Diversify At Your Own Risk

 

In “What Me Worry” we noted that the closely watched equity volatility index (VIX) was at a level of investor complacency rarely seen, not only in election years but over decades of market history. We also mentioned anxiety surrounding the upcoming election is palpable, and that equity valuations are at rarefied levels without supporting earnings and economic data. Given these factors we ended the article with the following: “The market, courtesy of complacent investors, is offering very cheap insurance for an event that has the potential to induce extreme volatility via VIX options and futures. Even if the next eleven weeks leading to the election prove to be uneventful, the VIX at current levels, as shown earlier, has been a prudent place to own protection. We recommend you consider this opportunity as a protective measure”.
Unfortunately, most professional investment managers are not adept and/or able to trade VIX futures, options or volatility in other forms to hedge their client’s equity positions. More often than not, concerned managers will instead reduce perceived risk by selling a portion of their equity holdings and increasing cash positions and/or shifting portfolio allocations from equities to fixed income. It is in this vain that we discuss how the latter option, shifting money from equities to fixed income, has risks that were not as evident during the 2000 tech crash and the 2008 financial crisis.
MPT
Harry Markowitz developed the Modern Portfolio Theory (MPT) in the 1950’s. Simply put his theory argues that portfolio risk can be reduced by holding combinations of different securities and asset classes that are not positively correlated. We agree with the theory that there are benefits to diversification but we do not subscribe to MPT. Diversification makes sense when you buy uncorrelated assets that are undervalued. Buying assets for the sake of diversification without regard for valuation is fraught with risk regardless of how many different securities and asset classes one may hold. In the words of Warren Buffett “diversification is a protection against ignorance. It makes very little sense for those that know what they are doing”. To paraphrase Warren Buffet, diversification is for those that do not know what they are doing.
The truth of the matter is that blind diversification does not work simply because it does not take into account the effects of volatility on asset prices. Chris Cole from Artemis Capital, one of the clearest thinkers on the importance of volatility as an asset class, highlights this point in the following graphic.

cole

Graph Courtesy: Artemis Capital

Contrasting the perception of a well-diversified portfolio with the reality of embedded volatility, the graph reflects enormous concentration risk in short volatility. Importantly, this risk matters most at the exact point in time when one expects – hopes – their strategy of diversification will protect them. Unfortunately, the well-diversified portfolio (left side) turns in to the short volatility-concentrated portfolio in periods of extreme market disruption. Mr. Cole’s analysis may be best summarized with the popular statement that correlations on many assets go to one during a crisis.
Without regard for Mr. Buffett’s or Mr. Cole’s perspectives, many investment managers tend to hold “diversified” portfolios of stocks and bonds in various forms and strongly believe that such diversification will protect their portfolios in the event of a serious market correction. Unfortunately, many investors are not basing this diversification strategy on a fundamental analysis of bonds but largely on a blind assumption that bond prices will rise – yields will fall – in the event of trouble in the equity market.
Bonds
Sovereign bond markets around the world are trading at their lowest yields in decades and in some instances, including in the United States, in centuries. In fact there are approximately $13 trillion worth of global bonds that have negative yields.
Bond investors today are faced with a unique problem resulting from these low yields. The potential for price increases versus price decreases is grossly asymmetric. In other words there is a lot more money to lose in bonds than can be made. To illustrate this consider a ten-year U.S. Treasury note maturing in August 2026, with a coupon of 1.50% annually, a price of 99.25 and a yield of 1.58%. The chart below shows a range of potential one-year total returns for various yield levels in the ten-year note described above. As a frame of reference the average yield during the 2008 crisis was 3.43%. If the yield on the current 10-year note were to rise to that level in a year an investor would suffer a loss of 14%.
Ten-Year Treasury Note Return Outcomes

yields
Data Courtesy: Bloomberg

Bond Upside
With the poor risk/reward skew in mind we turn back to the idea of using bonds to hedge against an equity market correction. If such a strategy is going to work, bond yields must fall further into record territory. Can this happen? We do not have the answer, nor does anyone else. Yields have already dropped well beyond the point that most professionals thought possible and given the potential for a deflationary economic recession, they may decline further. Additionally, the Federal Reserve will almost certainly employ bond friendly actions, as they have in the past, to quell equity market and economic turmoil. If Japanese and German ten-year notes are indications, U.S. Treasury yields can certainly go negative.
The question you must consider is, given extremely low yields and seemingly limited room to decline, do you have confidence that, in the event of an economic recession and severe equity market correction, yields will drop further? If so, then to what extent will such a decline protect you?
Bond Downside
If one is to hedge with Treasury securities, they must also consider what happens if yields do not decline during a market correction. What if “safe-haven” securities traditionally used for hedging purposes were to lose 5% to 10% or even 20% or more?

Below is a list of circumstances that could lead to rising bond yields, in a departure from prior major market corrections:
• Increased fiscal stimulus to combat a recession results in massive bond issuance
• U.S. Dollar decline incites international bond holders to sell
• Federal Reserve takes extreme actions (helicopter money) and inflation expectations soar
• Record low yields lead to a flight to safety in cash and precious metals instead of bonds
• Erosion of investor confidence in the ability of central bankers to protect markets

Current yield levels alter the traditional protection U.S. Treasuries and other bonds now afford. As James Grant of Grant’s Interest Rate Observer has stated, instead of risk-free return, one gets return-free risk. In other words, the past may not be prologue to the future. The hedging benefits that bonds have provided in the past do not appear to offer the same protection of prior periods. This analysis implies an important message for those looking to take a traditional equity hedging approach: the margin of error is quite small for anyone assuming that tomorrow will be like yesterday.
Summary
Recent history has favored those that used fixed income, especially U.S. Treasuries to hedge equity market drawdowns. That however does not take away one’s responsibility to question whether the current risk/reward proposition is still applicable. In a world of declining inflation, stagnating global economic growth and aggressive central bankers, such a hedging strategy may still make sense. However, we would be remiss if we did not reiterate a point made earlier – diversifying for diversification’s sake makes little sense if you are not buying assets that offer value.
There is relatively little upside for Treasury prices and a number of legitimate reasons yields could defy the pattern of the past 35 years and actually increase. Accordingly, one looking for true diversification should consider increasing cash positions, hedging with volatility instruments and/or options, and adding alternative assets such as precious metals.
Finally, we were gratified to see this news clip posted from Bloomberg as we were finalizing this article.

bbg

720 Global is an investment consultant, specializing in macroeconomic research, valuations, asset allocation, and risk management.

Our objective is to provide professional investment managers with unique and relevant information that can be incorporated into their investment process to enhance performance and marketing.

We assist our clients in differentiating themselves from the crowd with a focus on value, performance and a clear, lucid assessment of global market and economic dynamics.

720 Global research is available for re-branding and customization for distribution to your clients.
For more information about our services please contact us at 301.466.1204 or email info@720global.com

©720 Global 2016 All Rights Reserved

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GDP – Even Less Than Meets the Eye

 The most common statistic used to measure the size and growth rate of a nation’s economy is Gross Domestic Product (GDP).  However, GDP as most commonly used can be a flawed measurement if one tries to infer that the size or growth of economic activity is well correlated to the prosperity of its people. Consider China and the United States for example. The U.S. has a GDP of approximately $16.5 trillion and a population of roughly 325 million while China has a GDP of nearly $11 trillion and a population of approximately 1.4 billion. One could say that China’s economy is about two-thirds the size of the U.S. economy, however when one considers how that activity is spread amongst the citizens, China’s economy is only one-seventh that of the U.S. Accordingly, Chinese citizens are clearly less productive and prosperous than U.S. citizens

GDP per capita (per citizen), as demonstrated above, is a valid way to measure the efficiency of one nation’s economic output versus another and is also an important statistic to gauge the productivity and prosperity trends in one country.  We have frequently shown the declining trend in secular GDP growth in charts like those shown below.

1-year Average GDP Growth

(Currently below levels preceding every recession)

3-year Average GDP Growth Trend

(Consistently trending lower)

 gdp 1  secular gdp 6
Data Courtesy: St. Louis Federal Reserve (FRED) Data Courtesy: St. Louis Federal Reserve (FRED)

 

Above, GDP is plotted on an absolute basis and does not take into account the amount of economic activity or economic growth per person. Below, we show the ten-year growth rate of GDP per capita.

Ten-Year GDP Growth Rate Per Capita

 

 graph-3
Data Courtesy: St. Louis Federal Reserve (FRED) and U.S. Census Bureau

 

As one easily notices GDP on a per capita basis is more worrisome than when viewed on a total basis as in the first two graphs. The economic growth rate per person is currently below one half of one percent. More concerning, it is below levels seen during the great financial crisis in 2008 and it is still trending lower.

This graph confirms our macroeconomic concerns and helps explain, in part, why so many U.S. citizens feel like they are being left behind. Factor in that many of the economic spoils are not evenly distributed, as assumed in this analysis, but are largely accruing to the wealthy, and the problem only worsens. As such, the growing social anxiety and trend towards populism, be it conservative or liberal leaning, will not likely dissipate if the aforementioned economic trends continue.

 

 

 

 

720 Global is an investment consultant, specializing in macroeconomic research, valuations, asset allocation, and risk management.  Our objective is to provide professional investment managers with unique and relevant information that can be incorporated into their investment process to enhance performance and marketing. We assist our clients in differentiating themselves from the crowd with a focus on value, performance and a clear, lucid assessment of global market and economic dynamics.

 

720 Global research is available for re-branding and customization for distribution to your clients.

 

For more information about our services please contact us at 301.466.1204 or email info@720global.com

 

©720 Global 2016 All Rights Reserved

 

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Bubbles and Elevators

 

Volumes have been written on behavioral finance and the seemingly “irrational” decisions investors tend to make to avoid straying from the herd. This article examines a current example coined “FOMO” (fear of missing out), in today’s texting parlance. Through a better understanding of the psychological dynamics of bubble mentality, we hope to help investment managers better grasp the complex role they must play when their concern for poor expected returns and higher levels of risk  are pitted against their client’s fear of not keeping pace with the market.

Candid Camera

Allen Funt and Candid Camera filmed a famous episode designed to show how humans tend to behave like each other, regardless of the logic in doing so. In their experiment, an unknowing man entered an elevator, followed shortly by a few Candid Camera actors. After entering the elevator, the actors faced the rear of the car. The man, clearly befuddled, slowly turned around and faced the rear of the elevator. In a second skit, another man not only followed the actors and actresses facing backwards, but then proceeded to rotate back and forth with the crowd. As the skit goes on, he also removes his hat and puts it back on following the actions of the actors and actresses.

While the skits were meant to be humorous, they clearly highlight the innate desire that humans have to follow the actions of others, regardless of whether there is any sense or logic in such actions. The Candid Camera skits can be viewed by clicking here.

Bubbles and Elevators

From time to time, financial markets produce a similar behavioral herding effect as those described above. In fact, the main ingredient fueling financial bubbles has always been a strong desire to do what other investors are doing. As asset bubbles grow and valuation metrics get further stretched, the FOMO siren song becomes louder, drowning out logic. Investors struggle watching from the sidelines as neighbors and friends make “easy” money. One by one, reluctant investors are forced into the market despite their troubling concerns.

Justification for chasing the market higher is further reinforced by leading investors, Wall Street analysts and the media which use faulty logic and narratives to rationalize prices trading at steep premiums to historical norms. Such narratives help investors convince themselves that, “this time is different”, despite facts evidencing the contrary.

To better appreciate the history of financial bubbles and the behavioral traits they seem to share, we recommend reading “Manias, Panics, and Crashes” by Charles Kindelberger. In the book, Mr. Kindelberger gives detailed analysis of numerous financial bubbles that were built on false premises and wild popularity.

Limiting Losses Redux

In “Limiting Losses” we detailed the basic math that explains how consistent positive returns, even if relatively small, provide a powerful compounding effect that has proven to be an efficient way to accumulate wealth. Such a “boring” investment style tends to outperform one with a volatile path that includes larger gains but significant losses on occasion. It is with this conservative mindset that investment managers should focus on the task of building wealth over the long term and aim to avoid the pitfall of large drawdowns at all cost. This logic is equally appropriate at market bottoms. Some of the greatest investment opportunities have occurred when the majority of investors were panicked and selling despite compelling valuations.

Dare to be Different

As a fiduciary of your client’s wealth, you are paid and trusted to quantify and understand the potential risks and rewards and invest their wealth accordingly. You cannot fall prey to periods of grossly unwarranted market optimism, nor should you be shy to invest during periods of deep pessimism. Avoiding these natural instincts, like not turning with the crowd in an elevator, is difficult to put it mildly.

While there are many ways to keep a level-headed approach, we think there are two concepts investment managers should consider:

Investment Strategy and Goals – Create appropriate investment strategies that encourage steady, long term returns. To do this, managers must have rules in place to limit exposure to assets that are overpriced, and increase exposure to those that are underpriced. They should also encourage clients to allow inclusion of a wide variety of permissible assets to make this task easier. Furthermore, understanding the correlation between portfolio assets during severe market drawdowns and periods of crisis is a key risk management metric that should be closely followed.

The task above is made easier when clients have clear and concise objectives that stress long term wealth management. When managers benchmark their clients’ performance to that of the stock and/or bond market, they are blindly aiming for a return that does not correspond with their clients’ wealth objective, but to the whims of other investors. A clear wealth building objective would be to outperform inflation by a given margin or, in other words, increase purchasing power. That said, we know most managers and their clients are programmed to compare investment results to market returns.  To see the problem with such a goal, consider a manager who in 2008 said “we were only down 30%, while the market dropped 50%, didn’t we do well?”  NO!!! The clients’ wealth decreased significantly.

Obviously, proper investment management and strategic goal setting is a complex and time consuming job. We do not make light of that or the “way things are done” by the vast majority of investment managers. Our point is to stress that when you buy what is cheap, sell what is expensive and sit on additional cash at appropriate times, your odds of long term investing success increase dramatically. As Warren Buffett said, “the stock market is a no-called-strike-game”. Successful investors understand that you can look at as many pitches as you wish until you get one you know you can hit – the proverbial “fat pitch”.

Client Education – The second requirement for taking an out-of-favor investing posture is properly educating clients on that approach and managing their expectations. First, clients need to understand and be consistently reminded that your goal is to grow their wealth over the long term, which is best done by avoiding losses. Contrast this perspective with the anxiety most investors feel because their returns are not keeping up with the Dow Jones Industrial Average or their neighbors’. Waiting for good opportunities and avoiding losses is the long game of wealth creation. Eliminating the short-term view of wealth management that most investors harbor is important.

The hardest part of helping clients understand this goal is convincing them that, at times like today, the market is fraught with risks. Ironically, such an environment fosters a sense of urgency, FOMO and a perceived need to “chase returns”.

In order to help investors understand the approach, a manager must clearly, succinctly and repeatedly explain their thesis on markets, particular investments, and economics. A client can more easily avoid popular investment urges when their manager has explained the logic behind a posture that is more conservative or aggressive than the norm. This can be accomplished through frequent verbal and written communication.

Summary

TINA is another popular acronym – “There Is No Alternative”. We think there is an alternative to chasing assets whose valuations imperil client wealth.  Focus on the fundamentals that underpin stock prices and own securities that are appropriate given the risk/reward objectives. Though it is especially difficult to be a contrarian at such times, the reward for doing so is preservation of wealth and the assurance of excellent value opportunities in the future.

FOMO can also be thought of as FONC “fear of not conforming”. As a steward of your client’s wealth, it is imperative that at market junctures like the present one, special care is taken to understand the risks and allocate investments accordingly. Timing the market is impossible, but keeping an eye on the long term goals will help your clients avoid the pitfalls (i.e. losses) that inevitably set investors back years. Equally damaging at that point is the inability to take advantage of the multitude of opportunities that no doubt will emerge.

 

 

 

 

720 Global is an investment consultant, specializing in macroeconomic research, valuations, asset allocation, and risk management.  Our objective is to provide professional investment managers with unique and relevant information that can be incorporated into their investment process to enhance performance and marketing. We assist our clients in differentiating themselves from the crowd with a focus on value, performance and a clear, lucid assessment of global market and economic dynamics.

 

720 Global research is available for re-branding and customization for distribution to your clients.

 

For more information about our services please contact us at 301.466.1204 or email info@720global.com

 

©720 Global 2016 All Rights Reserved

 

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What, Me Worry?

As we contemplate the upcoming U.S. presidential election one of our chief investment related concerns is the potential for the election results to roil markets. Strangely, the equity markets trade as if the election results, be it a Clinton or Trump victory, are inconsequential for share prices. That stance is greatly at odds with what many of us think, as well as the palpable anxiety voiced by many traditional and social media outlets.
In prior articles, including our most recent “Mm Mm Good”, we discussed economic and market distortions caused by extraordinary central bank monetary policy. In this instance we focus on a behavioral distortion that is, also, partially a result of central bank policy, actions and words.
Bad News is Good News
The BREXIT vote in the United Kingdom was feared to have negative consequences for the financial markets if U.K. voters favored exiting the European Union (EU). As we now know, the “leave” votes won despite the vast majority of polls predicting a “stay” victory right up to the end. Following the surprising result, stock markets behaved as expected, with most markets around the world plummeting. Within days, however, markets snapped back, and after only a couple of weeks, many had not only fully recovered but some had actually risen above pre-vote levels.
This abnormal behavior is something that has become common place in the last few years. The market has coined this type of market reaction “bad news is good news”. From both a logical and a fundamental view it is senseless, unless one considers why the market thinks bad news is good news.
In 1998 Alan Greenspan and the Federal Reserve helped bail out Wall Street and the failing hedge fund Long Term Capital Management. From that day forward, central bankers around the world have pursued an increasingly proactive approach towards steering economic growth and, more recently, financial asset prices.
Over the last few years, actions and words aimed to halt downward trending markets, have become strikingly obvious. In July 2012, Mario Draghi, President of the European Central Bank (ECB), vowed to do “whatever it takes” to calm financial market fears that were hammering the Euro region. Shortly after uttering those famous words, European stock markets and most others around the world rallied significantly. On October 14, 2014, Fed Governor James Bullard suggested the Fed pause the tapering of Quantitative Easing (QE) in response to a 10% stock market decline and an affiliated drop in bond yields. Within two weeks of his comments, the stock market had more than erased its losses and was back to setting new all-time highs.
Bullard’s so called “stick save”, Draghi’s promise to do anything, and many other similar statements and actions from central bankers have not only reassured investors but they have bred a high level of investor complacency. On a daily basis, it is commonplace to witness market indifference or even strength on weak economic data. Most recently, on July 28, 2016, a much weaker than expected GDP release, which should have caused concern for investors, resulted in equity market gains.
Investors are electing to ignore fundamental news and data, which ultimately underpin equity valuations, on the presumption that the Fed and other central banks will “do whatever it takes” to prevent markets from correcting.
Election Complacency
As we approach the coming election, the U.S. stock markets are trading as if it were a typical lazy summer with not a care in the world. That is in direct contrast to the risks that many of us foresee with the coming election.
Realized volatility is a measure of the degree of variation of a series of historical prices. Implied volatility (VIX) is a forward looking measure of realized volatility, derived from call and put option pricing. Frequently, implied volatility increases when investors are concerned the market may be entering a risky period and it decreases when there is little to worry about. Realized and implied volatility help us quantify the level of market complacency or concern.
The graph below shows implied equity volatility from prior election year periods as of the end of each respective July leading to the election, as well as at the end of July 2016.
Implied Volatility Leading up to U.S. Elections

implied 1
Data Courtesy: Bloomberg

Note that current annualized implied volatility of 11.87% is well below any other level seen since at least the Bill Clinton-Bob Dole election of 1996. Additionally, when compared to the entire data set going back over twenty years, as shown below, the current index (red dotted line) is well below the average and 95% of all other observations. In other words the market is extremely confident there are no surprises looming and no cause for concern, election or not.
VIX 1994-Present

long term vix
Data Courtesy: Bloomberg
Implied volatility is not a perfect measure to assess market concerns directly related to the election, as it can also reflect concerns about other events as well. Accordingly, comparing current implied volatility to recent realized volatility provides a baseline from which to gauge the degree that implied volatility is elevated. One would assume that as uncertainty and risk increase as an election gets closer, implied volatility, or future volatility expectations, would trade higher than realized volatility. Prior to this coming election, the data clearly supports that logical theory as shown in the table below.

 

table 2

As of late July, in each of the last five elections, implied volatility was at least 20% higher than realized volatility. 2016 is an anomaly. Going into one of the more unpredictable elections, implied volatility is trading at a discount to realized volatility.
Summary
Can we assume the Fed will ensure the markets behave appropriately regardless of who wins the election? Answering this question is difficult. Recent history sides with those answering yes. That said, there is a risk that the 2016 election results upset markets, and when needed, Fed statements and/or actions will not have their desired effect. When that risk is considered alongside already troubling factors such as stagnating economic growth, declining earnings, high valuations and numerous geopolitical risks, investors may be well-served to question many bullish market forecasts and the popular blind faith assumption in Fed effectiveness.
The market, courtesy of complacent investors, is offering very cheap insurance for an event that has the potential to induce extreme volatility via VIX options and futures. Even if the next eleven weeks leading to the election prove to be uneventful, the VIX at current levels, as shown earlier, has been a prudent place to own protection. We recommend you consider this opportunity as a protective measure.


720 Global is an investment consultant, specializing in macroeconomic research, valuations, asset allocation, and risk management. Our objective is to provide professional investment managers with unique and relevant information that can be incorporated into their investment process to enhance performance and marketing. We assist our clients in differentiating themselves from the crowd with a focus on value, performance and a clear, lucid assessment of global market and economic dynamics.

720 Global research is available for re-branding and customization for distribution to your clients.

For more information about our services please contact us at 301.466.1204 or email info@720global.com

©720 Global 2016 All Rights Reserved

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“Mm Mm Good” – But Very Expensive

 

No U.S. bond trader under the age of 56 has traded in a prolonged bear market. That striking fact is a function of steadily falling bond yields since 1981. Over this era, investors have been increasingly mesmerized into trusting that yields may never go materially higher. That belief seems stronger than ever in the U.S. as yields are dropping to levels not seen at any point in American history (since at least 1790). In the U.S., one can still find Treasury bonds with a positive yield but globally over $13 trillion of sovereign bonds have negative yields. The poster child for this insanity is a 50-year Swiss sovereign bond which yields negative .023%. Try to make sense of intentionally investing your money for 50 years with the guarantee of losing money.

As described in prior articles, when yields are lower than appropriate, capital gets mis-allocated. The result is economic distortions closely followed by hostile economic and financial consequences.  This article offers two examples intended to highlight market distortions resulting from abnormally low interest rates.

The Hunt for Yield

With “risk free” U.S. Treasury bonds and other relatively safe investment-grade bonds offering yields in the low single digits, “conservative” investors are struggling to find investments that provide decent credit quality and respectable returns. The result of this quest for yield has been a mad rush by investors into dividend yielding stocks.

The following two graphs highlight how those stocks with the highest dividend yields are clearly most in demand this year.  The first graph below plots the average, non-weighted, year-to-date returns for the stock of each S&P 500 company, categorized by their respective dividend yield ranges.

 

 

 

 

 

 

Year to Date Total Returns per Dividend Yield Ranges

 

 div yld 1
Data Courtesy: Bloomberg

 

The following scatter plot shows the S&P 500 by sector, highlighting how sectors with the highest dividend yields are also the best performing.

Dividend Yield and YTD Return by Sector

 

 div yld 2
Data Courtesy: Bloomberg

 

The data in both graphs strongly suggest that in 2016 equity investors have a strong preference for companies and sectors with higher dividend yields.

Campbell’s Soup

Campbell’s Soup (CPB) provides great insight into this phenomenon. CPB currently trades at a Price to Earnings ratio (P/E) of 23.  As shown in the graph below its P/E has spiked over the last two years and stands at a 50% premium to its average since the 2008 recession. Over the course of just the last 7 months, CPB’s stock price has risen 25% while earnings remain flat. As a result the dividend yield was reduced from a somewhat respectable 2.50% dividend to 2.00% currently.

Campbell’s Soup (CPB) Price to Earnings Ratio

 

 CPB pe 3
Data Courtesy: Bloomberg

 

Investor demand for CPB appears to be a function of investor appetite for yield. We deduce this because CPB is not a growth company. Since 1991 its annualized revenue growth has been 0.97%. In the last 5 and 10 years revenue growth has slowed to 0.63% and 0.82% respectively.

This concept of a no-growth soup company with soaring valuations is alarming. The price of CPB would have to drop 30% to return to its post-recession average P/E. If that were to occur, it would take 16 years’ worth of dividend payments to recoup the price loss, assuming dividends remain stable!

Utility Stocks

Utility stocks offer another poignant case study. These providers of electric, gas, sewage and water services are well known for higher relative dividends, low revenue growth and reduced price volatility. Year to date, the popular ETF representing utility stocks (XLU) has risen 20%, and in the process its dividend yield dropped from 3.70% to 3.00%.

Not only are current investors of utilities receiving a lower dividend yield, but they are paying an extremely high valuation in order to earn 3.00%.  Consider the graphs below showing the Price to Sales ratio and the Price to EBITDA ratio for the utility sector.

Price to Sales Ratio

 

 price to sales 4
Data Courtesy: Bloomberg

 

Price to EBITDA Ratio

 

 price to ebitda 5
Data Courtesy: Bloomberg

 

As the graphs show, the Utility index now trades at valuations that are at or near three standard deviations away from the average. Both readings dwarf any prior level since at least 1990. As is the case with CPB, these valuation anomalies are a function of investors demand for yield and not the potential growth of the underlying companies. In fact, revenue growth in the utility sector is worse than that of CPB. Revenue per share has declined in each of the  last eight quarters and is currently the lowest in over a decade.

The Bottom Line

The bottom line as shown through two examples, is that insatiable demand for stocks with above average dividends is forcing valuations to diverge significantly from historical norms. Investors buying the equity of these and many other companies with high dividend yields are seeking the perceived safety of dividends and reduced price volatility. However, in our opinion, what many of these investors will receive is low absolute dividends and more price risk. Beta driven strategies, and some so-called “smart beta” portfolios, may be in for a rude awakening if, as we suspect, many of these safe dividend stocks exhibit a larger draw down than their historical betas would predict.

The valuations of many companies providing higher dividend yields have changed drastically in a relatively short time period. This is not an imminent warning to sell but an alert to monitor valuations and not just dividend yields. The grab for yield could easily persist driving prices even higher, but do not lose sight of underlying valuations. At some point, as is true throughout the history of financial markets, regression to the mean will occur.

Summary

Negative and zero interest rate policies are creating significant distortions across the global economy and financial markets. The examples in this article are just two of many instances. For those who say that we should not worry about the current state of monetary policy, this article provides further evidence of the distortions these aggressive monetary actions create and makes the reader aware of the wealth destruction that will eventually occur as a result.

 

 

 

 

720 Global is an investment consultant, specializing in macroeconomic research, valuations, asset allocation, and risk management.  Our objective is to provide professional investment managers with unique and relevant information that can be incorporated into their investment process to enhance performance and marketing. We assist our clients in differentiating themselves from the crowd with a focus on value, performance and a clear, lucid assessment of global market and economic dynamics.

 

720 Global research is available for re-branding and customization for distribution to your clients.

 

For more information about our services please contact us at 301.466.1204 or email info@720global.com

 

©720 Global 2016 All Rights Reserved

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Another Warning in the GDP Data

 

On Friday July 29th, 2016, the Bureau of Economic Analysis (BEA) released the second-quarter GDP figures and revisions for prior quarters. At a disappointing annualized growth rate of only 1.20%, second quarter GDP widely missed consensus expectations of 2.50% growth.  Coincidentally the current 1-year average growth rate has risen at the same 1.20% and that annualized growth rate has declined for five quarters in a row.

For the most part, the recent bout of stagnant GDP data has not caught the attention of the media or the markets. As consultants to those who manage wealth we believe this data is vitally important, regardless of what others may think. Accordingly, we provide some context around this data to help you better grasp its magnitude.

The graph below plots average 1-year GDP growth on a quarterly basis going back to 1948. The blue shaded areas represent periods deemed recessionary by the National Bureau of Economic Research (NBER), and the red dotted line facilitates the comparison of the current 1.20% reading versus those of the past.

1-Year Average GDP Growth

 

 gdp 1
Data Courtesy: St. Louis Federal Reserve (FRED)

 

Here are four important takeaways:

  • All recessions since 1948 started with an average growth rate greater than the current 1.20% rate.
  • There are only three instances where the 1-year growth rate was below the current level and recession did not occur. In the two most recent instances (2011/2012), weak growth was met with renewed rounds of extraordinary stimulus in the form of quantitative easing (QE).
  • Only 18% of all observations going back to 1948 are below the current 1.20% level.
  • Of that 18%, 94% occurred during or within a quarter of a recession.

Based on recent history, one might elect to maintain an aggressive stance towards equities and other risky assets in anticipation of another round of stimulus from the Federal Reserve. One should be reminded however, the primary difference between where we are today versus those two recent periods is that the Fed’s posture was not leaning toward interest rate hikes as they are now.

Though difficult in a world of poor returns, equity investors should remain defensive and highly concerned by the recent economic data.  As a reminder, re-consider the following table and excerpt from “Dear Prudence” published in April 2016.

The possibility of a recession while equity valuations are extreme is deeply troubling.  Since 1929, there have been 14 recessions. All but one, in 1945, coincided with a period of negative returns for stocks. Included in this data, as shown in the table below, are periods when stock valuations ranged from greatly undervalued to extremely overvalued.   –Data and Table Courtesy Doug Short

GDP and valuations

 

720 Global is not calling for an immediate equity market sell-off. In fact, the market may appreciate further, irrespective of weak economic data, declining earnings and historical precedent. That said, periods like today, characterized by extreme valuations and weak economic activity, have ultimately proved disastrous for investors. Those managing wealth for others should be cognizant of the implications present in today’s stagnating economy.

 

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Kyōki (Insanity)

Pondering the state of the global economy can elicit manic-depressive-obsessive-compulsive emotions.  The volatility of global markets – equities, bonds, commodities, currencies, etc. – are challenging enough without consideration of Brexit, the U.S. Presidential election, radical Islamic terrorism and so on.  Yet no discussion of economic and market environments is complete without giving hefty consideration to what may be a major shift in the way economic policy is conducted in Japan.

The Japanese economy has been the poster child for economic malaise and bad fortune for so long that even the most radical policy responses no longer garner much attention. In fact, recent policy actions intended to weaken the Yen have resulted in significant appreciation of the yen against the currencies of Japan’s major trade partners, further crippling economic activity. The frustration of an appreciating currency coupled with deflation and zero economic growth has produced signs that what Japan has in store for the world falls squarely in to the category of “you ain’t seen nothin’ yet.”  Assuming new fiscal and monetary policies will be similar to those enacted in the past is a big risk that should be contemplated by investors.

The Last 25 Years

The Japanese economy has been fighting weak growth and deflationary forces for over 25 years.  Japan’s equity market and real estate bubbles burst in the first week of 1990, presaging deflation and stagnant economic growth ever since.  Despite countless monetary and fiscal efforts to combat these economic ailments, nothing seems to work.

Any economist worth his salt has multiple reasons for the depth and breadth of these issues but very few get to the heart of the problem.  The typical analysis suggests that weak growth in Japan is primarily being caused by weak demand.  Over the last 25 years, insufficient demand, or a lack of consumption, has been addressed by increasingly incentivizing the population and the government to consume more by taking on additional debt.  That incentive is produced via lower interest rates.  If demand really is the problem, however, then some version of these policies should have worked, but to date they have not.

If the real problem, however, is too much debt, which at 255% of Japan’s GDP seems a reasonable assumption to us, then the misdiagnosis and resulting ill-designed policy response leads to even slower growth, more persistent deflationary pressures and exacerbates the original problem.  The graphs below shows that economic activity is currently at levels last seen in 1993, yet the level of debt has risen 360% since 1996.  The charts provide evidence that Japan’s crippling level of debt is not helping the economy recover and in fact is creating massive headwinds.

Japan GDP 1990-2015

 

 gdp 1
Data Courtesy: World Bank

 

Japan Government Debt to GDP ratio

 

 debt gdp 2
Data Courtesy: Japan Ministry of Finance (MoF)

 

What is so confounding about this situation is that after 25 years, one would expect Japanese leadership to eventually recognize that they are following Einstein’s definition of insanity – doing the same thing over and over again and expecting different results.  Equally insane, leaders in the rest of the developed world are following Japan over the same economic cliff.

Throughout this period of economic stagnation and deflation, Japan has increasingly emphasized its desire to generate inflation. The ulterior motive behind such a strategy is hidden in plain sight. If the value of a currency, in this case the Yen, is eroded by rising inflation debtors are able to pay back that debt with Yen that is worth less than it used to be.  For example, if Japan were somehow able to generate 4% inflation for 5 years, the compounded effect of that inflation would serve to devalue the currency by roughly 22%.  Therefore, debtors (the Japanese government) could repay outstanding debt in five years at what is a 22% discount to its current value. Said more bluntly, they can essentially default on 22% of their debt.

What we know about Japan is that their debt load has long since surpassed the country’s ability to repay it in conventional terms. Given that it would allow them to erase some percentage of the value of the debt outstanding, their desperation to generate inflation should not be underestimated. One way or another, this is the reality Japan hopes to achieve.

QE

Quantitative easing (QE) is one of the primary monetary policy approaches central banks have taken since the 2008 financial crisis.  With short term interest rates pegged at zero, and thus the traditional level of monetary policy at its effective limit, the U.S. Federal Reserve and many other central banks conjured new money from the printing presses and began buying sovereign debt and, in some cases mortgages, corporate bonds and even equities. This approach to increasing the money supply achieved central bank objectives of levitating stocks and other asset markets, in the hope that newly created “wealth” would trickle down.  The mission has yet to produce the promised “escape velocity” for economic growth or higher inflation. The wealthy, who own most of the world’s financial assets, have seen their wealth expand rapidly. However, for most of the working population, the outcome has been economic struggle, further widening of the wealth gap and a deepening sense of discontentment.

The Nuclear Option

In 2014, as the verdict on the efficacy of QE became increasingly clear, European and Japanese central bankers went back to the drawing board. They decided that if the wealth effect of boosting financial markets would not deliver the desired consumption to drive economic growth then surely negative interest rates would do the trick.  Unfortunately, the central bankers appear to have forgotten that there are both borrowers and lenders who are affected by the level of interest rates.  Not only have negative interest rates failed to advance economic growth, the strategy appears to have eroded public confidence in the institution of central banking and financially damaging the balance sheets of many banks.

In recent weeks, former Federal Reserve (Fed) chairman Ben Bernanke paid a visit to Tokyo and met with a variety of Japanese leaders including Bank of Japan chairman Haruhiko Kuroda. In those meetings, Bernanke supposedly offered counsel to the Japanese about how they might, once and for all, break the deflationary shackles that enslave their economy using “helicopter money” (the termed was coined by Milton Freidman and made popular in 2002 by Ben Bernanke).  What Bernanke proposes, is for Japan to effectively take one of the few remaining steps toward “all-in” or the economic policy equivalent of a “nuclear option”.

The Japanese government appears to be leading the charge in the next chapter of stranger than fiction economic policy through some form of “helicopter money”.  As opposed to the prior methods of QE, this new approach marries monetary policy with fiscal policy by putting printed currency into the hands of the Ministry of Finance (MOF or Japan’s Treasury department) for direct distribution through a fiscal policy program.  Such a program may be infrastructure spending or it may simply be a direct deposit into the bank accounts of public citizens.  Regardless of its use, the public debt would rise further.

According to the meeting notes shared with the media Bernanke recommended that the MoF issue “perpetual bonds”, or bonds which have no maturity date.  The Bank of Japan (BOJ or the Japan’s Central Bank) would essentially print Yen to buy the perpetual bonds and further expand their already bloated balance sheet. The new money for those bonds would go to the MoF for distribution in some form through a fiscal policy measure.  The BoJ receives the bonds, the MoF gets the newly printed money and the citizens of Japan would receive a stimulus package that will deliver inflation and a real economic recovery.  Sounds like a win-win, huh?

Temporarily, yes.  Economic activity will increase and inflation may rise.

Let us suppose that the decision is to distribute the newly printed currency from the sale of the perpetual bonds directly into the hands of the Japanese people.  Further let us suppose every dollar of that money is spent.  In such a circumstance, economic activity will pick up sharply.  However, eventually the money will run out, spending falters and economic stagnation and decline will resume.

At this point, Japan has the original accumulated debt plus the new debt created through perpetual bonds and an economy that did not respond organically to this new policy measure.  Naturally the familiar response from policymakers is likely to be “we just didn’t do enough”. It is then highly probable another round of helicopter money will be issued producing another short lived spurt of economic activity.  As with previous policy efforts, this pattern likely repeats over and over again.  Each time, however, the amount of money printed and perpetual bonds issued must be greater than the prior attempts. Otherwise, economic growth will not occur, it will, at best, only match that of the prior experience.

Eventually, due to the mountain of money going directly in to the economy, inflation will emerge.  However, the greater likelihood is not that inflation emerges, but that it actually explodes resulting in a complete annihilation of the currency and the Japanese economy.  In hypothetical terms as described here, the outcome would be devastating.  Unlike prior methods of QE which can be halted and even reversed, helicopter money demands ever increasing amounts to achieve the desired growth and inflation. Once started, it will be very difficult to stop as economic activity would stumble.

The following paragraph came from “Part Deux – Shorting the Federal Reserve”. In the article we described how the French resorted to a helicopter money to help jump start a stagnant economy.

“With each new issue came increased trade and a stronger economy. The problem was the activity wasn’t based on anything but new money. As such, it had very little staying power and the positive benefits quickly eroded. Businesses were handcuffed. They found it hard to make any decisions in fear the currency would continue to drop in value. Prices continued to rise. Speculation and hoarding were becoming the primary drivers of the economy. “Commerce was dead; betting took its place”. With higher prices, employees were laid off as merchants struggled to cover increasing costs”.  

The French money printing exercise ultimately led to economic ruin and was a leading factor fueling the French revolution.

Summary

Is it possible that Bernanke’s helicopter money approach could work and finally help Japan escape deflation in conjunction with a healthy, organically growing economy?  It has a probability that is certainly greater than zero, but given the continual misdiagnosis of the core problem, namely too much debt, that probability is not much above zero.  There is a far greater likelihood of a multitude of other undesirable unintended consequences.

Of all the developed countries, Japan is in the worst condition economically.  Most others, including the United States, are following the same path to insanity though.  Unlike Japan, other countries may have time to implement policy changes that will allow them to avoid Japan’s desperate circumstances.

To gain a more complete understanding of 720 Global’s economic thesis and the policy changes required, we recommend our prior articles “The Death of the Virtuous Cycle” and “The Fifteenth of August”.

 

 

 

 

720 Global is an investment consultant, specializing in macroeconomic research, valuations, asset allocation, and risk management.  Our objective is to provide professional investment managers with unique and relevant information that can be incorporated into their investment process to enhance performance and marketing. We assist our clients in differentiating themselves from the crowd with a focus on value, performance and a clear, lucid assessment of global market and economic dynamics.

 

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