by David Robertson, CFA
January 2018
Dreams can have a powerful effect on us, for better and worse. Martin Luther King's famous "I have a dream" speech is a notable example of how a "dream" can inspire individuals to be better versions of themselves and entire communities to become stronger together. Dreams can also be used to describe delusions, however, such as when we don't exercise as good of analysis or judgment as maybe we should—as in, "You must be dreaming!"
There are almost always instances of both types of dreams and often they work in concert. The tech bubble, for instance, was characterized both by the vision that the internet would become a massively beneficial utility and by the delusion that such possibilities would generate almost limitless growth and profitability for its participants. The key for investors is to avoid conflating the two kinds of dreams by identifying the line between the two. By doing this, investors distinguish between investment and speculation and vastly improve their chances of maintaining and growing their hard-earned savings.
In regards to stock performance in 2017, the best characterization might be "dreamlike". The S&P 500 posted handsome total returns of 21.83% for the year in a nearly steady upward climb. Indeed, the market "notched up 14 straight months of gains — the longest run on record" [here] amid an environment of record low and declining volatility. One account [here] noted "VIX closed below 10 more times last year than any others [sic] year in its history, and until today, closed below 10 for the first 5 days of 2018..." Such conditions are creating an environment in which "people [are] having a hard time even imagining how the market could decline." It's as if stocks finally reached cruising altitude and the autopilot was switched on.
Media accounts almost universally attributed the smooth advance to improving economic performance and phrases like "synchronized global recovery" were sprinkled liberally through reviews. One commentary from the Financial Times [here] was representative: "Rarely has the outlook for a new year been as encouraging as it is today ... We expect the synchronized global upswing to continue in 2018."
Those looking for benign causes in justifying their optimism have had plenty of fodder from which to choose, but in each case there is far less than meets the eye. Non-gaap earnings are increasing nicely for the S&P 500, but operating cash flows are just nudging ahead. Lower taxes will provide some short term stimulus but at the longer term cost of higher debt. While sentiment is strong and there are some modest indications of improved consumer spending, it looks like consumers are putting the cart before the horse. As Gluskin Sheff points out, "13-week annualized credit card balances in the U.S. have gone completely vertical in the last few months of 2017" [here].
Further, As David Collum reports in his "Year in Review" [here], "The reported P/Es are not that bad. The high-growth QQQ index, for instance, is sporting a P/E of only 22, and the Russell 2000—the small-cap engine of economic growth—is in the same neighborhood." But as Collum goes on to report, however, there is almost always a more sinister explanation behind optimistic headlines: "Alas, Steve Bregman of Horizon Kinetics notes that the P/E of the QQQ is calculated by rounding all P/Es above 40 down to 40 and assigning a P/E of 40 to all negative P/Es—companies losing money, aka Money Pits ... In the scientific community, we call such adjustments 'fraud.' Bregman pools the market caps and earnings to give a more honest analysis, which gently nudges the QQQ P/E to 87. In short, Wall Street is 'making shit up'."
Indeed, our own analysis corroborates these findings in a clear and powerful way. We calculate returns on a large universe of US stocks based on consensus estimates and then back out the cost of capital the market is requiring based on current market values. In doing so, we differentiate between value attributed to cash flows generated from existing assets and value attributed to cash flows generated from future investments, yet to be made. What is clear is that the value attributed to existing assets has barely budged. Virtually all of the increase in market value has arisen due to a combination of higher growth expectations and lower perceived risk (lower cost of capital).
Close evaluation of relevant factors leads respected economist, David Rosenberg, at Gluskin Sheff to conclude, “This is not an earnings-driven market; it is a momentum, liquidity, and multiple-driven market, pure and simple." In other words, efforts to explain rising stock prices by way of improving underlying economic growth and cash flow generation is fundamentally (pun intended) misguided—and this speaks loudly to the nature of recent market activity.
There is probably no better indication of momentum and liquidity factors than bitcoin. The cryptocurrency-cum-market darling grabbed headlines throughout the year by rapidly and repeatedly setting new highs. Once again, the story surrounding bitcoin contains positive elements. There is a real concern that governments have almost unlimited power to devalue fiat currencies and that it would be better to limit that power. It is also true that the blockchain technology that underpins bitcoin is a clever idea that may well be disruptive to parts of the financial world.
However, and it's a big however, the list of valid challenges for bitcoin is even more impressive. Collum cites competition, instabilities, volatility, and legality as key problems with bitcoin. In particular he notes, "I am doubtless that central banks and sovereign states will never endorse Bitcoin in its current form. They have their own digital currencies and a monopoly on the power to create more ... Existential risk will bring on the power of the State."
John Hussman chimed into the debate [here]: "Bitcoin ... is just one application of Blockchain, and a rather awkward one. It’s not unique, meaning that other competing "cryptocurrencies" can be established just as easily. It’s not fiat, meaning that no country requires it to be used as legal tender. But beyond anything else, its inefficiency is so mind-boggling that the continued operation of the Bitcoin network could plausibly contribute to global warming."
If there is one story that sums up the market environment (and bitcoin phenomenon) as well as any, it is that of the public company Long Island Iced Tea [here]. The microcap company makes lemonade but in December decided to shift "its primary corporate focus towards the exploration of and investment in opportunities that leverage the benefits of blockchain technology." In connection with this shift, the company also changed its name to "Long Blockchain" (LTEA) instead. With this news only, the stock nearly tripled. As the FT noted, "It is hard to understand why the mere mention of blockchain should be capable of sending stock prices soaring. Something else must be going on."
What might that something else be? John Hussman offered an idea: "Garety & Freeman found that delusions appear to reflect not a defect in reasoning itself, but a defect 'which is best described as a data-gathering bias, a tendency for people with delusions to gather less evidence' so they tend to jump to conclusions." The FT offered a similar hypothesis, "If you associate abstract terms with positive connotations often enough, people will eventually interpret them as they see fit and not see them for what they really are."
In other words, enthusiasm for stocks and cryptocurrencies may reflect a lot less sober analysis than a case of "seeing what one wants to see". If this is true of assessing upside opportunities, it is just as true in reverse of assessing downside risks—of which there are plenty.
As Ben Inker notes in GMO's latest quarterly letter [here], "The hypothetical inflation case is a scary one, but inflation is far from people’s minds as a big risk." He goes on to characterize the risk of significant inflation: "The loss of paper wealth could be massive. This doesn’t mean such an inflation surge is inevitable, or even particularly probable. It is, however, something that investors should have in the forefront of their minds when they think about what could go wrong for their portfolios."
Further, Inker makes clear that in the event of inflation, there would be few places to safely hide: "The basic trouble with the rising inflation environment on investor portfolios is that it hits every asset class with significant duration. Stocks, bonds, real estate, private equity, infrastructure, all should take a hit. And there are few, if any, assets that reliably do well in the event of unanticipated inflation."
Another risk is that central bank liquidity is now moving in the wrong direction. Alberto Gallo notes [here] that, "we may well be entering the point in the cycle when central banks withdraw stimulus to help 'build a policy buffer for a future slowdown'." Torsten Slok, chief international economist at Deutsche Bank, expressed particular concern in the FT [here] that, "the ECB's exit from bond markets is the biggest risk facing global markets in 2018, given how the eurozone's bond purchases have sent money sloshing everywhere." Pierre-Henri Flamand, CIO at Man GLG added, "Yes we know that central banks will do less next year but no one knows what the price should then be ... I think people will be shocked by the magnitude."
In addition, the flow of money into index funds presents a risk, even if such flows remain positive. Horizon Kinetics describes the risk in their Q4 2016 commentary [here]: "But long before such exhaustion of the pool of actively managed equity mutual fund AUM, those outflows must decline significantly. They don’t just continue at a steady rate, then stop on a dime. Moreover, there is some significant number of investors who prefer and will maintain their actively managed assets."
The analysis continues, "To keep the perceived equilibrium going, the index fund organizers need to go beyond merely continued net inflow; they need proportionately increased flow, because the market value of everything they are buying is going up; it’s a law of large numbers dynamic. They need more and more money to hold the prices where they are, but the inflow is being drained from a shrinking pool of non-indexed AUM. That’s how all bubbles work ... But the minute the inflows slow meaningfully ... the index will no longer set the price, the ETFs will no longer be setting the prices of the winners." What this means is that when the tipping point is reached, momentum will stop working and fundamentals will matter in a big way.
Of course the tried and true portfolio response to such conditions is to diversify, but the efficacy of that approach has also been undermined. Ashish Shah, head of fixed income at Alliance Bernstein, noted [here], "People have taken their fixed income allocations and turned them into credit allocations because they are scared of rising rates." Since a company's creditworthiness is highly correlated with its stock performance, "stock and bond portfolios are becoming stock and credit portfolios, which is the way I think about it is just stock and stock." He concludes by observing, "When investors now look at their portfolio, they don’t have anything that does well when stocks sell off."
If all of this sounds like an unusual confluence of severe risks, that's because it is. It is probably not a coincidence that Eurasia Group’s Ian Bremmer identifies 2018 as "by far the greatest geopolitical risk environment that we’ve ever seen" [here]. In his mind, "this could be the year where the international community witnesses the geopolitical equivalent to the financial crisis."
Bremmer's geopolitical assessment makes the findings of the recent paper "The Rate of Return on Everything, 1870-2015" [here] especially poignant. One of the most interesting findings, according to the FT [here], is that although the returns on safe assets are often stable, "they periodically display unexpectedly massive swings." As the authors conclude, "But if the past 145 years are any guide to the future, it can be a dangerous mistake to assume that 'safe' assets will always be boring in the long term."
Ben Hunt seems to be observing a similarly chaotic and risky environment [here] but goes further in his assessment by noting, "There is a non-trivial chance that structural changes in our social worlds of politics and markets have made it impossible to identify predictive/derivative patterns." In other words, good luck in trying to make sense of where things might be going.
This assessment may come across as more than a little fatalistic, except for the fact that Hunt offers with it a constructive suggestion: "I think we should adopt a classic game theory strategy for dealing with uncertain systems — minimax regret." He goes on to describe, "The idea is simple, but the implications profound: instead of seeking to maximize returns, we seek to minimize our maximum regret. Keep in mind that our maximum regret may not be ruinous loss! I know plenty of people whose maximum regret is not keeping up with the Joneses ... The point being that we need to be painfully honest with ourselves about our sources of regret and target our investments accordingly. If we can be this honest with ourselves, it’s a VERY powerful strategy."
Part of the reason why the minimax strategy is so powerful is because it helps clarify difficult tradeoffs. Nobody likes to watch stock investors get rich while sitting in cash themselves—unless they are long term investors who would have even more regret for losing hard-earned money in what evidence and analysis deem as treacherous conditions for investing. It can be expected that this regret would weigh most heavily on boomers and Xers since they simply may not have enough time in their productive careers to recoup major losses.
By the same token, there are certainly groups of investors who, on the margin, would have even more regret for missing out when the market is so strong. It is helpful to consider who might be in such a position. Some investors, as Hunt suggested, may care more about relative wealth than absolute wealth. In addition, some investors may just not have much to lose. As zerohedge reported [here], "30.4% of US families have negative net worth despite the recovery in housing and the stock market." So it may well be that some market participants are chasing returns simply because they see it as their only chance to get ahead.
Of course there is also a host of "investment professionals" who may experience relatively more regret for missing out on strong markets. Pension fund managers whose plans are significantly underfunded may find it easier to reach for returns with progressively riskier investments than to have difficult conversations with beneficiaries. Further, a number of advisors and money managers may worry more about losing their job if they miss out on strong markets than suffering large losses with everyone else. The common thread in each of these situations is other people's money; the regret related to investment decision making is felt by someone other than the owner of the assets.
At the end of the day, it doesn't so much matter what camp you are in, as to know the difference between the two and to identify the source of maximum possible regret for you. For long term investors who are finding it hard to resist the temptation to increase exposure to the market right now, the best advice is to listen to that little voice in your head that is saying, "Don't do something you'll regret." If you give in to temptation, you might be having some seriously bad dreams.
January 2018
Dreams can have a powerful effect on us, for better and worse. Martin Luther King's famous "I have a dream" speech is a notable example of how a "dream" can inspire individuals to be better versions of themselves and entire communities to become stronger together. Dreams can also be used to describe delusions, however, such as when we don't exercise as good of analysis or judgment as maybe we should—as in, "You must be dreaming!"
There are almost always instances of both types of dreams and often they work in concert. The tech bubble, for instance, was characterized both by the vision that the internet would become a massively beneficial utility and by the delusion that such possibilities would generate almost limitless growth and profitability for its participants. The key for investors is to avoid conflating the two kinds of dreams by identifying the line between the two. By doing this, investors distinguish between investment and speculation and vastly improve their chances of maintaining and growing their hard-earned savings.
In regards to stock performance in 2017, the best characterization might be "dreamlike". The S&P 500 posted handsome total returns of 21.83% for the year in a nearly steady upward climb. Indeed, the market "notched up 14 straight months of gains — the longest run on record" [here] amid an environment of record low and declining volatility. One account [here] noted "VIX closed below 10 more times last year than any others [sic] year in its history, and until today, closed below 10 for the first 5 days of 2018..." Such conditions are creating an environment in which "people [are] having a hard time even imagining how the market could decline." It's as if stocks finally reached cruising altitude and the autopilot was switched on.
Media accounts almost universally attributed the smooth advance to improving economic performance and phrases like "synchronized global recovery" were sprinkled liberally through reviews. One commentary from the Financial Times [here] was representative: "Rarely has the outlook for a new year been as encouraging as it is today ... We expect the synchronized global upswing to continue in 2018."
Those looking for benign causes in justifying their optimism have had plenty of fodder from which to choose, but in each case there is far less than meets the eye. Non-gaap earnings are increasing nicely for the S&P 500, but operating cash flows are just nudging ahead. Lower taxes will provide some short term stimulus but at the longer term cost of higher debt. While sentiment is strong and there are some modest indications of improved consumer spending, it looks like consumers are putting the cart before the horse. As Gluskin Sheff points out, "13-week annualized credit card balances in the U.S. have gone completely vertical in the last few months of 2017" [here].
Further, As David Collum reports in his "Year in Review" [here], "The reported P/Es are not that bad. The high-growth QQQ index, for instance, is sporting a P/E of only 22, and the Russell 2000—the small-cap engine of economic growth—is in the same neighborhood." But as Collum goes on to report, however, there is almost always a more sinister explanation behind optimistic headlines: "Alas, Steve Bregman of Horizon Kinetics notes that the P/E of the QQQ is calculated by rounding all P/Es above 40 down to 40 and assigning a P/E of 40 to all negative P/Es—companies losing money, aka Money Pits ... In the scientific community, we call such adjustments 'fraud.' Bregman pools the market caps and earnings to give a more honest analysis, which gently nudges the QQQ P/E to 87. In short, Wall Street is 'making shit up'."
Indeed, our own analysis corroborates these findings in a clear and powerful way. We calculate returns on a large universe of US stocks based on consensus estimates and then back out the cost of capital the market is requiring based on current market values. In doing so, we differentiate between value attributed to cash flows generated from existing assets and value attributed to cash flows generated from future investments, yet to be made. What is clear is that the value attributed to existing assets has barely budged. Virtually all of the increase in market value has arisen due to a combination of higher growth expectations and lower perceived risk (lower cost of capital).
Close evaluation of relevant factors leads respected economist, David Rosenberg, at Gluskin Sheff to conclude, “This is not an earnings-driven market; it is a momentum, liquidity, and multiple-driven market, pure and simple." In other words, efforts to explain rising stock prices by way of improving underlying economic growth and cash flow generation is fundamentally (pun intended) misguided—and this speaks loudly to the nature of recent market activity.
There is probably no better indication of momentum and liquidity factors than bitcoin. The cryptocurrency-cum-market darling grabbed headlines throughout the year by rapidly and repeatedly setting new highs. Once again, the story surrounding bitcoin contains positive elements. There is a real concern that governments have almost unlimited power to devalue fiat currencies and that it would be better to limit that power. It is also true that the blockchain technology that underpins bitcoin is a clever idea that may well be disruptive to parts of the financial world.
However, and it's a big however, the list of valid challenges for bitcoin is even more impressive. Collum cites competition, instabilities, volatility, and legality as key problems with bitcoin. In particular he notes, "I am doubtless that central banks and sovereign states will never endorse Bitcoin in its current form. They have their own digital currencies and a monopoly on the power to create more ... Existential risk will bring on the power of the State."
John Hussman chimed into the debate [here]: "Bitcoin ... is just one application of Blockchain, and a rather awkward one. It’s not unique, meaning that other competing "cryptocurrencies" can be established just as easily. It’s not fiat, meaning that no country requires it to be used as legal tender. But beyond anything else, its inefficiency is so mind-boggling that the continued operation of the Bitcoin network could plausibly contribute to global warming."
If there is one story that sums up the market environment (and bitcoin phenomenon) as well as any, it is that of the public company Long Island Iced Tea [here]. The microcap company makes lemonade but in December decided to shift "its primary corporate focus towards the exploration of and investment in opportunities that leverage the benefits of blockchain technology." In connection with this shift, the company also changed its name to "Long Blockchain" (LTEA) instead. With this news only, the stock nearly tripled. As the FT noted, "It is hard to understand why the mere mention of blockchain should be capable of sending stock prices soaring. Something else must be going on."
What might that something else be? John Hussman offered an idea: "Garety & Freeman found that delusions appear to reflect not a defect in reasoning itself, but a defect 'which is best described as a data-gathering bias, a tendency for people with delusions to gather less evidence' so they tend to jump to conclusions." The FT offered a similar hypothesis, "If you associate abstract terms with positive connotations often enough, people will eventually interpret them as they see fit and not see them for what they really are."
In other words, enthusiasm for stocks and cryptocurrencies may reflect a lot less sober analysis than a case of "seeing what one wants to see". If this is true of assessing upside opportunities, it is just as true in reverse of assessing downside risks—of which there are plenty.
As Ben Inker notes in GMO's latest quarterly letter [here], "The hypothetical inflation case is a scary one, but inflation is far from people’s minds as a big risk." He goes on to characterize the risk of significant inflation: "The loss of paper wealth could be massive. This doesn’t mean such an inflation surge is inevitable, or even particularly probable. It is, however, something that investors should have in the forefront of their minds when they think about what could go wrong for their portfolios."
Further, Inker makes clear that in the event of inflation, there would be few places to safely hide: "The basic trouble with the rising inflation environment on investor portfolios is that it hits every asset class with significant duration. Stocks, bonds, real estate, private equity, infrastructure, all should take a hit. And there are few, if any, assets that reliably do well in the event of unanticipated inflation."
Another risk is that central bank liquidity is now moving in the wrong direction. Alberto Gallo notes [here] that, "we may well be entering the point in the cycle when central banks withdraw stimulus to help 'build a policy buffer for a future slowdown'." Torsten Slok, chief international economist at Deutsche Bank, expressed particular concern in the FT [here] that, "the ECB's exit from bond markets is the biggest risk facing global markets in 2018, given how the eurozone's bond purchases have sent money sloshing everywhere." Pierre-Henri Flamand, CIO at Man GLG added, "Yes we know that central banks will do less next year but no one knows what the price should then be ... I think people will be shocked by the magnitude."
In addition, the flow of money into index funds presents a risk, even if such flows remain positive. Horizon Kinetics describes the risk in their Q4 2016 commentary [here]: "But long before such exhaustion of the pool of actively managed equity mutual fund AUM, those outflows must decline significantly. They don’t just continue at a steady rate, then stop on a dime. Moreover, there is some significant number of investors who prefer and will maintain their actively managed assets."
The analysis continues, "To keep the perceived equilibrium going, the index fund organizers need to go beyond merely continued net inflow; they need proportionately increased flow, because the market value of everything they are buying is going up; it’s a law of large numbers dynamic. They need more and more money to hold the prices where they are, but the inflow is being drained from a shrinking pool of non-indexed AUM. That’s how all bubbles work ... But the minute the inflows slow meaningfully ... the index will no longer set the price, the ETFs will no longer be setting the prices of the winners." What this means is that when the tipping point is reached, momentum will stop working and fundamentals will matter in a big way.
Of course the tried and true portfolio response to such conditions is to diversify, but the efficacy of that approach has also been undermined. Ashish Shah, head of fixed income at Alliance Bernstein, noted [here], "People have taken their fixed income allocations and turned them into credit allocations because they are scared of rising rates." Since a company's creditworthiness is highly correlated with its stock performance, "stock and bond portfolios are becoming stock and credit portfolios, which is the way I think about it is just stock and stock." He concludes by observing, "When investors now look at their portfolio, they don’t have anything that does well when stocks sell off."
If all of this sounds like an unusual confluence of severe risks, that's because it is. It is probably not a coincidence that Eurasia Group’s Ian Bremmer identifies 2018 as "by far the greatest geopolitical risk environment that we’ve ever seen" [here]. In his mind, "this could be the year where the international community witnesses the geopolitical equivalent to the financial crisis."
Bremmer's geopolitical assessment makes the findings of the recent paper "The Rate of Return on Everything, 1870-2015" [here] especially poignant. One of the most interesting findings, according to the FT [here], is that although the returns on safe assets are often stable, "they periodically display unexpectedly massive swings." As the authors conclude, "But if the past 145 years are any guide to the future, it can be a dangerous mistake to assume that 'safe' assets will always be boring in the long term."
Ben Hunt seems to be observing a similarly chaotic and risky environment [here] but goes further in his assessment by noting, "There is a non-trivial chance that structural changes in our social worlds of politics and markets have made it impossible to identify predictive/derivative patterns." In other words, good luck in trying to make sense of where things might be going.
This assessment may come across as more than a little fatalistic, except for the fact that Hunt offers with it a constructive suggestion: "I think we should adopt a classic game theory strategy for dealing with uncertain systems — minimax regret." He goes on to describe, "The idea is simple, but the implications profound: instead of seeking to maximize returns, we seek to minimize our maximum regret. Keep in mind that our maximum regret may not be ruinous loss! I know plenty of people whose maximum regret is not keeping up with the Joneses ... The point being that we need to be painfully honest with ourselves about our sources of regret and target our investments accordingly. If we can be this honest with ourselves, it’s a VERY powerful strategy."
Part of the reason why the minimax strategy is so powerful is because it helps clarify difficult tradeoffs. Nobody likes to watch stock investors get rich while sitting in cash themselves—unless they are long term investors who would have even more regret for losing hard-earned money in what evidence and analysis deem as treacherous conditions for investing. It can be expected that this regret would weigh most heavily on boomers and Xers since they simply may not have enough time in their productive careers to recoup major losses.
By the same token, there are certainly groups of investors who, on the margin, would have even more regret for missing out when the market is so strong. It is helpful to consider who might be in such a position. Some investors, as Hunt suggested, may care more about relative wealth than absolute wealth. In addition, some investors may just not have much to lose. As zerohedge reported [here], "30.4% of US families have negative net worth despite the recovery in housing and the stock market." So it may well be that some market participants are chasing returns simply because they see it as their only chance to get ahead.
Of course there is also a host of "investment professionals" who may experience relatively more regret for missing out on strong markets. Pension fund managers whose plans are significantly underfunded may find it easier to reach for returns with progressively riskier investments than to have difficult conversations with beneficiaries. Further, a number of advisors and money managers may worry more about losing their job if they miss out on strong markets than suffering large losses with everyone else. The common thread in each of these situations is other people's money; the regret related to investment decision making is felt by someone other than the owner of the assets.
At the end of the day, it doesn't so much matter what camp you are in, as to know the difference between the two and to identify the source of maximum possible regret for you. For long term investors who are finding it hard to resist the temptation to increase exposure to the market right now, the best advice is to listen to that little voice in your head that is saying, "Don't do something you'll regret." If you give in to temptation, you might be having some seriously bad dreams.
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