Could a Drop in Real Estate Prices Lead to Another 2008?
Dear Valued Clients and Friends,
The main driver of markets this week was earnings results, which explains why some companies saw big increases to their stock prices, and others saw drops. The Thursday melt-up in markets was a by-product of really outstanding results from a few key companies (it looks like the Quarter Pounder is not dead yet), and Mario Draghi’s inference that further easing in Europe is coming. Divergent earnings results meant a wide dispersion of stock price movements. Some Dow leadership names dropped over 5% this week while many other leadership names advanced over 5%. A market moving in what we call that “Darwinian” way is our favorite kind of stock market. It is still too early to tell exactly how this earnings season will fully play out, and certainly to tell how the market will do for the rest of the quarter. What we know now is what we knew before we knew it (think that over twice) – the panic selling of August and September was punished in a meaningful way already. We say, “We knew it before we knew it.” because it would have been true even if this market rally of the last few weeks had not yet happened. For all investment decisions rooted in the deep emotions of fear, greed or the ill-advised, and are proven as such through time. It is to that end that we work – the avoidance of emotional investing. Beyond that, cerebral investing isn’t so easy itself. Let’s get into that, though, and look at what is on our minds at The Bahnsen Group this week in terms of markets and portfolios.
The very top question/answer below summarizes rationale behind some of this week’s actionable portfolio maneuvering. The chart of 1998, 2011, and 2015 (provided below) show a sort of creepy similarity. There is a lot of short-covering to go if shorts were to bring their position levels back to summer 2015 levels. Earnings season is playing out thus far as we might have expected: Some great results, some bad results, and an aggregate result that is not blowing anyone away, but not bad enough to sell off the market en masse. You can evaluate MLPs by a lot of different measures, but you won’t find any that do not reflect a compelling valuation at present levels. MLP creditworthiness is boosted by their untapped bank lines and lengthy average maturities on bond debt. Our skepticism of Europe’s economic potential is structural: We believe their monetary union without a fiscal union creates an unresolvable tension. The European Central Bank and their experiment with Quantitative Easing is another notch in the long belt of examples of central bank inability to create the inflation they say they want to create. Tax loss management is an important part of a portfolio management process (guiding principles provided below).
What would be a concise summary of the major portfolio activities undertaken this week after your trip to New York?
- A tax-loss swap on legacy MLP positions to new MLP positions both for enhanced dividend, tax benefits, and structural improvement in the MLP exposure and composition
- The elimination of positions whose liquidity and reliability concern us
- A de-risking of client bond portfolios across the board, with the addition of short-term treasuries (dry powder) and Ginnie Mae bonds
- A tactical increase in High Yield bond exposure given recent weakness
- Healthy rebalancing of all client portfolios back to targeted weightings of asset classes and specific securities
How do you think your earlier analogies of this summer’s market dive to 1998 and 2011 are playing out?
The most important thing I will say is that it is too early to tell. With that said, these charts may be of interest to you.
What do you think lingers as a potential market-moving catalyst? The shorts would have to buy $90 billion of stock right now just to bring short interest levels back to where they were before August. That doesn’t mean it will happen, but shorts tend to be programmatic as to where to take their losses (or gains), and we could very well see a further short covering rally just to see markets return to equilibrium.
Who else makes for a natural buyer of U.S. stocks besides short sellers who may need to buy to cover short positions?
We were quite surprised this week to read that total foreign ownership of U.S. stocks is only at 20%. We would expect this number to grow past 30% in the years ahead, as many more foreign investors look for opportunities that provide less geopolitical and currency risk, and a stronger economic backdrop. If a U.S. stock market is to stay in a bull market, it will be a shame if the greatest beneficiaries of that are non-U.S. investors.
Where do things stand so far in earnings season?
Thus far Q3 earnings season has looked like this: 73% of companies have beaten their earnings expectation (out of the 30% that have reported); it is early but we are tracking towards 2.4% earnings growth ex-energy on the quarter (-3.9% with energy). Top-line revenue estimates have only been beaten by 43% of companies so far. When the gap between earnings surprises and revenue surprises is so high, there is only one mathematical explanation: Margins continue to expand!
How badly have MLP earnings been hurt this year?
To our knowledge, we are unaware of any that have seen earnings decline year-over-year, or any (in the midstream space) that have had to revise earnings downwards for next year either. MLP prices went down, but not earnings, and not dividends. We generally look at MLP valuations in terms of their spread over treasuries, spread over corporate bonds, and price-to-distributable cash flow. By all measures, the valuations are extremely compelling at these levels.
Are you concerned about the credit worthiness of many MLP operators?
We took in a 75-page report from Barclays this week and were fascinated to read the following about the liquidity and debt metrics of the 20 largest names in the midstream MLP space. First of all, the weighted average maturity of their bonds is over 10 years out. Only $4 billion is set to mature across the space in the next 12 months. Additionally, Barclays noted that nearly $29 billion sits in the credit facilities of these companies untapped. Average leverage is barely 4x, below historical averages.
Why are you fundamentally so skeptical of Europe’s economic potential?
Their experiment with the Euro currency contains an inherent tension for which we see no resolution. There is a “European Union”, sure. But it has no authority and no ability to impose fiscal restraint or fiscal responsibility on its member countries. They may do as they please. But the tension is that each member country on the Euro currency is then tied to a currency for which no monetary levers exist to devalue (or otherwise pull things in the favor of a particular country). In other words, the interests of certain countries are at odds with others, but no fiscal or monetary compact exists to address this. This has been the source of much pain already, and we believe will be a long-term secular headwind for Europe for many years to come.
Do you believe the European Central Bank will continue to pursue a weaker Euro?
The ECB has been working for the same thing nearly every central bank on the planet has been working for over the last five + years: Staving off deflation. Their chosen means of doing so was to try to hold bond yields down (so member countries could pay their debts and continue to access debt markets), and to weaken their currency to essentially export as much deflation as possible. The tactic used to accomplish these policy goals: Quantitative Easing (the buying of bonds with money that doesn’t exist). Have they successfully weakened the Euro through this policy? Well, actually the Euro is up 8% against the dollar since their QE began, and 5% against a basket of other currencies. It turns out the ECB ended up fighting a market that now does not believe the Federal Reserve is as prone to tighten U.S. monetary policy as had been previously believed. On Thursday, policymakers met and essentially announced that they will ease further, and are likely to extend the time period that they perform this quantitative easing. The QE bet has never been one that was going to end easily.
We know you are bottom-up (company) focused when it comes to international markets, but tell us your top-down views right now on China,
Russia, Brazil, and Japan …
The primary issue China has to deal with in its efforts to (laudably) restructure its economy is that it is dealing with a credit bubble while it tries to do so. (A greater percentage of consumer activity and less dependence on production is a good thing, but the challenges are big when loan growth exceeds nominal GDP growth!) As for Russia, they remain devastated by low oil prices and the sanctions that their moves against Ukraine have created. They have more people in poverty per capita than any developed country on earth. Investment opportunity is low there not merely because of their challenged national economics, but because of the lack of rule of law. Brazil is a mess (looking at perhaps a 6% contraction this year, double that of the United States financial recession of 2008), but has several companies very attractively priced. Japan is what it is – there are certainly some great companies there which will continue to be great. From a macroeconomic standpoint, their “kitchen sink” approach towards fighting deflation is not working, and we don’t believe it will in the long run, either.
Did this week’s economic data out of China mean anything to us? We think it is important to take note of how much the narrative has changed in less than two months. The market was walloped in a very short period of time in August as we were told that China’s economic slowdown was worse than expected (fair enough) and this would lead to global contagion effects that would hurt the U.S. (theoretically fair enough). This caused a sell-off in U.S. stock markets, and that sell-off caused a bigger sell-off as a the tragic realities of emotional investing kicked in. Now, with stock markets off their lows but not back to their highs, how many are still talking about China slowdown/contagion risk as the headwind for U.S. equity markets? Not many! The narrative has changed to fears over earnings growth and uncertainty around the Fed (both reasonable narratives, in our view). The China Q3 GDP number came in at +6.9% this week, so below a 7% growth rate, but still the envy of the developed and emerging world. The consensus was 6.9%, and China is known as the great data manipulator, so take it with a grain of salt. Regardless, it has not yet hit the point of “hard landing”, and we remain firm in our contention that should it get there (we suspect it will), China has a literal bazooka of monetary stimulus it can and will deploy.
Were a lot of your bond changes recently driven by fears of a liquidity crunch?
Yes and no. We are very confident a “liquidity crunch” is coming in a lot of credit markets, where managers have to take lower prices to sell certain bonds because inadequate liquidity exists in the market (insufficient amount of buyers). We slightly lowered our floating rate bank loan allocation around this concern and dramatically lowered bond ETF and corporate bond exposure. However, we increased High Yield bond exposure, a sector that is certainly exposed to liquidity concerns during times of distress. The reality is that we do not think we can time this, and we do not think it is imminent. The liquidity concerns center primarily on regulatory issues post-Dodd Frank (there are now way, way fewer dealers). But the other issue is the fact that more “panic prone” investors have come into credit markets in recent years as they attempted to find higher yields in the face of a zero-interest-rate policy. These investors are the ones most likely to run for the exits in times of distress. We think some sectors are less exposed to this than others, hence our increased allocation to securitized credit. The more diversified we can be, the better. And from a valuation standpoint, we are prudently watching our High Yield position! The recent increase in High Yield goes against the crowd, not with it.
Why has the U.S dollar been declining the last six weeks?
We sarcastically want to say, “because everyone else predicted the opposite,” and that is actually what we contrarians believe, but it wouldn’t be a helpful fundamental answer. Besides the fact that crowded trades generally do reverse, the reality is that global growth prospects likely had most of their pessimism baked in, which forms a bottom around other currency depreciation (or dollar appreciation). Additionally, the idea of the Fed being the first central bank to step up and begin tightening monetary policy is looking less and less likely. Ultimately, an end to the escalating dollar (let alone a reversal) is bullish for Energy and Materials.
Do you believe we face a crash like we saw in 2008 if real estate prices were to drop?
We do believe that a lot of real estate pockets are substantially overvalued, but we do not feel the housing bubble was what caused 2008. The 2008 crisis was the result of a credit bubble implosion where the cartoonishly overpriced real estate blew up for the lenders, and the lenders had leveraged up their own balance sheets with the toxic real estate and notes linked to the
real estate over and over and over. That financial leverage was the basis of the 2008 crisis. The housing market may be overheated but it is not in the same category as 2005-2007. If housing were to fall off, it would be the borrower holding the bag this time – not the lender.
Is it really your contention that market drops like what we had this summer are “normal”?
Let’s get into market volatility’s history, as I think it is a very important topic.
This summer’s drop was not “normal” in recent years, meaning that 2012, ‘13, and ‘14 had not one … However, as a matter of history, we had 53 drops of 10% or more since World War II ended (almost one per year – not quite). Once every three years the drop has exceeded 15%. Once every six years it has exceeded 20% (that is 12 “bear market” declines since 1946). The mother of all post-WWII bear markets was the 2008-09 drop, and our contention remains that that pain and phobia is very much real in the minds and emotions of investors.
What do you see as a prudent policy around taxable capital gain management etc.?
- We frequently rebalance just to “trim” positions back to “target allocation”, realizing tiny gains year by year instead of huge gains at once (as a general rule).
- When large gains are realized because of valuation or risk or circumstances, we nearly always have other losses in the portfolio to use to offset those to some degree (as a general rule).
- We believe in harvesting losses whenever possible as long as investment theses are not remotely compromised.
- While tax efficiency is important, the tax tail can never wag the investment dog.
Quote of the Week
“There is a very precise technical term in advanced capital markets theory which is used to describe such an exquisitely rare confluence of events.
That term is: ‘A Buy Signal From God’.”
– Nick Murray
We will leave it there for the week. Please do reach out with any questions or comments. I am off to Los Angeles now (Torrance, to be precise) where I will be speaking to hundreds of people who are all attending a three-day conference on the work of my late father, who was a renowned philosopher, theologian, and public intellectual. He passed away 20 years ago this December, and while this conference is happening to stew over his contributions to such topics as epistemology and ethics, I will be giving the keynote address on him as a person – the man who was my dad. I am looking forward to it. I really cannot believe it has been 20 years since he passed, but I can assure you I carry him with me every single day. Most people do not get to grow up with someone as smart as my dad, but beyond his incredible skills as an academic, he was a truly warm and magnetic person and father. We’ll see if I can’t capture that for a bunch of people looking to hear about his doctoral dissertation and so forth. (If you think my commentary is hard to read sometimes, try reading dad’s dissertation on a conditional resolution of the apparent paradox of self-deception – just for starters J). Okay, I will leave you alone now. Enjoy your weekends. Fight on, Trojans (of which my dad was one of the best).
Originally posted on High Tower Advisors.