While retail investors inevitably get a lot of the blame for the speculative craziness seen in some stocks this year, institutional investors can't be let completely off the hook either, given that many of them aggressively piled into high-growth software and Internet stocks at nosebleed valuations.And when the dust settles, I suspect recency bias -- the tendency among people to assign greater weight to recent events than older ones when making decisions -- will be seen as a key reason why 2021 saw a lot of questionable and risky behavior from retail and institutional investors alike.
Multiple Expansion for Growth Stocks
One of the ways in which recency bias has contributed to market froth is pretty straightforward: Investors kept piling into certain types of tech stocks because they were the kinds of stocks that had produced very strong returns in recent months and years (in some cases, since 2009). Likewise, many such investors became dismissive of valuation concerns raised about these stocks because it had proven wise to dismiss such concerns in recent months and years, as share prices and sales/earnings multiples kept inflating.
This dynamic ultimately drove a lot of FOMO behavior in the shares of everything from electric car makers such as Tesla (TSLA) and Rivian (RIVN) , to consumer Internet companies such as Snap (SNAP) and Affirm (AFRM) , to high-growth software firms such as Asana (ASAN) and Unity Software (U) . Investors -- including, in some cases, sophisticated ones -- kept buying these stocks in part because their memories of recent returns were much fresher than their memories (if they existed at all) of how crowded trades in various stocks that had been delivering big returns and were seen as having great long-term prospects blew up badly in 1973, 1987, 2000 and 2008.After the last few weeks, of course, investor awareness of such blow-ups is probably a little stronger. Though with many growth stocks still sporting historically high multiples, the market might not be done imparting a painful history lesson.
Dismissing Inflation Risks Too Quickly
Another, more subtle way in which recency bias clouded the judgment of many investors (in tech and elsewhere) is in how it has led worries about inflation -- and with it, worries about tightening monetary policy -- to be glibly dismissed. Because the U.S. hadn't seen a period of sustained inflation in nearly 40 years, and because the inflation scares that had been seen since then were typically more bark than bite, a lot of institutional investors were quick to buy arguments that inflation is a transitory problem caused by pandemic-related supply-chain issues.
The idea that massive and unprecedented amounts of fiscal and monetary stimulus, together with the asset bubbles and related wealth effects this stimulus helped create, might make inflation something more than a transitory/supply chain-driven issue (and something at least a little more like what was experienced in the 1970s and early 1980s) didn't have nearly the traction it should've had until November. As a result, many investors were confident until last month that the ultra-loose monetary policies that they relied on to justify paying through the nose for their favorite growth stocks would largely remain in place.
Even now, with Treasury yields implying fewer 2022/2023 rate hikes than the six implied by the Fed's December dot plot, an argument can be made that many investors remain too dismissive of inflation risks -- particularly since home prices/rents continue rising, labor markets remain very tight, consumer services spending hasn't yet returned to its pre-Covid trend line, and rising inflation expectations are creating feedback loops in which consumers and businesses become more accepting of higher prices.
Recency bias often dies hard.
Viewing Chip Stocks Through the Lens of Recent Industry Cycles
Recency bias can work in the opposite direction as well, making investors too bearish or at least not bullish enough about a company, sector or asset class because of its recent history. This was the case for chip stocks in late 2018, as fears of a major cyclical downturn similar to the one the industry saw in 2008/2009 led many quality chip developers and equipment makers to sport rock-bottom P/Es. Though the industry did see a down-cycle in 2019, it wasn't nearly as bad as what many feared, and those who bought chip stocks in December 2018 were generally up big even before 2020 arrived.
And while chip-stock valuations are higher now than they were three years ago, multiples for some industry names might still be a little too weighed-down by memories of past downturns, given both the industry's 2022 demand outlook and the presence of long-term growth drivers such as rising cloud capex, automotive chip content growth, efforts to localize more chip production and the growing capex-intensity of advanced chip manufacturing processes.
All things considered, the sub-20 forward P/Es sported by companies such as Applied Materials (AMAT) , KLA (KLAC) , Qualcomm (QCOM) , NXP Semiconductors (NXPI) and Broadcom (AVGO) are arguably pretty reasonable. While there will probably be a down-cycle along the way, just maybe the chip industry's growth outlook over the next several years better resembles that of the 1990s, when soaring PC, server and mobile phone demand fueled strong industry sales growth more years than not, than the slower rolling five-year growth rates the industry has posted more recently.
If (as the old saying goes) those who can't remember the past are condemned to repeat it, then investors who can only remember the market's recent past are prone to repeat the mistakes of investors in earlier eras, getting burned and/or missing out on opportunities when the behavior of an industry, the economy or financial markets starts approximating what happened many years ago. And perhaps that's especially true during a time that's given us extremes in both investor behavior and economic activity.
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