Managers Focused On Risk

A recent poll by the Economist Intelligence Unit and BNY Mellon (via FT) gave 800 institutional investors and executives various economic/geopolitical themes.  They were then asked how likely they thought each theme was and what impact that theme would have on their portfolio.   Below are some of my key takeaways:

• Many of the themes were rated as “Highly Negative” in terms of the impact on their portfolio.  To me this signifies the heightened risk aversion given the global financial crisis of 2008.
• The only “Likely” positive impact theme was that the internet and social media will be a catalyst for economic change around the world.  This always appears to be the case – a technological advancement stimulates global growth.
• The only “Highly Likely” and “Highly Negative” theme was unrest in the Middle East.  When is this never likely or negative? 
• A sovereign default is toeing the “Unlikely” and “Likely” line while being highlighted as negative.  You can read in my Greek posts here and here why that might be bad.
• Any theme involving Emerging Markets is either in the “Highly Positive” or “Highly Negative” categories or close to it, which shows the growing interconnectedness of the global economy/markets, the rising dependence on those markets for growth, and/or the increasing stakes portfolio managers have in those markets.
• There was one theme that highlighted the risk of monetary or fiscal tightening.  That is one of my concerns. 

You may have noticed, I like lists and graphs as they are not only fun to look at, but also can provide some good data that would have slipped through the cracks.  This one in particular was good because it highlights many themes and risks that are often overlooked, but need to be considered when constructing a portfolio. 

Depends on Your Definition of “Long Run”

The graph below, which I created in Excel from Bob Shiller’s Real S&P 500 data, does a good job illustrating secular market cycles:

I like to use the S&P 500 Index adjusted for inflation (i.e. in today’s dollars) to more easily demonstrate market cycles. The red lines indicate the start of secular bear markets and the green lines indicate the start of secular bull markets. Both of those were subjective determinations on my part.

The point of this graph is simply to illustrate that markets don't move up forever; in fact there are long periods of time (20+ years at times) when equity prices can trend flat or downward. That being said, markets can deviate from their secular trend (e.g. a cyclical bull market in a secular bear market) as all secular bull and bear markets have periods of reversal from the longer-term trend.

Since 2000 we appear to be in a secular downward trend.  While it is possible that we are starting (from March 2009) a new secular bull market, it appears secular trends tend to last roughly 16 years.  Thus, based on the history of market cycles alone we appear to be in a cyclical bull market within a secular bear market.

The Perils of Contagion

In my last post I highlighted why Greece is so important to global markets and the global economy.  I mentioned why contagion, especially in the financial markets, is so dangerous.  In a recent article, Ed Harrison does a good job of explaining the ripple effect of the Greek default.  Below I try to summarize the general idea:

European banks own Greek debt.  To insure this debt they purchase a CDS contract.  In this contract banks (i.e. the buyer) pay the writer of the contract every year.  The writer of the contract promises to pay the buyer the face value of the contract in the event of default.  A CDS is essentially insurance on the Greek bonds.

Thus, if Greece defaults the writers of these contracts will have to pay out.  These contracts may have been written by US financial institutions.  Therefore, a default by Greece could trigger large cash payments from US institutions, putting them at risk.

These payments may or may not be manageable.  A greater issue would probably be if Ireland or Portugal or a larger European country is forced to default as credit markets cease up.  This would in turn force US institutions to pay out CDS contracts on those countries debt instruments.

Going even further, a default in Greece could put European financial institutions at risk even with CDS contracts insuring the debt.  If those banks take large hits to their balance sheets or even fail, any US financial institutions with direct exposure (e.g. loans) or who wrote CDS contracts would be under pressure.

Essentially, the above excerpt illustrates how global financial markets have become interconnected and interdependent upon one another.  How exposed is the US to European sovereign bonds and bank debt?  I don’t believe anyone is quite sure, especially given the lack of transparency in the CDS market.

The point of concern is that one relatively small event can cause a systemic disruption across global financial markets given how interconnected and opaque they are.  This is why the prospect of a Greek default is negatively impacting our markets.   

Why Greece Matters

When looking at world, GDP Greece is ranked 39^th, roughly .50% of World GDP.  The logical question is: why is Greece having such an impact on our domestic market?  Here are some reasons off the top of my head:

1. Uncertainty – It seems nobody is sure how Greece restructuring or a bailout will work.  The longer it takes to find an actual solution (as opposed to kicking the can down the road) the more uncertainty for global markets and the more default issues will keep creeping up.
2. Contagion:

• Debt:  If Greece defaults does that create a run (i.e. institutions no longer will roll over purchases of short-term debt) on Ireland, Portugal, Spain, etc., and thus lead to their subsequent default? 
• Unrest: There has already been rioting in Greece.  Social unrest spreading through Europe would have economic consequences.
• Financial Markets: A default in Greece has vast ripples all over the financial system making a small country paramount in how capital flows.

It is contagion that I want to focus on.  There has already been talk of a U.S. bailout of Greece.  This is mostly likely because U.S. officials fear contagion spreading into the financial markets.  Think about what happened with AIG after Lehman (although now it would appear banks are in a better capital position). 

In my next post I will delve into the particulars of why contagion, especially in the financial markets, could be extremely harmful.

Analysts Could be More Reliable

David Bianco recently posted on The Big Picture a piece that outlines the S&P Earnings versus analysts' expectations a year prior.  I encourage everyone to follow the link and see the great graphs.  Here are my takeaways and various points outlined in the article: 

• Earnings estimates seem to never account for recessions as analysts seem to be overly optimistic.
• The biggest divergence between analysts and the earnings reality was during the most recent financial crisis and subsequent traumatic recession.
• Similarly, analysts seem to undershoot earnings during recoveries.  Although they don’t miss by as much as they do during recession.  
• Top down (macro, economic predictions) and bottom up (micro, company predictions) have moved more in sync over the last decade.

I think the point is this: Don't take analysts conclusions at face value, but rather as one tool in an arsenal of many in making a well informed decision. Use the estimates as guidance, but be careful not to put too much credence in their numbers.  Most importantly, don’t make any investment decisions based purely on what analysts are estimating.  

Spending Cuts Now Put Stocks on Shaky Ground

I am a proponent of continued cyclical government spending, which differs from secular government spending.  Cyclical government spending is critical in the short-term to keep the economy from faltering and corresponding cuts in long-term spending to keep the deficit under control.  I don’t think those beliefs are at odds with each other

Despite all of the chatter in Washington interest rates are still falling and core inflation is still tame.  High interest rates and high inflation are often seen as reasons to rein in spending.  It seems imprudent in this environment to cut spending and tighten the fiscal belt.

A recent Credit Suisse report (via FT Alphaville) adds fuel to my “fiscal tightening concern” fire by highlighting how fiscal expansion is needed in order to maintain profit expansion and thus a continued rise in stock prices:

• The average duration of profit expansion is 14 quarters going back to 1949.  We are in quarter 10.
• Three of the last 12 quarters have lasted much longer than the average – 32, 31, and 20 quarters, respectively.
• The key to maintaining profit expansion for that long appears to be strong employment growth and/or strong private sector credit expansion.
• Both employment growth and private sector credit growth are weak and still below the previous peak.
• At the same time government liabilities have grown, making the recovery’s reliance on government strong.

The conclusion is essentially that a contraction in government spending will result in a contraction in earnings.  That won’t be good for stocks or the economy.

This is NOT an argument against cutting spending, but a discussion over where and when.  Cutting short-term, economically stimulating spending now is NOT a good time nor is it a good place.

Tech Stocks Look Relatively Handsome

In a pseudo follow-up to my last post, there are compelling arguments that technology companies present a good relative value.  Bloomberg published some items highlighting this:

1. Computer stocks trade at 9.3 times EBITDA, which relative to other stocks is the lowest ratio since 1998.
2. Based on analyst projections, technology stocks trade for 12.8 times forward earnings.  This is lower than the S&P 500, which trades at 13.1 times forward earnings.
3. Technology stocks trade at 9.3 times EBITDA, which is lower than the 14.5 times EBITA average since 1992.
4. The S&P 500 Information Technology Index trades at 2.4 times sales, which is lower than the average of 2.6 since 1992.

In this sense, relative value is the value of technology stocks relative to the overall market or past valuations of technology stocks.   Thus, if these stocks are truly undervalued it would logically follow they should have higher long-term returns relative to the broader market.

Further, when looking at the current situation these types of stocks seem poised to have better relative returns to the broader stock market anyway.  Aside from being relatively undervalued let’s look at two scenarios – the economy does well, the economy does badly.

If the economy does well, what will businesses do?  They will invest.  If they invest, what will they invest in?  Most likely they will upgrade their technology. 

If the economy does badly, which companies hold up the best?  Companies with cash to navigate tightening credit markets and falling revenues.  Also, companies with diverse and global revenue streams will be able to generate sales from outside the US. 

Companies Got Cash

A recent CNBC article notes the growing cash on corporate balance sheets (via the WSJ roughly $1T for S&P 500 companies) and outlines why the growing cash hasn’t translated into larger dividend payouts:   

1. Companies no longer wish to finance through short-term credit markets if they don’t have to.
2. Americans are saving more and taking on less debt.  This mutes future growth and consumption.

I will add one more reason:

     3.  Non-financial companies haven’t really deleveraged and liabilities are still near an all-     time high.  

And here is why those issues lead to lower dividend payouts:

• If we have another disruption in the credit markets the blow won’t be as hard to companies flush with cash.
• Heightened consumer saving and decreasing debt points to consumer uncertainty.  This leads to an unclear business environment where cash can help ride out a fall in revenues.
• There are two-sides to the balance sheet equation.  Companies increase their cash stake to pay down liabilities in the future. 

Ultimately, the high cash levels are mildly bullish for the market in general.  I doubt items 1 and 2 are changing anytime soon.   That said, if they do change then companies with stockpiles of cash should be in good shape to issue dividends or deploy for investment.

It’s not bearish for the market because having cash is a good thing.  Cash is king.  If credit markets freeze or the economy stalls, companies with a lot of cash should be in better shape.  Thus, investing in cash rich, financially strong companies should give you some cushion if the broader market moves down. 

Valuation Levels – The Long and Short of It

I came across a well written piece on valuation (found here) referencing Shiller P/E  (price to earnings ratio).  I usually keep an eye on Shiller P/E as it appears to give a good perspective on the type of future returns going forward for equities.  As the chart below shows long lasting bull markets tend to happen when Shiller P/E is at lower multiples:

As of now Shiller P/E is around 24.  So based on this metric does that mean stocks will inevitably disappoint?  Of course not; however, as the article indicates the probability of having stellar returns over the next 10 years isn’t high.  In fact, the average annual real returns (after inflation) for the subsequent 10 years is -2.6%.  Thus, it would appear stocks aren’t priced well for fantastic returns over the next 10 years.  I would like to add a few caveats though:

• Different subset equity asset classes may be priced differently.  GMO research in the article suggests Large Caps are priced better than Small Caps. 
• In the short-term, Shiller P/E does a poor job of forecasting.  
• Per Sitka Pacific Capital, LLC research  when the Shiller P/E starts the year above 21  the returns ranged from -30% to +33% in the current year. 

Interest Rates Have Been Falling For a Long Time

Anyone who is trying to save or generate income off of their savings knows that interest rates are low.  Very low.  The graph below shows that interest rates have in fact been trending lower for about 30 years.

Now in our office anyone who comes in pitching their investment strategy (except maybe the traders) says that interest rates are going higher.  Fair enough; in fact I agree with such an assessment, but the question is when.

When looking at this chart I am reminded of an old article Dave Rosenberg wrote noting that interest rates cycles tend to last 22 to 37 years.  Further, Japan showed even with an exploding monetary base, the yield on their 10-year bond remained low and inflation remained tame as the private sector deleveraged. 

So while I do think interest rates will rise at some point, they won't necessarily do so in the near future. As the above paragraph points out, it could take some time.  So buy long dated bonds?  Not necessarily; I still don’t think you get compensated for the risk.

Thus, I think the best strategy is to stay short enough so you don’t get killed if interest rates rise, but go longer than cash so you don’t miss out on the higher income an upward sloping yield curve brings.  In other words, stay hedged for either outcome.