Investors are finding gaps between perception and reality

This article appears in the March 2021 issue of Advisor’s Edge magazine. Subscribe to the print edition, read the digital edition or read the articles online.

I’ll just say it: cryptocurrencies have no part in a rational investment portfolio. Like gold and conventional currencies, cryptos pay no interest or dividends, and so they have no expected return. (I reserve judgment on non-fungible tokens, such as Ethereum’s KnownOrigin.)

Yet if early 2021 market activity is any indication, people still equate speculation with investing.

Who can blame them when confusing contradictions exist? Stock prices reach new highs as a pandemic-impaired economy continues to struggle. The stocks of failing companies explode to the upside when retail investors organize on social media and pile in. And renewed inflation fears arise despite abundant labour and industrial capacity.

Are gaps between perception and reality spreading? Is investment risk increasing — or do we just have too much time on our hands?

Stock prices and the economy

The link between the economy and capital markets is loose. Stocks broadly reflect growth prospects, not what is happening right now. The real challenge is to arbitrage the spread between perception and reality. Time accounts for much of the difference.

For example, one could reasonably predict that, post-pandemic, things will return to normal and pent-up demand for restricted services, like restaurants and travel, may create an economic surge.

The reality is likely to be different. Rebound percentages from a depressed 2020 will sound more impressive than they are — 50% declines need 100% gains to get even. Consumer confidence, rehiring and recovery will be tempered by uncertainty about the nature of the rebound. Remote working will change how some businesses choose to operate in the future. Rerouting supply chains may take more time than expected. Some consumer behaviour, like mall shopping, may never return to pre-pandemic levels.

How will stock markets respond if the economic rebound doesn’t measure up?

GameStop and uncertain business valuations

The perception–reality gap was on full display in stock markets early this year. Shares of video game retailer GameStop rose from $20 to $467 (in U.S. dollars) thanks to the speculation driven by the WallStreetBets forum on Reddit and traders using commission-free online brokerage firm Robinhood. GameStop shares then fell to around $45 before rising again at the end of February.

Robinhood’s 13 million accounts were encouraged to participate in the stock market (many on margin) while everyone was locked down because of Covid-19. Many traders were relative newbies — the platform added more than 3 million accounts in 2020. Robinhood’s median accountholder is 31, with less than $5,000 in their account (compared with six figures at firms such as Fidelity and Schwab). Buying the big March 2020 dip meant everybody made money early. Success emboldened the new players.

Meanwhile, short sellers attracted to the “Blockbuster of video games” were betting GameStop would join the major retailers that filed for bankruptcy in 2020.

The corporate reality is that new board members may transform GameStop into an online business, albeit against heavy odds. The short-term market reality is that Reddit populists were able to inflict large losses on hedge funds through their short squeeze. The longer-term reality is that business fundamentals must develop to support apparently lofty valuations.

Even if they lost, the retail traders will have learned a valuable lesson: speculation is different than investing, and stocks can go down too.

Inflation

Rising inflation holds the most risk for capital markets today. The current bull market is predicated on low inflation and falling interest rates. Thirty-year U.S. Treasury bond yields rose from 1% in March 2020 to 2% in February 2021. If they double again to 4%, the perceived value of future earnings will have to be adjusted upward and P/E multiples downward, making stocks vulnerable.

Determining the extent to which inflation will impact other sectors in coming periods is the key to the market’s movement. But if you remember when inflation was in double digits and how the psychology of rising prices impacted economic pricing, you are either retired or thinking about it.

An entire generation of investment professionals is watching for something they have never personally experienced. The perception is that inflation doesn’t rise, held in check by secular demographic and technological trends. The reality could be very different.

A real risk is not understanding the dynamics between the reality and perception of inflation’s impact. Will this be a GameStop-like educational moment? Time will tell.

Mark Yamada

Investments

Mark Yamada is president of PÜR Investing Inc., a software development firm specializing in risk management and defined contribution pension strategies.