On My Radar: Grantham, HY And The Cyclical Bear In Gold by Steve Blumenthal, Capital Management Group
“If you’re young, take the whack [and] if you’re old, pray for the Fed to keep going.”
– Jeremy Grantham
Grantham was the opening keynote at the Morningstar Investment Conference in late June. There were several notable insights I share with you this week. The intro quote above pretty well sums up his outlook. All about that (bass) Fed, about that (bass) Fed. The jingle continues to ring in my mind.
I believe the high yield debt market can help us identify market inflection points. High yield tends to be a leading market indicator. A default wave is in our near future and I suspect the opportunity it will create may arrive sooner than many expect.
I’m not sure if you saw the recent heated debate between Blackrock’s Larry Fink and the great Carl Icahn. It was about the potential illiquidity in fixed income ETFs. Icahn said, “There is no liquidity. That’s my point. And that’s what’s going to blow this up.” I’m grateful for all Fink has created but put me in the Icahn camp on this issue. My two cents is the inherent problem will be one of the driving sources of the great future opportunity.
It is estimated that nearly three quarters of U.S. investment wealth will be in the portfolios of pre-retirees and retirees by 2020. While the younger investor can “take the whack”, the pre-retiree and retiree can’t. Ten years recovering from decline is different for a 45 year-old than it is for a 65 year-old. “Pray for the Fed to keep going”- indeed.
Another storm is ‘a brewing. Yet, we don’t need to take the whack. As was the case in prior overvalued, over-leveraged and aged bull markets, the game for now is to participate and protect.
Let’s also take a look today at what is going on in high yield bond market. I believe it can tell us a great deal about the timing of future opportunities.
Included in this week’s On My Radar:
- Grantham – Keynote Highlights (Morningstar Investment Conference)
- What Do High Yield Maturities Tell Us About Timing the Credit Cycle? GMO’s Ara Lovitt
- Gold – What to do with Gold
- Trade Signals – Zweig Back On A Buy, Trend Remains Positive, Sentiment Bullish – 07-22-2015
Grantham – Keynote Highlights (From the Morningstar Investment Conference)
- Equity valuations are heading toward the “two-sigma” level that is the requisite threshold for a true bubble (referring to a 2 standard deviation move from its long-term trend)
- A “trigger” will precipitate the reversion back to the mean levels
- He said, “The market is driven by career risk where investors’ job descriptions are to keep their jobs. They deal with the mindset to “never be wrong on your own” and if you are going to be wrong, make sure you have plenty of company.” This process guarantees that investors herd together and drive asset class valuations way beyond fair value.
- GMO’s seven-year forecast assumes valuations will normalize over a seven-year time horizon, with both lowered profit and PE levels.
- GMO is forecasting a -2.3% seven-year return for U.S. large-cap stocks.
- In order for equity yields and returns to increase, “we have to take a hit because the market is overpriced”
- A younger investor with less accumulated assets will benefit more than an older investor with more accumulated assets
- Government policies have prevented capitalism from working in normal ways
- Fed policy has fueled high margins, a stock-option culture and a fixation on short-term results
- 30 years ago, 20% of senior management pay was attributed to stock options; today it has exploded to 80%.
- In line with this incentive, corporate management teams have chosen the much less risky path of stock buybacks to drive valuations and profitability. It is easier for corporations to meet their quarterly numbers through stock buybacks than it is through capital investment.
- The pace of stock buybacks has accelerated dramatically and is at a record annualized rate of $700 billion per year to date while capital spending is 4% below average even after a six-year recovery with record profit margins.
- This is a high price to pay to make senior management rich and the lack of capital spending is a drag on economic growth. Management teams are more comfortable buying back stock, pushing stock price up and making their stock options more valuable.
- He challenged the Fama-French market efficiency theory citing his team’s work that identified 28 important investment bubbles that all “broke completely”. Citing a 2 standard deviation move above the mean, in all cases two-sigma events, were highly predictable and lead to collapses.
- GMO’s research showed that we are getting close to another two-sigma event, as the markets are hovering around 1.5 sigma.
- He said, “There is no chance it will break until we get over two sigma.”
- He believes the market will “plod higher” and follow the Fed at least until the election; citing the election as a potential bubble breaking trigger. He added, “I’m going to be incredibly prudent closer to the election.”
- There are no “institutional pessimists,” he said, “and there will be no trigger until individuals pour into the market. We need to wait until deals become more frenzied and individuals become crazy buyers.”
- He does not see a Fed rate hike as the trigger. He forewarned the audience, “you have to wait for the trigger so be brave.”
What Do High Yield Maturities Tell Us About Timing the Credit Cycle? GMO’s Ara Lovitt
I favor price behavior to best identify the high yield market’s primary trend but clearly underlying fundamentals matter. I’ve been writing to you about a coming default wave and how I believe it will be the largest default crisis on record. Too many low quality companies have received funding and at terms least favorable to investors. There will be defaults and there will be many. It will be crucial to get the timing right if you want to take advantage of the opportunity the sell-off will create. Oftentimes, analysts look to the maturity calendars as logical market inflection points. That is the date the IOU comes due and without refinancing, there is not enough money in the corporate kitty to pay back the lenders (bond holders).
PJ, President of CMG, forwarded me a new White Paper on the high yield market. It is loaded with a number of important insights. Here are a few (I then link to the full piece):
- For those invested in high yield bonds and leveraged loans, accurately timing the cycle will be the difference between safely clipping coupons and realizing painful losses.
- The turn of the cycle should create the next great opportunity.
- Credit strategies and portfolio managers frequently point to the timing of debt maturities as a major determinant of near-term default rates.
- Over 50% of the outstanding debt matures within the next three to six years.
- Lovitt took a closer look at three of the last credit cycles looking to see if the “maturity wall” gave investors a useful “buy” signal at the cyclical bottoms of the market. Contrary to popular belief, he found that often companies default years before their debts technically mature.
- Credit cycles typically turn after a long boom. Toward the tail end of the boom, most companies with access to capital markets are likely to have refinanced