Grey Owl Capital Management investment commentary for the second quarter ended June 30, 2015.
Captain’s Log, Stardate: July 17, 2015. Our position. Earth, America. Question. Is it? Day by day, we are more convinced the planet is foreign. Central bankers manipulate the price of interest and distortions grow. The bull market is seven years old; the longest since World War II; investors are sanguine. Superficial analysis shows bonds more overvalued than stocks. Uncertain. I’ve asked Mr. Spock to dig deeper. Either way, there is a dearth of value. Yet, this tool they call “Priceline” seems to hold promise. Hmm… with a click of the mouse, or a tap on the iPhone… to boldly go where no man has gone before.
"Now Mr. Spock, there's really something about all this that I don't understand, so maybe you could explain it to me, logically of course... Now, when you jettisoned the fuel, and ignited it, you knew that there was virtually no chance of it being seen and yet you did it anyway. Now that seems to me like an act of desperation." -- Kirk
"Quite correct, Captain." -- Spock
"Now we all know, and I'm sure the doctor would agree with me, that desperation is a highly emotional state of mind. So how does your well known logic explain that?" -- Kirk
"Quite simply Captain, I examined the problem from all angles, and it was plainly hopeless. Logic informed me that under the circumstances, the only logical action would have to be one of desperation. Logical decision, logically arrived at." -- Spock
Captain Kirk’s explorations continue below. First, here is the performance table for the Grey Owl Opportunity Strategy as of June 30, 2015:
Grey Owl Capital Management - Bond Bubble: The Bigger Short?
The already strong consensus continues to grow: bonds are in a bubble and stocks are the only place to preserve capital. Turn on CNBC and you are sure to hear comments to this end. We have written in recent letters of our belief that central bank intervention has elevated all asset prices and that stocks are particularly vulnerable given their place in the capital structure and historical volatility. We maintain that view today.
At first blush, the consensus idea that stocks present more value (or at least, less downside) than bonds seems to have some merit. At 2090, the S&P 500 trades at just under 18.8x trailing twelve-month operating earnings.3 This is about 13% above the 10-year average operating price-to-earnings (PE) ratio of 16.6x. A tad expensive, but by no-means a bubble when viewed through this prism. On the other hand, the 30-year United States Treasury bond (UST) ended 2014 with a yield of 3.3%, and as of mid-July yields 3.2%. That is meaningfully lower than the average yield on the 30-year UST over the past 10 years: 4.1%.4 By this measure, bonds look about 22% overvalued. Still not a bubble, but more expensive than stocks.
As one might expect, this simple view is, in fact, too simple. Examined from a different angle, stocks look more dangerous than bonds. Research Affiliates is a highly respected, quantitative asset management firm with $170 billion in assets under management. They publish 10-year asset class forecasts using a methodology that has historically shown very high correlation to future, actual returns over the 10-year period. Research Affiliates projects a nominal 10-year return for US large capitalization equities (i.e. the S&P 500) of 0.8% annualized with 14.7% volatility.5 Today, an investor can purchase a 10-year US Treasury with a 2.4% yield. There may be volatility over the next 10-years, but it is pretty much guaranteed that the investor will receive a coupon worth 2.4% of principal every year and get their money back in ten years. Because both the equity and bond returns are nominal, inflation will have the same impact on both. From that perspective bonds appear far less risky than stocks.
Let’s dig just a bit more below the surface. How else might we think about “fair value” for bonds? There are numerous ways to approach the concept of fair value, multiple investment-specific variables to inform the calculation, and macro-economic and demographic considerations to further confuse the matter. Comparing the current yield to historical averages of varying period lengths is one approach as we did above. We can also look at bonds from the perspective of the economic fundamentals that, over the longer-term, influence bond prices (i.e. a bond’s version of the earnings, margins, and return on capital analysis we apply to stocks and equity indices).
Taking the fundamental route, we can use a modified version of Knut Wicksell’s “natural rate of interest” to assess fair value of government bonds based on fundamentals. In as-close-as-we-can-get-to layman’s terms6, the natural rate of interest on a government bond7 should equal the return on all capital in an economy. Flawed as it is, nominal gross domestic product (GDP) growth is the proxy most used for return on the economy’s capital. Over the past 10 years, real GDP growth has averaged just 1.6% while consumer price inflation (CPI) has averaged 2.1%. Combining the two, we get a nominal growth rate of 3.7%. If 3.7% is “fair value” for a UST, then bonds are, like stocks, about 13% overvalued. Quite a bit less than the overvaluation based only on historical yield averages.
Yes, the Federal Reserve members (and other central banks) have their collective thumbs on the scales of the world’s developed economies. However, many investors seem to be missing the fact that developed markets have, at the same time, slowed considerably from their post –World War II average growth rates. AND, the weight of collective societal and government debt levels have (so far) had more of a disinflationary impact despite central banks’ extensive efforts to spur inflation. For the fifty years from 1955 through 2004, real GDP in the United States grew at an average rate of 3.4%. As indicated in the above paragraph, the average for the last ten years is 1.6%, less than half the fifty-year number. CPI is a similar story. From 1955 through 2004, CPI averaged 4%. Over the past ten years, it averaged 2.1%. Over the past 5 years, the average is even lower: 1.7%. Last year (2014) CPI was just 0.8%! If we use the 5-year CPI average and the 10-year real GDP average, we get a natural rate of interest of 3.3% - about where the 30-year UST yield is today. The Federal Reserve is meddling for sure, but it is both the tail and the dog.
While a review of bond fundamentals paints a more optimistic view of bond prices and yields, the opposite is true for equities. The price-to-earnings ratio comparison used to value the equity market in the introductory paragraph to this section is significantly influenced by corporate profit margins. During expansions, profit margins increase, and they decrease during contractions. Towards the latter part of expansions (where we find ourselves today), wide profit margins overstate earnings relative to their cycle average and thus understate the price-to-earnings ratio. Stocks appear cheaper than they really are. Comparing price-to-sales ratios is one of several ways to