July 29, 2016
By Steve Blumenthal
“Last week, market conditions joined the same tiny handful of extremes that defined the 1929, 1972, 1987, 2000 and 2007 market peaks.”
– John P. Hussman, Ph.D. (Source)
At a recent investment conference, one of the panelists was an investment officer for the China Investment Corporation (CIC) – the Chinese sovereign wealth fund. She was particularly critical of the performance of their hedge fund managers. The CIC and others have been exiting their hedge fund investments. A common theme of late.
“The secret to my success is I buy when everyone else is selling and I sell when everyone else is buying,” said the great Sir John Templeton to me in 1985. He added, “If you can do that, you’ll be amongst the best in the business.” The contrarian in me just couldn’t help but to think back to that sage advice. It seems to me like we may be arriving at one of those points in time, Sir John. Just saying.
“Sell stocks and buy gold,” former hedge fund great Stan Druckenmiller says. We’ll likely look back and say that was a great call. But such concentration into one asset class is speculation, not investing, and besides who has got the guts and conviction to do that. Stan sure does. Though I do advise to own up to a 10% portfolio weighting to gold.
Stocks are richly priced and have been for several years. I suspect that negative interest rates in Europe and Japan will drive capital from there to here and further boost U.S. stocks and bonds. Who in their right mind could have imagined nearly $12 trillion in negative sovereign bond debt in much of the developed world? The unimaginable has happened. So we watch for global capital flows to flee Europe and come here.
There is no way a pension fund or insurance company can meet its 7.5% return mandate by buying negative yielding German bonds. They will shift out of sovereign debt and seek opportunity. Where are they going to go? They need yield.
U.S. bond and dividend yields are higher than they are in Europe and Japan. The capital market’s infrastructure is the best in the world. The U.S. economy is in ok shape. A sovereign debt crisis in Europe will cause money to seek a safer haven. So watch capital flows for clues. Watch the dollar for clues. And know that what is inflated in price could grow to be more inflated. But keep Sir John in the front of your mind.
This week let’s take a look at two research letters. One is from GMO’s Ben Inker. He talks about how returns have been pushed forward due to the unprecedented drop in interest rates. All assets with long durations (stocks, bonds, private equity, real estate, etc.) have benefited by the drop in interest rates to near zero. He used the following example to explain it:
Let’s say that you will need, with absolute certainty, $1 million in 2026. The safest way to reach that goal is to buy a $1 million face value 10-year zero coupon Treasury bond maturing in 2026. Such a bond currently has a yield of 1.625%, which means it will cost you $851,127 to buy it today. Assume that tomorrow the yield falls by 1% to 0.625%. Your brokerage statement will declare the value of your bond to be $939,596, a gain of over $88,000. Whoopee! You’ve just made over half of the necessary return over the next 10 years in a single day. But the value of that bond in 2026 has not changed at all. It has a fixed maturity value of $1 million. The only thing that has changed is the discount rate being applied to that cash flow, not the cash flow itself. Assuming you still need $1 million in 2026, there is no windfall to spend. Economically, nothing has changed for you, whatever your brokerage statement says.
Ben concludes that investors should expect low returns and it is time to allocate more money to alternatives.
The second letter is from John Hussman. I bet you know of him and may have had money invested in one of his funds. He is an active mutual fund manager but missed much of the post-2008 recovery rally. But don’t let that fog your goggles. He is bright and what he shares is important to keep on your radar.
Grab a coffee and find your favorite chair.
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Included in this week’s On My Radar:
- The Duration Connection, by Ben Inker
- Speculative Extremes and Historically-Informed Optimism, by John P. Hussman, Ph.D.
- Trade Signals – Strength in Health Care, Telecom & Fixed Income
- A Few Photos from Lake George
The Duration Connection, by Ben Inker (footnotes omitted)
Over the last six or seven years, most financial assets have done very well. The performance divide has not been between low-risk assets and high-risk assets or between liquid assets and illiquid assets, but between long-duration assets and short-duration assets. Long-duration assets such as stocks, bonds, real estate, and private equity have benefitted from a large fall in the discount rate associated with their cash flows, while short-duration assets have been hurt by the same fall. Investors tend to tilt their portfolios in favor of those assets that have done well, and today that pushes them to be increasing effective duration in their portfolios, just when the potential returns to those assets have dropped. What we believe would be most helpful to investors are short-duration risk assets, as they offer the potential of decent returns over time with less vulnerability to rising discount rates. These assets, generally lumped together under the “alternatives” title, are generally out of favor today given their disappointing performance since the financial crisis, but the characteristics that made them disappoint may well prove a blessing if discount rates start to rise.
In most of the economic ways that count, the years following the financial crisis have been somewhere between disappointing and unspeakably bad. Economic growth in the developed world has been slower than at any comparable period barring the Great Depression. Productivity growth has been the worst since the invention of GDP, and corporate investment has remained stubbornly low. According to a McKinsey Global Institute report, two-thirds of households in the developed world had incomes as of 2014 that were flat or fell relative to 2005 (81% of households for the US in particular). After a burst of growth in the emerging world associated with China’s enormous stimulus policy of 2008-10, growth has also come to a crawl in the emerging economies, laying bare corruption and structural problems that appeared to be minor when times were better. But in one way, the last seven years have been a glorious success. Performance of most financial assets has been very strong, with assets from US equities to global real estate and infrastructure to credit and government bonds all giving strong returns. Even the laggards – non-US developed and emerging equities – have been disappointing on a relative, though not really an absolute basis. It isn’t all that often that everything does well at the same time. We have been conditioned to think of