“The narrative fallacy addresses our limited ability to look at sequences of facts without weaving an explanation into them. Where this propensity can go wrong is when it increases our impression of understanding.” Nassim Taleb (The Black Swan)
In the complex world of finance, there is a strong human desire to create narratives that somehow make sense of it all. By assigning a logical and sequential story to explain markets, we unknowingly build an often misguided confidence in our ability to understand changes in equities, interest rates, oil prices and inflation, to name a few.
And it’s no wonder. We are hit on all sides with market “stories.” If you regularly watch financial news networks or visit their websites, you’ve noticed that each and every day the closing value of a market is followed by commentary on WHY it went up or down. Equity markets rise on strong retail sales. The most amusing days contain a very rationale headline explaining why the market opened higher (easing fears of COVID, as an example), only to see it reverse and close lower for a different reason (high oil prices).
Consensus narratives can be the most dangerous for investors. They are widely accepted and very likely backed by recent trends, creating a feedback loop to investors that supports the thesis. But what happens when current prices fully reflect the consensus narrative? It can be lonely and painful at times to lean against a consensus view, but it can also be a profitable one.
In October 2020, CNBC perpetuated a frenzied narrative on so-called COVID stocks. In one segment of a popular show, the network highlighted specific companies that were obvious beneficiaries of our economic lockdown period. To add a little sizzle to the show, they were even grouped together and named the “Magnificent Seven.” Sounds like the 2020 version of the “Nifty Fifty.” Here is the list: Peloton, Netflix, Zoom, PayPal, Roku, Tesla and Square. The Magnificent Seven had an equal-weight return of 210% in the previous seven months compared to a paltry 28% for the S&P 500. It was an easy story to tell. Demand for services/products of these companies were boosted by a work-from-home economy. And look at the returns! On occasion you would even hear the argument that traditional valuation techniques don’t apply. The feedback loop continued. . .
Here is the problem. The median price-to-sales ratio was a magnificent 12x. This was a five-time premium over the broad US market, which frankly, was not historically all that cheap in its own right. Not every stock that trades at that level is doomed to fall, but the bar was set unbelievably high for these businesses to sustain their growth and justify their multiples.
Sales growth has actually been very strong for these companies since that time, but even so, the stock prices have fallen under the weight of those massive growth expectations. Since October 2020, the Magnificent Seven group has declined by 49% compared to a 27% gain for the S&P 500. This occurred as the group generated average sales growth of 27% in 2021, higher than the S&P 500 growth rate of 16%.
Around that same time, another popular narrative was impacting a different sector – and this one was quite the horror story. The combined energy and metals sectors’ weights in the S&P 500 had declined to less than 3% shortly after the COVID lockdown. For context, several individual tech companies in the index had larger market capitalizations.
The excitement surrounding electric vehicle (EV) adoption and the prospect of growth in renewable energy eventually minimizing the need for fossil fuels was causing many investors to nearly abandon the sector altogether, pushing valuations to extremely low levels. According to GMO, at one point in mid-2020, the valuation of the MSCI ACWI Commodity Producers Index approached a 70% discount to the broad MSCI ACWI Index. Disappointing recent returns supported and reinforced this view and sentiment.
Regardless of different views on a realistic mix of energy sources or the role of fossil fuels in the future, the important point is the popular narrative was so extreme it ignored current key facts. First, even assuming optimistic expansion of renewable energy, we are still years away from peak demand in fossil fuels according to the International Energy Agency (IEA). Second, the call on natural resources – such as copper, lithium, cobalt and nickel – necessary to sustain a growing fleet of EVs will support demand for these metals for years to come.
In short, the renewable energy transition will occur over years and decades and impact producers differently. It is certainly more nuanced than – sell them all. Yet valuations applied to energy/industrial metals commodity producers seemed to imply their imminent demise.
What happened next? From October 2020 to April 2022, the S&P North American Natural Resources Index returned 103%. While it’s true the Russian invasion of Ukraine amplified the impact on commodity prices via a supply side disruption, the majority of the gain occurred prior to the invasion – a 53% spread over the S&P 500 from October 2020 to February 2022.
It is important to remember capital markets are extremely complex and shouldn’t be distilled down or woven into a neat story. The attraction of the Magnificent Seven and the negative sentiment towards energy and metals were near a peak in October 2020. And yet, from that point forward, the performance spread has been +152% in favor of the iShares North American Natural Resources ETF.
Valuations matter. Eventually. Be wary of widely held views and compelling narratives that attempt to explain and justify what seems to be unreasonable. These can be sources of opportunity and risk as shown above. As we say within our Oxford investment team, “the most dangerous view is the one shared by all.”
The above commentary represents the opinions of the author as of 5.4.22 and are subject to change at any time due to market or economic conditions or other factors. The information above is for educational and illustrative purposes only and does not constitute investment, tax or legal advice. No offers to sell, nor solicitation of offers to buy any securities are made hereby. Solicitations of investments and any offers to sell securities, if any, will be made only through an offering document clearly identified as such. Certain of the statements in this document are forward‐looking which cannot be guaranteed. These statements are based on current views and assumptions and involve known and unknown risks and uncertainties that could cause actual results or future performance to differ materially from those expressed or implied in such statements. OFG-2204-5