Month: January 2019

An interesting debate in the world of finance is what drives markets? Some say fundamentals and some say liquidity.

This is a relatively advanced topic, but let’s dive in. Fundamentals are the characteristics of the securities within the markets. These characteristics for example could be PE ratios, which can be used to suggest valuation relative to other markets and historical precedent. The idea is that if stocks are cheap, then they will go up and vice versa. On the other hand of the debate is liquidity. Liquidity is like the Brita filter in your kitchen and everyone’s cups are different markets. If the Brita filter has water in it, then markets can rise.

The tough question for me has been defining and quantifying liquidity beyond that abstract definition. The first definition you learn on liquidity is the ease at which you can get in and out of a market. Essentially, this is the idea that there is another buyer when you want to sell. If there is no next buyer, then the market price for the asset will go down to create a buyer.

The original question devolves to what causes markets to have a next buyer so that prices do not descend in search of the next buyer? Is it fundamentals or liquidity?

The question I propose to the audience is when fundamentals no longer support stock prices, how can fundamentals continue to drive markets higher? This is where I believe the debate takes a decisive turn. I believe both stances are correct under specific market conditions. If liquidity is overabundant, then I believe that liquidity overpowers fundamentals and drives markets. If liquidity is not filling everyone’s cups, then I believe fundamentals drive markets. There are nuances to this, but this is the main point.

I will now use this mental framework to discuss current market conditions. Being a fan of mean reversion and a skeptic of “this time is different,” I will use the Shiller PE ratio to discuss fundamentals. The fundamentals show us that the Shiller PE ratio is at its third highest level, which suggests third highest level of overvaluation in history. For you to believe that fundamentals drive markets you would have to believe that earnings will move up in order to compress PE ratios to normal levels. I have created a graph of S&P 500 earnings by year since 1950 in blue with a moving average line in orange. This graph is particularly interesting because it suggests that over time earnings revert to the mean. Earnings are currently at all time highs, so for fundamentals to drive markets it means you place a higher likelihood on further record earnings than the eventual reversion to the mean that has happened time and time again.

So where does liquidity come from? The main source is the central banks. Quantitative easing is a complex term, but it really just means central bank asset purchases. This means that the central bank enters the markets, buys assets, and electronically creates currency to give to the previous owner of the asset. This expands the money supply. We operate under a system called fractional reserve banking. The reserve requirement is 10%. This means that when a bank eventually receives this new liquid currency, they have the ability to lend 90% of it out. This 90% eventually finds itself in another bank that can lend out 81% of it and so on. What you need to understand is the vast power global quantitative easing has on supporting and boosting asset prices like stocks.

Below, you will find a chart of quantitative easing since 2003 by the Fed (US central bank), ECB (European Central Bank), BOJ (Bank of Japan), and China. Further below, I have created a chart of the S&P 500 that highlights, to the best of visual ability, time periods where global QE went from extremes to near zero. You can see that markets struggled in these time periods until Global QE returned.

So do fundamentals or liquidity drive markets? I think prior to 2006, I would have said fundamentals. Since 2008 though, we have entered the global quantitative easing experiment, and it is tough to dismiss the power of liquidity.

People are way to quick to assume that cash is an enormous mistake of a position in a portfolio. I am about to have a fun time debunking this one as it is complete and utter conventional wisdom nonsense. It may have been a tad more difficult to make this argument a couple years ago, but now many money market funds are returning over 2%, and the old saying Cash is King is being remembered.

The time for cash to be a prominent portfolio position is specific. Cash is not always King, but when valuations are at extremes, it is a wise position. The term “extremes” is subjective, but I will let you be the judge. Below you will find a chart of the Shiller PE ratio. The Shiller PE ratio is a special kind of PE ratio. First, a PE ratio is a price to earnings ratio. It is a valuation metric, and it tells you the multiple that each share of stock costs in relation to earnings. The significance is that if a company makes $1/share and you pay $50 for the share, then the company is priced at 50x earnings. Earnings can be volatile so PEs can be subject to short term volatility that should not affect the valuation of the company, but due to the way the PE ratio is calculated it may unfairly signal that a company is overvalued or undervalued. The beauty of the Shiller PE ratio is that instead of just using recent earnings, it uses the average earnings of the past 10 years in the denominator. This smooths out the ratio from any arguably insignificant volatility. The current Shiller PE ratio resides at levels only seen around the time of the 1929 stock market crash, which preceded the Great Depression, and the dot-com bust of 2000. Also, note that before the prior selloff the Shiller PE ratio for this cycle was higher than that of the 1929 cycle peak making it by historic Shiller PE ratio standards the second most overvalued stock market in US history.

The focus of this post is not how such irrational company valuations occur, but what they signify. Ever hear of buy low sell high? Well simplistically, this could serve as a guide for a novice investor. As one can see when stocks are overvalued, they are due for correction. Let me provide you with some downside risk reference. Peak to trough, the crash of 1929 cost investors in the Dow Jones Industrial Average 89%. Peak to trough, the dot-com bust of 2000 cost investors in the Dow Jones Industrial Average 34%, but more relevant is what was lost in the Nasdaq 100. The Nasdaq 100 is a composite of the 100 largest tech companies in the US, and this index lost 81%.

I am not saying that because valuations are on par with these past disasters that north of 80% losses are in the cards. What I am saying though is that the market is just like a casino, and if you do not step away from the table when you still have chips, then those past “gains” may be nothing but a memory.

Let us now consider the naysayers. They will say things along the lines of look at all the gains that you are missing out on as overvaluation extends into even more ridiculous territory. They may ask you, “When will you get back in the market?” I would propose the question, “When will you get out?”

I do not anticipate a continuation of this trend, but it is certainly noteworthy that cash was even the best performing asset in 2018 per the above figure.

So in holding an allocation towards cash, not only will you be relatively defended versus adverse market conditions, but you will even be compensated for it. Let us not forget the last benefit. When stock markets crash, investor sentiment tends to sway to a state of over panic, which creates fire sales.

Warren Buffett famously said, “Be fearful when others are greedy and greedy when others are fearful.”

You cannot take advantage of the fire sales and the fear unless you have dry gun powder (cash) at the ready. It should come as no surprise in such cyclical times that the legend is preparing.

At the beginning of 2018, Buffett and Berkshire Hathaway sat on $116 billion in reserve. This cash is crisis ready. In line with what the Shiller PE ratio was telling us, Buffet has yet to see value opportunities arise. The difficulty with cash is that people will constantly tell you that you are a fool for holding it. I presume that Buffett made a few mistakes during the year due to shareholder pressure, but nevertheless he still has over $100 billion in reserves, and is ready for what may be coming based on history.

Many pundits often say something along the lines that the bond market is 6 months ahead of the equity market. I would like to examine why this can be the case and examine some current events that are occurring that may be signaling such a concept.

I would like to try to break this down in simple terms. Bond yields are the compensation an investor receives for lending money. There are a variety of risks that push up interest rates such as inflation risk, exchange rate risk, and liquidity risk, but for the purposes of this post we will focus on default risk. Other listed risks equal, bond yields are primarily based on default risk. One thing many people get confused with is the relationship between price and yield (interest rate). They move in opposite direction because when a bond is less intrinsically valued (demanded), then the yield must adjust higher in order to compensate the investor for the lower perceived intrinsic value. The idea here is if all risks among bonds are equal except for default risk, then bonds of entities with higher default risk will need to offer higher yields in order to attract buyers.

With some basics now out of the way, let us attempt to perform some application to today’s markets. Below you will find a chart showing corporate debt to GDP over time. Knowing that GDP is constantly growing in the long term, and seeing that corporate debt as a percentage of GDP is at all time highs, we can conclude that corporate debt is at all time highs.

Below you will find a chart showing that nearly half of investment-grade bonds are rated BBB. Bonds are either investment-grade or junk in the most general of ratings. So what does that mean? BBB signifies lower medium grade within the investment grade market. This is the lowest grade within the investment grade section. Many funds buy these bonds simply because their mandate forces them to buy any investment grade bonds. The issue is that if these bonds were to downgrade, then those particular funds would be forced to sell to comply with their investment policy. If those funds were to cease buying these bonds due to a downgrade, then yields would surely rise due to less demand for those bonds and the admittance of the rating agencies that these bonds are at more default risk than their prior BBB rating would have portrayed. Holders of BBB bonds would lose due to having to take any price in order to get out of the downgraded position, investors in company stock of those downgraded BBB bonds would lose due to increased borrowing costs eating in to future earnings, and the junk bond market would get hit with over supply.

So one question to ask is how accurate are the ratings? Jeffrey Gundlach is known as the “Bond King” on Wall Street. He spoke last night and said that “By historic standards 62% of BBB rated bonds should be considered junk status right now but are not.”

So what? There will come a time when the rating agencies have no other choice, but to downgrade some of these “BBB” bonds. This could simply be due to the fact that over the past few years interest rates have been steadily climbing, but more importantly than the climb is the percent change in the climb. Companies will eventually have debt coming due, which was previously locked in at much lower rates, and when that occurs companies that over-binged on cheap credit for the past decade will be in for a rude awakening when they have to refinance at higher rates. Below you will find that this time called “eventually” is now. Through 2022, the amount of debt coming due to many S&P 500 companies will be rising year over year. In a rising interest rate environment, this is a no bueno situation keeping the above logic in mind. One last note is to consider all the companies that are likely on the brink of downgrade based on Gundlach’s comment…do you really think that they will remain investment grade if an inevitable recession were to occur?

The below situation of PG&E being downgraded due to liability from the California fires is entertaining to mull over. My takeaway is that rating agencies will not issue downgrades until it would become obscene if they did not. The point is that when recession eventually hits profitability of debt-riddled companies, then ratings will finally come down.

Let’s imagine that a glut of BBB bonds hit the junk bond market via downgrade. Since, there is only so much demand for junk bonds, then all things equal junk bond yields will have to rise in order to absorb the larger supply. Below you will see that junk bond yields began a significant rise back in September. One way to read that is to presume that such a glut of future junk bonds hitting the market is beginning to be priced into the junk bond market. Therefore, junk bond investors are preparing themselves for such an event. Also, Lisa Abramowicz is on the mark here as she speaks to the volatility growing within the junk bond space, which means a diminishing amount of liquidity due to junk bond investors being more apt to stay on the sideline during this uncertainty.

In conclusion, I think it is possible that the junk bond market is pricing in recession based on the over 50% rise in junk bond yields since September. I will continue to watch how things develop and keep you updated as best I can.