Third Quarter 2017 Investment CommentaryBlack Monday…Thirty Years Later
Thirty years ago, on October 19, 1987, the Dow crashed with a one-day drop of 508 points—a 22% decline. The 508 points at that time would be equivalent to about 5,200 points on today’s Dow. The day after the crash, Fed Chairman Greenspan began adding money to the financial system to promote stability. About 21 years later, following the great financial crisis of 2008, the money creation process expanded much more significantly in an attempt to prevent a severe crisis and perhaps a depression. This became known as Quantitative Easing (QE).
An Act of Congress established the Federal Reserve System (Fed) in 1913. From 1913 until 1987, the Fed’s balance sheet grew very slowly. In October of 1987 it stood at just about $200 billion in conjured up money. However, since the 2008 crisis, the growth rate has been about 25% per year, 7 to 10 times faster than the real growth of the economy. The Fed’s balance sheet now adds up to about $4.4 trillion.
Money creation has been a global effort. Since the 2008 crisis, global central banks have collectively created over $10 trillion in an arguably failed attempt to achieve recovery level economic growth. What they have failed to achieve in terms of wages and incomes, they have more than made up in terms of financial leverage and high asset prices. The drastic suppression of interest rates that resulted from the massive debt purchases by the Fed, and other global central banks, caused bond yields to fall to non-natural, record low levels, thereby causing asset prices to rise in the equal and opposite direction. So, in an effort to create the “wealth effect”, the Fed has accomplished the great inflation of financial assets. For example, since March 2009, US stock valuations have increased by about 270%. But, from 2000 till now, annual economic growth has averaged only about 2%.
QE and ZIRP (Zero Interest Rate Policy) were crisis measures but they are still in place about 9 years after the crisis ended. I think it’s very important to realize that the Fed has now begun the process of reversing the financial market manipulation that has been building for many years. We don’t know what the outcome of the unwinding process will be because the world has never been in this position before. We have never experienced a crisis like the one in 2008-2009 and we have never experienced the crisis measures that were implemented. We don’t know the long-term consequences of the crisis, the unintended consequences of QE and ZIRP, or the huge amount of money that was added to the system. The unwinding process is a very serious challenge because we don’t know the extent to which it will negatively impact the valuation of financial assets. If global central banks efforts have had a significant impact on the 270% increase in stock values since March 2008, what will be the resulting percentage decrease as they “normalize policy”? Perhaps normalization is no longer possible without a severe retrenchment in asset prices.
CAPE – a Valuation Tool
Some stock market basics: Stocks represent fractional ownership of a business. Each share’s value is a function of the whole company’s value. And the whole company is worth the present value of its anticipated future profits, relative to other alternatives. “Anticipated” means that we can’t know for sure what they will be. That uncertainty is one reason why stock prices fluctuate. The amount investors will pay changes as we acquire additional information about the company’s circumstances, the economy in general, politics, etc.
The most common way to measure a company’s value is with the price-to-earnings ratio (P/E). How much will you pay today for the right to own future earnings? For example, if you expect earnings of that big fruit company (Apple) to be $10 per share per year, and you pay $100 for a share of stock, your P/E ratio is 10. Analysts compile P/E and other indicators from many companies to give us valuation metrics on entire markets and indexes. This is where we get opinions like “the market is overvalued/undervalued”.
In 1988 Yale professor Robert Shiller and his Harvard colleague John Campbell developed an indicator to predict long-term stock-market returns. It is called the “Cyclically Adjusted Price-to-Earnings Ratio” or CAPE. It is found by dividing the real (inflation-adjusted) stock index by the average of ten years of earnings. Higher-than-average ratios imply lower-than-average returns going forward. The CAPE has averaged 16.8 from 1881 through the present time. The ratio now stands at over 30. It has exceeded 30 only twice: in 1929 and in 1997-2002. According to their research, a high CAPE ratio implies potential vulnerability to a bear market. Though it is not a perfect predictor of a bear market, it is an indicator of a highly valued stock market.
Their research indicates that real (after inflation) S&P Composite stock earnings have grown an average of 1.8% per year since 1981. For the past year, earnings growth has been much higher than the average, but their research also shows that high earnings growth does not reduce the likelihood of a bear market. In fact, to the contrary, markets tended to show high earnings growth in the months prior to past bear markets. For example, at the market peak just before the biggest ever stock-market drop of 1929-1932, the earnings growth rate stood at 18.3%.
Going back to 1881, a CAPE ratio higher than 30 has generated future 7-year annualized returns of about 2%. After inflation, average returns have been negative. It’s so simple even I can understand it: the more you pay for a dollar of earnings, the smaller your expected percentage return on investment. According to their research, the US stock market today looks a lot like it did at the peaks before most of the 13 previous bear markets.
Strange things are going on out there. North Korea shot two rockets over the land mass of Japan and what happened in investment markets…nothing. The bull market continues in the face of record investment market conditions such as negative interest rates in large portions of Europe and continued central bank asset purchases despite the absence of recession in any major economy. Economic policy uncertainty is very high but, according to the indications, investment market uncertainty is very low. Numerous market-unfriendly events have failed to negatively impact the markets.
Hedge funds are closing at the fastest pace since the global financial crisis. Formerly very successful hedge fund managers are closing shop and sending the money in their funds back to the clients. They’re confessing that they don’t know how to handle these markets. Proven investment management principles don’t work any longer.
A commonly-used stock-price volatility gauge indicates that volatility has averaged about 3.5% over the long term, but it now stands at an extremely low point of 1.2%. Stock-price volatility was lower than the 3.5% average in the year leading up to the peak month preceding the 13 previous US bear markets. Prior to the 1929 crash, volatility was 2.8%.
It appears that one reason for a lack of market reaction to negative conditions is the disproportionate buying by ETFs and the dominance of quant strategies causing stock prices to be pushed higher. Quantitative trading consists of trading strategies based on quantitative analysis, which rely on mathematical computations and number crunching to identify trading opportunities. Quantitative trading is becoming more commonly used by individual investors. Computers are programed to make high-volume, high-frequency trades in fractions of a second. So, the volume of trades being made by robots is increasing rapidly. When investors become agnostic to fundamentals, when all dips in the market are always bought, it causes stock prices to rise in regular fashion. But It seems to me that risk is being significantly undervalued.
As of the end of the third quarter, BlackRock reported a year-to-date flood of assets flowing into their iShares ETFs at $264.3 billion. Vanguard reported an increase of $291.7 billion in new funds flowing into their ETFs year-to-date. On August 24, 2015, one-fifth of all equity ETFs experienced price drops of 20% or more (subsequently called the “flash crash”). Nobody seems to know why. But it makes me wonder what becomes of ETFs and the passive uprising if (when) conditions do shift. Be alert to events and an abrupt change in trend—it could happen at any time. The data and events will matter. With some careful observation and planning, we may be able to profit from the next flash crash.
ETFs are low-cost funds that, for the most part, follow some index. The fund managers don’t make decisions about which individual security to buy or sell, they just stay in balance with the index. Therefore, the managers not only buy the superior quality companies with reasonable valuations and reasonable earnings, they also indiscriminately buy the one-third or so of companies that overly indebted and losing money. ZIRP and other easy lending policies have allowed these companies to continue to exist. Constant purchases by ETFs and other index funds have kept their stock prices artificially high. Seems to me that these companies will make good short-sale candidates once the market turns south. Hmmm. And don’t forget that your safe, high quality, blue chip company stocks will be sold indiscriminately along with all the rest when the passive index selling begins.
Elimination of Cash
More strange things out there: Some government leaders and other influential individuals are proponents of eliminating cash. For example, famous Harvard Prof. Ken Rogoff wrote a book titled, The Curse of Cash. Australia’s government is considering elimination of their $100 bill. The European Central Bank eliminated their €500 note. India declared their two most popular forms of cash to be illegal…overnight…without warning. India is Socialist, but it appears that Communists are leaders in the effort, especially China. The reason for this may be that Communists don’t like privacy and they do like control. If citizens are limited to a few digital payment systems, the ability to maintain control is much improved. If they can be monitored, they can be cut off from the system if they don’t behave.
But cash recently became important in Puerto Rico. The hurricane knocked out about 90% of power and, at this point, only about 65% has been restored. Credit cards, debit cards, and ATMs don’t work. Bitcoin requires electricity and an internet connection. ATMs ran out of cash; banks ran out of cash; people who had cash began to hoard it since they probably couldn’t get any more. Some stores had batteries, water and other needed supplies but they couldn’t sell them because not many people had cash. They couldn’t even access Facebook! The Fed, who apparently wants us to keep cash in digital form in their banks, flew cash into Puerto Rico and distributed it to the banks. “That can’t happen here”, you say. If I understand correctly, technology exists in the hands of our enemies that can knock out large sections of our power grid. So maybe in addition to a stock of water, flashlights and batteries, we should also keep a stock of cash…and a Bible.
As I suggested, the exit from radical monetary policy will be difficult. Gold is a hedge against the real possibility that the Fed will be unable to exit its super-easy stance without triggering significant disruptions in financial asset valuations, jeopardizing already weak economic momentum, and damaging stability. A 1% rise in interest rates increases the federal deficit by 25%. Monetary weakness is emphasized by the fact that 50% of the debt matures in less than three years. The U.S. debt-to-GDP is now 106%, a level that has historically been economically destabilizing to other countries and that has often led to obvious monetary printing and currency destruction. It is not just a U.S. problem; world-wide global debt burdens are sufficiently high that only small rate increases can cause significant economic and investment market damage.
Early this month, the Republic of Ireland issued €4 billion worth of five-year debt, priced to yield negative 0.008%, in a deal that was 2.5 times oversubscribed. That accomplishment is made even more unusual considering the Republic’s obvious struggles during the 2011 European sovereign debt crisis. In a struggling banking system that lead to the end of the 134-year old Irish Nationwide Building Society and forced the government to supply bailout funds to the Bank of Ireland and Anglo Irish Bank in order to avoid a similar situation, Irish sovereign borrowing costs spiked to panic-type levels. Yields on the 10-year government debt jumped above 14% in the summer of 2011, with 5-year yields reaching even higher to nearly 17%. Just over six years later, investors are lined up, pushing and shoving, to lose money (yep, it’s a sure thing if the bonds are held to maturity) by financing the same country. Based on the greater fool theory, someone will buy them out at a profit (maybe).
The Dow has recorded 66 record highs (probably more by now) since the 2016 presidential election. It appears that investors became overjoyed about the prospect for rapid economic growth, a surge in corporate profits and renewed inflation. Almost a year later, the campaign promise results have faltered but stock valuations continue to climb.
Valuation excesses occasionally need to be reversed and excessive risk takers need to be financially punished as only Mr. Market knows how. To create the wealth effect, the Fed has limited the downside as if still in a crisis mode even though the crisis past eight years ago. I’m convinced that we are in a manipulated and overpriced investment market. Unwinding of the manipulation process has begun and I don’t see how it can be accomplished without a proportionate decrease in the valuation of investments. We can be fairly sure that, this time too, stock valuations will at some point mean revert and stock markets will decline…a lot.
I believe that both fixed income and equities are set to deliver very low real returns over the next five years. But investment markets can remain over valued for a long time. We can’t know how this journey will transpire in the interim. On the other hand, opportunities arise in every investment environment. I do not ignore opportunities. It is my job to help my clients make money even though, in this market, it is more important not to lose it. So, I think it is important to hold stocks, bonds and alternatives at some percentage of a portfolio. It is my job to help my clients determine the allocations based on their individual financial plan and related risk tolerance and to choose the best investments with which to implement the allocations through this very difficult investment climate. My job is to stay in the market to some extent yet to avoid negative outcomes. I am determined to help my clients avoid the next crisis and yet take advantage of as many opportunities as possible. I’m not passive. We don’t own the market. Though the market is overvalued, our portfolios are not.
Based on my observation and experience as well as research that I buy from others, people aren’t saving and investing enough for retirement. People aren’t spending enough of their time and effort in managing their portfolios, controlling their budgets or planning for their future. One reason for that is that we live in a very materialistic society and we are all caught up in it…. some more than others.
Definition of Materialism: a tendency to consider material possessions and physical comfort as more important than spiritual values.
"Greed is good! Greed is right! Greed works! Greed will save the USA!" - From movie Wall Street - 1987 (I didn’t see it. I understand it is quite nasty.)
Watch out! Be on your guard against all kinds of greed; a man’s life does not consist in the abundance of his possessions. -- Jesus
That man is the richest whose pleasures are the cheapest. – Thoreau
Thank you for reading and thank you for the opportunity to serve.
May God bless you richly,