Author: François Sicart

I  recently returned from France, where local colleagues pointed out how a few high-capitalization (market value) names were disrupting the performance game for French money managers. Popular luxury-oriented companies– which had already outperformed the CAC 40 index for several years thanks to superior operating performances – have further accelerated recently with signs of recovery in China’s consumer spending.

Several of these companies are included in the relatively narrow CAC 40 French stock index. Since they had already sold at much higher price/earnings ratios (and thus market capitalization) than the majority of French shares, they now have a disproportionate influence on the behavior of the index. For example, the following three companies account for nearly 35% of the CAC 40’s total capitalization, which makes it difficult for a portfolio to outperform without owning them:

 

Company                 Capitalization % CAC 40             Price/Earnings Ratio

LVMH                                    17.3%                                           30x

HERMES                                  8.4%                                           61x

L’OREAL                                 9.1%                                           39x

Total / Average                      34.8%                                          43x (*)

(*) vs. 23x for the CAC 40 as a whole

 

Lack of breadth is not just a French phenomenon. According to Forbes Magazine (6/2/2023), the ten largest stocks in America’s S&P 500 are responsible for nearly 90% of the index’s return this year. That represents the highest percentage in history. The five largest companies in the S&P — Apple. Microsoft, Amazon, Nvidia, and Alphabet (Google) now comprise almost a quarter (24%) of the index’s market capitalization. Apple alone exceeds the combined value of all stocks in the Russell 2000 Small Cap index.

The focus of enthusiasm or speculative activity differs by market. At the moment, for instance, luxury dominates in France and artificial intelligence in the United States. Nevertheless, the lack of breadth remains disturbing for investors with a sense of history. The sectors to which investors’ money is flowing often do deserve to be favored based on their long-term fundamentals. But the investment public tends to mistake an industry’s promise and its ability to generate profits over time.

In this respect, I am grateful to the insightful team at Grant’s Interest Rate Observer for having recently quoted from my December 1999 paper: “AOL, RCA and the shape of history.” In that paper, I drew a parallel between radio in the 1920s and the internet in the 1990s. Radio revolutionized man’s perception of space and time in the 1920s, just as the internet began to do in the 1990s. The growth of radio did not disappoint and was explosive even through the Great Depression. However, investors in RCA and many other radio-related shares saw their large, early market gains evaporate in the ensuing years. I ventured to anticipate a similar future for AOL and some early leaders of the internet.

The biased weighting of leading indexes is aggravated by the increased role of performance measurement consultants, who tend to influence investment management systematically and over shorter and shorter periods of time. To avoid underperforming the indexes against which they are measured, investment managers feel pressured to load up their portfolios with stocks carrying the greatest weight in these indices. In doing so, they further inflate the price of the indices and make it more challenging for portfolios to perform according to consultants’ criteria.

These self-feeding episodes are the times when it is wise to ask oneself: “Do you want to look right temporarily or to become richer eventually?”

A company’s stock price is the result of two influences: its profits and its price-to-earnings ratio (P/E). Profits derive from the uniqueness of its products and the quality of its management, while the price/earnings ratio reflects the investing crowd’s hope for its future. Of these two influences, the price/earnings (P/E) ratio is by far the most volatile, often being cut in half or doubling within one stock market cycle.

In theory, contrarian investing and value investing are supposed to have much in common. The lower the P/E for a stock, the less enthusiastic potential buyers are about that stock’s prospects. The converse is also true: a higher P/E indicates high hopes among the investing set.

However, there is something paradoxical about stock selection, and this is where value investing and contrarian investing come closest to each other. The more expensive a stock is, based on its P/E ratio, the more vulnerable its price is to earnings disappointments. Conversely, the lower its P/E ratio, the further a favorable surprise can boost the share price. This is particularly relevant to the present situation: it can be observed that many stocks today are expensive historically – in particular, the heavy-capitalization members of the leading indexes — but this is not true of all.

I recently re-subscribed to the Value Line Investment Survey of more than 1600 companies, mostly but not solely American. The median P/E of the survey (half above, half below) is just under 17, but there are many names, including the usual suspects with wonderful narratives, with current P/Es above 30 or 40. On the other hand, I found a surprisingly large number of companies with current P/Es close to the single digits and fairly strong and liquid balance sheets.

So, it seems to me; the question is: what kind of surprise are we willing to take a chance on? Expensive companies with immaculate narratives where the slightest disappointment might prove painful? Or companies with no narratives where any positive surprise likely would lead to an upward reappraisal?

 

François Sicart – June 21, 2023

 

Disclosure:

The information provided in this article represents the opinions of Sicart Associates, LLC (“Sicart”) and is expressed as of the date hereof and is subject to change. Sicart assumes no obligation to update or otherwise revise our opinions or this article. The observations and views expressed herein may be changed by Sicart at any time without notice.

This article is not intended to be a client‐specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. This report is for general informational purposes only and is not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally.

Back in June of 1993, I wrote for Tocqueville Asset Management (the firm that I had created in 1985) a short paper entitled “As Adam Said to Eve.” The somewhat tongue-in-cheek title announced a major transition in the post-WWII world order. Until that point in the 1990s, the global system had been led and controlled by the United States, and that was slowly changing.

In my paper, I pointed out that serious economists and historians are prone to claiming that we are in a period of transition. Today, after several recent economic accelerations and slowdowns, this prediction seems to be gaining momentum again. We may, in fact, be in phase two of the Great Transition announced 30 years ago.

US leadership and the beginning of globalization

Since the end of WWII, the United States has fulfilled the leadership role of “lender of last resort,” as described by Charles P. Kindleberger in his treatise on The World in Depression – 1929-1939. The U.S. also played the role of buyer of last resort for the world, as was made plain  by an increasingly large balance-of-trade deficit with struggling or developing economies. This deficit was counterbalanced by a large inflow of capital, taking advantage of America’s “exorbitant privilege” of being able to print the U.S. dollar at will. This permitted the dollar to become the de-facto world currency. Jacques Rueff, the adviser to French President de Gaulle, initially pointed out and criticized this privilege and thus prompted the abandonment of the link between the US dollar and gold.

Early globalization of the world economy under American leadership allowed other countries, largely European, to rebuild after World War II. Another result was the development of newer economies across the globe. The system was neither perfect nor intended to be eternal, but certainly, in those years, many nations grew and prospered. Little by little, however, they began to desire more independence and initiative while the United States gradually realized the burden and economic cost of its global responsibilities.

From free markets to neo-protectionism

More recently, as pointed out by The Economist magazine (1/12/2023), “President Biden’s abandonment of free-market rules for an aggressive industrial policy has dealt (the old order) a fresh blow.” This transformation — which alert observers could have seen coming — was sharply accelerated by the COVID  pandemic, the Russia-Ukraine war, and the resulting supply-chain disruptions. The vulnerabilities of an increasingly-integrated world economy were clearly exposed.

And the US is not alone; this new protectionism is spreading throughout the world. One result is that more nations thrive to protect themselves from foreign competitors by penalizing imports. Another is the effort to ensure the national production of essential resources, products, or technologies that had been previously sourced from the cheapest or fastest producers, regardless of location. As a result, we expect to see misallocated capital, periodic excess supplies, and probably greater-than-optimal costs for some products. Those factors will prompt slower growth in both revenues and profits for most economies and several industries.

How do we investors  protect ourselves

First, in spite of the slower growth trend of various economies, I doubt that most central banks’ goal of 2% inflation can be durably achieved because it implies the acceptance by populations of unbearable amounts of pain. Even a 2% inflation rate implies a 22% loss of purchasing power in just ten years, while a 4% inflation would mean a near-50% impoverishment. Secondly, the misallocation of capital from rushed investment programs implies periodic oversupplies of individual products and commodities. This may not affect the long-term trend of inflation, but could depress profits over shorter periods. It may thus be prudent to avoid industries where investment is dictated by government policy rather than the traditional profit motive.

40 years of declining interest rates

The above chart depicting the long-term history of interest rates in the United States is interesting from two points of view. First, it illustrates that, before the creation of the Federal Reserve, interest rates were relatively stable on a declining trend. Since the creation of the U.S. central bank, they have become more volatile, subject to spikes during inflationary episodes (such as the 1960s and 1970s) and – since the early 1980s — on an unprecedented downtrend, which recently culminated with a very low-to-negative cost of money.

Perhaps this is due to the fact that, in the earlier period, interest rates were more influenced by the external behavior of gold and the dollar, which were theoretically linked — whereas more recently, interest rates have depended on the human (not to say political) decisions of a board ironically entrusted to eliminate the cyclical vagaries of the economy.

Separately from this observation, it is interesting to reflect on the impact of the 40-year decline in the cost of money, which has accelerated sharply since the Great Recession of 2008-2009. This long decline has had a profound effect on the behavior of consumers, businesses, and investors. I have often referred to Hyman Minsky’s hypothesis that (economic and financial) stability eventually feeds instability by fostering the acceptance of risk, financial leverage (debt), and speculation.

It could be argued that the recent years hardly constitute an example of economic stability. Yet major economies – especially that of the United States – have survived and often experienced steady employment and subdued inflation. These two statistical phenomena could be interpreted as a form of stability.

More importantly, we believe negligible interest rates and central bank-induced ample liquidity have promoted increasingly speculative activities and behaviors. This phenomenon has ranged  from faster IPOs (initial public offerings) of companies that still offer more promises than earnings, to SPACs (blank-check companies), to cryptocurrencies and related activities, and finally to small investors’ speculative mob- or meme-centered stock market gyrations. Not surprisingly, this speculative boom has been accompanied by an increase in fraudulent and Ponzi-like schemes.

How do we protect ourselves as investors?

Walter Mewing, one of my most influential mentors and a financial analyst, warned me that sometimes companies with minimal earnings may nevertheless sustain their price because their stocks are selling on the basis of dreams. When they start earning money, however, their prices may weaken because they will be bought on the realistic basis of a calculated value reflecting those earnings.

In light of this advice, one of my reservations about the behavior of the stock market over the last 20 years is that the companies presenting themselves as “disruptors” of industries (from technology to sales and distribution) are trying to convince that boosting sales very fast will allow them to garner a commanding share of their target market. Then, theoretically, profits will follow once the expenses from swift investment and massive personnel hiring are covered by growing revenues. Some of these potential “disruptors” are projecting dreams that seem credible in an era of costless capital, but issues may appear when interest rates rise, or plentiful liquidity evaporates.

The market and the economy

In periods of crisis (actual or expected) central banks have a tendency to provide more liquidity than the physical economy can absorb. As a result, the excess liquidity tends to flow over to the financial markets.

The following chart depicts one of Warren Buffett’s preferred measures of value in the US stock market. It compares the total value of the 5,000-odd companies in the Wilshire 5000 index (most of the US-listed companies) to the size of the US GDP. As can be seen, US stocks became overvalued in the late 1960s-early 1970s inflation, in the early 2000s’ dot-com boom, and even more so in 2022, before the recent retreat. As a result, in the past twenty or thirty years, the share of the population with savings invested in the stock market has become increasingly rich. Meanwhile, the rest of the population saw their incomes stagnate or fail to keep up with even the subdued cost of living.

How to protect ourselves as investors

According to the chart, even after the recent correction the US stock market may still be 30% overvalued. Thus, it may be prudent to avoid recent favorites that have driven the stock market indexes to new highs.

The question of the dollar

Currency fluctuations are particularly difficult to anticipate. In a relatively free-trading world, when the currency was a main factor of competitiveness for businesses, I used to monitor corporations to detect the point at which their leaders claimed that the overvaluation of their main trading currency necessitated a change in their production or sourcing profile. Today, when geopolitical considerations dictate government industrial policy decisions and incentives, the pure profit motive has become less obvious.

How to protect ourselves as investors

In a world where unpredictable geopolitical dislocations increase, businesses and investors tend to seek havens from currency gyrations. In recent years, it seems that many have looked for refuge in the US dollar, which, until very recently, had been steadily rising against other currencies. Now, however, many governments are unnerved by the unpredictability of American political and economic policies. This sentiment has been reflected in a new appetite for gold.

The social/political pendulum

The last 30-odd years have evidenced a growing disparity between those who are rich and getting richer, and those who once hoped to become rich but have felt left behind. Directly or indirectly, many of the newest fortunes have been produced by the stock market. Even owners of successful industrial or commercial businesses have been helped by going public and by the subsequent appreciation of the stocks of the companies they own or control.

At the same time, a smaller group became even richer. I used to count myself among the 1% of richest Americans, but recently, the ranks of the 0.1% of richest Americans have ballooned. The beneficiaries have been the creators of “disruptive” companies, but also their investment bankers, advisers, and hedge fund managers, who often receive stock-linked compensation that may be occasional but stands to create immediate, large fortunes. What’s more, while they still represent a minority, they have become an increasingly visible one.

Basically, I now feel like part of the very comfortable middle class. But this is not necessarily how others perceive me.

The 1% who have passively participated in this enrichment include my clients and myself; a consequence of the automatic appreciation of the assets we own. Although we now belong to a second class of the rich (behind the 0.1%), to the rest of the world and to some politicians, we are a class that deserves to be punished by the reversal of political momentum toward the “working” classes, in my opinion.

How do we protect ourselves as investors?

One way or another, and whether or not policies achieve campaign promises, the motto is likely to become “tax the rich.” We’re likely to see increased taxes on the highest incomes, wealth taxes, taxation of the carried interest on private equity, etc. I believe escaping such financial obligations will become increasingly difficult, if not outright risky.

On the other hand, I am convinced that the best way to invest remains to own shares of successful businesses and that the most logical way to participate in this wealth creation is the stock market. I believe the best way to protect ourselves is to avoid investing in tax-oriented deals (which may be withdrawn) and to avoid dependence on businesses that reflect incentives granted by more socialistic government policies.

The universe of companies that avoid these pitfalls — both in the United States and abroad — is substantial and has become even larger after the recent corrections. I believe that it is no time to abandon the stock markets. However, we must work harder in our selection of investments and tighten our selection criteria to adapt them to the changing political environment.

François Sicart – February 14, 2023

 

Disclosure:

The information provided in this article represents the opinions of Sicart Associates, LLC (“Sicart”) and is expressed as of the date hereof and is subject to change. Sicart assumes no obligation to update or otherwise revise our opinions or this article. The observations and views expressed herein may be changed by Sicart at any time without notice.

This article is not intended to be a client‐specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. This report is for general informational purposes only and is not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally.

On January 14th, I published this article which predicted that one of these days, after a spectacular decade of progress, the stock market would encounter a serious air pocket. Investors  would then ask the perennial question, “What caused the market collapse yesterday?” But this is not a helpful question. The more discerning  inquiry would really be, “Why did the market rise so much before yesterday’s crash?”

Since then, we have not seen a sudden crash. The investing crowd, exhibiting more fast-changing opinions than longer-term convictions, has been busy worrying alternately about inflation and recession while generally looking to the Federal Reserve for answers. Meanwhile, financial markets have done what they do. Since January 14^th, the S&P 500 index has lost about 22%, and the more “tech-heavy” NASDAQ 33% (Source: Bloomberg).

In the original article, I referred to Hyman Minsky, an economist who was widely overlooked until the Great Recession of 2007-2008. That disruption vindicated his hypothesis that “stability breeds instability.” In other words, when markets or economies are stable (or on a seemingly predictable uptrend), businesses and investors tend to accept ever more risk. For Minsky, this primarily meant taking on more debt, but “risk” should be understood more broadly as getting involved in all sorts of speculative activities. We have had a long, uneven period of recovery from the Great Recession of 2007-2008, but high inflation and threats of recession persist. So where does this leave us, looking forward?

I have been investing long enough to remember first-hand the 1973-1974 bear market. It followed a long investor infatuation with theoretically recession-resistant “Nifty Fifty” growth companies, which climbed to stratospheric valuations for the period. From its early 1973 level, the Dow Jones Industrial Average lost 44% of its value in about two years and took eight years to return to its previous high.

Importantly, those statistics still understate the damage that was done to one-time market favorites. For instance, McDonald’s declined 73%  and Coca-Cola 69%. Disney, which had reached a price/earnings ratio (P/E) of 70 at the peak of the bubble, wound up selling at 13 times earnings, while beauty giant Avon declined 85% as its P/E collapsed from 63 to 9. (Source: Wikipedia)

This flashback merely reminds us that even significant market corrections, such as the one we are currently experiencing, seldom reflect the full capitulation and re-evaluation when real bear markets end, especially among previous favorites. Obviously, some re-evaluation of this kind is already occurring. Former super-favorites such as the FANG stocks (Facebook, Amazon, Netflix, and Google) have already lost more than $2 trillion of combined market value.

The more speculative areas of the investment universe have evolved away from early “TINA” stocks — short for “There Is No Alternative” — to so-called “ABTE” (“Anything But Traditional Equities”). Since realizing that bonds were doomed after the long spell of near-zero interest rates, and since stocks seemed endangered as well, investors have engaged in a frantic search for presumably “uncorrelated” investment vehicles such as private equity. The field was initially known as “venture capital” before it began to involve the purchase of companies with overwhelming financial leverage (debt). More recently, investment vehicles have extended to art, wine, bitcoin, and crypto innovations (NFTs), among others. These involve some new areas of speculation that have been enthusiastically adopted among less-knowledgeable “investors” encouraged by recent excess liquidity.

Some stocks where volatility and speculation have been most visible have reached valuation ratios (price/earnings and other, more exotic creations) that seem stratospheric even when compared to the Nifty Fifty or Dot.com follies. I would argue that a downward adjustment is not complete for those securities. For others, however, it is possible that declines of more than 50%, 60% or more, which are already numerous, may have brought us closer to the ultimate lows. My advice to my younger partners is to “get our feet wet” in the stocks of likely survivors (good businesses with essential, proven products and services reflected by strong balance sheets).

I recently retrieved a January 15th, 2018, mention of John Neff by Jason Zweig in his blog Articles & Advice. This iconic investor, who retired from the Vanguard Windsor fund in 1995, beat the market by more than 3 percentage points annually for 31 years. But he reminded people that he lost 25% in 1973 and 16.8% more in 1974 before regaining 54.5% in 1975 and another 46.4% in 1976. He also pointed out that  “a noticeable portion of [his] cumulative performance came from these two years alone.”

I am also convinced that it is possible to beat the market over long periods covering several cycles, but recoveries from severe bear markets are when meaningful outperformance is achieved. To achieve this, however, it is advisable always to keep very liquid reserves (like cash) while things are less compelling. Also, since catching the ultimate bottom of a market is hard to time, we tend to invest progressively into new names. In a portfolio of about 30 stocks, for example, an initial purchase may amount to 1% of the portfolio value, followed by subsequent purchases of 1% or  2%, as market conditions allow or dictate.

Good luck getting your feet wet!

 

François Sicart – November 17, 2022

 

Disclosure:

The information provided in this article represents the opinions of Sicart Associates, LLC (“Sicart”) and is expressed as of the date hereof and is subject to change. Sicart assumes no obligation to update or otherwise revise our opinions or this article. The observations and views expressed herein may be changed by Sicart at any time without notice.

This article is not intended to be a client‐specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. This report is for general informational purposes only and is not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally.

www.sicartassociates.com/always-the-wrong-question

As a group, economists (or practitioners of what is often called “the dismal science”) have failed to anticipate some of the most severe recessions and best economic recoveries of the last century. Even as a professed contrarian, however, I cannot defend their forecasting record. I would also take with a grain of salt the advice of investment strategists who base their recommendations on what economists expect the economy to do. Paraphrasing Goethe, “when ideas fail, [big] words come in very handy.”

The Economy and the Stock Market Are Two Different Animals

Crestmont Research (www.crestmontresearch.com) produces a wealth of stock market and economic data primarily focused on medium and long-term cycles, which I have often used in these letters. Their latest update contains a table that shows the lack of correlation between America’s GDP (Gross Domestic Product) and its stock market over the years: the stock market appears to move independently from the growth of the economy as measured by the Gross Domestic Product (GDP).

 Stock Market P/E Ratios and Interest Rates Tend to Move in Opposite Directions

Another document, from BigTrends.com, illustrates how bond interest rates tend to have an inverse relationship with the Price/Earnings ratio of the stock market, which is the main determinant of short- and medium-term moves in stock prices. Both are generally influenced by the rate of inflation, as the returns on both the stock and bond markets must rise when higher prices erode the purchasing power of money.

This is particularly relevant to today’s environment: on many days, we have seen the stock market rise because some strong economic statistics were released. But, as we write, interest rates still stand near historic lows. It appears that the investment crowd has been ignoring the fact that a faster-growing economy might strengthen the resolve of the Federal Reserve to let interest rates rise to more natural (less manipulated) levels and that higher rates tend to depress stock prices through a downward adjustment in the Price/Earnings ratios of shares. If the economy further strengthens, and unless corporate profits actually go through the roof, a stronger economy might not actually be good news for the stock market. So, we have to ask ourselves: “Could corporate profits go through the roof?”

Profit Margins Are Already at a Record

The chart below, from another source of very valuable statistics – Yardeni Research, Inc. — clearly shows that, after moving in a fairly stable range until the early 2000s, corporate profit margins have shot up in the last several years.

Several factors seem to have contributed to this increase in reported profitability.

First, the composition of the American GDP has changed, with lighter industries growing faster and making up a larger share of the pie. Because they use less materials and sometimes direct labor, they tend to have higher gross margins and more relatively-fixed overhead. This gives them greater operating leverage –  profits tend to grow faster than revenues when sales increase.

Second, during the uncertain times that we have confronted in the last several years, corporations have naturally tended to underinvest, especially in projects with long-term horizons. This reduces depreciation, which comes as an annual charge against reported income, thus boosting reported profitability.

Additionally, while the purchases do not necessarily show up in aggregate, economy-wide sums like the GDP, corporations have been buying back large numbers of their shares in the open market.

“All told, buybacks may exceed $870 billion for 2021, according to Silverblatt’s data. That would eclipse the record of $806 billion from three years earlier when companies used repatriated funds from the federal tax overhaul.” (Bloomberg)

Buybacks reduce a corporation’s number of outstanding shares and, as a result, increase its reported earnings per share. This will be reflected directly in the performance of capitalization-weighted indexes such as the S&P 500, especially since some of the largest-capitalization companies, which have not reinvested all their cash flows in their businesses, have been the most active in buying back their shares. The buybacks create a disproportionate effect on the behavior of major indices, prompting the stock market to perform better than the GDP in recent quarters.

Finally, even the real economy has benefitted from the pandemic in a somewhat perverse way. Liquidity injections from the Federal Reserve have enriched the wealthier, stock-owning segment of the population, while income-supporting budgetary assistance has helped poorer households and small businesses. Since opportunities to spend that extra money were limited by the pandemic, overall savings have built up, which are being released into the purchase of goods and services now that these restrictions are being loosened.

 

The Paradox of Inflation

William E. Simon, Secretary of the Treasury during the Nixon administration, once remarked that the American people have a love-hate relationship with inflation. They hate inflation but love everything that causes it. We have enjoyed what causes inflation (more liquidity, government spending, and an ebullient stock market) for the last several years and must now face the consequences of the phenomenon itself. If history is any guide, those results will come in the form of diminished spending power and higher interest rates that will depress stock market and real estate valuations.

 

A De-globalizing World

No one knows how the Russia-Ukraine situation will evolve, but its sequels will most probably affect the global economy for an extended period of time. We believe that supply chains will be disrupted for longer, and some may be permanently shut off; financial flows will be redirected and become less fluid and more expensive; several commodities, including agricultural ones, will remain more expensive.

Geopolitically, one of the main goals of Russia’s original saber-rattling and natural gas blackmail to Europe was to disrupt NATO’s unity, which is why I had assumed that an all-out invasion might be unnecessary.

For the moment, the way things have been going, Mr. Putin’s war seems to have actually reinforced NATO’s solidarity. But when the immediate fears abate, I suspect that the internal tensions of many global organizations – including NATO, the United Nations, and the European Union — will resurface. In sum, the globalization of the world economy, which was one of the motors of post-WWII economic prosperity, may recede or need to be re-invented.

 

* * *

 

I have often referred in these pages to Hyman P. Minsky, a professor of economics at Washington University in St. Louis and a distinguished scholar at the Levy Economics Institute of Bard College, who introduced The Financial Instability Hypothesis in 1992.

This hypothesis essentially posits that stability is destabilizing. If the economy or financial markets remain stable (for example, within a well-established uptrend) for an extended period of time, the attitudes of economic and financial participants change as they become more willing to accept risk (debt) and speculation.

To me, the most important implication of the hypothesis is that economic recessions or financial crises do not need an immediate trigger to happen: they are due to the very nature of free markets and crowd psychology. What has been labeled a Minsky Moment refers to the onset of a market collapse brought on by the reckless speculative activity that defines an unsustainable bullish period. It cannot be precisely predicted, but one can prepare for it.

Today, as inflationary pressures linger, especially on the cost side, recessionary forces may also become more prominent. As usual, good investors should remain alert and prepare for both.

Good luck and clear minds…

 

François Sicart – March 7th, 2022

 

Disclosure:

The information provided in this article represents the opinions of Sicart Associates, LLC (“Sicart”) and is expressed as of the date hereof and is subject to change. Sicart assumes no obligation to update or otherwise revise our opinions or this article. The observations and views expressed herein may be changed by Sicart at any time without notice.

This article is not intended to be a client‐specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. This report is for general informational purposes only and is not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally.

One of these days, after a spectacular decade of progress, the stock market will encounter a serious air pocket. The investing crowd will then ask the perennial question: “What caused the market collapse yesterday?” But, as usual, this will be the wrong question. The intelligent inquiry would really be: “Why did the market rise so much before yesterday’s crash?”

The Minsky Hypothesis

Over the years, I have become increasingly attracted by what is called the “Hyman Minsky hypothesis” and have referred to it in several papers. Hyman Minsky was a professor of economics at Washington University and a distinguished scholar at the Levy Economics Institute of Bard College. His theory was that economic “stability breeds instability:” as people feel good about current economic prospects, they tend to consume more, take on more debt, and, increasingly, speculate.

The idea that stable economies sow the seeds of their own destruction — and that this is just the nature of free markets — sounded a bit too Marxist for the western economic establishment, and Minsky was not particularly popular until the financial crisis, and Great Recession of 2007-2009 seemed to vindicate his views.

What intrigues me most about the hypothesis is that it implies that financial crises and economic recessions need not be prompted by a specific, immediate trigger. Rather, instability builds slowly but steadily as economic actors and investors are lured by apparent stability or momentum into undertaking more financial leverage (debt) and accepting (or ignoring) more risk. In doing so, they are often abetted by so-called “experts” who are best at rationalizing what people want to hear.

The Case of the 1970s’ Inflation

The mid-1970s are remembered as a period of double-digit price inflation, followed by the first severe recession of the postwar era. The recent uptick in prices and interest rates has revived curiosity about that period, which was followed by a stock market decline of over 45% (as measured by the Dow Jones Industrial Average between January 1973 and December 1974).

Experts of the day were prepared to find multiple causes for the accelerating inflation that continued into the next decade (after a recession-induced pause in the early 1970s). One was the collapse of the Bretton Woods system and Nixon’s shock devaluation of the dollar under the Smithsonian Agreement; another was the 1971 abandonment of the gold standard followed by the quantum increase in the price of oil after OPEC’s oil embargo (1973).

However, the following chart illustrates that inflation had clearly begun to accelerate years earlier, in the mid-to-late 1960s. In fact, it could be argued that the later developments were perhaps the result of rising inflation and its corollary – the depreciating purchasing power of the US dollar.

A Wall Street Flashback to the 1960s

If inflation actually appeared before these supposed “trigger” events, some explanation can probably be found in instability that had slowly built up in prior years, as Minsky had foreseen. And the 1960s, which are now often referred to as the “Go-Go Years,” were indeed rife with ample liquidity, mounting financial leverage, and speculation. According to the SEC, assets of stock mutual funds doubled in the five years from 1960 to 1965 and doubled again from 1965 to 1970, peaking at $56 billion in 1972. (ICI Securities Law Procedures Conference, Washington, D.C. – 1997)

John Brooks’ The Go-Go Years (Wiley Investment Classics, 1999) tells “the story of the growth stocks of the 1960s and how their meteoric rise caused a multitude of small investors to thrive until the market crashed devastatingly in the 1970s. It was a time when greed drove the market, and fast money was being made and lost as the ‘go-go’ stocks surged and plunged.” (From the book’s flap copy)

One example gives a feeling for the atmosphere of the 1960s. Investors Overseas Services, Ltd. (IOS) was founded in 1955 by financier Bernard Cornfeld. By the 1960s, it employed 25,000 people who sold 18 different mutual funds door-to-door all over Europe. In the following decade, the company raised $2.5 billion, due in part to its “Fund of Funds,” which invested in shares of other IOS offerings. Though popular, the Fund of Funds eventually turned into a Ponzi-type operation, paying investors promised dividends from newly-raised capital. After efforts at refinancing and a bailout from another troubled financier, Robert Vesco (who utilized IOS money to bail out his own ventures), IOS went out of business. Cornfeld was tried and acquitted, and Vesco fled to Havana.

To put into perspective the size of these ancient events, $1 billion in 1960 would have been the equivalent of $9.4 billion in today’s dollars. When I joined Wall Street in 1969, the New York Stock Exchange traded about 12 million shares on a good day. Even this kind of volume was overwhelming for the existing infrastructure and forced the NYSE to restrict trading to four days a week. (In comparison, today’s technology and logistics allow for a daily trading volume that approaches and often exceeds one billion shares.)

To understand how the apparent stability of the 1960s fed the instability of the 1970s, it should also be remembered that, except for cyclical slowdowns and minor or short-lived recessions, the post-war economy had experienced a long period of growth and stability. The economic establishment became complacent as a result, with several popular economists actually claiming that we had conquered the economic cycle. One of the few contrarians was Paul Volcker, who was then President of the New York Federal Reserve before becoming Chairman of the whole Federal Reserve System. Volcker had become concerned very early with the inflationary trends inflamed by the “guns and butter” economic policies of President Lyndon Johnson and his successors throughout the Vietnam war years.

Experts Always Rationalize the Recent Past and Project it Into the Indefinite Future

Amidst this complacency, a recession hit the United States in 1970. The stock market, as measured by the S&P 500 index, fell 35%.  However, the overall economic recession was relatively modest and, importantly, was mostly domestic in nature. Experts, in particular from the largest wealth management banks, were prompt to concoct a new investment theme. Noticing that a number of companies had survived the recession and the stock market declined relatively well, they started promoting investment in the so-called “Nifty Fifty,” arguing that these recession-resistant stocks could be bought and held forever, regardless of the price. (Source: USA Today, 4/1/2014)

Post Mortem: In the 694 days between January 11, January 11, 1973, and December, December 6 1974, the Dow Jones Industrial Average benchmark lost over 45% of its value, but the Nifty Fifty stocks fell even further. The market, as measured by the Dow Jones Average, did not recapture its 1973 high until the early 1980s. Many of the Nifty Fifty took much longer to recover, while some never did.

Fast Forward to 2022

The fundamental question facing investors today is whether the current acceleration of inflation will be “transitory,” as the Fed seemed to believe until recently, or more sustained, as skeptical economists have argued. Personally, I tend to see inflation as a trend that is not easily halted or reversed. But, in periods like the current one, I tend to revert toward the Minsky view of the world.

Greed, risk-taking, and speculation are not easy to measure. Equally, the level at which exuberance becomes intolerably irrational is subtle. These attitudes usually announce themselves by a series of anecdotes rather than by concrete data. Still, the anecdotes are now accumulating – slowly but increasingly difficult to ignore. As usual, they seem to be rationalized by self-anointed “experts.”

Consistent with their past record, growing numbers of strategists, asset-allocators and wealth managers have joined the FOMO crowd, feeding their clients’ “Fear Of Missing Out.”

For a while, with interest rates close to zero, the philosophy became TINA – “There Is No Alternative” (to equities, i.e., the stock market). Then, as the US stock market was irrepressibly carried higher by a handful of very successful, though very expensive companies, the FAANG stocks (Facebook, Apple, Amazon, Netflix, and Google) came to the fore. They could be considered the modern-day version of the 1970s Nifty Fifty.

More recently, investment experts have steered their clients to more exotic “alternative” investments: private equity, private credit, etc. One of the main attractions here is that, contrary to the structure of the stock market, precise valuations are unavailable or hard to fathom in the near term. This situation promotes the promise of better eventual returns as a trade-off for the lack of liquidity in the near term – a splendid way to tie up investing clients’ funds.

Money has been diverted to assets such as real estate, art, wine, etc., increasingly fusing investment greed and lifestyle aspirations. But then, the internet took over from the experts. Now, websites and chatrooms promote products such as cryptocurrencies, NFTs (Non-Fungible Tokens, or digital pictures of an original product), memes of fashionable stock tips, etc. Most of these new products attract millions of small, inexperienced investors, but, occasionally, they are also endorsed by investing stars, who know how to capitalize on a new trend when they see one.

If you still doubt that there is too much money sloshing around and getting “invested” mindlessly, just read this recent headline:

January 8, 2022

A reality star who says she made $200K from selling her farts in Mason jars is pivoting to selling them as NFTs

On pornographic grounds, one might understand the idea of paying real money for the packaged farts of a sexy influencer. But pictures of the jars???

The Rewards of Being an Early Skeptic

Bernard Baruch (1870-1965), the famed speculator whom historian Thomas A. Krueger described as one of the country’s richest and most powerful men for half a century, famously said:

“I made my money by selling too soon.”

Times like now seem like good ones to emulate his investing style…

François Sicart – January 12, 2022

 

Disclosure:

The information provided in this article represents the opinions of Sicart Associates, LLC (“Sicart”) and is expressed as of the date hereof and is subject to change. Sicart assumes no obligation to update or otherwise revise our opinions or this article. The observations and views expressed herein may be changed by Sicart at any time without notice.

This article is not intended to be a client‐specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. This report is for general informational purposes only and is not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally.

 

During the pandemic, I have been using my forced time out of the office to review in detail my investing experience of the past fifty years – hoping to gain some enlightenment from this broad view.

My first observation is that, contrary to public complacency induced by twelve years of the current bull market, there have been some serious breaks in the progression of the major indices over this time span.  I experienced these firsthand, and a partial review is very enlightening.

The Pain and Opportunity in Bear Markets

For one thing, I remember well some of the S&P 500 losses that are easily ignored by newcomers to investment as well as by veteran investors. Among those, four stand out:

    Start and End Date        % Price Decline                     Length in days

11/29/1968 – 5/26/1970                   36%                                         543

1/11/1973 – 10/3/1974                     48%                                          630

3/24/2000 – 9/21/2001                      37%                                         546

10/9/2007 – 11/20/2008                    52%                                         408

(Source: Crestmont Research)

This is a small sample to remind the reader that while market declines averaging 43% and lasting longer than a year are somewhat rare, they cannot be viewed as “black swan” events.

Moreover, losses of that magnitude are not recouped rapidly. For example, it took 1.7 years to recover the market peak of 1968, while the Nifty Fifty loss of 1973-1974 took 3.8 years. And after the bursting of the 2000-2002 dot.com bubble, the market did not break even until 4 years had passed. More recently, the losses of the Sub-Prime crisis were only erased after 3.1 years. (Source: www.awealthofcommonsense.com) I should add that declines in some sexier indexes have often been more severe, such as the 77% loss in the tech-heavy NASDAQ Composite Index after the dot.com bubble burst. It took almost 15 years (!) to be recouped.

Obviously, there have been many “corrections” of up to 20% or more over the years. But despite the often-dramatic media headlines and sensational TV “breaking news” that they prompted, I attribute those to the normal volatility of investment markets, and to the investing crowd’s bipolar nature. I generally treat these milder episodes as opportunities to fine-tune our portfolios rather than as reasons for panicky overhauls.

Another observation from this retrospective exercise is that we all tend to measure market fluctuations from bottom to top and from peak to trough.  But to get a rational appraisal of the investment performance over a full cycle, we should measure the market progress from peak to peak.

Still another remark is that cash reserves in portfolios provide only a partial safeguard in declining markets. If your stock selections have been strategic, you may do a bit better than the majority of investors, but when the broad market goes down, all portfolios are nevertheless likely to suffer.

Cash should not be viewed as a sanctuary, but becomes very important when the market has already declined and buying opportunities abound. This may seem like an obvious point — but it is only if you have ready cash that you can seize these opportunities. At such times, those who are fully invested have to sell (probably devalued) holdings from their portfolios in order to to purchase attractive stocks that have become irresistibly cheap.

From Value-Contrarian to Contrarian-Value Investing

I sometimes mention that over the years, I have evolved from a value-contrarian investor to a contrarian-value one. This is a nuance, but a significant one. Historically, “value investing” has been nearly synonymous with “contrarian investing.” This made sense, because the stock market is effectively an auction market. If buyers become less aggressive and sellers become more so, the result should be lower prices (hence better value) for the commodity being auctioned.

In more recent years, however, the notion of “value” has become more diffuse. When Benjamin Graham articulated his value-investing philosophy, it was essentially a balance-sheet notion: a company’s readily saleable (current) assets minus total liabilities represented the minimum value of the business in a possible liquidation. If you could buy the company’s shares in the stock market for less than that amount, you made a great purchase.

Since then, powerful inexpensive computers and readily-available databases of corporate financial statements have rendered these value calculations easier and faster to make. The advantage of original value investors has diminished as a result. In addition, the make-up of corporations has evolved from traditional physical product-related activities to lighter, more service-oriented ones, including more immaterial assets such as goodwill, research, or patents, which are harder to evaluate in current dollars and cents. As a result, the focus of valuation has evolved from assets to earnings and, more recently, to estimates of future earnings and growth rates.

Fortunately, technology and the global environment in which businesses operate may have changed, but human nature has not. Hence my own increased emphasis on contrarian investing, which brings me to the meaning of the P/E, or Price-to-Earnings, ratio.

The P/E Ratio: Where Psychology and Value Meet

The P/E is simply the ratio of a stock’s Price over its company’s Earnings per share. Since the dollar price of a stock in the market really tells you nothing about what you are buying, the cost of a share is often expressed, for comparisons, by its P/E ratio, which shows how much you are paying for one dollar of a company’s profits.

Ed Easterling, author of Unexpected Returns: Understanding Stock Market Cycles and President of Crestmont Research, writes “History shows that the change in the market P/E ratio over decade-long periods often doubles or halves investor returns in the stock market.” And, truly, whereas corporate earnings for the whole stock market tend to move up cyclically but in a relatively moderate trend, it is the ups and downs of P/E ratios that command the preponderance of stock market movements. Crestmont Research has on its website a graph that illustrates quite clearly that this volatility reflects the rising optimism or pessimism of the investing crowd – as illustrated by the ups and downs of the market P/E. The site has a wealth of (free) educative statistics and I encourage the reader to visit it: www.crestmontresearch.com.

P/E Ratios Say Something About Subsequent Returns

I should point out that the above remarks apply to the market as a whole. It is possible for stock pickers to uncover stocks of individual companies whose earnings progress will dwarf the negative performance of broad indices. Still, it is an elusive challenge: the chances of identifying enough such pearls to build a properly diversified portfolio are slim. More importantly, it is rare that periods of outsized operational overperformance last forever, and even minor disappointments can be very costly when they occur. Also, when operational success is widely recognized and becomes extrapolated into the future by more investors, these companies’ valuations in the market, i.e. their P/E ratios, reflect higher expectations and become increasingly vulnerable to the slightest shortfall.

It is only prudent to be aware of the broader market environment and also to retain sufficient cash reserves to take advantage of more numerous opportunities when they become available. Such occasions may not be frequent, but in my experience, they provide opportunities to make a difference in long-term patrimony-building.

A few historians and analysts have documented the stock market returns in the 3-to-11 years following various levels of initial P/E ratios. It makes sense that, if you buy an investment whose price already incorporates high expectations, as reflected by the Price/Earnings, your future returns will be reduced accordingly, as the ratio will tend to decline cyclically. Most historical studies vindicate this view. Steve Blumenthal (blumenthal@cmgwealth.com) regularly compiles updates of several such studies. He summarized his September 10 review as follows:

“Logic tells us that coming returns will be negative for the S&P 500 Index over the next 11 years.”

I should stress that this prediction does not suggest that the stock market will go down without interruption for 11 years in a row. It merely indicates that, based on historical precedents, the average annual return on the S&P will probably be close to zero over this kind of longer period. Valuation is not a timing instrument, and that average will probably encompass shorter up and down cycles. But acknowledging the possibility or likelihood of intermediate trends should not prompt us to forget the lessons of history and common sense. Don’t succumb to FOMO (Fear Of Missing Out) as stories of instant and easy fortunes multiply! Instead, keep a steady focus on the goal of building your own patrimony over time.

François Sicart, November 11, 2021

Disclosure:

The information provided in this article represents the opinions of Sicart Associates, LLC (“Sicart”) and is expressed as of the date hereof and is subject to change. Sicart assumes no obligation to update or otherwise revise our opinions or this article. The observations and views expressed herein may be changed by Sicart at any time without notice.

This article is not intended to be a client‐specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. This report is for general informational purposes only and is not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally.

Famous quotes are difficult to attribute. Mark Twain may never have said that “history does not repeat itself but that it often rhymes.”   Winston Churchill may have been paraphrasing George Santayana when he wrote that “Those that fail to learn from history are doomed to repeat it.” Still, with these maxims in mind, I have tried to recall a few investment episodes from my own experience when I learned something that would help me avoid future mistakes.

Some of these episodes were (or should have been) foreseeable. At the very least, common sense should have told us that trees do not grow to the sky. I would place these events in the Bubbles category. Examples are the “Nifty Fifty” craze of the 1970s in the United States, the outrageous valuations of Japanese equities and real estate during the 1980s, the dotcom folly of the late 1990s the U.S. sub-prime crisis of 2007 along with its aftermath, the Great Recession.

Other episodes have been less predictable, like the 1987 stock market crash in New York: I classify those as Minsky Moments, due more to the bipolar nature of investment markets than to traceable causes or events.

As Robert Armstrong, who writes the Unhedged column for the Financial Times, remarked on September 21, 2007, “In financial markets, prices lead and explanations follow.” Stock market historians and chroniclers often make a distinction between “smart” and “dumb” money, implying that the “smart” money is in the hands of Wall Street professionals while the dumb money belongs to the ignorant private investor crowd. In fact, the striking characteristic of many identifiable bubbles is the role that reputed experts and “professional” investors have played in justifying and bidding up exuberantly overpriced investment concepts.

THE NIFTY FIFTY EPISODE of THE EARLY 1970s

One memory is the role of advisers from leading banks in promoting shares of the early -1970s so-called Nifty Fifty companies as fool-proof investments because they had survived unharmed the relatively mild recession of 1970. Since it is easier to sell something that has already worked well, this feat was paraded by many professional advisers as proof that some companies, because of the resilience of their growth and the strength of their balance sheets, were recession-proof. Consequently, they claimed that these “one-decision” stocks should be purchased at any price and held forever.

No need to remind readers of what followed. Well-known names of then-successful companies with overpriced shares destroyed the dreams of many gullible investors. Xerox, traded for 49 times earnings in late 1972 before falling 71% from its 1972 high to its 1974 low. Avon, which had sold as high as 65 times earnings, fell 86% while Polaroid lost 91% from its high at 91 times earnings to its 1974 low.

Of course, those are among the worst examples of mindless investing in stock market leaders, but most of the Nifty Fifty suffered badly and many never recovered.

THE JAPANESE ASSET BUBBLE of THE 1980s

In the 1980s, Japan was eating America’s economic lunch. Its economy was growing fast, partly as a result of a very expansive monetary policy. Meanwhile a major speculative boom developed in real estate and the stock market on the heels of a highly productive and successful export sector. At the same time, US industrial companies were struggling from stagnating productivity and an overvalued dollar.

Between 1985 and 1991, commercial land prices rose more than 300%, while residential land and industrial land price jumped 180% and 162%, respectively. In 1984, the Nikkei 225 index had largely moved within the 9900–11,600 range. But as land prices in Tokyo began to rise in 1985, the stock market also moved higher. In 1986, the Nikkei 225 gained close to 45% and the trend continued throughout 1987, when it touched as high as 26,000 before being dragged down by New York’s stock market Black Monday. Still, the Nikkei’s strong rally resumed and continued throughout 1988 and 1989, closing near 39,000 at the end of December 1989.

Ben Carlson, now with Ritholtz Wealth Management, states that in the 1980s, share prices increased 3 times faster than corporate profits for Japanese corporations. I think this should serve as a reminder that major market fluctuations generally are more a matter of crowd perceptions than of underlying fundamental values.

Finally, by August 1990, after five monetary tightenings by the Bank of Japan, the Nikkei stock index had plummeted to half its peak. But even though asset prices had already collapsed by early 1992, the economy’s decline continued for more than a decade. This decline resulted in a huge accumulation of non-performing assets loans, causing difficulties for many financial institutions. The bursting of the Japanese asset price bubble contributed to what many call Japan’s Lost Decade.

THE DOT.COM BUBBLE of THE 1990s

This episode is recent enough that many of today’s stock market participants do, or should, remember it.

In the late 1990s, the investing crowd discovered the magical promise of the internet, much as the speculators of yesteryear discovered radio in the 1920s. Just like radio then, the internet was a revolutionary discovery that would change how the world operates. But, just as for radio in the 1920s and beyond, while the innovation was a phenomenal societal and commercial success, only few investors made durable fortunes on it, and those mostly several years later. As far as I can remember, most other sheep-like investing followers lost money on the dot.com bubble when it burst.

In the five years between 1995 and its peak in March 2000, the Nasdaq Composite stock market index rose 400%, only to fall 78% from its peak by October 2002. So, assuming my math is correct, if you timed the bubble perfectly, you earned only 10% in seven years. A majority of investors, however, were drawn in by the allure of the poorly-understood promise of tech and underestimated the challenges of bringing its innovations to commercial success. Naturally, they lost money.

THE SUBPRIME CRISIS AND GREAT RECESSION of 2007-2008

With a little help from Wikipedia, this is a quick summary of what I remember from that episode.

Subprime (lower quality) home mortgage were marketed to  clients with low solvency, and therefore with a higher risk of default, who would not have had access to traditional mortgages. Their interest rate was higher than for personal loans, and bank commissions were more burdensome, which made them more attractive and easier to sell for banks and other financial intermediaries – at least for those with a predilection for quick profits rather than long-term value creation.

In that low-interest-rate environment, everyone wanted to share in the fat margins and large new market being opened by subprime mortgages: many brokers and marketing teams “initiated” new loans on behalf of actual banks without proper due diligence on the solvency of the borrowers.  Indeed, they often actually encouraged those clients to paint a rosy picture of their finances. The loans were then typically resold by banks to other, less-informed institutions.  Eventually, thanks to the creativity of investment bankers and the complacency of rating agencies, mortgages were aggregated in such a way that a package of mortgages with disparate levels of reliability could be sold to the public as an instrument with a superior safety rating. Additionally, In the US, the purchase and sale of housing for speculative “flipping” purposes spread and was accompanied by high leverage, which amplified the ballooning of debt. Often safeguards of prudence and ethics were abandoned.

Eventually, though, the progressive rise in interest rates by the Federal Reserve increased the delinquency rate and the level of foreclosures. From 2004 to 2006 the interest rate went from 1% to 5.25%. The rise in house prices, which had been spectacular between 2001 and 2005, turned into a sustained decline and foreclosures due to the non-payment of debt grew dramatically. Many financial entities experienced liquidity problems and difficulty returning  money to investors or receiving financing from lenders.

The mortgage crisis resulted in numerous financial failures, bank nationalizations, constant interventions by the central banks of major developed economies, deep drops in stock prices and general deterioration in the global economy. The US entered a deep recession, with nearly 9 million jobs lost during 2008 and 2009. Its economy  did not return to the December 2007 pre-crisis peak until May 2014.

THE 1987 “BLACK MONDAY”

I launched the Tocqueville Fund in early 1987. By that time, the S&P 500 index of the US stock market had taken only five years to nearly triple from its 1982 recession low. At 18x, up from 8x at the 1982 bottom, the index’s price-to-earnings ratio had been multiplied by 2.3, and thus had accounted for a major portion of the advance. At 18 times earnings, the index had not yet reached the 33x multiple at the top of the 1999 dot.com bubble or the “new-age” 36x of early 2021, but it was high by historical standards and enough to make me worry about valuation.

As a result, I kept most of the money from the initial subscriptions into the fund in cash and liquidities. Soon, the early shareholders, who were largely colleagues and friends, caught the FOMO (Fear Of Missing Out) bug and started calling me to say that, if they had wanted to own a money-market fund, they would have invested in one.

Listening to the “voice of the people,” I finally invested much of the fund’s assets in selected stocks … shortly before the fateful Black Monday of October 19, 1987. Then, in one day, the Dow Jones Industrials index fell nearly 23%.

On that day, I was in London making a presentation to a group of institutional investors, who surprisingly all showed up in spite of probably having seen on the hotel lobby televisions, as I had, what was happening in New York.

Back in my room, I called my partner Jean-Pierre Conreur in New York to ask him what he was doing in that financial tempest. He answered: “Not very much, because the tape is hours late and we have no idea of where stock prices are. I am just making lists of companies whose shares we might purchase when the markets function again.” For many stocks, we would only know prices days later. The only thing I could do was to call clients to reassure them that we were watching the markets closely and we were in charge, ready to act when things stabilized.

When the one-day crash was absorbed, we reviewed the various accounts under our management and they were down a bit, but much less that the leading indexes. I felt we were geniuses! But I forgot one thing: in a panic and faced with the need to sell in a hurry, investors sell what they can and that is large stocks with presumably liquid markets, even in a downdraft. Our portfolios, importantly, were in smaller, somewhat less-liquid shares and were initially bypassed by those who’d been forced to sell.

However, by the end of the year, only two months later, our portfolios had caught up with the debacle: they were down less than the market, because they held mostly value stocks with strong balance sheets, but still down for the year. We would have done much better with the cash we had held until I succumbed to the pressure of the “crowd.”

The interesting thing is that subsequent studies of the crash could not trace any immediate cause or trigger. Several excesses should have warned investors to be cautious: economic growth had slowed while inflation was rearing its head. After tripling in value In the five years preceding October 1987, stocks were generally overvalued, with the overall market’s price-earnings ratio above 20 and estimates of future earnings trending lower. Debt levels had increased fast with the ebullient stock market (for example, leveraged buyout activity mushroomed from less than $3 billion annually to more than $30 billion in 1987). The dollar had been declining after the Louvre currency accord, and interest rates had been rising.

However, Nobel-prize winning economist Robert J. Shiller surveyed 889 investors immediately after the crash regarding several aspects of their experience at the time. According to Shiller, the most common responses were related to a “gut feeling” of an impending crash, perhaps brought on by “too much indebtedness.”

But most of these opinions were garnered with hindsight. The truth is that investors were aware of the issues facing the stock market but had become complacent, lulled by innovations such as portfolio insurance (using computer programs and derivatives), which gave them a false belief that it would prevent a significant loss of capital if the market were to crash. In other words, everything was set for a “Minsky Moment” (when a long period of economic and financial stability transforms into a sudden bout of instability) but its timing, as always, remained elusive.

LESSONS OF HISTORY

It may be presumptuous to draw definitive conclusions about financial history from the limited sample of my fifty years on Wall Street. But the few financial bubbles that I witnessed were long to inflate and then exacerbated and extended by economic recessions that were either concurrent with or the consequence of these financial excesses and complacency.

In contrast, the 1987 crash was generally unanticipated or, at least, its early warning signals were largely ignored. It was not accompanied by an economic recession and, maybe for that reason, it was exceptionally short – though still quite painful for investors.

The criteria for asset under- and over-valuation change from period to period. But all financial crises are caused by preceding ebullient markets fed by speculation and the crowd’s fear of missing out on widespread gains (or at least increased complacency in the face of “irrational exuberance.”) The timing of the reckoning is elusive, but seems to be unavoidable in time.

This is why, over time, I have evolved from my training as a pure value investor to my current emphasis on contrarian investing. The economic environment and technologies change, but human nature remains fairly constant in its bipolarity.

Today, again, experts are arguing that an overextended bull market fueled by zero or negative interest rates, computerized/algorithmic trading, SPACs, memes, Bitcoin, FANGs, etc. is justifiable regardless of valuations. The names and concepts may have changed, but experience tells me that the human characteristics of the investing crowd have not.  I may not have seen it all, but I have witnessed much of it before and I have survived and reasonably prospered.

François Sicart – October 4, 2021

 

Disclosure:

The information provided in this article represents the opinions of Sicart Associates, LLC (“Sicart”) and is expressed as of the date hereof and is subject to change. Sicart assumes no obligation to update or otherwise revise our opinions or this article. The observations and views expressed herein may be changed by Sicart at any time without notice.

This article is not intended to be a client‐specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. This report is for general informational purposes only and is not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally.

The title of this paper is stolen from an autobiography by renowned French actress Simone Signoret. It has only marginal relevance to my subject here, but I have long dreamed of using this catchy phrase.

In any case, I was reorganizing my library this week and came across many books that I had not opened in years. Among them was a little booklet published by The Free Press under the aegis of New York University, entitled “The Rediscovery of the Business Cycle.” It was in fact the text of a lecture given by Paul Volcker in 1978, when he was still President of the New York Fed and one year before he became Chairman of the whole U.S. Federal Reserve system.

The lecture is interesting on many fronts.

First, it clearly shows Volcker’s overwhelming concern with inflation, which was raising its menacing head at the time, and which he would courageously vanquish later at the cost of a painful recession (1980-1982). But in addition he describes the complacency of most economists of the period, who essentially thought that postwar economic management and countercyclical policies had definitively conquered the traditional business cycle. Famous last words!

Particularly interesting is the distinction Volcker made between the traditional business cycle of about 3 years, and a longer cycle of maybe 17 years or more that would be hard to measure or anticipate precisely.

The traditional business cycle could be largely traced to the fluctuations of inventories in an economy that was essentially physical (as opposed to today’s increasingly digital one). The longer cycle was more elusive and, without going into the specifics of modern behavioral economics, it was clearly associated in Volcker’s mind with the vagaries of human nature and the psychological biases of the crowd.

In fact, though I am not sure of the chronological relationship between the two, his remarks reminded me very much of Hyman Minsky’s hypothesis, which I have mentioned in previous papers, that long periods of economic and financial stability automatically lead to instability (and crises) by inducing people to assume more risk. Since Minsky saw no need for specific shocks to prompt such crises, they were difficult to anticipate precisely, but you could become aware of their eventual likelihood as excesses built up.

Of course, it also reminded me of the “black swan” analogy enunciated by Nassim Taleb in the book of that title. For Taleb, a “black swan” is an unpredictable event that is beyond what is normally expected of a situation and has potentially severe consequences.

Someone once joked that economists call a black swan any event that they failed to foresee. But it is telling that Taleb’s first book, which introduced the theory, was entitled Fooled by Randomness, implying that the world is full of unpredictable events if you only anticipate what you are familiar with (white swans).

As I was rehashing these thoughts, John Mauldin, of Mauldineconomics.com, re-issued a paper he had authored in 2006 (just before the 2007 financial crisis and the ensuing Great Recession). It is entitled Ubiquity, Complexity and Sandpiles.

One of the interesting examples in this paper is the parallel with a sandpile where one would add sand grains one at a time. Most of the time, nothing would happen (stability) and then, suddenly one grain would cause an avalanche that would partly or entirely destroy the pile.

The timing and the severity of the avalanches are unpredictable. But mathematicians have identified some areas in the sandpile (“fingers of instability”) where a network of vulnerabilities develops and could work in domino effects to cause an avalanche. We, as investors, should be able to discern some vulnerabilities in markets or economies as excesses develop. But we are still far from being able to predict the exact trigger and timing of the next crisis or recession.

All this also reminds me of an acronym that became popular in the 1990s: VUCA (volatility, uncertainty, complexity, ambiguity). The acronym was coined at the United States Army War College to describe the less-predictable world that emerged after the end of the Cold War. Ours is also an era of increasing volatility, uncertainty, complexity and ambiguity. But as French mathematician and philosopher Blaise Pascal said in his Pensées: “It is not certain that everything is uncertain.” One thing I feel pretty certain about, though, is that when we misbehave – either through bad deeds or through laxness – a time comes when we must pay the piper, i.e., accept the consequences of our thoughtless or rash actions.

Over the past decade, in the aftermath of the Great Recession (2007-2009) and particularly during the COVID-19 pandemic, governments have given their populations ample reasons to become complacent, if not irrationally exuberant. In a K-shaped economy, where different sectors recover on sometimes diverging paths, segments of the population have been affected differently.

After a decade of gains, regardless of the many problems facing the world today, the relatively small percentage of the population that owns most of the nation’s savings invested in the stock market is very comfortable, feels entitled to more gains and is willing to accept more risk to achieve them.

In addition, many investors have come to believe that, no matter what happens to the market, the Fed will “have their back”. Many members of this segment of the US population also have access to credit at record-low interest rates to finance housing and other heavy purchases. As a leading stock market strategist said last week, “There are very few bears left”, implying that there is no reason to expect significant corrections as long as there are no sellers.

Much of the rest of the population often owns little in the way of liquid savings and investments and therefore must depend mostly on wages and salaries to sustain its standard of living. But in the last couple of years, this group has received significant support from the government in the form of unemployment assistance and other income-maintenance programs.

For many individuals who had lost jobs, these programs have sustained a minimum level of income. As a result, the United States now seems to experience a worker shortage, even though the economic recovery is not complete, as businesses have difficulty bringing back the workers they furloughed or laid off.

All in all, the COVID episode has capped a decade of irregular recovery with what cynics might call a relatively “comfortable” crisis. But the Federal Reserve’s monetary profligacy and the record size of the government’s fiscal support cannot be sustained indefinitely. When they diminish or reverse, the moment to pay the piper will have arrived.

Many observers have concluded that all these budget deficits, increased debt and money-printing can only lead to higher inflation. Based on decades of history, they also argue that there are only two ways to erase unsustainable government debt: through default or by reducing the value of a country’s currency (and obligations) through inflation. Unlike Volcker’s example in the 1980s, I doubt that many of today’s politicians would have the courage to risk a national default. So, inflation seems a logical outcome of our current conundrum.

On the other hand, my partner Bogumil Baranowski, upon learning the subject of this paper, pointed out that my tentative prediction (inflation) was more in line with the recent consensus than it was contrarian, and he suggested investigating the possibility of an opposite (deflationary) outcome.

Indeed, a minority of economists (such as Dr. Lacy Hunt of Hoisington Management) argues that when you finance a debt-laden economy with more debt, each new layer of additional debt becomes less effective at stimulating demand, until recession and perhaps deflation ensue. The investors who follow these economists’ logic are those buying bonds even at today’s record-low interest rates.

Celebrated Italian theoretical physicist Carlo Rovelli once wrote: “The very foundation of science is to keep the door open to doubt.” (Seven Brief Lessons on Physics, Penguin Books, 2016) This precept is valuable for investors as well. But either way, the complacency and fear of missing out that have driven investors to increasing recklessness in recent years should not remain costless forever.

In the stock market, except for brief interludes, there are only two directions: up or down. Fortunately, even though both scenarios facing us (inflation or deflation) are unlikely to end painlessly, for those who have prepared and possess liquid reserves for the aftermath, outsized buying opportunities should emerge in time — as they have in previous crises.

 

François Sicart – September 1, 2021

 

Disclosure:

The information provided in this article represents the opinions of Sicart Associates, LLC (“Sicart”) and is expressed as of the date hereof and is subject to change. Sicart assumes no obligation to update or otherwise revise our opinions or this article. The observations and views expressed herein may be changed by Sicart at any time without notice.

This article is not intended to be a client‐specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. This report is for general informational purposes only and is not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally.

In a 2016 article entitled “Why Does Pessimism Sound So Smart?” Morgan Housel mentioned the English philosopher John Stuart Mill. It was Mill’s observation,150 years ago, that the individual  most admired as a sage is “not the man who hopes when others despair, but the man who despairs when others hope.” At Sicart Associates, as convinced investment contrarians, we agree with Mill’s perception. Pessimists do often appear smarter than optimists because they acknowledge the complexity of situations and thus appear profound. Optimists, in contrast, tend to be perceived as superficial or naïve.

In the last ten years, I may sometimes have come across as a pessimist regarding the stock market. I don’t think this has made me look particularly discerning as stock prices kept rising, but I definitely am not a perma-bear. On the contrary, I consider myself an optimist since I am constantly looking for opportunities to invest, as I have during my whole career through bull and bear markets alike.

 “Being Right or Making Money” – This is the title of a book by renowned market strategist Ned Davis, and the question it implies is utterly legitimate. The answer depends on what you desire in life: to make guesses or predictions that will flatter your ego when you are right? Or to build a quiet fortune over time simply by being right a bit more often than you are wrong?

I was reminded of this when looking at the short history of our very small private fund, which we started on April 1, 2020. As a rule, we have eschewed in-house funds to avoid the many potential conflicts of interest between the firm and our clients. But we needed some kind of published indicator of Sicart Associates’ performance. Most of our accounts are custom-managed individually to take into consideration the goals and family circumstances of each client, as well as the tax considerations in their countries of residence. So, we decided to create this fund, which generally mirrors the main investment positions of the firm. Its performance track record is available upon request. At this time, the partners of the firm are its only investors.

The point of this long explanation is that since the fund’s inception, in spite of generally successful stock picking as reflected in the equity portion of the portfolio, we have basically been wrong on the trend of the stock market. Our economic and market views have been cautious and defensive, as reflected in the high portfolio levels of near-zero-yielding cash and presumably-protective positions such as gold. Still, the market has continued to rise to new highs.

The brief existence of this fund makes performance figures irrelevant; nevertheless, here is an overview versus the indices.

Since the fund’s inception, the S&P 500 is up 44.9% and the Nasdaq up 66.8%. While we have beaten these indices with the equity portion of the account as a whole account (which includes cash equivalents as well as gold and small protection derivative ETFs), we were slightly below the indices, net of fees.

However, I believe that being “wrong” in the short term has not penalized us in a long-term perspective. We obviously could have made more money by being “right,” but what I view as our long-term goal of letting compounding work to build our wealth has not been interrupted, as it would have been by a severe loss. And we still have ample “dry powder” to seize future opportunities when they arise.

 

The “FANGs Are Not the Market, and the Stock Market Is Not the Economy CMG Wealth’s January 15 issue of Steve Blumenthal’s “On My Radar” lists the following statistics of 2020 stock market performance:

S&P 500 Index:                                  18.40%

S&P “6” equal-weighted:                   49.32% (Facebook, Apple, Amazon, Alphabet, Microsoft, Netflix)

S&P “494” * equal-weighted :           4.05%

It is clear, therefore, that if 6 of the heaviest tech stocks are excluded, the remaining 494 stocks in the S&P 500 index do not come close to the “official” performance of the leading US stock market index.

Similarly, the last ten years have amply demonstrated that the economy and the stock market are very different animals. The economy has recovered from the Great Recession of 2007-2009 through fits and starts, further aggravated by the COVID-19 crisis, while the market has experienced a seemingly irrepressible rise, only interrupted by a couple of brief corrections.

The dichotomy between the market and the real economy, especially over short and medium-length periods, is not news. It has been amplified since the invention of the “Greenspan put” in response to the 1987 crash, and that evolved into the “Fed put” after subsequent Federal Reserve Bank chairs adopted similar policies. The principle of these policies is to pump liquidity into the economy at the first sign of weakness. Since the stock market is widely viewed as a leading indicator of the economy, the policy has increasingly meant to pump liquidity into the economy at the first sign of stock market weakness.

But monetary policy is a macro-economic tool, not particularly adapted to stimulating specific sectors of the economy – a dilemma which I once likened to trying to fix a carburetor while wearing boxing gloves. This is a disadvantage in normal times, and it was already felt in the uneven recovery from the 2007-2009 Great Recession. But it really began to create severe imbalances during the COVID-19 crisis, when whole segments of the economy were decimated, such as travel, hotels and restaurants, retail stores, etc., while others prospered, such as internet shopping and do-it-yourself home improvement.

Among consumers, a large proportion of the population had little or no accumulated savings and minimal access to credit when COVID hit. They required basic government help just to survive layoffs or furloughs. For those consumers, the pandemic period was, at best, one of suppressed spending. For the more fortunate ones, who kept their jobs or their small businesses, the inability to travel, visit restaurants, or enjoy weddings and other gatherings resulted in forced additional savings.

For businesses, most of which had access to cheap borrowing, the high level of economic uncertainty dissuaded many from investing that money in long-term opportunities. They often preferred to buy back their own shares in the stock market, buoying both their reported earnings and the major market indices in the process.

The net result of these trends was that much of the liquidity created by the central bank (through either money creation or lower interest rates and easier credit) was either not received or not used by large segments of the economy.

“Liquidity” is a somewhat elusive notion that may describe either ownership of liquid assets (cash and other very short-term, saleable investments) or easy access to cash through borrowing. My observation, over the years, is that liquidity created by central banks tends to flow as in communicating vessels: it enters the financial markets first, boosting the price of financial assets, but eventually finds its way into the “real” economy. When the real economy accelerates and requires more liquidity to function, the financial markets’ “vessel” empties, depressing the price of assets such as stocks and bonds. Hence the paradox, and the explanation of the dichotomy between the economic and the stock market performances.

The net result of easy-money policies, from the “Greenspan Put” to QE (Quantitative Easing) and now ZIRP (Zero Interest Rate Policy), has been to constantly prop up stock valuations without allowing the market to “purge” itself of excesses during more propitious economic times. This failure has been aggravated by the shape of the economic recovery.

While it was initially debated whether the recovery would look like a V, a W, or even a square-root sign, the consensus of economists seems to have settled on a K-shaped recovery. I am not sure how economists write their Ks, but this appellation is meant to describe an economy in which two different parts behave at very different paces. There is little doubt that investors whose assets have appreciated significantly in the last ten years have done much better than workers who depend on a salary or savers who must live on a fixed income.

 

 

Risk Rising

With interest rates at zero percent or lower, there develops a frantic hunt for alternatives, marked by diminishing regard for safety considerations. Traditional income investors first crowded the High Yield (formerly known as “Junk”) space. Then they moved to “credit” and distressed vehicles with higher risk and fewer covenant protections. That is without counting many derivatives-filled products invented by mathematicians at the service of bank marketing departments.

On December 14, 2020, Financial Times editorial, Mohamed El-Erian argued:

“Nothing is more reassuring to an investor than the knowledge that central banks, with much deeper pockets, will buy the securities they own — particularly when these buyers are willing to do so at any price and have unlimited patient capital… The result is …seemingly endless liquidity-driven rallies regardless of fundamentals.” El-Erian concludes that while investors will continue to surf a highly profitable liquidity wave, for now, things are likely to get trickier as we get further into 2021.

Steve Blumenthal of CMG Management Group Inc. recently had a conversation with William White, the highly respected former Chief Economist of the Bank for International Settlements (a.k.a. the central banks’ bank).

Mr. White, who warned of the Great Financial Crisis of 2007-2009, famously believes that debt creation facilitated by central banks in recent years has materially weakened the world’s financial system and made it unstable. He argues that traditional remedies like saving more or engineering faster growth to facilitate repayment are not practical today because one might throw the economy back into recession and that already-high debt levels are likely to hamper growth anyway. This leaves two options: inflation, which raises nominal rather than real growth and thus makes repayment less painful as the value of money shrinks, or debt restructuring and write-offs. White advises a combination of these two, and they may also shape the eventual outcome.

Shades of the 1970s

As I was finishing this paper, I came across an editorial by John Authers, formerly head of the “Lex” column and chief markets commentator for the Financial Times, and now a senior editor at Bloomberg. He mentioned a name almost forgotten today except by economic historians: Nikolai Kondratieff.  In the 1920s, this Soviet economist documented the existence of a cycle of about fifty years (47-60) in commodities prices, which he eventually labeled “the Long Wave.”

Like many of my Wall Street contemporaries, I spent quite some time in the mid-1970s studying the Long Wave as inflation was accelerating. Now I vividly remember the 1974-75 global recession and bear market in stocks (which, for a while, was attenuated for our clients by the foresight of my then-mentor and later partner Christian Humann, who had invested heavily in commodities and gold a few years earlier).

The more I think about the current situation, the more it reminds me of the early 1970s, coincidentally about fifty years ago. Of course, there are many differences between the two periods, but (as Mark Twain may never have really said) history may not repeat itself, but it often rhymes.

So when clients ask me about the future — which, as a rule, I don’t predict — I answer that with effective vaccines and massive infrastructure projects, it makes sense to anticipate a strong economic recovery within a couple of years, but that this may result in a drying-up of liquidity for financial markets, and ultimately, lower stock market valuations.

 

François Sicart

January 27, 2021

Disclosure:

The information provided in this article represents the opinions of Sicart Associates, LLC (“Sicart”) and is expressed as of the date hereof and is subject to change. Sicart assumes no obligation to update or otherwise revise our opinions or this article. The observations and views expressed herein may be changed by Sicart at any time without notice.

This article is not intended to be a client‐specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs, and investment time horizon. This report is for general informational purposes only and is not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally.

I was prompted to write this paper by a new book from Ben Carlson, author of the always-stimulating blog “A Wealth of Common Sense.”  Reading his book Don’t Fall for It: A Short History of Financial Scams (Wiley, 2020) reminded me what I really always knew: speculative bubbles do not need fraudsters to happen. The victims can both create and succumb to the schemes all by themselves — out of ignorance or greed, and sometimes both.

The timing of the paper was also influenced by younger colleagues, several of whom recently asked me how previous bubbles, which they had not experienced directly, had felt in real life.

Over an investment career encompassing many bull and bear markets, I have witnessed only four (and a half) genuine bubbles and their aftermaths: The Nifty Fifty episode of the early 70s, the Japanese asset bubble of the late 80s, the Dot-Com bubble of the late 90s. the sub-prime lending bubble and crisis of 2007-2009, and the current “fleeing forward” of the tech sector which has not burst yet but, in my opinion, looks like a bug in search of a windshield.

The Go-Go Years and the Nifty Fifty

Although the stock market and the economy do not necessarily move in sync, the1960s enjoyed both an economic boom and a buoyant stock market. So much so, in fact, that a leading economist proclaimed that we had now “conquered the economic cycle”, implying that we would no longer suffer recessions. Right on cue, of course, a recession and stock market downturn hit the United States in 1969 and 1970, with the stock market shedding 35% of its value.

Bankers and money managers, shaken by the surprise loss, nevertheless noticed that fifty or so companies had continued to be profitable and to grow throughout the recession. As a result, these recession-resistant, “one-decision” stocks (which should theoretically be bought and never sold), became known as The Nifty Fifty. Major institutional investors began to concentrate their portfolios into those shares, whose valuations, measured by their Price-to-Earnings ratios (P/Es), rose stratospherically as a result, further helped by synergy-creating acquisitions and earnings-inflating “pooling-of-interest” accounting.

Of the Nifty Fifty stocks documented by Morgan Guaranty, the top dozen sported P/Es between 50- and 90-times earnings before the stock market (as measured by the S&P 500 index) lost 45% of its value between December 1972 and December 1974.

Quite a few of the Nifty Fifty survived and prospered over time, although usually after a multi-year lull.  Among the institutional favorites, Avon Products dropped 86% from $140 to $19 between the end of 1972 and the end of 1974, while Coca-Cola lost 70% from $149 to $45. More generally, the majority of the Nifty Fifty underperformed the broader S&P 500 index for the next 29 years and even long-term survivors like Disney, Coca-Cola, Eli Lilly and Merck were still down after ten years.

On the other hand, such Nifty Fifty stars as Polaroid, Simplicity Pattern, Kresge (later Kmart), Burroughs and Eastman Kodak disappeared — or nearly so. (Sources: The Journal of Investing – Fall 2002 and a blog post by Jason Zweig with Malcolm Fitch  – 12/11/2016)

Personally, I have pleasant memories of the Nifty Fifty episode for two reasons: first, value-type stocks did not lose as much in the decline as the previously-favored, “one-decision” shares; second, my mentor and partner Christian Humann had anticipated very early the return of inflation and had invested heavily in producers of natural resources and commodities, from oil to copper, gold and even sugar. All I had to do was to hold on to them. Even after the bubble burst and former favorites started declining, inflation hedges continued to rise with the accelerating inflation and the declining dollar.

All in all, I was lucky that my investment record started at a time of depressed prices for the stock market, and benefited from the first couple of years of the rebound, augmented by the good returns of the natural resources sectors. This taught me that the way to make money over time is, first to avoid periods when a few names are responsible for the momentum of the broad stock market indexes; and second, to possess cash to invest at market bottoms, when most investors are forced to sell – rules that I still follow.

The Japanese Asset Price Bubble

In the late 1980s, Japan’s swift money-supply growth and credit expansion resulted in grossly inflated real estate and stock market prices. In only six years between 1985 and 1991, commercial land prices in six major cities rose 302% while residential land gained 180%, while the Nikkei 225 stock market index tripled to a record 39,000 between 1985 and 1989 — after being briefly interrupted by New York’s Black Monday crash in 1987.

The yen also appreciated strongly against a weakening dollar after the Plaza Accord of 1985. The value of the dollar in yen was almost cut in half, from 260 in early 1985 to 139 by mid-1989. This allowed Japanese companies to spend huge sums to acquire trophy properties abroad. In the United States, such acquisitions included Firestone Tire, Columbia Pictures and Rockefeller Center in New York — which pretty much marked the top of the Japanese bubble.

I must say that the Japanese bubble of the 1980s left me essentially unscathed, since I had no investment in Japan at the time. My worst memories of that episode are from TV interviews where I was exposed to the irony of temporary “experts”, who explained that Japanese assets were not expensive in view of Japan’s much lower interest rates and its corporations’ generally more conservative accounting and reporting practices.

Yet, when I saw the Japanese shares’ valuation statistics and the prices Japanese buyers were paying to acquire American companies and properties, my convictions were strengthened rather than shaken.

As usual, it took some patience but by 2004, for example, the price of Tokyo’s homes was less than a tenth of its peak, and the Nikkei 225 stock index fell almost 80% from 39,000 in December 1989 to 8,000 in March 2003.

 The Dot-Com Bubble

In a way, it is best to be contrarian when the “madness of crowds”, as Charles Mackay called it in 1841, becomes evident in the financial markets. Even so, ample patience is still required because, as John Maynard Keynes said, “the market can remain irrational longer than you can stay solvent”.

The late 1990s present a perfect example of this phenomenon. All reasonable valuation criteria were thrown to the wind for Internet-related companies. Companies could simply add “.com” to their name and watch their shares explode upward in the stock market. Even a hint of involvement in the Internet could create millions or billions of stock market wealth almost overnight. Between 1995 and its peak in March 2000, the NASDAQ Composite index, which included most of the Internet-related companies, rose 400%. The index’s price/earnings ratio reached 200x in 2000, more than twice that of the Nikkei 225 at the peak of the Japanese asset bubble in 1989.

In subsequent years, the dot-com stocks gave back all of their gains.  Ben Carlson’s book, mentioned earlier, contains a table depicting the carnage:

Tech Stock Losses During the Dot-Com Crash

Amazon           -95%

Apple               -80%

Cisco                -86%

Intel                 -78%

Oracle              -83%

Microsoft         -60%

Note that most of these companies have remained among the top technological leaders in the world to this day. Yet even the stock of Amazon.com, for example, did not reach its bubble high again until October 2009 – nine years later.

The memories of the bursting of the bubbles of the Nifty Fifty in the 1970s and the dotcoms in the 2000s remain vivid, even for those who were relatively unscathed.

My old friend and colleague Jean-Marie Eveillard, who was eventually inducted into the Morningstar Hall of Fame for his career achievements, lost many shareholders of his mutual fund during the bubble because, as a staunch value investor, he temporarily “underperformed” trendier managers. He famously stated in an interview: “I would rather lose some shareholders than lose my shareholders’ money”, a phrase of which I am envious. Not only did his fund continue to prosper, but it reached a record size in the few years after the dot.com craze.

The main teaching from the dot.com episode is that bubbles usually spring from valid observations and ideas. They only become bubbles when analysts and money managers with plentiful intelligence, knowledge and money (but no discernment or common sense) start justifying the prices fetched by trendy favorites, and promote them to investors without regard to valuation or potential limits to their success. As Warren Buffett famously stated: “Price is what you pay, value is what you get”.

There is a danger in buying at any price shares of companies that promise to change the world. I once wrote a paper comparing RCA in the 1920s to AOL in the 1990s. Radio did change the world and “disrupted” traditional and advertising media and RCA’s earnings and stock price exploded accordingly. The number of households with radio sets grew from 2.75 million in 1925 to 10.25 million in 1929 and, through the Great Depression, to 27.5 million in 1939.

But investors were wrong about RCA’s price. As we can see in the following chart, the fate of AOL’s stock was not different in the 1990s after its vogue during the early Internet boom.

 As Warren Buffett once said: “Price is what you pay, value is what you get”.

 The Great Recession and the Fed “Put”

In late 1987, Federal Reserve Chairman Alan Greenspan invented a policy orientation then labeled the Greenspan “put”. A put is a stock market instrument which gives the holder the option to sell a security at a given price in the future. Investors typically use that option to protect themselves against a decline in the price of the security, thus reducing the risk of their investments.

After subsequent Fed chairs adopted a similar policies, the “Greenspan put” simply became known as “the Fed Put”. This is important, because the new asymmetry of monetary policy explains the length and severity of subsequent bubbles.

Greenspan and his successors became convinced that financial market turmoil was a sign of looming economic recessions, and proceeded to implement aggressive monetary easing at the first sign of stock market weakness. This tended to cut short bear markets in stocks and often postponed economic recessions – for a while. But it also failed to fully correct speculative excesses, setting up the stage for future crises..

After the “Sub-Prime” financial crisis of 2007-2009 and its resulting “Great Recession” engulfed the United States, a relatively unknown professor of economics named Hyman Minsky was re-discovered. Minsky had hypothesized that financial crises and recessions did not require a trigger: they were inherent to the free market system and long periods of financial and economic stability were naturally destabilizing over time. Stability made people feel more adventurous, and prone to risk-taking (usually by undertaking more debt) until too much became too much and the speculative bubble burst.

I always felt that Minsky’s lack of renown (in spite of the intuitive logic of his “hypothesis”) resulted from his blaming the economic cycle on the very nature of free markets. In a way it reeked of Marxism, which was of course very unpopular on Wall Street. Personally, I never felt that Minsky was particularly left-wing, and his views have now become more mainstream, with the development of behavioral finance recognized by a few Nobel Prizes in recent years. The experience of recent bubbles has also tended to reinforce Minsky’s ideas.

In the years leading up to 2007, increasingly easy monetary policy led to historically-low mortgage interest rates and loosening bank-lending criteria: borrowers lied about their financial situations and bankers failed to verify their information or, sometimes, even encouraged them to lie.

The following paragraphs, extracted from Wikipedia, provide a brief but sufficient description of the domino effects of the crisis and recession:

“Excessive risk-taking by banks… combined with the bursting of the United States housing bubble caused the values of securities tied to U.S. real estate to plummet, damaging financial institutions globally, culminating with the bankruptcy of Lehman Brothers on September 15, 2008, and an international banking crisis. The crisis sparked the Great Recession, which, at the time, was the most severe global recession since the Great Depression. It was also followed by the European debt crisis…

“U.S. home mortgage debt relative to GDP increased from an average of 46% during the 1990s to 73% during 2008… The increase in cash-out refinancing, as home values rose, fueled an increase in consumption that could no longer be sustained when home prices declined. Many financial institutions owned investments whose value was based on home mortgages such as mortgage-backed securities, or credit derivatives used to insure them against failure, which declined in value significantly. The International Monetary Fund estimated that large U.S. and European banks lost more than $1 trillion on toxic assets and from bad loans from January 2007 to September 2009.”

From October 9, 2007 to March 9, 2009 the S&P 500 lost approximately 50% of its value. Severe setbacks were also experienced by other world stock markets and the economic recession spread to foreign countries as well. It could be argued that the recession lasted until 2016 and some of its effects even longer, but the duration of the bear stock market was shortened by aggressive monetary policy (“quantitative easing”) from the Federal Reserve board, all the way to near-zero or even negative interest rates.

Still, a fellow value manager later reflected that, in 2006-2007, rather than focusing only on stocks’ valuations, “we probably should have paid more attention to the macro economy”.

 The Era of TINA, FAANGS, NASDAQ and FOMO

More than 10 years after the Financial Crisis and Great Recession, and after the longest statistical recovery in recent history, unemployment remains stubborn and many businesses are weakened by heavy debt burdens. These trends have recently been aggravated by the Covid-19 pandemic, and the efforts of governments and central banks have mobilized unheard-of fiscal and monetary resources to prevent their economies from falling back into recession.

But it is hard to stimulate economies when many consumers are unemployed, general uncertainty prevents many businesses from investing, and governments realize that their current stimulative efforts will burden their budgets for years or maybe decades to come.

In recent times, the main responsibility for supporting weak economies has rested with central banks.  The usual reaction has been to lower interest rates, which fell toward zero or, in some countries, lower. With bond interest also hovering at the same level, savers and retirement or insurance funds could only invest in the stock market or real estate, both of which have been in a price uptrend for more than a decade.

This is why TINA (“There Is No Alternative”) and the old adage “don’t fight the Fed” have become popular themes in recent years. With many traditional, mature industries still reeling from the recession and lukewarm recoveries, a large proportion of investing money flowed to shares of companies expected to grow faster, in technology-related activities. Since many of these companies such as the FANMAG (Facebook, Amazon, Netflix, Microsoft, Apple, Google) are listed on the NASDAQ, this group outperformed older and more diversified indexes by a wide margin.

As had been the case with previous bubbles, investors and advisers who often have more smarts than common sense formulated and promoted the rationale for holding these stocks above all others. Under their influence and the “evidence” of the tech sector outperformance in the stock market, much of the investing crowd succumbed to FOMO (Fear Of Missing Out) and added to the demand for this relatively small sample of companies.

In this respect, the following chart, from Ned Davis Research (www.ndr.com) courtesy of Steve Blumenthal’s blog, is strikingly self-explanatory.

As can be seen, the FANMAG stocks have gained over 30% this year to-date, while the other 494 stocks in the S&P 500 index have lost almost 7%.

As I conclude this brief overview of my experience with investment bubbles, I wonder what some of the great entrepreneurs of history, who painstakingly built their iconic fortunes, would think of today’s wave of financial “unicorns”. In today’s stock market parlance, a unicorn is a privately held startup company valued at over $1 billion. Thanks to the huge overflow of central-bank-provided liquidity into the stock market, many of these startup or near-startup companies raise phantasmagoric amounts of capital through Initial Public Offerings (IPOs) before producing even a dime of profit.

TESLA, founded in 2003 by visionary Elon Musk, has yet to make a profit according to some of the best financial analysts, if one excludes revenues from selling to customers and competitors the carbon credits granted by the government to “green” companies. Yet, TESLA is valued by the stock market at $380 billion!

In the words of my early mentor Walter Mewing, “As long as a company makes no money, its shares can go up indefinitely, because they sell on hope. But when they start earning a measurable profit, BEWARE, because you will now have to deal with data.” A word to the wise…

François Sicart – September 30th, 2020

Disclosure:

The information provided in this article represents the opinions of Sicart Associates, LLC (“Sicart”) and is expressed as of the date hereof and is subject to change. Sicart assumes no obligation to update or otherwise revise our opinions or this article. The observations and views expressed herein may be changed by Sicart at any time without notice.

This article is not intended to be a client‐specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. This report is for general informational purposes only and is not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally.

Some years ago, I advised my clients: “Never invest in something where you can’t lose money”. This was the time when investors were beginning to mistake market volatility for risk, (which has now become a habit) and financial marketing departments were obliging the hungry crowd with a multitude of mathematicians-created products that promised to make you money whether the market went up or down. Face you win, tails you don’t lose.

The problem with the accounting approach to auditing

There were a number of problems with buying these complex products. The most prevalent was that very few people were capable to understand or deconstruct them. Another was that many people did not have the common sense to know that there is no such thing as a profitable but riskless proposition in investing.

Then, there was a minority of intelligent and educated investors, who assumed that they were smart enough to understand everything. By definition, they were incapable to admit: “I don’t understand”. By refusing to acknowledge their limitations, they often wound up losing just as much as the supposedly ignorant ones.

Some of these same people were caught in the Enron scandal (publicized in October 2001), which was the largest bankruptcy in American history at that time, and perhaps also the biggest audit failure, leading to the de facto dissolution of Arthur Andersen, one of the five largest audit and accountancy partnerships in the world.

Enron, a self-described new-era energy company, had for several years reported stellar profits. However, they had done so, it was discovered, by using accounting loopholes, special purpose entities, and questionable financial reporting, and were able to hide billions of dollars in debt from failed deals and projects.

Two of my partners at the time, who were extremely knowledgeable about energy, went to visit the company twice. Both times, they came back saying: “We just don’t understand”. This is why we never bought the stock in spite of growing pressure from younger clients seduced by the company’s glamourous aura and its officers’ very public contempt for those who dared question them…

This should serve as a reminder to be wary of the “accounting” approach to auditing, which aims to make sure that the reported figures match mathematically, but forgets to understand how these results are generated. In doing so, they ignore the precept that John Maynard Keynes apparently borrowed from a less-famous 18^th century author: “It’s better to be approximately right than exactly wrong”.

(After graduating from business school and assisting for a year two tenured professors, I did a stint for a year teaching accounting to candidates to the French equivalent of the CPA. Since I soon realized that they knew the required “entries” better than me, I decided to teach them the “philosophy of accounting’. I don’t know how they did at their exams, but it made me very popular with my class… and perhaps helped some students become better auditors.)

More recent and perhaps more extreme was the Madoff scandal. Bernie Madoff had been, among other things, a market maker and former non-executive Chairman of the NASDAQ until Bernard L. Madoff Investment Securities, which he created and chaired, was convicted of operating a massive Ponzi scheme, in December 2008.

The Madoff investment scandal defrauded thousands of investors of billions of dollars over more than twenty years. The irony is that the outstanding returns his firm reported were never actually achieved. His small staff created false trading reports, based on the price performance of stocks chosen after the fact. One of the back-office workers would then enter a false trade report with a previous date and enter a false closing trade in the amount required to produce the profit demanded by Madoff. The figures matched, but the trades were phantom.

I don’t think I would have been tempted to invest with him, but I was fortunate never to have heard of Madoff before the scandal burst into the open. After it was discovered, a few investment bankers I knew admitted to have oriented many of their clients to him but they all claimed that they had performed all the necessary due diligence before doing so.

Only one felt guilty enough to commit suicide. But, for all, the “due diligence” consisted in checking the reported numbers without checking how they were arrived at. Only a small team, whose board I had joined at the time, had not invested with Madoff because they had tried to virtually replicate the system Madoff claimed to follow, and concluded it was impossible to produce such superior results with such unfailing regularity.

This, I am afraid, is the kind of accounting-based due diligence that most fiduciaries and consultants still perform today.

 

Eliminating the risk in investing

What led me to write this paper was an article that my partner Bogumil Baranowski forwarded to me, which asked what money managers should do if the Federal Reserve, in order to fight the deep recession induced by the current pandemic, started to buy every security in sight.

After broadening its original mandate from trading Treasury bills and notes to buying other fixed-income securities and, most recently, even high-yield (junk) bonds, the article wondered if the “Fed” might go further and start buying common stocks as the Bank of Japan has started experimenting.

Already, the routine of announcing and implementing a policy of near-zero interest rates eliminated the risk of losses for bond buyers should interest rates rise.

Now, buying junk bonds, usually issued by financial “zombie” companies eliminated a new risk layer from the panoply of instruments money managers can buy or sell. If the Fed started buying a portion of the stock market, there would be almost no instrument left where you could lose money.

You may ask why it should be bad to eliminate risk from financial markets? One of the essential roles of the stock and bond markets, for example, is “price discovery”. This is the process through which the interaction of buyers and sellers in the marketplace determines the price at which an asset will change hands. If the central bank substitutes for one of the participants, price discovery will be potentially dictated by the government and the odds for an investor of beating “the market” will be distorted.

The original advice I offered my clients concerned individual investment products. But if the Fed decides the price at which stocks should trade, the true performance game will be over for money managers and then I will probably retire.

 

François Sicart – August 5, 2020

 

Disclosure:

The information provided in this article represents the opinions of Sicart Associates, LLC (“Sicart”) and is expressed as of the date hereof and is subject to change. Sicart assumes no obligation to update or otherwise revise our opinions or this article. The observations and views expressed herein may be changed by Sicart at any time without notice.

This article is not intended to be a client‐specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. This report is for general informational purposes only and is not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally.

Back in 1999, at the peak of the dot.com bubble, I wrote an article for Tocqueville Asset Management, the firm I had founded in 1985. It was entitled “AOL, RCA and The Shape of History” (Tocqueville Asset Management, December 1999) and was inspired by the chart below, borrowed from that Thanksgiving’s issue of The New Yorker. It compared the 1920s bubble in the shares of RCA to the stock performance of AOL in the late 1990s:

As a preface, I quoted from a report prepared for RCA in 1929 by Owen Young, then Chairman of General Electric, about radio in the 1920s: “[It] has helped to create a vast new audience of a magnitude which was never dreamed of… This audience, invisible but attentive, differs not only in size but in kind from any audience the world has ever known. It is in reality a linking-up of millions of homes.”

It was clear to me that radio — especially when combined with the growth of automobile and air transport — revolutionized the perception of space and time in the 1920s, just as the Internet and globalization are doing today. It also reminded me of a piece of sage investment wisdom: never invest in a company that promises to change the world. The point is not that the most promising companies do not deserve their reputation. Rather it is that, once a business’s prospects are widely recognized, those prospects affect its stock price, often dramatically. This makes the risk/reward ratios unacceptable.

The story of radio is instructive: it did change the world and “disrupted” traditional news and advertising media.  In the six years between 1922 and 1928, sales of radio sets rose from $60 million to $843 million! RCA, as the largest manufacturer of radio sets and also the leading broadcaster, saw its earnings grow from$2.5 million in 1925 to $20 million in 1928; its stock price rose from $1.50 in 1921 to a high of $549 in 1929. Yet few of radio’s early developers and participants made lasting gains from this, as competition and industry changes eroded the hoped-for profits.

As Mark Twain is reputed to have said: “History does not repeat itself but it rhymes.” My own explanation of the shape of History is illustrated in the following graph.

In this illustration, point B will display enough similarities with point A so that economists with a good memory will experience a strong sense of déjà vu. Yet, between these two periods, many structural changes will have taken place – in societies, in world trade and in technology, for example. As a result, point B will resemble point A, but it will also be different enough that precisely forecasting what C will look like or when it will occur is all but impossible. The only certainty (for me) is that there will be a point B.

Investors in RCA at the top of the 1929 speculative boom were right about radio’s fundamentals: the number of households with radio sets grew from 2.75 million in 1925 to 10.25 million in 1929 and, through the Great Depression, to 27.5 million in 1939. But the investors were wrong about RCA’s stock price. As we see in the chart below, included in a November 2002 follow-up paper, the fate of AOL’s stock following the 1990s dot.com boom was not very different.

AOL was selected to illustrate what happened more generally to internet stocks once the dot.com bubble burst. I hope the following graph will awaken in our readers some memories of how history often rhymes:

Source: Wall Street Journal Data Group

What triggered the current article was my watching the stock market performance of many of the new industries, as illustrated by the so-called FANG stocks (Facebook, Amazon, Netflix and Google) as well as those of some other “disruptors.”  The chart below of the performance of the S&P 500 information technology index relative to the total S&P 500 index gives some idea of the disparate performances of the “disruptors” against the overall index. The ratio of the two is close to the level it had reached at the top of the dot.com bubble, in 1999.

Source : FT Market Forces, JUNE 29 2020

Particularly striking is the fact that the technology and health care sectors now represent 40% of the total capitalization of the S&P 500 index. Furthermore, the four companies in the so-called FANG index account for 22% of the total capitalization of the 500 companies in the S&P index. (Note: this index only counts 4 companies since both shares classes of Google, which are listed separately, are included). If we also included Apple and Microsoft, the so-called FAANGM would add up to 25% of the capitalization of the S&P 500.

Source : BESPOKE 4/20/20

Needless to say, the weight of these new-era leaders in the leading indexes has been a major factor in the behavior of the market as we usually follow it. For example, the “narrow” FANG index has risen almost 62% year-to-date while the total S&P 500 index has gained only 4.8%. Furthermore, since the FANGs are included in the broad index, we can infer that the rest of the market has not gained much in this “great” recovery.

One of the most reliable signals of market excess is its narrowing breadth – when the performance of a relatively narrow sample of companies takes off, while the broad market fails to follow. The “Nifty Fifties” in the 1970s were such a sample, which few of today’s investors can remember first-hand. Major institutional investors had been traumatized by the unexpected 1969-1970 recession on the heels of a long and prosperous expansion that had led a number of reputable economists to declare the economic cycle vanquished and recessions a thing of the past. As a result, these institutional investors had concentrated their portfolios on fifty or so companies of the highest quality. They had potential to grow fast and were considered “recession resistant.” This relatively small sample did temporarily outperform the economy and especially the stock market, hence their nickname of the “Nifty Fifty.” (They were also known as the “Vestal Virgins” because analysts could find no fault in them.)

Something similar happened in the late 1990s with the dot.com companies around the development of the Internet, an episode which many younger investors remember, even if they have forgotten AOL and other Internet pioneers.

Both of these episodes were initiated by smart and sophisticated people, expert at articulating the case for the companies or the industries they were promoting. The problem arose when a large crowd of investors joined them, pushing up prices to unreasonable levels. In each of these examples, a small sample gained a price advance against the market at large, which is why the breadth of the market advance deserves attention.

In my view, a similar fad has developed with the FANGs or FAANGMs today. The details and the techno-socio-economic environment may differ, but we should not forget that History usually does rhyme… eventually.

François Sicart – July 3rd 2020

 

Disclosure:

The information provided in this article represents the opinions of Sicart Associates, LLC (“Sicart”) and is expressed as of the date hereof and is subject to change. Sicart assumes no obligation to update or otherwise revise our opinions or this article. The observations and views expressed herein may be changed by Sicart at any time without notice.

This article is not intended to be a client‐specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. This report is for general informational purposes only and is not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally.

As I began writing this paper, the following headline flashed on CNBC.com: Wall Street rally gains steam, with the Dow up 900 points after record surge in US jobs. It didn’t take long for the media to endorse a new narrative: Trump declares jobs coming back on heels of surprise labor report (FoxNews.com) and Trump: This is a ‘rocket ship’ recovery (Yahoo.com), for example.

To me, these are just the latest instances of how, in the last few years, financial markets have been interpreting any kind of good news, or even the simple promise of good news, as a signal to jump onto the bandwagon of the decade-old bull market and, in today’s language, to adopt a risk-on investment posture.

As these headlines popped up, 30 million workers were still collecting unemployment benefits in the real world. In an interview with the Washington Post Jay Shambaugh, an economist at the Brookings Institution, pointed out that  “… a 13.3 percent unemployment rate is higher than any point in the Great Recession. It represents massive joblessness and economic pain. You need a lot of months of gains around this level to get back to the kind of jobs totals we used to have.”

A combined look at the two charts below makes it clear that the recent stock market bounce is disproportionate to the small downtick in unemployment.

 

In their May 15, 2020 Market Perspective, Charles Schwab strategists recall that “Some investors were surprised by US stock market gains in April and early May, during a period of dismal economic news. Although the US unemployment rate surged to 14.7% in April, a month in which 20.5 million jobs were lost, the S&P 500© index rose 13%.” Yet, as we know, the bad news continued into late May and early June, and on Jun 6, 2020 The Journal Times of Racine, Wisconsin recollected:

“On March 23, 3.3 million people had newly filed for unemployment under lockdown efforts. At the time, 31,000 Americans had been diagnosed with COVID-19, and about 400 had died. On that date, the S&P 500 hit bottom, down about 34% from the high on Feb. 20 …Fast-forward to today, and there are almost 1.8 million confirmed COVID-19 cases, more than 114,000 Americans have died, and millions more people are out of jobs as unemployment has skyrocketed to almost 15%. Yet the market is 37% higher than it was 10 weeks ago.”

On top of this, in the last two weeks, millions of protestors – mostly peaceful but sometimes violent – have confronted the police and the National Guard, barely avoiding a controversial call for the military to intervene to “dominate” the civilian insurrection.

As a contrarian, I subscribe to the old adage: “Buy when there’s blood in the streets.” However, I usually find it safer to be a contrarian on financial markets than on fundamental economics or politics. And, given the recent behavior of the financial markets, it is more tempting for me as a contrarian to be cautious than to join the crowd of investors afraid of missing out.

In their paper mentioned earlier, the Schwab strategists explain:

“… one of the more powerful forces driving markets has been the massive injection of liquidity from both the Federal Reserve and Congress. The Fed’s balance sheet has grown exponentially, surpassing $6.7 trillion as of May 6, as the central bank bought securities in an effort to support prices and flood markets with cash [See chart below]. Meanwhile, Congress has reacted to the COVID-19 pandemic by doling out more than $2.5 trillion …  to taxpayers and businesses in the form of direct relief payments, loans and grants.” They conclude that section as follows:

“At the March lows, stocks were pricing in the kind of economic collapse we’re currently in the midst of. However, the subsequent rally was less about economic optimism, and more about Fed-provided liquidity.”

Recent Bloomberg.com articles (June 3 and 9, 2020) pointed out that much of the most recent stock buying came from (small) brokerage customers. Trading activity among individuals has almost tripled this year, according to data from retail brokerages compiled by Goldman Sachs.

Apparently, retail investors’ buying power has replaced the share buy-backs of corporations, which reportedly were a main factor behind the 2018-2019 stock market advance but have since subsided.

I have long been convinced that there was at best a loose relationship between economic activity and the stock market. Certainly, the financial markets are much more volatile over short or medium-term periods, and the dichotomy between the two can persist for many years.

 

I am fully aware that, historically, the stock market tends to turn up or down ahead of the economic cycle. But it seems to me that from a cyclical point of view, the market has discounted by a wide margin any significant recovery from the COVID-associated recession.

In his June 5 “On My Radar” newsletter, Steve Blumenthal mentions that the S&P 500 median P/E ratio now sits at 24.6 times trailing 12-months earnings vs. a 52-year average of 17.3 times. Now that the S&P 500 and the NASDAQ 100 have approached or exceeded the levels reached at the February 2020 stock market peak, the real questions are whether the economic recovery will be as fast as the market seems to have anticipated, and whether some unanticipated developments might still rock share prices.

It is wise to remember that price/earnings and other valuation ratios are not very useful as predictors of the stock market over the short-term but can give a very good idea of future returns over a 7-10-year horizon. (See Crestmont Research et al.)

As for the speed of the recovery, I am willing to accept the scenario of a sharp bounce from the bottom of the recession, when a significant share of the economy was shut-in. But I find it hard to imagine the previous peak in economic activity being equaled or exceeded while many labor-intensive businesses (travel, hotels, restaurants, and possibly shopping malls and office space rental) will not fully recover or fully re-hire their past personnel any time soon.

In terms of unanticipated developments, they are by definition hard to forecast, but they might occur in weak parts of the economy. For example, the May 16, 2020 issue of The Economist foresees “a wave of bankruptcies” ahead, and Steve Blumenthal cites James Bullard, President of the Federal Reserve Bank of St. Louis, warning that: “You will get business failures on a grand scale” (May 12, 2020). Edward Altman, Professor Emeritus at NYU’s Stern School of Business and inventor of the Z-score for predicting bankruptcy, also expects at least 165 large firms with more than $100 million in liabilities to go bankrupt by the end of 2020.

The more I watch the rapidity of daily developments in the economies and the financial markets, the more I am tempted to prepare for a continuation of a W-shaped behavior for the US stock market in coming months. As we observe the appearance of economic green shoots in late 2020 and early 2021, it will be prudent to watch for any over-discounting of the economic recovery by the financial markets.

François Sicart

June 12, 2020

Disclosure:

The information provided in this article represents the opinions of Sicart Associates, LLC (“Sicart”) and is expressed as of the date hereof and is subject to change. Sicart assumes no obligation to update or otherwise revise our opinions or this article. The observations and views expressed herein may be changed by Sicart at any time without notice.

This article is not intended to be a client‐specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. This report is for general informational purposes only and is not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally.

 

I began my investing career in 1969, following the value philosophy enunciated by Benjamin Graham in his seminal book Security Analysis (1934) and the later (and lighter) The Intelligent Investor (1949).

One of the earliest and simplest approaches advocated by Ben Graham was to buy shares of companies selling at or below their net working capital, which he calculated as adjusted current assets minus total liabilities. “Adjusted current assets” included cash and cash equivalents at full value, accounts receivable reduced for doubtful accounts, and inventories at liquidation values. Graham’s reasoning was that, following that formula, you would buy a company at or below its strict liquidating value and would receive for free all its other assets (land, buildings, equipment, etc.).

That original approach was therefore derived almost entirely from the companies’ balance sheets. Less weight was given to profits and even then only actual, realized earnings were included, rather than estimated or projected ones.

From Value to Contrarian Investing

In those ancient times – before 1981 — there were no personal computers. The machines then available were bulky, expensive, slow, and lacked today’s omnipresent and user-friendly software. Similarly, large financial databases were mostly distributed in printed format (like the traditional phone book!) or for use only on very powerful computers; generally, they were not accessible to small users. If you were able to consult the few existing databases and had the patience to search them for the stocks offering the kind of value I define above, you were one of a relatively small number of professionals and life was good for value investors.

Unfortunately, in subsequent years, technology ruined the idyllic advantage enjoyed by early value investors.

First, the introduction of cheap and very fast personal computers, the digitalization of large financial databases and the development of filtering tools put the calculation and sorting of simple ratios such as Graham’s “share price to net working capital” within the reach of even unsophisticated investors and run-of-the-mill financial journalists.

Second, as industry became lighter and supply chains more global, we were still using 19^th-century accounting to assess the businesses of the 20^th and 21^st centuries: traditional accounting, invented when raw materials and manual labor constituted the bulk of business costs, ceased displaying an accurate picture of modern companies’ results and financial strength. In particular, asset-light companies in electronics, service industries, and eventually those involved in or using the Internet had fewer hard assets on their balance sheets. Furthermore, the values of the assets they reported (such as patents, know-how, contracts and other so-called intangibles) were difficult to appraise. Even profit and cash-flow figures increasingly became subject to management choices and interpretations.

Thirdly, in an era like the present when many industries are new or are disrupted by new entities with novel business models, it has become difficult to assess “value” Perhaps as a result, corporate managements have begun to promote criteria other than the traditional profitability to analyze the performance of their companies. Not surprisingly, the financial media and many financial analysts have begun to focus their reporting on these new yardsticks, which now often overshadow more tangible results.

When I started in the investment business, the terms “value” and “contrarian” were practically synonymous: If the shares of a company sold at a low price compared to their calculated value, it indicated that this company was not in great favor with investors and thus presumably cheap. Over time, one could hope to make a significant profit at a relatively low risk if and when the market brought prices more in line with intrinsic values, or sometimes above them. As the notion of value was slowly being eroded by the changes described above, I have found it useful to emphasize the contrarian aspect of my investment discipline, while keeping measures of value as checking tools to preserve the rationality of my stated contrarian/value approach.

The Rise of Contrarianism

In recent years, behavioral finance has taken center stage in the analysis of human strengths and weaknesses in investing, in particular thanks to the awarding of Nobel Prizes to two leading practitioners of the discipline: Daniel Kahneman and Richard Thaler. One of the interesting distinctions that has arisen as a result of all this work is the one between momentum investing and contrarian investing.

Momentum investing consists of buying securities that have had high returns in the recent past, on the assumption that superior price performance tends to continue… for a while.

Contrarian investing consists of purchasing and selling contrary to the prevailing sentiment of the time. The assumption is that crowd behavior among investors generates excesses of optimism and pessimism that create exploitable episodes of mispricing in securities markets.

The paradox I have observed over the years is that momentum investors are right most of the time – especially in rising markets — as what has gone up will usually continue to go up for a while. Since it is difficult to recognize when excesses have become unsustainable, momentum investors can make steady albeit relatively small gains during bull markets. However, since trees don’t grow to the sky, they usually miss the major turning points in a costly way. In contrast contrarian investors usually forego the speculative phases of rising markets, but can realize big gains when it counts, i.e. when bubbles burst and in their aftermath.

A Major Turning Point?

The Coronavirus pandemic and its increasingly predictable economic consequences are likely to trigger a change of tone in the markets after the economic recovery from the 2008-2009 “Great Recession”, in which the decade-long spectacular performance of the stock and bond markets has been recently interrupted by trading volatility. This may foreshadow the imminence of a major turning point in financial markets.

Given the difficulty of evaluating the future in the midst of the current crisis, the question we ask ourselves is how to be a successful contrarian investor today. Without going into the details of specific industries and companies, we discern several macro trends that are likely to affect all major sectors of the economy if and when they reverse.

Interest Rates as a Contrarian’s First Choice

After a peak at more than 15% in 1981, the yield on 10-year Treasury bonds has been in a relentless decline to almost zero at this writing. This means that bond prices have been in an unprecedented bull market for 38 years.

Declining and very low interest rate, in my observation, tend to make things look easy. Some beneficiaries simply take it for granted, while some speculators and would-be entrepreneurs optimistically credit their early successes to their business acumen and view it as an encouragement to take more risk.

As a rule, we at Sicart do not sell short, though we have very occasionally used “inverse” Exchange-Traded Funds (ETF) that move in the opposite direction to their underlying securities. Nevertheless, it is tempting to look for investments that would benefit from a recovery or “normalization” of interest rates.

I should remind readers that the argument for interest rates bottoming out could have been made at almost any time in the last few years – and it was, including by me. Now, many other economies have engineered negative interest rates, where lenders actually pay you to borrow money! Perhaps more importantly, some credible economists, including Harvard professor and former IMF director of research Kenneth Rogoff, have argued “The Case for Deeply Negative Interest Rates.”

With central banks desperate for new monetary tools, the suggestion may seem attractive, although it is not clear that countries which have adopted that approach (including Japan, Switzerland, and several European Union members) have benefited a great deal. One of the risks of “deeply” negative interest rates is that they would be an incentive for populations to save rather than spend, with obvious recessionary or deflationary implications — at a time when global governments are trying to engineer an acceleration of their economies.

Deflation or Hyperinflation?

Readers will not be surprised to see on the graph below that the U.S. inflation rate has followed more or less the same pattern as interest rates (shown earlier). When inflation rises and erodes the purchasing power of money as a result, interest rates must also rise to compensate savers.

 My experience with high inflation is rooted in the 1970s, and when I see huge government spending programs and gaping budget deficits, I am reminded of President Lyndon Johnson’s “Guns and Butter” policies during the Vietnam war years, which ushered in the inflationary bubble of the early 1970s. Indeed, it is hard for me to envision how today’s massive income-maintenance policies and the further programs to stimulate the world economies could not, in time, cause a re-acceleration of inflationary pressures.

On the other hand, a number of prestigious economists foresee a continued period of slow growth, over-supply of both goods and labor, and overall dis-inflation if not deflation (declining prices). In particular, Lacy Hunt of Hoisington Investment Management Company and Harvard University’s Kenneth Rogoff point out that rescuing already-overindebted governments by issuing more debt causes a decline in the stimulative power of the new debt and a slowdown in the growth trend of the borrowing countries. Accordingly, some economists anticipate years of dismal growth ahead for the United States and other leading economies.

At this juncture, I find it hard to discern whether inflation will prevail as a result of the massive sums thrown at the world’s economies or if, on the contrary, weak demand and oversupply of goods and services will send the global economy into a decelerating spiral accompanied by debt defaults and declining prices. For someone who, like us, prefers to “be prepared” rather than make predictions, both scenarios are credible and can be envisioned, possibly within different time frames.

Is Gold an All-Terrain Vehicle?

Before I joined him at Tucker Anthony, my mentor and later partner, Christian Humann had already established investment positions in gold mining shares, when gold was trading in the low $40s per ounce, if I remember well. In my early years as an analyst, inflation was accelerating and the portfolios under our supervision benefited accordingly. This lasted for a number of years, but Christian often asserted that gold offers protection in inflationary periods but would do the same under deflation.

Since, at the time, I was primarily concerned about inflation, I did not pay too much attention to the deflationary argument, even though in the late 1970s I authored a report somewhat pompously entitled “Between Inflation and Deflation – The Dislocating World Economy.” The principal benefit from that report was that one day I received a letter from René Larre, then the General Manager of the Bank for International Settlements, congratulating me on my analysis and pointing out that he had made similar arguments in a recent speech. That was the beginning of a stimulating relationship that lasted several years until his retirement.

We usually met for lunch once a year at a restaurant close to the BIS tower in Basel (Switzerland). Because of his participation in regular meetings of the world’s leading central bankers, Mr. Larre was very careful never to share with me anything sensitive. Similarly, by courtesy, I avoided any questions dealing with his classified activities. We just chatted about economics and the general state of the world.

By the late 1970s, however, the price of gold had risen exponentially to around $800 per ounce and had become the talk of the town in financial circles. I casually asked Mr. Larre what he made of this and he answered just as casually: “Of course, I have no particular information, but gold looks a bit toppy to me.”

Mr. Larre and I were so used to avoiding sensitive topics that I paid no attention to what, in retrospect, could have sounded like a very timely piece of advice. As can be seen from the graph above, it took more than 20 years for gold to resume its 1980 price. I did sell Christian’s very successful investment in gold mines sometime later but my obliviousness to the sagacious opinion of my lunch companion at what turned out to be a major historical top demonstrates my preference (at the time) for theory over trading practicality.

As a result of mulling over these events, I called my former partner John Hathaway, one of today’s foremost experts on gold, to see if he might elucidate Christian Humann’s claim that gold could protect investors in both inflationary and deflationary times. One of the points that stood out for me from a lengthy and learned conversation is that, besides being a hedge against inflation, gold tends to be a refuge against chaos and uncertainty. The kind of deflation that experts like Lacy Hunt and Kenneth Rogoff envision in coming years is likely to be accompanied by many corporate defaults and generally deteriorating balance sheet values. With interest rates at zero or below and the solvency of corporations in doubt, investors will be hard-pressed to invest their savings or their pensions. At that point, gold may once again appear as the ultimate safe haven.

A Contrarian View of Oil

One reason for the strong performance of gold in recent months is that it has benefitted at the same time from a rising price for the commodity itself and flat or declining costs of its two main mining inputs: labor and energy. For different reasons, almost the opposite can be said of petroleum.

Normally, supply and demand for a commodity will trend together, although with significant leads and lags, which cause the main fluctuations in price. This is because increased demand tends to eventually attract higher production, while decreased demand will eventually result in a cut of productive capacity, after shutdown costs and delays.

Atypically, in early 2020, a major disagreement caused a price war between the two leading members of the OPEC-Plus oil producing group – Saudi Arabia and Russia. Russia refused to join the production cuts demanded by Saudi Arabia and the kingdom retaliated by massively  increasing its own production, pushing down oil prices accordingly. When the Coronavirus pandemic then practically destroyed many sources of demand for oil, the world was simultaneously faced with an artificially-inflated supply, and a depressed demand for petroleum.

When oil is not selling, production continues and the excess oil produced must be stored. In April, we reached a point when all storage space, including empty tankers, had been filled. With the resultant shortage of storage capacity to contain the incoming supply of oil, desperate traders and producers briefly had to accept a negative price to get rid of their production and inventory.

 

Since then, assisted by OPEC-Plus members’ production cuts and some “re-opening” in the most visible world economies, the price of oil has recovered somewhat to around $33 — but well short of the more than $60 it commanded less than a year ago. Judging by the tone of specialized media, the investor consensus for the longer term still contains a hefty dose of skepticism and pessimism about oil. This is why the views of natural resources experts Goehring & Rozencwajg make an interesting contrarian argument.

Goehring & Rozencwajg estimate that, sometime in May, global oil consumption was oversupplied by 21 million barrels per day. If world storage remains around full capacity, “a good portion of that 21million barrels per day will have to be shut in.” This is significant when compared to global oil consumption of probably around 100 million barrels per day before the trade war and virus crisis, and around 80 million barrels per day in April.

They offer an array of reasons why oil production is set to decline sharply in the next few years, if not sooner. Once global storage is full, the global petroleum supply chain will be forced into a “just-in-time” mode, where supply must equal demand. The recent cuts agreed on by OPEC-Plus are not sufficient to balance global supply and demand, but the recent events will also force producers everywhere to quickly shut in marginal or unprofitable wells. For example:

— Old and small “stripper” wells with declining production and estimated lives

— Expensive heavy-oil production from Canadian oil sands

— Production from offshore locations such as the Gulf of Mexico

— Shale oil production from “fracking”, which has boosted US capacity dramatically in the last couple of years but needs constant investment to prolong the life of its fast-depleting existing reservoirs. (In any case, other studies had previously pointed out that much oil shale production was uneconomical below prices in the mid-40s, which few experts are currently anticipating in the foreseeable future.)

According to Goehring & Rozencwajg, most of the diminished production will never be restored because of the costly investment to revive it or the damage to reservoirs. They also point out that the US oil-rig count has fallen 45% in the last six weeks. Such a decline is not rapidly offset once skilled personnel has been laid off.

To end on a silver lining, the reduction in oil production should also reduce the supply of natural gas, which had not benefited from the bull market in oil. According to a note from Mauldin Economics, 32% of total US natural gas production comes from wells that primarily produce oil. They mention that Goldman Sachs expects natural gas prices to double by the end of the year.

* * * * *

Good luck being prepared!

 

François Sicart – May, 27 2020

 

Disclosure:

The information provided in this article represents the opinions of Sicart Associates, LLC (“Sicart”) and is expressed as of the date hereof and is subject to change. Sicart assumes no obligation to update or otherwise revise our opinions or this article. The observations and views expressed herein may be changed by Sicart at any time without notice.

This article is not intended to be a client‐specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. This report is for general informational purposes only and is not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally.

 

One of my early and most influential mentors, Walter Mewing, began his career before the Great Depression as a messenger on Wall Street. Reportedly, just before the onset of the Depression, he sold all the stockholdings he had managed to accumulate from his small savings in order to buy a chicken farm. Upon returning to Wall Street in the early 1930s, he embarked on a career as a financial analyst and investor. Somehow, he became a partner with my other two (much wealthier) mentors and the much younger Christian Humann, who eventually became my boss and, ultimately, partner.

Walter Mewing had one passion in life: financial analysis. He was devoted to the philosophy of Benjamin Graham, the Columbia University professor who is widely considered the father of value investing. But Walter was no academic. I believe he was self-taught, and had acquired his knowledge in the field and by reading endless annual reports (including the SEC-mandated footnotes to the financial statements). By the time I knew him, he assiduously attended the daily meetings of the National Association of Security Analysts, where listed companies would make presentations and answer questions. Even his vacations were usually spent visiting companies.

On a few occasions, as we were discussing companies going public out of venture-capital firms, he had advised me, “When a company has no earnings yet, there is no upper limit to its share price, because it is selling on the basis of dreams. But be careful when it starts making money, because it will then begin selling on the basis of hard figures from its income statement and balance sheet, and its price is likely to fall back to earth.”

Today, with the recent years’ popularity of “unicorns” (billion-dollar start-ups), many of which are still not earning any meaningful profits, there is a plethora of shares to avoid if an investor wishes to follow Walter’s advice.

On the other hand, I remember that in the late 1990s, when the dot.com boom was raging, the price of many industrial metals had collapsed and many mining companies were losing money. My then-partner John Hathaway asked for a meeting of the senior members of the firm to make his case for what a mining company like Phelps Dodge could earn if only the price of copper returned to the level it had reached several times in previous years. I don’t have a detailed recollection of the episode, and no longer have access to Phelps Dodge trading at that time. But — based purely on memory — John’s case was very convincing to me because I had witnessed this kind of cycle on a few occasions.

When business is good and the price of copper is high, all producers tend to open new mines at the same time, eventually resulting in overcapacity and low prices. Subsequently a few financially-marginal producers might close, while stronger ones simply cut capital spending. As a result, the supply/demand balance is restored. Then a new investment boom will generally get underway, but it takes several years to build new mines and reopen operations, so that copper becomes scarcer and thus more expensive.

The following chart will give an idea of the situation at the time. I believe the price of copper had collapsed to around 65 cents per pound and stayed in that range for a while. But by the early 2000s it doubled to levels it had previously reached in the late 1980s and mid-1990s. (As can be seen from the chart below, it then went on to attain much higher prices, but that is another story and by then our firm had probably sold out of our copper investments.)

Copper Price                     $/lb.

        

The lesson I retain from that episode is that cycles in industrial commodities prices take time to unfold. Yet because producers tend to behave as a crowd, investing and cutting back at roughly the same time, lagging behind the physical supply/demand dynamics, these companies also tend to oscillate between rich profits and deep losses. Of course, this is my opinion and history does not always repeat itself. But it tends to “rhyme”.

So, how does this apply to the current situation?

The Coronavirus pandemic and its dramatic effect on the world economies pretty much guarantee that some economic sectors will be losing money for at least a couple of quarters and possibly longer. My observation, over the years, is that most financial analysts and the investors who follow their advice do not look much further than a few quarters in advance, if that much. This is especially true when corporations themselves stop issuing projections, as is now the case. Thus, we believe it is likely that the shares of companies in the sectors most affected by the developing economic vacuum — such as hotels, restaurants, airlines, shipping, and many companies involved in tourism or international trade — will sell as if they would never recover.

Of course, some companies will go out of business in the industries most directly affected. Nevertheless, the financially stronger ones will probably survive to enjoy the next boom in demand for a diminished supply of their products or services. As often in periods like this, it will be important for investors to select, not companies that felt comfortable and aggressive when liquidity was plentiful and readily accessible, but those that have low debt, ample reserves of cash, and the ability to survive several quarters of negative cashflow without curtailing essential operations.

One last memory flash: the 1973-74 bear market erased almost 50% of the Dow Jones Industrials value in almost two years before it was concluded by a double (or W-shaped) bottom in the three months between October and December 1974. In view of the rapidity and violence of both the decline and recent bounce in 2020, a similar pattern would not be overly surprising. Please also note that the 1974 economic recession only ended officially in March 1975.

 

Dow Jones Industrial Average from January 1974 to February 1975

Source: A History of Stock Market Bottoms – TheIrrelevantInvestor.com — Dec 27, 2018

 

* * *

 

Just as those patients with otherwise good physical health will likely survive the Coronavirus pandemic and recover from intensive care to prosper and possibly help other patients thanks to a newly-acquired immunity, the financially-stronger and more resilient companies will likely be the survivors from the economic recession and contribute to the future recovery of the country’s whole economy.

François Sicart – April 15, 2020

 

 

Disclosure:

The information provided in this article represents the opinions of Sicart Associates, LLC (“Sicart”) and is expressed as of the date hereof and is subject to change. Sicart assumes no obligation to update or otherwise revise our opinions or this article. The observations and views expressed herein may be changed by Sicart at any time without notice.

This article is not intended to be a client‐specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. This report is for general informational purposes only and is not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally.

The always-stimulating Farnam Street blog recently discussed the classic example of The Chesterton Fence. In a 1929 book, The Thing, English writer G.K. Chesterton, offered the following advice:

“Do not remove a fence until you know why it was put up in the first place.”

As Chesterton explained, fences don’t just happen. They are built by people who had some reason for thinking they had a purpose. Until we establish that reason, we have no business taking an ax to them. This observation has become one of the pillars of a discipline that has recently become popular in action-oriented thinking circles: second-order (or second-level) thinking.

As it applies to investments, second-order thinking was clearly illustrated by Howard Marks, in his book The Most Important Thing (Columbia Business School Publishing) and his periodic letters to clients of the firm he co-founded, Oaktree Capital Management:

“First-level thinking says: ‘It’s a great company, let’s buy the stock.’ Second-level thinking says: ‘It’s a good company, but everyone thinks it’s a great company, and it’s not. So, the stock is overrated and overpriced; let’s sell.’”

From my point of view, the second-order approach has several attractive features:

• It clearly is different from the usual approach and, by definition, to be better than the majority of investors, you must first behave differently. (See Howard Marks, above)
• It is contrarian, but in a thoughtful way rather than merely as a reflex.
• It forces one to look beyond the immediate future, which is one way in which we at Sicart try to differentiate ourselves from the crowd of analysts.

So, how should we look at today’s situation from a second-order perspective?

Most world economies have struggled to recover even partially from the so-called Great Recession of 2007-2009. Now, the economic consequences of the Coronavirus pandemic almost guarantee that the world economy is about to fall into recession. Forecasts of recovery and future growth are being scaled back accordingly. So, the consensus looks to and prepares for a recession of still unknown length and depth.

However, to offset the fast-deteriorating outlook, most governments are devising (and promising to soon start implementing) stimulus programs of unprecedented sizes. These programs include what central banks can still do with their few yet-unused tools to sustain liquidity in economies and especially financial markets. But they also incorporate large fiscal spending to sustain jobs and incomes, as well as unprecedented programs to protect or boost activity in industries threatened by the pandemic.

Unfortunately, if there is one thing that history has taught us, it is that it is easier to throw money at a deteriorating economy than to “take away the punch bowl just as the party gets going,” as the late Fed Chairman William McChesney Martin famously advocated. There is a good chance, therefore, that pandemic-relief and stimulus programs will continue well after the health of populations and economies have turned around and started to recover.

To summarize, a first-order look at the current situation tells us that we are taking the measures required to fight a developing global recession. A second-order look tells us that these measures will likely outlast the recession, eventually turn out to threaten budget balances, and possibly trigger a revival of inflationary pressures.

Today, inflationary pressures are very far from the minds of younger observers. The last peak in U.S. inflation was almost 40 years ago and we have since experienced declining and then stubbornly-low inflation, so that younger analysts and investors may have read about it in history books but they don’t remember personally experiencing it.

Most current observers are more likely to draw parallels with Japan’s contemporary struggle against deflation than with Germany’s hyperinflation under the Weimar republic, between the two world wars.

My First Encounter with Inflation in the Midst of a Recession

Between January 11, 1973 and December 6, 1974, the Dow Jones Industrial Average lost over 45%. The crash came after the collapse of the Bretton Woods system over the previous two years, then the US dollar devaluation, the Watergate political crisis, and the first oil crisis in October 1973.

As I was trying to remember this first experience of my career with inflation rising in the midst of a global recession, I came across a paper on “The 1972-75 Commodity Boom” which confirmed that paradoxical occurrence (Brookings Papers on Economic Activity Vol. 1975, No. 3, 1975 – Richard N. Cooper, Robert Z. Lawrence).

Thanks to the foresight of my mentor and boss at the time, the late Christian Humann, our portfolios had been holding large positions in shares of raw materials and energy producers. They continued to rise as the overall market decline got under way, significantly helping our performance that year.

In their paper, Professors Cooper and Lawrence summarized: “An extraordinary increase in commodity prices occurred in 1973-74. Even leaving aside crude oil as a special case, primary commodity prices on one index more than doubled between mid-1972 and mid-1974, while the prices of some individual commodities, such as sugar and urea (nitrogenous fertilizer), rose more than five times.” They added that the sharp rise in commodity prices had startled most observers, as it came on the heels of apparent oversupply in 1970-71.

The mechanics of the cycle in industrial commodities need to be kept in mind. Capacity closures are not easy or cheap to implement and are thus often delayed. But once they have been made, it usually takes several years to plan, build, and ramp up new capacity. So, the workings of supply and demand are not well synchronized and can be slow to develop.

 The Intriguing Case of Oil

Even though oil was excluded from the 1975 Brookings study because of the volatility caused by the oil embargo and the creation of OPEC in 1973, it has proven to be an excellent case study of such cycles.

The two charts below are of particular interest.

The first one illustrates that, after the investment boom that followed the second oil shock, triggered by the 1979 Iranian revolution, oil prices began a 20-year, 60 percent decline, except for a brief rebound during the Gulf War.

The second shows that the oil price is now back to its 1990s level of around $20 per barrel.

Of course, there is little doubt that there is a long-term tendency for the world to move from fossil fuels such as oil, gas and coal to alternate sources of energy such as solar, wind, etc. But in a medium-term perspective, for cost/price and infrastructure factors, as well as regional and economic development considerations, this transition is likely to remain relatively marginal for a number of years.

The proximate causes of the recent price decline are:

1. The destruction of demand in travel, tourism and transportation activities due to the Coronavirus pandemic
2. The feud between Saudi Arabia and Russia for effective control of the OPEC-plus group

Presumably, these two influences may have some lasting impact, but they should nevertheless prove temporary. With regard to the Russian-Saudi feud, although the two main protagonists disagree on many points, they seem to agree, openly or not, that a lower oil price will help reduce or eliminate the threatening competition from America’s rising production of shale oil.

It seems that this part of their agenda is meeting with some success. According to brokers Wood Mackenzie, a tenth of the global oil production may become uneconomic at current prices. This would represent about 10% of the global supply, estimated at 100 million barrels per day by the International Energy Agency. Heavier oil production from Venezuela or Mexico requires prices above $55 a barrel; Canadian oil sands need $45 a barrel. RS Energy Group estimates the break-even price for oil from the best shale-producing areas is $43 a barrel. Meanwhile, Saudi Arabia or Russian oil may cost $10 a barrel or less to produce. (All above data from the Financial Times, 3/22/2020)

US shale operators will suffer rapidly because their reservoirs tend to be depleted over much shorter cycles. The shale revolution allowed the US to become the world’s biggest oil and gas producer, with a record oil production of 13 million barrels a day — estimated by some analysts to shrink by 2.5 million barrels a day by 2021. Meanwhile, capital spending across the shale sector will fall from $107 billion last year to $64 billion this year, according to the consultancy Rystad Energy.

Jamie Webster, of the BCG Center for Energy Impact, summarizes his view of the situation as follows: “Shale thrives at $100 a barrel, survives at $50 and dies at $25.”

There will come a time when the Coronavirus pandemic is only a very bad memory. Meanwhile, both Russia and Saudi Arabia reportedly need oil at prices much higher than the current price-war levels in order to meet their governments’ budgetary obligations. It seems likely that, sooner or later, they will declare victory and settle on an acceptable oil price. Then, the lowest-cost and financially strongest shale producers may not “thrive” but they are likely to survive profitably after their weakest competitors have disappeared and global demand volumes have recovered.

My experience with highly cyclical producers of industrial commodities (such as copper and other metals) is that the best time to buy shares of the financially stronger companies is when the industry is losing money. The recent behavior of the oil price has not escaped the media, who shape our view of the world, as the Financial Times, among others, reminded us on 3/24/2020:

OIL INDUSTRY FACES BIGGEST CRISIS IN 100 YEARS

 This may be a good time to remember the famously contrarian record of the most sensational newspaper headlines.

Second-order Look: Watch for a New Inflationary Cycle?

Price inflation is often described as “too much money chasing too few goods.” While it is clear that money and liquidity have been plentiful in recent years (quantitative easing, zero percent interest rates, etc.), it would be harder to argue that there have been too few goods available to buy. Globalization, the offshoring of production to cheaper manufacturing regions, as well as progress in productivity and logistics have made ample supplies of most goods readily and cheaply available.

On the other hand, recent experience may have radically altered the most efficient supply chains that were developed in the last couple of decades. This, and maybe some new protectionist trade policies, may reverse the race to the cheapest possible products.

Meanwhile, trillions of dollars are in the process of being injected into the world’s leading economies and further stimulus is already being planned. As I mentioned, it will be easier to spend that money than to withdraw it when it is no longer needed for non-inflationary growth.

William White, former Head of the Monetary and Economic Department at the Bank for International Settlements, and Deputy Governor of the Bank of Canada, just wrote a paper for the Official Monetary and Financial Institutions Forum, in which he discusses, among other topics, the unintended consequences of past policies (OMFIF, 23 March 2020). He concludes that “It would be wrong to assume a zero threat of higher future inflation.”

The drawback of second-order thinking is that it may suggest investment opportunities for a time horizon well beyond the impact of first-level thinking. But it takes time to stand out from the crowd, and we plan, as always, to be patient.

François Sicart – March 30, 2020

Disclosure:

The information provided in this article represents the opinions of Sicart Associates, LLC (“Sicart”) and is expressed as of the date hereof and is subject to change. Sicart assumes no obligation to update or otherwise revise our opinions or this article. The observations and views expressed herein may be changed by Sicart at any time without notice.

This article is not intended to be a client‐specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. This report is for general informational purposes only and is not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally.

Warren Buffett has famously quipped that we only find out who has been swimming naked when the tide goes out. During the spectacular bull market since 2009, many “professionals” and people relying on their advice have insisted that we at Sicart were holding too much cash in our accounts. Our guess is that many naked swimmers who followed their advice are now beginning to sell shares indiscriminately, prompted either by panic or lack of liquidity. Nothing new there: this is what typically happens after periods of greed, thoughtless complacency, or fear of missing out in a rising market.

In our view, the Coronavirus epidemic was not directly responsible for the recent upheaval: for a while, the stock market had been looking like a bug in search of a windshield. Following Minsky’s hypothesis, we believe that financial corrections and crashes do not need a proximate cause in order to happen: in free markets, there is a natural tendency for investors and business people to oscillate between periods of excessive optimistic risk-taking and periods of fear-driven financial timidity or retreat.

Famous Keynesian economist Paul Samuelson used to joke that the stock market had predicted nine of the past five recessions. Nevertheless, it has now become clear that the Coronavirus crisis will transform whatever financial correction we might have suffered spontaneously into an economic recession.

We have lived through a dozen-odd bear markets since the1960s. Most have caused losses equivalent to the current decline of around 25% from the stock market high in February. But a few suffered larger and/or more extended losses, notably:

36% in 1968-1970 in 18 months

50% in 1973-1974 in 21 months

28% in 1980-1982 in 21 months interrupted by an energy-related spike in 1981

34% in 1987 in only 3 months

49%% in 2000-2002 in 30 months

56% in 2007-2009 in 17 months

(Sources: Global Financial Data; msnbc.com research)

 As it happens, though I certainly do not accept responsibility for these setbacks, I witnessed all of them as a concerned investment professional. Except for the flash crash of 1987, all were accompanied or preceded by economic recessions. This is why I mentioned in my previous paper that bear markets associated with economic recessions tend to dig deeper and last longer than those resulting from a mere correction of asset price due to a change in the investing crowd’s psychology.

At the moment, enough damage has already been done to all industries that benefited from the world’s globalization (including labor-intensive airlines, shipping, hotels and restaurants, tourism and leisure activities, as well as products resulting from complex and far-reaching supply chains, such as electronics) to all but ensure a recessionary environment for at least the balance of 2020. GDP will slow or temporarily decline and, in all likelihood, so will profit margins and corporate earnings.

To counterbalance these considerations, it is now clear that, in a more or less coordinated manner, most major economies are in the process of devising and beginning to implement very strong measures to halt the progress of the Coronavirus and mitigate the impact of the pandemic on employment and living standards.

As usual, the sequence of events will determine the extent and shape of the damage or the success of these countervailing measures. My guess is that the progress of the virus and of the market correction will initially be faster than the benefits of any fiscal stimulus, especially where infrastructure projects are contemplated. So it is likely that we will see statistics of declining economic activity before the main benefits of the planned stimulus programs are fully visible.

Between the heightened market volatility and the sharp losses of the past couple of weeks, it is tempting for contrarian/value investors like ourselves to use the near-panic to buy more aggressively. As I mentioned last week (https://www.sicartassociates.com/the-point-and-challenge-of-being-prepared/), we have already used the first, emotional phase of the decline to put a portion of our cash reserves to work by adding to some existing positions and starting a few new ones. The main idea was to wait for confirmation of an economic recession, assuming that (as they often have in the past) it might drive the markets lower and create even better buying opportunities.

Besides confirmation of an economic recession, the other signal I would like to see is a much bigger correction of the FANG-related indexes (Facebook, Apple, Netflix, Google and a few others). These bull market favorites, after driving the overall market higher for a few years, have participated in the most recent decline, but not to the extent that previous bull market favorites did after reaching greatly overvalued prices.

As panic spreads, however, it will probably put disproportionate pressure on stocks that account for a large proportion of major indexes: the mutual funds or exchange-traded funds that own large positions in these index stocks will have to sell them as the funds are liquidated by hard-pressed, overextended investors.

Things may have moved a little too fast for comfort, but major investment opportunities seem to be coming closer and closer.

 

François Sicart – March 18, 2020

The information provided in this article represents the opinions of Sicart Associates, LLC (“Sicart”) and is expressed as of the date hereof and is subject to change. Sicart assumes no obligation to update or otherwise revise our opinions or this article. The observations and views expressed herein may be changed by Sicart at any time without notice.

This article is not intended to be a client‐specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. This report is for general informational purposes only and is not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally.

Beyond the traditional choice of our investment management style between categories such as value or growth, fundamental or technical, trading or buy-and-hold, we have tried to abide by two precepts:

• One is that it is futile to try and predict the future, especially with regard to its timing. What is more important is to be prepared for what may happen, no matter how unlikely.

• The other, derived from the work of Prof. Hyman Minsky, is that financial crises do not require a proximate cause: they are a natural consequence of the free-market cycle where the investing crowd becomes first increasingly complacent; then willing to accept excessive risk; and eventually succumbs to panic, at which point when the liquidity that seemed to make everything so much easier dries up.

For the last couple of years, these beliefs have led us to push back against the increasingly strident pressure from some fiduciaries, consultants and, fortunately, very few clients, who had been clamoring for us to reduce our large, prudential cash reserves.

The over 4,000-point decline in the Dow Jones Industrial Average in less than two weeks did not merely erase a full year of previous gains. More importantly, it raised an additional question:

“What do you do with your prudential cash reserves when their use becomes justified?”

Although financial crises may not require a proximate cause, investors and observers often have little difficulty finding culprits after the fact.

There is little doubt that the current market correction was at least triggered by the spreading Coronavirus panic, which seems a legitimate concern. Still, judging from historical examples, while affected populations will undergo considerable suffering, it seems likely that the health problem will abate and hopefully be solved in a matter of months — or perhaps a couple of years.

From an economic point of view, however, the problem is the advanced level of globalization that the world has achieved in recent years. Today, most products are the end result of complex and far-reaching supply chains. Difficulties in any one of the countries making parts or supplies for an end product can badly disrupt the supply of that product around the world. Even if the supply chains can be restored, the process will take time and money, and cause labor displacement.

So, there is a chance that what could have been an economic hiccup will morph into a global recession. From an investment perspective, we believe, bear markets associated with economic recessions tend to dig deeper and last longer than those resulting from a mere correction of asset price due to a change in the investing crowd’s psychology. Past examples are all over the map but a typical correction might produce a 15-20% stock market decline, while one associated with a true economic recession could be as high as 50%.

Since we don’t know how things will eventually turn out, we need to be prepared for both the short term and the longer horizon.

In recent years, it seems that investors have put their steady faith in the power of central banks. At the first signs of weakness in financial markets, central bankers could be counted on to pump liquidity into their economies. With the physical economies remaining lackluster and resisting incentives to invest in plants and equipment, most of that added liquidity tended to flow into financial markets. That tendency largely explains the bull markets of the years following the Great Recession of 2008-2009.

Today, with interest rates close to zero (or even lower in much of the world), investors’ doubts have begun to appear as to how much more central banks can do to fight recessions. Even some central bankers seem to wonder how much dry powder they have left. Nevertheless, it is possible that, in a central bank last hurrah, a coordinated stimulus effort could produce a violent (and probably short-lived) stock market bounce back, based on investors’ remaining faith in the infallible power of central bankers to direct at least the stock and bond markets, if not the economies.

Without entering into a dangerous exercise in short-term trading, we have decided, for clients who are in a position that makes it possible, to invest about 10 percent of their current excess cash reserves in shares that are down 40%-50% from their highs. Most of these companies will typically be ones where we already own positions in our portfolios. However, we have also included a couple of companies with high growth profiles that, although still expensive by our traditional “value” standards, are seldom available at very low valuations.

For a portfolio that might have had cash reserves of 30% of its total value, for example, this recent decision would now leave it with 20% in cash and equivalents.

Beyond this first adjustment, committing the rest of our excess cash will probably await the kind of deeper decline typically associated with economic recessions – whenever one comes. But I have noticed, over a number of past bear markets, that the deeper and longer ones tend to produce a compression in the range of valuation measures such as ratios of price-to-earnings, price-to-cash flow, etc.

This means that in a major bear market, many companies with superior growth and profitability sell at valuations which, while not as low as those of classic “value” stocks, are much closer to them than in normal or more ebullient times. Often, these episodes constitute a rare occasion to acquire the shares of superior companies at reasonable prices.

Being prepared does not mean making decisions in advance. We have not yet reached compelling valuation levels for shares that have until recently remained quite expensive. But we have intensified our research on such companies, so that we may seize opportunities when their prices seem right. When this happens (and in full-fledged bear markets it can happen quite fast), we will be prepared with reserves of cash, and thus well-positioned to upgrade the long-term potential of our clients’ portfolios. Stay tuned…

 

François Sicart, March 2, 2020

 

Disclosure:

The information provided in this article represents the opinions of Sicart Associates, LLC (“Sicart”) and is expressed as of the date hereof and is subject to change. Sicart assumes no obligation to update or otherwise revise our opinions or this article. The observations and views expressed herein may be changed by Sicart at any time without notice.

This article is not intended to be a client‐specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. This report is for general informational purposes only and is not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally.

Part I of this paper (July 30, 2019) concluded that conditions have gathered for a “Minsky Moment” (the time when apparent financial and economic stability turns into instability and eventually financial crisis or recession). The wait may be long for that precise moment to materialize, but since, as the saying goes, “trees don’t grow to the sky,” education and experience can give us a pretty good idea of the ultimate outcome. Thus, the main challenge lies in determining the likely timing of that moment, which is what we are going to investigate in this Part II.

I have not yet come across a model or formula allowing investors to predict stock market turning points with any accuracy. On the other hand, many studies by reputable analysts and research organizations are useful as backdrops to exercise one of our principles: “You cannot predict the future, but you can prepare.”

Understanding The P/E ratio

From its 2009 low of 677, the S&P 500 index has now gained more than 300%. Because earnings were temporarily suppressed by the Great Recession, it is difficult to compare gains in earnings and those of the stock market. But even using more “normal” dates such as July 1, 2007 (before the crash) and April 1,2019 (close to the recent high) the index progressed 90% while the S&P 500 earnings gained less than 30%. This is a useful reminder that big moves by the stock market are driven principally by changes in the Price/Earnings ratio (P/E), an indicator that is easy to understand and to monitor.

Two of the best researchers and writers about the stock market, John Mauldin and Ed Easterling, recently joined forces to write: “Valuation Determines Return” (in John Mauldin’s Thoughts from the Frontline, 3/15/2019)

One of the most useful graphics, from Easterling’s Crestmont Research, which keeps a wealth of economic and financial statistics, illustrates how the stock market “total return” is generated:

The authors further make the essential point that:

Over 10–20 years, the P/E [Price/Earnings ratio] can dramatically increase or decrease, resulting in a significant addition or reduction in total return. In the secular bear market of the 1960s and ’70s, the decline in P/E virtually eliminated the return from earnings growth and dividend yield. In the 1980s and ‘90s, the increase in P/E more than doubled the return for many of the decade-long periods during that secular bull market.

The Future Can Be Told…

In his March 8, 2019 newsletter “On My Radar”, Steve Blumenthal of Capital Management Group reviews many studies of what current equity market valuations can tell us about coming long-term returns (7 to 10 years or even 20 years, depending on the study). Morningstar does the same in the 2019 edition of its annual “Experts Forecast Long-Term Stock and Bond returns.”

For most of these studies, valuation is measured by the current Price/Earnings ratio, although many use a moving average of earnings to calculate the P/E. This tends to understate the earnings (when previous years’ profits were lower) and to overstate the resulting adjusted P/E ratio; but it generally eliminates the effect on profits of most cyclical fluctuations. The following graph illustrates how Yale University’s Robert Shiller (CAPE P/E 10) and Crestmont Research, for example, smooth earnings to calculate their versions of the Price/Earnings ratio.

Using Shiller’s CAPE (Cyclically-Adjusted Price/Earnings ratio), Crestmont Research tallied 110 decade-long periods between 1900 and 2018 and grouped them by quintiles. The chart below shows how starting valuations strongly influence the S&P returns in the following 10 years. As the market’s starting valuations rise, future returns decline:

Ned Davis Research conducted a similar study using the stock market’s median P/E, e.g. the P/E with as many numbers above it as there are below. The median tends to be less influenced by extremes in a sample than the average, for example.

Using data from 1926 to 2014, median P/E was sorted into five quintiles. Quintile 1 is the lowest 20% of all month-end median P/Es and quintile 5 is the highest. In the following table, next to each quintile is the annualized nominal returns over the following 10 years.

 

The most important thing to remember from all these studies is that today’s valuation can give an excellent idea of the likely future stock market returns.

… But Not in Detail

The problem is that forecasting, for example, an 80% gain for the stock market over the coming 10 years (roughly equivalent to 6% per year) does not tell you when this performance might be achieved. For example, a two-year 56% gain could be followed by a 44% loss, then another gain and so on, with the ten-year net change totaling 80%.

For those readers whose memories may have been numbed by the central bank-engineered, momentum-driven stock and bond markets of the last ten years, the following graphs from Crestmont Research (1965-1981 and 2000-2016) may remind them of what volatility feels like in real life:

Even Warren Buffett’s Berkshire Hathaway (presented here as a case study, not an investment recommendation) endured this kind of volatility which, of course, he viewed as opportunity.

 

This, as can be seen below, did not hurt Buffett’s long-term record of building wealth. Yet his shareholders who did not have the courage or the patience to endure the volatility and sold Berkshire Hathaway during those episodes probably suffered the fate of the so-called “dumb money.” There is magic in having ready cash when opportunities arise.

Strategy

Value investors have traditionally been more focused on stock-picking than on macro analysis of the economy. But when my friend Jean-Marie Eveillard and I had lunch in July and were reminiscing about the financial crisis and Great Recession of 2007-2009, we concurred that it would have served us well to pay more attention to the macro environment.

This conversation got me thinking and I reviewed the main stock market declines of the past few decades. I observed that the general difference between “corrections” and “bear markets” was that full bear markets tended to be accompanied by economic recessions and were often longer and deeper (30%-40% declines or more), whereas mere corrections, up to 20% declines, could be purely financial phenomena, not fundamentally affecting the country’s core economic activity.

Source: Seeking Alpha – Dec. 26, 2018

Note: 1998 was in the midst of the Asian currency crisis and 1987, while traumatic, was a one-day stock market crash, too short to turn into a recession. Economic activity in 1962 felt the impact of a major strike.

* * *

Nobel Laureate Paul Samuelson famously quipped that the stock market has predicted nine of the past five recessions. Indeed, whether they come from the private sector, academia, central banks or the International Monetary Fund, forecasts of economic activity have historically been inaccurate. Thus, we should view prediction of a possible recession and its timing with a grain of salt.

After remaining relatively sanguine about economic activity early in the year and even worrying about a re-awakening of inflation (prompting the adoption of higher interest-rate policies), a majority of economists has now been shifting to concern about a global recession, on the backdrop of weakening global economies and the trade wars initiated by the American government.

Of course, when both governments and central banks focus primarily on preventing stock market declines, as they have done recently, the distinction between financial crisis or bubble-bursting and economic recession may become moot. Economic policies may delay the pain, only to make it more acute later.

The Asian currency crisis of 1997 not only awakened my interest in Asia and particularly China, it also made me realize that the trigger of a financial crisis may be an apparently remote development (such as the devaluation of the Thai Bath) that is followed by a domino effect of other, bigger crises. The globalization of finance affects institutions and their clients in unpredictable places.

At the moment, among our worries are a large number of bonds and loans that are hover just above the “junk” label and which could be downgraded in coming months, especially if  global economies continue to weaken. This development would prevent major pension funds and other large fiduciaries from holding these investments in their portfolios and could trigger a massive selling wave, putting into question these institutions’ liquidity. Somewhat related, for many corporations and governments outside the United States who borrowed in dollars, a continued appreciation of the U.S. currency may also mean the difference between apparent solvency and default. In addition, the ultimate effects of the current trade war, tariffs game, and now-threatened competitive or retaliatory currency devaluations are beginning to be felt in overall economic decisions and activity.

From our perspective, this is a good time to be prepared, for both the volatile environment ahead and the opportunities that it may create for investors with cash to invest.

 

François Sicart

August 12, 2019

 

Disclosure:

This article is not intended to be a client‐specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. This report is for general informational purposes only and is not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally.

This review of what shapes our investment strategy could have wound up being quite long. We therefore elected to first review some lessons of experience and the unbending principles that guide our attitudes toward investment over the cycles. In a coming paper, we will describe how the two interact to yield our investment strategy.

EXPERIENCE

A few weeks ago, I had lunch with my old friend and colleague Jean-Marie Eveillard, an investment manager whose career has been as long as mine and quite successful, including the stewardship of one of the first global funds from $15 million to $50 billion and a Lifetime Achievement Award from Morningstar. But his feat I envy most is his statement during the Internet bubble of the 1990s, which we both shunned, that: “I would rather lose half my shareholders than lose half my shareholders’ money”.

Over lunch, we naturally wound up reminiscing about the speculative bubbles we had lived through and their aftermaths.

The Nifty Fifty Stocks and the Two-Tier Market

Of course, we remembered the beginning of the 1970s, early in our careers, when 50 stocks, the “Nifty Fifty”, came to be viewed as “one-decision” stocks due to their assumed continued fast growth, high margins and perceived resistance to recessions and disruptions (most of them had survived well the 1970 recession, shortly after a leading economist had proclaimed “we have conquered the economic cycle”).

As a result of this extrapolation, these fifty stocks were aggressively accumulated by major institutions and were largely responsible for the extent of the bull market of the late 1960s and early 1970s. But that performance came at a price. In 1972, the S&P 500 Index’s P/E already was 19, but the Nifty Fifty’s average P/E had reached 42x with Polaroid at 91x, McDonald’s at 86x, Walt Disney 82x and Avon Products at 65x.

Not surprisingly, in the stock market collapse of 1973-74, the Dow Jones Industrial Average fell 45% in just two years while, for example, Xerox lost 71%, Avon 86% and Polaroid 91%.

The Japanese Bubble

Not surprisingly, Jean-Marie and I both had vivid memories of the 1980s Japanese bubble as well, perhaps, I believe, because neither of us participated in that stubborn episode to any extent. At the time – as may be happening with China today — Japan was portrayed as an irrepressible force and the greatest economic threat to the United States, whereas economists and politicians were becoming increasingly aware of a hollowing out of US manufacturing and a widening bilateral trade deficit.

Experts and specialists found many reasons to rationalize the elevated prices of Japan’s stocks — from the more conservative quality of Japanese reported earnings to the very low interest rates already prevailing in that economy. Most of these arguments were legitimate but the ultimate bursting of the bubble was a stark reminder that, in the end, it is the prices you pay that count.

The bubble was multifaceted: land prices, according to Stephen S. Roach, a senior fellow at Yale University’s Jackson Institute of Global Affairs (May 27, 2019), had increased 5000% from 1956 to 1986 even though consumer prices had only doubled in that time: by 1990 the total value of the Japanese property market had reached roughly four times the real estate value of the entire United States. Even golf club memberships could fetch as high as the equivalent of $2 million in 2019 dollars.

Also overlooked was the fact that Japanese share prices had increased three times faster than corporate profits during the 1980s, as their Price-to-Earnings ratios were exploding on the upside. In 1989 the P/E ratio on the Nikkei reached 60x earnings but, rewarding the patience of those who had had the conviction to wait, the Japanese stock market lost roughly 80% of its value over the next decade.

Similar experiences followed in the late 1990s and early 2000s (the Internet bubble) and eventually in 2007-2008 (the subprime crisis, followed by the “Great Recession”, of which the consequences are still being worked out). Those episodes are recent enough that many of today’s market participants probably don’t need to be reminded of them here, but the story of speculative euphoria and its aftermath continues to “rhyme” over the cycles.

In a January 2019 white paper (“Is the U.S. Stock Market Bubble Bursting”, January 2019, GMO), GMO argues that bubbles are discernable not only by elevated valuations: “they are also about animal spirits captured in stories of euphoria” such as, for example, the recent enthusiasm for crypto-currencies, Big Data, Artificial Intelligence and (my addition) perceived “disruptors” of established industries. The reluctance of many market participants to libel the current environment as a bubble is due to the absence of market-wide euphoria because irrational exuberance is only visible and measurable in selected speculative pockets.

Backdrop: Paradigm Shifts

In the United States today, the employment rate is near a record while inflation seems to remain hibernating. Yet, digging a bit deeper below the surface, it feels like there are two distinct economies, with savers/investors enjoying a prosperity that mirrors the performance of the stock market or the quick access of new technologies to easy money, while salaried workers in traditional industries are having trouble navigating today’s economic schizophrenia. To a degree or another, similar trends seem to be affecting most other major economies.

When I look at today’s sometimes puzzling world economic order, I am reminded of the American Agricultural Revolution. Over 200 years ago, 90 percent of the U.S. population lived on farms and fed mostly themselves but today, just two percent of the population produces food not only to feed the country but also to be a major exporting sector. During that process, farming appeared to shrink in importance when measured by employment, but was really experiencing an extended surge in productivity, producing a 2018 trade surplus of $10.9 billion. Through the use of technology, each farmer is now able to feed 155 people, versus only 19 people in 1940.

Economic history is full of such periodic paradigm shifts, although few extended over such long periods as the agricultural revolution. In my experience, these shifts can render some of our traditional economic and financial statistics temporarily confusing or outright misleading.

In the mid-1980s, near the peak of the Japanese bubble, many experts were proclaiming the death of American manufacturing. This contrasted with what my team was observing on our visits to factory floors, with new disciplines such as just-in-time, cell-manufacturing and total-quality being actively taught and implemented. We became convinced that, instead of dying, American manufacturing was in fact being reborn. Interestingly, only the American Manufacturing Association and the Japanese Chamber of Commerce were interested in our theory and both invited me to speak to their constituencies.

Robert Kaplan, now Emeritus Professor of Leadership Development at the Harvard Business School, was one of the leading academics who helped us investigate this discrepancy further.

Traditional management accounting had been developed when materials and direct (manual) labor made up the bulk of industrial companies’ costs. Those were relatively easy to measure and the practice developed of allocating so-called “overhead” costs, such as marketing, R&D and administration, in the same proportions as those easily-allocated direct costs. But, as industrial activities became lighter, cost structures evolved: by the 1980s, for example, in the growing electronics industry, materials and direct labor no longer represented more than 10%-15% of total costs.

Prof. Kaplan commented that U.S. companies were still using a 19th-century accounting framework to measure their activities in the 20^th and soon-to-come 21^st centuries. This misallocation led to the wrong investment decisions at the corporate level and, in the aggregate, the wrong assessment of U.S. competitiveness.

A New Paradigm?

It is possible that we have entered another paradigm shift, with so-called “asset-light” companies taking the leadership of the economy and certainly of the financial markets, while activities such as heavier industry and even traditional brick-and-mortar retailing are struggling.

The new leaders often spend more on acquiring or creating intellectual property than on traditional assets and infrastructure. Moreover, as they often are so-called “disruptors”, who aim to replace traditional, formerly entrenched businesses, they are currently keener to quickly acquire significant market shares than on attaining traditional profitability levels. Their benchmarks, which they have convinced a majority of analysts to adopt, are sales revenues and growth, the number of users of their services, etc. These benchmarks tend to ignore or inflate reported earnings per share, such as the lack of significant investment depreciation, the dilution from executive options and other incentives and the boost to reported earnings per share from massive share buybacks on the stock market.

The impact of asset-light companies and their accounting on the S&P 500’s reported profit margins can be induced from the chart and table above. It seems doubtful that a continuation of recent advances can be caused by a further increase in profitability.

PRINCIPLES

One overwhelming principle that drives our investment philosophy is that you cannot predict the future, but you can prepare. What does this mean in practice?

Hyman Minsky and the Random Timing of Financial Crises and Recessions

Hyman Minsky was a professor of economics at Washington University in St. Louis, and a distinguished scholar at the Levy Economics Institute of Bard College but, until the subprime crisis and the ensuing Great Recession of 2007-2008, which brought him relative though posthumous fame, his writings had remained relatively confidential. Minsky’s Financial Instability Hypothesis was that financial crises (and the recessions that often accompany them) need not be triggered by outside events:

A fundamental characteristic of our economy, is that the financial system swings between robustness and fragility and these swings are an integral part of the process that generates business cycles. (September 15, 1974 — “Our Financial System is Fragile” — Ocala Star Banner)

In prosperous times, when corporate cash flow rises beyond what is needed to service debt, a speculative euphoria develops, and soon thereafter debts exceed what borrowers can pay off from their incoming revenues, which in turn produces a financial crisis. In the aftermath of such speculative borrowing bubbles, banks and lenders tighten credit availability, even to companies that can afford loans, and the economy subsequently contracts. This time of reckoning is sometimes labeled a “Minsky moment”.

If we cannot forecast the future, including the Minsky moments, how can we estimate future returns from the stock market? The answer is that we cannot predict the timing of Minsky moments but we can be assured of the ultimate outcome of these oscillations between stability and fragility.

Testing Minsky’s Hypothesis

According to the McKinsey Global Institute (courtesy of Mauldin Economics’ Thoughts from The Frontline (6/8/2018):

From the Great Recession’s beginning through Q2 2014, global debt grew $57 trillion to $199 Trillion, including household, corporate, government, and financial debt. This sounds like the prelude to a Minsky Moment.

Throughout my career, I can’t remember any instances when global debt stopped growing durably, but there still has been a litany of warnings that the ratio of debt to GDP had reached unsustainable levels in various countries. For example, in A Decade of Debt, Carmen Reinhart and Kenneth Rogoff argued that public debts in the advanced economies have surged in recent years to levels not recorded since the end of World War II, surpassing the heights reached during the First World War and the Great Depression and that, historically, high leverage episodes have been associated with slower economic growth and a higher incidence of default or, more generally, restructuring of public and private debts. (National Bureau of Economic Research – 2/2011)

It is true that countries such as France, Japan, Finland, Sweden and the Netherlands have reached ratios of domestic debt to GDP well above the danger levels set by Reinhart and Rogoff without running into trouble. My conviction, however, based on observation of both human nature and crowd behavior, is that an increase of debt indicates that one has lived beyond their means and that, sooner or later, they will either have to go on a painful spending diet or go bust…

Liquidity and Negative Interest Rates

It used to be that a liquid entity meant one with ample reserves of cash or readily saleable (short-term) assets. In the 1980s and 1990s, as interest rates declined from record highs toward historical lows, debt became fashionable and liquidity increasingly was defined as the ability to borrow.

Supported by central bank policies, that trend accelerated after the recession of 2007-2008: today, there are around $13 trillion of bonds outstanding with negative yields — ones that do not pay you interest but, instead, where you have to pay for the privilege to invest. According to Bloomberg and Mark Grant, of B. Riley FBR Inc., some 40% of global bonds are now yielding less than 1%, including government and corporate bonds – some of them high-yield or “junk”.

This has two consequences:

– One is what was often referred to in the early 2000s as TINA (There Is No Alternative). With secure bonds yielding very little, most investors needing income or institutions faced with actuarial goals have no choice but to take more risks than usual.

– The other is a tremendous incentive to borrow to invest since your debt indebtedness carries little or no immediate cost.

The extent to which debt has become apparently painless is illustrated by the U.S. government. According to Treasury Direct, U.S. Government debt has grown a whopping 280% from less than $6 trillion to $22 trillion between 2000 to 2018. Thanks to steadily declining interest rates, however, the annual interest expense on that debt has only increased 44% from $362 billion to $523 billion in that same period.

Mauldin Economics points out (6/8/2018) that 60% of new corporate debt is in the form of new bank loans with maturities averaging only 2.1 years, at which point they will need to be refinanced. It also points out that many emerging market businesses and financial companies borrowed money in dollars to take advantage of the then relative weakness of the U.S. currency and its very low interest rates. For many, a stronger dollar and higher interest rates could prove lethal.

Among other, anecdotal signs of increased risk-taking, there already has been a sharp increase in corporate defaults among smaller, less-well capitalized, energy companies, especially some that were acquired by private equity funds, which often add debt to already rather leveraged companies.

Margin debt (buying stocks on credit) as a percentage of GDP has already exceeded its record levels reached at the market peaks of 2000 and 2008.

* * * *

 

Thus, the question today is not whether we will face a Minsky Moment, but when? That is a question we will try to investigate in PART II of this paper.

 

François Sicart

July 30, 2019

 

Disclosure:

This article is not intended to be a client‐specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. This report is for general informational purposes only and is not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally.

 

We question some “certainties” held by the investing majority because, as Mark Twain said:

“It ain’t what you don’t know that gets you into trouble.

It’s what you know for sure that just ain’t so.”

                                                            * * *

In recent months, we have revisited the performances of some of our accounts as well as those of a few other portfolios managed by highly successful long-term investors.  The periods under review ran between 20 years and 40-plus years: anything shorter would not include enough cycles to be instructive and anything longer, unfortunately, tends to be scarce.

Our aim was to try and distillate some wisdom about how long-term performance is achieved and, especially, to dispel some widespread assumptions or preconceived ideas that may lead us to use less-than-optimal tools and techniques for achieving it.

Being Right Is Not the Same as Building a Fortune

One of our favorite titles for an investment book, is Being Right or Making Money, first published in 1991 by Ned Davis Research, which tests and publishes a wide array of economic and financial indicators and tools for managing risks and making money.

We particularly like the contrast Davis’ book draws between being right and making money: The two are usually assumed to go hand in hand but, in fact, they often represent very different outcomes of the research and investment process.

Investment markets are auction markets, where companies’ fundamentals and investors’ emotions are constantly interacting in intricate and, at times, seemingly contradictory ways.

For example, after a company’s stock has risen for an extended period on a string of good results, its price reflects not only all its measurable qualities, but also investors’ psychological extrapolation of future progress.  Then, unless the company’s fundamentals keep improving faster than anticipated, its stock’s potential to rise further is limited. On the other hand, any shortfall from investors’ growing exuberance may cause significant corrections. This asymmetry is why a good company does not necessarily make a good investment.

Beyond that, being right implies a closure marking the end of a finite period after which a new bet must be made to follow the preceding one.  Building wealth, in contrast, does not imply any time limit and refers instead to a continuous process relying on the long-term magic of compounding.

Compounding consists of reinvesting income (interest or gains), rather than paying it out as realized, thus actually earning income on past income. It has been praised as a source of wealth creation by such iconic investors as Warren Buffett and Peter Lynch, but it also reportedly inspired scientists like Albert Einstein, who once said: “Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.”

Much of the difference between being right on the stock market and building a fortune in it thus depends on an investor’s time horizons. Personally, we find analyzing investment performance over shorter periods of time, even several years as do consultants, most media and many fiduciaries, irrelevant to wealth-building and much more akin to some competitive sports or games: good for immediate excitement, but not for value-creation.

Great Long-Term Wealth Builders Have Experienced Bad Years

Another fundamental realization was that most successful, long-term wealth builders have endured periods of significant underperformance or even severe losses, as illustrated by the following table of Warren Buffet’s losing stretches, borrowed from Business Insider (2/24/2018):

Warren Buffett’s Berkshire Hathaway – Truly Major Dips

Referring to these episodes, the Oracle of Omaha himself stated: “Unless you can watch your stock holding decline by 50% without becoming panic-stricken, you should not be in the stock market.” And it is a fact that, despite these periodic, huge losses, Warren Buffett has been one of the greatest wealth builders of all time – over the long run.

This snapshot fits neatly into the ongoing debate about risk and volatility. Most consultants and theoreticians would assume that the kind of volatility depicted in the table above was the result of accepting too much risk in the quest for performance.

Successful wealth builders would answer that volatility is not risk, which implies the possibility of permanently losing one’s capital. This is unlikely if one feels confident about the conclusions of one’s analyses, exercises patience and shows character. In fact, with these qualities and adequate cash reserves, volatility can be viewed as an opportunity rather than as a risk, since it allows the owner to invest “when there is blood in the streets”, as the advice goes.

Absolute vs. Relative Returns

In recent years, with the proliferation of handlers of OPM (Other People’s Money), the emphasis in money management has shifted from absolute returns to relative performance.

It is perfectly understandable that operators or even fiduciaries that compete for market share in that universe need to shorten the performance-measurement periods even if this makes them less relevant to wealth-building. “I’ll measure your investment performance over the long-term and report to you every ten years” lacks the decision-making urgency which would appeal to most of today’s financial marketing departments.

Yet, it remains that wealth builders and owners are (or should be) interested primarily in the absolute returns (the end-results) generated by their assets, rather than by the interim scores achieved on the way, which are the main subject of relative-performance measurement.

Perverse  Passivity                                                                                                                                                  

So-called active investing is primarily concerned with selecting individual securities in the hope of outperforming benchmark indexes, whereas passive investing consists of investing mostly in products that mimic leading indexes – as a way of approaching those indexes’ performances, an elusive achievement for a majority of investors.

Unfortunately, most leading indexes are “weighted”, which means that companies with the highest total stock-market values carry the greatest weights in the indexes. When a market or a sector becomes fashionable with investors, the corresponding index goes up and the manager of a portfolio mimicking that index is mandated to add to the portfolio’s individual positions — particularly those already carrying the greatest weight in the index.

The danger of automatically buying stocks as they become more popular – e.g. more expensive – is that they will suffer most when the market psychology changes and overall liquidity shrinks.

So, contrary to the label’s implication, passive investing is not really passive but, instead, transforms portfolio managers into momentum investors and even momentum amplifiers. It also does not allow for building cash buffers to take advantage of unusual opportunities when they arise.

A distinctive decision of active vs. passive management is to not invest when conditions are deemed inadequate and thus to occasionally build significant cash reserves. But…

The Main Benefit of Cash Reserves Is Not to Protect from Market Declines

It is generally assumed that holding significant cash reserves while markets are declining protects portfolios against bear market losses. And it does, mathematically: if the stock market goes down 40% and the portion of your portfolio invested in stocks is 70%, your portfolio will decline by “only” 28%. If, additionally, you are a successful value investor, it is possible that the portion of your portfolio invested in stocks will decline less than the market because it was undervalued to start with.

These assumptions are generally verified over time: value investors tend to underperform during phases of upward market momentum and irrational exuberance but, because they normally invest less as cheap buying opportunities dry up, they tend to build up cash reserves which help them outperform the markets when prices go down.

A closer examination of the portfolios we surveyed did show a tendency of cash-rich portfolios to outperform slightly during declining markets. But more striking was the very significant outperformance of many during the couple of years of recovery after the declines.

Upon reflection, this made sense, too. If you hold cash while a majority of stocks are declining from overvalued prices to undervalued ones, you are in a position to buy aggressively when stocks approach compellingly low prices and to fully benefit from the initial post-decline bounce. Of course, fully-invested managers will also see their portfolio bounce but remember: it takes a 100% gain to recover a 50% loss. [You start with $100. You lose 50% to $50. You then must double to return to $100.]

Fish from an Empty Barrel?

In recent weeks, our regular Sicart research meetings have generated more investment ideas than in the last couple of years, at valuations not too distant from levels where we might start buying shares in earnest.

Since we have been careful not to deplete our cash reserves with the stock market hovering near an all-time high, we questioned what had changed to generate such opportunities. Upon further investigation, we unearthed the following facts:

As recently as a year ago, the market’s overall volatility was at a record low, with most stocks close to their all-time highs. Today, we are seeing 3-4% moves in opposite directions day after day, sometimes within a single day. And the number of stocks that are down 10%, 20%, 30%, 40% from their all-time highs has more than doubled in the last 12 months.

A stealth bear market seems to have been developing, obscured by rotating exuberance in groups such as the notorious and capitalization-heavy FAANGS (Facebook, Apple, Amazon, Netflix, Google), now correcting, and a number of other niches with superior growth — real or hoped for.

The Great Minsky Experiment

Economist Hyman Minsky hypothesized that crashes do not need a specific trigger because they are a phenomenon inherent to the capitalist system — a parallel with Marx that made him suspect to the profession until the 2007-2008 debacle.  According to Minsky, stability feeds instability: the longer things stay stable, the more businessmen and investors become willing to ignore risk and become reckless – usually through a massive increase in the use of financial leverage (borrowing).

Whether they burst of their own pressure, or they are bared by the disappearance of liquidity (the ability to refinance), debt bubbles are thus the main source of recurring financial crises and recessions. Unfortunately, there is little in the theory that helps foresee when the bubble will burst – only that the more we inflate it, the closer we get to the bursting.

Not surprisingly, borrowers seldom acknowledge that they are undertaking more risk and the prelude to bubble bursting often looks like mere complacency rather than like outright speculation. We believe this is the case today.

Back in the early 1980s, US interest rates for various maturities reached between 15% and 18%; they currently hover between zero and 5% as a result of quantitative easing and other interest-rate restraining policies by leading central banks.

We believe that observers tend to underestimate the massive changes that have taken place in the perception of risk by consumers, businesses, investors and governments over the last nearly 40 years of declining and then repressed interest rates.

One example of this recurring loss of investor memory is that Argentina, which had defaulted on its debt seven times in the past 200 years and three times in the past 23 years, was nevertheless able to sell to the public in June of 2017 almost $3 billion of bonds with a 100-year maturity. Not too surprisingly, with the country now in the midst of a major currency crisis, the bonds have already lost more than 20% of their value in a matter of 12 months.

Another example of investor amnesia is the relationship between interest rates and the US Federal budget deficit. According to the New York Times of September 25, 2018: “Already the fastest-growing major government expense, the cost of interest is on track to hit $390 billion next year, nearly 50 percent more than in 2017, according to the Congressional Budget Office. The federal government could soon pay more in interest on its debt than it spends on the military, Medicaid or children’s programs.”

Government borrowing is supposed to be countercyclical – expanding during recessions and declining during recoveries. But the US economy has now fully recovered from the Great Recession of 2007-2008 and yet the deficit is soaring, meaning that the stimulus is pro-cyclical, and that the government will have less room to maneuver when the economy slows.

As government spending, deficit and debt soared, in recent years, the cost of servicing (paying interest on) that debt did not increase proportionally because the Federal Reserve suppressed the cost of money by keeping interest rates artificially very low. Now, any inkling that interest rates might “normalize” at higher levels threatens to trigger a panic revision of future deficits upward. But until that happens, complacency reigns.

In a related set of assumptions, a number of observers have begun to worry that higher US interest rates might strengthen the US dollar and that the combination of a stronger dollar and higher interest rates might make it very difficult for emerging countries to repay the dollars they borrowed heavily during the most recent crisis.

We believe that we are currently in the midst of one of the long periods when Minsky saw apparent stability feeding instability. The results, when they become apparent may be described as “Black Swans” – rare and destructive events that could not have been anticipated. But one observer remarked that they could not have been anticipated mostly by those who did not want to look for them.

Where to next…

If not for a last-minute rally, October would have ranked among one of the worst months in global equity markets since the 2008/2009 financial crisis. We believe it may soon prove to be only an early preview of what may follow.

We have no way of knowing if that leads to a prolonged major sell-off or a series of more erratic price declines in various segments of the market, while the overall indexes remain range-bound trading sideways. Our patient, focused, disciplined approach prepares us well for both.

On one hand, we are keeping higher cash levels ready to deploy, and compelling opportunities are already starting to appear, on the other hand, we consciously continue to avoid potentially highly risky investments in the winners of the last few years.

 

François Sicart & Bogumil Baranowski

 

Disclosure:

This article is not intended to be a client‐specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. This report is for general informational purposes only and is not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally.

In a comment on my recent paper (Picking daisies under a fuming volcano, 11/30/2017) a European colleague with some affinity for our investment style nevertheless reminded me that “for us, asset managers, timing is of the essence” and that “clients will resent our missing another year of rising markets.”

This warning was sent before the recent rout in the global stock markets, but it does not affect my strong views on the difference between short-term and long-term investing.

There is no indication that measuring performance over shorter-term periods — as do many consultants, boards of trustees and others without their own money on the line — would produce superior long-term results. As Joe Wiggins, who is responsible for running a range of multi-asset fund of funds at Aberdeen Standard Investments, writes in his blog Behavioural Investment (1/31/18):

“It is not only that headline performance consistency is a deeply misleading means of assessing the ability of an active equity manager, but as a  characteristic, it is the exact opposite of what fund selectors should be seeking.  By definition, long-term … conviction investors will not deliver performance consistency over the short-term.  There will be periods (often prolonged) when their style is out of favor and the ‘market’s perception’ diverges materially from their own.  Through such spells of challenging performance, we should expect them to remain disciplined and faithful to their philosophy and approach; not wish them to latch onto the latest market fad in an effort to achieve improved short-term returns.

Consistency is absolutely paramount to the assessment of active equity managers, but we are focused on the wrong sort of consistency.  Rather than obsess over the persistence of short-term outcomes; we should focus our attention on the consistency of manager behavior relative to their stated philosophy.”

This being said, I do not need to be reminded of clients’ occasional impatience with idle cash, especially in ebullient markets. I launched the Tocqueville Fund in January 1987, when still under the auspices of Tucker Anthony/John Hancock. Since my partner and I were relatively unknown to the public and we did not do any marketing, the few early investors were mostly traders and brokers of Tucker Anthony, who had known and followed me for more than a decade.

1987, John Authers points out in the Financial Times (1/26/18) was the last time the S&P started a year as strongly as it has this year. But, in early 1987, I was already very wary of the stock market because of valuation, some signs of economic slowdown and fallacious promises of “portfolio insurance” through derivatives. Much of the early inflow into the Tocqueville Fund thus stayed in cash.

Until that is, I began receiving phone calls from my friendly investors pointing out that, if they had wanted to own a money market fund, that was what they would have bought! So, I yielded and invested most of the Fund’s cash only weeks before Black Monday (October 18, 1987). By the end of October, the US stock market was down almost 23%, with several foreign markets faring even worse.

In the past, bear markets associated with economic recessions suffered even greater, and usually longer, declines. In this case, the US economy never fell into recession and 1988 was an excellent year if you had the cash to invest. In fact, by early 1989, the market was back to its pre-crash high — though many professionally-managed portfolios were not.

As I write this, the ranks of pessimists among investors have been shrinking fast.

Some have simply joined the index-hugging crowd under cover of politically-dictated arguments: economic stimulus from tax cuts, short-term budgetary help from the repatriation of accumulated foreign profits, empowerment of business through reduced regulation, and promised huge infrastructure programs. There are as many reasons to doubt as to believe the validity of these arguments but for the moment, the arbiter seems to be the stock market. In fact, what this group of optimists really believes is that stocks should continue to rise because they have been rising.

More intriguing is the “temporary” capitulation of a (much smaller) number of estimable, historically successful investors. These longer-term investors usually subscribe to Ben Graham’s definition that, in the long run, the market is a machine that weighs fundamentals, but that, in the short run, it is merely a voting machine.

These elite investors do believe in fundamental analysis but recognize that recently, central banks have prodded, first the US market and now most advanced economies’ markets, with artificial, excess liquidity (ZIRP, QE, etc.). As a result, with quality bond yields and sometimes even junk-bond yields hovering around zero, we have been in a TINA — There Is No Alternative (to stocks) — environment. That era may be coming to an end (see chart below), but until central bankers are absolutely sure, they may continue to flood the stock markets with excess liquidity – an attitude that might be reinforced by the recent mini-correction.

 

Many investors are well aware that current valuation levels call for sub-par results from equities over the next decade. A number of models illustrate the link between asset valuations at the beginning of a decade and the return from those assets in the following ten years: GMO, Oaktree, Crestmont Research, John Hussmann and of course Nobel Laureate Robert Shiller’s CAPE (Cyclically Adjusted Price/Earnings).

These models never were intended to become timing tools but, rather, mere indicators of likely average future returns over long periods. Yet the longer their warnings have been calling for sub-par future returns in the face of rising markets, the more criticism (of one aspect or another) of these models has proliferated.

Fortunately, a report published this month by Robert D. Arnott, chairman of Research Affiliates LLC, with his team, dismisses most of these critiques. (1) Research Affiliates specializes in quantitative investing. They have thoroughly studied how various investment styles and selection criteria work over time, and currently advise over $160 billion of institutional investment assets (2015). So, when they claim that “It’s NOT different this time”, it is worth paying attention.

On the other hand, given the global economic recovery, no signs of imminent economic trouble and ample central bank liquidity, several of the sophisticated investors mentioned above have been considering the possibility of a market “melt-up.” As its name implies, this would be the opposite of a meltdown: a bubbly last hurrah of the long bull market that started in 2009.

I cannot entirely discard this possibility but I believe that stock markets now are mostly in their “voting machine” mode. In other words, they depend almost entirely on the psychology of crowds.

In many ways, the 1987 crash was what Nassim Nicholas Taleb later famously labeled a Black Swan: an event that is rare, has an extreme impact and, because it has never happened before, is hard to anticipate. So, a Black Swan may be waiting for us around the corner. Yet comparably rare events are mostly called Black Swans by those who failed to anticipate them or at least failed to protect themselves against their possibility.

If we leave aside “end-of-the-world” scenarios such as nuclear war, or the most obvious areas of blind greed and speculation such as bitcoin, the best way to protect ourselves financially is to heed the warning of Hyman Minsky. He observed that economic and financial stability leads to instability without the need for an external trigger, simply by making people more complacent and more willing to accept risk through the imprudent use debt.

Two obvious areas where complacency and increasingly blind risk acceptance have become the norm since the Great Recession (2007-2009) are:

• Interest rates They have been “suppressed” (kept artificially low) by central banks, giving consumers and businesses the false impression that their actions are essentially riskless. As one example, the yield spread of junk bonds over Treasuries has shrunk to the point where investors may no longer be compensated for the additional risk they incur by buying “junk.”

 

• Stock market valuations Are they merely high, or unsustainably so? It depends where. In some areas of the markets, the answer is obvious. David Stockman, director of the Office of Management and Budget under President Reagan, made the point eloquently in the Daily Reckoning (8/1/2017). He pointed out that in the 31 months between January 2015 and August 2017, the weighted P/E (price/earnings ratio) of the so-called FAANGs + M (Facebook, Apple, Amazon, Netflix, Google and Microsoft) increased by some 50%!

The total market capitalization of the S&P 500 rose from $17.7 trillion to $21.2 trillion. The six FAANGs + M accounted for 40% of the entire gain, meaning that the market capitalization of the other 494 stocks only rose from $16 trillion to $18.1 trillion — only 13% in 31 months vs the 82% gain of the six super-momentum stocks. If that is not a bubble, I don’t know what is!

The irony, of course, is that by imposing as benchmarks indexes that contained these heavy-capitalization stocks, consultants, directors, and trustees forced many money managers to buy more of these expensive stocks as they became ever more expensive. Naturally the reverse dynamic will come into play when the stock market ultimately declines.

* * * *

It is our belief that an advisable policy at this juncture is to look for investment opportunities among the less-inflated segments of the global markets. This is where we are searching for new ideas. Meanwhile, having maintained adequate cash reserves will allow us to seize these opportunities as they arise.

At the same time, one of the rules for making money over time is, first, to avoid losing it. When markets decline, it is hard to escape the outgoing tide altogether. But we hope to minimize losses by avoiding the idolized and overpriced favorites of the preceding advances, as well as steering clear of companies that have burdened themselves with excessive or unnecessary debt (to buy back their own shares, for example).

“Over the years, Institute research has shown active managers, even the best-performing ones, suffered periods of weak returns relative to benchmarks and their peers. But underperformance, up to three years, had relatively little impact on the best-performing funds’ ability to deliver success over 15 years… We think that underperformance in shorter periods—such as one quarter, one year, and perhaps even a few years—can be a normal part of the investment experience, even for funds that perform well over longer periods.”

                          The Brandes Institute, September 2014

 

François Sicart – 2/6/2018

 

 

(1.) CAPE Fear: Why CAPE Naysayers Are Wrong – Research Affiliates – January 2018

 

 

 

Disclosure:

This article is not intended to be a client‐specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. This report is for general informational purposes only and is not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally.

“Today is already the tomorrow which the bad economist yesterday urged us to ignore.” – Henry Hazlitt

In July 2007, near the top of big real estate bubble and only weeks before the Lehman Bros. bankruptcy and the onset of the Great Recession, Charles O. Prince III, then CEO of Citigroup, notoriously declared:

“When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.”

The following cartoon, recently published by Horizon Kinetics, echoes this past episode and reminds us that contexts may change, but human nature does not.

Source: Horizon Kinetics.

 

Bubble or no bubble? High valuations are a concern…

Depending on the valuation tool, the current US market could be considered either:

The third priciest market ever…

Source: Robert Shiller.

The second priciest market ever…

Source: Robert Shiller.

The priciest market ever…

Source: Robert Shiller / 720 Global

The general perception, including ours, has been that much of the strong performance of the US stock market in the last ten years, as well as its current statistical overvaluation, can be traced to the increased weight in the major indices of the so-called FANG or FAANG (Facebook, Amazon, Apple, Netflix, Google) and a handful of others.

However, while stressing the worrisome popularity of the FANGs, with dedicated FANG indices and futures now available to so-called “passive” investors and momentum traders, investment manager GMO recently argued that the FANGs are not overvalued relative to the market but that it is the entire US market that is overvalued.

“Cyclically-adjusted earnings multiples have come under criticism because they include the earnings recession of 2009. But when GMO used price/sales ratios using sales for the last 10 years – affected less drastically by the recession – they found out that the S&P 500 was almost as expensive as it was at the top in 2000… So, US overvaluation appears to be real, and it cannot be blamed on the FANGs.” (John Authers – The Financial Times – 11/9/17)

…But bubbles are not only about valuations

High valuations may increase the markets’ vulnerability in a downturn or even be the harbingers of lower returns in the longer run, but they do not necessarily equate with the irrational exuberance of a bubble.

In fact, The Collaborative Fund’s Morgan Housel argues that people who bought Florida property during the 2004-2006 housing bubble, for example, should not necessarily be viewed as irrational.

The high prices did make little sense for traditional home buyers, who typically measure a property’s price against its potential to generate income if rented for a number of years; But, if buyers were purchasing with the intention to “flip” the property within six months, as the graph below implies, then long-term valuation criteria were becoming irrelevant to a growing number of housing market participants.

Source: Robert Shiller / 720 Global

In the same way, today’s equity investors may be focusing less than historically on valuations because they also have no intention to hold on to their position for much longer than a few months (See the cartoon at the top of the article).

In Housel’s view, bubbles develop when investment horizons shrink, and more and more long-term, fundamental investors capitulate to join the recently successful short-term momentum game. In doing so, they lose sight of the risks that will come when the stock market reverses.

Yet, “flipping” can prove an expensive gamble, as buyers of apartments in “Billionaires ‘Row”, across the street from our office, are now learning with several units being sold or foreclosed at 30%-plus discounts from their $30-$50 million purchase prices a few months ago.

Shrinking horizons, the hunt for yield and greater risk acceptance

With peak valuations, and investment horizons shrinking, investors and speculators alike are increasingly desperate for returns and yield. Growing interest in emerging markets and ever-falling emerging markets junk bond yields are premier example of this phenomenon.

Source: Bloomberg, Real Vision (left), J.P. Morgan (right).

But desperation and the feeling of having no alternative are no recipe for successful investment in anything.

Maybe not euphoria, but complacency for sure

In spite of peak valuations, shorter investment horizons, and proliferation of risk taking, it is hard to characterize the recent bull market as euphoria-driven. Instead, it has been slow and sustained, with many investors having had no experience of a serious down market or choosing to forget previous crises. This mindset has translated into highly passive and complacent investment approaches. With no down years or months, the most successful choice, so far, has been to remain fully invested.

Source: ICI, BofA, Rydex, Federal Reserve, Sentimentrade.

Source: Gallup.

The current low (perceived) volatility, low volume and passive, complacent markets awaken memories of Dr. Hyman Minsky, for whom financial and economic crises did not need an outside trigger, but were a natural stage of the free-market cycle.

 

Stability leads to instability

The Minsky Moment: We know how, but when is another question

According to Dr. Minsky, a period of sustained economic and financial stability encourages risk taking – especially through the growing use of debt – until excess leverage causes a sudden collapse in asset prices, which is a normal part of the credit cycle.

Long periods of stability thus naturally lead to instability, though with elusive timing.

Source: Economic Sociology

Source: Michael Roscoe, US Federal Reserve / BIS/ Economist / World Bank

 

The sand pile model

If, according to Minsky, financial crises and recessions do not require an external trigger, why do they develop?

A useful way of understanding the apparent randomness of market crashes is the Abelian sand pile model. The computer model of a sand pile is developed by virtually dropping individual grains from above: it continues to grow, apparently smoothly, until a critical state is reached from which a single grain can cause a collapse of the whole structure.

Fingers of instability

According to physicist Mark Buchanan, the critical state of the sand pile is characterized by ‘fingers of instability’ that develop through it under the surface.

John Mauldin, who introduced us to the analogy several years ago, further explains that after the pile evolves into a critical state, many grains rest just on the verge of tumbling, and these grains link up into ‘fingers of instability’ of all possible lengths. While many are short, others slice through the pile from one end to the other. So, the chain reaction triggered by a single grain might lead to an avalanche of any size whatsoever, depending on whether that grain fell on a short, intermediate or long finger of instability.” (Thoughts from the Frontline – John Mauldin –  MAY 6, 2013)

We don’t know how to predict which grain will be the one that triggers that avalanche. Similarly, when signs of vulnerability build in the economy or the financial market, it is hard to predict if, or when, their accumulation will trigger a simple correction or a major crisis.

Where would we look today for such fingers of instability? Most likely in areas where published statistics are contradicted by discrepancies below the surface.

Illusion of stability, but below the surface…

With the majority of money managers struggling to keep up with official market benchmarks, more investors have been adopting passive (index-linked) strategies rather than active ones (stock picking). Since major stock indexes are capitalization-weighted, the higher the stock market capitalization, the greater a company’s weight in the index. This is why, in recent years, the overall market performance has been increasingly influenced by relatively few “mega caps” such as the so-called FAANG (Facebook, Amazon, Apple, Netflix, Google). As a result, trading volumes in the rest of the market have collapsed and volatility seems to have evaporated.

Source: MSCI.

Under the surface of peaceful and calm markets, however, many smaller companies, even in the same industries, tend to trade in a wide range with violent rallies and sell-offs.

The chart below depicts a one-month price action of two of our holdings from the same industry that proved to be surprisingly volatile and erratic despite the calm we see on the surface of the equity markets.

Source: Bloomberg.

Major indexes keep rising but market breadth is weakening

During a prolonged period of stability, historically, an early indication that a bull market is aging has been when a group of stocks eventually dominates trading volumes, index performances, and the news, while the broader market begins to lag. We saw the Nifty Fifty stocks in the 1970s, the internet bubble stocks in the late 1990s, and today’s we are watching the FAANGs take the spotlight – Facebook, Amazon, Apple, Netflix, Google.

The discrepancy between the volumes of trading in mega-cap stocks and the rest of the markets under passive, index-shaped investing has created a divergence in price performance as well, between the few large-cap winners and the many losers in the current stock market.

Source: Steve Bregman, Horizon Kinetics, Real Vision.

Source:  Real Vision, Hexavest, Datastream.

Economic growth borrowed from the future

Despite recent releases of continued strength in the United States and accelerating economic growth in Europe and maybe even China, it seems that much of that growth is being “borrowed”.

For example, if we account for the share of the Federal Debt in US GDP growth, we’ll see that the economy net of borrowing has actually been shrinking since the Great Recession.

Source: 720 Global.

Furthermore, in spite of its use by some politicians as a measure of the economy’s well-being, it should be remembered that the stock market has greatly outpaced both GDP growth and corporate sales growth. Thus, the real economy may be less robust than indicated by Wall Street.

Source: Real Investment Advice.

Not only governments, and corporations have borrowed more in the last decade, but also consumer. It is increasingly worrisome how a fragile consumer depends on credit & assistance.

Source: 720 Global.

There may be some argument about the conclusiveness of the chart above, but there should be none about the following one: delinquencies are on the rise, especially in the last couple of years. We live beyond our means, and for a while now, we’ve tried to maintain the same lifestyle with the help of increased debt, and public assistance.

Source: Real Investment Advice.

Record help from non-traditional investors

Not only do investors remain complacent, but corporation themselves helped prolong the rally with buybacks of their own shares, partly funded by massive borrowings.

Source: Standard & Poor’s Corporation.

But, even as corporations’ support of stock prices seemed to abate, Central Banks took the relay, by accelerating a buying spree – not only of government bonds, as traditionally, but now also of corporate bonds and equities.

Source: Real Vision, Bloomberg.

Source: BofA Merrill Lynch Global Research.

Source: SG Cross Asset Research/ETF, Bank of Japan, Bloomberg.

In summary, we have undergone an unprecedented expansion of central bank balance sheets, which has stabilized most economies and propelled many markets to new highs. It would be naïve to believe that a reversal of those policies can leave investors, businesses and consumer unscathed.

The policy challenge: dual economy, one set of tools

Given peak market levels, fragile stability, and borrowed growth, the policy makers are facing a major challenge.

Their policies of further easy money, and more fiscal stimulus may do more harm than good, especially in the today’s world of dual economy. Part of the economy is growing fast, and requires little assets and labor, while the other part, more traditional, seems to be falling behind, because has excess capacity, and it is s asset heavy, and labor intensive.

There is also a mismatch in the supply and demand for labor. The growing economy needs more employees than it can find, while the traditional economy has fewer job openings that those willing to them.

To save the latter, we may be overheating the first. And anyone who still believes there is no inflation, we recommend taking a look at exponential growth in bitcoin price, new, breath taking record in art price sales, and record asset prices all around.

To conclude

That brings us to the wisdom of the father of value investing – Benjamin Graham, who famously said: “The essence of investment management is the management of risks, not the management of returns”

Being optimists at heart, we believe that those high-risk markets are usually if not always followed by some of the best buying opportunity of a generation. We trust that we are prepared for it, and we are looking forward to it.

Francois Sicart & Bogumil Baranowski

Disclosure:

This article is not intended to be a client‐specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. This report is for general informational purposes only and is not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally.

“Shirtsleeves to shirtsleeves in three generations.” United States

“Clogs to clogs is only three generations.” England

“Rice paddies to rice paddies in three generations.” Japan

“The father buys, the son builds, the grandchild sells, and his son begs.” Scotland

“Wealth never survives three generations.” China

 

The universality of the proverb above is the reason why, as investment advisers and family office to several generations, we view it as one of our primary missions to help our client families avoid the “curse of inherited wealth”. A good place to start is to try and avoid speculative bubbles and their fortune-destroying aftermaths.

* * * *

The history of investment markets is punctuated by the building and bursting of speculative bubbles, often accompanied or followed by economic recessions.  Avoiding these dangerous periods should be a major goal of investment for the long-term growth and protection of family patrimonies. In spite of this, after hundreds of years of experience, eliminating the impact of bubbles from truly long-term investment performance remains more an art than a science.

Venture capitalist Morgan Housel recently remarked that, because we do not know exactly when and how asset bubbles build up, our commentaries usually take refuge in the comfort of blaming others, such as the Fed, banks or Congress:

“Bubbles’ outcome is known in hindsight but the cause and blame are never settled on and in hindsight we are more apt to blame than learn”. ⁽¹⁾

Contradicting this natural tendency to blame, one of the originalities of Hyman Minsky’s Financial Instability Hypothesis was to state that “the financial system naturally swings between robustness and fragility and these swings are an integral part of the process that generates business cycles.”  The booms and busts that tend to accompany these swings are thus inevitable in a so-called free-market economy and do not need an external trigger, such as policy error, natural disaster or war, to occur. ⁽²⁾   So. Where should we watch for potential bubbles?

Is Valuation an Anchor?

Many investors accept that bubbles are primarily a psychological phenomenon and thus a product of the “madness of crowds”. ⁽²⁾

In recent years, this view has been reinforced by work from a newly-popular branch of psychology, behavioral investing, whose researchers hope, one day, to develop precise indicators of irrational excesses of greed or fear that would tell us when to buy or to sell financial assets. Unfortunately, those kinds of signals are anything but precise. The professionals’ favorite tool to detect bubbles probably remains valuation, of which one of the simplest and most widely used form is the price/earnings ratio (P/E).

Two groups have contributed to the upward pressure on stock prices and thus P/E ratios.

Corporations buying back their own shares boost earnings and lower P/E ratios

By buying in their own shares on the stock market, companies reduce shares outstanding and thus boost reported earnings per share, though at the expense of increased balance sheet leverage (equity and cash shrink, while debt does not), so that there is a limit to this trend.

As can be seen on the following graph, corporations have been the most aggressive buyers of their own shares since the stock market low in 2009.

As If Life Was Not Complicated Enough, Central Banks Enter the Stock Markets

Much discussed, as a reason for high P/E ratios on stocks, is the artificially-low level of interest rates engineered by the world’s leading central banks. Stocks compete with bonds for investors’ favor, so when interest rates are low, P/E ratios tend to be high. And when interest rates are very low…

But, as if ultra-low interest rate policies were not enough, central banks now have begun to aggressively acquire common stocks directly.

In April, Bank of America noted that central banks around the world had already purchased $1 trillion in assets to that point of the year (an annualized rate of $3.6 trillion) and said it was the “best explanation” for record-high stocks. ⁽³⁾

The Swiss central bank bought $80 billion worth of U.S. stocks through the end of the first quarter 29% more than at the end of last year. ⁽⁴⁾

The Bank of Japan is now among the five largest owners in 81 companies on the Japan Nikkei 225 index… and nearly the primary owner in 50 of them. ⁽⁵⁾

A recent Invesco poll of currency reserve managers at central banks revealed that 80% of the 18 central banks polled plan to increase their stock holdings. ⁽⁶⁾

 Creating the Illusion of Perpetual Motion with a Minority of Stocks

When dealing with stock market indexes rather than with individual securities, the weighing of the stocks making up the index may also hide the fact that “bubbles” are concentrated in some segment of the market. As such, they may not necessarily show up in statistics for “the market” at large. Or, on the contrary, they may artificially boost these statistics. For example:

Goldman Sachs points out that 55% of the Nasdaq’s gains this year (to June 7) have been due to the top 5 large-cap tech stocks: Apple, Google, Amazon, Facebook and Microsoft. ⁽⁷⁾

Bloomberg (08-04-2017) reports that large-capitalization stocks have risen six times as fast as smaller companies in the Russell 2000 Index. The advance in mid-size companies is about half the S&P 500.

At the same time, the large positions occupied in leading stock market indexes by recent top performers mean that, as index-mimicking funds attract capital, they have to buy large amounts of these stocks, further fueling their rise.  Howard Marks observes in his July letter:

“In the current up-cycle, over-weighted, liquid, large-cap stocks have benefitted from forced buying on the part of passive vehicles, which don’t have the option to refrain from buying a stock just because it’s overpriced.

Like the tech stocks in 2000, this seeming perpetual motion machine is unlikely to work forever.  If funds ever flow out of equities and thus exchange-traded funds (ETFs), what has been disproportionately bought will have to be disproportionately sold.  It’s not clear where index funds and ETFs will find buyers for their over-weighted, highly appreciated holdings if they have to sell in a crunch.” ⁽⁹⁾

Historical Background and Necessary Flashbacks

Valuation measures may not be ideal timing indicators, but when one compares the price of a stock or of an index to a single figure like its last twelve months’ earnings, there is no escaping the logic that the higher the ratio, the more optimistic investors are.

This is why an index’s P/E ratio materially exceeds its historical norm, there must be a strong presumption of a bubble in formation. In his July 26 letter, Oaktree’s Howard Marks points out that “the S&P 500 is selling at 25 times trailing-twelve-month earnings, compared to a long-term median of 15. The Shiller cyclically-adjusted PE ratio stands at almost 30 versus a historic median of 16. This multiple was exceeded only in 1929 and 2000 – both clearly bubbles”. ⁽⁹⁾

In early August, David Stockman calculated that Facebook, Amazon, Google, Netflix, Apple and Microsoft saw their weighted average P/E increase by 50% over the previous 30 months. He recalled the Internet bubble when, at the March 2000 peak, Microsoft’s P/E was 50x, Intel’s was 60x and Cisco’s was 200x: this compares to Facebook’s 40x, Amazon’s 190x and Netflix’s 217x today. Two years later, he reminds us, the four tech giants of the Internet bubble had lost 75% of their value. ⁽¹⁰⁾

Amazon’s 1997 letter to shareholders states: “We established long-term relationships with many important strategic partners, including America Online, Yahoo!, Excite, Netscape, GeoCities, AltaVista, @Home, and Prodigy”.

“Unless you believe Yahoo remains a leading force in that space, none of these “important strategic partners” still exist in a meaningful way today. The super-stocks that lead a bull market inevitably become priced for perfection.  And in many cases the companies’ perfection turns out eventually to be either illusory or ephemeral.  Some of the “can’t lose” companies of the Nifty-Fifty were ultimately crippled by massive changes in their markets, including Kodak, Polaroid, Xerox, Sears and Simplicity Pattern.  Not only did the perfection that investors had paid for evaporate, but even the successful companies’ stock prices reverted to more-normal valuation multiples, resulting in sub-par equity returns. ⁽⁹⁾

A Bubble in Complacency

Basically, Minsky’s Financial Instability Hypothesis says that economic stability naturally breeds instability. But it helps to have a fertile soil and, there, debt and borrowing can help:

 

• When an economy is perceived as stable, people become optimistic.
• When people get optimistic, they pile on debt in an effort to increase their returns.
• When they pile on debt, the economy becomes unstable.

Thus, debt plays a central role in the bubble-building process and, from this vantage point, there is reason to worry when the economy appears stable and borrowing becomes overly easy:

In early May, Netflix issued €1.3 billion of Eurobonds, the lowest-cost debt it ever issued.  The interest rate was 3.625%, the covenants were few, and the rating was single-B.  Netflix’s GAAP earnings run about $200 million per quarter, but according to Grant’s Interest Rate Observer, in the year that ended March 31, Netflix burned through $1.8 billion of free cash flow.  According to Howard Marks, “The fact that deals like this can get done easily should tell you something about today’s market climate”. ⁽⁹⁾

He goes on to quote a comment from a leading strategist about the return of Argentina to the bond market after five defaults in the last hundred years (one in the last five): “It’s just shocking that they exit default and their bond issue is a century bond”. Nevertheless, the strategist was advising her clients to buy the bonds “at least for a short-term trade”.

Shifting Time Horizons May Explain Bubbles

In his blog article on bubbles, Morgan Housel adds a dimension to the definition of bubbles by bringing into the discussion the time horizons of various investors.

“One of the biggest flaws to come out of academic finance is the idea that assets have one rational price in a world where investors have different goals and time horizons… When investors have different goals and time horizons, prices that look ridiculous for one person make sense to another, because the factors worth paying attention to are totally different”. ⁽¹⁾

Since bubbles are bubbles, Housel’s comments on shifting time horizons apply to the housing market as well:

The following chart shows the percentage of Florida home sales whose previous owner held the property for less than six months. “It’s hard to justify paying $700,000 for a two-bedroom Miami track home to raise your family in for the next 20 years. But it makes perfect sense if you plan on flipping it in a few months into a liquid market with price momentum…  You can say a lot about these investors. You can call them speculators. You can call them irresponsible. You can shake your head at their willingness to take huge risks. But I don’t think you can call all of them irrational.

Bubbles are not so much about valuations rising. They are about time horizons shrinking. They aren’t so much about people irrationally practicing long-term investing. They’re about people somewhat rationally moving toward short-term trading to capture momentum that had been feeding on itself. ⁽¹⁾

 

Conclusion

Successful long-term investing is primarily about understanding your own time horizon and not being persuaded by the price actions caused by people with different time horizons.

I believe that, by being drawn by consultants and new regulations toward the measurement of short-term “competitive” performance (e.g. performance relative to specific indexes or narrowly-defined competitors), many fiduciaries have been losing track of their long-term responsibilities to family fortunes.

As Warren Buffett may have said: “To finish first, first you need to finish.” And to finish, you must first avoid succumbing to speculative bubbles.

 

François Sicart

September 11, 2017

 

Notes:

1. Morgan Housel – The Collaborative Fund blog – 6/22/2017
2. The Jerome Levy Economics Institute of Bard College – May 1992
3. Charles Mackay – Extraordinary Popular Delusions and the Madness of Crowds (1841).
4. Business Insider – April 21, 2017
5. Forbes – May 16, 2017
6. Bloomberg.com – August 14, 2017
7. The Daily Reckoning, July 19, 2017
8. Zero Hedge – June 9, 2017
9. Bloomberg.com – 08-04-2017
10. “There They Go Again . . . Again” – Howard Marks – Oaktree, July 26(The Daily Reckoning –  8/1/2017)
11. The Daily Reckoning –  8/1/2017

 

 

Disclosure:

This article is not intended to be a client‐specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. This report is for general informational purposes only and is not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally.

According to Bloomberg.com, a luxury condo on “Billionaires’ Row,” across the street from our office, is scheduled for a July foreclosure auction that might be the biggest in New York City residential history.

A shell company bought the condo in December 2014 for $50.9 million and took out a $35.3 million mortgage from a Luxembourg private bank in September 2015. Since the loan was not repaid one year later, when it was due, the bank is forcing a sale to recoup the funds, plus interest.

This news brings a few remarks to mind:

First and foremost, I am reminded of the high risk of investing with borrowed money. If our unfortunate billionaire across the street cannot sell his condo for more than $35.3 million dollars (and who can assess the true worth of a condo?), he will have lost his entire investment.

Second, people like us might have thought that we were comparatively rich – even part of the fabled “one percent.” But we are nowhere near the really rich who can afford the condos on “Billionaires’ Row.” These truly wealthy individuals are often foreigners. Some are American entrepreneurs who recently floated their startups on the stock market, others are those entrepreneurs’ investment bankers or and a few finance-related operators who have closed a major deal or received an exceptionally large special bonus. No one whose lifestyle depends on a salary or another traditional form of income can join the club of the truly rich.

My third point, however, is that the last eight years have been characterized by a steady upward run in stock and bond prices. As a result, (and this is often overlooked), life has been surprisingly comfortable for the relatively small segment of the population that directly owns investment portfolios.

Who are we, the investors?

In “The Dwindling Taxable Share of U.S. Corporate Stock” (taxpolicycenter.org, May 16, 2016), Steven Rosenthal and Lydia Austin reckon that there is $22.8 trillion in stock outstanding in the USA. ⁽¹⁾

Of this total, retirement accounts such as IRAs and pension plans own roughly 37%. Since most of these tax-deferred accounts will not be spent until retirement, I assume that they do not affect Americans’ perception of their current standard of living.

Meanwhile, the authors find that the amount of stock directly owned by individual investors (including taxable funds) has dropped from 80% in 1965 to only about 25% in 2015.

The danger is that the shrinking minority of investment-portfolio owners is increasingly viewed by today’s voters as a privileged elite not representative of the overall electorate.

Future elections may not favor investors

A majority of Americans in the lower income brackets admire high-earnings sports and entertainment stars, as well as ultra-rich business moguls. This was illustrated most recently by the election of Donald Trump to the U.S. presidency.

However, while the visibly, even ostensibly very rich do not seem to attract popular resentment, the story may be different for the merely rich.

NPR’s Steve Inskeep recently reviewed a new book, Dream Hoarders, by Richard Reeves, a senior fellow at the Brookings Institution. The author argues that the top 20 percent of Americans — those with six-figure incomes and above — dominate the best schools, live in the best-located homes and pass on the best futures to their kids:

“We protect our neighborhoods, we hoard housing wealth, we also monopolize selective higher education and then we hand out internships and work opportunities on the basis of the social network.”

According to Reeves, the American upper-middle class is essentially “hoarding the American dream.”

The perception is that the American upper-middle class is making out pretty well from current trends and that it is increasingly detached – occupationally, residentially, educationally and economically — from the rest of society. The fact that its members are not only separate but unaware of the degree to which the system works in their favor strikes Reeves “as one of the most dangerous political facts of our time.”

This is why, although the world’s economic and financial situation has remained worrisome for most, investors should not forget that they have had it pretty good for the eight years since the last financial crisis and so-called “Great Recession.” My partner Bogumil Baranowski reminds me that the net worth of U.S. households fell from a pre-recession peak of $67 trillion to $54 trillion in the midst of the recession, only to recover to $95 trillion today. This adds up to $40 trillion wealth creation from real estate and securities in the past eight years, mostly for the benefit of the upper middle-class.

A Judeo-Christian view of the stock market

My father, who was anything but a religious person, nevertheless taught me that, eventually, we are all rewarded or punished for our actions.

In most cultures, the bad deeds are fairly easy to recognize and are usually explicitly identified by laws or rules of good conduct. But even if we personally stay out of trouble, we may be guilty “by inaction” — allowing other individuals or groups to misbehave, out of complacency, moral myopia or mere denial. In the Judeo-Christian tradition, this complacency is complicated by the notion of guilt – in particular when you allow dubious things to happen that you might subconsciously enjoy or benefit from.

Maybe it is my heritage, or simply my innate contrarian bias, but I also always feel that when things go too well in the economy or the stock market, we do not fully deserve these good times, and we ultimately will have to pay for them.

Currently, the length of the global stock markets’ advances since 2009 puts me on alert, along with:

–the excesses I observe in debt use

–financial risk acceptance under the umbrella of record-low interest rates

–central bank inflationary or bubble-creating policies

–historically-high asset price valuations

–and finally, the complacency of most investors toward these excesses, which make me think, “Beware the day of reckoning!”

ASSETS DECOUPLING FROM INCOME SIGNAL FINANCIAL DANGER

Source: Bloomberg, TCW.

Investing like ostriches

Ostrich syndrome: “Denying or refusing to acknowledge something that is blatantly obvious as if your head were in the sand like an ostrich” (urbandictionary.com). This definition could be a Wall Street sage’s description of current investor sentiment.

One way to play the ostrich is to rationalize whatever the markets do, in an attempt to make it look logical and credible.

The Fed Model promoted by former Federal Reserve Chairman Alan Greenspan basically states that when the earnings yield on stocks (earnings divided by price) is higher than the yield on Treasury bonds, you should own stocks. Many of today’s rationalizers use versions of this model to argue that investors should disregard current overvaluations and continue to chase stocks up, because interest rates are historically extra-low (in fact, negative in some countries).

In a 2003 critique of the Fed Model, Cliff Asness, a founder of AQR Capital Management and pioneer of quantitative asset management, criticizes pundits who illustrate (with a graph or a table) that P/Es and interest rates move together, and who then jump to the conclusion that they have proven that these measures should move together. In this view, which Asness challenges,  investors are thus safe buying stocks at a very high market P/E when nom­inal interest rates are low.

Separately, economist Lance Roberts illustrates that what these pundits really should say is that it WAS a good time to buy stocks ten years ago (May 18, 2017 post, realinvestmentadvice.com). As shown in the chart below, which compares earnings yield (E/P: inverse of the P/E ratio) to following 10-year real returns, when the earnings yield has been near current levels, the return over the following 10-years has been quite dismal.

Source: Real Investment Advice.

For my part, I will just point out that, yes, interest rates have been declining for almost 40 years and are now near all-time lows. But in a cyclical world, low interest rates today foreshadow rising rates in the future.

Reformed Pundits

Even some of the pundits are beginning to worry about prevailing investor complacency. Rob Arnott is the founder and chairman of Research Affiliates. He has pioneered several modern portfolio strategies that are now widely applied, including tactical asset allocation, global tactical asset allocation, and the Fundamental Index approach to investing. With regard to Smart Beta, one of the most fashionable quantitative investment disciplines of recent years, the Research Affiliates website even claims that: “Clearly, Research Affiliates was offering investors smart beta strategies long before the term smart beta even existed.”

In February 2016, however, Arnott published with three  colleagues a new paper: “How Can Smart Beta Go Horribly Wrong?”

The authors propose that the reassuring message of smart beta proliferators has two primary and interrelated flaws:

First, many of these… claims are based on a 10 to 15-year backtest that won’t cover more than a couple of market cycles. Second, such a short time span is very vulnerable to distortion from changing valuations. Our analysis shows that valuation has been a large driver of smart beta returns over the short and even long term. How much can we reasonably expect in future returns from these factors and strategies, net of valuation change?

Generally speaking, normal factor returns, net of changes in valuation levels, are much lower than recent returns suggest… If rising valuation levels account for most of a factor’s historical excess return, that excess return may not be sustainable in the future; indeed, our evidence suggests that mean reversion could wreak havoc in the world of smart beta. Many practitioners and their clients will not feel particularly “smart” if this forecast comes to pass.

 Risk myopia

Michael Lewis’ Liar’s Poker (WW Norton & Company, 1989) is considered one of the books that defined Wall Street during the 1980s. The book is a semi-autobiographic, unflattering portrayal of Wall Street traders and salesmen, their personalities, their work practices and their ethics. However, six months after Liar’s Poker was published, Lewis reports finding himself “knee-deep in letters from students at Ohio State University who wanted to know if I had any other secrets to share about Wall Street. They’d read my book as a how-to manual” (Prologue to The Big Short 2010 – W.W. Norton & Co.)

Obviously, not everyone on Wall Street is crooked or unethical. But there is little doubt that, knowingly or not, many of its influential leaders and innovators are prone to take outsized risks with other people’s money. And, since “other people” is us, we owe it to ourselves to avoid playing the ostriches.

As early as March 26, 2014 Bloomberg.com quoted investor Seth Klarman as saying: “Giddy investors are living an existence where, on the surface, everything seems idyllic. In reality, the manufactured calm — thanks to the free-money policies of Ben Bernanke, Janet Yellen and Mario Draghi — anesthetizes us to the looming trouble. The longer QE continues, the more bloated the Fed balance sheet and the greater the risk from any unwinding.”

This is a stark reminder of economy professor Hyman Minsky’s warning that financial crises tend to arise naturally (without a necessary outside trigger) when a long period of stability and complacency eventually leads to the buildup of excess debt and overleveraging.

Source: Abbas and others 2010: Bank of International Settlements; Dealogic, IMF, OECD.

To try and quantify the stock market risk, I turn to John Hussman, in the Hussman Funds letter of June 26, 2017:

On the basis of the most reliable valuation measures we identify (those most tightly correlated with actual subsequent 10-12-year S&P 500 total returns), current market valuations stand about 140-165% above historical norms. No market cycle in history, even those prior to the mid-1960s when interest rates were similarly low, has failed to bring valuations within 25% of these norms, or lower, over the completion of the market cycle. On a 12-year horizon, we project likely S&P 500 nominal total returns averaging close to zero, with the likelihood of an interim market loss on the order of 50-60% over the completion of the current cycle.

Granted, Hussman has been cautious-to-negative about the stock market long enough to acquire the identity of a perma-bear. But he is also one of the experts who has thoroughly studied the correlation between various levels of stock market valuations and future multi-year returns.

We cannot forecast the timing of the next “Minsky moment” but we should keep in mind that, based on history, it could be painful.

François Sicart

6/27/2017

 

1. Not including U.S. ownership of foreign stock and stock owned by “pass-through entities” such as exchange-traded funds.

 

Disclosure: This report is not intended to be a client‐specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. This report is for general informational purposes only and is not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally.

In a previous paper (http://sicartassociates.com/would-the-real-economy-please-stand-up/), I argued that policy makers are being increasingly misled by statistics that were created to measure the 20^th-century industrial economy. Our more virtual, 21^st-century economy is hard to capture with such obsolete methods.  I concluded with a question, which I promised to answer in a forthcoming paper:

“Faced with contradictory indicators that seem to be confusing policy makers, what should investors do?”

My intuitive answer to such a question would be: “Nothing special.” Many observers, ourselves included, believe that there is little usable correlation between the growth of economies and their stock markets’ performances.

Economy and Stock Market: A Very Independent Relationship

Renowned economist and 1970 Nobel Prize winner Paul Samuelson famously quipped that: “The stock market has called nine of the past five recessions.”

Indeed, the correspondence between the strength of a stock market and the health of its economy is not what the public generally assumes. One of the best-known studies on the subject was done by Elroy Dimson, Paul Marsh and Mike Staunton at the London Business School in 2005. They examined 17 countries over more than 100 years and actually found a negative correlation between investment returns and growth in GDP (Gross Domestic Product) per capita:

“Historically, buying into equity markets with a high GDP growth rate has given a return that is below the return of markets with a low GDP growth rate. There is no apparent relationship between equity returns and GDP growth.” (Global Investment Returns Yearbook, 2005)

More recently, according to the New York Times (“The Economy and Stocks: A Big Disconnect” 12/16/12), the Vanguard Group looked at equities’ returns going back to 1926. They examined the predictive power of important variables such as price-to-earnings (P/E) ratios, growth in GDP and corporate profits, past stock market returns, dividend yields, interest rates on 10-year Treasury securities, and government debt as a percentage of GDP. Their conclusion was that “none of these factors come remotely close to forecasting accurately how stocks will perform in the coming year”.

“Even over a 10-year time horizon, considered by many investors to be long term, only P/E ratios had a meaningful predictive quality.”

With a narrower focus on just the US market, Crestmont Research compared GDP growth and the change in the Dow Jones Industrial Average (without dividends) decade by decade and also for selected secular bull and bear cycles through 2015.

The disconnect between economic growth and stock market performance is inescapable.

Source: Crestmont Research

Looking for Wisdom Outside of Economics

Early in my career, an economist at the US Federal Reserve consulted me about opening an account with my firm, Tucker Anthony, because she realized that “economists usually do a poor job of managing their own investment accounts.” The same realization may explain why the 2002 Nobel Memorial Prize in Economic Sciences was awarded to Daniel Kahneman — a psychologist!

I have long been fascinated by the relatively new discipline of behavioral finance, also popularized by researchers such as Richard H. Thaler (Misbehaving: The Making of Behavioral Economics, 2015) and Robert J. Shiller, another Nobel laureate (Irrational Exuberance, 2000). Kahneman’s book (Thinking Fast and Slow, 2011) on the psychology of judgment and decision-making is full of profound and entertaining insights, including many about investing. For instance:

Hindsight, the ability to explain the past, gives us the illusion that the world is understandable… We should accept the world is incomprehensible much of the time… You can protect against certain scenarios better than you can predict them.

Many individual investors lose consistently by trading — an achievement that a  dart-throwing chimp could not match…

Unfortunately, Prof. Kahneman is not impressed by the competence of investment managers either:

For a large majority of fund managers, the selection of stocks is more like rolling dice than like playing poker.

There are domains in which expertise is not possible. Stock picking is a good example. (Time Magazine – 11/28/11).

It is wrong to blame anyone for failing to forecast accurately in an unpredictable world. However, it seems fair to blame professionals for believing they can succeed in an impossible task.

Some Investors, Including Professionals, Consistently Fail to Perform

It is no secret that most professional investment managers fail to equal the performance of their benchmark indices and that many individual investors actually lose money over long periods. Performance-measurement firm DALBAR tracks mutual fund purchases and redemptions by investors to calculate the actual returns earned by these investors, with the following results:

The following press extracts also confirm that most investors underperform the main stock market indices over time:

In Europe, 86 per cent of active equity funds failed to beat their benchmarks over the past decade, according to S&P’s analysis of the performance after fees of 25,000 active funds. (Financial Times – 3/20/16)

According to S&P Dow Jones Indices, 82% of large-cap funds generated lower returns than the S&P 500 in the latest 10 years.  (USA TODAY– 3/14/16)

Despite this evidence, I respectfully disagree with Prof. Kahneman. If a majority of investment managers fails to equal or beat their benchmarks over relevant periods of time, it must mean that a minority does achieve that goal.

Of those, no doubt a few possess exceptional skills that common mortals do not. Their results would be hard to replicate. But I usually try to follow the advice of Warren Buffet and Charlie Munger, which they learned from nineteenth-century mathematician Carl Gustav Jacob Jacobi’s advice for solving problems: “Invert, always invert.”

In our case, that inversion means not seeking out popular stocks for their potentially big returns. Instead, we should concentrate on avoiding the mistakes that cause the majority of stock market losses.

What are (some of) those mistakes?

The Mythology of Investment Success Can Be Dangerous to Your Wealth

One common error is viewing the stock market as some magical box that can be unlocked by discovering a secret formula. Another is the belief that the stock market is constantly being manipulated by obscure forces beyond the common man’s control. More routinely, some clients expect their investment advisers to be omniscient, with a special gift for predicting the future.

These attitudes derive from what an early mentor of mine called “the quest for certainty in an uncertain world” – by definition a hopeless endeavor. In fact, one of the first precepts of investing is (or should be) that there is no certainty in investment. This is why we diversify our holdings.

The title of a 2014 book by strategist Ned Davis asks what should count most for investors: Being Right or Making Money?

If the main goal of diversification is to avoid being hurt by rare but unavoidable mistakes, then a useful investment goal would be a good “batting average” rather than a few “home runs.” The batting-average approach seems particularly appropriate to me, because it calls for common-sense discipline and avoids the dangerous tendency to be lured by narrative. One can lose a lot of money on “good companies” or “good stories” if stocks are not bought at the right price. But how to determine the right price?

Dollar Quotes Are Not an Accurate Measure of a Stock’s Popularity

 The stock market is an auction process, i.e. the price of a stock is determined by the bidding tussle between buyers and sellers. In the very long term, it can be argued that stock prices will grow with corporate profits. But over shorter periods of several years, the stock market is volatile and functions, frankly, more like a popularity contest.

To understand this, it is important to realize that the quoted price of company’s stock is meaningless in itself: it only has significance when compared to some fundamental value of the underlying company. For instance, the price/earnings ratio enumerates how much investors are willing to pay for the portion of that company’s earnings accruing to one share of stock. Note that price/earnings ratios give no precise signal to buy or sell a stock. But numerous studies have demonstrated that fluctuations in stock prices are caused more by changes in price/earnings ratios than by changes in earnings alone.

Furthermore, buying stocks at low price/earnings ratios results in better investment gains in the ensuing 10 years or more than buying at higher price/earnings ratios.

For example, Dreman Value Management measured the performance of the 500 largest US companies between 1970 and 2010. Here is what they found:

Including dividends, stocks with the lowest 20% of P/E multiples increased 15.3% annually, while stocks with the highest 20% of P/E multiples increased 8.3% annually, on average. The sample average, which closely tracks the S&P 500 Index, returned 11.7% annually during the same period.

When one looks at the compounded returns, the difference is staggering. An investment of $1,000,000 in the lowest P/E group in 1970 and switched annually would have ended up at $327 million at the end of 2010, compared to $26 million for the highest P/E group.

This corroborates our earlier comment: the batting average of investing in stocks with low price/earnings ratios should be better than the batting average of investing in stocks with high price/earnings ratios. And overall, investing in stocks with high price/earnings ratios tends to lower our odds of achieving excellent returns.

Putting Some Horse Sense in Investing

We cannot forget that fluctuations in price/earnings ratios are dictated principally by emotional and psychological factors. This is why, without assimilating it to gambling, stock market investing can in many ways be compared to betting on horse races. Expectations clearly differ from fundamentals when betting on horse races; they also do in the stock market. Michael J. Mauboussin explains, in The Success Equation (2012):

The fundamentals are how fast a horse is likely to run. A handicapper might estimate that based on factors that include the horse’s past finishes, the track condition, the jockey, the distance, and the strength of the field.

The expectations are the odds on the tote board, which can be translated into a subjective probability of a horse’s likelihood of winning…

[But] making money through betting on horses is not at all about predicting which ones will win or lose. It’s about picking the ones with odds—or a price— that fail to reflect their prospects—or value. In other words, [those where] expectations are out of sync with fundamentals.

Being Guided by Price/Earnings Ratios Improves Our Potential Returns

Valuation can help improve the timing of our exposure to the general market as well. In 1988 Harvard economist John Y. Campbell and Yale economist Robert Shiller developed a cyclically-adjusted price-to-earnings ratio (CAPE), which divides the current market price by the average inflation-adjusted profits of the previous 10 years (to attenuate the impact on earnings of the business cycle). Their work showed that for the general market, too, periods of high valuation tend to be followed by years with low returns and are better avoided, while periods of low p/e ratios are more propitious to investment, on a 10-year horizon:

“It’s in The Price!”

The nature of an auction process is that the more broadly the object offered is desired, the higher its price goes. In the stock market, the better the fundamental story is, and the more widely it is known by the public, the higher the price/earnings ratio will be. This is why the odds of making money get worse as a stock rises: as old pros will warn you, by the time the story about a great company reaches you, it is likely that that story “is already in the stock’s price.”

In The Four Pillars of Investing (2002), William Bernstein reminds us that exciting investments are those that have attracted the most public attention and are thus “over-owned” In other words, their fame has attracted excess investment dollars. This drives up their price, thus lowering future returns:

… purchasing the past five or ten years’ best-performing investment invariably reflects the conventional wisdom, which is usually wrong.

… more times than not, the purchase of last decade’s worst-performing asset is a much better idea.

… In investing, the most exciting assets tend to have the lowest long-term returns, and the dullest ones tend to have the highest.

“Dare to be dull,” Bernstein advises… “A superior portfolio strategy should be intrinsically boring. If you want excitement, take up skydiving or Arctic exploration.”

Hubris, Naiveté and Marketing

In Thinking Fast and Slow, Daniel Kahneman explains why experts always seem so confident:

Experts who acknowledge the full extent of their ignorance may expect to be replaced by more confident competitors… An unbiased appreciation of uncertainty is a cornerstone of rationality—but it is not what people and organizations want. Extreme uncertainty is paralyzing under dangerous circumstances, and the admission that one is merely guessing is especially unacceptable when the stakes are high. Acting on pretended knowledge is often the preferred solution.

Investing under the illusion that certainty exists in our uncertain world is dangerous. In the current environment, uncertainty reigns. In a recent paper, I concluded:

No matter who won the elections, the task of the new President was bound to prove very challenging… The continued conflict between the forces of inflation and recession will likely intensify somewhat under a Trump presidency and we believe that keeping ample cash reserves remains the wise position for investors, especially at current valuation levels.

(http://sicartassociates.com/between-inflation-and-deflation/)

We now know that under Mr. Trump’s presidency, expansive fiscal programs run the risk of re-igniting inflationary pressures in an economy that, despite statistical confusion, is close to full employment. At the same time, promised mercantilist and protectionist policies are reminiscent of the deflationary ones that preceded and caused the global Great Depression, in the 1920s.

With today’s delicate balance between powerful forces of inflation and deflation, no one can credibly forecast the future. If the initial weeks of a Trump presidency have indicated anything, it is that erratic policy-making — in an environment where every decision has consequences to the second, third level and beyond — holds the promise of increased financial volatility.

For example, since no one really knows which countries might get hurt by America’s protectionist tendencies, the dollar has risen strongly since 2015, to reflect its potential position as a refuge currency.

More recently, however, large foreign holders of US debt (Treasuries), including China, seem to have become aggressive sellers of dollars.

Uncertainties exist elsewhere as well. For example, reflecting election jitters and low (but not nonexistent) odds of a French exit from the Euro, spreads of French interest rates over those of other Euro debt have spiked to levels not seen in recent years.

Meanwhile, unstable foreign exchange and interest rate markets are potentially harmful to large banks, such as Deutsche Bank, which has encountered recurring problems. Recently, Deutsche Bank AG bought full-page ads in all major German newspapers to apologize for “serious errors” after misconduct costs helped tip the company into two years of losses.

Conclusion

In our view, global stock markets currently offer few compelling values. Optimists argue that historically-high price/earnings ratios are justified by historically-low interest rates. But investors who do not enjoy dancing on top of volcanoes cannot ignore that record-low interest rates are usually followed by higher ones.

Erratic policies in the United States, and possibly in other countries facing changes in governments, are likely to trigger changes in expectations and thus increased volatility in price/earnings ratios. Yet experienced investors often view volatility as opportunity. If higher interest rates prompt lower price/earnings ratios, those of us who seek out value – and a few base hits to boost our batting average – may see new possibilities in the market.

One cannot forecast the future but ample cash reserves with, of course, minimal levels of financial leverage, remain the best way we can think of to be ready for it.

François Sicart

2/16/2017

Disclosure:

This report is not intended to be a client‐specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. This report is for general informational purposes only and is not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally.

“Consumer sentiment in U.S. hovers near highest in 12 years.” This cheerful headline from Bloomberg on January 13 reflects the general tone of the media during the recent “Trump Rally.” At the same time, the Gallup organization reports that “In the US, personal satisfaction [is] back to pre-recession levels.”

But, as John Authers had pointed out in the Financial Times a few days earlier:

Those strong consumer confidence numbers came as the new year dawned with some horrific announcements from the biggest department stores, traditionally the beneficiaries of consumer confidence and also big employers.

Indeed, Macy’s plans to close 100 stores. Sears is shutting 30 Sears and Kmart stores in addition to selling its well-respected Craftsman tool line to raise cash. The list of such announcements is unprecedently large and still growing. Moreover, Morningstar analysts pointed out in October that when an anchor store like Sears or Macy’s closes, that event often triggers “co-tenancy” clauses that allow the remaining mall tenants to terminate their leases or renegotiate terms. This fact supports to Credit Suisse’s estimate that, if Sears continues to close stores, about 200 shopping malls are at risk of shutting down.

It is hard to believe that the trend in retail will not have an impact on U.S. employment and, indeed, on overall consumer behavior.

Consumer optimism at odds with employment statistics

Robert Samuelson explains the apparent contradiction between store closures and consumer optimism in a recent RealClear Markets column (1/12/17):

We have two systems to do one job. Companies have to support the old as well as the new technology. People no longer buy everything in stores, but stores are still necessary. (In 2016, e-commerce totaled [only] about 8% of retail sales.) Still, the loss of sales makes the brick-and-mortar stores less productive, and their loss of productivity offsets some or all of the gains from digital technologies. Macy’s and Sears have to invest in the new technology, even as the value of the old technology erodes.

As I write this report, my partner Bogumil points out that major retailer Target just announced a 3% year-to-year drop in the November/December holiday season store sales while digital sales grew more than 30%. As a result, overall sales for the period declined 1.3%.

Samuelson lists other industries and products where “parallel technologies” compete: smartphones and traditional landlines; paper and digital newspapers; cable TV and streaming internet video, etc.

The fact that structural shifts can make accepted economic statistics and indicators misleading or even obsolete is not a new realization. In what would probably be considered a politically incorrect example today, Nobel Laureate Paul Samuelson often joked that if a man married his maid, GDP would fall because the money earned by the maid had been counted in the GDP, whereas the new wife’s chores would not earn her a salary — so her work would not be counted.

The new economy: highly successful but statistically invisible

In today’s digital economy, official statistics are increasingly misleading because they ignore a growing segment of the economy. Tom Goodwin, strategist for a major marketing/advertising group published a post on TechCrunch entitled “The Battle is for the Customer Interface.” It made the following points:

• The world’s largest taxi company owns no vehicles (UBER)
• The world’s most popular media owner creates no content (FACEBOOK)
• The most valuable retailer has no inventory (ALIBABA)
• The world’s largest accommodation provider owns no real estate (AIRBNB)

The statistical problem this highlights, according to veteran venture capitalist Bill Davidow, is that we live in two worlds, physical and virtual. (The Atlantic – 07/2014)

In the physical economy, almost every activity is measured in dollars. If more dollars are spent or earned, we conclude that the economy is growing. But this economy is anemic, struggling, biased toward inflation and shrinking.

In the virtual economy, a lot of the services provided to us are free. If we paid dollars for these services, they would be counted as part of the GDP and would add to economic growth. But we don’t, so they are not counted. A pity, because this economy is robust, biased toward deflation, and growing at staggering rates.

Larry Downes explains in the Washington Post (10/24/16) that key economic benchmarks, including the GDP, historically ignore everything without a price! And Edoardo Campanella, in a Project Syndicate article (11/4/16), confirms that national accounts ignore most of the highly valuable services provided for free by tech giants like Wikipedia, Facebook, Twitter or Google.

Is it possible that, broadly speaking, a lag in middle-class incomes is being off-set by a rising standard of living? This would explain the statistical contradictions puzzling observers today. Davidow suggests that many economists, policy makers, and politicians, using 20^th-century methods to analyze our 21^st-century economy, fail to grasp the situation.

Manufacturing production at odds with manufacturing employment

Another area where assessments of economic health and growth differ widely depending on one’s lens is the manufacturing sector. A typical headline relating to it might be this one from CNNMoney (3/29/16): “U.S. has lost 5 million manufacturing jobs since 2000.”

But, in an op-ed for the Los Angeles Times (8/1/16), Daniel Griswold of George Mason University reminded us that American manufacturing is actually at a peak, not a trough. Industrial production hit a record high just before the Great Recession and is nearing that level again.

The apparent contradiction stems from the fact that, while U.S. factories are about 2.5 times as productive as they were in the early 1970s, this massive expansion in output was achieved with fewer and fewer workers.  According to government data, manufacturing employment has fallen from 19 million in 1970 to about 12 million today.

This is how Daniel Gross, executive editor of Strategy+Business, explains the discrepancy:

First, the production of less-expensive goods, like T-shirts, toys, and the like, has long since gone offshore. As a result, manufacturing in the US is disproportionally a high-end activity: heavy machinery, tools, cars, jets.

Second, there’s productivity. Manufacturing’s constant efforts to produce more (and faster) with fewer resources – raw materials, energy, effort, and, yes, labor…

Third, in the digital age, manufacturing incorporates a growing proportion of services input; today, more “manufacturing tasks” are performed by people who do not work directly at manufacturers. So, manufacturing probably supports more employment than people think.

According to Alana Semuels (The Atlantic 1/6/17), manufacturing still makes up about 12.5% of America’s GDP, the same as it did in 1960, but with proportionally fewer people. As a result of this trend, the average factory worker now makes $180,000 of goods every year, more than three times what he or she produced as recently as 1978.

Also as a result of this transformation, the average manufacturing worker now makes $26 an hour (nearly $50,000/year, if my math and assumptions are correct). Since 2000, manufacturing jobs for people with graduate degrees have grown by 32%, while those for people with less than a high-school education fell by 44% (between 2000 and 2013). Michael Hicks, of Ball State University, concludes: “We’ve lost the bad-paying jobs to China and gained good-paying jobs.”

Is the trade deficit a measure of the economy’s dynamism?

Today’s economic models — and the institutions using them for forecasting and policy-making –rely on a built-in theory of the economy which enables them to “assume” certain relationships. According to Robert Skidelsky (Project Syndicate -12/19/12), it is among these “assumptions” that the source of recurring errors in economic analysis and forecasting can be found.

In the “prehistoric” times when I learned economics in business school, one of these assumptions was that when a country incurs a trade deficit with the rest of the world by selling fewer goods and services abroad than it buys, it must make up that deficit by borrowing or somehow attracting an equivalent amount of capital from other countries. Since then, the frantic globalization and financialization of the world economy have turned this assumption on its head.

Today, the vast number of financial transactions between countries dwarfs the value of international trade in goods and services. My own observation is that international capital is attracted to a country either by higher interest rates, attractive investment opportunities or safety considerations.

When the amount of capital flowing into a country increases, consumption and investment in that country rise, leading to increased imports – especially since, as a result of the capital inflows, the local currency generally has appreciated. Since exports are not increased at the same time, and may in fact be reduced by the currency’s appreciation, the country’s trade balance deteriorates toward deficit.

In the last 6 years, American imports have exceeded exports by about $500 billion a year. In the same time, Net Foreign Ownership of American capital assets has risen by an average of $900 billion per annum – nearly double the pace of the trade deficit growth.

Gregory Mankiw, professor of economics at Harvard concludes that, rather than reflecting the failure of economic policy, the trade deficit may be better viewed as a sign of success. As such, he argues that if President Trump wants to restore growth, focusing on the trade deficit may not be the best way to achieve it.

There is an additional way in which trade statistics may be a poor guide for policy-making. According to Mark Perry, scholar at the AEI and professor at the University of Michigan, “Importers are exporters and exporters are importers” (AEIdeas — 1/6/17).

According to The Economist, every $100 of goods the United States imports from Mexico contains $40 of goods that it had previously exported to Mexico and that are embedded within the products returning as imports. Meanwhile, the Wall Street Journal reports that the 2017 Chevy Cruz actually contains a large foreign content (56%) whereas, year after year, Toyota and Honda have dominated the rankings of the most “American-made” cars.

The inflation dichotomy.

As the chart below illustrates, inflation is another widely-watched statistic that may explain why some consumers feel more comfortable than others. Commenting on this AEI chart, Christopher Ingraham of Wonkblog wrote: “The stuff we really need is getting more expensive. Other stuff is getting cheaper.”

AEI Scholar Mark Perry, reminding us that many of today’s statistical distortions are related, points out that many of the items falling in price are manufactured goods. Many of these manufactured goods, like TVs and appliances, come from overseas, where labor costs are cheaper.

On the flip side, he says, goods like education and medical care can’t be produced in a factory, so trade-related pressures do not apply.

Sources: American Enterprise Institute; Bureau of Labor Statistics

Further complicating the measurement of inflation’s impact on households is the fact that– through private and public insurance or other forms of assistance –  many Americans are insulated from the full cost of the services with the fastest price inflation. Unfortunately,  others are not.

Not surprisingly, the arms of government which, like the Federal Reserve, dispose of a single tool (like the supply of money) to regulate a diverse economy, are in the position of a car-owner trying to fine-tune a carburetor while wearing boxing gloves. Other government agencies that, in theory, dispose of a more diverse arsenal of policy tools, are often paralyzed by lobbies and other political considerations. In politics, acknowledging that problems are complex does not get as many votes as oversimplifying slogans.

Faced with this confused and confusing policy environment, what should investors do?

This a question that I will attempt to answer in my next article.

François Sicart

January 23, 2017

Disclosure

 This report is not intended to be a client‐specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon.. This report is for general informational purposes only and is not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally.

The last few weeks following a surprise outcome of US presidential elections had a meaningful impact on the market. Half of the gains came from financials, the rest from energy, industrials, materials. The markets are hoping for looser regulatory restrictions for banks, and faster growing economy.

After nine years of record low and unchanged rates (federal fund rate of 0-0.25%), we saw the first increase in December last year (to 0.25-0.50%). A year later, this December, the Federal Reserve increased the rate by another 25 points (federal funds rate 0.50%-0.75%), and expects a 75 point increase through 2017, which is a faster pace that previously projected. The Fed is more confident in the progress the economy is making, and it is seeing strong labor market, and inflation picking up.

With rates going up, bond prices have come under pressure, and we believe it’s only the beginning. Mr. Trump’s high spend fiscal policies re-ignited fears of a potential acceleration in inflation, which support further rate increase. Thus, a long running bull market in bonds has finally come to an end.

Initially, since the money has to go somewhere, equities have been the obvious alternative to declining bonds, but caution is warranted in view of already elevated valuations, prices, and record highs.

Meanwhile, weaker growth in Japan, China, and Europe, and relatively healthy economic growth in the US have helped the dollar, where our portfolios have had the largest exposure. Rising interest rates tend to make the dollar more attractive, and since the new US president is expected to boost growth further, at least initially, further support to the dollar would not be surprising.

After a strong recovery from multi-year lows, gold has been under pressure starting last summer. This is not surprising since a stronger dollar and increasing interest rates make gold less attractive. While, for now, the investment argument in favor of gold is less compelling, we have always viewed gold as an insurance premium against unforeseen crises and the nature of insurance premiums is to cost money when things go well.

Two sectors deserve special comments: biotech and energy

Our biotech/pharmaceutics holdings had a particularly strong few weeks after Trump was elected as the next U.S. president.   The sector itself had been lackluster year to date, amid fear of government mandated price control on drugs.  While we are hopeful that the current political environment would give the sector some tailwind, our reason for keeping or reinforcing our specific biotech holdings is that we remain enthusiastic at their prospects for the next several years.

The energy sector has been undergoing exactly what we had expected, with energy price gradually shifting upwards.  Our view is that the energy sector’s turn has begun and, as a typical cyclical industry, it will have another few years of strong prospect before the market enthusiasm peaks.  Our exploration and production names have already gone up more up 50% year to date.  The service providers will follow, which is typical in this industry, as the energy price rebalance plays out in the next 1-2 years.

In a broader perspective, disciplined contrarian investors may have trouble finding compelling investments in the current environment. The majority of the stocks are close to their all-time highs, and those that are down tend to have some major issues that make them too risky to consider. With very few immediately actionable ideas, we focus on building our wish lists, and holding a higher than usual cash position as dry powder. Meanwhile, we believe that our energy and healthcare holdings leave us well positioned for the current market backdrop.

François Sicart, Allen Huang, Bogumil Baranowski

 

This presentation and its content are for informational and educational purposes only and should not be used as the basis for any investment decision. The information contained herein is based on publicly available sources believed to be reliable but not a representation, expressed or implied, as to its accuracy, completeness or correctness. No information available through this communication is intended or should be construed as any advice, recommendation or endorsement from us as to any legal, tax, investment or other matters, nor shall be considered a solicitation or offer to buy or sell any security, future, option or other financial instrument or to offer or provide any investment advice or service to any person in any jurisdiction. Nothing contained in this communication constitutes investment advice or offers any opinion with respect to the suitability of any security, and has no regard to the specific investment objectives, financial situation and particular needs of any specific recipient. Any reference to a specific company is for illustrative purposes and not a recommendation to buy or sell the securities of such company.

The 1970s and early 1980s were years of turmoil. From 1963 to 1969, US President Lyndon Johnson had pursued “Guns and Butter” policies that simultaneously financed an escalating war in Vietnam and his “Great Society” welfare programs at home. Boosted by these expenditures, the economy seemed to boom. However, after a long period when the absence of recession had convinced many economists that the economic cycle had been conquered, the United States experienced a first, relatively mild, recession in 1970.

President Richard Nixon thus inherited an economy entering recession and, to maintain the stimulus, he initially followed the same policies as his predecessor.

By 1971, however, America’s bloating twin deficits (budget and trade) had made it impossible to maintain the existing system of fixed exchange rates based on a US dollar theoretically convertible into gold.

That system had maintained an artificially high exchange rate for the dollar which, in turn, had helped to hold inflation in check. Once President Nixon ended the dollar’s convertibility into gold, the so-called Bretton Woods system collapsed, to give place in 1973 to a new system of floating exchange rates. As can be seen below, the dollar lost more than 50% of its value against the Deutschemark between 1972 and 1980.

As a result of lax US economic policies, the first signs of inflation actually had begun to appear as early as the late 1960s. But the dollar’s collapse aggravated the tendency and, since oil is priced in dollars, this probably was a factor in OPEC’s October 1973 decision to declare an embargo and to triple the price of oil practically overnight. With this last blow, inflation surged from an annual rate of 3% in 1972 to over 12% in 1974.

The surge in the prices of oil and other commodities not only triggered overall inflation but, aggravated by OPEC’s difficulty in recycling to the rest of the world their sudden dollar influx from oil exports, also acted as a severe tax and liquidity strain on the world economy. This triggered a recession in 1975, which not only was severe but, for the first time, was also truly global.

Then, after only three years of economic recovery, an Islamic revolution deposed the Shah of Iran in 1979 and triggered a war between Iraq and Iran that lasted from 1980 to 1988. Initially at least, this conflict reduced the flow of oil from both countries and triggered the Second Oil Shock.

At first glance, the recession that ensued from the second oil shock in 1980, looks very short and relatively mild on economic charts. But that is due mainly to a mini spending boom on oil equipment and exploration, which only lasted three quarters in 1981. After that spike, it should be noted, oil prices declined for 18 years and the need for oil-related capital spending seemed less urgent.

Thus, the entire period 1980-1982 should really be viewed as a one of the longest and most severe recessions in history.

Around the middle of the long, crisis-laden period between the late 1960s and the early 1980s, I wrote for my firm, Tucker Anthony, a paper entitled “Between Inflation and Deflation: The Dislocating World Economy”. The paper described the conflicting forces of inflation and deflation shaping the emerging post-Bretton Woods and post-OPEC economies.

It is entirely possible that President-elect Donald Trump will inherit a situation just as problematic as Richard Nixon did in 1969 – at least from an economic point of view.

While no one knows much about his detailed economic agenda beyond campaign slogans, there is a good chance that US international relations during his tenure will be more confrontational and, on the trade front, more mercantilist and protectionist than in the last few decades.

Trade is not a zero-sum game and if the United States manages to import less, it is likely that other countries or blocs will either retaliate or pursue similarly restrictive policies. Historically, periods like this have resulted in downward spirals for world trade. In turn, periods of slowing or declining world trade seem have caused a slowdown in global economic growth.

The above comments derive from my personal experience but in today’s New York Times, Ruchir Sharma, chief global strategist at Morgan Stanley Investment Management, pens an editorial drawing another striking and scary parallel: the period of de-globalization that started with the outbreak of World War I, in 1914.

Following four decades of rising migration and trade, that period of de-globalization encompassed the 1920s, 1930s and early 1940s. As Sharma points out, “National economies move from boom to bust in cycles that last a few years but… the flow of goods, money and people across borders has advanced and retreated in decades-long waves.”  (When Borders Close, New York Times, 11/12/06)

Many regions of the globe are still fighting the consequences of the financial crisis and Great Recession of 2007-2009. Recoveries have remained subdued and uneven. Even in the United States, which by all accounts has had the strongest economy, the recent elections seem to indicate that not everyone feels that they are sharing in the improvement depicted by recent statistics on employment and wages. The allure of protectionism is growing.

Sharma argues that the more recent globalization boom, which gained momentum in the 1980s, has been in a retreat that began in 2008 and is still accelerating, with anti-globalization populists having already won control in Britain and gaining momentum in Italy, France and Germany. The likely fallout, he argues, is “slower growth, inflation and rising conflict”.

“History doesn’t repeat itself but it often rhymes”, as Mark Twain may have said. Today’s rising protectionist tendencies around the world can only be intensified by Donald Trump’s promised tough approach to international trade and must be counted as a recessionary force in the global outlook.

Domestically, to fight any recessionary tendencies and provide employment to those left behind by the more dynamic but increasingly intangible and global economy, Mr. Trump has indicated that he favored fiscal (budgetary) spending and investment over the recent monetary experiments of the Federal Reserve, which he has found ineffective. Tax cuts and spending on infrastructure construction and repair, which will create jobs in older industries, are likely to be favored.

While there are arguments in favor of Mr. Trump’s preferred fiscal approach, it also faces potential challenges.

First of all, there necessarily will be a time lag between immediate increases in government expenditures or tax cuts and any resulting revenue gains from higher economic growth. In the meantime, it will appear as if the Federal deficit, already large, is bulging further and boosting the already worrying level of Federal debt. I think we can trust the media and the usual pundits to claim early that the new policies are either not working or fraught with dangers.

Second, although all sectors and regions are not participating fully, the US economy has been relatively strong. Overall, unemployment is low and wages have recently been increasing. In fact, after much debate and hesitation and presumably remembering William McChesney Martin’s admonition that the role of the central bank is to take away the punch bowl when the party gets going, the Federal Reserve seemed ready to increase interest rates even before the recent elections.

Since some of Mr. Trump’s early proposals are aimed at stimulating some of the economy’s areas that have been lagging, the result is likely to be some acceleration of inflation. Interest rates, which have been suppressed by the Federal Reserve are likely to rise, with the consequences that we discussed in our September paper (http://sicartassociates.com/baby-boom-investors-genius-or-just-lucky/)

Note, however, that monetary and fiscal policies are not independent from each other. A rise of interest rates from today’s very low levels will necessarily increase interest payments on the Federal Debt, which already constitute one of the largest expenditures of the Federal Budget.

Another economic uncertainty is the fate of the US Dollar. At the moment, the consensus of professionals seems to anticipate a strong dollar, reminiscent of its performance in the early Reagan years. In this view, fiscal stimulus and a somewhat less accommodating monetary policy in the United States (with the resulting higher interest rates) on the one hand, and weak economies and continued monetary easing in Europe and Japan on the other, justify a run-up in the US dollar.

In our view, the likelihood of more protectionist and mercantilist trade policies may lessen the prospects for this scenario. The volume of international trade, nowadays, is dwarfed by the volume of international capital flows, and investment incentives play the greater role in attracting or discouraging capital. Initially, Mr. Trump’s promise of a tax break on the repatriation of corporate holdings held overseas may give a boost to the consensus scenario. But thereafter, the outlook for a closed American economy in conflict with various trading partners may temper that early enthusiasm.

No matter who won the elections, the task of the new President was bound to prove very challenging, starting at the end of a long period of declining interest rates and probably on the eve of a long period of rising interest rates. The continued conflict between the forces of inflation and recession will likely intensify somewhat under a trump presidency and we believe that keeping ample cash reserves remains the wise position for investors, especially at current valuation levels.

François Sicart – November 14, 2016

This presentation and its content are for informational and educational purposes only and should not be used as the basis for any investment decision. The information contained herein is based on publicly available sources believed to be reliable but not a representation, expressed or implied, as to its accuracy, completeness or correctness. No information available through this communication is intended or should be construed as any advice, recommendation or endorsement from us as to any legal, tax, investment or other matters, nor shall be considered a solicitation or offer to buy or sell any security, future, option or other financial instrument or to offer or provide any investment advice or service to any person in any jurisdiction. Nothing contained in this communication constitutes investment advice or offers any opinion with respect to the suitability of any security, and has no regard to the specific investment objectives, financial situation and particular needs of any specific recipient.

A bull market makes every investor a genius — while it lasts

I founded Tocqueville Asset Management in 1985, with what turned out to be incredibly good timing. Since then, the S&P 500 index of the US stock market has risen from 210 to almost 2,200 — a more than ten-fold appreciation in just over 30 years. Admittedly that rise was punctuated by some scary episodes. Nevertheless it resulted in an annual compound rate of nearly 8%. If we include dividends, as is the recommended practice, the compound, annual “total return” from stocks over the period was in excess of 10% per annum.

One factor in that performance was a steady decline of interest rates, which boosted stock prices along with bond prices. According to Bill Gross of Janus Capital, the price of investment-grade US bonds produced an average compound rate of return of 7.47% since 1976.

As a result, many baby-boomers pride themselves on investment performances that seem to prove their acumen while in fact, their secret is simply fortuitous timing. An old stock market truism: “It’s better to be lucky than smart.”

Unfortunately, entrepreneurs who start out as financial advisors today may not prove as lucky as I was in 1985. The mere fact that the percentage of US GDP attributable to asset management has been multiplied by ten since 1980 should serve as a contrarian warning.¹ Popularity of a concept or an activity is seldom a good sign: I like to remind budding financial entrepreneurs of Howard Marks’ observation that in the ’70s, there were 10 hedge funds run by 10 geniuses; in 2004, there were 5,000 hedge funds, and he didn’t think that they were run by 5,000 geniuses. Today there are probably 10,000 or so hedge funds.²

Sailing against the wind is not the same as sailing with the wind at your back

As we see in the graph above, the steady decline of interest rates in the last 30-plus years was preceded by an equally long period of rising interest rates, which peaked at 15% in the early 1980s. But who remembers that? Not most baby boomers. Investors who started their careers in the early 1980s, when interest rates began their long descent, would be approaching retirement today. For younger ones, what preceded is history and does not shape reflexes and behavior in the same way as direct experience.

In that respect, at least, I am fortunate to have started working on Wall Street in 1969. Many of the portfolios I analyzed back then contained long-term bonds purchased after World War II at very low yields. By 1969, many were selling for around 50 cents on the dollar and were mostly useful for generating tax losses to offset the capital gains on our stock portfolios. I never forgot that, and it did shape my reflexes and behavior for the long term.

Given today’s ultra-low interest rates, Bill Gross estimates that yields would have to drop to minus 17% in order for the bond market to match its return of the last 40 years! There does not seem to be much chance of this happening. Perhaps instead we should brace ourselves for the mirror image of the recent era of declining rates.

Sustained low interest rates change our economic behavior

Lower interest rates make borrowing cheaper and easier. In the early stages of an economic cycle, this dynamic will normally stimulate a recovery by providing incentive to spend and invest. However in the long uneven recovery from the 2007-2009 recession the US Federal Reserve (followed later by other major central banks) resorted to more desperate measures. These included zero interest rates policies (ZIRP), quantitative easing, and negative interest rates – policies which are collectively known as financial repression.

After years of interest rates being artificially repressed, the behavior of economic agents has altered: we increasingly act as if interest rates would remain low forever. In short, a new complacency about the current abnormal state of affairs has set in.

The first, dramatic consequences of “preventive” easy money were observed as early as 2007 in the private banking sector, with the bursting of the sub-prime lending bubble and its catastrophic results. But more recently, the stubbornness of central banks in repressing interest rates seem to be creating a bubble the world’s bond markets. So far, investors are merely enjoying the ride, thinking they are coping well with a difficult environment. But painless excesses seldom come to a painless resolution.

Harvard University’s Kenneth Rogoff describes the current situation as follows:

The US Treasury and the Federal Reserve Board, acting in combination, have worked to keep down long-term government debt, in order to reduce interest rates for the private sector. At this point, the average duration of US debt (integrating the Fed’s balance sheet) is under three years… Given that the interest rate on 30-year US debt is roughly 200 basis points higher than on one-year debt, short-term borrowing has saved the government money as well… [But] The potential fiscal costs of a fast upward shift in interest rates could be massive. If the US ever did face an abrupt normalization of interest rates, it could require significant tax and spending adjustments.³

I believe that a majority of investors is ready to acknowledge such a scenario in theory but that as consumers, businesspeople and taxpayers, few are prepared to adapt to such a change if it becomes reality.

Impact of low interest rates on the stock market

The tendency of stock valuations (Price/Earnings, or P/E, ratios) to rise when interest rates go down has been well documented and makes intuitive sense. Stocks compete with bills and bonds for investors’ money and when interest rates earned on bills and bonds decline, the relative attractiveness of stocks improves, raising P/E ratios.

Corporate profits, while cyclical, tend to grow rather steadily over the years. The main difference between major bull and bear markets really comes from changes in P/E ratios. As can be seen below, P/E ratios have been the main force at the back of the major bull market of the last 30-plus years.

[In the graph, the P/E ratio has been replaced by its inverse, the earnings yield (E/P %) to better illustrate the relationship with interest rates.]

With today’s interest rates in major markets hovering around zero, it is not surprising that, depending on the index used, global P/E ratios are somewhere between above-average and very expensive historically. Without making specific predictions, it is prudent to be prepared for a normalization of interest rates someday.

If lower interest rates boost the price of bonds, stocks (P/E ratios), real estate, art and (as a result of the so-called “wealth effect”) our propensity to spend, what do we think will happen when they rise again?

Desperate monetary policies trigger a desperate quest for returns

The reduced income available from bonds and other fixed income instruments is changing investors’ attitudes. There are indications that many, deprived by the low interest rate environment of their traditional income-producing investments, are assuming increased risk – sometimes to foolish levels – to try and improve their total returns.

The anguish of retirees who depend on fixed-income portfolios to meet their living expenses is readily understandable. But this phenomenon also affects the beneficiaries of many older pension funds, whose employers are still assuming that the future overall return on their pension portfolio will be 7% per annum. In fact, the income on the bond portion of these portfolios should trend closer to zero as maturing, older bonds, are replaced by lower-yielding new ones. Meanwhile, a number of models predict that stocks in general cannot exceed a 5-6% total return annually over the next 10 years, given today’s extended valuations. So it is very likely that the actuarial assumptions underlying many pension plans are unrealistic and that the companies or state entities that sponsored them will have to fund their pension obligations from their own pockets (or, more likely, from those of their shareholders or taxpayers).

As I write this, Business Insider reports on “a company with no revenue, $1,000 in the bank, and a $35 billion market cap” which is now under investigation by the SEC “because of concerns regarding the accuracy and adequacy of information in the marketplace… ”

There will always be gullible people ready to invest blindly in a “story.” In recent years some global companies have taken advantage of low interest rates to issue record levels of perpetual debt, i.e. debt that never needs to be repaid. Bonds of such companies thus may never return to their issue price.

At the same time, the value of negative-yielding bonds issued globally — primarily government bonds in Europe and Japan, but also a mounting number of highly-rated corporate bonds — has now reached $13.4 trillion. The German government recently issued 10-year notes with a negative yield of 0.5%. Buyers will receive zero interest for ten years and at maturity will only be repaid 0.995 cents on the dollar.³

No wonder Leon Cooperman, of Omega Advisors, likens buying bonds today to “walking in front of a steamroller to pick up a dime”⁴, while The Interest Rate Observer’s James Grant observes that insurance companies which invest their premiums in fixed income are “dying on the vine.” ⁵

Sidney Homer and Richard Sylla, the authors of A History of Interest Rates, found no instance of negative interest rates in 5,000 years. ⁶ I can easily understand how attractive it is for corporations or governments to borrow under today’s unique conditions. But my questions are: “Who in the world is buying these certificates of guaranteed confiscation?” and, if not: “What risks are investors accepting to try and match their obsolete income expectations?”

Reckoning delayed: complacency is not justified

One of my concerns about the near-term future is that many of the excesses we are witnessing seem painless. For example, even though the US government has issued $8 trillion of new debt since the financial crisis, its interest rate costs are lower than before the crisis: as debt has doubled, the rate of interest has halved, helping keep the government budget deficit (and our taxes) in check. So far: no pain, all relief.

In the private sector, more debt can be undertaken on houses at historically low rates so that the monthly interest payments on mortgages are painlessly low. But debt is debt and someday, the principal of the loan will become due.

In many other areas, current incomes are similarly sustained or even enhanced at the expense of deteriorating balance sheets. For example, many companies periodically buy back blocks of their own shares to support stock prices. They thus also increase reported earnings per share by reducing the number of shares outstanding. On the balance sheet, however, this strategy reduces the company’s cash and, importantly, the shareholders’ equity. Some companies are taking further advantage of suppressed interest rates by actually borrowing to repurchase their shares in the market, thus boosting stock prices (instant pleasure) at the expense of their balance sheets (future pain).

Finally, as always when central bank money is plentiful, private pockets of speculation have also developed. Unicorns is the new name for privately-held, often profitless startups “Uber-valued” at $1 billion or more. Business Insider counts 143 such unicorns today, compared to 45 two years ago. All or most are looking to go public, constituting a potential $513 billion new supply overhanging the stock market. But, if early Facebook investor Jim Breyer is right in thinking that 90% of these unicorn startups will be repriced or die, this might also constitute a new supply of disappointments. ^7,8

On the whole, the current environment can be better described as one of self-satisfied complacency than as one of irrational exuberance. With very few alternatives to generate positive returns, many investors choose to remain fully invested in stocks. While US statistics indicate outflows from equity mutual funds and ETFs, there are indications that the money is not actually leaving the stock market. Instead it is being invested in the large companies that drive the performance of major capitalization-weighted indexes. It’s a sneaky form of indexing under the guise of “active management,” but a practice that props up both the major stock market indexes and the already-extended valuation of their major components.

We are not pessimists but we try to learn from experience

In spite of the cautionary tone of this first investment letter, we are neither timorous investors nor “perma-bears.” We actually keep a thick and growing file tracking all the reasons to be optimistic about the future. But in keeping with our commitment to think and invest as contrarian value investors, this file will only be opened when we sense that the investing crowd has become irrationally pessimistic. Today, we see it more as overly complacent. So, what to do?

Traditionally, value investors like us have tended to follow a “bottom-up” rather than a “top-down” approach. We don’t focus on analyzing the macroeconomic outlook or devising stock market strategies. Rather we concentrate on valuing individual companies and comparing our estimations to these companies’ stock prices. In the past, both logic and experience have vindicated that approach: It was fine to remain fully invested at all times because value stocks, often underpriced to start with, generally withstood price corrections better than the overall market.

But the recent 2007-9 financial crisis and recession demonstrated how global economies and financial markets are now so intertwined that a single event like the collapse of Lehman Brothers in 2008 can threaten the worldwide economic and financial order. This deflationary tornado changed many value investors’ views (including ours) on the subject of bottom-up vs. top-down investing, because all stocks — big and small, growth and value, financially strong and weak –were caught in the whirlpool.

The benefit of such traumatic events is that they create opportunities to invest at once-in-a-generation prices. The drawback is that their timing is almost impossible to predict. This is why we agree with Allianz’s chief economic adviser Mohamed El-Erian that, in today’s situation, keeping as much as 30% of your investment portfolio in cash is “not idiotic,” even though it will earn nothing or even less.⁹

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References

1. Michael Edesess in Advisor Perspectives,10/12/2015
2. Howard Marks, Oaktree Capital Management – Business Insider, Jul 28, 2016
3. Project Syndicate – 8/8/2016
4. Forbes – Jul 18, 2012
5. James Grant – The Enterprising Investor – 8/8/2016
6. Business Insider January 25, 2016
7. Seth Klarman – The Baupost Group 2015 year-end letter
8. Forbes, 2/24/2016
9. Business Insider – 3/15/2016

Disclosure: This report is not intended to be a client‐specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. This report is for general informational purposes only and is not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally.