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While the country has struggled before, it has never been tested with so many consequential and diverse challenges at once. First and foremost, COVID-19 has been the most significant and widespread pandemic of modern times, the fallout of which has affected lives on countless fronts. Second, in addition to the health implications of the coronavirus, the U.S. has experienced the most precipitous economic drop since the Great Depression, with massive job losses and shutdowns of numerous sectors of the economy. Next, last year’s racial unrest has renewed attention to long-standing fissures in the country’s social fabric. Last but not least, deep political divisions and the spread of misinformation have damaged democratic norms, in part leading to the first breach of the U.S. Capitol since 1812.
The peaks of most of these once-in-a-generation challenges seen to be behind us now. And, while the road to full recovery as to all of them will be long — and there are many miles to go — Americans are starting to see light at the end of the tunnel.
The Roaring 1920s
As the nation and the economy reawaken, it may be instructive to look back at a period of American history that bears important similarities: The Roaring Twenties.
Following the gloom and austerity wrought by the Spanish flu and World War I, the beginning of the 1920s exploded with prosperity. The economy boomed with new technologies and mass-produced goods, from automobiles to radios to vacuum cleaners. Credit flowed easily, and the stock market surged. Women secured the right to vote under the Nineteenth Amendment.
But celebration eventually morphed into excess, which manifested into a growing “mother of all bubbles” amid surging conspicuous consumption. Investors began putting money into more speculative ventures without knowing how they worked and with little regard for risk.
By 1929, the pendulum swung hard and the financial markets – and the entire economy – came crashing down. So began the Great Depression.
Roaring Twenties anew?
If history is any guide, the country’s current rebirth and surging optimism could lead to excess and a possibly new Roaring Twenties — the 2020s — and with it similar risks.
For starters, there appear to be emerging bubbles in many key facets of the economy:
- A volatile stock market crashed in early 2020 when the pandemic hit, but stocks later rebounded, with the S&P 500 gaining 76% since its lowest point a year ago.
- A real estate bubble and housing shortage have sent home prices soaring, a boon for sellers and a nightmare for buyers. One economist told CBS News: “I wouldn’t call this a normal market.”
- Inflation could seriously imperil the bull market and require intervention from the Federal Reserve Board.
- The national debt continues to surge, with congressional action needed by this summer to prevent default.
- Expectations of returns are increasingly unrealistic, as investors get accustomed to returns of the past and demand the same or greater gains moving forward.
To be sure, stock market success is certainly not a bad thing, but the question is whether market performance during such catastrophic economic events as the country has recently experienced has created a false expectation for future performance that is not attainable. Today, stock prices for many companies seem to no longer correlate with any reasonable or realistic assumptions of the company’s potential future returns and growth.
Consider the recent frenzy over GameStop in early 2021, when trading volume surged as amateur traders battled with prominent hedge funds over the stock price. While some hedge funds had shorted the stock, a group of individual traders, sensing an uptick in the price, bought up shares, which helped the price soar. Shares went from $43 to as high as $380 and have since plateaued. The ordeal resulted in billions of dollars lost and congressional hearings. The $380 per share valuation was simply irrational and disconnected from any realistic expectations as to GameStop’s future performance. This was a modern-day Dutch Tulip fever that – predictably – caused grievous losses when it broke, as it always does.
The rapid collapse of U.K.-based Greensill Capital is another cautionary tale. The British firm provided supply chain finance, something banks have long offered, but the company also packaged its financing deals into assets that were sold as investments to increasingly overly-optimistic investors that, the media reports now suggest, may have not done proper homework before investing. After an insurer pulled coverage, Credit Suisse stopped selling Greensill’s packaged assets and the company became insolvent. Multiple European regulators are investigating what seems to be another example of an investment program gone awry amongst unrealistic expectations.
Also consider the implosion of hedge fund Archegos Capital Management, which was using borrowed money to bet on stocks, and employed opaque financial instruments in some positions, potentially to avoid having to disclose its exposure. When lenders made margin calls in March, Archegos couldn’t pay up and the lenders sold their shares in a forced liquidation. Archegos – a gigantic investment fund nearly nobody even knew existed – lost tens of billions of dollars in a matter of days, and caused venerable, multinational banks to suffer grievous losses. This is shaping up to be another example of irrational behavior on a grand scale, on the part of the financial and banking industry.
These were all massive collapses, but the companies were widely unknown before they blew up. They shook much of the global financial world to its core. The gargantuan risk exposures went largely unnoticed until they materialized — until it was too late.
Chasing exotic assets
Traditional, or “normal” investment returns seem to no longer be sufficient for many investors, from small and novice individual investors to experienced hands and large institutional ones. More and more investors are turning to exotic opportunities to chase increasingly unrealistic profits.
For instance, cryptocurrencies are all the rage, but they remain risky, volatile, and poorly understood. The hype has concealed widespread fraud, security breaches, and significant losses. One joke on Saturday Night Live is sufficient to send cryptocurrencies tumbling and erase tens of billions of dollars of value overnight, prompting the question: was that value ever there, or was it illusory? While some cryptocurrencies may eventually become more secure and stable, prudent investors would be well-advised not to risk their hard-earned life savings – or their clients’ life savings – in that arena unless they’re willing to lose it all or are looking to commit financial suicide.
Other newly popular investments making headlines include non-fungible tokens (NFTs), cannabis/CBD investments, Special Purpose Acquisition Companies (SPACs), and other digital assets.
It is nearly impossible to turn on the TV or read the news without being inundated with claims that these investments will provide exponential growth. Great reward typically comes with great risk, and these investments are textbook examples.
What they all have in common are: (1) they’re poorly understood by most investors; (2) they come with promises of stellar returns, far above the market norm; and (3) there is little to no detailed information about them of the type that investors need to make an educated investment decision. Yet, oftentimes, the lure of quick and substantial returns proves irresistible even to experienced investors.
Making sense of market fever
Economic growth and innovation are undoubtedly essential for a healthy society, but current trends in the market suggest investors should proceed cautiously.
History tells us that bubbles inevitably burst sooner or later, and we can expect that the bubbles created by this period in our history will eventually burst, too. Bubbles are hard to predict, and timing is particularly difficult even when the bubbles become obvious.
Former Fed Chairman Alan Greenspan summed up such circumstances best in his 1996 address where he coined the phrase “irrational exuberance,” which is market optimism without a solid foundation. His speech was targeted at the dot-com bubble specifically, but the sentiment applies to all of the current bubbles the unfounded market confidence is creating.
So, how might investors approach today’s market in a way that makes sense?
Investors should start thinking about to protect their life savings when the market fever is spreading and the enthusiasm becomes disconnected from reality. As complex as the stock market is, the time-tested principle of the market remains that the price of an asset is tied to, and in the end will reflect, the financial performance of that asset.
While some stocks may be trading at unfounded and inflated prices, investors may be well advised to focus on the fundamentals of the underlying companies, and be cautious or skeptical about the fads of the day. They should consider researching the companies they invest in and staying away from investments they don’t fully understand. These are sound principles of long-term, value investing.
It is perhaps not a coincidence that the value investing principles were published by Benjamin Graham and David Dodd in 1928 just as the Roaring Twenties were about to morph into the Great Depression. While Graham never actually used the phrase, value investing refers to finding undervalued stocks from strong companies and holding them. Value investing is not a get-rich-quick scheme and requires careful research and, oftentimes, fortitude during market downturns, which are the inevitable consequence of bursting economic bubbles. Buying time-tested, quality investments that are well understood might be less exciting than investing in the latest fad, but investors should consider which one might serve them better if or when the exuberance ends and the market crashes back on earth.