For a fundamental analyst, it is difficult to determine the exact date of a “market value readjustment.” But counter-trend icon Crispin Odey says there is a logical method to determine when such potential disruptions are on the horizon. And he currently sees such issues on the horizon and has adjusted the portfolio accordingly.
In part, his logic to stay out of the perceived overvalued stock market is negatively impacting fund performance in the short term, he acknowledged in a July letter to investors reviewed by ValueWalk. But Odey points out “markets do not stay stupid forever,” it’s just a matter of when they realize the stupidity and adjust for the miscalculation.
Logical fundamental value metrics have been thrown out the window before, most notably leading up to 2001 and 2008
In the lead-up to the Dot-com bubble bursting, those involved in the markets at the time might remember a few fundamental value voices in the wilderness questioning inflated tech stock prices that seemingly had no path to a logical price earnings ratio, with Pets.com and a sock puppet leading the historical absurdity at the time.
The market eventually “re-adjusted,” as the often complex and sometimes fantastical explanations for tech unicorn valuations discovered gravity. In the aftermath, the fittest among the group ultimately survived but in general investors suffered.
Leading up to the 2008 financial crisis, what might be generally described as fundamental value analysis pointed out that loans with no income verification and people holding multiple mortgages they had no realistic chance of paying was a logical problem. Then, too, the market ultimately corrected, this time with a more complex derivatives stew being the largest contributor to bank losses and the bailout panic that resulted.
A fundamental value mis-match is taking place, and stupid will eventually self correct
Odey thinks the same fundamental performance drivers are clearly present in today’s markets, it’s just a matter of when the absurdity is generally recognized.
From Odey’s point of view, stock market investors are confusing bonds, once considered a “risk-free” asset, with stocks. With yield at or near nothing – if not negative interest rates pervading around the world – Odey says stock investors have convinced themselves of a convenient falsehood: stocks will deliver consistent and safe returns.
“Equities are not bonds, even when investors decide that they are,” Odey quipped, questioning the effectiveness of general market wisdom. “Bonds can certainly sometimes turn into equities, but the opposite rarely occurs. The current shortage of positive yielding bonds has persuaded many investors to pretend that equities are fixed interest securities.”
Odey argues that investors are paying up for trend GDP growth that is actually diminishing. He says central bank central planners are behind the market moves through their numbing use of quantitative stimulus which is seldom called into question.
“Investors apparently now want to pay more for equities because they have discovered that future profit growth will be slower than they originally thought,” he wrote. “To a financial market practitioner, it makes the most perfect of sense. It is called the Fed model, so it must be right, right?”
This, in part explains the Odey Odyssey Fund’s negative -11.5% year to date performance:
Our own refusal to pay more for slower future earnings growth is the main reason we are not making any money in our fund. Stupid is as stupid does, one might be tempted to comment. And indeed, there is little honour and no gain in being intellectually correct and commercially wrong. However, history is unequivocal in showing that the markets do not stay stupid forever. If they did, the world would long ago have abandoned markets as a resource distribution mechanism.
Outlook is not much better, its just a matter of when markets recognize the truth
His prognostication for the economy, and by extension the stock market, does not get much better.
With talk of fiscal stimulus gaining steam, Odey says that this and other methods to tickle the economic growth engine into action won’t be effective. He says the economic leavers are being driven by political concerns and central bank measures are likely to do more damage than good:
If the decline in productivity growth lies at the root of our economic malaise, it is unlikely to be cured by the newly-popular panacea of fiscal easing. To be sure, an increase in government spending on education and research should – over the long term – enhance productivity growth and thereby lead to a faster pace of trend economic growth. However, the operational reality for governments is the political present, not the potential economic future. Boosting growth in ten years’ time is not a recipe for getting elected next year. Which is why historical examples of fiscal stimuli are typically orientated around high visibility, job creating projects. Overpaying for an entirely unnecessary high speed railway makes a much bigger splash in the national accounts than spending a bit more on training teachers. The key point is that the type of fiscal spending that might enhance potential growth rates is not the type of spending that would enhance present growth rates. Which is why economic history – including very recent history – suggests that a substantial increase in government-directed spending tends to increase the misallocation of productive resources. In the current context of depressed productivity growth, it is entirely likely that excessive counter-cyclical policy – both fiscal and monetary – risks doing more damage to potential growth rates than it benefits immediate growth.
A significant economic concern Odey raises – very specifically challenging Bank of America Merrill Lynch research – is that fiscal stimulus could expand debt levels beyond that level that markets can tolerate. The BAML research argued that there was an identifiable level to which debt to GDP levels could be pushed before a market reaction were to occur. Odey disagrees:
The scope for aggressive fiscal easing is in any case severely circumscribed. Government debt/GDP levels are dangerously elevated. There is no way of knowing in advance the “safe” level of government indebtedness at which extra borrowing does not prompt a debilitating increase in real interest rates. The past five years of Chinese economic history provides a clear object lesson against excessive meddling with countercyclical fiscal policy. The entire concept of fiscal stimuli is anathema to Germany and is therefore verboten to the rest of Europe. Quite how an expansion of government spending is supposed to pass a Tea Party dominated Congress is also open to question. It is possible that a New Deal style approach to government spending might emerge at some point, but the political obstacles suggest that it lies on the other side of a recession.
Overall, we see little reason to change our expectations for a further slowdown in global growth. Equity markets, in contrast, retain their belief that a resumption of faster global growth lies just around the corner. This belief is embodied in the perennially upward sloping trajectory for future earnings growth. These optimistic corporate profit projections can only be rationalised on the basis of magical agency. An expectation of faster profit growth, at current levels of unemployment, must necessarily assume faster productivity growth. An expectation of faster productivity growth implies either an economic miracle or a reallocation of productive resources, the latter implying a recession.
Governments have moved away from free market philosophy and the economy no favors the well-connected, Odey says
Odey says that what has resulted from a move away from free markets is one where government and economic policies are working to protect oligiarctical interests that would, under a free market system, have been vanquished:
This zombification of the economy favours incumbent enterprises, allowing them to bloat their way to a size and influence that would be unthinkable under more predatory economic structures. The modern multinational corporation is an unaccountable, untaxable entity that cocoons its oligopoly within an impenetrable thicket of competition-repelling legislation. And as more and more of the economy has become subject to oligopolistic behaviour, so productivity growth has declined. There are solid grounds for arguing that an excess of counter-cyclical policy has numbed the market’s resource allocation mechanism and in so doing, exacerbated the very problem the policy was designed to ameliorate.
The decline in productivity growth lies at the root of our economic malaise, it is unlikely to be cured by the newly-popular panacea of fiscal easing. To be sure, an increase in government spending on education and research should – over the long term – enhance productivity growth and thereby lead to a faster pace of trend economic growth. However, the operational reality for governments is the political present, not the potential economic future. Boosting growth in ten years’ time is not a recipe for getting elected next year. Which is why historical examples of fiscal stimuli are typically orientated around high visibility, job creating projects. Overpaying for an entirely unnecessary high speed railway makes a much bigger splash in the national accounts than spending a bit more on training teachers. The key point is that the type of fiscal spending that might enhance potential growth rates is not the type of spending that would enhance present growth rates. Which is why economic history – including very recent history – suggests that a substantial increase in government-directed spending tends to increase the misallocation of productive resources. In the current context of depressed productivity growth, it is entirely likely that excessive counter-cyclical policy – both fiscal and monetary – risks doing more damage to potential growth rates than it benefits immediate growth.
What is now occurring is consistent with a theme Odey voiced in a July investor call: Central planning influence in the market has distorted reality. The market will at some point wake up from its slumber, its just a matter of when.
The hedge fund letter ends off the letter stating:
We believe that Chinese and US economic data, for the next 3-4 months, will sway opinion back towards a gloomier view of economic growth. In China, private investment has continued to slow over the summer, growing just over 2% in July (YTD). Compared to the same month a year ago, private investment spending growth was negative. State investment spending has also started to slow, presumably in reflection of a change in policy, as presaged by the comments from “an authoritative person,” earlier in the year. We have no difficulty in believing in an official move away from the credit-fuelled growth model, for the simple reason that the most recent episode served to demonstrate an almost complete collapse in the credit multiplier. M2 growth and financing flows have also slowed sharply, suggesting an air pocket for GDP growth over the next 3-5 months. In the US, the June and July employment data, along with the Q2 consumer data, have created the illusion that all is well with the economy. The reality is that the underlying employment trend has slowed, as has the growth in personal income. The pace of consumer spending in Q2 was wholly unsustainable (and probably an illusion generated by an insensitive price deflator), a point that has been supported by the abrupt halt in retail sales growth in July. Meanwhile, private fixed investment and corporate profitability are both declining, typical auguries of recession. To summarise, we do not expect the current market phase of elevating equity valuations to persist in the face of an unfavourable change in recessionary odds. As the old adage goes, nobody rings the bell at the top of the market. But there are usually plenty of hazard lights and most of those seem to be flashing right now.
The Fund has been generally short European and Japanese equity indices over the past couple of months, long high duration government bonds in the US and EU, short sterling (now closed) and short the US dollar. We are explicitly positioned for slower global growth, but are also of the view that the long bond position helps offset some of the losses in equity shorts, if stable growth leads to further yield compression across all financial assets.