February 18, 2020
Black Swan Sighting as Tech Stocks Power On
Please read important disclosures HERE.
February 18, 2020
Please read important disclosures HERE.
Stocks in the U.S. and overseas generated robust returns last year as interest rates in the U.S. declined and economies around the world avoided recession. Entering 2020, the outlook for global stocks appeared upbeat with U.S. economic growth expected to remain on track and growth in other developed economies projected to pick up modestly from last year’s slow rate. With the U.S. Federal Reserve intent on keeping interest rates low and stocks riding positive momentum, the planets appeared aligned for further strong stock market gains this year.
This positive backdrop was challenged, however, in the second half of January as news of the deadly coronavirus trickled out of China. As reports of the number of infected people reached 10,000, stocks around the world sold off. While the odds of a global pandemic were perceived to be low, the impact of such an event would be devastating. Along with the tragic human toll, a pandemic would quite likely trigger a steep recession and major stock market sell-off.
The coronavirus is a classic example of a “black swan.” In his book, Fooled by Randomness, scholar and risk expert Nassim Nicholas Taleb uses an example of a black swan1 to help explain an important type of risk. According to Taleb, black swan risks represent extreme events that typically have little, if any, historical precedent. Since they have not been observed in the past, we assume they cannot happen in the future and thus fail to build in appropriate precautions. As a result, we expose ourselves to catastrophe that we might otherwise have avoided.
A recent real-life example of a black swan was the financial crisis in 2007–2009 and, more specifically, the central role that declining housing prices played in the crisis. In the years prior, banks created increasingly risky mortgage securities based on the assumption that housing prices could never decline on a nationwide basis since they had never done so in the past. When this assumption turned out to be wrong, the prices of the mortgage securities crashed and the banks and other financial institutions who owned these securities required bailouts.
While black swan risks are impossible to quantify, it is nevertheless prudent to acknowledge their presence and plan accordingly. From an investment perspective, one way to position for these risks is to maintain a reasonable balance (diversification) between risky assets such as stocks and more stable assets such as high-quality, short-term bonds. This balanced approach may, at first blush, seem unnecessarily conservative at times when stocks have been rising and appear poised for further gains. However, we only need remind ourselves that black swan risks are always lurking to appreciate the prudence of maintaining balance.
Technology Stocks Lead the Way
Technology stocks, and the broader category of growth stocks, have been on a tear of late. Tech stocks were the best-performing sector of the S&P 500 Index2 last year, up 50%, and their strong performance continued into 2020.
These robust returns have been driven by revenue and profit growth in some of the largest tech and “new economy”3 companies, including Apple, Microsoft, Alphabet, and Amazon. These companies have established dominant positions in their businesses and their futures appear bright. Given these positives and the momentum in their stock prices, it can be quite tempting to allocate more investment assets to them.
For our clients’ portfolios, we counsel against adding to these large, growth-oriented companies for a few reasons. First, our clients already own substantial allocations to tech stocks even if these allocations are not quite as high as the overall market. Technology and other new economy stocks comprise 32% of the stocks within the B|O|S U.S. equity portfolio4 as compared to 37% within the S&P 5005. Given our structural tilts to value and small company stocks, both of which tend to have lower allocations to tech stocks, our underweight position to these stocks is not surprising. That said, with nearly one-third of U.S. stocks allocated to these growth stocks, our clients are already well-positioned to participate in any future gains in these securities.
Second, the current environment seems increasingly reminiscent of past periods when investors overpaid for technology and other growth stocks on the basis that “this time is different.” In the 1960s and early 1970s, the mantra was “growth at any price,” as investors bid up the prices of a group of large growth stocks dubbed the “Nifty Fifty” that included tech companies such as Polaroid, Xerox, IBM, and Texas Instruments. But when the 1973–1974 recession hit, this group of stocks suffered substantially greater losses than the overall stock market. Twenty-five years later, investors bid up the prices of tech and telecommunications stocks to unsustainable levels on the basis that we had entered a new paradigm in which the old rules of investing no longer applied. When the bubble burst in 2000, the subsequent losses were huge. From 2000 through 2002, the tech-heavy NASDAQ 100 Index6 declined 73%7. In both of these previous experiences, investors were right to assume that technology would continue to play a vital role as a driver of growth in the global economy. Their mistake was to assume that these companies’ stock prices did not already reflect this growth. While valuations of tech stocks are not nearly as high as they were in the late 1990s, they are becoming increasingly stretched.8
Third, considering the long-term data going back 93 years, growth stocks, consisting of technology and other fast-growing companies, have lagged the overall market largely for the reason noted — investors have tended to overpay for growth stocks. Value stocks, at the other end of the valuation spectrum, have been the stronger performers. The following chart shows that on average large cap value stocks have outperformed large cap growth stocks by more than 2% per year while small cap value stocks have outperformed small cap growth stocks by more than 5% annually.
We advocate tilting portfolios toward value stocks given their long-term return advantage and our expectation that this value premium will persist in the future.
Key strategies for successful long-term investing include avoiding catastrophic portfolio losses and putting the odds in your favor. Planning for black swans and tilting toward value stocks are effective strategies in this regard. You may miss out on some returns in the short term but the trade-off is worthwhile in order to increase your likelihood of long-term investment success.
1. Nassim Nicholas Taleb, Fooled by Randomness, 2004. Prior to the 17th century, black swans were presumed not to exist and the phrase “like a black swan” was used to describe something that was nonexistent. Then, in the late 1600s, Dutch explorers saw black swans in Western Australia.
2. S&P 500 Index: A market capitalization-weighted index that generally contains the 500 largest publicly traded stocks in the U.S., subject to certain restrictions. An index is unmanaged and not available for direct investment.
3. B|O|S defines “new economy” stocks as all stocks in the S&P 500’s Information Technology and Communication Services sectors plus Amazon (which is classified by S&P in the Consumer Discretionary sector).
4. Source for B|O|S equity portfolio sector allocations: Bloomberg
5. Source for S&P 500 sector returns: Morningstar
6. NASDAQ 100 Index: A market capitalization-weighted index of the largest 100 companies listed on the Nasdaq stock exchange. The index is heavily weighted towards stocks in the Technology and Communication Services sectors. An index is unmanaged and not available for direct investment.
7. Source for NASDAQ 100 Index return: Morningstar
8. Per Siblis Research, the price-to-book ratio of the S&P 500 Information Technology sector reached 7.53 at the end of 2019, its highest year-end level since 1999.