“This time is different”
Looking back over the last 30 years, I can proclaim that this time is different. Government and central bank intervention is at its highest. The market moves based on statements and actions by Yellen and the other CBs and not based on fundamentals. An irrational market is not something new but such manipulation is. Every time one of the “gods” will speak the market positions itself based accordingly. This can be seen both intraday and in the days that follow. Yellen’s recent speech push the market out of a 7-day range and through April’s high. At the same time, earnings are expected to drop in Q2 for the fifth consecutive time, while revenues are expected to drop for the sixth consecutive time. Net margins have not changed while forward earnings are near its highest in the last decade.
Negative yielding government debt has surpassed the $10 trillion mark which means that almost 1/3 of ALL global government debt has a negative yield. Japan accounts for most of the negative debt, while Germany, France and Italy together account for 28%.
If we look at the positive yielding debt, the United States accounts for the majority, at 60%.
But what implies is that bond investors should brace themselves for low returns going forward. As GMO points out it would be impossible for the Barclays U.S. Aggregate Bond Index to continue its 7.7% return from inception performance. (Based on GMO calculations “to achieve a return of 7.7% for the index over the next seven years, yields would have to fall to approximately negative 17% at the end of the period, ignoring roll and convexity effects”).
No matter what risk premium used for equities over bonds, the obvious result is an unimpressive low to middle single digits at best. It’s a simple matter of valuation and risk. As Bill Gross also points out: “…this 40-year period of time has been quite remarkable – a grey if not black swan event that cannot be repeated. With interest rates near zero and now negative in many developed economies, near double digit annual returns for stocks and 7%+ for bonds approach a 5 or 6 Sigma event… Capitalism has entered a new era in this post-Lehman period due to unimaginable monetary policies and negative structural transitions that pose risk to growth forecasts and the historical linear upward slope of productivity…. “Carry” in almost all forms is compressed and offers more risk than potential return…”
The punch line is that this very best single digit return will obviously not be in a straight line. Even if we don’t have a recession or large decline, volatility is only natural in the market. Therefore the lower potential returns going forward imply that volatility will take us to negative returns as well.
Considering the young age of the “easy on the eyes” media they should be completely ignored. That includes the bald scream men and ones with ponytails. I actually spent about 2-3 months listening every day to CNBC’s Fast Money. While entertaining they really had little to offer. (I would recommend though checking out Bloomberg Surveillance’s free podcast as the quality is decent).
But the problem expands beyond the media. The asset managers themselves (including myself) may be too young to deal with today’s markets. (Note that the great majority of asset managers are under 70 which would be the possible age needed to have witness sufficient events). The tech bubble while obvious saw a lot of investors lose money. This continued in the sneaky housing bubble. I say sneaky because it was less obvious and timing was difficult. My good friend Kevin opened my eyes on the housing crisis in 2006 but it took 2 years to play out. A similar scenario is playing out now. It’s impossible to perfectly time these things but asset managers can prepare. Unfortunately that is not something we will see going forward as mandates do not permit it.
Furthermore we have an agency issue as brought up by Joel Greenblatt in his interview with CNBC. The problem is that asset allocators are judged on short-term performance. As a result these allocators then judge fund managers on short-term performance. This leads to a suboptimal allocation. Greenblatt did a study of the performance of the top 25% fund managers over the 2000-2010 period. Over that period, he found that 97% of these top managers spent at least 3 years in the bottom 50%. 79% at least 3 years in bottom 25% and 47% (basically 1/2 of the best 25% of fund managers) spent at least 3 years in bottom 10%. (Take note of the “at least”). According to Greenblatt this is logical because in order to be a top manager, you need to do something different, be contrarian. As a result periods of underperformance are natural. This obviously creates a huge problem for anyone allocating money, be that an endowment fund or even a small investor. Do you select bad performers expecting to improve, or buy good performers and plan to ride out the bumps? The answer in my opinion is to focus on the asset manager’s strategy. For example, a growth biotech strategy has a lower probability of success.
The oracle of Omaha, Warren Buffett, underperformed the market 31% of the time over 1987-2013. In other words, 3 year out of every 10. That fits exactly into Greenblatt’s study! Actually over 2003-2013, he underperformed for 4 years of which 3 were consecutive. Despite this an investor would have gained 111% with Buffett versus 66% with the market!
Turning to FatAlpha, the month of May saw both strategies gain ground with the Active Strategy rising 0.27% and the Market Neutral Strategy 0.62%. Retail stocks continued to hurt returns as GameStop, Kohl’s and Stage Stores registered double digit declines. This was offset by HP Enterprises, Sanmina, Insight and the short positions. Insight was sold over the last few days as it reached our fair value estimate of $28 and Sanmina has been reduced, as it too, closed in on fair value. Technology distributors is an interesting space where results have been relatively stable but stocks have gyrated quite a bit. Based on my observations on this area, an investor could do well trading the extremes so keep that in mind. The short portfolio did well with the exception of Zillow that will be revisited.
Tim du Toit (of Quant Investing) and I will be organizing an Equities Investment Event on September 29th and 30th in Nicosia, Cyprus at the Cleopatra Hotel. Investment professionals from the U.S., Canada, Germany and Finland will be speaking. This will be a great opportunity to meet fund managers, network and to hear specific investment ideas (in value stocks, banking, international equities, etc). If you are interested in attending this 2-day event which will include lunch on each day and a gala dinner on the evening of the 29th then please respond to this e-mail. We are finalizing the details. The cost per participant will be under EUR 300 and hotel rooms have been reserved at a starting price of EUR 80.
On a different note, I will be teaching a course at the Cyprus International Institute of Management (CIIM) starting January 2017. It will be a practical course on investing with a focus on equities. I look forward to the experience.
Finally, as I mentioned last month, I moved the website from Wix over to WordPress. Wix is a publicly listed company and my thoughts on the company and my experience as a client can be read in my article “Are Wix’s Goals Out of Reach”.
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