September’s Reader Mailbag Q&A

We are back again with your monthly mailbag! Let us see what is on your collective minds and how we may be able to help.

Are defense stocks a good buy during periods of conflict?

Sometimes. It is logical to assume they would be. Conflict, tragically, means higher use and consumption of weapons, which means higher revenues and earnings for Aerospace & Defense firms. Presuming, of course, that costs play ball and consumer segments of these businesses are performing up to snuff.

But there is a wrinkle: Markets are efficient and pre-price well-known and widely expected events quickly. This includes war, which gets baked into investors’ expectations.

You can see this in global Aerospace & Defense stocks’ performance after Russia invaded Ukraine in late February 2022 and after Hamas’s attack on Israel last October. On both occasions, Aerospace & Defense had sharp bursts of outperformance, then performed in line with global stocks—with volatility—several months after. For much of 2023, Aerospace & Defense underperformed despite the war in Ukraine grinding on. War is a factor affecting profits, but not the only one, and the relationship between reality and expectations matters.

Exhibit 1: Aerospace & Defense Stocks’ Relative Returns

Source: FactSet, as of 9/6/2024. MSCI World Index and MSCI World Aerospace & Defense, 12/31/2021 – 9/5/2024.

In your recent chart comparing stocks’ long-term returns to gold prices, I imagine the trends and returns would experience some effect from the large capital losses associated with bankruptcies. How is that accounted for in your graph?

The question refers to Exhibit 1 in our August 28 article, which shows the hypothetical growth of $74,600 invested in either a single gold bar or the S&P 500 on December 31, 1974, when gold ownership became legal. The short answer is that this shows the index’s return, an effort to reflect a diversified portfolio. Returns include each constituent’s performance from listing to de-listing, which usually precedes or accompanies bankruptcy—and utterly awful declines tend to precede the de-listing.

So index construction accounts for this, without the need for any sort of manual bankruptcy adjustments. This is the nice thing about well-constructed indexes with long histories: You don’t need to worry about survivorship bias skewing things, as you might with a newfangled, back-tested index.

We should stress, however, that charts like this are illustrative. Back in the 1970s, index funds were in their infancy and not widely used. Your typical investor wouldn’t simply “buy the S&P,” and attempting to do so would have racked up a boatload of commissions. So we run charts like this to show stocks’ broad history for illustrative purposes. But we are well aware that even now, simply running an index chart doesn’t wholly represent any one investor’s actual experience. Unfortunately, perfect just doesn’t exist, so illustrative is the best you can do.

What is your market outlook for next year?

Still cooking. We are thinking about this, of course, and assessing the landscape carefully, but it is still too early—especially without knowing the election’s outcome and whether it will yield more or less gridlock. There are a lot of factors to weigh and moving parts that need to settle before we can start assigning probabilities. The time will come, but much closer to the turn of the year. So stay tuned.

Y’all often observe that markets are forward-looking. But you also look at the past and show us historical returns a lot. Why is this?

Markets are indeed forward-looking. They also move on probabilities, not possibilities. Looking at history is a great way to start framing the range of probabilities. The past doesn’t dictate the future, but it gives us a good starting place to determine the likelihood of the stock market doing well if A, B or C were to happen.

There is rarely anything new under the sun. For instance, the circumstances and participants in a regional war may differ from conflict to conflict, but regional war itself isn’t new. So when a conflict erupts, we can look at all the past times markets dealt with regional war to assess the probability of a long decline. This doesn’t preclude weighing the specifics of the situation, naturally. But the vast majority of the time, the effect on markets is temporary and sentiment-related. This doesn’t guarantee an identical reaction the next time, but it helps us start estimating probabilities and analyzing what might need to happen for markets to behave differently.

History is the best lab we have to test claims about the markets. If someone argues Event X is good for Sector Y, then we can look at Sector Y’s long-term returns, find all the times X happened, and then test the statement. Is it true always? Often? Sometimes? Never? That is the baseline. But then we always must remember that correlation isn’t causation, so we dig in and look at the circumstances, what else was going on, etc. It is fun and nerdy and a lot of work, but it helps us put things in perspective for you, so we are happy to do it.

What do you think about investing in SPACs and IPOs?

This refers to initial public offerings and special purpose acquisition companies, which bring startups public through mergers—skirting the cumbersome and costly IPO process with its strict disclosure requirements. People tend to see both as roads to quick riches, thanks to high-profile success stories of new offerings that hit the bigtime. But big hits tend to be the exception, not the rule.

We often quip that IPO should really stand for It’s Probably Overpriced. The incentives for IPOs are just not in investors’ favor. The goal is for the early investors and underwriters to sell at a high enough price that they maximize their returns. If the IPO booms at the bell, then chances are it means they left a lot of money on the table. The underwriters failed.

SPACs are a bit different. You invest in the SPAC, an IPO with no underlying business except to gather capital to use in acquiring a privately held firm, thereby taking the target public. The principals have a set amount of time to do so or disband the SPAC and return money to IPO buyers.

Often, people buy SPAC shares because they are confident in the principals themselves—the investors don’t know what they will end up owning, presuming a merger even goes through. Sometimes it works. Sometimes SPACs boom and bust. Sometimes they just bust. In some instances, the SPAC doesn’t make its buy within the allotted time (usually two years), triggering a refund to investors. You could say it stands for … Speculation Pipedreams and Codswallop? (We will workshop this and get back to you.)

At any rate, many investors learned that lesson the hard way the last couple years. Back in 2020 and 2021, SPACs were in the spotlight frequently. One index provider even launched an index to track them all! The IPOX SPAC Index boomed in late 2020 and early 2021, before giving nearly all the gains back.^[i]

In both traditional IPOs and SPACs, we think it behooves investors to keep proper expectations and not get seduced by the prospect of quick riches. Investing is a long-term endeavor, centered around the magic of compound growth. In many cases, taking a flier on SPACs and IPOs runs counter to this, leaving a lot on the table in pursuit of a unicorn. In general, they are better deals for the suits involved than they are for individual investors.