The first quarter of 2021 ushered in a new political regime, fresh stimulus and continued vaccine progress while also starring the return of an age-old market concept: exuberance. Below is a brief summary of what happened in financial markets between January 1 and March 31, 2021 followed by some perspective on markets in both the present and the future.
After a few quarters of double-digit performance off the March 2020 lows, stocks delivered more modest returns for the first quarter. The S&P 500 added 6.2% and the Russell 3000 similarly finished up 6.4%. International markets lagged with the MSCI EAFE up 3.5% and the MSCI Emerging Market Index adding 3.3%. Value stocks’ strength continued from the fourth quarter with value outperforming growth across the size spectrum.
In fixed income markets, the yield curve steepened and corporate spreads ended flattish after some volatility throughout the quarter. Bonds saw poor performance this quarter with the core US government and credit market losing a couple percent and international bonds losing more. The high yield bond market finished marginally positive.
Last quarter’s WoodTrust Market Perspectives closed with a few comments on uncertainty and the speculation that often accompanies it. Serendipitously, these concepts played an important role in the first quarter of 2021.
First, a couple of definitions: Speculation, in its most basic sense, is a very common market phenomenon. It involves buying an asset with the belief (or hope) that a future buyer will emerge who is willing to pay a higher price.
Exuberance, or excitement, drives markets every day. When exuberance is rational, such as the excitement around the reopening of the global economy, the downside risk is often mitigated. On the contrary, irrational exuberance, which seems to rear its ugly head at least once during every economic cycle, has the potential to end in turmoil.
Speculation, while risky by nature, grows exponentially more dangerous when mixed with irrational exuberance.
This quarter’s episode of irrational exuberance featured a set of companies targeted by a unified group of individuals focused on driving up the companies’ stock prices. (source) The targeted group of companies consisted of video game retailers, movie theaters, fallen angels from the technology world and the like. While the investment thesis to purchase many of these stocks started with the rational view they were being inappropriately bet against and were undervalued, it quickly turned into a flurry of people buying the stocks at any price with a fear of missing out on big returns. Without any research, people used personal loans, vacation savings and stimulus checks to purchase stock in these companies. (source)
Unfortunately, after a quick and several fold rise, most of these stocks fell in ranges from 60-90% off their highs, ending in tears for many. While these stocks continued to be volatile for the duration of the quarter, many investors had cashed out and remained on the sidelines.
While the goal of this Market Perspectives was not to summarize these events, they provided a great opportunity to talk about the spectrum of market activity and market participants.
Importantly, this speculative exuberance is not new. In somewhat recent memory, investors can think back to the rise and fall of the “dotcom” bubble when individuals were willing to pay huge sums of money for any business that had a “.com” attached to its name. (source) However, even back in the 1600s speculation and exuberance took hold as people clamored to buy tulip bulbs for a price in today’s money that exceeded half a million dollars per bulb. (source)
Unsurprisingly, the market participants that have been discussed so far are considered “speculators”. Speculators are just one player on the market participant spectrum. For simplicity, WoodTrust narrows this spectrum to three important buckets: traders, speculators and investors.
1) Traders: Traders are extremely short-term oriented. They generally seek to profit off of market trends that have momentum over minutes or hours. Occasionally, traders will also make decisions off expected reversals in trends. Most of the time, a trader’s goal is to have no stocks or bonds at the end of the day; this is referred to as having an “empty book”.
2) Speculators: Speculators, the participants discussed at length in this piece, tend to be less bound or defined by time than traders. As mentioned, speculators often buy a stock, bond or other financial product with the belief that at some time in the future someone else will be willing to buy it from them at a higher price. It’s important to understand speculators generally do not have a specific view on a stock’s “intrinsic value” or worth. Instead, they just expect someone else will emerge that ascribes a higher value to the stock than their original purchase price.
3) Investors: Investors tend to be long-term oriented. More important than their focus on long holding periods is the thought process of an investor. Investors focus on “intrinsic value”. Intrinsic value is the belief that a stock or bond trades at a price that all market participants consider to be fair based on the underlying company’s future prospects and earnings power. When an investor purchases a stock, they believe that the stock is trading at a discount to its intrinsic value. An investor believes that, over time, other market participants will realize that the stock is mispriced based on its future potential, and the stock price will eventually move upwards towards its fair price.
Being an investor is WoodTrust’s bread and butter. Throughout WoodTrust Asset Management’s investment programs, the focus is on buying businesses at a reasonable price based on their perceived intrinsic value. Further, WoodTrust utilizes investment managers with the same mindset, expecting that they emphasize consistency, stability and a long-term focus.
There are many ways to grow and retain wealth in financial markets. There are just as many ways to destroy and lose wealth in the same space. For decades, we have prided ourselves on managing our clients’ wealth with a well-researched and methodic process focused acutely on managing risk while avoiding greed and excess.
We continue to employ this strategy in times when irrational exuberance takes over and drives pockets of the market to the edges of sanity. This process and philosophy allow our clients and ourselves to rest easy each night, keeping an ever-confident eye on the future.
As always, we thank you for your trust and look forward to our meetings with you in the near future.