As I have commented on before, markets are by their basic nature always uncertain, even when the real world can seem so black and white sometimes. And as I have said before, perceived wisdom is rarely correct and as traders and investors we have to learn to be able to reject or ignore the views espoused by even so called experts and the highest achievers. I recall an interview I read with George Soros’ son. I don’t remember the exact wording but what the son said amounted to was that his father could say one thing in the morning and then the exact opposite by lunch time. So opinions can be interesting but never take them at face value.
Right now the perceived wisdom is stocks are massively overvalued, for example that according to the Tobin Q method of valuation, which is to look at market caps of stocks versus the replacement value of the underlying business, we are now in the third most extreme stock market bubble in history. Consensus wise judging by how far equity indices have run, you’d be forgiven for thinking being long is a high consensus position and view. In fact, examining a range of indicators such as the newsletter survey and the AAII survey consensus is somewhat bullish but not at an extreme. As for my own estimate, a guess, I’d say we are about neutral. It seems to me the majority view is risk levels are high and listening to CNBC, the end is nigh tribe probably outweigh the bullish camp by quite a wide margin.
To some extent we hear the over valuation opinion everyday now. We hear crashes are near, rates are low but going to rise soon, we are warned high yield bond are another bubble, then there is the inflation monster under the bed and many other viewpoints that make us want to keep our cash under the mattress and our heads in the sand until one day soon we wake up, having lived through the coming market hurricane and can buy stocks and bonds at super low valuations agains in a world free of fear and uncertainty and central bank distortion. On that day the birds will tweet, the sun will shine, there will be a rainbow in the distance, we will walk with a sping in our step and making money will be easy.
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Well, I can tell you, with certainty, that day will never come, even if the hurricane does. We will never know certainty. If the crash happens most people will be too frightened to step up to the plate, uncertain as to whether the lower levels are a buying opportunity, or if they are catching a falling knife, or if in fact the financial system really has reached the point of total and permanent collapse in which case we will instead be looking to buying some land, some guns and go into survivalist mode, like in that zombie movie.
But having said we mustn’t trust the views of others, why am I writing? Why write and express my view if I have just told you the views of others should be ignored? Well, you see, I’m really writing for myself, writing is a great way to gather your own thoughts. Ignore me, don’t ignore me, I really don’t care either way. And even if what I am writing is the gospel truth if wouldn’t matter. Or if one day a man with a white beard appears in the sky and gives you a stock tip, you wouldn’t listen anyway, you would still just copy your friends or colleagues, do what your cousin said to do, or fall for some CNBC snake oil salesman.
So, we are told stocks are massively overvalued and there is a crash coming. There are many ways to value equities. Let’s just say Tobin Q is high. Okay, just accept that. If it’s high and that’s that and that’s a risk. I will not fight that argument at all, it’s a numerical truth. But the argument is with respect to the S&P and US stocks in general, not all stocks and not all international markets. So first, if we buy stocks we would prefer non US markets where levels are off their highs and perhaps already corrected. By the way, the last correction to international stocks, which has actually not yet fully corrected back, was due to a fear of higher yields. So this leads onto the next point on yields, which is surely priced to a large extent anyway. Examples are Asian high dividend stocks, including Singapore REITS as a local example.
We can also talk about buy backs, the story being they are the only driver of the rallying equity markets. We can talk about earnings and the ever low revenues and inevitability of margin mean reversion. Of buy backs, even if we fall for the sinister explanation of buy backs as a sneaky financial engineering trick, they still reduce the float and this mean a smaller number of buyers is needed to support levels. And as a side note, of we are to accept the story of buy backs being the key driver of the equity rally, then how can we simultaneously believe those who say the market consensus is extremely bullish? They can’t really both be true statements.
On earnings, first, we hear the same doom talk ahead of every earnings season. Second, the analyst expectation bar is always made low and so even if earnings aren’t really great, they usually look okay anyway. So it’s a question of two ways to look at these things. I’ll stick with the glass is half full for now, the buoyancy bias, and as bearishness and doom is nigh seems the consensus view, I’m happy to err no the bullish side for now.
On the interest rate front, I will resist the perceived wisdom slightly here. First, on a really long history yields are a lot higher versus history than most people think. By history I mean look at 100 years, say, for a truly meaningful context. If we look at the US govt 10yr bond for example, not the front end of the yield curve for obvious reasons, yields are low but not ultra low. If we just look back across our own life times we tend to be excessively skewed by recent history, meaning the 90′s, 80′s or 70′s depending on our ages. The 80′s in particular were a period of unusually high yields, from which it has taken decades to normalize from. Would I buy US bonds now? No, but I would buy if there is a spike in yields of 20 or 30 bp.
Continuing with yields, how badly will medium and long maturity bonds perform when the Fed finally does start hiking? Well, first, looking at the last two hiking cycles, bonds have actually rallied rather than fallen once hiking has started. Now, I doubt that will happen this time but I also doubt risks of a sell off are high. First, as I said above, yields are not as low as people think on a long time scale. Second, I personally believe in the new normal, i..e, lower growth than pre GFC. Third, I believe inflation is unlikely to move uncontrollably higher because of restrained wage growth, plentiful oil supply and a high chance the US will break out of its low productivity trap…humans are innovative…at least the US has been. By the way I’m not American.
So what this amounts to is although yields will probably rise a little, that will take time and the rise will be limited to approximately what is already priced into the various curves. Eventually, if yields move to a high enough level, i.e., policy rates in real yield territory as implied by the Eurodollar futures curve for 2018, then some of the buoyancy that ZIRP has provided will be taken away. So in a few years we may see more meaningful corrections on stocks, especially in the US, but we aren’t at that point yet and until that point I would expect to see continued buoyancy. When I say buoyancy what I mean it is just hard for equities to fall as long as there is no where else for return seeking cash to go, because rates are just too low so stocks just bob back up again. To imagine this take a nice long bath and have some of those little plastic ducks…it’s hard to keep them under the water. Baths are also great places to think about things. Once rates are higher and equities face some competition then this buoyancy will be diminished. But until that time I believe markets may remain overvalued in the traditional senses.
And so for the time being, buoyancy, rather than printing, will support equity, and we should seek out value selectively and especially on non US markets and we should expect high yield hunger will continue as an investment theme. And as government bond market sell offs will be shallow and stock market corrections will also be shallow for the time being, then sell offs in high yield bonds, preference shares and muni’s should also be limited, as they represent a sort of mixture if risks. I am not trying to paint a perfect world, just one in which the risks aren’t presently as critical as the media would have us believe. Perhaps smoking is a good analogy…I don’t deny the connection between lung cancer and smoking but it does take time to develop. Looking forward risks look of greater magnitude, as must be the case if risk hasn’t been removed from the equation, it hasn’t. So less now means more later…but later is later and now is now.
On an allocation basis, if my choice is to now horde cash that is being eroded by inflation, or to allocate say, 50% into certain high yielding bonds and high dividend equity then I will choose the latter. By high yielding bonds I also mean to be as selective as with equity. I notably dislike sectors represented by ETFs such as LQD US (iShares iBoxx $ Investment Grade Corporate Bond ETF) or HYG US (iShares iBoxx $ High Yield Corporate Bond ETF) as spreads are just too narrow to warrant buying these instead of longer dated US Treasury bonds on dips. Instead, I prefer discounted closed ended funds that specialise in preference shares. Or, if we see a bit of a correction, then discounted closed end Muni bond funds. These were beaten down by both rates fears as well as stories of default in Detroit and Puerto Rico but have recovered a little too well for my tastes. Note that these types of funds are often quite illiquid, which presents it’s own risks and therefore it’s own opportunities to buy at cheap levels. In allocating our cash It is as dangerous to stay all the way out as it is to stay all the way in. The choice is either bleed slowly to death if severely under invested, or risk occasional non life threatening injury if moderately invested/allocated. I choose moderate allocation into companies with safe balance sheets, in well regulated environments and into stocks that are sensibly valued even if not cheap. These can include Asian markets such as Singapore, as well as pockets of value in Europe, but probably not the US for now.