Broyhill Asset Management 2013 letter to investors
January 31, 2014
Investment Review & Outlook
The market climbed a wall of worry last year. Stocks outperformed bonds by the widest span since 1958 – only the fourth time since 1926 that the spread exceeded 45% when measured against Barclay’s Long Term
Treasury Index. Despite concerns over central bank policy, budget sequestration, a government shutdown and an emerging market currency crisis, the S&P exhibited its lowest daily volatility since 2006 and only experienced a single correction of five percent, the least since 1995. Coincidentally, 1995 was also the only year with a higher Sharpe ratio in the past five decades. In contrast, bonds posted their worst losses in twenty years, and as a result, bond proxies were among the market’s weakest performers.
of this magnitude are simply not sustainable for an extended period of time. This bull is aging. The current rally has lasted almost five years and produced cumulative returns over 200%. Only five bull markets have lasted longer and only 7% have matched gains of this magnitude over the past century. As the chart below shows, it has been some time since we’ve seen a correction in stock prices – the current stretch is the eighth longest on record. To put it short, we wouldn’t be surprised if the turn of the calendar represented an inflection point in both investor psychology and market trend.
Bear markets have historically been kicked off with tightening monetary policy at the Fed in the form of rising short-term interest rates. The two bear markets since the turn of the century are indicative of this cause and effect relationship. Consequently, with short rates pegged at zero for the foreseeable future, the bulls would appear to have the upper hand until central banks change course.
Yet, our work suggests otherwise. Central banks are not the only entities that can tighten monetary policy and markets often disagree with the wishes of central bankers. While short rates are unlikely to move higher anytime soon, we fear that a continued increase in long term yields could pressure asset inflation and lead to a sharp decline in stock prices, particularly in the context of today’s overhyped, overvalued and overbought market. This is difficult to consider in the face of daily new highs and perpetually bullish commentary, both of which are typical in the later stages of bull markets. But this is precisely when it matters most to take a step back and consider the big picture.
Risk assets have been pushed higher by unprecedented stimulus since the financial crisis. Broadly speaking, markets have been dominated by policy decisions. The world has become dependent upon two policies which remain the only game in town – China’s decision around structural reform and the Fed’s decision around quantitative easing.
The unwinding of stimulus is a delicate affair. Move too slow and risk igniting larger bubbles and greater financial instability down the road – the worst developed world crises in the past century (in 1929, in 1990 Japan and in 2008) were preceded by extreme levels of private sector debt. Move too fast and risk a bigger mess today – each period was followed by crisis triggered by large falls in inflated asset values.
The magnitude and duration of the stimulus this time around makes this balancing act all the more difficult, particularly as it coincides with new leadership at both ends of the globe. Bernanke has set the tone for the Yellen Fed, which is likely to continue the reduction of quantitative easing throughout the year. At the same time, new leadership in China has demonstrated a clear shift in policy toward growth – one that favors quality over quantity.
Through our eyes, it appears as though the momentum has shifted beneath the only game in town. Investors should ask if markets are priced for such a shift in policy. They might also ask what the insiders know that the Average Joe does not (see chart above). History is an accomplished teacher.
Running with the Bulls
Deeply stressed asset prices provided a large margin of safety for investors at the depths of the financial crisis. As a result, our work pointed to double-digit expected returns on stocks five years ago. Today, the S&P 500 is nearly three times higher than its crisis lows and consequently, stocks are priced to deliver negative real expected returns. In other words, that wide margin of safety has vanished. With expectations and prices significantly greater today, risk assets are more vulnerable to inevitable disappointments and negative surprises, given the smaller buffer to absorb adverse developments. Great businesses are not always great investments and stocks are not always priced to generate “average” long-term returns. An investor’s margin of safety is always and only dependent upon the price paid. It can be large at one price. It will be small at some higher price. And it can vanish at some still higher price. With respect to today’s margin of safety, one word comes to mind. Poof.
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