Seven Reasons To Listen To Carl Icahn’s Danger Ahead

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Carl Icahn

By Worth W. Wray, Chief Economist, Evergreen GaveKal – EVA on Carl Icahn

EVA Summary: This week’s Guest EVA features a video from the legendary activist investor, Carl Icahn, who is starting to make a lot of noise about frothy valuations, fuzzy accounting, and the corrosive consequences of zero interest rate policy. In the video, the billionaire corporate raider approaches the United States like a firm turnaround, employing the same thought process he typically applies to troubled businesses with ineffective management. While Mr. Icahn isn’t saying anything radically new, his warning deserves your attention. Investors who can weather the next downturn will find themselves well-positioned to capitalize on historic long-term opportunities. This week’s Guest EVA features a rare video message from an indisputable Wall Street Legend. [While my colleagues and I know online video may not be the ideal medium for some EVA readers, let me say that you don’t want to miss this video. It’s getting a ton of attention in the press and for good reason. If you are adamant that you don’t “do” video, my text should give you a decent overview.
[drizzle]Still, there’s no question that Carl Icahn’s decades-long track record ranks him right up there with elite investors like Benjamin Graham, George Soros, and Warren Buffett. Time Magazine even called him the “Master of the Universe” and “the most important investor in America.” The man clearly understands financial markets, Corporate America, and the tax/regulatory environment coming out of Washington… which is why his latest warning deserves your attention. In the 15 minute video, Icahn basically treats the United States like a corporate turnaround, employing the same thought process he typically applies to troubled companies with ineffective management. First, he sets his sights on a country that is still not living up to its potential and where he’s already acquired a large, albeit a non-controlling stake ($22 billion across more than 10 industries). Then he lays out several steps for unlocking the economy’s productive potential and makes an aggressive push for the CEO (in this case, President) he believes should lead the charge (Donald Trump). And finally, with this video, Icahn is doing his best to sell shareholders on the overall vision (in this case, American voters). Rather than getting bogged down by Carl Icahn’s politics – or what he stands to gain from the tax/regulatory changes he is advocating – I’d encourage you to focus on the very real reasons he sees “danger ahead” for US financial markets. Here are some of the highlights from Carl Icahn… (1)The United States needs meaningful tax & regulatory reform, which is unlikely without a strong President who can “move Congress” and “wake [this country] up.” At a time when the US electorate has become more polarized than at any other time in decades, it will take a special leader to win an election dominated by extremes and then unify the nation. (2)The United States is “shooting itself in the foot” by double-taxing foreign profits, discouraging US-based multinationals from repatriating roughly $2.2 trillion, and driving some firms to leave the country altogether. We’re talking about overseas profits after foreign taxes have been paid – roughly equivalent to half of the Federal Reserve’s balance sheet. This massive sum could have a material impact on productivity and employment in the United States in the event that tax-free repatriation is allowed in exchange for investing a portion of those funds in people, plant, and equipment. (3)Reported earnings in publicly-traded securities are highly suspect despite the broad adoption of GAAP accounting standards. In practice, headline earnings often do not account for stock compensation; they don’t amortize intangible assets, and they largely ignore restructuring and/or takeover costs. Thus, most investors are overestimating earnings, valuations, and debt sustainability at both the individual security and broad market levels. (4)Financial engineering benefits companies’ income statements at the expense of their balance sheets. Low interest rates have enabled firms to engage in financial engineering through share buybacks and M&A. These practices – which both hit record highs in 2015 – boost earnings and stock prices temporarily, but leave firms with little buffer in the event of special situations, adverse economic conditions, or an abrupt increase in the cost of capital. The irony, of course, is that Icahn has forced these kinds of financial engineering activities – especially stock buybacks – on a number of firms in recent years. (5)Ultra-low interest rates are fueling asset bubbles & threatening to trigger another financial crisis. With interest rates so low, savers are being forced to take more risk in asset classes like equities and high yield bonds. And the longer rates stay at zero, the greater the misallocation it feeds within Corporate America. Icahn says the Federal Reserve should raise interest rates immediately before the asset bubbles forming across the US financial markets give way to another 2008-style crash. [Our view at Evergreen GaveKal is that these bubbles have already formed and some are currently in the process of bursting.] While we have all heard this argument a thousand times in recent years, it has never been more compelling than it is today. (6)Low-rated bonds are almost certain to collapse. While he believes an equity market crash is likely, Icahn says the risk of a crisis in high yield is a “no brainer” which he handicaps as a “98%” probability. It’s also worth noting that Mr. Icahn is heavily short junk bonds in anticipation of that event. He may be talking his book, but we agree the risk of wicked spread widening, and even defaults, in junkier ratings is higher than most investors realize. As Icahn outlines in the video, the retail rush away from high yield ETFs and mutual funds – which investors have piled into in recent years – could lead to the same kind of forced liquidation that we saw in 2008. [It’s worth noting that Evergreen believes “high-grade, high-yield” credits remain attractive, though we have been trimming some of those issues due to “collateral damage concerns.”] (7)Liquidity is an illusion. If interest rates begin to rise or economic conditions begin to deteriorate – especially in the credit markets – investors may find themselves in a situation where the markets cease to function. That means that investors may find themselves in a position where they cannot sell at any price. That’s when the low interest rate party bus goes off a cliff… and when large cash positions will become invaluable. Wild stuff, isn’t it? Before you dismiss this message as rambling from a perma-bear selling fear, note that Carl Icahn is actually one hell of a risk-taker.A quick look back at the Forbes billionaires list reveals that Icahn’s personal net worth fell from $14 billion in 2008 to $9 billion in 2009 and then surged to $22 billion by 2015. He made a fortune by sticking to his discipline during the financial crisis and then capitalizing on the recovery in asset prices. Mr. Icahn didn’t become the greatest turnaround investor of all time without being both and optimist AND a realist. And yet, he is starting to make a lot of noise about frothy valuations, fuzzy accounting, and the corrosive consequences of zero interest rates… which long-time EVA readers will certainly recognize from the extensive writings of our very own Chief Investment Officer, David Hay. While Icahn isn’t saying anything radically new, the fact that he shares our concerns on so many levels should make your ears perk up. It prompts an important question. What does it mean when a legendary investor – whose personal fortune is so levered to positive economic growth and rising stock prices – starts to worry publicly that financial markets look like “2007 all over again?” Perhaps it signals danger ahead as the ongoing correction in commodity, credit, and equity markets threatens to give way to a sharper panic. If his warnings prove accurate, the investment implications are clear. Investors who can weather the next downturn will find themselves well-positioned to lock-in more attractive yields (in assets like MLPs, Canadian REITs, and corporate bonds) and capitalize on historic long-term opportunities in everything from energy and emerging markets to European banks. It won’t be easy to part with cash in that kind of environment, but try to channel your inner-Carl-Icahn.
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