Peak Ahead, But Not Just Yet
(Editor’s note: This article was originally written on 15 December).
In a somewhat long, scary piece on the re-hypothecation of gold bars, John Hathaway of Tocqueville Asset Management intones, “In the financial markets, a person that is one step ahead of the crowd is considered a genius, but two steps ahead, a crackpot.”
I do not claim to be a genius; I am just an investment manager who attempts to anticipate problems. There is a danger in this; my wife and driving companion urges me to forget the ways I learned to drive in New York City. For example, when the center traffic light on a broad Manhattan avenue is yellow, it is a command to speed up. Ruth stresses the danger in this approach, as other drivers perpendicular to my direction may anticipate the change in their light signal from red to green and jump out as my cautionary light is changing to red. The investment message is that we do not know for sure what will happen and thus we can not anticipate every turn of events. All that I can do is to fall back to my handicapping days at the local racetracks. I can assess the reasonable possibilities and probabilities versus the weight of money calculated odds derived from the parimutuel pools (where there are less track and government takes). With these thoughts in mind, I will list some of the positives and negatives looking forward for the next one to three years. (For those investors who properly view their investment horizons beyond five years, these discussions are less germane.)
Annual statistics — Jeff Tjornehoj from the Denver office of Lipper, Inc., now an affiliate of Thomson Reuters, has studied the history of the Dow Jones Industrial Average (DJIA) since 1896. His analysis shows that the year following a 20% gain produces an average 8% gain. In 18 years, nly two down years occurred after years of a 20% gain. Steve Leuthold’s group also noted that the DJIA in November reached an inflation-adjusted high that took 13 years and 11 months to accomplish. The S&P500 needs to reach an equivalent inflation-adjusted 2061, which is above the 2014 year-end estimate of ten leading market strategists according to Barron’s.
Valuations — We have been looking to add additional large-cap growth funds to client portfolios. In three cases of well-performing funds we have noticed that the current valuations based on their current measures have taken a significant gain in terms of price/earnings, price/book value, and price/sales ratios. In terms of P/E, comparing the three funds’ current vs. 2012 ratios results in the following numbers: 35.22x vs. 29.46x, 30.52x vs. 24.58x, and 33.52x vs. 27.36x. There is a logical explanation for this escalation. If we go back to the period of the former DJIA inflation-adjusted high some 14 years ago, we had 8,823 individual stocks listed on the principal US stock exchanges. At the end of November 2013 there were 4,916 listed stocks. With interest rates manipulated below their inflation-adjusted credit risks, it is not surprising that the money flowed into the equity market, creating the TINA impact (There Is No Alternative). Most of the almost four thousand missing companies did not go out of business; they were acquired by larger companies or taken private. (See more about the next logical development of this trend in the lists of negatives.)
Enthusiastic managers — On Saturday night, Ruth and I went to a wonderful Pops Concert at the New Jersey Symphony Orchestra featuring John Pizzarelli as well as the Salvation Army Band. Ruth is the very active co-chair of the NJSO. Our guest for the evening works for one of the most successful hedge funds, and he repeated his leader’s published bullishness about the outlook for more than the next year. I have read similar comments from three UK managers who are quoted as saying that the “outlook for equities has never been better.” A US small-cap manager has now a greater willingness to embrace risk. Part of this enthusiasm is based on the bear market–induced concentration of correlation. They all went down. Statistical correlation is becoming less binding and this is the phase when security selection should pay off. In a recent survey, analysts with CFAs were given the choice of what would produce the biggest performance for their funds; 47% voted for security selection with only 26% for asset allocation and only 12% for macro bets. This raises lots of questions as to the fad of running money through the use of exchange-traded funds (ETFs).
Destruction of capital from too much money — As an electronics, broadcasting, and aerospace analyst and eventually a multi-product conglomerate analyst, I was in a small department with an aluminum analyst. He was a profitable contrarian. The market got excited when the companies he followed brought more furnaces and mills on line. He recommended sales of these stocks and only recommended purchases when there was a pretty massive shutdown of facilities. He believed accurately that over time, when too much capital was committed to a market, it would lead to price wars. Price discipline was eventually restored when companies had to earn at least their cost of capital. A somewhat similar philosophy is espoused by a very successful London-based manager, Marathon Asset Management, that applies to numerous sectors globally. In the positive section above, I highlighted the substantial drop in the number of securities. As someone who has been both a buyer and a seller of companies as well as benefited from acquisitions of stocks that clients and I have owned, I suggest that most acquisitions lower the buyers’ long-term margins and return on invested capital. This factor plus the need of various private equity and venture capital funds to produce cash returns suggest to me that we will see at some point and perhaps soon an increase in the number of new issues. While at the moment many financial institutions and individual investors have excess cash, at some point the cash needed to take up these IPOs will come from sales of existing holdings. (This is a familiar pattern in a number of cash-short non-US markets.) While the new shares may rise in price, the shares sold will put pressure on the older position.
Perhaps a clearer example of a market that is absorbing too much capital and with a limited number of experienced players is the hedge fund market. This will be the fifth year that the aggregate number of hedge funds has underperformed the stock market. While there have been a number of very successful hedge funds, many funds — particularly some new entrants — have not been able to generate sufficient performance to get properly funded so that they can attract necessary talent, not only on the investment side, but also in administration, trading, compliance, investor relations, and sales.
Less enthusiastic managers — According to the British newspaper the Telegraph, BlackRock, the world’s largest investment manager, predicts the US rally is near exhaustion. Further, they are warning their clients to pull out of global markets at the first sign of trouble. BlackRock does believe, however, that there is a 25% chance of a “growth breakout.”
Other managers, particularly small-cap managers, have closed their funds to new money. Some of the more successful hedge funds are sending money back to their holders. (Understand the math: With less money and a proportionately greater percent owned by the managers, there is an improved chance of earning various performance fees.) In theory, all managers get paid on the total of the assets that they manage; doing anything that results in smaller inflows or a reduction in actual size of their funds is a near-term hit to their bottom line, but they may be preserving their good records.
Bond market worries — The first worry is that eventually we will see interest rates go up, which will push already outstanding bond prices down. This could start soon. Lower bond prices will lead to negative returns for bond funds, which will accelerate the outflow from bond funds. Switching bond fund investors to equity investors within the same investment complex may be difficult without figuring a way to compensate the distribution channel for the switch. The redemption proceeds can be new money for a different organization and its distributions channel.
The second worry focuses on the high-yield part of the market. The current yield spread between the high yield and the high quality parts of the market is historically quite narrow. There are a couple of concerns going forward. First, during the period of low interest rates and substantial flows into the high yield arena, some issuers may have loosened their financial disciplines; there may be an increase in defaults. The second concern is that we are entering a period where there will be an increased need to issue new debt as a way to pay off maturing debt.
The importance of these concerns to the equity market is that, directly or indirectly, any of the merger & acquisition activities require the sale of high-yield bonds to finance the equity deal.
“Brace for a 20% correction” This week’s Barron’s has an interview with Ned Davis and two of his leading associates under the headline, “Brace for a 20% Correction.” Ned Davis is a very well known and respected source of technical analysis. At the moment they remain positive, but they can foresee a 20% drop in the future.
My investment take
Unfortunately, too many so-called investors have short investment time horizons of a year or less. For these accounts I would begin to raise cash slowly, withdrawing a portion each month so that a 20–25% decline would not interfere with meeting short-term funding requirements. For the investor that has at least a five year time horizon, moving slowly into high quality stocks, particularly well-priced value and high quality bonds, makes sense. For my favorite investors, who look to a ten year or longer time horizon, I would be shortening my fixed-income maturity so as to have additional cash to invest for high quality growth with an understandable future.
Please share your thoughts with me; I hope to learn from you.
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