First, apologies to Grant Williams, author of “Thoughts that make you go hmmm!” for bastardising the name of his research letter.
We sit here running out of superlatives to describe the majesty of the rise in risk assets. Not just equities but also corporate bonds and basically any asset that investors can get their hands on. For those that have followed what they believe to be the prudent path and chosen not to participate fully in markets say since early 2015 (as the Fed ended their QE programme), they run the risk of losing client assets and being vilified by the financial media. For those remaining fully committed to risk assets, they look like heroes. We’re not so sure the same outcome will be seen in the next few years.
This note has more charts than usual but hopefully takes no more time to read than usual. We are not trying to discuss short-term market timing dynamics, but we do feel that with US equities at all-time highs and risk premiums very compressed in all assets, a look at some charts to illustrate the long-term return potential from here is worthwhile. So here goes.
We have been in the prudent camp in the last two years. When we step back from the coal face of day to day market gazing, we try and rationalise the current valuation of various asset classes. As John Hussman rightly points out (and we paraphrase here), valuations are what drive long term returns but investor risk appetite is what drives short term returns. Mr Hussman regularly illustrates valuation models that have a very high correlation with long term investment returns. His favoured is the relationship between market cap/corporate gross value added and subsequent 12 year annualised returns. Chart 1 below shows this, with market cap/GVA in blue (inverted) and subsequent 12 year nominal total returns in red.
The correlation between this valuation model and subsequent 12 year returns is about 93% which is extremely high. At the bottom right, we can see that current valuations indicate that investors should expect about 1% annualised total returns which implies a capital loss over the next 12 years.
Chart 1 – US market cap/GVA and subsequent market returns
Now here’s an interesting thing. Back in 2001, Warren Buffet explained how market cap to GNP may be one of the best single indicators of the valuation of equities. Although not shown, the message from market cap to GNP is very similar (VERY) to market cap/GVA. And yet at his recent annual shareholder meeting, Buffet said equities are cheap relative to interest rates. This is what he said;
“Measured against interest rates, stocks actually are on the cheap side compared to historic valuations. But the risk always is, is that interest rates go up a lot, and that brings stocks down. But I would say this, if the ten-year stays at 230, and they would stay there for ten years, you would regret very much not having bought stocks now.”
It’ll be a long time in coming, but we cannot wait to see who is right. Who’s your money on? Hussman or Buffett or something else? Perhaps Buffett will be a winner in that he invests in companies as opposed to the market. He is a stock picker, and historically a very good one. Perhaps there is value to be had in sifting through the market looking for cheap stocks? Well, that may well be true, but chart 2 below (again from John Hussman) shows the median price to sales for S&P 500 components. It would appear that there are very few bargains within the blue chip index with this particular indicator some 30% higher than pre crisis and tech boom levels.
Chart 2 – Median price to sale for S&P 500 components
So, if the bargains are not to be found in large cap stocks, what about elsewhere? Well, chart 3 below from Evergreen Gavekal shows the EV/EBITDA for the Russell 2000 Small Cap Index. It looks like it will be difficult to find cheap stocks in that corner of the market as well.
Chart 3 – EV/EBITDA Russell 2000 Small Caps
But as we said above, valuations only concern the long term market potential, and it is investors risk appetite that matters for short term returns. And boy have some investors become bullish in recent weeks/months. Chart 4 below shows the bullish percent from newsletter writers as measured by Investors Intelligence. This has a decades’ long history but the chart below show the last 12 years or so – sufficient to take in the pre-crisis mania. As can be seen, this particular group are now more bullish that they were during the peak of QE in 2014 and just prior to the crisis in October 2007.
Chart 4 – Investors Intelligence Survey, percent of bulls
Another group that has fully embraced the Trump rally are small traders in equity futures. Chart 5 shows the S&P in blue and the smoothed average of bullish sentiment for the small traders in orange/grey. This group is now the most bullish since at least 2008, and at levels only seen during the gogo years of QE in 2013. As we have consistently said about these sorts of sentiment indicators, extreme readings do not in themselves mean that prices must mean revert, but extreme readings are a decent indicator for knowing when to fade the prevailing market narrative. For a little bit of fun, we went back and checked the daily readings for this indicator around the market low in March 2009. Literally four days before the low on 6th March 2009, the daily reading was 2% bullish. This past week, the daily reading reached 92% – fun fact for the week!
Chart 5 – S&P 500 and bullish sentiment of small traders
Without going into details, we all know that Wall Street has been in the ascendency over main Street since at least 2009 – many would argue for a lot longer. When prices rise faster than fundamentals, the market gets more expensive as P/E multiples expand. Chart 6 below shows periods of expanding multiples (above the zero line) and contracting multiples. The current period has been going on for 57 months, longer than the 47 months during the tech boom of the late 1990s.
Chart 6 – Annual changes in P/E multiples
That is quite incredible. Investors have been continually bidding up US equities (price > fundamentals) for longer than the halcyon days of the tech boom. There are probably several competing factors, but we all know that central bank largesse remains top of the list. Chart 7 from Citigroup shows that central banks are printing enough money to buy all new securities issued in developed markets, and more. The right hand chart also shows the rolling three month change, peaking about $600 billion.
As can be seen, the ECB and BoJ have been doing most of the heavy lifting in recent months with small supporting roles from the Bank of England and the Swiss National Bank. Well, the Bank of England has now ended QE and the ECB is reducing monthly purchases by EUR20 billion next month. Things are clearly changing slowly, and if the Fed decides to reduce their balance sheet (something that appears to be moving up the agenda), then the change will become more rapid. The reason this is important is that, despite central banks trying to tell us that it’s the stock of their purchases that matter, that is not really true. It is the flow that matters more, and at the margin, flow is already reducing and is set to reduce further.
Chart 7 – Central Bank balance sheet expansion swallow up all developed market new securities issue, and more
So central banks are in effect monetising everything! As we all know, this printing coupled with historically low and even negative interest rates, is distorting market prices not just for equities but also all sorts of bonds. Never did we ever believe that investors would ever accept a negative yield on any asset, but this has been happening for over two years now if we just look back at when the German 2 year bond yield moved into negative territory.
What’s even more bizarre is that apparently some investors have recently been getting worried about what may happen to their investments if Marine Le Pen wins the French Presidential election. This may not be strange in the post Brexit and Trump world, but what is strange is that 5 year French Government bonds basically yield zero – or 4.3 basis points to be precise. Is this really sufficient compensation for the risk of political upheaval? Or for that matter, is 77 basis points on the Italian 5 year or minus 8 basis points on the Italian two year sufficient compensation, especially now that the ECB is beginning to reduce QE. And with inflation in Europe now at their 2% target, will the pressure on Draghi to reduce stimulus increase? Are Italian and French bonds dependent on ECB largesse that is potentially receding?
Chart 8 – French 5 year Government bond yield
There is little doubt that the mis-pricing in Government bonds (most obvious in Europe but also in Japan) is spilling over into corporate bonds. As investors sell their bonds to central banks, they are forced into buying riskier assets and central banks have been delighted that investors are taking more risk as this lowers yields for all borrowers. But when does this search for yield go too far? Risk premiums for corporate bonds have fallen back towards historically low levels. Chart 7 below compares US high yield bonds to investment grade bonds. As can be seen, the extra yield demanded by investors for holding lower quality bonds is extremely low and not far off historic lows. There is simply no safety cushion for high yield investors now. Nothing can go wrong for them; there can be no recession where corporate cash flows dry up for the riskiest borrowers thereby risking a rise in the default cycle.
Chart 9 – High Yield bonds (or Junk) relative to investment grade
One of the side effects of central bank QE (and their purchases of corporate bonds) is that bond issuance itself has exploded. Surely this should have been expected as those investors who sold their government bonds to the central banks have to invest in something else. And the one thing we can rely on Wall Street for is if more product (corporate bonds and other risky assets) is required, they will be very happy to source it for yield hungry investors.
We are sure that central banks hoped that the extra corporate bond issuance would happen as a result of their actions, but we are also sure they hoped that companies would use the proceeds of the issued bonds issued to invest in plant and equipment, hiring and training. As it turns out, they have used the bond proceeds to buy back shares as seen in chart 10 below.
Chart 10 – Share buybacks and change in corporate debt
The recent debt binge has left corporate balance sheets in poor shape. Chart 11 shows the debt/EBITDA for the S&P non-financials.
Chart 11 – Debt/EBITDA for S&P 500 non-financials
Of course, changes to the tax code could mean that hundreds of billions of Dollars come back onshore US, and they could be used to fund buybacks, and keep this particular aspect of the financial mania alive for a few months longer. However, the offshore cash is concentrated in the coffers of a relatively small number of mostly tech companies, leaving the majority of companies still highly leveraged. Furthermore, the Fed are finally raising interest rates at a slightly faster than glacial speed, and so the record debt pile is going to become only more expensive for the majority of companies to service.
So, who is it that is buying all these financial assets are what appear to be near record valuations? It would appear that Mom and Pop have consistently been buying bonds. Chart 12 below from Fidelity shows that investors have piled into bond funds since 2007 with cumulative flow approaching $1.1 trillion.
Aside from a couple of brief periods the flows into bonds have been persistent since 2007, and we suggest this is mostly down to the ageing demographic factor, and the desire for more income and safety as investors approach and move into retirement. What is not apparent from Fidelity’s chart is just how far out the credit curve some of these investors have gone when reaching for yield in their bond funds. Also, have they invested in actively managed bond funds or bond ETFs. This matters as bond indices (which ETFs track) have a nasty key trait of the largest issuers (sometimes the most leveraged and therefore most vulnerable) being the biggest index components.
Chart 12 – Investor fund flows since 2007
As for equity flows, it would appear that they did not really get going post crisis until 2012, coinciding not just with the Fed’s massive increase in QE in their third programme, but also whatever it takes from Mario Draghi and the subsequent massive QE programmes from both the ECB and BoJ.
Again, the Fidelity chart is not quite up to date and doesn’t show the post Trump election flows into mutual funds. For that, we show the recent data from Bank of America Merrill Lynch in chart 13. Since early January, their data shows that hedge funds and institution have been net sellers whereas retail investors have been net buyers. It is worrying that retail investors, who have a nasty record of piling into equities near the market highs and dumping near the lows, have suddenly decided, after years of central bank induced speculation driving valuations to historically very elevated levels, to jump into equities now.
Chart 13 – Recent client equity flows from BoAML
We would point out that aside from the recent (worrying) surge in retail equity buying, there has been persistent demand from central banks (e.g the Swiss National Bank) and the corporate sector. Both of these are price insensitive which in part helps explain the persistence in the bullish trend in equities. But here too things may be changing. With balance sheets stretched and rates rising, companies are buying back fewer shares. We also wonder whether central banks begin to curtail their equity buying. If these price insensitive players begin to reduce their buying activity, equity prices should at least stop rising so fast.
Back to retail investors and their jumping into equities of late, investors (not just retail) have been switching from active to passive management in droves for several years now as can be seen in chart 14. With the recent trend of active managers underperforming passive, and with lower costs as well, is this not an obvious win/win for these investors? Well, perhaps this is not just part of, but also a driving force in what appears to be a speculative bubble. ETFs by their nature are fully invested with a beta of one. Furthermore, ETFs very probably invest a greater proportion of assets into more expensive stocks (or riskier issuers in the case of bond ETFs) or at least being prone to momentum bias. And in terms of price sensitivity, when they receive new money from investors, ETFs invest straight away regardless of recent price action.
Chart 14 – Excess of investment flows into passive funds relative to active funds
We could literally show dozens of charts showing similar points as those shown here. There is no hiding from the fact that risk premiums for all virtually publicly traded securities are extremely thin now. For those willing to hold these assets for the long-term (say 7 years or more) they will probably have to be content with very low nominal returns. Furthermore, the margin of safety now is extremely small. Equities and corporate bonds of all but the highest quality issuer are vulnerable in the event that something goes wrong.
Most investors seem to be either ignoring these flashing warning signals, or unable to do anything but remain fully invested as this is their mandate or they are unwilling to take career risk and go against the crowd. Either this or they are still holding to the belief that central banks have their backs. On this point, we would highlight a recent book written by Danielle DiMartino Booth called “Fed Up”. The author spent about a decade working in the Dallas Fed, and she writes extremely eloquently about the inner working of the Fed and details some of the policy debates during the crisis.
For those who think that the Fed is an institution that is capable of understanding the economy and how to fine tune policy so that performance is maximised whilst ensuring financial stability, they need to buy a copy of “Fed Up” immediately and read it thoroughly.
The Fed is staffed with hundreds of PhDs that have no interest in how markets and banking function. Nor are they interested in research that considers how past policies have affected the economy and whether such policies have been good or bad or successful or not. Not only did none of these PhDs at the Fed predict the 2008 crisis and the deepest recession since the 1930s, but FOMC members including the Chairman continually ignored the financial instability signals prior to the crisis. They failed to understand the financial crisis as it was unfolding in 2008 and they failed to understand the deleterious effect a financial crisis would have on the economy.
Fast forward to today, and the world has significantly more debt than pre crisis and financial markets are more highly valued than pre crisis. The Fed have made the same mistakes as they made before the last crisis. This time round, they have ventured into areas they dared not before; they have found the printing press! Virtually anyone who holds bullish long term positions in mainstream assets hoping for suitable returns for the risk they are taking is either expecting or hoping this time will be different, or that if something goes wrong, they will be bailed out by central banks.
Alternatively, they are expecting the policies of the new US administration to succeed in regenerating growth/productivity, whilst becoming more insular and as the Fed begins to raise interest rates at a slightly faster pace. We have said before that there are some good proposals from the Trump team, and some bad ones. Investors had better hope he focuses on the good ones and gets them in place in double quick time. Is this possible? Well, the best hopes lie with fair but drastic deregulation and tax reform. So far, the noises from Washington seem to be that these changes may take a bit longer than many bulls would like.
Even if Trump somehow does pull off a miracle, it won’t be smooth sailing all the way. The last period of intense political and economic change brought about in the 1980s by Thatcher and Reagan were hardly all plain sailing. Furthermore (and yes it’s a massively complex comparison), the valuation of assets was much lower (investors being pad to take risks), interest rates were descending from double digits all the way to low single digits, globalisation and demographics were clear tailwinds and debt levels were almost insignificant compared to today.
Frankly, we doubt that Trump will be able to pull off an economic and political miracle. The Fed are tightening policy and QE programmes are being either curtailed or reduced elsewhere. The party in financial assets has been extraordinary in this cycle and those that have not made their exit should surely being doing so now or planning to do so very soon. Those without a plan are exposed to a potentially very nasty hangover from the third boom in less than two decades, and one that has driven valuations to levels comparable in some respects to the greatest peak ever seen in 2000 and above those seen in 2007 and 1929.
Stewart Richardson
RMG Wealth Management
