The Late Stages Of A Bear Market – The Big Long by Dave Iben, Kopernik Global Investors
The Big Short is a movie that is currently in theaters and is nominated for five Academy Awards, including best picture. Based on Michael Lewis’ well written book about the actions, travails, agony, and eventual triumphs of a group of eccentric, independent and contrarian-minded investors who bet on the “inconceivable”, yet, in reality, inevitable collapse of the mortgage market. In two hours and ten minutes, the picture does a decent job of portraying the pain that is inflicted upon investors who are too early. The collapse of the hugely overextended, and arguably corrupt, mortgage market took over three years to unfold. Once it did, Wall Street ignored it at first, and refused to reflect reality into the price of securities. It had to be excruciating for these maverick investors. As Howard Marks notes, “successful investing requires the ability to look wrong for a while.” He mentions David Swensen’s (of Yale) ‘terrific phrase’: “Uncomfortably idiosyncratic.”
The movie begins in an era, roughly a decade ago, when, because mortgages in aggregate had been stable, arguably safe for decades, people ignored the principles of economics; didn’t worry about oversupply; didn’t worry about a borrower’s ability to meet obligations. At the same time, investor aversion to negative cash flow, and to short-term loss, allowed astute investors to buy optionality (on the collapse of mortgage values) at extremely attractive prices. The result is legendary. Hence an Academy Award contending movie.
And here we are in early 2016, with much of the public fearful that, as we watch The Big Short in theaters, the real world is scripting the sequel. It is understood that the GFC (great financial crisis) in 2008 was the unintended, but inevitable, consequence of excessively easy monetary policy conducted by the Federal Reserve. This policy of profligacy was designed, perversely enough, to repair the damage caused by the collapse of the tech bubble seven years earlier; a bubble that, not surprisingly, was caused by excessive easing by the Federal Reserve. Slow learners, the Fed has spent much of the last decade trying to fix the problem by using a turbo-charged version of the very policy that caused the past two bubbles. Back then, people feared that the banks were “too big to fail.” Now they are much bigger. People worried about excessive debt. It is now larger, both in absolute terms and, more importantly, in relation to the size of the economy. The 2007 bubble caused malinvestment in the housing and banking industries. Malinvestment is now prevalent in finance, energy, commodities, consumer discretionary goods, emerging markets and others. It’s wreaking havoc. Investors feared that stock prices were unsustainably high in 2007, as the ensuing crash validated. Yet, eight years later, prices are even higher for many U.S. stocks, for high-end real estate, art, collectibles, tuition, healthcare and entertainment. Alarmingly, tens of trillions of bonds are priced at or near the highest prices (lowest yields) in the history of mankind. Clearly, we believe, the central banks messed up royally. For the third time in less than two decades ‘the Piper’ seems to be asking for payment: U.S. stocks struggle, post a 6 ½ year run; junk bonds are plunging from prior excessive values; and commodities have nosedived; etc. Many people are rightfully worried.
At this juncture, the tone of this Commentary changes. We hereby put forth the argument that this is not the beginning of a bear market, but rather is the late stages of a bear market.
Don’t misconceive us; we won’t quibble with the distinct possibility that we’ve just seen the end of the bull market for larger cap U.S. stocks or for “quality” growth stocks or for the U.S. dollar. And the end of the astonishing 35-year bull market in bonds is inevitable – it is just a matter of when. But, it is essential to notice that the impressive performance of these select groups has obfuscated the existence of a deep, long-enduring bear market. While the press tends to gravitate to simple definitions, such as, “a bear market is a decline of 20% or more” or “a decline of a year or more”, we prefer to think about them as lasting years, often delivering torturous, deep losses, ultimately leading to panic and capitulation, and behavioral change. Let’s delve into the current market further.
Facebook stock hit a new all-time high this month (February 2016). Netflix, Google (Alphabet, now) and Amazon hit new all-time high price levels in December 2015. All was right with the world. The NASDAQ composite index, though technically having peaked in July of 2015, was still plugging along quite nicely as recently as December. The S&P500 peaked two months earlier, but really meandered sideways from November 2014 through the end of 2015. The ACWI (MSCI All-Country World Index) peaked the same month. What was very different from the S&P was that it peaked at roughly the same level as it peaked in 2007. Eight years, same level. The S&P was a third higher. Leaving the U.S. aside for a moment, it becomes clear that things haven’t been firing on all cylinders for many a moon. The ACWI ex-US peaked almost a full year earlier in July 2014. And that was a secondary peak that came nowhere close to the all-time peak established way back in 2007. To repeat, the index most investors use to represent the global market suggests that beyond U.S. borders, the bear for stocks may have started in September of 2007. How can this be? The table on the following page shows the details, country by country. Enlightening.
Countries that are down on a 1, 3, and 5 year basis (in US$) include France, the UK, South Korea, Netherlands, Hong Kong, Australia, and Canada, i.e. most of the large economies. China, the second largest economy, is down on a 5 year basis, but not three (Shenzhen Stock Exchange Index). Germany, Japan and the U.S. are among the few that have fared better. Australia and Canada are both down over 30% on a 3-year and 5-year basis. The formerly exulted BRICs (Brazil, Russia, India, China)? See below.
Human emotions are interesting. We all know to buy low and sell high. But things looks so damn good at the top, and so abysmal at the nadir. Oil, gas, coal, uranium, and hydroelectricity were not competitors at the top, they were all important parts of the solution to a very important question: How are we ever going to meet the insatiable energy needs of 7.3 BILLION people?! Now investors are grappling with how to unload the stigma and potential liability associated with owning archaic relics of a bygone era; so unappealing in the contemporary “post-hydrocarbon” world. People viewed China as a dynamo, a must-own economic juggernaut, destined to