Beyond The Headlines
How to save a fortune, and make money in these perilous times?
Our clients are families, and our job is to take good care of their fortunes for generations to come. We are playing the very long term game. We can wait. Today investing may feel like shopping in a crowded department store at the peak of pre-holiday frenzy, but we all know what happens after New Year’s Day -- fewer shoppers, better selection, better prices. It only takes some patience.
It’s obvious to us that the US equity market is overheated, and that we are due for what may prove to be one of the biggest corrections ever recorded. We don’t claim to know when exactly it will happen, how much stocks will decline, and for how long. We are no prognosticators, we are just trying to make an intelligent interpretation of the familiar facts.
We consider ourselves value contrarian long-term focused investors. We like to buy good companies when they are down, cheap or out of favor. Even today’s market’s tech darlings had their long spells in the doghouse not that long ago.
We don’t usually bother to make market forecasts. We enjoy learning about businesses, distinguishing good ones from bad ones, and maintaining discipline in buying them. For us at Sicart this is more satisfying than analysis of the big-picture macro backdrop. Normally we find that to be a futile endeavor. Nevertheless, from time to time it’s the big picture that matters more than stock picking. This is one of those times.
What do we see?
— markets hovering at all-time highs
— valuations at record levels
— fiscal and monetary stimuli unleashed to the limits of imagination
— more of the same being offered as a recipe for lackluster growth
Yet there is a dwindling conviction that even with these measures, growth could be swift and orderly.
Thus, we choose capital preservation over near term growth at a record high risk.
As we are reminded by the past and by observations credited to such financial masterminds as Baron Rothschild, J.P. Morgan, and Bernard Baruch, fortunes are made by selling too early. Seeing a problem is one thing; acknowledging and speaking up about it is another. Acting on that conclusion is a whole different thing.
From the big picture, top-down point of view, we see a lot of red flags; from the bottom-up point of view, we see little (if anything) that we really like.
If you just look at the price chart of any major US or global index or for that matter, you’ll see an all-time high. Momentum investors might get excited about it, though they get easily bruised in this flattening market. We, on the other hand, are curious as to how much further can this go on, and what will follow.
No matter which metric you like to use — trailing 12-month price-to-earning, cyclically adjusted price-to-earnings, PEG ratio to account for meager growth — the conclusion is self-evident; the market is very expensive. According to many metrics, it’s the most expensive it has ever been, going back to the foundation of modern stock markets.
We would have no issue with a chart climbing to the sky, and valuations on a similar trajectory, if we held only stocks characterized by accelerating growth and improving margins. However, that does not reflect the broader market. GDP growth and underlying earnings growth have been decelerating.
S&P 500 companies are enjoying peak margins mostly because of the artificially low cost of borrowing, which is responsible for the majority of margin improvement since the 2009 market low. If that wasn’t enough, S&P 500 companies (excluding financials) almost doubled their leverage (debt-to-EBITDA), which helped grow earnings per share through record high buy-backs, and top-line through acquisitions. That one-time tactic has its limits.
Some pundits argue that during the internet bubble some valuation metrics were even higher. This, they claim, creates more headroom. They forget to mention that the last 5 years do not compare at all to the late 1990s. Back then the GDP was growing at twice the current rate while productivity grew at three times the current rate. What’s more, 5- and 10-year average EPS growth was in high single-digit percentage vs. less than 1% for the same periods today.
Let’s prime the pump!
With fragile growth, one might hope for more counter-cyclical monetary and fiscal stimulus from Washington. How much dry powder is left, though? Interest rates are close to zero. The Fed’s balance sheet hasn’t been this big since the Great Depression. US government debt hasn’t been this high since funding the world’s biggest war (WW2). Meanwhile total US debt –including corporate and consumer –has also peaked. These conditions would usually prompt easy money policies and more fiscal stimulus to “prime the pump” when the growth stalls. However, those tools have already been used extensively. What’s more, they have their limits. The record shows they haven’t been very effective. If anything, they’ve helped inflate asse pricess even beyond the peaks the market reached prior to the Great Recession.
The broad economic picture is only one side of the current situation. Looking at it another way, very few individual stocks meet our strict contrarian criteria. Yet a high concentration of all stocks hovers close to 52-week or even multi-year highs. That reminds us of a store where everything is priced the same, regardless of quality.
At the same time, very few stocks trade at comparably low prices: 52-week or multi-year lows, our usual hunting ground. The majority of companies that happen to be down have been tarnished by fraud, litigation, or questionable business practices.
Given the macro and micro backdrops, you’d think this supposedly efficient market would price the risks and rewards properly.
Unfortunately, the market sometimes operates like someone who boldly runs out of the house with no umbrella because it’s not raining — only to get drenched 5 minutes later. So, who is making calls in this so-called efficient market? With an unprecedented expansion of passive index investing, there’s less independent thinking and more blind following. This is a worrisome development.
More and more debt is not a sustainable solution.
Human civilization offers over 5,000 years of recorded history of debt. Bubbles go back as far as the Babylonians, Ancient Greeks and Romans over-expanded with the help of easy credit and debased currency. These cycles have been repeated throughout history. We have nothing against the use of credit but there is such a thing as excess leverage, as mankind has learned and forgotten over and over again.
Deleveraging is usually disruptive to the economy, society, markets, asset prices, and asset allocation.
There are at least four possible scenarios: 1) initial deflation followed by an over-large stimulus, leading to hyperinflation (example: the Weimar Republic in the 1920s) 2) just enough stimulus to keep the economy alive while escaping deflation for decades (example: contemporary Japan) 3) we miraculously grow our way out of trouble (historical example: none) 4) governments and central banks step aside, and let the free market correct itself, resulting in deflation, temporary recession, subsequent honest debt repayment through higher taxes, followed by interest rate normalization.
In more detail:
- A likely scenario would lead to stalled growth, increased unemployment, and deflationary pressures – massively unpopular results. The Fed and the government would follow their Pavlovian response and cut the rates to zero. Unleashed asset buying would swell the Fed’s balance sheet with more air. Meanwhile the government would augment the stimulus with higher spending and lower taxes. Debt levels would balloon further. Eventually creditors would have doubts about the government’s, consumers’, and corporations’ ability to pay their debts. As faith in the currency wavers, inflation would finally kick in.
- Or: just enough fiscal and monetary stimuli would keep growth above zero, teetering between deflation and hyperinflation. (Imagine a tightrope walker on a windy day with a bit of rain and hail.) Government could keep this up for as long as possible, as Japan did for almost 30 years while a dramatic asset deflation eroded wealth (stocks and real estate lost 80%+ of their value over time). It’s a path of slow, almost invisible nationalization, where private market participants are gradually replaced by the government.
- We would like to be wrong about the near-term challenges. We would love to see growth accelerate at unprecedented levels so we can grow our way out of public, consumer, and corporate debt while the level of interest rates normalizes. However, history offers no examples of this.
- The most rational scenario is like an unpleasant dose of medicine, i.e. allowing free market forces to take over after decades of counter-cyclical fiscal and monetary interventionism. Deflation would take its toll across services, goods, and assets, while we deleverage the economy. Taxes would rise to pay off the excess debt we’ve accumulated over many decades. (Not only unpleasant, but difficult to execute politically.) Once this is accomplished we can grow from a new, healthier base. This process was carried out in the US in early 1920s and again after WW2, when fiscal discipline and responsible monetary policy were still virtues. This path could be self-imposed or enforced by creditors.
Clearly, the only two options are tightening and deleveraging now, or deleveraging later. The order of steps the economy follows will determine which assets will prove safe havens, and which ones eventually offer satisfactory returns.
The global GDP grows in two ways – population growth and productivity growth. Every other kind of growth is borrowed (or stolen) from the future, through the use of debt. Given current demographics and the immigration stance of today’s administration, population growth cannot provide a sufficient boost for the US economy. Meanwhile productivity plateaued a while ago. Apparently sharing selfies, lining up to buy electric sportscars, and binge-watching streamed TV shows have not been incremental enough to our economic output – hence our obvious doubts about the rosy scenario.
Neither excessive public debt or attempts to turn them into success stories are a 21-st century invention. In the early 18th century, Mississippi Company was a vehicle set up to help consolidate and reduce the cost of a massive national debt in France, and South Sea Company was a similar attempt in the UK, we all know that both led to infamous bubbles that fooled such brilliant minds as Sir Isaac Newton himself.
Today, successful investing is less about chasing the tail of a tired bull market, and more about preserving the capital.
Our clients are families, and our job is to take good care of their fortunes for generations to come. Today, our best course is
–to hold only “highest conviction” stocks
–maintain excess cash positions
–keep fixed-income durations short given interest rate uncertainty
–consider some small gold exposure.
(We are more concerned about deflation hitting us first before inflation catches us by surprise later; thus, the possible role for gold.) Finally, to benefit from a potential market drop, we’d consider a very gradual use of an inverse ETF tracking a broad market index, and preferably one that is not leveraged. Additional leverage can give us a boost if we are absolutely right about the timing of the sell-off, but that’s hard to guarantee.
Why are we optimistic despite such a gloomy backdrop?
We are big believers in the strength and resilience of a free market capitalist economy with its natural business cycles. We are highly skeptical of the efficiency and lasting success of counter-cyclical fiscal and monetary state interventionism. What gets us excited is the prospect of bargains across all asset classes that will follow the current effort to overrule inevitable forces of the free market.
We are playing the very long term game. We can wait. Today investing may feel like shopping in a crowded department store at the peak of pre-holiday frenzy, but we all know what happens after New Year’s Day — fewer shoppers, better selection, better prices. It only takes some patience.
Bogumil Baranowski, Sicart Associates, LLC – 5/19/2017
The article was also published by Seeking Alpha
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.