Will An Asset Class Bubble Similar to 2008 Housing Bubble Form?
There is slightly less concentration in this week’s commentary (last week we had a particular focus on the subject of MLPs) and much more diversification (covering topics from Greece, to debt, to the Fed, to interest rates, to valuations, to alternatives, to, well, you name it). If that doesn’t have you excited, nothing will. Because we have so much to cover we will go ahead and jump into it now. However, as you are reading through, please feel free to jot down comments or questions that the reading provokes. There is nothing we want more than for this commentary to grow your understanding of markets – and particularly your understanding of our investment worldview.
At least as of the time of this writing, markets have had a very positive week, and when combined with last the Friday before last have served as impressive bounce off the volatility of the last couple weeks (though a gap still exists between present market levels and the highs of mid-May). European markets joined the rally, as well. MLP distress continues, but not for their income flow. The only solution to global debt concerns is growth, and many of the most over-indebted are not going to achieve it. Fear of credit markets need not be default nor interest rate oriented. It can and should be liquidity oriented. One’s perspective on the bond market and where rates go must be connected to a timeline. Present Fed interest rate approach is hurting growth, not helping it. Growth-of-income (and just plain income) will be the investor need of the decade to come. Cash will not provide it. Neither will bonds.
What happened in the markets with Greece, with Europe, etc. last week?
Monday morning it was announced that European leaders had agreed to terms for a third bailout with Greece, returning the matter to the Greek parliament for sign-off. Markets rallied on the news. Tuesday continued a move higher and Wednesday stayed flat. Earnings season began to pick up steam going into the middle part of the week. We opened up Thursday with more upside in stocks, perhaps also led by the Greek Parliament’s (expected) acceptance of the latest iteration of Greek/Euro bailout terms. As we write this, it looks to be a strongly positive week in stocks, with bond yields modestly down on the week, as well. Even crude oil stubbornly stayed in the $52 range (up against a media frenzy that the Iran deal would flood the market with new supply, a mistaken notion as we address elsewhere). The European Central Bank fed some cash to the emergency fund and the Greek banks will soon reopen. Strong earnings were a big factor, too.
What are your thoughts on MLPs?
It is interesting to us that a couple of weeks ago we saw MLPs advance nearly 1% in one of the more volatile market weeks of the year, one in which interest rates went higher and oil prices went lower. This week we saw MLPs drop further despite more distribution increase announcements. One of the key areas to watch right now in terms of market sentiment around midstream MLPs is the price of natural gas liquids. The 12-month drop of 28% in ethane and 60% in propane is every bit of an impact player on sentiment (whether it is rational or not) as crude oil and natural gas prices.
When you look at the level of debt so much of the world faces, what do you think is the end play?
Our hope is for long-time readers to know our stated belief that growth and only growth can serve as a long-term solution. Mathematically, the present strategy being used in the most overly indebted of nations (Japan, for example) is currency depreciation. We believe there is limited (or no) longterm utility in that strategy, which basically amounts to taking growth from others – not creating it on one’s own – which then sparks a retaliation (hence, a currency war). There are transitory benefits in currency depreciation, but not material improvement. Long-term deleveraging and economics of growth are the need of the hour. Those require demographic advantages not present in many indebted countries.
As a bond investor, what do you think is currently the single greatest theme that warrants discussion outside of the Fed and interest rates?
There is no question – it is the feared and actual decrease in liquidity for credit bonds in the aftermath of Dodd-Frank. If you noticed that we’ve written about this already several times and now are mentioning it again, it is because you are right – and we’re just getting warmed up. We have credit markets largely working on the backs of a low-rate environment and a low default/low economic distress environment. There is ample and justifiable conversation right now what happens to liquidity should there be a run for the exits, as Dodd-Frank regulations have taken so many dealers out of this game. It is something we must be informed about and ready to act upon for the foreseeable future.
Why not just dump all bonds now?
The chorus of anti-bond hatred is the main reason, in terms of our contrarian commitments. But we also do have an underweight position, we don’t see the fear being imminent and we seek to maintain discipline as asset allocators. The key issue here is one we believe is constantly missed in commentaries about the bond market: Is one’s macroeconomic view on interest rates and forecast for bonds about the next quarter, year, or decade? It’s entirely possible that over 10 years, a 2.5% treasury ends up at 4%, but along the way hits 1.5%. It is also entirely possible that it ends at 2%, but along the way hits 4% (well, not super likely, but you get the idea). Forecasts about rates can only be applied to bond allocations in the context of a timeline.
So you don’t think bonds are generally overvalued?
We certainly do in a generic sense – locking one’s money up for 10 years for less than 2.5% is not a value proposition in our opinion – but there is more nuance to the discussion than that. Take the chart below, for example. On one hand, it clearly shows that bonds are currently in an expensive mode (i.e., dividing the 10-year treasury yield by 100 to create a “value” number). But something else from the “P/E” chart of bonds here grabs our attention: The variance of data! Treasuries “averaged” a 3.125% yield for the entire 1950s (32.1 “P/E”), but averaged 7.35% during the entire 1970s (where the figure is 13.6). Decade by decade, the results are prone to great dispersion as you can see. We determine value by discounting the expected return up against inflation and the risk of volatility. We see in this case the need to hold bonds, but the need to underweight those holdings.
Well, how do broad equity valuations look when comparing average P/Es decade by decade?
Do you fear a new bubble forming in some asset class like 2008 Housing or 2000 Dotcom?
It is important to distinguish between a debt bubble (a bubble formed by something with borrowed money) and an asset bubble (something that is just way overpriced). The Dotcom/Tech boom was a great example of an asset bubble – silly, unsustainable, fantasy-land valuations that popped. Who got hurt? Those who owned the assets in a bubble – that’s it. A debt bubble, though, like housing, was when something was very over-priced in value, and had been financed with debt. Then there are lots of people who get hurt – the people who own the underlying assets, the people who loaned the money, and the people who owned anything connected to the debtors or creditors (in other words, everyone). Because creditors get hurt in a debtfinanced bubble, they have to tighten their belts after the bubble bursts, meaning money isn’t available to fund other non-bubble projects either. It is what we call “systemic.”
Our defense against asset bubbles is to not buy them. No amount of client pressure could ever get us to buy nonsensical valuations like what we saw in Dotcom Land (and see in other certain sectors now). As bubbles grow and grow and grow, your risk as a money manager is that you look stupid not owning that growing asset price. When a bubble bursts, though, your risk if you do own it is that you can financially destroy people. Our philosophy on this is well-documented. There are currently certain areas of the market that strike us as being in a form of asset bubble, and we avoid those investments. As far as debt-financed potential bubbles, we believe China real estate has been in such for quite some time, but the more systemic risks would be more things like high yield bonds and, per the above paragraphs, we think there is time there to plot an exit.
So no bubble about to burst in the U.S. stock market and no recession on the horizon?
We are of the opinion that there is not a bubble in U.S. stocks, so 25-50% drops in the near future do not look likely. However, to read that as saying that a 5-15% drop could not happen at any time is to dramatically misread it. There does not need to be a bubble bursting to accelerate stock market volatility. So when a valuation bubble is not bursting, the only other historical cause of massive stock market drops are full-blown recessions, generally forecasted by a stock market decline. Economic data is slow, tepid, unimpressive, and inadequate – but it is not recessionary. It just isn’t. Yet. The dynamic we are watching is whether or not stock market problems could cause a recession, not merely forecast one. We do not believe there is precedent for such, but history is full of first-time events. For now, our monthly health check metrics look okay.
But stock valuations do look a bit stretched, right?
Across broad market indices, we think so, yes. But valuation is a terrible indicator of short-term market movements, and more a hugely important indicator of long-term investment results. We also have to look at valuation from a bottom-up stock perspective, not merely in the context of a broad market we do not own.
What’s the best contrarian indicator recently?
We talk all the time about the different metrics that indicate an excess on one side or the other when it comes to the markets. We fully concede that this bullish take we are about to offer is somewhat offset by the fact that margin debt is theoretically at its highest – which would be a bearish indicator for a client. (As stated in the past, there is ambiguity about whether or not the margin debt levels we see at highs has been used to buy more of the securities which collateralize the debt, or is just a replacement debt to other conventional forms of loans like auto loans and mortgages. That answer is key in knowing how to analyze margin levels.) But basically the point is this: If the present market is not about to experience a 2008 phenomenon, it would seem that this metric indicates a large, short-covering rally could ensue:
What country in Europe scares you the most in terms of “next shoe to drop” volatility?
We have written about the truly perilous situation in France, but if we were being sequential about the discussion, and have moved on from all of this headline noise in Greece, there is a dynamic in Italy that we must share with you. First, out of its four major political parties, it should be said that fully three of them categorically favor a Eurozone exit. It is simply the present electoral advantage of the one party that is pro-Eurozone that has kept this topic from generating more heat. Second, their economy has contracted 10 percentage points since 2008 and unemployment is highest now. Nonperforming loans are nearly 22% of their GDP. Collapsing bond yields from their massive QE and ECB intervention bought them time, but Italy is by no means out of the woods – quite the contrary.
Do you believe the proposed U.S. deal with Iran represents a potential further leg down in the price of oil (because this could free them to add another one million barrels of oil per day to global supply)?
We have far greater concerns about this Iran deal than that, we assure you. The fact of the matter is regardless of what happens with this U.S./Iran deal, we do not believe Iran has the production capacity to produce a million barrels per day, and some reports we are reading indicate they may not have 20% of that capacity! The more important current issue to follow is the 50% of daily oil production coming outside the U.S. and outside OPEC. This is where we expect production declines which, met with sustained and even increased demand, are likely to push oil prices higher.
What are the metrics that you think would cause the Fed to become more hawkish in their monetary policy?
(Vocabulary lesson: Just as “bullish” means “good for a market” and “bearish” means “bad for a market,” we use the terms “hawkish” to describe tighter money, higher rates, more constrictive monetary policy. We use “dovish” to mean easier money supply, lower rates, more loose monetary policy. The Bernanke and Yellen Feds can be said to have had a couple “hawks” on their board, but to have been ruled in the majority by “doves”.) We believe the Fed will stay quite dovish for some time. We do not say that because we want it to be the case. In our mind, ultimately, regardless of the short-term impact on market volatility, the sooner we can see normalization in rates the better, as markets benefit from price discovery, and ultimately entrepreneurs now are forced to deal with fear of future demand evaporation (because too much of it was brought forward by present low rates). The velocity of money is handcuffed by artificially low rates. With all that said, analyzing what we think will be and not what we want to be is the need of the hour. Our suspicion is that faster wage growth is needed before we will see real rate hikes. (A one-quarter point hike later this year or early next year is not what we mean. It is actual, material movement of the Fed Funds rate towards normalization we are talking about.) Hourly earnings growth is practically non-existent. The core consumption price deflator (their favorite measurement of inflation) is at 1.2%. We think it will need to be 2% before they care. Credibility – or the perception of credibility – is important to central bankers. We expect that macro concerns like Greece, the Puerto Rico, Europe at-large, U.S. dollar strength, and a yet-to-surface event provide enough cover for them to stay dovish longer than they otherwise would.
What do you see investors most needing in the decade to come?
As our friends at Miller-Howard reminded us, in their most recent quarterly commentary, that there are 10,000 boomers retiring every single day, and those people need income, not capital gains. Pensions and endowments and foundations live off income, not capital gains. When capital gains are clear, consistent, linear, and low volatility, investors can get away with substituting them for income, but at the end of the day, cash flow is the need of the hour. We hold this truth to be self-evident, by the way, and completely and utterly timeless – we are merely highlighting that it will be of particular focus in the decade to come for reasons of demographics, etc. And so with growing demand for income, our investment focus on those vehicles which can most reliably grow that income become very attractive. And the math of how growing dividends work in creating a phenomenal Yield-on-Original Investment (YOI) is well, totally mathematical. (We are working, by the way, at adding their YOI Calculator tool to our website, something we believe brilliantly illustrates this entire new perspective on investing.)
What’s the state of the floating rate bank loan market?
The asset class, which as you know makes up over 20% of our taxable fixed income allocation, had its first negative month in June since the end of 2014 (down 0.42% at the index level). This seemed to coincide with heavy outflows from the high yield bond asset class which pushed high yield spreads higher, basically indicating a slight “risk off” mood in the bond market. As an asset class, it still finished the first half of the year with nearly a 3% return (+2.83% to be exact), basically annualizing at +5.66% vs. a bond market slightly down on the year). We note that a negative .42% return in June actually still left it the best performing asset class for the month as treasuries, corporates, high yield, and emerging bonds all dropped over 1% on the month. Defaults were non-existent in the month of June.
QUOTE OF THE WEEK
“I would caution again that, at best, the economic forecasts and interest rate projections of the Federal Reserve Open Market Committee are ultimately pure guesses.”
— Richard Fisher (long-time Federal Reserve Governor)