Broyhill Asset Management letter to investors for the month ended August 31, 2015.
“The easy money has been made.” This is a phrase you might hear hanging out among traders after an investment has rebounded sharply from prices which, in hindsight, reflected too much pessimism1. It is not a phrase you are likely to hear very often today as the “easy money” is very hard to find.
Monetary policy has left investors with very uncomfortable choices – accept zero returns on cash or stretch for yield in liquidity-driven and increasingly speculative risk assets. There are no easy choices. There is certainly no easy money. Choose wisely.
Broyhill Asset Management – Divergent
Over time, monetary cycles across the globe have become more synchronized. Central banks now react to similar developments with similar tools in an increasingly connected global economy. However, interest rates can and will diverge from time to time, and when they do, monetary policy demands greater attention as divergences can have a significant impact on relative asset prices.
Today, uneven economic performance around the world has created sharp contrasts in monetary policy. Until recently, the symptoms of divergence have been greatest across interest rates and currency markets where volatility has been most extreme. JPMorgan Chase Chairman and CEO, Jamie Dimon, for example, referred to the intraday swing in the ten-year bond last October as a 7-8 standard deviation event that is “supposed to happen” about once every 3 billion years.
Domestic equity markets, on the other hand, traded in their tightest band for the first half of any year since 1928. The S&P 500 Index had gone almost 1,000 days without a 10% correction3. The absence of volatility had lulled investors into complacency.
Beneath this seemingly calm surface, cracks are appearing in our aging bull market. Momentum is waning. Market breadth is deteriorating. Earnings expectations are falling. Oil prices are collapsing. Uncertainty is increasing around the stability of a certain monetary union. And the effectiveness of government intervention in a certain “mainland” stock market is being called into question. As a result, stocks were largely unchanged through the first half of the year – the worst start to a pre-election year since 1941.
Against this backdrop, investors continue to obsess over the impact tighter monetary policy will have on elevated stock and bond prices4. While it is true that tightening monetary and credit conditions have preceded most bear markets, experience suggests that tops are more often processes than discrete events. It takes time for asset prices to respond to tighter credit conditions. The first hike rarely convinces anyone that the party is over. The chart below illustrates this process. During the last two hiking cycles, it took multiple rate hikes (dashed blue line) over the course of several years for tighter monetary policy to stall the aging bull market in stocks (grey line).
The experience in bond markets has been similar and understandably counterintuitive. During the last cycle, the fed funds rate climbed from 1% in 2004 to 5.25% in 2006. Over that period, the ten-year bond yield barely nudged higher while the thirty-year bond yield actually declined. A rising policy rate is more often coincident with a flattening yield curve. If the past is prologue, a flattening yield curve would, should translate into healthy gains for several closed-end municipal funds in the portfolio today.
Despite ongoing apprehensions permeating high yield credit markets, we see little cause for concern outside of the energy sector. It is important to note that credit spreads have historically behaved similar to equity markets in response to policy changes. As illustrated below, high yield credit spreads (grey line) actually compressed during the Fed’s last hiking cycle (dashed blue line). Counter to conventional wisdom, spreads didn’t widen until the Fed actually began cutting rates.
Corrections are natural and inevitable occurrences within stock and bond market cycles, but the worst sell-offs have typically been associated with recession5. While there are a number of indicators flashing yellow today, we do not yet see the traditional signs of a looming bear market that would warrant a significant reduction in risk. Outside of recession, we believe our current allocation to event-driven, distressed credit represents a compelling value today with the average bond in the portfolio trading near 70 cents on the dollar and a yield approaching 10% – a coupon far greater than the expected returns on offer across broad equity indices.
Broyhill Asset Management – Risk Management & Value Investing
Stocks entered the year overpriced based on any objective, long term measurement. But valuations can stretch a long way before they break. We know major stock indices are very expensive (those arguing to the contrary have a different agenda). We know major stock indices have fallen spectacularly from previous peaks of this magnitude. And we know another bear market is inevitable. We just don’t know when (those that claim they do likely have the same agenda as noted above). We also know that most investors will overact when it does.
Short term market volatility is notoriously difficult to time and most long term investors are better served to ignore it. This has certainly proven to be the correct approach over the last several years as declines have been particularly short and shallow. Nonetheless, we believe an emphasis on capital preservation over capital gains will prove prudent in the seasonally weak period ahead. We are not hiding in the basement with guns and ammo. Instead, we are preparing our shopping list and hope to be buyers of good businesses at lower prices in the future (perhaps sooner than we had initially thought). In the interim, we have taken some precautions.
In the absence of a severe economic contraction, it would be foolish to liquidate risk assets and sit on the sidelines for an unknowable period of time. Risk management is not the same as risk avoidance. Eliminating risk eliminates returns.
Rather, managing risk means working hard not to lose money. Most of the time, this can be accomplished by buying right. Buying right also provides the value-oriented investor with a margin of safety.
Broyhill Asset Management – Consequently, value investing is synonymous with risk management.
Most value investors stop here. Knowing that they have invested with a margin of safety, they choose to remain fully invested at all times, so as to maximize their exposure to the long term growth of the economy which is ultimately reflected in the long term uptrend in stock prices. There is nothing wrong with this approach – so long as investors are willing (and able) to ride out large intermittent drawdowns.
Many of the top minds in the business have generated impressive long term returns doing just this. It is worth noting, however, that their investors’ actual returns are often significantly lower than reported returns.
Since the average investor tends to buy after a good run and sell after a bad run, actual returns to investors in more volatile strategies are often lower than those generated by