Crescat Capital Q1 letter to investors
May 1, 2017
By keeping interest rates on the world reserve currency too low for too long, the Federal Reserve has created speculative asset bubbles in far-reaching areas of the globe:
? Currency and credit bubbles in China
? Housing bubbles in Australia and Canada
? Worldwide gluts in industrial commodities including fossil fuels, iron ore, and steel
? US passive index and ETF investing bubbles
? Financial asset and net worth bubbles in the world’s major developed countries
The catalyst today to burst these and other asset bubbles is the Federal Reserve’s recent interest rate hikes. The Fed has already raised the Fed funds rate three times since December 2015. While it may not seem like a big move, the increase in the Fed funds rate from 12.5 to 91 basis points in the last 16 months equates to a 628% increase in the interest cost of borrowing Fed funds. Foreign banks are the largest Fed funds borrowers illustrating the Fed’s global impact. By starting from such a low rate, as is evident in our log-scaled chart shown in Figure 1, it’s the largest Fed funds rate hike in any past US business cycle, and it has come late in the economic cycle.
Valuations are at Record Highs
Understanding the extent of the overvaluation in financial assets today is a key part of reading the overall macro cycle, because it is when speculative financial asset bubbles burst that the downturn in the real economy follows. As we show in Figure 2, in the US, the aggregate valuation of financial assets (stocks, bonds, and cash) relative to after-tax income is more overvalued than it was in both the tech bubble and the housing bubble.
Also, as shown in Figure 3, US household net worth relative to income is also at record valuation levels. This measure also includes real estate.
And according to the Organization for Economic Cooperation and Development (OECD), similar record imbalances in the valuation of financial assets and net worth to disposable income currently exist in Europe, Canada, Japan, and the UK. The speculative financial asset bubble in today’s market brought on by record easy central bank policies is a global phenomenon. The Fed is leading the charge globally on ending these easy money policies.
To illustrate the breadth of the valuation bubble in the US equity markets, the median stock in the S&P 500 is at its highest valuation level ever, as shown in Figure 4, higher than the tech and housing bubbles on a price-to-sales basis. Furthermore, median debt-to-assets in the S&P 500 is at its highest levels ever while the profit margin in the S&P 500 has already peaked out.
Across a broad swath of valuation measures (see the tables in the appendix) for both the S&P 500 and the Russell 2000, US stock valuations are either in the same range or in many cases significantly higher than they were at the tech bubble peak and the housing bubble peak. Sure, high valuation multiples might theoretically be justified in a low interest rate environment, but we must keep in mind that equities are the lowest asset class on the credit totem pole. Therefore, a generous risk premium or margin of safety must always be applied. If the Fed is raising interest rates in a possibly deliberate attempt to deflate speculative asset bubbles, valuation multiples are highly at risk of contracting. Is an aggregate P/E ratio of 115, as it is today, on the Russell 2000 small-cap index really justified? We don’t think so.
In order to see the impact of the Fed’s recent interest rate changes on small cap companies, we studied the Russell 2000 Index since the time the Fed began hiking rates in December of 2015. Since that time, the aggregate P/E ratio of the Russell 2000 has moved up from 46 to 115 times earnings. During the same time, aggregate interest expense has increased by 19% and corporate profits have declined by 33%! In median terms, Russell 2000 companies are now paying 24% of their operating profits in interest expense. That’s exactly what these companies were paying as a percentage of operating profits at the height of the tech bubble and 10 percentage points more than they were paying prior to the global financial crisis.
In the Russell 2000 today, only 68% of the index is made up of profitable companies. At the peak of the tech bubble, 76% of these companies were profitable. At the peak of the housing bubble, 79% of them were profitable. Clearly, for small cap stocks, the valuations are higher today and the fundamentals are weaker than they were at the prior two stock market tops.
Stock markets top out when valuations are extended, when corporate earnings and the economy appear strong, and when measures of consumer, business, and stock market sentiment are strong. These conditions are currently in place. We believe that this is as good as it gets. At times like this, everything is set up to fail. The catalyst for failure today is the same as the demise of every US business cycle: The Fed is tightening credit late in the business cycle.
Fed funds rate hikes usually have major ripple effects through the whole the global credit system. Equities and a broad range of credit instruments are highly at risk of a correction in today’s global markets.
With the Fed raising its funds rate, foreign banks today are highly at risk. They are the largest borrowers in the Fed funds markets. Such banks include Australian and Canadian banks that have also issued substantial dollar-denominated bonds. In other words, the US credit markets have been the fuel for the Australian and Canadian housing bubbles. Mortgage originator Home Capital Group plunged 58% last week, signaling that the Canadian housing bust may already be underway. Rising Fed funds combined with the declining Australian and Canadian dollars spells trouble for Australian and Canadian banks. We are short these banks in our hedge funds.
The housing bubbles in Australia and Canada are the product of capital outflows from China, a country that is plausibly at the peak of a historic economic boom. The Fed rate hikes, we strongly believe, are putting devaluation pressure on the Chinese yuan. We have written extensively about the currency and credit bubble in China in prior quarterly letters. We have had fits and starts with the yuan devaluation, but haven’t seen anything yet in terms of the big move that we are expecting. When the Chinese currency finally breaks, we are looking for a 30%+ devaluation. At that point, the Australian and Canadian housing bubbles will have already burst. Global asset bubbles of all kinds are now poised to unwind courtesy of the recent Fed rate hikes.
We hope to have shown herein, that there is indeed a business cycle. Contrary to some investment philosophies that claim it is too hard to time the business cycle or that macro is not a worthy part of a part of value-oriented investment discipline, in our experience that is pure nonsense. That is industry propaganda to keep long-only investors from pulling their money out ahead of or during a downturn. While the business cycle may not be easy to time, it is something that we believe is well worth the effort.
As a recent example, when the global economic growth and business cycle first started to crack surrounding the first Fed interest rate hike in December 2015, Crescat was ready. Starting with just the anticipation of the first Fed increase, China and the global oil industry went into crisis mode. The S&P 500 Index had a 14% correction from July 2015 to February 2016. The Shanghai Composite crashed almost 47% from its high in June 2015 to its low in January 2016.
See full letter below