Bad parents, Playing God with Markets, and Overvalued Equities
by Jeffrey Miller, Partner, Eight Bridges Capital Management
September 3rd, 2016
Wade Wilson: I had another Liam Neeson nightmare. I kidnapped his daughter and he just wasn’t having it. They made three of those movies. At some point you have to wonder if he’s just a bad parent.
What is your goal as a parent? That’s a trick question because I didn’t give you a time horizon. “What is your long-term goal?” is more precise. An answer might be “provide guidance and life lessons so that your children become good people.” That seems like a good goal. What if I asked what are your near-term goals for your children? Then your answer might be for them to be safe, or healthy, or happy. Also a good goal.
But you probably wouldn’t answer “My goal is for my children to always be happy, to never experience pain, or sadness, or disappointment. To always get what they want, and to never have to hear the word ‘No.’” That sounds like a recipe for disaster, right? It would mean giving them unlimited ice cream, access to Netflix, and no boundaries. What would you think of that parent? Clearly, you would say that they were spoiling their kids and that they are probably going to turn out badly. Like a Hilton or Kardashian-kid-badly.
And yet…central bankers around the world are those parents. The bad ones. The one’s you don’t let your kids play with. Because eventually, bad things happen there. Those spoiled kids take greater and greater risks, do dumber and dumber things, because there are never any consequences for their actions. Our Federal Reserve is encouraging people to do riskier and riskier things because they fear upsetting them with a few rate hikes and a fall in asset prices. They want markets to always be happy. They want markets to never go down, to have no volatility. They never want to tell the markets “No.” And like Wade Wilson, at some point you have to wonder if they’re just bad parents.
We all know what risky behavior looks like in children, but for some reason, when it comes to financial markets, lots of investors act like risk is something you can’t control, so why bother trying. That’s like saying a kid is just going to do whatever they want even if I say no, so I’m not even going to try to set boundaries. Investors in bonds with a negative yield are engaging in risky behavior because their bad central bank parents aren’t home. They’ve lost all sense of right and wrong, because they’ve never experienced the consequences of their actions. Is it the Fed’s fault? It is for bond investors. But there are lots of bad parents out there.
Deadpool: Did I say this was a love story? It’s a horror movie.
Maybe I’m just a mean dad, but I think kids benefit from knowing that someone is setting limits, providing guidance on right and wrong behavior, and trying to inculcate a sense of responsibility in them. What is risk in investing? Missing out on a potential return, or losing money – maybe for decades or even permanently? How long is permanently for a saver? For a retiree?
Millions of investors have been seduced by a famous mutual fund company founder, who shall remain nameless to protect the guilty, into thinking that managing risk is pointless, that markets are inherently unpredictable, and that everything will always be fine “in the end” so long as you remain fully invested. (Ok, its Jack Bogle of Vanguard.) But when is “the end.” What if it is soon, or now, because you are already in retirement?
People like Bogle say that even when markets break, they eventually recover, so there is no need to worry about market crashes. Just ride them out and everything will be ok. Except this ignores the fact that many times in history, markets have crashed and taken much longer than a decade to recover. Especially when “safety stocks” are trading at 25 times earnings. Got a spare decade or two? Ok then, you can ignore the current risks. The rest of you need to think about a backup plan.
Time horizon and need should drive risk/reward choices. Currently monetary policies around the world have converted savings into non-assets. They are effectively worth nothing. In Europe and Japan, they are worth less than nothing. As Bill Gross wrote recently, negative yielding debt is not an asset, it’s a liability. There literally is a line you can cross to convert an asset into a liability. It’s zero. Multiply your asset by a negative number. Your positive income becomes a negative. You owe someone money. Negative rates work like that. It’s middle school math. Zero is the line. Except no one at the ECB apparently remembers their middle school math.
This is why so many smart investors seem so angry with central bankers both in the U.S. and abroad. They have callously eviscerated the value of retirees’ savings. Remember when CDs paid interest you could live on? The old paradigm of work hard, save a lot, buy safe bank CDs and have enough money to pay your mortgage, food, and transportation expenses is gone. But the bad parents at the Fed don’t realize that if they take away someone’s “safe” income, they aren’t going to have any money to spend, or that forcing them to buy dividend stocks, or MLPs, or some other yield producing but-not-100% safe asset, is not going to make them comfortable enough to spend, and that really, those are the only two outcomes that a rational person will come up with. Reducing the security of someone’s income stream will make them want to protect what remaining income and assets they have, and save more, because they will probably have to live off of more principal and less income. It’s just math. That’s it. And like in middle school, when you multiply by a negative number, you get a negative. That’s all you need to know.
Recruiter: You’re looking very alive.
Deadpool: Ha! Only on the outside!
Recruiter: This is not going to end well for me, is it?
Deadpool: This is not gonna end well for you, no.
Stock markets are also engaging in some risky behaviors. There are many ways to measure riskiness in stocks, but Steve Blumenthal does an excellent job in covering most of the good ones, and he does it every week for free. Go and read his latest “On My Radar” here. But the cliff notes: stocks are really expensive based on actual earnings when compared to history. Like 28.7% above median fair value if you go back to 1964. Or using another metric, the Shiller P/E ratio, stocks have only been more expensive in the late 1920s (just before the crash) and in the very late 1990s (just before the crash). From this level, the subsequent 10-year annualized real return has averaged about 3%.