The Lowest Common Denominator

At a recent investment conference, hedge fund billionaire Stanley Druckenmiller predicted that interest rates would continue rising. Specifically, he suggested that, consistent with the prospects for economic growth, the 10-year U.S. Treasury yield could reach 6.00% over the next couple of years. Druckenmiller’s track record lends credence to his economic perspectives.  While we would very much like to share his optimism, we find it difficult given the record levels of public and private debt.

Druckenmiller’s comments appear to be based largely on enthusiasm for the new administration’s proposals for increased infrastructure and military spending along with tax cuts and deregulation. This is consistent with the outlook of most investors today.  Although proposals of this nature have stimulated economic growth in the past, today’s economic environment is dramatically different from prior periods.  Investors and the market as a whole are failing to consider the importance of the confluence of the highest debt levels (outright and as a % of GDP) and the lowest interest rates (real and nominal) in the nation’s history.  Because of the magnitude and extreme nature of these two factors, the economic sensitivity to interest rates is greater and more asymmetric now than it has ever been.  Additionally, due the manner in which debt and interest rates have evolved over time, the amount of interest rate risk held by fixed income and equity investors poses unparalleled risks and remains, for the moment, grossly underappreciated.

Proper assessment of future investment and economic conditions must carefully consider changes in the debt load and the interest rates at which new and existing debt will be serviced.

A 45-year Trend

For more than a generation, there has been a dramatic change in the landscape of interest rates as illustrated in the graph below.  Despite the recent rise in yields (red arrow), interest rates in the United States are still near record-low levels.

yield-chart

Data Courtesy: Bloomberg

Declining interest rates have been a dominant factor driving the U.S. economy since 1981. Since that time, there have been brief periods of higher interest rates, as we see today, but the predictable trend has been one of progressively lower highs and lower lows.

Since the Great Financial Crisis in 2008, interest rates have been further nudged lower in part by the Federal Reserve’s (Fed) engagement in a zero-interest rate policy, quantitative easing and other schemes.  Their over-arching objective has been three-fold:

  • Lower interest rates to encourage more borrowing and thus more consumption (“How do you make poor people feel wealthy? You give them cheap loans.” –The Big Short)
  • Lower interest rates to allow borrowers to reduce payments on existing debt thus making their balance sheet more manageable and freeing up capacity for even more borrowing
  • Maintain a prolonged period of low interest rates “forcing” investors out of safe-haven assets like Treasuries and money market funds and into riskier asset classes like junk bonds and stocks with the aim of manufacturing a durable wealth effect that might eventually lift all boats

In hindsight, lower interest rates were successful in accomplishing some of these objectives and failed on others. What is getting lost in this experiment, however, is that the marginal benefits of decreasing interest rates are significantly contracting while the marginal consequences are growing rapidly.

Interest Rates and Duration

What are the implications of historically low interest rates for a prolonged period of time?  What is “seen” and touted by policy makers are the marginal benefits of declining interest rates on housing, auto lending, commercial real estate and corporate funding to name just a few beneficiaries. What is “unseen” are the layers of accumulating risks that are embedded in a system which discourages savings and therefore eschews productivity growth. Companies that should be forced into bankruptcy or reorganization remain viable, and thus drain valuable economic resources from other productive uses of capital. In other words, capital is being misallocated on a vast scale and Ponzi finance is flourishing.

In an eerie parallel to the years leading up to the crisis of 2008, hundreds of billions of dollars of investors’ capital is being jack-hammered into high-risk, fixed-income bonds and dividend-paying stocks in a desperate search for additional yield. The prices paid for these investments are at unprecedented valuations and razor thin yields, resulting in a tiny margin of safety. The combination of high valuations and low coupon payments leave investors highly vulnerable. Because of the many layers of risk across global asset markets that depend upon the valuations observed in the U.S. Treasury markets, deeper analysis is certainly a worthy cause.

At the most basic level, it is important to appreciate how bond prices change as interest rates rise and fall.  The technical term for this is duration. Since that price/interest rate relationship is the primary determinant of a bond’s profit and loss, this analysis will begin to reveal the potential risk bond investors face. Duration is defined as the sensitivity of a bond’s price to changes in interest rates. For example, a 10-year U.S. Treasury note priced at par with a 6.50% coupon (the long term average coupon on U.S. Treasury 10-year notes) has a duration of 7.50. In other words, if interest rates rise by 1.00%, the price of that bond would decline approximately 7.50%.  An investor who purchased $100,000 of that bond at par and subsequently saw rates rise from 6.50% to 7.50%, would own a bond worth approximately $92,500.

By comparison, the 10-year Treasury note auctioned in August 2016 has a coupon of 1.50% and a duration of 9.30. Due to the lower semi-annual coupon payments compared to the 6.50% Treasury note, its duration, which also is a measure of the timing of a bonds cash flows, is higher. Consequently, a 1.00% rise in interest rates would cause the price of that bond to drop by approximately 9.30%. The investor who bought $100,000 of this bond at par would lose $9,300 as the bond would now have a price of $90.70 and a value of $90,700.

A second matter of importance is that the coupon payments, to varying degrees, mitigate the losses described above. In the first example, the annual coupon payments of $6,500 (6.50% times the $100,000 investment) soften the blow of the $7,500 loss covering 86% of the drop in price. In the second example, the annual coupon payments of $1,500 are a much smaller fraction (16%) of the $9,300 price change caused by the same 1.00% rise in rates and therefore provide much less cushion against price declines.

In the following graph, the changing sensitivity of price to interest rate (duration- blue) is highlighted and compared to the amount of coupon cushion (red), or the amount that yield can change over the course of a year before a bondholder incurs a loss.

duration-coupon-protection-graph

The coupon on the 10-year U.S. Treasury note used in our example only allows for a 16 basis point (0.16%) increase in interest rates, over the course of a year, before the bondholder posts a total return loss. In 1981, the bondholder could withstand a 287 basis point (2.87%) increase in interest rates before a loss was incurred.

Debt Outstanding

While the increasing interest rate risk and price sensitivity coupled with a decreasing margin of safety (lower coupon payments) of outstanding debt is alarming, the story is incomplete. To fully appreciate the magnitude of this issue, one must overlay those risks with the amount of debt outstanding.

Since 1982, the duration (price risk) of nominal U.S. Treasury securities has risen 70% while the average coupon, or margin of safety, has dropped 85%. Meanwhile, the total amount of U.S. public federal debt has exploded higher by 1,600% and total U.S. credit market debt, as last reported by the Federal Reserve in 2015, has increased over 1,000% standing at $63.4 trillion. When contrasted with nominal GDP ($18.6 trillion) as graphed below, one begins to gain a sense for how radically out of balance the accumulation of debt has been relative to the size of the economy required to support and service that debt.  In other words, were it not for the steady long-term decline in interest rates, this arrangement likely would have collapsed under its own weight long ago.

debt-outstanding

Data Courtesy: St. Louis Federal Reserve (FRED)

To provide a slightly different perspective, consider the three tables below, which highlight the magnitude of government and personal debt burdens on an absolute basis as well as per household and as a percentage of median household income.

debt-tables

Data Courtesy St. Louis Federal Reserve (FRED) and USdebtclock.org

If every U.S. household allocated 100% of their income to paying off the nation’s total personal and governmental debt burden, it would take approximately six years to accomplish the feat (this calculation uses aggregated median household incomes). Keep in mind, this assumes no expenditures on income taxes, rent, mortgages, food, or other necessities. Equally concerning, the trajectory of the growth rate of this debt is parabolic.

As the tables above reflect, for over a generation, households, and the U.S. government have become increasingly dependent upon falling interest rates to fuel consumption, refinance existing debt and pay for expanded social and military obligations. The muscle memory of a growing addiction to debt is powerful, and it has created a false reality that it can go on indefinitely. Although no rational individual, CEO or policy-maker would admit to such a false reality, their behavior argues otherwise.

Investors Take Note

This article was written largely for investors who own securities with embedded interest rate risks such as those described above. Although we use U.S. Treasury Notes to illustrate, duration is a component of all bonds. The heightened sensitivities of price changes coupled with historically low offsetting coupons, in almost all cases, leaves investors in a more precarious position today than at any other time in U.S. history. In other words, investors, whether knowingly or unknowingly, have been encouraged by Fed policies to take these and other risks and are now subject to larger losses than at any time in the past.

This situation was beautifully illustrated by BlackRock’s CIO Rick Rieder in a presentation he gave this fall. In it he compared the asset allocation required for a portfolio to achieve a 7.50% target return in the years 1995, 2005 and 2015. He further contrasts those specific asset allocations against the volatility (risk) that had to be incurred given that allocation in each respective year. His takeaway was that investors must take on four times the risk today to achieve a return similar to that of 1995.

Summary

We generally agree with Stanley Druckenmiller. If enacted correctly, there are economic benefits to deregulation, tax reform and fiscal stimulus policies. However, we struggle to understand how higher interest rates for an economy so dependent upon ever-increasing amounts of leverage is not a major impediment to growth under any scenario. Also, consider that we have not mentioned additional structural forces such as demographics and stagnating productivity that will provide an increasingly brisk headwind to economic growth. Basing an investment thesis on campaign rhetoric without consideration for these structural obstacles is fraught with risk.

The size of the debt overhang and dependency of economic growth on low interest rates means that policy will not work going forward as it has in the past. Although it has been revealed to otherwise intelligent human beings on many historical occasions, we retain a false belief that the future will be like the past. If the Great Recession and post-financial crisis era taught us nothing else, it should be that the cost of too much debt is far higher than we believe.  More debt and less discipline is not the solution to a pre-existing condition characterized by the same. The price tag for failing to acknowledge and address that reality rises exponentially over time.

 

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.

 

Coming soon 720 Global will offer “The Unseen”, a subscription-based publication similar to what has been offered at no cost over the past year and a half.  In fact, what the subscription offers is precisely what we have delivered in the past, a substance in style and form that provides unique analysis and meaningful value to discerning investors. Those that have read our work understand the comparative advantage they have gained over the vast majority of investors that solely focus on the obvious. Our readers are prepared for what few see.

 

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 2017 All Rights Reserved

 

 

NOTICE AND DISCLAIMER: This material has been prepared by 720 Global, LLC. Opinions expressed herein are subject to change without notification. Any prices or quotations contained herein are indicative screen prices and are for reference only. They do not constitute an offer to buy or sell any securities at any given price. No representation or warranty, either express or implied, is provided in relation to the accuracy, completeness, reliability or appropriateness of the information, methodology and any derived price contained within this material. The securities and related financial instruments described herein may not be eligible for sale in all jurisdictions or to certain categories of investors.

Neither 720 Global, LLC nor its directors accept any liability for any loss or damage arising out of the use of all or any part of these materials.

All rights reserved. This material is strictly for specified recipients only and may not be reproduced, distributed or forwarded in any manner without the permission of 720 Global, LLC. 

 

 

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Great Expectations

 

“Never ever lose sight of long term relationships” Paul Krake – View from the Peak

 

Throughout 2016 we highlighted that various measures of equity valuations are at historically high levels and present an unfavorable risk/reward profile.

Comparing valuation metrics to their respective longer term averages is a good way to gauge richness or cheapness, but it does not necessarily paint a complete valuation picture. For instance, Amazon’s stock trades at an astronomical price to earnings ratio (P/E) of 172 or about seven times that of the S&P 500. Despite the seemingly high ratio, one cannot single-handedly declare that Amazon is expensive. If Amazon’s sales continue to grow at a torrid pace, a ratio of 172 may not be out of line.

The objective of this article is to form a complete valuation picture of the S&P 500. Although the work behind valuations and rich/cheap analysis is never complete, this exercise will help you understand the earnings growth priced into current valuation levels. It also provides a framework to evaluate the upside and downside of various combinations of earnings projections and price multiples. From there, you can make your own judgment about whether current valuations make sense.

P/E

The graph below plots the Cyclically Adjusted Price to Earnings ratio (CAPE) since 1883, its average and plus/minus one standard deviation levels from the average. The current ratio of 28.14 is approximately 1.75 standard deviations higher than average and stands perched above almost every prior observation in the last 130 years except those of the late 1920’s and the late 1990’s.

cape

Data Courtesy Robert Shiller – http://www.econ.yale.edu/~shiller/data.htm

Calculating P/E ratios may be done using CAPE, earnings for the trailing twelve months (TTM) or numerous other methods. While market practitioners tend to favor TTM, CAPE is used here for the same reasons Ben Graham and Robert Shiller preferred it – ten years of earnings data helps eliminate short-term noise that frequently distorts quarterly and annual earnings. CAPE takes an additional step and adjusts for inflation, thus normalizing the ratio for different inflation environments. While some may claim that these two approaches yield wildly different results, we found only a minor variance. TTM P/E for the S&P 500 is currently 1.50 standard deviations above its 130-year average, only slightly below that calculated using CAPE (1.75).

The bar chart below shows the distribution of CAPE values or the percentage of time the ratio was in each respective P/E band on the x-axis.

distro

Data Courtesy Robert Shiller – http://www.econ.yale.edu/~shiller/data.htm

While not a perfect bell curve, the chart above does have a similar shape, albeit with a long right tail. Over 80% of the data lies between a ratio of 8 and 20. The current ratio of 28.14 has only been eclipsed by 3% of the observations. Put more bluntly; the S&P 500 is in no man’s land by this measure.

Earnings

To gauge the expected earnings growth that is currently priced into the market, we could take the all too popular consensus forecasts published by Wall Street at face value. While that might be a fast approach, history, as discussed in “Earnings Magic Exposed”, has proven misleading.

Instead, we prefer to solve for the expected earnings growth rate using the CAPE ratio. If one believes in mean reversion, then it is likely CAPE will regress to its historical average ratio (16.7) within the next five years. If we further assume the price of the S&P 500 does not change, we can easily solve for expected earnings growth. Given those assumptions, the required annualized earnings growth for the next five years is nearly 11% at current valuations. In other words, the S&P 500 price would be unchanged over the next five years if corporate earnings grow 11% annually and CAPE regresses to its long-term average. However, if we assume investors expect the S&P 500 price to grow 5% a year as it has averaged this century, then earnings must increase 16.50% annually to offset the reversion to the mean of CAPE. If we take a more conservative stance and assume that CAPE will remain at one standard deviation above average at 23.35 and the S&P 500 price will grow 5% annually, earnings must grow at an annualized rate of 4.50%.

A scenario in which earnings grow annually at 4.50% may seem reasonable, but it is relatively optimistic when put in context with previous growth trends and economic impediments. Consider that over the last three, five and ten years, S&P 500 earnings have grown at annualized rates of -0.48%, 2.34%, and 1.80%, respectively. It is worth noting that the three- and five-year periods do not include a recession. Expecting that streak to continue five more years fails to incorporate reasonable recession probabilities into the analysis.

To put additional perspective on expected earnings growth, we analyze the nation’s economic growth rate. Since 1947, real GDP and corporate earnings have grown at nearly identical long-term rates. The graph below charts the cumulative growth of earnings and GDP over this period. Note that, while the growth rates vary wildly, they have been well-correlated over the longer-term as witnessed by comparing the less volatile earnings polynomial trend line (blue dotted line) with GDP (green line).

earng-vs-gdp

Data Courtesy: St. Louis Federal Reserve (FRED) and Bloomberg

The graph below aids in forecasting earnings growth by highlighting the secular trend of GDP growth since 1950.

gdp-trend

Data Courtesy: St. Louis Federal Reserve (FRED)

The trend was confirmed by Janet Yellen, who on January 18, 2017, stated that the long-run GDP growth rate is expected to fall under 2%. Based on the GDP trend line and the correlation of earnings to GDP expectations, one should assume earnings growth will follow GDP and be 3% or less.

The future growth rate assumption mentioned above is not solely a function of extrapolation from previous trends. It is truly arrived at with a thorough understanding of the economy’s structural impediments – debt, demographics, and productivity as we have noted in numerous prior articles.

Scenario Analysis

At this point, we have presented you with historical earnings trends and a way to estimate future earnings growth. Additionally, we provided a long history of the price to earnings ratio and the statistically significant distribution it has followed. With this data in mind, we present the table below which allows you to forecast stock price changes based on future P/E ratios and earnings growth estimates. Note the three colored boxes reflect what we consider to be optimistic, fair and pessimistic estimates. Here are the simple steps to evaluate forward returns:

  1. Select the CAPE ratio you expect to see in 2022. At the top of the table are six options ranging from 10.1 to 28.1 (current level). The range is based on standard deviations as shown above each P/E level.
  2. Select the expected annualized earnings growth for the next 5
  3. Find the intersection of your CAPE and earnings growth estimates. The number at the intersection is the expected annualized price return for the S&P 500 for the next five years. As a quick example, a projected CAPE of 20.0 and 3% earnings growth will result in an expected annual return of -2.57% for each of the next five years.

expected-returns-table

As illustrated in the table, the risk/reward profile is very unbecoming unless you believe CAPE will stay grossly elevated and earnings will grow significantly more than they have over the past ten years.  A relatively riskless strategy, whereby one buys and holds to maturity a five-year U.S. Treasury bond yielding 1.98%, beats all but the most optimistic scenarios highlighted above.

Summary

Many investors believe that the initiatives of the new administration will provide an economic spark generating economic growth and increasing corporate earnings. Although confidence is a cheap form of stimulus, reality is that the structural headwinds the economy faces are brisk. Given the historically high valuations and poor risk/reward ratio, we prefer to let the market prove us wrong.

One final note for consideration; since January 1, 2012, the S&P 500 has increased 75%, while earnings have increased 2%. In other words, for all intents and purposes, the entire rally from 2012 is a function of multiple expansion and is in no way supported by fundamentals. For investors who hold mean reversion as an important guiding principle, it is not unrealistic to expect the CAPE multiple to regress back towards its historical average. Indeed, it is entirely expected.

We leave you with the article’s opening quote as it is such an important concept to grasp.

“Never ever lose sight of long term relationships”.

                                                           

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.

 

Coming soon 720 Global will offer “The Unseen”, a subscription-based publication similar to what has been offered at no cost over the past year and a half.  In fact, what the subscription offers is precisely what we have delivered in the past, a substance in style and form that provides unique analysis and meaningful value to discerning investors. Those that have read our work understand the comparative advantage they have gained over the vast majority of investors that solely focus on the obvious. Our readers are prepared for what few see.

 

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 2017 All Rights Reserved

 

NOTICE AND DISCLAIMER: This material has been prepared by 720 Global, LLC. Opinions expressed herein are subject to change without notification. Any prices or quotations contained herein are indicative screen prices and are for reference only. They do not constitute an offer to buy or sell any securities at any given price. No representation or warranty, either express or implied, is provided in relation to the accuracy, completeness, reliability or appropriateness of the information, methodology and any derived price contained within this material. The securities and related financial instruments described herein may not be eligible for sale in all jurisdictions or to certain categories of investors.

Neither 720 Global, LLC nor its directors accept any liability for any loss or damage arising out of the use of all or any part of these materials.

All rights reserved. This material is strictly for specified recipients only and may not be reproduced, distributed or forwarded in any manner without the permission of 720 Global, LLC. 

 

 

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Extrapolate at Your Own Risk

 

As we dig through S&P 500 price forecasts for the year 2017, we discover that a majority of “Wall Street’s top strategists”, are calling for a year-end S&P 500 price in the 2,300-2,450 range. None of the forecasters expect a down year, but that’s an article for another day. Not surprisingly, a year-end index price in the aforementioned forecasted range would put growth in line with that experienced since 2012. While the strategists will claim they have extensive multi-factor models that help them arrive at their estimate, it is quite likely many of them rely on extrapolating prior price performance into the future based on the dangerous assumption that the future will be like the past.

Such a forecasting strategy may seem logical, and has worked well for the last four years, but it fails to acknowledge that earnings growth, which have repeatedly been grossly over-estimated, have been relatively flat over the same period. Since 2012, the S&P 500 has risen almost 70% while earnings are up a mere 2%. The graph below plots the S&P 500, earnings per share and their respective trend lines.

sp-vs-earnings

Data Courtesy: Bloomberg and Standard & Poor’s

When price increases are not accompanied by earnings increases, it indicates that multiple expansion has occurred. In other words, the ratio of price-to-earnings (P/E) is expanding almost entirely because of its numerator- price increases.

Whether or not an observed expansion of the P/E multiple makes sense depends upon the context. Such a situation may be justified when valuations are at or below the long run average, but keep in mind that current valuations are at levels that have rarely been eclipsed in history. The current P/E multiple is not just above average, it is 70% above the average of over 130 years of observations.  For those that follow the consensus expectations, we suggest that you also extrapolate expected returns for ever increasing valuations. The graph below plots the S&P 500 and expected ten-year annualized returns. The expected return is calculated from the regression of monthly Cyclically Adjusted Price to Earnings ratio (CAPE) and the associated annualized returns that occurred over the following ten years. The data encompasses 130 years’ worth of data.

sp-vs-expect-returns

Data Courtesy: Bloomberg and Standard & Poor’s

It is plausible that earnings will increase at a healthy clip and valuations will normalize. However, if we are to extrapolate prices like the so-called experts, then to be consistent, that same logic should also be applied to earnings and expected returns. Expected returns, having trended lower since 2012, are now forecasting a sub-1.00% annualized return for the next ten years.

This brief note is a simple reminder that extrapolating price without considering future earnings trends and valuations is a fool’s game. Extrapolating the past is relatively harmless for street prognosticators. Basing an investment strategy on such a plan, however, can have severe financial repercussions.

 


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.

 

Coming soon 720 Global will offer “The Unseen”, a subscription-based publication similar to what has been offered at no cost over the past year and a half.  In fact, what the subscription offers is precisely what we have delivered in the past, substance in style and form that provides unique analysis and meaningful value to discerning investors. Those that have read our work understand the comparative advantage they have gained over the vast majority of investors that solely focus on the obvious. Our readers are prepared for what few see.

 

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 2017 All Rights Reserved

 

NOTICE AND DISCLAIMER: This material has been prepared by 720 Global, LLC. Opinions expressed herein are subject to change without notification. Any prices or quotations contained herein are indicative screen prices and are for reference only. They do not constitute an offer to buy or sell any securities at any given price. No representation or warranty, either express or implied, is provided in relation to the accuracy, completeness, reliability or appropriateness of the information, methodology and any derived price contained within this material. The securities and related financial instruments described herein may not be eligible for sale in all jurisdictions or to certain categories of investors.

Neither 720 Global, LLC nor its directors accept any liability for any loss or damage arising out of the use of all or any part of these materials.

All rights reserved. This material is strictly for specified recipients only and may not be reproduced, distributed or forwarded in any manner without the permission of 720 Global, LLC. 

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Hoover’s Folly

image

In 1930, Herbert Hoover signed the Smoot-Hawley Tariff Act into law. As the world entered the early phases of the Great Depression, the measure was intended to protect American jobs and farmers. Ignoring warnings from global trade partners, the new law placed tariffs on goods imported into the U.S. which resulted in retaliatory tariffs on U.S. goods exported to other countries. By 1934, U.S. imports and exports were reduced by more than 50% and many Great Depression scholars have blamed the tariffs for playing a substantial role in amplifying the scope and duration of the Great Depression. The United States paid a steep price for trying to protect its workforce through short-sighted political expedience.

On January 3, 2017 Ford Motor Company backed away from plans to build a $1.6 billion assembly plant in Mexico and instead opted to add 700 jobs at a Michigan plant. This abrupt reversal followed sharp criticism from Donald Trump. Ford joins Carrier in reneging on plans to move production to Mexico and will possibly be followed by other large corporations rumored to be reconsidering outsourcing. Although retaining manufacturing and jobs in the U.S. is a favorable development, it seems unlikely that these companies are changing their plans over concerns for American workers or due to stern remarks from President-elect Trump.

What does seem likely? Big changes in trade policy occurring within the first 100 days of Trump’s presidency. The change in plans by Ford and Carrier serve as clues to what may lie ahead and imply a cost-benefit analysis.  In order to gain better insight into what the trade policy of the new administration may hold, consideration of cabinet members nominated to key positions of influence is in order.

Trump’s Trade Appointments

As we close in on Trump’s inauguration, his cabinet and team of advisors is taking shape.  With regard to global trade, there are three cabinet nominations that most capture our attention:

  • Peter Navarro is a business professor from the University of California-Irvine. Mr. Navarro has been very outspoken about China and the need to renegotiate existing trade deals in order to put America on a level playing field with global manufacturers. The author of the book, “Death by China”, will lead the newly created White House National Trade Council.
  • Wilbur Ross is a billionaire investor who made his fortune by resurrecting struggling companies. In the words of Donald Trump, Mr. Ross is a “champion of American manufacturing and knows how to turn them around”. The long time trade protectionist will now serve as Commerce Secretary.
  • Robert Lighthizer is currently a lawyer with a focus on trade litigation and lobbying on behalf of large U.S. corporations. Earlier in his career, he served as deputy U.S. Trade Representative under President Ronald Reagan. Mr. Lighthizer has been very outspoken about unfair trade practices that harm America. In his new role he will serve as Trump’s U.S. Trade Representative.

Donald Trump said that Mr. Lighthizer will work “in close coordination” with Wilbur Ross and Peter Navarro. The bottom line is that these three advisors have strong protectionist views and generally feel that China, Mexico and other nations have taken advantage of America.

Gettysburg and other Rhetoric

On October 22, 2016 in Gettysburg Pennsylvania, Donald Trump delivered a litany of goals that he hopes to accomplish in his first 100 days of office. Within the list are seven actions aimed at protecting American workers. Four of them deal with foreign trade. They are as follows:

These four proposals and other trade-related rhetoric that Donald Trump repeatedly stated while running for president suggest that he will take immediate steps to level the global trade playing field. At this point, it is pure conjecture what actions may or may not be taken. However, the article, “We need a tough negotiator like Trump to fix U.S. trade policy”, penned by Peter Navarro and Wilbur Ross from July 2016 offers clues.

In the article, Navarro and Ross took the World Trade Organization (WTO) to task for being negligent in defending the United States against unfair trade. Additionally, they note the WTO “provides little or no protection against  four of the most potent unfair trade practices many of our trade partners routinely engage in — currency manipulation, intellectual property theft, and the use of both sweatshop labor and pollution havens”.

They also note that the U.S. does not have a Value-Added Tax (VAT). Heavily used in the European Union and much of the rest of world, a VAT is a tax imposed at various stages of production where value is added and/or at the final sale. The tax rate is commonly based on the location of the customer, and it can be used to affect global trade. Manufacturers from countries with VAT taxes frequently receive rebates for taxes incurred during the production process. Because the U.S. does not have a VAT, the WTO has denied U.S. corporations the ability to receive VAT rebates. In fact, the WTO has rejected three congressional attempts to give American companies equal VAT rebate treatment. By denying VAT rebates the WTO is “giving foreign competitors a huge tax-break edge.” 

It is possible that, within weeks of taking office, President-elect Trump may threaten to leave the WTO. In what is likely a negotiating tactic, we should expect strong proposals from Trump and his team with the goal of forcing the WTO to alter decisions more to the favor of the United States. Among the actions the Trump administration may take, or threaten to take, is the pulling out of prior trade agreements and/or establishing tariffs on imports into the United States. Because of its efficiency and simplicity, border tax adjustments, which are similar to VAT, seem to be a more logical approach as they would effectively assess a tax on importers of foreign goods and resources without affecting exporters.  Border tax adjustments seem even more plausible when considered in the context of a recent Twitter message that Donald Trump posted: “General Motors is sending Mexican made model of Chevy Cruze to U.S. car dealers-tax free across border – Make in U.S.A. or pay big border tax!

Ramifications and Investment Advice

Although it remains unclear which approach the Trump trade team will take, much less what they will accomplish, we are quite certain they will make waves. The U.S. equity markets have been bullish on the outlook for the new administration given its business friendly posture toward tax and regulatory reform, but they have turned a blind eye toward possible negative side effects of any of his plans. Global trade and supply chain interdependencies have been a tailwind for corporate earnings for decades. Abrupt changes in those dynamics represent a meaningful shift in the trajectory of global growth, and the equity markets will eventually be required to deal with the uncertainties that will accompany those changes.

If actions are taken to impose tariffs, VATs, border adjustments or renege on trade deals, the consequences to various asset classes could be severe.  Of further importance, the U.S. dollar is the world’s reserve currency and accounts for the majority of global trade. If global trade is hampered, marginal demand for dollars would likely decrease as would the value of the dollar versus other currencies.

From an investment standpoint, this would have many effects. First, commodities priced in dollars would likely benefit, especially precious metals. Secondly, without the need to hold as many U.S. dollars in reserve, foreign nations might sell their Treasury securities holdings. Further adding pressure to U.S. Treasury securities and all fixed income securities, a weakening dollar is inflationary on the margin, which brings consideration of the Federal Reserve and monetary policy into play.

Investors should anticipate that, whatever actions are taken by the new administration, America’s trade partners will likely take similar actions in order to protect their own interests. If this is the case, the prices of goods and materials will likely rise along with tensions in global trade markets. Retaliation raises the specter of heightened inflationary pressures, which could force the Federal Reserve to raise interest rates at a faster pace than expected. The possibility of inflation coupled with higher interest rates and weak economic growth would lead to an economic state called stagflation. Other than precious metals and possibly some companies operating largely within the United States, it iummaryc or global assets that benefit. d to envision other assets lation, higher interest and stagnant economic growth would lis hard to envision many other domestic or global assets that benefit from a trade war.

Summary

We like to think that the lessons from the Great Depression would prevent a trade war like the one precipitated by the Smoot-Hawley Tariff act. We must realize, however, that nationalism is on the rise here and abroad, and America will soon have a president that appears more than willing to take swift and aggressive  action to ensure that it is not taken advantage of in the global trade arena.

It is premature to make investment decisions based on rhetoric and threats. It is also possible that much of this bluster could simply be the opening bid in what is a peaceful renegotiation of global trade agreements. To the extent that global growth and trade has been the beneficiary of years of asymmetries at the expense of the United States, then change is overdue.  Our hope is that the Trump administration can impose the discipline of smart business with the tact of shrewd diplomacy to affect these changes in an orderly manner. Regardless, we must pay close attention as trade conflicts and their consequences can escalate quickly.


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.

 

Coming soon 720 Global will offer “The Unseen”, a subscription-based publication similar to what has been offered at no cost over the past year and a half.  In fact, what the subscription offers is precisely what we have delivered in the past, substance in style and form that provides unique analysis and meaningful value to discerning investors. Those that have read our work understand the comparative advantage they have gained over the vast majority of investors that solely focus on the obvious. Our readers are prepared for what few see.

 

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NOTICE AND DISCLAIMER: This material has been prepared by 720 Global, LLC. Opinions expressed herein are subject to change without notification. Any prices or quotations contained herein are indicative screen prices and are for reference only. They do not constitute an offer to buy or sell any securities at any given price. No representation or warranty, either express or implied, is provided in relation to the accuracy, completeness, reliability or appropriateness of the information, methodology and any derived price contained within this material. The securities and related financial instruments described herein may not be eligible for sale in all jurisdictions or to certain categories of investors.

Neither 720 Global, LLC nor its directors accept any liability for any loss or damage arising out of the use of all or any part of these materials.

All rights reserved. This material is strictly for specified recipients only and may not be reproduced, distributed or forwarded in any manner without the permission of 720 Global, LLC. 

 

 

 

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Deception

deception

Janet Yellen

At the December 14, 2016 FOMC press conference, Federal Reserve Chairwoman Janet Yellen responded to a reporter’s question about equity valuations and the possibility that equities are in a bubble by stating the following: “I believe it’s fair to say that they (valuations) remain within normal ranges”. She further justified her statement, by comparing equity valuations to historically low interest rates.

On May 5, 2015, Janet Yellen stated the following: “I would highlight that equity-market valuations at this point generally are quite high,” Ms. Yellen said. “Not so high when you compare returns on equity to returns on safe assets like bonds, which are also very low, but there are potential dangers there.”

In both instances, she hedged her comments on equity valuations by comparing them with the interest rate environment. In May of 2015, Yellen said equity-market valuations “are quite high” and today she claims they are “within normal ranges”? The data shown in the table below clearly argues otherwise.

table

Interestingly, not only are equity valuations currently higher than in May of 2015 but so too are interest rates.

Further concerning, how does one define “normal”? Does a price-to-earnings ratio that has only been experienced twice in over hundred years represent normal? Do interest rates near historical lows with the unemployment rate approaching 40-year lows represent normal? Is there anything normal about a zero-interest rate monetary policy and quadrupling of the Fed’s balance sheet?

Does the Federal Reserve, more so than the collective wisdom of millions of market participants, now think that it not only knows where interest rates should be but also what equity valuations are “normal”?

One should expect that the person in the seat of Chair of the Federal Reserve would have the decency to present facts in an honest, consistent and coherent manner. It is not only her job but her duty and obligation.

Homebuilders

On December 15, 2016, CNBC reported the following:The National Association of Home Builders/Wells Fargo Housing Market Index (HMI) rose to 70, the highest level since July 2005. Fifty is the line between positive and negative sentiment. The index has not jumped by this much in one month in 20 years.”

The graph below shows how much house one can afford at various interest rates assuming a $3,000 mortgage payment.

mtg-graph

Over the past two months U.S. mortgage rates increased almost a full percent from 3.50% to 4.375%. Given such an increase, a prospective homeowner determined to limit their mortgage payment to $3,000 a month would need to seek a 10% reduction in the price of a house. In the current interest rate environment, this equates to drop from $668,000 to $601,000 in order to achieve a $3,000 a month mortgage payment. One would expect that homebuilders temper their optimism, given that a key determinant of housing demand and ultimately their companies’ bottom lines is facing a sturdy headwind.

Advice/Summary

The point in highlighting these examples is to remind you that people’s opinions, especially those with a vested interest in a certain outcome, may not always be trustworthy. We simply urge you to examine the facts and data before blindly relying on others.

We leave you with historical insight from a few so-called experts:

  • “We will not have any more crashes in our time.”: John Maynard Keynes 1927

 

  • There is no cause to worry. The high tide of prosperity will continue” : Andrew Mellon 1929

 

  • Stock prices are likely to moderate in the coming year but that doesn’t mean the party is coming to an end.” : Phil Dow 1999

 

  • The Federal Reserve is not currently forecasting a recession.” : Ben Bernanke 2008

 

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Banks in Drag : The Russell 2000 Exposed

In “Passive Negligence”, we highlighted how investors, on the margin, have been shifting from an active investment style to a more passive approach by favoring index and sector ETFs and mutual funds over individual holdings. We raised a concern that, in this mad dash towards the latest fad, many investors are falling prey to complacency by failing to properly analyze the underlying companies in which they are ultimately investing.

Since Donald Trump won the election, the Russell 2000 (R2K) has been the darling of the market, increasing approximately 15%. There are many narratives that support investing in small cap stocks, as represented by the R2K, and some even have credence. That said, investors should look beyond these narratives and analyze the index’s current valuation and its underlying holdings to better judge if the R2K is a good investment.

This article was written in conjunction with J. Brett Freeze, CFA from Global Technical Analysis.

The Russell 2000

Passive investors looking to diversify their equity holdings frequently hold a number of ETFs and mutual funds that blindly follow an index or sector. Many investment professionals employ a similar approach called “closet indexing”. In other words, they own a portfolio of different equity indices and some specific sectors as a decoy to their clients. They want the appearance of providing real value by generating alpha through security selection and not simply buying the “market”. Typically such strategies, over time, provide market-like returns and little diversification.

The R2K, in the words of Wikipedia, is “by far the most common benchmark for mutual funds that identify themselves as small cap”. Therefore, the R2K is a favorite among “closet indexers” looking to diversify their portfolios with small-cap holdings.

Like many broad-based indices, the R2K is composed of a diverse group of companies from varying industries. Currently, technology, services, healthcare and financials account for approximately 75% of the market capitalization of the index.

The following aggregate analysis of the R2K decomposes the index into nine industry classifications as well as a small catch-all category for unclassified companies. The current index constituents were held constant over the 13 year period that we reviewed. In other words, the data analyzed assumes the companies currently in the R2K, were in it for the last 13 years. This method allows for a more consistent evaluation of the index as it is currently composed. Note that 34 of the index constituents were excluded from this analysis as no data was available. The data used in this analysis is courtesy of http://www.gurufocus.com.

Net Income

Over the last five years, the R2K’s aggregate annual net income has shrunk from $33.6 billion to $9.7 billion, a 73% decline. That compares with nominal GDP growth of +18% and a 1% decline in S&P 500 earnings growth over the same period. Of the nine industries and the catch-all category that comprise the R2K, only four have experienced income growth over the last five years. Even more interesting is that 83% of the R2K’s earnings growth over the last five years is from one sector, financials.  Exclude financial companies from the index, aggregate earnings have been negative in each of the last two years. The chart below highlights the declining trend in R2K earnings since 2003, which marks the start of the market’s recovery from the Technology crash.

income-graph

R2K earnings, as highlighted above, have declined at an annualized rate of 7.81% despite the 4.15% annualized earnings growth of financial companies.

Market Capitalization

Market Capitalization, also known as market cap, is the aggregate value of the equity shares underlying the index at a specific point in time. Currently, the R2K’s market cap stands at $2.311 trillion. Financial companies comprise the largest share at 25.4%, followed by technology (17.5%) and services (16.8%). Over the last five years, as shown in the graph below, the market cap of the R2K has nearly doubled, rising 91% despite declining earnings over the same period.

income-market-cap-graph

As the R2K’s market cap steadily increases and earnings fail to follow, the valuation of the index naturally richens. In particular, note the last two years in which the market cap increased despite a sharp decline in earnings. Currently, the ratio of market cap to net income is at an astronomical 237x, significantly above the post-2003 average of 33x. Holding earnings constant and regressing the index back to its post-2003 mean, market cap to earnings ratio would produce an 86% decline in the R2K. Even in an optimistic scenario, where earnings rebound to the high water mark of $40.90 billion set in 2013, the R2K would need to decline by 42% from its current level to produce a market cap to earnings ratio of 33x.

As a point of comparison, the widely reported P/E ratio of 46 for the R2K appears to be much lower than our value (237x). Unlike, the market benchmark S&P 500, the reported Russell P/E ratio excludes companies with negative earnings. Our analysis appropriately includes both positive and negative earnings.

What is the Russell?

Thus far, we have shown the paltry earnings growth of the R2K and the unsubstantiated rise in its market cap. To try to make more sense of this conflict we return to a point made earlier:  financial companies have provided 83% of all the earnings in the R2K over the last five years. From a fundamental perspective, an investor in the R2K has relied almost entirely upon earnings from financial companies, but has retained exposure to three-quarters of the index which have produced negligible aggregate earnings. In other words, investors are paying a steep premium for what amounts to earnings exposure from financial stocks.

The KBW bank index is a popular benchmark for the performance of domestic regional banks. Unlike the major national banks, such as J.P. Morgan and Bank of America, these banks are smaller in size, have less global exposure, and do a majority of their business in specific regions of the country. The largest banks in the index are household names such as KeyCorp, M&T Bank and BB&T Corporation. Some of the lesser-known banks are Berkshire Hills Bancorp, Hanmi Financial Corporation, and Cardinal Financial Corporation. Nearly 65% of the stocks in the KBW index are included in the R2K index.

Passive investors could have extracted a large portion of the fundamental benefits of owning the R2K by purchasing the KBW index. In substituting KBW for R2K, they would have retained similar exposure to financials while avoiding a portfolio of additional stocks trading at extreme valuations. The financial stocks within the R2K currently have a market cap to income ratio of 22.2, well below the 237.4 ratio of the entire index.

The table below compares the results of R2K and KBW. We used popular ETF’s to replicate investor performance of the two indices – IWM (R2K) and KRE (KBW).

table

KBW outperformed the R2K on an annualized return basis over the last two and five year periods and provided better risk-adjusted returns.

Having identified a meaningful anomaly, the next question is how can an investor or portfolio manager capitalize on it? For those who already own the R2K and are comfortable with market valuations, the recommendation would be to replace the R2K with a combination of the S&P 500, Wilshire 5000 and the KBW banking index. The Wilshire 5000 also provides some small cap exposure, but at comparatively reasonable valuations.  For those looking to exploit what seems like a mispricing of the R2K, we recommend a paired trade approach whereby one shorts the R2K and goes long the KBW and the S&P 500.

Summary

Much of the recent post-election price appreciation in the R2K has been based on the performance of financial stocks. The KBW index, again solely a financial stock portfolio, is up approximately 25% since the election, compared with 15% for the broader R2K.  The recent appreciation in financials is apparently a response to the new administration’s planned policies that are generally viewed as beneficial for the financial sector.  Given the regulatory oppression of the past eight years, this may very well be a sound reason to own bank stocks. However, the R2K index is trading at grossly elevated levels. Owning the index for anything other than pure speculative trading is ridiculous. Owning the index for its bank exposure is insane.

Active investment may not be in style, but that is certainly no reason to ignore sound analytical rigor and proper logic in making prudent investment allocation decisions.

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Mind Games

 

In “Bubbles and Elevators”, we discussed how human beings do seemingly ridiculous things to fulfill their instinctive need to mimic what others are doing, right or wrong, logical or illogical. The greatest investors, those that make money when markets are rising and avoid the pain when bear markets occur, are a limited bunch. It is not luck that makes them special, nor is it necessarily their ability to find fundamental and/or technical set ups that provide great opportunities. Ultimately, these investors possess the ability to understand and overcome the inherent behavioral traits that handicap most investors. To use a trite phrase- the great ones are truly able to think outside of the box.

Behavioral Traits

Confirmation bias, group think, and cognitive dissonance dominate our logic and the way we interpret the world around us. It is our hope that, through a better understanding of each of these behaviors, we may encourage you to consider views that are outside of the box.

  • Confirmation Bias – This bias, a form of cognitive bias, is a condition of the human mind that occurs when we seek or interpret information in a manner that tends to confirm our existing beliefs or hypothesis. Those exhibiting this bias pay little attention to opinions and data that may offer alternative possibilities.
  • Group Think – This mental occurrence arises when a group of people seeking conformity think and act in similar fashion to each other. Typically the group will reach a consensus opinion without proper evaluation and with a lack of alternative viewpoints.  **From Wikipedia- “Group think requires individuals to avoid raising controversial issues or alternative solutions, and there is loss of individual creativity, uniqueness and independent thinking.”
  • Cognitive Dissonance – This condition is experienced by an individual that holds two or more inconsistent thoughts at the same time, including new information that conflicts with existing beliefs. Frequently humans actively avoid information or opinions that may introduce or strengthen discrepant views.

People naturally find immense comfort in thinking and behaving like everyone else. Think about how exhilarating a football game can be when the crowd is roaring the fight song, everyone is wearing your team’s colors and strangers are high-fiving each other.

We tend to ignore or shun alternative views that may challenge our ideas or beliefs. How many people subscribe to the liberal New York Times and watch the conservative FOX News?

How often do we seek and create narratives to help defray the stress of having opposing views? In “A Narrative for Every Season” we showed how a “panic born narrative” formed to help explain why a Trump presidency is good for the equity market despite a host of reasons that question the efficacy of his policy proposals.

Summary

By falling victim to these traits we essentially guarantee that our investment returns will fall in line with the markets returns. In other words, if we think and act like every other investor, why should we expect returns that are any different. Therefore as investors and fiduciaries of others wealth, we owe it to ourselves to entertain and understand alternative views. We need to watch FOX News and read the New York Times. We need to challenge ourselves to better understand things that may not be comfortable.

Whether one is bullish or bearish, seek out and spend time studying the views of others with whom you disagree. By better understanding opposing opinions, investors will either strengthen their existing views and/or better understand the potential flaws in their current thinking. Either way, an investment or economic thesis is the better for it.

“The Unseen”, our upcoming subscription service, will provide readers with a perspective that is largely overlooked by other research services, most of which focus only on the obvious. Like ideas, policy and valuations have consequences and very often those consequences are neither foreseen nor predicted. We take pride in presenting views that challenge the conventional mindset. While you may agree or disagree with our thoughts, our goal is not to win your approval but to better prepare you for what few see.

 

 

 

 

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