Outlook

The Art of Low Turnover (Smead)


Wednesday, June 19th, 2013

by William Smead, Smead Capital Management

We have argued vociferously that active managers have given up their preferred position in the investing marketplace to passive indexes because of high turnover. A recent Wall Street Journal article referenced 78% turnover as being the average among large-cap US equity funds. Studies have shown that as much as 144 basis points each year in return is chewed up by trading costs. Explaining turnover and its impact is one thing, but it is more important to ask a question. How do you practice low turnover while seeking maximal long-term performance?

We at Smead Capital Management practice low turnover in the following ways. First, we like to buy at what John Templeton called, “the point of maximum pessimism”. If you follow an admirable company long enough, either the stock market, industry wide difficulties or an inner-company stumble of their own making will cheapen their shares to the lowest P/E quintile in the S & P 500 index. Valuation matters dearly to low turnover, because the original depressed price leaves a wonderful company plenty of upside potential at historically normal P/E ratios. If a stock has gone up markedly since you bought it and is a superior company in many ways, then you are in position to make attractive returns at a fair price. Warren Buffett reminds us of why below: “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price”

Second, owning high quality companies allows for long holding periods. In his 2005 study on quality aspects of a company which provide long-term alpha, Ben Inker of GMO, showed that low leverage, low earnings volatility, high and consistent profitability, and low stock price volatility (beta) contributed significant alpha over 24 years from 1980-2003. We use wide moats, long histories of high profitability, high and consistent free cash flow, and strong balance sheets as our qualitative aspects of stock selection. We believe that humans are unlikely to hold low quality securities through multiple cycles. We like to look at a company in their darkest hour and ask if we could have withstood the pressure to sell at that point before we buy it originally.

Third, we have what we consider a sensible sell discipline and appreciate the way your sell discipline can lead you to either high or low turnover. In our case, we sell for three reasons. 1) We sell if one of qualitative criteria get violated going forward. Did they lose their moat, permanently damage their balance sheet or cease to maintain historical profit margins? 2) We sell investments which we were wrong on. We sell a stock which declines 15-20% in the first three years we own it, if when re-analyzed, doesn’t motivate us to buy more. In other words, some companies are not meant for us to be a long-term holder (we have duds). 3) Sometimes the wonderful companies we are part owners of get maniacal pricing in the market place. This usually means a P/E ratio two times the norm for that company. Extremes of popularity must be avoided even for those of us who resist turnover.

Lastly, holding winners to a fault contributes to low turnover and maximal long-term portfolio performance. The math of common stock investing is very simple: generally stock performance tends to fall along a bell curve in the long run. Good stock picking and portfolio management seeks to find a few of the companies which make it to the best 5% of performance among all stocks on that bell curve. We argue that active managers have given up too much advantage to the index on the simple math. In the Bible, love covers a multitude of sins. In portfolio management, our theory is that a ten-fold increase or greater in a few stocks out of 20-30 covers a multitude of duds.

The S&P 500 holds its winners straight through without any effort to weed out maniacal securities. Therefore, they satisfy the bell curve. In our opinion, most active equity managers spend way too much time attempting to determine the top in a stock under the guise of price targets and intrinsic value calculations. We believe that the urge to smooth returns for short-term performance reasons and/or an effort to be smarter than anyone really expects them to be drives stock picking organizations that direction. When an equity manager research person asks us what our price target is for a certain company we cringe. The whole idea behind what we are doing is auditioning companies for use in our portfolio in hopes of finding multi-decade success stories! Other than maniacal pricing, we believe equity managers kill long-term performance by cutting off their best performers. The crime is the penalty to short-run performance coming from the trading costs associated with their impatience and attempts at perfection.

Think of it this way. If you were a producer of plays and movies, you would audition actors and actresses. If everything works well, you could find a Meryl Streep, George Clooney, Kevin Bacon, Reece Witherspoon, Bradley Cooper or Jack Nicholson. Think how depressed you’d be today if you had Meryl under contract in the 1970s and 1980s and let her go in the early 1990s because you thought she was “fully valued”. She is still cranking out hits in this decade, 20 years after a pretty actress like her is supposed to be left with supporting roles. I’m pretty sure that the “Devil Wears Prada” and a devil sits on the shoulder of active managers and begs them to sell out of their best performing securities.

In conclusion, we believe that low turnover is critical to outperforming the S&P 500 index. We also believe that every stock picking organization should consider establishing a discipline to promote low turnover to get at bell curve success and low trading costs. We believe that Michael Price, former manager of Mutual Shares said it best, “The fewer decisions I make, the smarter I am”.

Best Wishes,

William Smead

The information contained in this missive represents SCM’s opinions, and should not be construed as personalized or individualized investment advice. Past performance is no guarantee of future results. It should not be assumed that investing in any securities mentioned above will or will not be profitable. A list of all recommendations made by Smead Capital Management within the past twelve month period is available upon request.

This Missive and others are available at smeadcap.com

 

Copyright © Smead Capital Management

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Hilsenrath Indicates Dovish Press Conference Coming


Monday, June 17th, 2013

by Mark Hanna, Market Montage

Well speaking to the comments just posted a few hours ago we just got a story from Fed mouthpiece Jon Hilsenrath at the WSJ, indicating we can expect a very dovish press conference from Bernanke next week.  The market rocketed up on the news and all is well in the world again as QE infinity still is boundless apparently.   Even after all this volatility we just went from red to green for the month of June on the S&P 500.  Thankfully there is no longer a need to know anything about earnings, revenue, margins et al – you just have to know what Ben is going to do or say.

At the same time, however, the Fed is talking about pulling back on its $85 billion-per-month bond-buying program. The chatter about pulling back the bond program has pushed up a wide range of interest rates and appears to have investors second-guessing the Fed’s broader commitment to keeping rates low.

This is exactly what the Fed doesn’t want. Officials see bond buying as added fuel they are providing to a limp economy. Once the economy is strong enough to live without the added fuel, they still expect to keep rates low to ensure the economy keeps moving forward.

It’s a point Chairman Ben Bernanke has sought to emphasize before. The Fed, he said in his March press conference and again at testimony to Congress last month, expects a “considerable” amount of time to pass between ending the bond-buying program and raising short-term rates.

He seems likely to press that point at his press conference next week, given that the markets are telling him they don’t believe it.

Copyright © Market Montage

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Borrowing From the Future (Tom Bradley)


Wednesday, June 12th, 2013

by Tom Bradley, Steadyhand Investment Funds

In his June Investment Outlook, PIMCO’s Bill Gross says that the Quantitative Easing policy (QE) of the U.S. Federal Reserve hasn’t worked. He points out that over the last 5 years there hasn’t been a 12-month period when the economy has grown faster than 2.5%. Thus his conclusion: QE hasn’t worked.

Now, let me first state that I too am of the view that the Fed has gone too far in trying to manage/stimulate the economy. They had to act during the 2008/09 crisis, and thank goodness they did, but they’ve continued to micro-manage ever since. Like Mr. Gross, I think the Fed has got in the way of economic healing, which has to occur before the next up cycle can start. I suspect we’re now behind where we’d otherwise be if the Fed had pulled back and let the cycle play out.

Having said that, I find Mr. Gross’ comment interesting. Yes, the economy has been growing slowly, but it has been growing while the rest of the western world (Europe and Japan) has not. How can he (along with many others who share his view) say it hasn’t been working if he doesn’t know what would have happened without the QE trilogy? It seems to me that the U.S. economy has done surprisingly well in the face of all its challenges. I’d say that the Fed’s meddling has enhanced GDP growth. Unfortunately, it’s borrowed the growth from a time in the future when the necessary healing will need to occur.

Copyright © Steadyhand Investment Funds

 

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The Bear Case for Equities


Tuesday, June 11th, 2013

The bear case for equities

by Cam Hui, Humble Student of the Markets

I have been fairly bullish in these pages and I remain cautiously bullish today. However, successful investors and traders look at the other side of the coin to see what could go wrong with their thesis. Today, I write about the bear case, or what’s keeping me up at night.

The signal from emerging market bonds

James Carville, former advisor to Bill Clinton, famously said that he wanted to be reincarnated as the bond market so that he could intimidate everyone. The message from the bond market is potentially worrying. In particular, emerging market bonds are selling off big time. The chart below of the emerging market bond ETF (EMB) against the 7-10 year Treasury ETF tells the story. The EMB/IEF ratio broke an important relative support level, with little signs of any further support below the break.

Technical breaks like these are sometime precursors of a catastrophic event, much like how the crisis in Thailand led to the Asian Crisis. For now, the concerns are somewhat “contained”. Yes, junk bond yileds have spiked…

On the other hand, the relative performance of high yield, or junk, bonds against 7-10 year Treasuries remain in a relative uptrend, which indicates that the trouble remains isolated in emerging markets.

Here is the relative performance of emerging market bonds against junk bonds. They have been in a multi-year trading range. Should this ratio break to the downside, it would be an indication that something is seriously wrong in EM that smart investors would be well advised to sit up and take notice of.

For now, this is just something to watch.

Are European stocks keeling over?

The second area of concern is Europe. Despite my bullish call on Europe (see Europe healing?) European stocks have been performing poorly in this correction. As the chart below of the STOXX 600 shows, the index has fallen below its 50 day moving average, though the 200 day moving average has been a source of support in the past.

The 200 dma is my line in the sand.

Faltering sales and earnings momentum

In the US, high frequency macro indicators are showing a pattern of more misses than beats, as measured by the Citigroup Economic Surprise Index.

Ultimately, a declining macro outlook will feed into Street sales and earnings expectations for the stock market. Ed Yardeni documented the close correlation between the Purchasing Managers Index against revenue estimates.

Viewed in this context, the PMI “miss” last week is especially worrying. Indeed, Yardeni showed that the Street’s forward 52-week revenue estimates are now ticking down. Unless margins were to expand, which is unlikely, earning estimates will follow a downward path and provide a headwind for equity prices.

As Zero Hedge aptly puts it, this is what you would believe if you were buying stocks right now:

My take is that the downturn in high frequency economic releases a concern, but it is something to watch and it’s not quite time to hit the panic button yet. I agree with New deal democrat in his weekly review [emphasis added]:

After several weeks of more positive signs, last week we returned to the pattern of gradual deterioration that began in February. This week most indicators remain positive and there were fewer negatives…

Last week I said that for me to be sold that the data is actually rolling over, I would want to see a sustained increase in jobless claims and a sustained deterioration in consumer spending. That wasn’t happening as of last week, and it certainly didn’t happen this week either. The economy still seems to be moving forward – but in first gear.

In summary, most of these concerns are on the “something to watch” list to see if any of these risks turn out to be more serious. My base case, for now, is that the market is undergoing a typical rolling correction, with leadership shifting from interest sensitive issues to deep cyclicals (see my recent post Commodities poised for revival). Until the late cycle commodity stocks roll over, there is probably more upside to stocks from these levels, but I am still looking over my shoulder and defining my risk parameters carefully.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

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Fickle Investor Sentiment


Monday, June 10th, 2013

One common trait of individual investors during the equity bull market run since November is restraint. Based on the American Association of Individual Investors sentiment survey, investor bullish sentiment fell over six percentage points to 29.47% for the weekly period ending June 6th. This follows a thirteen point decline in the prior week after moving up by over ten points during the week of May 23rd. This two week decline in bullish sentiment occurred during a period when the S&P 500 Index experienced a 5% correction on an intraday price basis.

Equity prices began turning higher at the end of the day on Thursday once the market (S&P 500) hit the technically important 1,598 level. The positive momentum carried through to Friday following the nonfarm payroll report. It seems the individual investor is anything but “all in” with their equity exposure.

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Jeff Gundlach: “What in the World is Going On?”


Wednesday, June 5th, 2013

It’s that time of the year again when DoubleLine’s Jeff Gundlach delivers his mid-year sermon, which with the fascinating title “What In The World is Going On”, promises to be quite a feast at 4:15 pm Eastern. So sit back, tune in, forget today’s “Unlucky 21″ Tragic Tuesday Taper (which would have been a victory for the bulls no matter what: Maria said so), and let some so very rare these days counterpropaganda wash over you.

 

Presentation slidedeck :

6-4-13 TR and Core Webcast Slides – FINAL

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How Big Institutional Money Distorts Housing Prices


Wednesday, June 5th, 2013

How Big Institutional Money Distorts Housing Prices

Submitted by Chris Martenson of Peak Prosperity blog,

The airwaves are full of stories of economic recovery. One trumpeted recently has been the rapid recovery in housing, at least as measured in prices.

The problem is, a good portion of the rebound in house prices in many markets has less to do with renewed optimism, new jobs, and rising wages, and more to do with big money investors fueled by the ultra-cheap money policies of the Fed.

On my recent trip to Salt Lake City, Utah, after presenting to a bi-partisan audience in the Capitol building, a gentleman came up to me and introduced himself as a real estate agent. He explained that he’d been seeing something very strange over the past six months, where very well capitalized, out-of-state private equity funds had been buying up huge swaths of residential real estate with cash. He wanted to know if I knew anything about this.

Of course I had been tracking this phenomenon for a while. But I had not been aware that Salt Lake City had been one of the targets, so I asked him how the deals worked there. Apparently, the hedge funds make “full ask” price offers, sight unseen and without conditions (such as inspections and the like), for whole baskets of available properties, typically in the middle to lower price ranges.

The effect, not surprisingly, is that regular home buyers are being outbid and eventually priced out of the market. Over time, these full cash offers at the ask get noticed and home sellers begin to raise their asking prices. For a young family saving to obtain the required 20% down, a 10% hike in price on a median house translates into an additional $3k – $4k that they must have to set aside to make the deal work (assuming they’ve not just been priced out of the house they wanted to buy).

The impact, he told me, is that a growing number of young families are finding themselves unable to obtain their first home.

They can thank Ben Bernanke for this. Here’s why.

The Back Story

The housing propaganda machine has been turned on in full force, as exemplified by this article in the Wall Street Journal that headlined the front page:

Home Sales Power Optimism

May 28, 2013

Home prices surged during the first quarter at their fastest pace in nearly seven years, the latest sign of a sustained warm-up in an economic recovery that has otherwise been marked by starts and stops.

The housing-market revival—and an accompanying report on consumer confidence—adds new grist for a debate inside the Federal Reserve about how far to push its easy-money policies, including an $85 billion-a-month bond-buying program which has helped to keep mortgage rates near historic lows, boosted asset prices and begun to stimulate hiring and spending.

Over the past year, the share of foreclosed property sales has fallen, particularly in California cities, Las Vegas, and Phoenix, which have posted the largest year-on-year price growth

The latest reports were big factors driving financial markets Tuesday. Stock investors, encouraged by the strong data, sent the Dow Jones Industrial Average to a new high.

There you have it. The rising house prices are being presented as a signal of a “sustained economic recovery” that feeds into consumer confidence and as reason to propel the stock market to new all-time highs. What’s not to like in that narrative?

However, if you value context, the above article will leave you disappointed because it omits the main driver of house price gains in the areas mentioned: big, institutional money seeking rental income and future capital gains.

As the article noted:

Many of the largest home-price gains have come in the West, including many markets hit hardest by the foreclosure crisis.

In March, prices were up by 22.5% in Phoenix from one year earlier, and by 22.2% in San Francisco. Other cities with double-digit gains included Las Vegas (20.6%); Atlanta (19.1%); Detroit (18.5%); Los Angeles (16.6%); Portland, Ore. (12.8%); Minneapolis (12.5%); San Diego (12.1%); Tampa, Fla. (11.8%); Miami (10.7%); and Seattle (10.6%).

The fact that big funds with big money have been very aggressive cash buyers in the formerly hardest-hit markets is very well documented and has been for well over a year. How such important context gets left entirely out of an article about house-price appreciation in exactly those same markets is something of a mystery, at least from the standpoint of honest journalism.

Here’s just one article out of many that have observed and reported on this issue:

Wall Street Institutions Behind Home Price Surges in Markets Like Phoenix

Mar 18, 2013

The March MarketPulse report from CoreLogic examines the rise of institutional investors and the effects they are having on distressed inventory. The analysis, compiled by CoreLogic deputy chief economist Sam Khater, looked at 16 major U.S. housing markets where bank-owned inventory (REOs) have been relatively high since the housing bubble burst.

He assessed whether local activity was comprised of mom-and-pop individual investors or institutional investors, defined as either entities that have purchased five-plus properties a year under the same name or under an incorporated name.

Here’s what Khater found: institutional investors have been targeting specific markets and then accelerating purchases of REOs in those markets, driving down distressed inventories and leading to notable increases in REO prices that have in turn led to larger market upticks.

Institutional investors have focused buying efforts strongly on south and southwestern cities that were hit hardest by the foreclosure crisis. The cities where investors activity has been particularly robust in the past year are Atlanta, Ga., Detroit, Mich., Las Vegas, Nev., Phoenix, Ariz., and Calif.’s Los Angeles, Riverside and Sacramento.

“In Q4 2012, Phoenix REO prices were 37% higher than a year ago, followed by Las Vegas (30%) and several California markets. All six markets with rising shares of institutional investors experienced double-digit increases and were among the top nine for REO price appreciation.

“More importantly, the ripple effects are greatly impacting the broader market. Lower-end home prices in markets with rising shares of institutional investors are up 15% from a year ago, compared to only 6% for the remaining markets.”

Institutions are most active in five states: Florida, Georgia, Arizona, Nevada and California. Interestingly the metro area that welcomed the most institutional activity in 2012 was Miami, Fla., with firms funding 30% of all sales. Single-family home prices for the Miami metro area rose about 11% in 2012 (including distressed homes), according to CoreLogic.

Institutional investors accounted for 21% of all sales in Charlotte, N.C., 19% in Las Vegas, and 18% in Orlando.

With up to 30% of all home sales in some markets going to funds that have been notable for buying with cash at the asking price, it is not hard to conclude that the big funds are driving up prices.

A simple comparison of the Case-Schiller Index, which the media trumpeted as revealing that housing has recovered with the list of areas where the big money funds have been most active, shows (noted by green circles over the blue bars) the following:

That is, the places where the biggest price increases have been noted are the same places that giant institutional funds are buying up tens of thousands of properties at the ask.

Where the first ‘rebound’ seen after a market correction is the prices of the asset merely stabilizing (because the yr/yr comparisons eventually head to zero), the most recent gains are definitely at levels that have been associated with bubbles and eventual corrections.

(Source)

Here are a few more articles for context, each of which demonstrates the obvious impact of institutional money on various key housing markets:

Hedge funds crowd first-time buyers out of housing market

Dec 10, 2012

There are still a whole lot of foreclosed houses out there. You would think that means it’s a great time for first-time buyers to purchase a house. But that’s not the case: One reason, private equity firms are buying up huge numbers of single-family houses. Wall Street wants to turn them into rentals.

Jonathan Shidler is a realtor in California. Lately he gets at least one call every day from a hedge fund manager who wants to buy single-family houses in bulk.

He says they are buying them like a financial instrument, “which is fine and dandy. But what’s different about these instruments is people live in them. You put your key in it and go inside. You get naked inside of it. So it makes it a little more personal.”

Wall Street has been investing in residential housing for decades. What is new is the scale of these purchases. Hedge funds are buying thousands of single-family houses around the country, especially in states hardest hit by the housing crash, like California.

“This is a 1,200 square foot house with detached two-car garage, O’Rafferty said as he put a key into a ranch style home on a corner lot. The house he showed is what he calls “The gold standard of entry-level homes.”

This is the type of home that hedge funds are snapping up. O’Rafferty put this house on the market on a Friday. By Monday he had 17 offers.

Those offers came from two types of buyers: Investors looking to turn a profit and families looking to get a piece of the American dream. These days O’Rafferty almost always sells to the investor.

Blackstone Buys Atlanta Homes in Largest Rental Trade

Apr 25, 2013

Blackstone Group LP (BX) bought 1,400 properties in Atlanta, some eligible for federal low-income housing subsidies, in the biggest bulk purchase for the fledgling homes-for-lease industry.

The private-equity firm, which has spent more than $4 billion on 24,000 rental properties in the last year making it the largest buyer in the U.S., purchased the residences from Building and Land Technology, said Marcus Ridgway, chief operating officer of Invitation Homes, Blackstone’s single- family rental division.

In the past twelve months, Blackstone has raised over $8 billion to buy up medium- and low-priced housing, while JP Morgan has initiated a fund to buy up to 5,000 homes. Morgan Stanley has raised a billion dollars to buy up to 10,000 homes.

If it strikes you as odd that the big banks would be bailed out by the taxpayers and then turn around and use that same money to buy homes to then rent back to those same taxpayers, then we hold the same view.

This trend has been running for so long, and it is so obvious, that it really raises a very important question as to exactly how such context can be left out of any article on the recent rebound in house prices.

As we saw with bonds being driven to generational lows, the Fed’s distorting buying habits shaped the prices for the entire bond market, ranging from Treasurys to corporate junk. Nobody in their right mind would ever consider the prices of bonds to be telling us anything useful about risk, reward, the future, or even current conditions without noting that their current prices are heavily manipulated to the upside.

Similarly, the stock market is clearly being driven upwards on a sea of Fed-supplied liquidity, and everybody knows that once if that Fed money dried up today, the stock market would fall like a stone.

Housing is no different. As big as the market is, prices are driven at the margins, and the buying pressure of institutional money snapping up thousands and thousands of properties in a single market in a single month means that this money, too, is having a distorting effect and is driving prices upwards.

Unfortunately, it seems like the lessons of 2008 went entirely unlearned.

Conclusion (to Part I)

It seems entirely wrong that the Fed bailed out big banks and made money excessively cheap for institutions, and that this is being used to price ordinary people out of the housing market. Said another way, the Fed prints fake money out of thin air, and some companies use that same money to buy real things like houses and then rent them out to real people trying to live real lives.

At the same time, we are also beginning to see the very same hedge funds that have re-inflated these prices slink out of the market now that the party is kicking into higher gear – all while new buyers are increasingly having to abandon prudence to buy into markets where the fundamentals simply aren’t there to merit it.

Didn’t we just learn a few short years ago how this all ends?

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Inflation at Odds with Equities


Wednesday, May 29th, 2013

by Cullen Roche, Pragmatic Capitalism

Another interesting divergence here via Societe Generale research.  Like the commodity trend, we’re seeing a big divergence in US inflation expectations and the S&P 500.  If deflation is truly a big risk then there’s an awful lot of faith being placed in the Fed’s hands at present through QE.  Me, I’m more in the low inflation camp as opposed to the deflation camp, but it’s hard to ignore these divergences….

Here’s more via SG:

  • While the S&P 500 is up 17% YTD, equity inflation is not in sync with the US economy, where inflation expectations fell below 2.3% to reach an 8-month low.
  • Inflation has been sinking in the eurozone at an accelerated pace in the past few months, reaching a 3-year low of 1.2% in April
  • Inflation has been trending down in many countries, including China where inflation accelerated a mere 2.4% in April 2013.

Chart via Orcam Investment Research:

inflation

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Robert Shiller Calls Bond Market “Dangerous”


Tuesday, April 9th, 2013

Robert Shiller, who predicted the bursting of the tech and housing bubbles, now calling the bond market “dangerous”? He shares his views and advice on the stock, bond and housing markets. WealthTrack #940 Originally Broadcast 29 March 2013.

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Bill Gross: Investment Outlook (February 27, 2013)


Thursday, February 28th, 2013

​Rational Temperance

by William Gross, PIMCO

But how do we know when irrational exuberance has unduly escalated asset values?
– Alan Greenspan 1996

PIMCO’s dear friend and former counselor Alan Greenspan coined this now famous phrase in the midst of what turned out to be a fairly rationally priced stock market in late 1996. While the market was indeed moving in the direction of “dot-com” fever three to four years later, the Dow Jones Industrial Average at the time was a relatively anorexic 6,000, and the trailing P/E ratio was only 12x. For a central bank that was then more concerned about economic growth and inflation as opposed to stock prices, risk spreads, and artificially suppressed interest rates, the Chairman’s query made global headlines, became a book title for Professor Robert Shiller and a strategic beacon for portfolio managers thereafter. Having experienced two and perhaps three bouts of significant market irrationality since Greenspan’s speech (the 1998 Asian Crisis, 2000 Dot-Coms, and of course 2007’s subprime euphoria), investors these days have their ears pressed to the ground and eyes glued to the tape for any sign of renewed irrationality. If the game is now musical chairs as opposed to Chuck Prince’s marathon dancing, it pays to be close to a chair, even as the “can’t miss” euphoria mesmerizes 2013 asset managers worldwide.

Into this academic but high-staked market fog has stepped another Fed official, this time not a Chairman but a relatively new yet similarly quizzical Governor. Jeremy Stein’s February 2013 speech has not gained the attention that Chairman Greenspan’s did, but it is remarkably similar in its intent and initial question: Governor Stein asks, “What factors lead to overheating episodes in credit markets?… Why is it that sometimes, things get out of balance?” Without mimicking Chairman Greenspan’s phrase, Governor Stein renews the quest, asking nearly a decade and a half later, “How do we know when irrational exuberance has unduly escalated asset values?”

I suppose it’s fair to criticize both queries on two grounds: 1) Although asked by Chairman Greenspan, it was never really answered in the 1996 speech. 2) If the Fed’s so smart, why are some of us still poor? Why did our 401(k)s become 201(k)s in 2009 before recovering to near peak levels currently? If they’re so smart, why the roller coaster ride, the 30% decline in home prices since 2006, and our current 7.9% unemployment rate?

Well to answer for the absent Chairman and the necessarily silent Governor Stein, the Fed incorrectly assumed that as long as inflation was benign, and future productivity prospects were near historical proportions, then asset price exuberance was an indirect and much less significant influence on economic growth. The Chairman admitted as much in a public “mea culpa” several years ago. We’re not that smart, he seemed to intone. Sometimes we make mistakes. I’m with you there, Mr. Chairman. Sometimes we all do.

So let’s approach this new paper with eyes wide open and pant bottoms close to those mythical musical chairs. Governor Stein’s speech reflects importantly on the answer to the question asked by a recent Wall Street Journal headline: “Is (the) Bull Sprint Becoming a Marathon?” Is there indeed “A Boom Time” in markets as the Financial Times queried on the heels of Dell, Virgin Media, and then HJ Heinz?

Governor Stein, as does PIMCO, suggests caution. On a scale of 1-10 measuring asset price “irrationality”, we are probably at a 6 and moving in an upward direction. Admittedly, Stein never ventures into the netherworld of stock market prices or leveraged buyouts. He appears to know better. What he does stake claim to however is a thesis for high yield spreads with the implication that other credit markets bear similar consequences. His initial starting point is that the pricing of credit is primarily an institutional as opposed to a household decision making process. Individuals may become unduly irrational when it comes to buying high yield ETFs or mutual funds, but it is the banks, insurance companies and pension funds, to name the most dominant, that influence the price of credit – high yield bonds – and by osmosis, investment grade corporates, municipals, and other non-Treasury risk credit assets. From this initial premise, he then points to recent research by Harvard’s Robin Greenwood and Samuel Hanson that suggests that while credit spreads are helpful future guides, that a non-price measure – the new issue volume (and perhaps quality) of high yield bonds – is a more trustworthy input. To quote: “When the high-yield share (of issuance) is elevated, future returns on corporate credit tend to be low.” And because of financial innovation and easier regulatory changes, institutional buyers such as banks, insurance companies and pension funds tend to match the mountains of issuance with an exuberance that eventually can be labeled irrational. Stein’s bottomline is that recent evidence suggests that we are seeing a “fairly significant pattern of reaching-for-yield behavior emerging in corporate credit.” In fact, investors bought over $100 billion of high yield and levered loan paper last year, a record level even exceeding the ominous levels in 2006 and 2007. Shown below in Chart 1 is a history of CLO issuance, admittedly a subset of high yield, but one which illustrates the supply pattern Governor Stein is leery of.

Now at this point, I suppose readers expect yours truly to jump all over the Governor’s speech/premise and to advance my own more learned thesis. Not really. With previously expressed reservations about the prescience of the Fed (or any of us!) I applaud his attempt to answer the initial 1996 question. I think Governor Stein’s speech was a little uni-dimensional, and a little too supply and model driven as opposed to behaviorally influenced, but I liked it, and PIMCO agrees with its conclusion. Corporate credit and high yield bonds are somewhat exuberantly and irrationally priced. Spreads are tight, corporate profit margins are at record peaks with room to fall, and the economy is still fragile. Still that doesn’t mean you should vacate your portfolio of them. It just implies that recent double-digit returns are unlikely to be replicated and that when today’s 5-6% high yield interest rates are adjusted for future defaults and recovery values, that 3-4% realized returns are the likely outcome. Just this past week the Financial Times reported that global corporate default rates are inching higher just as companies with fragile balance sheets sell large amounts of debt. Don’t say Governor Stein didn’t warn you.

But I would step now into the forbidden territory of equity pricing by presenting additional historical correlations compiled by Jim Bianco of Bianco Research – admittedly not a thickly populated academically staffed organization like the Fed, but a well-regarded one nonetheless. He points out in a recent daily release that high yield and corporate bonds are really just low beta equivalents of stocks. It appears that they are. The following charts show a rather commonsensical negative correlation of high yield spreads (and therefore future high yield returns) to stock prices.

 

The conclusion would be that where high yield prices go, stock markets follow, or vice versa. Narrow yield spreads in high yield credit markets appear to be accompanied by “narrow” equity risk premiums in the market for stocks, which is another way of saying that the course of future equity returns may not resemble its recent exuberant past. 3-4% high yield returns over the next few years? Why shouldn’t that logically lead to a generalized 5-6% return forecast for stocks? Admittedly, returns for both high yield and equity markets have been unduly influenced in the past few years by Quantitative Easing, the writing of trillions of dollars of Federal Reserve checks and the exuberant migration of institutions and households alike to the grassier plains of risk assets dependent on favorable economic outcomes. It is what central banks encourage and to date it has been successful. If and when that support dissipates or if the economy remains anemic, investors should be cautious and temper their enthusiasm.

PIMCO’s and Governor Stein’s “rational temperance,” in contrast to excessive historical bouts of “irrational exuberance,” simply counsels to lower return expectations, not to abandon ship. PIMCO is a global investment manager – not one with a perpetual frown or even an ever-present half empty glass – but one which hopes to provide alpha and above market returns while still standing tall in the aftermath of future irrational bouts of exuberance. We join with Governor Stein and perhaps Alan Greenspan in encouraging not an exit but a reduced expectation. Credit spreads nor interest rates cannot be artificially compressed forever, nor can stock prices rise perpetually on their coattails. Be rational, be optimistic if so inclined, but temper it with a commonsensical conclusion that we have seen something similar to this before, and that previous outcomes seldom matched the exuberance.

IO Speed read:

1) Chairman Greenspan’s “irrational exuberance” speech in 1996 posed an excellent question, and history provided the answer.

2) Fed Governor Jeremy Stein asks the same question in 2013 with a uni-dimensional but useful model.

3) Stein’s paper, accompanied by correlations from Bianco Research, suggests caution in today’s high yield market.

4) High yield bonds, stock prices and other risk spreads move in relative tandem.

5) PIMCO cautions “rational temperance”: be bullish if you want, but lower return expectations on all asset classes.

William H. Gross
Managing Director

Copyright © PIMCO

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