Bad parents, Playing God with Markets, and Overvalued Equities
by Jeffrey Miller, Partner, Eight Bridges Capital Management
September 3rd, 2016
Wade Wilson: I had another Liam Neeson nightmare. I kidnapped his daughter and he just wasn’t having it. They made three of those movies. At some point you have to wonder if he’s just a bad parent.
What is your goal as a parent? That’s a trick question because I didn’t give you a time horizon. “What is your long-term goal?” is more precise. An answer might be “provide guidance and life lessons so that your children become good people.” That seems like a good goal. What if I asked what are your near-term goals for your children? Then your answer might be for them to be safe, or healthy, or happy. Also a good goal.
But you probably wouldn’t answer “My goal is for my children to always be happy, to never experience pain, or sadness, or disappointment. To always get what they want, and to never have to hear the word ‘No.’” That sounds like a recipe for disaster, right? It would mean giving them unlimited ice cream, access to Netflix, and no boundaries. What would you think of that parent? Clearly, you would say that they were spoiling their kids and that they are probably going to turn out badly. Like a Hilton or Kardashian-kid-badly.
And yet…central bankers around the world are those parents. The bad ones. The one’s you don’t let your kids play with. Because eventually, bad things happen there. Those spoiled kids take greater and greater risks, do dumber and dumber things, because there are never any consequences for their actions. Our Federal Reserve is encouraging people to do riskier and riskier things because they fear upsetting them with a few rate hikes and a fall in asset prices. They want markets to always be happy. They want markets to never go down, to have no volatility. They never want to tell the markets “No.” And like Wade Wilson, at some point you have to wonder if they’re just bad parents.
We all know what risky behavior looks like in children, but for some reason, when it comes to financial markets, lots of investors act like risk is something you can’t control, so why bother trying. That’s like saying a kid is just going to do whatever they want even if I say no, so I’m not even going to try to set boundaries. Investors in bonds with a negative yield are engaging in risky behavior because their bad central bank parents aren’t home. They’ve lost all sense of right and wrong, because they’ve never experienced the consequences of their actions. Is it the Fed’s fault? It is for bond investors. But there are lots of bad parents out there.
Deadpool: Did I say this was a love story? It’s a horror movie.
Maybe I’m just a mean dad, but I think kids benefit from knowing that someone is setting limits, providing guidance on right and wrong behavior, and trying to inculcate a sense of responsibility in them. What is risk in investing? Missing out on a potential return, or losing money – maybe for decades or even permanently? How long is permanently for a saver? For a retiree?
Millions of investors have been seduced by a famous mutual fund company founder, who shall remain nameless to protect the guilty, into thinking that managing risk is pointless, that markets are inherently unpredictable, and that everything will always be fine “in the end” so long as you remain fully invested. (Ok, its Jack Bogle of Vanguard.) But when is “the end.” What if it is soon, or now, because you are already in retirement?
People like Bogle say that even when markets break, they eventually recover, so there is no need to worry about market crashes. Just ride them out and everything will be ok. Except this ignores the fact that many times in history, markets have crashed and taken much longer than a decade to recover. Especially when “safety stocks” are trading at 25 times earnings. Got a spare decade or two? Ok then, you can ignore the current risks. The rest of you need to think about a backup plan.
Time horizon and need should drive risk/reward choices. Currently monetary policies around the world have converted savings into non-assets. They are effectively worth nothing. In Europe and Japan, they are worth less than nothing. As Bill Gross wrote recently, negative yielding debt is not an asset, it’s a liability. There literally is a line you can cross to convert an asset into a liability. It’s zero. Multiply your asset by a negative number. Your positive income becomes a negative. You owe someone money. Negative rates work like that. It’s middle school math. Zero is the line. Except no one at the ECB apparently remembers their middle school math.
This is why so many smart investors seem so angry with central bankers both in the U.S. and abroad. They have callously eviscerated the value of retirees’ savings. Remember when CDs paid interest you could live on? The old paradigm of work hard, save a lot, buy safe bank CDs and have enough money to pay your mortgage, food, and transportation expenses is gone. But the bad parents at the Fed don’t realize that if they take away someone’s “safe” income, they aren’t going to have any money to spend, or that forcing them to buy dividend stocks, or MLPs, or some other yield producing but-not-100% safe asset, is not going to make them comfortable enough to spend, and that really, those are the only two outcomes that a rational person will come up with. Reducing the security of someone’s income stream will make them want to protect what remaining income and assets they have, and save more, because they will probably have to live off of more principal and less income. It’s just math. That’s it. And like in middle school, when you multiply by a negative number, you get a negative. That’s all you need to know.
Recruiter: You’re looking very alive.
Deadpool: Ha! Only on the outside!
Recruiter: This is not going to end well for me, is it?
Deadpool: This is not gonna end well for you, no.
Stock markets are also engaging in some risky behaviors. There are many ways to measure riskiness in stocks, but Steve Blumenthal does an excellent job in covering most of the good ones, and he does it every week for free. Go and read his latest “On My Radar” here. But the cliff notes: stocks are really expensive based on actual earnings when compared to history. Like 28.7% above median fair value if you go back to 1964. Or using another metric, the Shiller P/E ratio, stocks have only been more expensive in the late 1920s (just before the crash) and in the very late 1990s (just before the crash). From this level, the subsequent 10-year annualized real return has averaged about 3%. Better than 10-year treasuries at 1.6%, but probably not what most people are expecting. And in the past, when stocks are this expensive, the subsequent 10-year return has been as low as negative 6% per year when starting at these valuations. Not exactly risk-less.
Colossus: [Deadpool is about to shoot Ajax.] Wade! Four or five moments.
Colossus: Four or five moments – that’s all it takes to become a hero. Everyone thinks it’s a full-time job. Wake up a hero. Brush your teeth a hero. Go to work a hero. Not true. Over a lifetime there are only four or five moments that really matter. Moments when you’re offered a choice to make a sacrifice, conquer a flaw, save a friend – spare an enemy. In these moments everything else falls away… [Deadpool gets bored and shoots Ajax in the head, killing him.]
Colossus: Really? Was that necessary?
Deadpool: You were droning on.
Janet Yellen gave a speech recently at the big Federal Reserve boondoggle in Jackson Hole. From Yellen’s speech:
As noted in the minutes of last month’s Federal Open Market Committee (FOMC) meeting, we are studying many issues related to policy implementation, research which ultimately will inform the FOMC’s views on how to most effectively conduct monetary policy in the years ahead. I expect that the work discussed at this conference will make valuable contributions to the understanding of many of these important issues.
This is not science. You don’t do research in a “lab”, apply some formulas, do some math, and then play god with the largest financial markets in the world. Unless you’re the Fed. Then you do just that. Even when your own charts show just how wildly you are guessing in your predictions. From her speech:
Like Colossus, I feel like I’ve been droning on about this issue forever. A year ago I was pounding the table and telling anyone who would listen (since I work with just one other person, it wasn’t a big audience) that the Fed should be raising rates because we had a small window to get them in before things went bad, because eventually, things always go bad. And once they do, you really don’t want to be raising rates. Markets will go nuts if you do. But…here we are. They didn’t do it, the economy is at stall speed, and the Fed is out of options. Maybe we can get some fiscal deficit spending going that will give a boost to the economy, but think through the timing. Nothing will happen until we have a new president, because this one is brain-dead when it comes to economics. So we’re into early 2017. Say whoever it is makes a massive infrastructure bill a part of their first 100 days agenda. Further say it actually makes it through Congress. How long for the rules of implementation to be written, then for contracts to be awarded, funds dispersed, workers hired, and so on. My point is, it’s not happening soon. The Fed missed their moment to be a hero, as did Congress and the President. Everyone just stood around doing nothing. And our economy, like Ajax, is about to get shot.
Don’t believe me? Hanjin of South Korea filed for bankruptcy this past week. It didn’t even make the front page of the WSJ. Which I find odd, because when one of the world’s largest shipping companies goes belly up, it’s something you should notice. Apparently, they handle about 7.8% of the total volume of goods shipped across the Pacific to the U.S. West Coast. As Joanie McCullough used to say, “that’s a numba.” Things break. They just do. Prepare for it.
Deadpool: Don’t worry. I’m totally on top of this.
In case you’re wondering why I keep picking on the Fed, well, it’s because it’s so easy to do. The following is taken directly from the Wall Street Journal’s transcript of an interview between WSJ reporters Jon Hilsenrath and Harriet Tory, and James Bullard, president of the St. Louis Federal Reserve Bank. The whole thing is worth reading to understand how we got here.
MR. HILSENRATH: What kind of compromise would it take to get the FOMC to move in September? I mean, so the tradition is there’s some kind of – like you say, some kind of agreement. What would it take to get them there?
MR. BULLARD: Well, I have no idea, so – and it’s really – it’s really the chair’s job to fashion that. But I will say that – I’ll talk historically about the FOMC, the kinds of things that the FOMC would do. You would trade off. You would say, OK, we could hike today, but then we’ll not plan to do anything in the future. That would be one way to – one way to go about a consensus. So that often happens on the FOMC. Or vice versa. If you read the Greenspan-era transcripts, he’ll do things like, OK, we won’t go today, but we’ll kind of hint that we’re pretty sure we’re going to go next time.
MR. HILSENRATH: Right.
MR. BULLARD: And so you get this inter-tempo kind of trade-off, and that often – that often is enough to get people to sign up.
MR. HILSENRATH: So, hike today and then delay.
MR. BULLARD: Yeah. (Laughs.)
MR. HILSENRATH: Or, no hike today and then no more delay.
MR. BULLARD: Yeah, yeah.
MR. HILSENRATH: Something like that.
MR. BULLARD: Yeah, those kinds of trade-offs are, historically speaking – I’m not saying I know what Janet’s doing, because I don’t. But, historically speaking, those are the kinds of things that the FOMC has done.
MR. HILSENRATH: I came up with my catchphrase for the – for the month. (Laughter.)
MR. BULLARD: Those are great. That’s worthy of a T-shirt. (Laughs, laughter.) You could have one on the front and one on the back.
MS. TORRY: Or a headline.
MR. HILSENRATH: Well, that’s the St. Louis framework now, right?
MR. BULLARD: Yeah.
MR. HILSENRATH: Hike today and then delay.
MR. BULLARD: Yeah. That’s what it would be, yeah.
Weasel: I would go with you, but… I don’t want to.
I’m still being cautious here. Maybe I’m just risk-averse. But continuing the parenting analogy, think back to a big college homecoming party. At some point most people realize they should leave a party. Some have been ingrained with enough common sense and self-worth to leave early – like when people start to get drunk and obnoxious. Some leave only when they are drunk and obnoxious, and their friends have to take them home. Others don’t leave until the cops show up. And then there are those folks who just hide and hope the cops don’t find them. Those idiots are the ones that get arrested. Don’t be an idiot. Protect your portfolio. I don’t want to go to this party anymore.
This week’s Trading Rules:
- Everyone always thinks they can leave the party before the cops show up.
- The cops always show up eventually.
SPY Trading Levels:
Resistance is the same as before, 219/219.50. Not much above that.
Support: 217/217.25, small at 216, a decent amount at 210/210/50, then 205 and 185.
Positions: Net neutral long/short. Long U.S. Stocks, short U.S. stocks, short XLU, SPY, XLP, and BWX.