but for now we view cryptocurrencies as too speculative to comprise a material part of portfolios.
    Financial headlines have been dominated over the past month with coverage of the rapid rise (and subsequent decline) in
    GameStop stock. GameStop is primarily a retail outlet that sells video games and has struggled as consumers have pivoted
    increasingly to online services. They have been operating at a loss for some time and as such have been a target of short
    sellers. Short sellers place bets that an asset will decline rather than increase in value. Influential and market moving short
    sellers are often large institutional investors (like hedge funds) with deep pockets and high levels of sophistication. The below
    graphic shows how short selling works:
    In the case of GameStop, the perceived grim prospects by many led to high short interest ratios (significant short positions
    relative to the number of shares available). The risk of high short interest ratios is that shares become scarce in the event that
    short sellers need to exit their positions. Short sellers in this position are vulnerable to a short squeeze. A short squeeze occurs
    when the price of a heavily shorted stock is abruptly bidded up. This forces short sellers to post more collateral in short order
    or exit their position by buying shares (which bids up the prices even further). GameStop provided an extreme example of a
    short squeeze as retail investors organized online in a concerted effort to bid up the price of GameStop through coordinated
    purchasing. The results were catastrophic for short sellers. The below hypothetical example illustrates how the GameStop
    short squeeze worked in practice:
  11. Hypothetical Hedge Fund A has a dim outlook for GameStop and sells 1,000,000 shares short @ $17.25 share ($17.25mm in
    sales proceeds)
  12. Individual investors note high short ratios, (share to cover are hard to come by) and/or better prospects for GME, and/or
    have a desire to squeeze hedge funds and coordinate purchase activity on Reddit and place orders on platforms like Robinhood,
    This activity and that of the purchases of hedge funds to cover, pushes prices as high as $347.51.
  13. If Hedge Fund A wasn’t able to cover short position until January 27, losses would have exceeded $330mm! Hedge Fund A
    would likely have been forced to sell well before then, but this extreme event highlights the steep losses that short sellers can
    be exposed to.
    The event raises many questions and here are some of the key points that we have considered:
    Does this Matter to Me as an Investor?
    For most, the answer is no. Most investors own diversified investments with limited single stock exposure. For speculative
    investors or those with concentrated positions, there is some potential concern. We DO NOT advocate short selling for
    individual investors.
    Why is Short Selling Permitted?
    Short selling is controversial, but theoretically plays an important role in the market. The ability to sell short provides incentive
    for investors to dig deeply into companies’ books and activities. This heightened level of due diligence aids in price discovery
    and potentially helps uncover fraud.
    Why Did Certain Firms Cut Off Trading?
    Certain online brokers restricted trading after the meteoric rise in price. This has elicited swift and sharp responses from some
    lawmakers and outrage among many individual investors. While we don’t know all the behind the scenes conversations around
    the rationale for these restrictions, we do know the following (see WSJ, Why Brokers Had to Restrain Trading in GameStop
  14. Brokers can carry liability for the illicit activity of their customers
  15. Brokers carry financial risk and potentially face huge losses if shares purchased on margin (with borrowed money)
    precipitously fall in value
  16. Clearing firms require brokers to post large deposits that can go up intraday depending on market conditions
    We do not know if any malfeasance occurred in terms of the motivations behind the trading restrictions, but there were clearly
    legitimate business concerns from a risk exposure perspective.
    We will be watching closely to see if the trend of retail short squeezes is an isolated incident or if this becomes a more common
    market occurrence. This is a very nuanced topic with more questions than answers. Is this just the next natural step in the
    democratization of investing? Does the activity that occurred constitute market manipulation? Is there a double standard
    between hedge fund activity and that of retail investors? Has social media been weaponized for finance? It will be interesting
    to watch these developments evolve.
    We look forward to meeting with you in the coming year and as always, feel free to reach out if you have questions on these or
    other topics.
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