Albert Einstein once said that “The one who follows the crowd will usually get no further than the crowd. The one who walks alone is likely to find himself in places no one has ever been”. When it comes to investing, walking alone is often how you eventually leave everybody else behind, regardless of the pain of being wrong over the shorter term. Generally we prefer to sell the market when it never looked better, and of course buy it when it never looked worse. However, one must be prepared to stand alone for some time before others reach this conclusion.
During strong global bull markets, as recently experienced, there are always many arguments for being 100% invested at all times. Investors get stressed about sitting in cash while watching everything go up, especially when cash returns are absolutely abysmal or pretty much non-existent, as they have been during most of this cycle.
Nevertheless, long term stable investment returns are always a function of being aware of all of the potential risks all of the time. Furthermore, it is vital to understand that you do not know what you don’t know, and that any of these unknowns can deal a blow that can decimate your returns in the blink of an eye. Money never sleeps and good investors pretty much are forced to sleep with one eye open at all times. Market events since January 26th of this year, have pretty much proven this point: Following a couple of years of very low volatility such that it fooled some into thinking that it was gone for good, investors bet billions of dollars against volatility returning to the markets. Needless to say, the day volatility returned, these funds were decimated by 80-90% in one day, forcing liquidations and shut-downs of funds that caused rapid market descents across many asset classes. As we have always said, when a crisis happens, you sell what you can, not what you want.
History has always proven that “this time” is never different and that fundamental forces always prevail in the long-term, no matter how tempting the short-term exuberance may be. This is true whether we are talking about levels of volatility, weed stocks, bitcoin, or whatever the latest madness may be. The only area where we would agree that “this time is different”, is the prevalence today of financial instruments that people do not fully understand and that have not been around long enough to be tested during market shocks. ETFs, and levered ETFs (which borrow to invest) such as the ones that caused the recent market drops in particular, come to mind. This would argue for more caution, not less, as we have seen in recent weeks up to the January 26th date.
In this article we discuss a few risk themes that we believe investors have been too complacent about and why a higher level of caution is warranted at this time. Sometimes, cash is a very important asset class and recent events would dictate that higher cash weightings were appropriate going into 2018 based on the known risks alone as explained below.
Known Risk Themes:
Too Much Euphoria: Ultra high, even nonsensical valuations, have developed in some areas, and promises of quick riches have led people to buy things that are not well understood or have any valuation support: bitcoin, weed stocks, low volatility ETFs, come to mind, among many others. Some have even borrowed to do this.
Flattening Yield Curve: The biggest threat to stocks is always in the form of bonds so interest rates matter a lot. When the yield curve is steep (short rates are much lower than long rates), banks can make money and they are quick to give loans driving growth in the economy; when short rates are higher than long rates (inverted yield curve), banks cannot make money and they do not lend, grinding the economy to a halt. The yield curve is starting to flatten which is the first step towards inversion and a sign that brakes may soon be put on the economy.
Elevated Valuations: The market is not cheap. It is not as expensive as it has been in other cycles but the margin of safety has diminished such that earnings must grow to justify current valuations. As long as earnings keep growing, stocks will go higher. However if they miss their estimates, and particularly if they are priced for perfection, a lower price will appear as soon as the stock opens, if not before. This year earnings should go higher, but next year is no longer that clear. The market often discounts this at least six months in advance. Furthermore, valuations are always a function of interest rates and as these climb, multiples go down, bringing stocks lower.
Too Much Debt
The ratio of total debt to GDP in the U.S. today is 350%. This compares to 130-170% in the late 19th and early 20th century, and 200% in the 1980s. Globally, this ratio is 324%, which implies that there is $225 trillion of debt outstanding. The scale of this debt in our financial system is truly astonishing, unprecedented, and unsustainable. The reason debt levels have been allowed to prosper without the automatic stabilization of natural supply/demand forces is because of Quantitative Easing (QE).
Since the Financial Crisis, we have not been operating in a normal environment as governments were forced to inject an astonishing amount of liquidity into the market (QE), keeping yields at rock bottom levels. This has allowed individuals, companies and governments to take advantage of this cheap debt and significantly increase their levels of debt (leverage). Consumer spending (paid for by debt) has prospered and lower interest rates have pushed valuations of assets higher, such as real estate or the stock market. The below chart shows just how correlated and dependent the S&P 500 has become on cheap liquidity as characterized by the total Federal Reserve assets.
The global economy is now doing very well. The crisis is over and this cheap liquidity is therefore finally coming to an end. Growth in major Central Bank’s balance sheets is set to drop well over a trillion dollars over the next 12 months as the U.S. Fed and other central banks pare back their monthly bond purchases. The graph above would indicate that it would be reasonable to believe that, as the Federal Reserve removes liquidity (the orange line) while raising interest rates, the backdrop for the S&P 500 will be negatively impacted. Who is going to buy all this debt when the Central Banks stop being the buyers of last resort? In order to entice investor demand, risk premiums must go up, which means higher yields.
In the private sector, taking advantage of low interest rates provided during this cycle, junk bond debt has exploded. In Europe, these high yield bonds from lower quality companies, are today trading at lower yields than US treasury bonds. This is unprecedented. Rational thinking is that higher risk should pay higher interest to the bond holder. Investors may soon be reminded why these bonds are referred to as “junk”. There are now mountains of junk bonds sloshing around the globe with unsustainably low yields that we know have absolutely no liquidity if they have to be sold. This can lead to the forced liquidation of high quality stocks as these investors will be forced to sell whatever they can if they need to raise cash.
In Canada, according to Global News, more than half of Canadians are $200 away each month from not being able to pay their bills and now owe $1.67 for every $1.00 of income. The financial struggles of over indebted Canadians will only get worse as interest rates rise. Too much debt inevitably leads to a period of mandatory deleveraging (forced savings to reduce that debt) and may even be accompanied by a financial crisis. Higher rates will move Canadians closer to this day of reckoning.
Too Much Euphoria
Financial markets have this way of magnifying irrational behaviour which can be observed in real time. So when investor and consumer confidence levels are high, as they are today, risk aversion tends to be observably ignored. A recent Merrill Lynch survey shows that client cash allocations going into 2018 were lower than the 2007 trough levels. This tells us that small (retail) investors were fully invested and therefore extremely optimistic and did not foresee any risk in the market. As a result, trading activity of retail investors has skyrocketed recently as seen below.
(Source: @Callum_Thomas, TopDownCharts)
Retail investors tend to pile into stocks, when risk profiles are the least attractive, at the end of a business cycle. When things start to go down they are the first to panic and order their brokers to get them out, usually booking tremendous losses in the process.
There are multiple examples of euphoric behaviour that emerges when consumers are feeling most confident, and when there is plenty of cheap money allowing people to borrow to make these investments, hoping for a quick buck. To put this euphoric behaviour in perspective, refer to the below chart. Bitcoin (at its high) became the largest bubble in human history; surpassing even the notorious Tulip Mania (at least then you ended up with a tulip bulb). Obviously many individuals thought that “this time would be different”. Some still do.
Flattening Yield Curve
Increasing short-term rates too quickly slows economic growth, lending shrinks, and the economy enters into a recession. We are now starting to see a firming of inflation as wage pressures pick up and a weaker US dollar makes imports more expensive. For the first time in a long time, inflation risk needs to be considered as inevitably, an increase in inflation will drive rates higher. Too much debt can also cause bond holders to lose faith in a currency, aggressively selling those bonds, which will also cause rates to go higher. It is not clear yet today why long bond yields in the US are climbing: whether driven by fears of inflation from too much growth forcing central bankers to increase rates, or by fears of the US moving towards unsustainable amounts of debt under Trump. Neither one is good, but the latter is definitely more problematic for markets than the first.
Bond yields are an extremely powerful force as the value of nearly every asset class is influenced by interest rates. This makes the shape of the yield curve extremely important. A steep yield curve signals healthy economic growth, a flattening curve illustrates a less robust economic backdrop while an inverted curve foreshadows a pending contraction in the business cycle (i.e. recession). An inverted yield curve has preceded the previous seven recessions. Today the yield curve is flat and the question is whether more rate hikes will lead to an inversion before the year is over.
Valuations across all asset classes are high. Even though lower interest rates justify higher valuations, consideration must be given to the fact that rates are now on the rise for the first time in many years. With elevated valuations come lower prospective returns for investors and thus the risk profile of stocks becomes less favourable. Higher interest rates translate into higher discount rates to value future cash flows of companies, making them ultimately not worth as much. Buying a stock is not that much different than buying a house. Just like a house is worth more when interest rates are low (as there is more demand for them because people can afford cheap debt), the same goes for the stock market. As an example, at 1% interest rates the multiple Price to Earnings (P/E) ratio that can be justified in the market is 29x while at a 3% interest rate, that multiple drops to 18x. This is why stocks go up so much in the late stages of an interest decline, but struggle when the opposite is true. Positive return from equities in a rising interest environment can only happen if earnings growth plus the dividend yield exceed the compression in the P/E ratio. In this scenario, only the companies that produce enough growth to offset the decline in their P/E multiple will see their stock prices climb, so stock picking is extremely important.
So where do we go from here?
As investment counselors we have a fiduciary duty to our clients to act in their best interests at all times. We take this role very seriously. So when it comes to the job of allocating our client’s capital, risk management and capital preservation are at the forefront of every one of our decisions. Last summer, the Summerhill Team came to the conclusion that the risk profile inherent in the market had reached an elevated state. For this reason we felt compelled to act differently and take action by increasing the weighting of cash in our clients’ portfolios.
Our October blog post, The Investors Curse, illustrated that the key to compounding wealth over time is to not take on undue risk where the investor would be unable to recoup losses over an appropriate amount of time. Sometimes the more prudent move is to preserve gains and wait for sunnier days. In this case, you can consider your cash position as a cheap and safe call option on future investment opportunities. As we look around now, we are starting to see some of these opportunities beginning to emerge. Nevertheless, the end of the cycle is closer than the beginning so as investors we must act more prudently and cautiously and ignore those that will try to convince us that “this time is different”. It never is!
The Summerhill Team