By Jack Forehand, CFA (@PracticalQuant)
Confirmation bias is one of the most damaging biases in investing. All of us want to be right. We all want to think that opinions that disagree with ours don’t have sensible arguments to support them. So we gravitate toward people who agree with ours. Whether it be in our personal relationships, or our virtual ones through things like social media, we all unconsciously want to seek out validation that proves that what we thought all along is correct.
This practice can be very problematic in normal times. In times like this, where emotions are running high and many of us aren’t thinking as clearly as we normally would, it can be much worse than that. I try to use my blog posts to share some lessons I have learned over the years, but to be honest, there is a selfish element to writing for me. I have found that writing helps me to better challenge my own beliefs and also invites others to challenge them as well. That process has made me a better investor. It has made me a better thinker as well.
Given the unprecedented situation we currently face and the fact that I am probably not thinking things through as clearly as I normally would, I thought now would be a good time to look at some things I currently believe, and to try to figure out why I might be wrong.
Here are some things I have been struggling with in relation to the COVID-19 outbreak and its impact on our lives and markets, and
My Belief: We need to shut down the country for a fairly long period of time
I was fortunate to follow some great thinkers coming into the situation we currently face. People like Ben Hunt at Epsilon Theory and Eric Townshend of Macro Voices were able to use data to see what was happening in China and predict that it would also likely happen here. They were also early proponents of social distancing and other things like increased testing capacity that could have helped limit the problems we are dealing with now. Based on their work and the work of others, I have learned that barring a breakthrough on the treatment front, social distancing, coupled with a rapid ramp up in our testing capabilities, is likely the best path out of the situation we find ourselves in. I am confident those approaches will eventually prove effective, but they may need a lot of time. This may require keeping our economy in its current shut down state for longer than many people believe.
Why I Might Be Wrong: The price of shutting down our economy is massive and isn’t just measured in dollars
As all of us are learning right now, shutting down our economy has massive costs. Not only are many people losing their jobs and their income, we will also likely see significant increases in things like depression and suicide rates. Although saving lives in the most important thing and social distancing is clearly the best way to do that, it will eventually have to be measured against these costs on the other side of the equation because there will be a major human toll both ways. I don’t pretend to understand when that point will come, but as I learn more about this issue, I am beginning to understand that it may come earlier than I thought it would. Hopefully we can ramp up testing quickly over the next several weeks, cases begin to decline, and we aren’t faced with a situation of picking the least bad option, but as I have studied this issue, I have learned there is more to it than I thought.
My Belief: This is a great buying opportunity for long-term investors.
If you look at a long enough time frame, every bear market has been a buying opportunity. So it is easy to use that fact to give the advice that for investors with a 5+ year time frame, panics like this should be bought. That is the advice I have been giving others. It is the advice I have been acting on myself. It is also the advice that history would suggest is most likely correct.
Why I Might Be Wrong: The economic situation we are likely to face is unprecedented and overall market valuations aren’t cheap
We have never just completely shut our economy down like this. As a result, we really have no idea what it will mean. And the longer this goes on, the more significant the impact will be. When you couple that with elevated valuations coming in, you could certainly argue that you have a recipe for something much greater than a garden variety bear market. Some of the smartest people I follow have been making that exact argument. It is certainly possible that my belief that buying in times like these historically has been a successful long-term strategy is clouding my ability to see how massive the problems we are facing truly are.
My Belief: This is a generational buying opportunity in small-cap value stocks
On a relative basis, small-cap value stocks are cheap. This chart shows the ratio of the valuation of small-cap value stocks relative to large-cap growth stocks. As I am writing this, it is the lowest it has been since 2006. And if you look further back, you will see we are at or near 2000 levels, depending on which metric you use.
And following this recent decline, small-cap value stocks are also cheap on an absolute basis. Although the overall market valuation is nowhere near 2008 levels, small-cap value stocks trade at similar valuations as they did then.
To me, this combination of absolute and relative valuations is something we will likely see once or twice in a generation. This tells us nothing about what might happen in the next 6 months or the next year, but for investors with a 5+ year time horizon, small-cap value seems like a major opportunity.
Why I Might Be Wrong: Many secular trends don’t favor small-cap value stocks and this crisis could impact them more.
I wrote a long article last year where I looked at the reasons value investing may not work in the future like it has in the past, so I won’t revisit all of it here, but technological shifts in our society certainly may not bode well for value stocks. Value investors generally hold a lot of stocks in sectors like financials, basic materials, retail, and industrials. None of those are likely to generate excitement about future growth. You could certainly argue that all of that is priced in given how low valuations are (as I have), but it is possible the prospects for these companies are even worse than the market thinks they are, which would render the typical mispricing argument for value much weaker than usual. Also, if you look at the companies that are likely going to be the most impacted by the coronavirus and the resulting economic shutdown, you will find that value stocks dominate that list. That could mean that value stocks still aren’t attractive even at these historically low levels.
The Benefits of the Other Side
My point in writing this article wasn’t necessarily to focus on the merits of any of the arguments I presented. There are many debates all of us will have in the coming weeks about both investing and life, and these are just a few examples. My point was that in times like these, all of us tend to dig in our heels and be even less open to opposing opinions than we usually are. We also tend to be much less pleasant to those who don’t share our views. If there was ever a time to be open to opinions that disagree with our own, it is now. If there was ever a time for us to respectfully disagree in an effort to find the best solution to the problems we have, it is now. We are all facing problems that may prove to be some of the most challenging we will face in our investing careers, and more importantly, in our lives. So whether it be major issues affecting all our health like the coronavirus or more trivial things that seem small in comparison like whether value stocks are cheap, it might be a good time for all us to take a step back and be more open to things that challenge our own beliefs. We will all be better for it.
Photo: Copyright: 123rf.com / Vitaliy Vodolazskyy
