Here’s a theoretical
question for you: If someone doesn’t realize they are standing on thin
ice, are they in a risky position if the ice doesn’t break?
This might sound like an odd, semi-obvious question, but when you apply the same basic concept to investing (i.e. “Does the stock market need
to fall before there is any ‘risk’ in holding stocks?”) you
might have a better understanding about some of the challenges we as
portfolio managers confront on a daily basis. Namely, what should I
advise my clients to do if I see dangerous levels of
"thin ice" building within the stock market?
I mention this theme
as a follow up to the note that I sent out at the beginning of 2016. In
that message, I took a bit of time to discuss the state
of the stock market (which was down a whopping 12% in the first 15 days
of 2016), and provided some observations about the health of the
economy, numerous interventions by the central banks and my concern
about the expanding gap that persists between underlying
fundamentals and share prices.
In my note sent January 15, 2016 I pointed out:
“…. Central bank bailouts (by the
Federal Reserve, Bank of England, European Central Bank, Bank of Japan
and the People’s Bank of China) were attempting to solve a complex
economic problem by simply burying it under a mountain
of money and a rising stock market.”
I followed that observation with:
“Investors took the central bank’s
pledge to “do whatever it takes” to heart, and share prices rose quickly
off their 2009 lows to all-time record levels a few years later. But,
as stocks raced to higher and higher levels,
a problem was building whereby either the economy would have to “catch
up” to the level of the stock market, or the stock market would have to
“catch down” to a more realistic measure of the underlying economy.”
As bleak as the
beginning of 2016 looked for investors, the year ended with a bang and
the S&P/TSX Composite Index, the S&P 500 Index and the Dow
Jones Industrial Average closed up at 17.5%, 9.5% and 13.4%
respectively. As with previous years (since 2009), the gains in the
stock market weren’t earned thanks to dramatically improving economic
growth or a strong rise in corporate earnings (earnings have
fallen by 18% since the start of 2015). Instead, the gains enjoyed in
the stock market were helped along by the promise of more central bank
support and intervention. Consider these comments from a news story (U.S. Stocks Rally Along With Global Markets
as Brexit Worries Ease, Wall Street Journal, June 29, 2016) that
discussed the sharp, three day 6.75% decline in the U.S. and Canadian
stock markets that immediately followed the shocking “Brexit” vote
results from June:
“Many investors now expect major
central banks to act to counter a potential drag on the global economy
after the Brexit vote, with some predicting rate cuts from the Bank of
England and further stimulus from the European Central
Bank. Some also expect the Brexit vote to derail the U.S. Federal
Reserve’s plans to raise interest rates this year.”
As you can see in
the chart above, the Federal Reserve was on the record stating that
investor concerns about the housing and financial sectors (i.e.
thin ice) were greatly overblown mere MONTHS before the Great Financial
Crisis started in earnest. Any investor who relied on the promises of
the U.S. Central Bank and remained ‘fully invested’ saw the value of
their holdings fall dramatically over the coming
year. A recovery in the stock market was only made possible via an unprecedented number
of coordinated central bank interventions (QE1, QE2, QE3, and Operation
Twist, European Central Bank QE, Bank of Japan QE and a move to
negative interest rates,
just to name a few).
Successful investing
requires people to buy good companies at cheap prices and sell those
shares when prices are high, thus inspiring the popular
expression “Buy low and sell high.” Unfortunately, markets
saturated with seven plus years of central bank accommodation and
intervention have become so distorted that it’s virtually impossible to
invest in stocks based on traditional fundamentals.
Given the gap between stock prices and fundamentals, investors are now
hoping to “Buy high and sell higher,” a strategy that history has proven countless times to be highly ineffective.
“I
don’t think a single trader can tell you what the appropriate price of
an asset he buys is, if you take out all this central bank intervention.”
-Alex Weber, former head of the Bundesbank (CNBC, October 10, 2016)
Some quick math puts the current market valuation in context:
For earnings to ‘catch up’ to the stock market, and push CAPE valuations back down to their 16.72x average, we would need to see earnings rise
by 56.2% (from their current level of $87.26 USD to $136.30 USD).
Conversely, if the stock market had to ‘catch down’ to fundamentals, thereby re-converging at the long-term average of 16.72x, the S&P 500
would have to fall from today’s level of 2,280 to approximately 1,458, suggesting a possible decline of 36%
just to get back to the long-term average.
This is just some of
the ‘thin ice’ that has me concerned as a portfolio manager. While this
thin ice hasn’t broken (yet), it certainly doesn’t mean
that the risks I’ve discussed here aren’t present. Given my mandate is
to not only invest to generate suitable returns, but also to mitigate
undue risk, I feel as though a cautious, defensive stance continues to
be warranted at this time, even as the market
continues its rapid ascent to new record highs.
I leave you with a wonderful quote from Seth Klarman (zerohedge.com, May 5, 2013), who is regarded as one of the best hedge fund (and risk) managers
in the world:
“Only
a small number of investors maintain the fortitude and client
confidence to pursue long-term investment success even at the price of
short-term under performance.
Most investors feel the hefty weight of short-term performance
expectations, forcing them to take up marginal or highly speculative
investments that we shun. When markets are rising, such investments may
perform well, which means that our unwavering patience
and discipline sometimes impairs our results and makes us appear overly
cautious. The payoff from a risk-averse, long-term orientation is just
that - long term. It is measurable only over the span of many years,
over one or more market cycles.
Our willingness
to invest amidst failing markets is the best way we know to build
positions at great prices, but this strategy, too, can cause short-term
under performance. Buying as prices are falling
can look stupid until sellers are exhausted and buyers who held back
cannot effectively deploy capital except at much higher prices. Our
resolve in holding cash balances - sometimes very large ones - absent
compelling opportunity is another potential performance
drag.
But we know that
in a world in which being anti-fragile is good, what doesn't kill you
can make you stronger. Short-term under performance doesn't trouble us;
indeed, because it is the price that must
sometimes be paid for longer-term out performance, it doesn't even enter
into our list of concerns. Patience and discipline can make you look
foolishly out of touch until they make you look prudent and even
prescient. Holding significant, low or even zero-yielding
cash can seem ridiculous until you are one of the few with buying power
amidst a sudden downdraft. Avoiding leverage may seem overly
conservative until it becomes the only sane course. Concentrating your
portfolio in the most compelling opportunities and avoiding
over-diversification
for its own sake may sometimes lead to short-term under performance, but eventually it pays off in out performance.”
I wish you all the very best in 2017!
