Covenant Weekly Market Synopsis as of August 4, 2017

August 7, 2017

Good to be back. Although I took some time away from writing each week, I remained engaged with the markets and investors, both professionals and non-professionals. Truth be told, not much has changed in the last four weeks relative to perceptions of the markets, not that I expected it to. Four weeks is a blink of an eye in investment terms…especially in the midst of a nine-year Bull Market. The market may very well continue to run higher, but counter to most previous cycles, the Bulls reasoning seems to be that slow economic growth will keep a lid on inflation, which in turn will allow central banks to maintain low interest rates.

…it is hard to overstate the extraordinary nature of today’s landscape. All previous periods of extreme asset valuation required investors to imagine…a wildly optimistic future…. But today they expect the opposite. Due to unfavorable demographics and over-indebtedness, investors expect…perpetually low interest rates, which they then use to justify extreme valuations across other asset classes in an endogenous loop that is increasingly disconnected from the real economy. This is the dominant pricing model for global assets today.

– Eric Peters, CIO OneRiver Asset Management

Low interest rates are the “mother’s milk” of discounted cash flow models used to justify historically high valuations of bonds, equity and real estate assets as a recent chart from The Economist highlights. Note, a discounted cash flow model is a valuation method that uses projections of future free cash flows and discounts them to arrive at a present value estimate. All else being equal, a lower discount rate (i.e. the prevailing interest rate adjusted for various risk factors) results in a higher estimate of present value.

image

But earnings have been strong, right? Yes, and no. Earnings per share have been beating analysts’ expectations, but actual earnings (that is, total corporate profits) as of Q1 were more than $150 billion lower than their recent peak in Q4 2014 (Source: U.S. Bureau of Economic Analysis). In the chart below, the corporate buying of stocks represents stock repurchases, which have reduced the number of shares outstanding. In reducing the denominator (i.e. the number of outstanding shares) in the earnings per share calculation, lower aggregate profits are disguised in higher earnings per share metrics.

image

When will it end? What will cause it to end? Nobody knows the answer to either question. But, outside of a geopolitical event or natural disaster, the most likely cause of the next market decline will be a monetary policy error by a major central bank. The mistake may not even be committed domestically, given the interconnectedness of the global economy. For example, China’s government could tighten monetary policy too much, causing a major slowdown in the world’s primary growth engine. The point is trying to pick a top is a fool’s errand, yet at the same time there will be a top…we just don’t know where or when.

Which brings to mind an excerpt from legendary value investor Seth Klarman’s book Margin of Safety. I’ve modified the numbers, but the math remains the same.

An investor [Investor 1] who earns 6% annual returns over a decade, for example, will, perhaps surprisingly, end up with more money than an investor [Investor 2] who earns 10% a year for nine years and then loses 25% the tenth year. There is an understandable, albeit uneconomic, appeal to the latter pattern of returns, however. The second investor will outperform the former nine years out of ten, gaining considerable psychic income from this apparently superior performance. If both investors are money management professionals, the latter may also have a happier clientele (90% of the time, they will be doing better) and thus a more successful company. This may help to explain why risk avoidance is not the primary focus of most institutional investors.

Stocks have lost an average of 33% from top to bottom in recessions going back to 1929 (Source: Credit Suisse). Due to compounding, a 33% loss in Year 10 would wipe out 5.5 years of paper profits. God forbid markets experience a loss similar to the Dot.com bust or the Great Recession, which would not only eviscerate 9 years of gains, but generate real capital losses (i.e. an initial $100 investment would be worth only $80 after ten years). The following graph illustrates Klarman’s point about the outcome for the two investors under various scenarios.

image

Source: Covenant Investment Research

The message here is a simple one: we live in extraordinary times, but not unprecedented times as it relates to market valuations.

Investing in risky assets has been rewarded for an extended period, but these conditions will not exist in perpetuity (though they may persist for longer than many people believe). While the next market downturn may be difficult to imagine given the performance of equities over the last nine years, it is inevitable.  And when it does occur, the key to succeeding through the downturn (just as it has been with all of the previous drawdowns), is to ensure your portfolio is not levered to a single risk factor in advance of the pullback. Importantly, this doesn’t imply that one should avoid equity exposure altogether – equities are an important component to portfolio appreciation, but equities should not be the only source of return (and risk) in a portfolio. Diversification may seem costly in the early and middle portions of a business cycle as Seth Klarman points out. Yet, it is the disciplined investor who pushes back against the siren song of “This Time Is Different” that will be able to mitigate losses and generate the greatest wealth in the market.

Be well,

Jp.