Trapeze Asset Management letter fors the first quarter ended March 31, 2017 titled, “Equilibrium.”
The study of economics tells us that supply and demand dictate pricing. When there are no excesses or deficits, such that a market is in balance, it is said to be in a state of equilibrium.
As investment managers, it’s our job to find areas of disequilibrium. Imbalances or disconnects that have created opportunities to buy or short until normalization occurs. Typically, as they teach us in business school, prices adjust until supply and demand are altered enough to reassert a supply/demand balance—equilibrium.
Almost all assets can be viewed through this simple lens. For example, take a recent hot topic, housing prices in the city of Toronto. Having risen by over 30% in the last 12 months, some are referring to it as a bubble. While this rate of ascent is clearly not sustainable, house prices over time tending to track the growth of personal income, prices have adjusted upwards to get the market closer to equilibrium. Toronto’s supply of housing has been too low, inventory at historically low levels from limited listings and too few new builds—attributable to a number of factors, including available land and zoning issues. And demand has been ever-growing, from general prosperity, low interest rates, and substantial immigration. Demographics also play a role—supply is lower because fewer are at an age that they’re looking to move while there’s a bulge of new buyers.
This phenomenon is not limited to Toronto. In Vancouver, they’ve had a robust market too, with foreign buyers as a driving source of demand. All around North America housing prices continue to recover nicely from the depths of the last recession. Low supply—inventories are at a multi-year low contrasted with the record highs set in '07—and continued economic growth, which propels demand, should continue to keep house prices high. Of course, that’s until the next recession when demand will shrink, and supplies ought to inevitably catch up, such that house prices will at best flatline and, in areas of accelerated growth like Toronto, we could see substantial declines. Interestingly, listings in Toronto just surged by a record 36%—here comes the supply.
Trapeze Asset Management - Buoyant Economies
When excesses occur in the economy—demand running well ahead of supply, central banks step in to rein in growth by raising interest rates and lowering the monetary aggregates. At economic troughs, when supply overhangs abound, governments act to stimulate demand. Without intervention, the economy would adjust on its own, though perhaps after greater extremes in magnitude and duration.
The current economic cycle has been elongated. With few excesses, the anemic growth and muted inflation have caused intervention to be that of continuous stimulation. Only in the last several months has the Fed begun to tighten, and more to ensure they don’t over-stimulate. And with zero interest rate policies, some foreign countries continue to be highly stimulative. The near-term prospect of a global recession remains highly unlikely. Our Economic Composite (TEC™), designed to alert us to recessions in various regions around the world, is suggesting the same. Though there have been a few signs of a slowdown—loan growth at U.S. regional banks slipped into negative territory in Q1, GDP growth was a mere 0.7% and, consumer spending has been relatively weak.
Interest rates around the world remain low. 10-year rates in the U.K., Germany and Japan are 1.1%, 0.4% and 0.04% respectively, so rates in the U.S. aren’t likely to jump materially. In fact, there’s an argument to be made that they can’t, given the extreme debt levels and the additional burden higher rates would cause.
U.S. economic growth continues, albeit at a relatively low rate, with unemployment, now at 4.4%, near full employment, without causing wage pressures. Canadian unemployment is down to 6.5%, below its 10-year pre-recession level. Lower corporate income tax rates, if Trump is capable of getting that through, should fuel U.S. growth too and boost profits—much of which is not discounted in stock prices, in our view, because Trump has been ineffective thus far or because of the longer-term negative impact of lower tax receipts (when they’ve already flatlined) on the deficits.
China’s growth had an uptick recently, though it has been obfuscated by the government’s steps to address the overzealousness in the shadow banking system. And Europe’s expected growth has picked up too, moving up to 1.7% for this year, and slightly higher for '18, with the European Union seeing risks as being more balanced.
The supply/demand equation for common shares remains favourable. Partially from demand for the scarce alternatives, with interest rates still so low. Perhaps if the speculators in the condo market get scared off there’ll be additional buyers entering the stock market. Corporations have been buying back their own shares at a record pace—a boost in demand and an equivalent drop in supply of shares outstanding. With the ongoing M&A activity, the buyouts have shrunk the number of actual issuers trading to a point where the number of hedge funds and ETFs greatly outstrips the amount of actual traded stocks. Even governments have gotten into the game, the Swiss and Japanese buying billions worth of the largest companies in America. The acceleration in passive investing has pushed up demand too, especially in the mega caps.
With share prices having risen, we expect buybacks to slacken and new issues to increase. Interest rates will ultimately rise enough to bring back some demand for fixed income investments too. That, and because the markets are trading above fair value (already in equilibrium) with weaker than normal earnings growth, we’d expect longer-term returns from the indexes to be below-average.
Though U.S. equities remain near all-time highs and somewhat above fair value in our work, absent a recession, we don’t anticipate a bear market. One would also expect to see euphoric sentiment—demand running wild—which isn’t really evident, prior to the next major top. Stock markets peak when there’s over-exuberance at a time when economic growth is about to be quelled. And, our TRIM™ stock market indicators are on buy in most regions providing confidence of an extended bull market. Earnings growth, the fuel for rising markets, continues too. With almost all S&P 500 companies having now reported Q1 results, nearly 80% beat profit expectations.
That said, since the market is somewhat ahead of itself, we wouldn’t be surprised to see a normal market correction—averaging about 6% in a bull market. Stocks do tend to inflect down from TRAC™ ceilings/FMVs (fair market values) once achieved, when they run out of short-term potential, as they appear to have now. A handful of some ultra-large cap bellwethers have been driving the market, such as Apple, Johnson & Johnson, Google, Procter & Gamble and Microsoft, all of which are fully valued, at best, and now at TRAC™ ceilings. We’d welcome a healthy correction in order to find more opportunities for us to get more fully invested. Our search for stocks trading for 85 cents-on-the-dollar or less is ongoing but providing few new potential investment opportunities.
One possibility, though unlikely, is that demand for shares begins to far outstrip supply, potentially leading to meaningful overvaluation. With the prospect of minimal returns from ultra-low interest rates and now rising