On Apple, Markets and Conviction
Investors would be wise to remember John Maynard Keynes' quote, "When the facts change, I change my mind. What do you do, sir?"
The investment business places a lot of importance on "conviction." Someone's level of conviction on the quality of an investment will determine whether or not your investment idea will be successful. The higher the conviction, the better the pitch was the accepted orthodoxy. People will always prefer an idea pitched with confidence over timidity, even if that idea is inferior.
This concept never sat well with me. If the investment environment and relative attractiveness of various asset classes is constantly changing, wouldn't a more flexible approach be preferable? After all, with conviction comes dogmatism, the inability to change your mind as the facts are changing. This mindset can prove very costly at turning points in the market, as we saw with the permanent bulls in October of 2007 and permanent bears in March of 2009.
It is also true that when conviction is at its highest levels you are at the greatest risk of a disappointment. Take Apple, for example. At its $700 peak last September, every Wall Street analyst had a high conviction buy on the stock and they were jumping over one other to have the highest price target. When the price began to drop sharply thereafter, this conviction quickly waned. In April of this year, after a 45 percent decline from its peak, conviction had come full circle with many predicting the stock would go lower.
In today's market, the highest conviction thesis is most definitely the "Bernanke Put," which is the idea that the Fed can prevent market declines with zero percent interest rates and unlimited quantitative easing or "QE." We see an example of this behavior as U.S. stocks have been the best performers over the past few years and have not suffered a meaningful correction during the entire year. However, it's worth remembering that all puts expire. When the inevitable correction comes, conviction in the "Bernanke Put" will wane. While that may not seem like a high-probability event today, how many investors would have predicted a 45 percent decline in Apple last September?
The other high conviction trades of today are a mix of companies with "disruptive" technologies that have a great "story" to tell. These include social media companies like Facebook, LinkedIn, Yelp, and Pandora; solar power companies like SunPower and Solar City; online media companies such as Netflix; and electrically-powered vehicle companies like Tesla. All of these companies are up multiples of the S&P 500 this year and trade at sky-high valuations due to high expectations for future growth. While a few of these stocks may grow into their lofty multiples over time, the vast majority will likely fail to live up to great expectations.
The question, then, is where are expectations lowest? What are the trades with the least conviction among analysts today? Within equities, emerging market stocks stand out and when looking at a performance chart over the past few years, it is easy to see why. While U.S. small-capitalization equities as measured by the iShares Russell 2000 ETF have posted gains of 64 percent over the past three years, all of the major indexes of emerging market BRIC (Brazil, Russia, India, and China) equities are down. This performance disparity has left a wide valuation gap between the two markets, with emerging market equities remaining cheap and U.S. small-caps being very expensive. This should act as a tailwind for emerging market equities going forward, making any good news a positive surprise.
Another asset class with low expectations now is long-duration bonds. Most Wall Street analysts are bearish on bonds as they have greatly underperformed equities this year. That serves as an additional tailwind in its favor. The fundamental factor favoring bonds here is the simple lack of reflation, as economic data is softening and inflation expectations remain low. In spite of record high U.S. equity prices, this is deflationary behavior that has typically led to higher bond prices and lower bond yields in the past.
That said, while there is a case for favoring bonds now, it's good to remain open to a shift back to equities when the environment becomes more favorable. In the equity space, investors should focus on emerging-market stocks, which have the additional tailwind of being a non-consensus, low-conviction trade.
High conviction will continue to be the gold standard across Wall Street because this is what sells best, but my firm, Pension Partners, prefers a different approach, rotating among asset classes as opportunities and investment environment change over time.
Simply, as the facts change, investors should their minds. What will you do?
Michael A. Gayed, CFA, is a chief investment strategist and co-portfolio manager at Pension Partners, LLC., an investment advisor which manages a mutual fund and separate accounts according to its ATAC (Accelerated Time and Capital) strategies focused on inflation rotation. In 2007, he launched his own long/short hedge fund, using various trading strategies focused on taking advantage of stock market anomalies. Follow him on Twitter @pensionpartners and YouTube.
This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.
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