The Paradox Of No Choice – Global Markets, Marginal Hurdle Rates, And Changing Rules by Jeffrey Miller, Partner, Eight Bridges Capital Management
Note: This week’s note was written on July 17th. I am traveling in Alaska with very limited internet access, and am just able to send it today. In addition, due to a lack of internet access, there will not be the usual quotes from popular music or movies. I’m sure you’ll all survive.
The Paradox of No Choice
The Paradox of Choice is a well-known psychological phenomenon in which a consumer, faced with too many choices, experiences anxiety about making the wrong choice and therefore makes no choice at all. Famously, emigrants from the Soviet Union, where they had few if any choices about their food in grocery stores, would come to America, with its seemingly limitless choices, and be paralyzed with indecision. Their lack of prior information and inability to anchor their choices on any prior experience made the situation, instead of an amazing one (“look at all this food!”) an ultimately stress-inducing nightmare. Eventually they would adjust and be able to function, but there is something about too many choices that makes the average consumer freeze. A similar condition is paralysis by analysis – faced with too much information and no good way to organize and process it, many people simply choose to do nothing – they make no decision at all.
Good stock pickers, on the other hand, often thrive when faced with many choices – in the U.S. alone, there are well over 4,000 individual companies to choose from. Investment managers thrive when they have a good system to sort through the choices and find those with the best chances of producing outsized returns over time. Over time, the best practices become rules, and by following their carefully crafted rules, the top stock pickers create enviable long-term track records of investment success.
But what happens when the market changes the rules? What does an investor do then? Well, this has happened before. Warren Buffett famously closed his hedge fund and returned capital to his investors when “he no longer understood the market.” That was in 1969. Then, in the mid-1970s, the market suddenly switched back to following the rules again, and he did quite well. Many investors with enviable long-term track records think we’re going through a similar phase today, where the old rules are being thrown out and replaced with, well, no one is really sure what. As a few market observers have written lately, in the 5,000 year history of interest rates, we had never seen negative rates – until now. So the rules of the game have changed, but it’s hard to suddenly switch your investment style every time the wind shifts direction, especially if you’ve built your reputation as a “long-term value investor.” (Full disclosure: I like to think of myself as a value investor, just not long-term. But that’s the topic for a future newsletter.)
Negative interest rates are making some well-established rules look obsolete. When I got into the investing business in the early 1990s, I was really sure that there was a “right” hurdle rate of return and that I could simply matrix my investment choices based on those that met it and those that didn’t, and invest accordingly. This worked really well until it didn’t (see internet bubble, late 1990s). When that bubble burst, value investing worked really well again, with 2000-2003 producing great returns for my fund. But this year the rules aren’t working, and investors like me have to decide a few things: a) are we wrong and b) if so, how long are we going to be wrong before things reverse and the rules start working again. As Joel Greenblatt likes to say, if value investing worked all the time, then it wouldn’t work at all. It’s the times that it doesn’t work that makes it work over time. Got that?
Intellectual Purity versus Intellectual Honesty: Which is the right mindset for investing?
I’m firmly in the Intellectual Honesty camp. I got there by losing lots of money being in the Intellectual Purity camp. I find that the best of my peers with whom I regularly speak have few fixed beliefs about valuation, trading levels, what makes a good company versus a bad one. Instead, investing for them is all about asking lots of questions and trying to figure out what works now. Lately, I find myself asking more questions than ever. What’s the right price for “the market?” Are historical averages really “right?” Or were they just a statistical quirk? What if in the past U.S. stock prices were being set at a time of low foreign investment in our markets, and now U.S. stock prices are being set by the marginal global investor with the lowest hurdle rate of return? How long with that continue, and what will happen when it ends? Will it end slowly, or all at once?
“The Market” is a weird term to begin with. Before ETFs, you could argue that there really was no such thing per se, that it was just the sum total of the individual companies, but the ability to cheaply and easily invest in a myriad of different permutations of asset classes has changed that dynamic. Today, often it is the asset allocation trade that drives the moves of the individual stocks, not the other way around. Look at the components of the KRE or KBE – they often move together. Then look at a similar stock that isn’t in the ETF. It may not move at all or even in the opposite direction. That isn’t the effect of new information about the individual companies, but the effect of asset allocation shifts.
So now if you’re an investor looking to generate returns that beat your benchmark and do it in a prudent manner, you’re facing a dilemma. Is the right price whatever someone else is willing to pay for it? Today it is. Or is the “right” price the price that is low enough to generate a return based on the company’s expected future cash flows that beats your hurdle rate? What if your hurdle rate is not only materially higher than the current market hurdle rate, but the poor global economic outlook makes it likely that the lower rate will persist for the foreseeable future. Then what? You have 2 choices: do nothing, and sit in cash waiting for a correction that gets prices down to your buy level, but in a low return world, that correction may not occur. Or you can invest despite the likelihood of generating lower returns than needed to satisfy your hurdle rate or target rate of return, and justify it by saying you have no other choice.
In today’s market, where capital can flow fairly easily from country to country, and where the prospects look fairly bleak in many countries outside the U.S., this phenomenon is called TINA: There Is No Alternative. In a world where nearly $13 trillion in debt has a negative yield, where economies struggle to avoid completely stalling out, where terrorism continues to strike innocent people in western democracies, what is the “right” price for financial assets in the U.S. that provide a fairly stable income stream? I have no idea. While I think the valuations that consumer staples stocks trade at are crazy, why can’t they continue to go higher? Just because I think 25 times earnings for a company growing revenue at 4-5% a year makes no sense from a mathematical return standpoint (I calculate an investor buying those stocks today can expect to earn between 4-6% annually at best before inflation), why can’t investors with no better alternatives continue to buy them until that return becomes 3-5%, then 2-4%, then 0%? In a world where 0% is a better return than you can get from a large portion of the global sovereign bond market, weird things can happen.
I could take the easy route and just say that this is all nutty and will end badly, as many commentators do, but unfortunately for me, I don’t usually take the easy route, so we need to consider the possibility that even though prices today make no sense to those of us who have been investing professionally for the past 10, 20, 30 years, they don’t have to make sense to us: they just have to make sense to that mysterious marginal buyer who’s hurdle rate of return appears to be at best 0% and may well be negative. In that world, trying to be “rational” means anger, angst, underperformance, and eventually, unemployment. Unfortunately, the other choice, to just reverse course and “buy buy buy” is probably a bad one and definitely not “prudent” if you’re managing money professionally. Missed the 25% year-to-date move in Utilities and then you bought them? Good luck writing that investor letter. Unfortunately, maintaining intellectual consistency, while fine in areas like academia and politics, isn’t always a the best choice in investing, but the alternative, having no firm beliefs about valuation, “correct” hurdle rates of return, and risk management just feels wrong. Even though in today’s market, it may well be the only way to beat the market.
This week’s Trading Rules:
- You can’t trade on what should be, you can only trade on what is.
- First you have to learn the rules of the game, and then you have to learn to play the game better than anyone else. Albert Einstein
In our last letter, written the weekend after Brexit, we said ignore the pundits who were predicting doom for the markets because of Brexit. Since then the S&P 500 has reached a few new all-time highs. I don’t see why this can’t continue. Market leadership is shifting from yield plays to other sectors, which is healthy overall. Valuations are expensive by historical standards, but that doesn’t mean they can’t get more expensive in the near-term. Long-term, returns will likely be muted, but stocks can go higher first. Stay hedged and be alert for sparks that could set the markets on fire. Chinese Yuan and emerging market currencies are my guess as to where the next fire for the markets will start.
SPY Trading Levels:
Support: 213/214, 210, then 205.
Resistance: Not much. Stocks will be short-term over-bought if we get to 221 quickly.
Positions: Long and short U.S. stocks, ETFs and options. Short XLP, XLU, SPY.