March Madness and the Dow
April 30, 2019
Market Summary – 1st Quarter, 2019
“There are three kinds of lies: lies, damned lies, and statistics.”
~Phrase popularized by Mark Twain
Movies frequently have disclaimers that read something like “the characters and events depicted in this film are fictional. Any similarity to a person living or dead is coincidental.” Perhaps a comparable disclaimer should be attached to major stock indices – “the performance of this index is not necessarily representative of the stock market as a whole. Any similarity to actual performance of the broader stock market is coincidental.”
That’s the reality of today’s stock market. The commonly quoted indices (Dow Jones Industrial Average, NASDAQ Composite, S&P 500) purportedly represent “the market.” Investors who choose to passively invest in index funds or exchange-traded funds (ETFs) tied to popular indices are led to believe it is a way to replicate “the market’s” performance. But it is increasingly evident that these indices are not “the market.” As investment vehicles, they carry more risk and less diversification than many investors perceive.
The Dow Jones Industrial Average (DJIA) may be the most frequently quoted index by the news media. For 123 years, it has been recognized as the primary barometer of the stock market. Many consider it a signal of how stocks as a whole, and by extension, the U.S. economy are performing. Yet on both counts, it comes up woefully short. For starters, the DJIA represents just 30 stocks. More concerning is it is a price-weighted index. The higher a stock’s price, the larger its position in the index – regardless of the impact the company has in the broader economy.
Two Days in March
Can the performance of only one stock significantly distort a major index like the Dow? Consider what occurred on two days in March. As reports surfaced of the second tragic crash in a six-month period of the new Boeing 737 Max jetliner, the Dow was suddenly out of sync. On March 11th, most stock indices were up in the one-to-two percent range, but the Dow only gained about half as much. On March 12th, most key market indices were up, but the Dow was down nearly a half percent.
Why did this happen? Note that with its lofty share price of $381.421, Boeing is by far the LARGEST stock represented in the price-weighted index, and comprises nearly 10% of the Dow2. By comparison, the smallest component in the index is Pfizer, hardly an insignificant company. Yet the performance of Boeing’s stock has about nine times more influence on the Dow than does Pfizer’s stock1.
This explains why the Dow Jones can be so deceptive and reflect the movements of one or two businesses rather than the entire economy. When indices fail to reflect the reality of the markets, they also may send out false signals about the relative strength or weakness of the economy. And it isn’t just the Dow.
The top ten stocks in the market-capitalization weighted S&P 500, about 2% of all stocks listed in the index, represent about 20% of its value3. This also distorts what’s really occurring in the broader market. In recent years, the S&P 500 soared on the strength of outsized returns generated by a select group of mammoth technology stocks that, in our judgment, carry grossly excessive valuations. If the S&P 500 gains 10% in a year, that doesn’t necessarily mean “the market” gained 10%. Its recent results primarily reflect the strength of a handful of companies.
The false impression created by distorted indices can impact how people make investment decisions. Money is pouring into index-driven ETFs in record amounts (see chart), creating a bigger issue.
An index investor today doesn’t “own the market,” but one representation of a portion of the market. As individual stocks generate “market-beating” returns, they become more dominant in their respective indices. Over the past decade, the stock market has, in many ways, been a popularity contest, favoring an increasingly narrow group of stocks that now represent outsized portions in the popular indices. As a result, index investing today shows a clear preference for growth stocks over value; large-cap stocks over mid-cap and small-cap; and U.S. over international stocks. Most investors would not consider investments only in large, U.S. growth stocks to be a broadly diversified portfolio. Yet most index investors may not realize that this is, in essence, what they own today. And it means they are carrying far more investment risk than they realize.
The proliferation of ETFs has facilitated individual investors’ ability to whimsically move money in-and-out of the market. High frequency traders and their kind make a living managing assets that way. These traders make decisions based on the day’s headlines and what is working at the moment, and often trade in accordance with the emotions of the masses.
An example of how headlines can cause dramatic tumult in the market was seen recently when we experienced an “inverted yield curve.” Consider that on March 21, stocks enjoyed a strong day of performance. At the end of that trading day, the yield on the 10-Year U.S. Treasury bond was 2.54%, just five basis points (.05%) higher than the 2.49% yield on 3-Month T-bills.
A day later, stock markets experienced a significant selloff. Why? Apparently because of seven basis points, or 0.07% in movement on the spread between the yields of the 10-Year and 3-Month Treasuries. The 10-Year yield dropped to 2.44% while the 3-Month yield closed at 2.46%. For less than one-tenth of one percent move in the spread of yields, it was as if the world changed overnight from a sense of contentment about solid, steady economic growth, to the supposed threat of a recession. But the trend was short-term. Weeks later, you would be hard pressed to find an economist willing to go on TV and speculate about the “upcoming recession.”
Is there value ten years into a bull market?
Understanding the dichotomy between the two primary styles of investing, growth and value, is essential. Growth investors, as the name implies, look to invest in businesses with high growth potential. Even if current earnings are nonexistent, growth investors are often willing to pay a substantial premium for a company’s prospects of generating significant earnings that are far off in the future.
Value investors tend to avoid the popular “story” stocks that infatuate the masses. They won’t pay premiums for businesses based only on future earnings potential. Instead, they look for businesses that, in combination with future growth potential and strong assets, also generate meaningful current earnings and cash flow. Value investments are in businesses that are typically out of favor and misunderstood by Wall Street. As a result, these stocks are inexpensively priced from a valuation perspective, making them less risky than growth investments, but still offering meaningful upside. At MPMG, we love investing in growing companies that are changing the world . . . but we won’t pay a premium to own them.
Growth stocks have benefited over the last decade as interest rates hovered near historically low levels. At the heart of fundamental valuation is the discounting of future earnings, or determining the present value of earnings to be generated in the future. Interest rates are a key determinant in the rate used to discount future earnings. When rates are this low, it makes the discounted present value of the future earnings higher, and inflates the stock prices of these growth companies.
Here’s a practical example. Consider a company that is expected to earn $1 million dollars ten years from today. This $1 million in 2029, discounted back at a 2.5% rate to today’s present value, would be worth about $780,0004. However, this same $1 million in 2029, discounted back at a 6.5% rate (closer to historical level of 10 Year U.S. Treasury bond) would be worth only about $530,000 in today’s dollars. The lower discount rate makes the present value of these future earnings nearly 50% higher.
Over the past decade, we’ve experienced an artificially low interest rate environment. This is the result of massive quantitative easing programs and monetary interventions by central banks around the world as a response to the 2008-2009 Financial Crisis. Because this environment favors the growth style, it has enjoyed one of its greatest periods of outperformance versus value in history. The valuation spread between growth and value recently reached its widest point in almost 20 years, and by other measures, this gap between growth and value is the widest that it has been in history5.
At times like these, investors may feel compelled to try to “keep up with the (Dow) Joneses” and other indices. But this is a fool’s errand. The excessive valuations of these high-flying stocks are likely to be unsustainable. History tells us that over the long run, value enjoys a substantial advantage over growth.
As the chart above shows, the cumulative results over a 91 year period of a $1,000 investment in U.S. value stocks delivered a return nine times greater than a $1,000 investment in growth stocks.
Despite the lagging performance of value stocks over the past decade, returns have still been substantial. They have generated these significant returns without taking on the ever-growing risk that exists for growth stocks. Wise investors should be asking themselves, “Will these historically low interest rate levels persist, or might they start to normalize? And if that happens, does it make sense to be more selective in what I own and protect my investments?”
This is the benefit to value investing. When the markets are roaring, value investors tend to do well – but not necessarily as well as growth investors. But when the cycle shifts, growth investors are prone to significant losses, while value investors tend to be much better protected . . . and can actually thrive. For many value investors, this means that you get to keep your money even when the cycle shifts, as it inevitably will. Common sense is anything but common on Wall Street.
It’s easy to find comfort in doing what’s popular. The problem is that doing what’s popular sometimes means compromising your principles and taking unnecessary financial risk. Chasing the Dow Jones and other indices, or trying to capture the market’s momentum is contrary to our own principles. We remain focused on identifying quality companies that are well positioned for future prosperity, but that are currently overlooked in the market. While most of the money has been on the other side of the “bet,” a contrarian point of view appears to be particularly valuable at this point in time.
Short-term popularity has never been the key to building long-term wealth. As history shows, paying attention to value ultimately generates the best results. The current environment of low interest rates and slow economic growth won’t last forever. As we have seen many times before, the parts of the market that are thriving off of momentum today will run out of steam, and losses will most likely be incurred.
Value will rise again. It requires patience, persistence and a discerning eye for true investment opportunity. In the end, we believe that the tortoise will once again defeat the hare.
A sneak peek at this year’s MPMG Speaker Series
We all remember moments in our history when our country has been unified in purpose. It is fair to say that usually, that common sense of purpose made our nation and our economy stronger. While a certain level of political discourse is healthy, when it becomes extremely divisive, as it has today, it can have a corroding effect not just on the culture, but on our economic well-being.
We’ve invited political satirist/social commentator Dennis Miller as the featured speaker for this year’s MPMG Speaker Series event to address this issue. In Miller’s presentation, entitled “America: A Ten Point Plan for a Return to Civility”, he has turned his sharp observational talent to the topic of how we can bridge this political divide.
Miller has been called “the most cerebral, astute and clever stand-up ever to put mouth to microphone.” You may remember that he came to fame as the host of “Weekend Update” on Saturday Night Live in the late 1980s and early 1990s. Since that time, he has hosted other television programs, written a number of books, and even spent two years in the broadcast booth for Monday Night Football.
In such polarizing times, we believe Dennis Miller’s pragmatic take on the world will provide a refreshing perspective on a hot summer night. Watch for more details about this event soon!
1. 1 As of March 29, 2019 close
3. As of December 31, 2018 close
4. 10 Year U.S. Treasury Bond yielded 2.41% on March 29, 2019
5. Max, Sarah (April 4, 2019). Value Investing Will Beat Growth Again – but Maybe Not for Years to Come. Barron’s
6. Russell 1000 Growth & Russell 1000 Value
Established in 1995, Minneapolis Portfolio Management Group, LLC actively manages separate accounts for individuals, families, trusts, retirement funds, and institutions. Our proven value-oriented investment philosophy has created long-term wealth for our clients.
Visit our website at: www.MPMGLLC.com
Although the information in this document has been carefully prepared and is believed to be accurate as of the date of publication, it has not been independently verified as to its accuracy or completeness. Information and data included in this document are subject to change based on market and other condition. All prices mentioned above are as of the close of business on the last day of the quarter unless otherwise noted. Market returns discussed in this letter are total returns (including reinvestment of dividends) unless otherwise noted.
The information in this document should not be considered a recommendation to purchase any particular security. There is no assurance that any of the securities noted will be in, or remain in, an account portfolio at the time you receive this document. It should not be assumed that any of the holdings discussed were or will prove to be profitable, or that the investment recommendations or decisions we make in the future will be profitable. The past performance of investments made by MPMG does not guarantee the success of MPMG’s future investments. As with any investment, there can be no assurance that MPMG’s investment objective will be achieved or that an investor will not lose a portion or all of its investment.