I do my best thinking on my bike. Endurance exercise is the only way I know how to empty the cranial clutter; to get to the bones of what is important, and to see clearly.

Recently, I have been scratching on two questions. First, how does COVID-19 end? If, on the one hand, a certain percentage of the population has immunity, and a certain percentage of the population will be vaccinated (eventually), we are making great progress. But if those percentages begin to approach the 60% range, a large part of the population will still be potential spreaders. When no one is sure of how long, exactly, immunity will last, it seems like we have a rolling problem. The second question I have been toying with – but have yet to find a concrete answer for – is, is this investing environment just like 1999?

I am amazed how it seems that everyone comes to the same conclusions at the same time. It is a perpetual phenomenon. One theory of social constructs is that each individual comes to their own conclusion at their own pace. Yet time and time again, real-life proves this theory wrong. You only need to look at how social constructs unfold to realize that as a society, we wallow around blindly for years until everyone comes to the same conclusion at the exact same time. There’s universal evidence to speak for the power of the masses, dating back centuries. As this pertains to capital markets, I am reminded of two seminal works from my book collection – “Manias, Panics, and Crashes: A History of Financial Crises” and “Extraordinary Popular Delusions and the Madness of Crowds.”

Speaking of crowds, a ritual of my long Saturday ride is to stop for a beer (a beer) at an outdoor beer garden near my house. Last Saturday, on a beautiful crisp afternoon, I rolled into Eventide, and thought, “Wait, what is happening?” People everywhere: lines, masses, no parking, bikes piled up. I started to get itchy. Who rang the bell? Is COVID over? As I lingered, trying to figure out what to do, I overheard someone say that “…bitcoin is the only hedge against the collapse of fiat currency”. Another conversation declared, “…diamond hands on GameStop…”. In a split second, I had the answers to both of my questions, and it was time for me to ride home and write, beerless. COVID-19 ends when people decide that they want it to end. And as of last weekend, it appears that Atlanta has collectively decided that COVID is over. People have released themselves – for social engagements, that is – and they (miraculously?) all decided this at the same time. On Monday, on my drive to my empty office tower, though, I quickly realized that while crowds are willing to drink together, they certainly don’t want to go back to work.

As for the current investment environment, it is just like 1999. There – I said it. Rolling bubbles everywhere.

For both questions, the answers don’t need to be logical. The answers just are what they are. It serves no purpose to academically analyze their validity because this is the answer that the public has chosen. And, as I have stated many times before, going backward is not an option. The only way to move is forward, in the environment the public creates, on the basis of what it wants the future to be.

As a bonus, I took the below picture on my ride home. Apparently, bitcoin is not for Fiats, but for BMWs.

Not at all a bubble? – Geremy van Arkel, Little Five Points, Atlanta GA, 2021

History Doesn’t Repeat, But It Does Rhyme

Ground Hog Day, February 2, is a day that has been hijacked by a movie that will forever refer to that strange Déjà-vu feeling that we have been here before. As for the current market environment, the feeling holds true: we have been here before.

There are so many similarities between what is happening now and what took place in 1999 that it is uncanny. I will just hit the highlights.

First off, 1999 occurred following a long and extended bull market. Ten years into that bull market, the obvious leaders of the day were known, and investors couldn’t get enough of them. This created a very narrow investment market environment – much like that of today with FAANGM (Facebook, Apple, Amazon, Netflix, Google, and Microsoft ).

There is no denying that these are some of the world’s best companies, but at what price?

The second facet of today’s market environment that is eerily similar to that of 1999 is the current concentration of popular holdings in indexes. It is important to remember that indexes are just formulas, and market cap weighting depicts the weightings to each stock. There is no magic in indexes and no qualitative reasoning – they simply hold each stock at its market cap weighting. The higher a stock’s price rises relative to other stocks, the larger the weighting in the index. In that manner, indexes are trend-chasers. Currently, FAAAMiT (Facebook, Apple, Amazon, Alphabet, Microsoft, and now including Tesla) represent 45% of the NASDAQ 100 Index and 24% of the S&P 500^® Index. Therefore, if the trend is your friend and continues until it hits a wall, then investment managers need to invest at least 25% of their client’s assets in these six stocks if the goal is to outperform the S&P 500 index. But, who in their right mind is going to do that?

As fewer and fewer rational investors are willing to put upwards of half their money in just six stocks, indexes end up being the only option for those wanting to ride the trend. Similar to 1999, index investing is extremely popular today. Investors want to believe that whatever returns that have occurred in the recent past will continue indefinitely. This, among a confluence of other factors, has caused the overall market price to rise to record levels. While we all love rising asset prices, some may be concerned about overall market valuations. Below is Robert Shiller’s visual of long-term market valuations. By almost all measures, stock valuations in the U.S. are at or near all-time highs.

In 1999, there was a revolution underway. The fledgling internet gave birth to online trading. Way back then, though, you had to open Netscape from the beige box under your desk to access your E*Trade account. Today, with the advent of fractional shares, instant leverage, and access to all instruments, millions of investors can simply push a button on their phones to make a trade. The revolutionary part of today’s day trading is not that the trades are now on your phone, but the use of social media to amass millions (yes, millions) of investors to make the same trade at the same time.

Just as in 1999, too, it is not a matter of whether one investment manager outperforms another. The longer this narrow market environment goes on, the worse it is for all professional money managers. Sooner or later, investors leave the system to chase performance on their own. There were 10 million new brokerage accounts opened last year, which is a record for any one year, by far. At last count, there were close to 13 million Robinhood accounts (April 2000), and the app gained 3 million new users in January 2021 alone. To put this in perspective, E*Trade has 5 million accounts, and investment giant Schwab has 30 million accounts.

Now some fun stuff! Or: cue the weirdness. Just as in 1999, with millions of day traders, lifelong experienced investors can be left fumbling around for professional explanations for weird market actions.  But as you know I like to say: no need to explain, let’s just enjoy the show. Here’s some of the weirdness that actually occurred.

1) For a short period of time, the number one performing stock last year was the wrong Zoom. With investors frantically buying popular names, dyslexic tickers became an actual strategy.

2) Kodak received hundreds of millions of dollars from the government, for no rational reason, and the stock went up 30-fold.

3) The online herd took a run at already bankrupt Hertz, and, as a consequence, the stock went up 5-fold (while being worthless.)

4) Tesla stock rose from $90 a share to over $800 last year, leaving it with a P/E of over 1,000. Tesla was added to the S&P 500 index near this ridiculous valuation!

5) Not to be outdone, electric car designer (not maker, mind you – they do not even have a factory, nor do they produce any cars for sale) Nikola (…aren’t they clever?) was valued for a short while at over $30 billion. The CEO stepped down on fraud allegations. The company is still worth $9 billion.

6) The cryptocurrency revolution has taught dudes standing around in bars what fiat currency is.

7) Similar to 1999, options volume has skyrocketed. Further, there were 407 IPOs in the U.S. in 2020, as private equity owners scrambled to unload their holdings on the public. The previous annual record was 1999 with 486 IPOs.

8) There are 8 million registered users (“Degenerates”– their term, not mine) on the WallstreetBets subreddit. Just as we now need to understand social media’s impact on politics and society, we also need to accept its presence in capital markets.

9) The thundering herd of combined trades from these social media day traders has now captured the nation’s attention. This time around, short squeezes. Next time, who knows?

10) Finally, if on any given day the stock market doesn’t go up, we need to know why, and the Fed/Government/someone better do something about it, stat!

So how does this all end, and what, if anything, should we do about it?  Are these the signs of a stable and efficient market environment? I will let you decide. What I personally learned in 1999 is that there is no way to win a bubble. I find it best to simply not participate. That way, I can sit back, watch, and just enjoy the show. The second thing that I learned is that there is a difference between an investment and a speculation. Here is a rule to live by, so ears up. An investment is an asset that you can hold forever. If investors only chose investments in light of the idea that they could never sell them, they would make much better decisions. A speculation, on the other hand, is when investments are chosen with the idea and intent that they will be sold at a higher price.

In 1999, the day traders were flushed out of the system when the NASDAQ lost 78% of its value over the following three years. And no, there was no trigger: no one rang a bell to tell the day traders to take their winnings and run. Most of the players left the table empty-handed, and some even worse.

With all that being said, I am by no means implying that the popularity of day trading will cause the stock market to collapse. For one thing, the structure of the NASDAQ is entirely different today than that of 1999. Today’s NASDAQ is made up of many of the greatest companies in history, and they have earnings!  Secondly, each market change is unique and is almost always different the next time around.

What I am implying, though, is that sometimes the current market environment appears impermeable, and that is when any change can be a big surprise. The collapse of the NASDAQ aside, when the market concentration changed in 2000, the dollars across assets evened out and money flowed from heavily concentrated areas to those areas that had been left behind. Instead of being Groundhog Day, it was opposite day: everything that had trailed in the prior environment thrived in the next.

Which leaves me with my third question.  Will the next five years be a mirror image of the last?

Capital Markets Overview

Clifford Stanton, CFA | Director of Investments

Investors shying away from U.S. large cap and international developed stocks during the month were not indicative of a change in economic sentiment or the outlook for risk assets. It appears that growing optimism about a recovery due to the vaccine rollout, clarity regarding pending stimulus, and hopes for more constructive trade policies extended the leadership of more cyclically exposed small caps and emerging market equities into the new year. Further, the voting machine that is the market declared that smaller was indeed better, as microcap stocks soared by about 14%. That gain brought their three-month total return to 48%, more than tripling the performance of the S&P 500^®, which advanced by a relatively uninspiring ~14% over the same time frame.

From a sector perspective, the market telegraphed mixed messages. Surfing on the black wave of Brent crude, which advanced by almost 8%, energy stocks led all the major sectors for the month (S&P 1500 Energy approximately +4.3%), with cyclically oriented consumer discretionary stocks (+1.4%) and more defensive healthcare stocks (+1.7%) advancing as well. Conversely, defensive consumer staples’ names were down almost 5%, and cyclical industrial companies were off by about 3.5% despite ever more encouraging signs of a surge in manufacturing activity. This tension between cyclicals and defensives could be emblematic of an inflection point, as investors sort out a rapidly changing and still highly uncertain environment.

On the earnings front, with about 43% of S&P 500 companies reporting as of month-end, GAAP earnings grew by 2.4% on a quarter-over-quarter basis but fell short of 4Q19 earnings by about 5%. Margins were slightly lower than a year ago, coming in around 10.4%, but were well ahead of where they stood at the end of the first quarter (+5.8%). In sum, the earnings picture has improved more quickly than most had expected after the chaos and destruction in the first half of 2020.

Given the market’s belief in a robust growth narrative, the yield curve steepened. Short rates were anchored around zero on Fed policy, while the 10-year Treasury ended at 1.11%, up 18 bps from year-end. Rising rates led to a decline of around 0.7% for the Barclays U.S. Aggregate Bond index and a loss of slightly more that 3.6% for the Barclays U.S. Treasury Long Index. Credit was mixed, with investment-grade corporates falling by 1.3% and high yield advancing by 0.33%. The fixed income landscape is challenging, to be sure, with seemingly limited upside and an evolving risk profile.

Commodities kept their positive streak alive, with the Bloomberg Commodities Index gaining a little more than 2.6%. Corn and tin were both up around 13%, while cocoa, coffee, and zinc were off by 2.8%, 4.1%, and 6.5%, respectively.

Strategy Overview

During the month of January, Frontier’s asset allocation mixes shifted more toward equities, specifically U.S. and international small caps, at the expense of long-term government bonds and TIPs. Our more conservative strategies also increased exposure to high-quality bonds while reducing cash.  Post-trading, our strategies remained underweight equities in total, but at the sub-asset class level, we are overweight U.S. small caps within our more conservative strategies. Further, within our more aggressive strategies we have modest overweights to international small caps and emerging market equities.

Frontier’s relative equity positioning was quite advantageous for the month. We were overweight in the equity classes that outperformed and underweight in the ones that underperformed. Unfortunately, the total weighting to U.S. and international large caps, which were both down, coupled with negative fixed income returns, overwhelmed the positive impact from our sub-asset class exposures. As a result, all but our most aggressive strategies – Global Opportunities and Focused Opportunities – produced lackluster results. Regardless, we are encouraged by the trends in favor of small caps and emerging markets and believe we are positioned to capture outperformance in those areas.

Finally, the recent trends in our long-term return expectations continued, with the outlooks for all equity classes and high-yield bonds declining, as valuation increases have surpassed the expectations for earnings growth. Conversely, the outlooks for high-quality bonds and long-term Treasuries were up yet again as rates increased. Nevertheless, they remain at unattractive absolute levels and are held primarily for risk reduction. Despite these trends, we have been selectively adding to risk assets for months now, as our risk indicators have continued to move in a positive direction. Instead of simply hoping that 2020 will just repeat itself, we at Frontier believe that our strategies are poised to capitalize on a different opportunity set going forward.