The Truth About Market Corrections
My top points of the week, noted with an asterisk (*).
1) The legitimacy of this lengthy and powerful bull market in stocks has been doubted and disrespected by many professional pundits who have been bothered by the Federal Reserve’s role in distorting risk assets, and by professional pundits who have failed to appreciate the disconnect between an economy and an equity market.
2) This powerful bull market has also been missed by many individual investors who were burned by two bubbles which burst in the decade preceding this rally. Investors are emotional.
3) Market drops greater than 20% are historically caused by recessions and by valuations gone crazy. Market drops greater than 5% can be caused by sitcoms getting cancelled. In other words, they blow around and come and go like dust in the wind and are of no consequence to investors who behave themselves.
4) A market analyst, strategist, or economist who ends up getting a conclusion wrong is not of great concern to me. No one in our business calls everything right. My criticism of the 2014 Europe bulls only applies to those whose conclusions came about as a result of a flawed premise – namely, the troubling presupposition that the European Central Bank was orchestrating a structural repair to what ailed them.
5) Management either believes that the free cash flow1 of a company belongs to the shareholders, under the stewardship of management, or they believe that it belongs to management. If the latter, they cannot be considered a pro-dividend culture. I favor companies for my dividend stock portfolio that philosophically view the shareholder as the rightful owner of free cash flow a company generates, and then from there make prudent business decisions about that cash flow.
Why do you believe this stock market rally has been so “disrespected”?
Before I answer, let me clarify what the question is addressing. It is no secret that we are over five years into a stock market rally that began at the depths of the financial crisis, with the market bottoming in March of 2009 and increasing 250%-300% since then (depending on which broad market index you are using). Since that time there have been over 20 times that the market dropped by 5% or more, and even one time with a 20% drop (summer/fall 2011), though since that time period there has not been a 10% drop. Earnings in the market have skyrocketed up each and every year of this five+ year recovery, and consequently multiples (price/earnings ratios) have increased as well (currently sitting around 17x). Throughout the course of this textbook bull market, there has never ceased to be a chorus of professional doubters, and a lack of “mom and pop” investor buy-in. Put differently, many individual investors have missed out, and many skeptics have been forced to defend their skepticism at increasingly higher levels in market prices. The question was, “Why have there been so many skeptics?”
* And what is the answer to that? At some point after the financial crisis with the market exhibiting this kind of resilience and strength, why wouldn’t at least the smart folks admit we were in a bull market?
I think the answer has to delineate between the professional doubter crowd and the individual investor crowd. Who I am not including in the answer is the “perma-bear” crowd (largely writers of Internet newsletters). That crowd lacks the legitimacy to be included in this, and frankly by being bearish over the last five years is not doing anything different than they have done the last 50 years. (Not to mention, they will not do anything different next time there is a market correction. They will take credit for predicting a 10% drop, 300% later. Remember the old adage: “Perma bears predicted all 20 of the last 3 market corrections.” But I digress … )
The reason many rational market analysts have been skeptical throughout this bull market is likely different than the reason many individual investors have. I believe a lot of market pundits have been tainted by Federal Reserve participation in monetary markets, and unable to fully buy in to the earnings growth that was taking place knowing so much of what was happening beneath the hood was colored by zero-interest-rate-policy and quantitative easing. I also believe that a few key principles were really forgotten by market skeptics throughout this bull market –the most important of which was that capital has to go somewhere. Skeptics saw certain problems in the U.S. and were unable to come to terms with the even greater problems that existed in the usual lot of options for capital allocation (China, Europe, Japan, the bond market, etc.). Real life capital cannot be hidden under a proverbial mattress, and the U.S. equity markets have been the best girl to dance with at the dance, despite certain apprehensions. These key principles have been missed by many professional doubters.
* What is another key principle that you believe professional doubters have missed?
Nearly all skepticism of this stock market rally has been rooted in a skepticism of the broad economy. But there is no longer an excuse for those of us who do this for a living to fall for the trap of believing the economy and the stock market are tightly correlated. They simply are not; they never have been. The raw data shows that sometimes an entire decade or more goes by in various regions (the U.S. included) where an economy could be growing rapidly with its stock market in the doldrums, or vice versa. Stock prices are discounting any number of moving parts pertaining to earnings of individual companies; macroeconomic data is capturing backward-looking metrics on the labor markets and GDP growth that stock prices have already discounted into how it affects certain companies. It seems to me that many in the professional class either disagree with the conclusion that markets and economies can go long periods of time with very low correlation to one another, or they have failed to apply that truism to their analysis in recent years.
* What about individual investors?
I am not sure if the “retail” investing public will be coming back into this stock market. The perverse euphoria and excess that led them into the tech boom of the late 1990s resulted in tears. For many, the financial crisis of 2008 was just too much to bear in a single decade. When professional advice does not steer you clear of two bubble manias, it is hard to imagine professional advice being effective at bringing you back in for the buying opportunity of a lifetime. Now, the problem is exacerbated because so many feel that they just plain missed it (and indeed, so much of the easy recovery money was missed, a huge reason why I decry the folly of market timing). Younger investors are dealing with student loans and increasingly difficult requirements to purchase a home. The 401(k) market keeps a lot of people modestly exposed to the stock market but even in that case there is a woefully inadequate amount of cogent advice available. Individual investors will always hate the pain of a market crash more than they love the gains of a market rally. For many, the 2008 crisis was their surrender. Only a select group have and will continue to proceed through this journey with a sensible process and appropriate strategy for dealing with risk/reward propositions. I view the delivery of that last sentence as my calling here on earth.
With Q2 earnings season now basically complete, can you summarize your major takeaways?
As evidenced by stock market prices, particularly with this rebound after the geopolitical noise of a few weeks ago, it was a robust earnings quarter with a lot of positive data embedded in it. Revenues themselves grew about 5% year-over-year (2),which is exactly the metric I have been writing would be necessary to see earnings growth continue. Margins themselves expanded (yet another historical high), driven largely by the high-margin sector of technology (2).Ten percent earnings growth for the quarter (over last year’s second quarter) is the by-product of this revenue growth and margin expansion (3).Management’s guidance into the remainder of 2014 has been “less negative than usual” (2),giving analysts confidence that the earnings results needed to create more P/E expansion or just plain old-fashioned earnings growth could very well materialize.
Do you believe that the tapering of quantitative easing has muted equity market performance this year?
No. Tapering was announced well over a year ago (15 months, to be precise). It began nearly a year ago (10 months, to be precise). Markets have rallied nearly this entire time. Markets had ample time to discount what was and was not happening as it pertained to the Fed’s bond-buying programs. I do believe a big (and surprising) removal of liquidity from the system would rattle much of world markets, but that is not what has happened. It takes a surprise to make an impact; not the mere implementation of what has been completely announced and forecasted.
* What causes 20%+ market drops?
Primarily economic recessions, but secondarily the bursting of excessive valuation bubbles. We have had 16 drops of 20% or more over the last 85 years. All of them were either recession-oriented (75% of the time) or valuation-oriented (25% of the time) (3).
* What causes 5%+ market drops?
Sentiment. Investor behavior. Market noise, Run-of-the-mill volatility. Etc.
Do you make any attempt to avoid 5% drops?
Do you make any attempt to avoid 20% drops?
I make an attempt to mitigate the effects of them through wise tactical asset allocations and valuation-sensitive decisions in how I strategically allocate client capital.
You seem really critical of those who have been bullish on European equities this year?
You know what? I re-read last week’s commentary where I talked a lot about the problems in European equity markets, and I do NOT want to give the impression that I am critical of those who were optimistic about Europe’s stock markets this year just because they have (thus far) failed to perform well. Our business is a business of making forecasts that will often not turn out as planned. That is NOT something of which I am critical. But a clarification is in order here. If one guy says X will do well this year and another guy believes it will not, that just sort of is what it is. One will be right or sort of right, and one will be wrong or sort of wrong. BUT, if someone says X will do well, BECAUSE of a recovery brought about by Mario Draghi, bond-buying, European Central Bank activities, etc. – in other words, if one’s basis for their forecast is the belief that fundamental economic recovery was forthcoming BECAUSE of Central Bank activity, and then the economic recovery does not come, and then the stock market moves do not come – I do then have a reason to be politely critical. One thing I want my clients to know is that there are systems of thought and investment and economic worldviews at play when folks formulate various outlooks and forecasts. I take those presuppositions very seriously and feel it my duty to discern which ones are cogent (from my perspective) and which ones are not when making investment decisions for my clients.
So, in this case, what was the flaw in thinking that you were concerned about when it comes to Europe?
Believing that the Central Bank of Europe may manipulate a move up in European stocks is an acceptable belief whether or not it pans out. And believing that Europe has bottomed out in the economic cycle and now faces stock market improvement as their economy enters a positive part of the cycle is an acceptable belief whether or not it pans out. BUT, believing that the actions of the Central Bank over the last 24 months were, in and of themselves, the sufficient resolution to the structural problems of the European economy, and therefore the beginning of the cyclical recovery, is a deeply flawed viewpoint (from my perspective). Advocates of this school of thought also believe that the only problems Europe ever faced were because their Central Bank did not do more to begin with to paper over their debt crisis. I honestly do not mind different conclusions on a wide variety of investment decisions, but in this case it was the PREMISE(S) that bothered me. There is a REAL situation in Europe going on and there has been for quite some time. Fundamental economic recovery has not been and is not now part of their landscape – and certainly not as a result of Central Bank activity.
* Explain more of what you mean about a company’s culture either being pro-dividend or not?
Management either believes the free cash flow of the company belongs to the shareholders, or they believe it belongs to the company. No intelligent shareholder would ever want ALL of the free cash flow given to him or her as shareholder; every shareholder is totally incentivized to want the company to have the resources it needs to grow, innovate, produce, and create. But when management fundamentally believes that a return of cash to shareholders is a privilege – a favor the company does rather than the return of cash that belongs to the shareholder – I believe the culture is likely not in the dividend-friendly paradigm I want to see.
Can you explain to us the basic approach you are taking in your bond portfolios right now? You seem to have a strategy very much outside the norm of traditional bond investments.
It is certainly true that my bond allocations are currently uniquely positioned. I will start with the macro: I am rather significantly underweight overall bond allocations right now. Where I might traditionally have a 35% weighting to bonds, I presently have 28%. As a general rule, I am probably 20% underweight bonds relative to where I may consider a “normalized” weighting to be. (This would then manifest itself differently for each and every client.) Now, what the question deals with is not so much my total weighting to bonds, but what I am doing differently within the bond allocations I do have. Typically, a traditional bond portfolio is really exposed to the opportunity of declining interest rates (as it causes bond prices to rise). Treasury bonds are the best example of something very related to interest rates (and virtually nothing else). I have tweaked my bond allocations to have very little exposure to interest rate movements, instead relying on non-traditional fixed income strategies such as Floating Rate (see below) and Unconstrained/flexible (where managers are working outside of normal benchmark constraints to try and protect to some degree and against duration risk).
My municipal bond holdings certainly still carry traditional interest rate risk. I believe my Global Bond holdings do as well. I have very modest return expectations across my bond holdings (2-5% per annum at the moment), and I do fear that my bond strategies may end up exhibiting higher correlations to equity markets than I want. (One of the major points of bond and stock co-existence in a portfolio is to reduce correlation.) I maintain risk in my bond allocations, but hopefully have diversified those risks away from mere interest rate risk, and instead am taking on manager risk (how good will my managers prove to be?); credit risk (are the individual credits we are buying going to perform?); and correlation risk (am I actually diversifying my bond weightings against other parts of our portfolio?).
What’s the monthly update in the Floating Rate asset class?
July was an interesting month for bank loans because “retail” investors continued pulling money out ($8.1 billion has left in the last four months) and yet CLO (collateralized loan obligation) issuance in that same period is over $50 billion (1), meaning liquidity has remained quite robust. I am always concerned when I talk about things like floating rate bank loans I lose a lot of you but I have to say that this whole subject is a very important part of my fixed income management, and fixed income is a very important part of ANY investor’s overall portfolio. But a basically flat return in July despite significant late month equity market and geopolitical volatility is a good sign.
What did you read this week that gave you pause about inflationary pressures and realities?
One of the great arguments the Fed and others have used to posit that inflation is not yet a concern is the lack of WAGE inflation. I certainly would be a proponent of the idea that there is not likely real inflation in the economy when there is not wage inflation. However, I read a report this week from the always thought-provoking James Paulsen (4) which informed me that the U.S. Bureau of Labor changed its metric for analyzing wage growth in 2010. For 50 years the metric used what was called “nonsupervisory” wages, but in 2010 began including both. As Paulsen argues, and I agree, this methodology change may very well be an improvement – I have no reason to believe it is not. However, the older methodology using only nonsupervisory wages has grown from 1.3% annual wage inflation to 2.3% in just the last year and a half. I need to digest this a bit more but I really do intend to be vigilant about understanding when I believe the low inflation narrative is changing, as it will have profound effects on monetary policy expectations, etc.
Free Cash Flow
A financial performance measure for businesses calculated by taking operating cash flow minus capital expenditures. It’s an important determinant of a company’s credit ratings and stock price value. This is cash a company can use to pursue opportunities that enhance shareholder value. The cash can be used to develop new products, make strategic acquisitions, pay off debt, buy back stocks, and – a key focus at The Bahnsen Group – pay dividends to shareholders.
QUOTE OF THE WEEK
“ Life is a long lesson in humility.”
– James M. Barrie