MARKETS IN 2021: A NEW WORLD, A MAJOR BUBBLE, OR SOMETHING IN BETWEEN? January 2021 Sam Wood, CFA & George Sugden

“The one reality is that a higher-priced asset will produce a lower return than a lower-priced asset.” This quote from GMO’s Jeremy Grantham is a good starting point for this note as it is a theme we will return to consistently throughout. It has long been established that forecasting is a fool’s game, and that predictions regarding the direction of the market over the next twelve months is an impossible skill. However, what is perhaps possible is an understanding of where we are in the market cycle today and a rational appraisal of current conditions compared to the past. That is what we will attempt to do here, pulling together all of the fascinating articles, reports, tweets, and charts which we think help tell the story of financial markets in 2020 and where we stand today. Firstly, 2020 was as remarkable a year in financial markets as it was in all other aspects. Take a look at the returns data below.

Index Returns as of 31.12.2020 Since 23.3.20 Since 9th Nov Index 2020 market bottom vaccine news Nasdaq 100 47.98% 84.27% 6.59% S&P 500 16.60% 62.96% 7.03% Dow Jones Industrial Average 7.53% 59.63% 8.06% Russell 2000 18.67% 94.78% 20.11%

FTSE 100 -14.85% 24.46% 9.31% Euro Stoxx 50 -5.22% 39.40% 10.88% Russell 1000 Growth 37.08% 80.24% 5.24%

Russell 1000 Value -0.30% 54.29% 11.27%

As a brief recap there were three major themes for the year: ▪ Large beat small (until a big reversal after the vaccine news) ▪ U.S. beat rest of the world ▪ Growth beat Value (on some measures by the largest amount ever) These bullet points might understate how bifurcated 2020 was for investment returns. If you bought large, expensive, fast-growing stocks in the U.S. then you had returns that would be stellar in any year, let alone amidst a pandemic. If you bought small, cheap, cyclical stocks anywhere, but especially in the U.K. or Europe, then you had a year more in-line with what you might have expected considering the environment. We won’t belabour the point, but the extent to which expensive stocks beat cheap stocks was astounding. Patrick O’Shaughnessy, the CIO of OSAM, provided this incredible stat (which we have used before but think it is so good it is worth repeating), “Between Jan. 1st and Nov. 30th, the 10% of large cap U.S. ARAVIS CAPITAL | MARKETS IN 2021: A NEW WORLD, A MAJOR BUBBLE, OR SOMETHING IN BETWEEN? stocks with the highest multiples/lowest starting yields (measured with a blend of sales, earnings, cash flows) outperformed those with the lowest multiples/highest yields by 91%.”1

100% Returns – Stick or Twist?

Clearly, the number of extreme winners in the stock market in 2020 was unusually high, especially in the U.S. This was also reflected in fund performance- a Morningstar study of U.S. mutual funds from 1990- 2020 found that 2020 had the third largest amount of funds that returned more than 100% in a calendar year, after 1999 (at the height of the Tech bubble) and 2009 (in the recovery from the GFC). According to Morningstar, there were eighteen funds that gained 100% or more in 2020, and they achieved this by investing in stocks that were “…very expensive…trading at around three times the valuation of the Nasdaq 100, on average.”2 There’s some good news and bad news for investors in these funds. The good news is obvious- they doubled their money last year. The bad news is returns from this point. See the chart below:

As Morningstar conclude, the managers of the 18 stock funds that doubled last year deserve credit for such an impressive achievement. But this type of performance tends to come during market conditions that are unsustainable. For example, 88 of the 123 funds since 1990 that have gained 100% or more in a calendar year were tech/internet funds in 1999.

Where We Stand

With that in mind, we said at the start of the note that our goal is to attempt to make sense of current market conditions. The market (or certain corners of it at least) is ticking numerous boxes that indicate we are in the late-stages of a bubble. This is the big question for Q1 2021. However, the evolution of prior bubbles suggests it could still be the big question in Q1 2022 or 2023. Plenty of investors and market participants far more qualified than us have offered their opinion, so we are happy to sit firmly on the fence, but we do think there are a number of illuminating data points that offer some perspective. Such as:

1 https://twitter.com/patrick_oshag/status/1333784919621955584 2 Jeffrey Ptack, CFA, What to Expect From Funds After They Gain 100% or More in a Year? Trouble, Mostly

ARAVIS CAPITAL | MARKETS IN 2021: A NEW WORLD, A MAJOR BUBBLE, OR SOMETHING IN BETWEEN?

▪ $642 billion worth of single stock options traded on January 8th; the highest single day notional ever – according to . ▪ The ARK family of ETFs led by Cathie Wood, which invest in the fastest-growing companies in the fastest-growing industries (and appear on the 100% performers list in the Morningstar study) had absorbed more than $11 billion of inflows in the five weeks leading to 12th January. That is on pace to match the inflows Blackrock received in 2020. ▪ There have been 53 SPAC IPOs so far in 2021, on track for over 950 in the year. For context, there were 248 raised in 2020- which was already more than the amount raised from 2009- 2018 combined. SPACs allow companies to outline their vision for the future while the traditional IPO process is focused on a company’s past, and full of boring things such as audited financials and legally required risk disclosures. As Myles Udland says in his newsletter, “a total buzzkill”3. ▪ On January 7th, Elon Musk tweeted “Use Signal”- a recommendation for the messaging service Signal. In response, investors bid up the stock of a medical equipment firm with the same name, and a starting market cap of $6.3 million, from $0.6 to nearly $40 intraday. ▪ The price target of $810 for Tesla at Morgan Stanley includes a $37/share valuation for its non-existent insurance business. This implies a value, today, of more than $40 billion for Tesla’s insurance operation. This is close to the size of Progressive, the third largest U.S. auto insurer. Remember, Tesla has never written an insurance policy4.

Finally, we think this chart explains a lot of what is going on:

Comparisons with the Tech bubble and 1999-like levels of exuberance are almost too easy, and we will hardly win points for originality bringing them up here. But we’re going to anyway. Consider this quote below:

“To my way of thinking, the fundamental problem…is that there are hundreds of companies required to grow earnings- earnings, not merely revenues, mind you- by rates of 40%-50% and greater for twenty years and more in order to justify their current market valuations. Very few of these companies will achieve such growth; ergo, hundreds of companies’ market values are at some point going to decline precipitously from current levels. The small number of winners are for the most part already priced to be winners. But the numerous inevitable losers are also priced to be winners.”

3 https://mylesudland.substack.com/p/spac-ev-bubble-2021 4 https://twitter.com/ChrisBloomstran/status/1348022244002430980

ARAVIS CAPITAL | MARKETS IN 2021: A NEW WORLD, A MAJOR BUBBLE, OR SOMETHING IN BETWEEN?

This sounds like a sensible analysis of the current environment but its hardly original. There is nothing in it that has not been said numerous times by various market observers at numerous points throughout 2020 and 2021. What makes those words so interesting to us is that they come from a research report written by a sell- side banking analyst, David Moore, on March 6th, 2000- just days before the absolute top of the Tech bubble5.

For our final history lesson we also wanted to include the following quote from the founder-CEO of Sun Microsystems, Scott McNealy, which we came across in Bronte Capital’s most recent investor letter6. Sun Microsystems was one of the darlings of the market in 1999. In March 2002, two years after the bubble burst, and after Sun had lost 90% of its market capitalization, McNealy said this:

“… two years ago we were selling at 10 times revenues when we were at $64. At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes with zero R&D for the next 10 years, I can maintain the current revenue run rate. Now, having done that, would any of you like to buy my stock at $64? Do you realize how ridiculous those basic assumptions are? You don't need any transparency. You don't need any footnotes. What were you thinking?”

In the third week of 2021 there are 73 stocks currently trading at more than 10x revenues in the Nasdaq 100 and S&P 500. Now, the merits of each business are beyond the scope of this note, and there are some great, fast-growing businesses in that list. But it is safe to say on aggregate investing in stocks at those levels rarely works out. However, we realise it is also easy to get carried away with the ‘bubble talk’ and lessons from history. There have been plenty of boom and bust periods in small groups of stocks over the past ten years which typically have no major bearing on the state of markets generally. Even Howard Marks, who has written books on the market cycle and is famous for his takes on ‘second-level thinking’, has recently admitted we are in a ‘new world’ and the “…basic equations of finance were not built to handle high- double-digit growth as far as the eye can see, making the valuation of rapid growers a complicated matter.”7 With some help from his venture capatalist son he recommends buying the best companies and never selling. Perhaps this is the 2020s brand of second-level thinking, but, admittedly, following that advice would have worked wonders at any point in the past decade.

Our final thoughts on the ‘bubble or not’ question is just how difficult it is to know when we are truly in a bubble and what has worked so far will stop working. Consider the following from a recent Verdad research piece8.

▪ In 1995 Ray Dalio and Peter Lynch began warning investors about a potential bubble in technology stocks. 1995 Nasdaq return: +40%. ▪ In 1996 Howard Marks lamented cocktail party guests and cab drivers talking about tech stocks and hot funds whilst Seth Klarman thought the “current mania” for internet stocks would “end badly”. 1996 Nasdaq return: +23%. ▪ By the end of 1998, had lost $700m shorting internet firms. Soros’s fund said: “We called the bursting of the internet bubble too early.” 1998 Nasdaq return: +40%.

Between 1995 and 1999 the Nasdaq Composite compounded at 43% annualized. So, we’re content that we have no idea if we are in a bubble or when it could ‘pop’.

5 http://www.mch-inc.com/pdf/and%20the%20Madness%20of%20Internet%20Speculators.pdf 6 https://mcusercontent.com/0d29cf83b737cac9573670d07/files/69b6a116-0847-4bbe-9392- 9521980ad76c/Ganymede_Update_202012.pdf 7 Howard Marks, Something of Value 8 Verdad Research, Investing in a Bubble- Spotting Bubbles is Easier than Investing through Them

ARAVIS CAPITAL | MARKETS IN 2021: A NEW WORLD, A MAJOR BUBBLE, OR SOMETHING IN BETWEEN? What Might Work 2020-2030

Will buying the best companies at high prices be the best strategy for the decade ahead, as it arguably was for the past decade? We started this note with Jeremy Grantham’s quote about the ‘reality’ of lower returns for high priced assets because it fits the narrative of historically expensive markets in the U.S.. But if we are in a ‘new world’ that reality may well be wrong. In which case, Growth stocks could continue their outperformance of the broader market as investors continue to be willing to pay up for winners that are growing revenues and earnings at accelerating rates.

In contrast, if lower prices and expectations do lead to higher returns, then we think Value stocks, in the U.S., Europe, or anywhere else, are well positioned at historically cheap levels. We’ve written about this on numerous occasions so won’t go into it here- but we think the current debate between Growth and Value is best summarized by this meme:

Hedge funds, after years of high fees and low performance, had a comparatively good year in 2020. The HFRX Global Index was up 7%. What conditions have been conducive to hedge fund outperformance historically?

- High levels of retail speculation ✓ - Markets driven primarily by emotion and sentiment ✓ - High levels of issuance in equities, bonds, SPACs etc ✓

If the trending markets of the past decade cease, and raising rates from zero at some point breaks the ‘easy’ long duration trade, then we think the market opportunity for hedge funds to outperform will be much improved.

Private markets, beneficiaries of the ‘reach for yield’ in a world of low rates, have seen progressive years of incredible inflows. As PE funds sit on billions of dollars of dry powder, historic IRRs for the asset class (which have resembled leveraged small cap value returns in public markets) might be harder to come by as

ARAVIS CAPITAL | MARKETS IN 2021: A NEW WORLD, A MAJOR BUBBLE, OR SOMETHING IN BETWEEN? deal sizes get bigger and average multiples paid reach historic highs.9 Return dispersion, the difference between the best and worst funds, is very wide in private equity markets, so finding the most skilled managers should continue to be the key to success.

Digital assets and Bitcoin have entered the institutional investor consciousness and are now impossible to ignore. Their properties as an inflation hedge, store of value, and as an uncorrelated asset continue to be debated, but there is no doubt the next generation of investors will be more familiar with, and perhaps more comfortable with, digital assets. Regulation and broader adoption loom in the next decade. Finally, Emerging Markets, after a decade out of favour amidst U.S. tech dominance, stand poised to benefit from cheap valuations and consensus expectations for a weaker US dollar and stronger global growth.

Conclusion

The only thing we know we can forecast with accuracy is that any predictions we might have made above, and we tried desperately hard to avoid making them, will most likely be wrong. The random nature of financial markets will continue, and if the best we can do is vaguely comprehend where we stand in the overall market cycle (if it still exists!) then we achieved what we set out to do. , in his 1994 talk to the USC Business School10, talks about the disastrous consequences of “man with a hammer syndrome”. We are aware that our hammer is the idea that there should be some link between price and fundamentals, and that our nail is all of the examples of a ‘bubble’ listed above. But as we have also admitted, it is quite probable that markets forge a new path, reversion to the mean disappears or becomes a much less powerful force than it has been in the past, and today’s winners become tomorrow’s winners too. Whatever happens, we look forward to a less eventful year and wish you all the best in 2021.

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9 Michael J. Mauboussin and Dan Callahan, CFA, Public to Private Equity in the United States: A Long-Term Look 10 https://fs.blog/great-talks/a-lesson-on-worldly-wisdom/