Preamble

This month’s Strategy Thoughts By Kevin Armstrong is the second edition written since Kevin resigned from ANZ. For the last four and a half years he has been writing Strategy Thoughts for the ANZ Private Bank and its clients throughout Australia, New Zealand and Asia and prior to that, right back to the 2002 cyclical bear market trough, he wrote Strategy Thoughts for the New Zealand Private Bank. His original reason for writing a monthly paper on his views of investment markets was that it was a very healthy, and valuable, discipline to attempt to put his thoughts on what was important in markets and what was driving markets each month ahead of chairing the bank’s Regional Investment Committee. ECINYA has a very high opinion of Mr Armstrong and we are pleased that he has used our web-site as a transmission vehicle for his unfolding views.

Introduction

In last month’s conclusion I wrote:

“The current cyclical decline, which has been seen in commodities as well as stock markets, probably has further to run. It will end with very depressed expectations, no sign of ‘hope’ from yet another summit, economists slashing forecasts for growth and a global recession probably imminent. By the time these things occur it will probably be the case that the recession (it will eventually be determined) had already started and with rampant gloom and dire forecasts abounding. By then another great opportunity, like those seen in late 2002 or early 2009, will be at hand. For most markets this will be another cyclical opportunity, however, it is possible that some of the most depressed markets may also be on the brink of a new secular bull market.”

Since then markets have generally continued to rally, however, I continue to view the current strength as being a bear market rally driven by rampant ‘hope’. This ‘hope ‘ has been supplied by central bankers committing to do ‘whatever it takes’ and by economic numbers that appear to show things as not being too bad after all. As I have written many times, characteristics such as this are not the foundations that enduring and rewarding bull markets, be they cyclical or secular, are built upon.

In this month’s Strategy Thoughts I will review the extent of the current ‘hope’, question its validity and explore perhaps the overriding characteristic of current markets; frustration. Despite the recent rally virtually all market participants have been frustrated as a result of the meandering nature of markets over the last few months and for many markets over the last decade or more. It has long been said that the primary aim of the market is to frustrate the maximum number of participants for the maximum length of time; currently the market is succeeding in this.

I have also been asked a number of times over the last month just what it would take to make me reconsider my overarching cyclical and secular views. This is a highly pertinent and valuable question so in the second half of this month’s Strategy Thoughts I will review what it would take to make me believe that a secular bear market had indeed ended and also that a new cyclical, and secular, bull market had begun.

Finally I will comment on the risk in chasing yield and the danger of high yield (junk) bonds. Last month I concluded with:

“In the meantime it will be prudent to avoid the excitement and attraction of the ‘hope’ that has accompanied this recent rally, and to maintain a very cautious investment outlook with a particular focus on high quality fixed income, don’t chase yield, and the still relatively depressed US dollar.”

The action of the last month has done nothing to soften these views with the exception that further capital gains are now unlikely in longer dated treasuries and yields may have recorded their final low, this only increases the danger in junk bonds.

Frustration

Levels of frustration are elevated, unusually, for both bulls and bears. Neither has got what they would have wanted from the recent market action, although periodically it has appeared that one or the others preferred, or hoped for, outcome was eventuating. Markets have neither broken out to new highs nor collapsed in a replay of 2008.

That frustration levels are high and rising is entirely understandable, the expectation that shares would outperform all other assets over the long term, which was born out of the remarkable boom period for markets in the eighties and nineties, has been totally misplaced. The MSCI World Index is currently at the same level as it was three months ago, one year ago, twenty one months ago, four years ago, seven years ago, eleven years ago and thirteen years ago. Obviously it has been both a lot higher and a lot lower many times over the last thirteen years but on balance any global investor that bought into the then prevailing conventional wisdom of the late nineties, that the secret to stock market investing was ‘buying and holding’, has been whipsawed several times and undoubtedly left very disappointed. Such disappointing market action over the long term and over the last few months will produce frustration. 

These repeated bouts of frustration, particularly over more recent months, were beautifully described by Jeremy Grantham of GMO in his most recent quarterly letter;

“The economic environment seems to be stuck in a rather unpleasant perpetual loop.  Greece is always about to default; the latest bailout is always about to save the day and yet never seems to; China is always about to collapse but instead teases us by inching down; and I swear the Financial Times is beginning to recycle its reports!  In the U.S., the fiscal cliff looms along with debt limits and the usual election uncertainties.  The dysfunctional U.S. Congress continues for the time being in its intractable ways.  The stock market rises and falls and rises and falls again.  It is getting difficult to find anything new to say at client meetings.  I, for one, wish that the world would get on with whatever is coming next.” 

I would echo those sentiments, but the likelihood is that frustration levels are likely to remain high for some time yet. What I do find remarkable are; the level of hope that remains out there amongst market participants, how little markets have risen on the back of this hope and the fragility of the news that has supposedly produced the hope.

Over the last month there have been innumerable headlines extolling the presence of hope:

Wall Street closes at three-month high on hopes for Europe Reuters, 6 August 2012

Australian sharemarket jumps on US jobs data, bond-buying promise The Australian, 6 August 2012 

Australian stockmarket jumps as hope grows for European action on crisis The Australian, 30 July 2012 

“The US stock market is riding on the wings of hope” written by Greg Weldon via Weldon Financial, 20 July 2012

Even in China there’s hope:

Investors look for hope amid sluggish market China.org.cn, 31 July 2012

And it has not only been in the stock market that hope has been found, it apparently reigns in foreign exchange markets too:

Markets Hope For More QE Forexpros.com, 11 July 2012

Having come across so many stories over the last couple of months explicitly expressing ‘hope’ I decided to do a Google search for the simple phrase ‘Stock Market Hope’. Over the last month alone this search yields over three and a half million hits, this is more than three and a half times the number of hits ‘Stock Market Fear’ generates over the same period. Most of the other months I looked at this ratio tended to only favour hope over fear by a factor of one and half to two times. Clearly this was far from a statistically valid or scientific review, however, it seems to highlight that levels of hope remain high.

Superficially this may appear to be a good thing for markets, unfortunately high levels of hope tend not to be found in the early stages of a cyclical bull market, rather it is found in the early stages of a cyclical bear, and it tends to rise in the back of each bear market rally only to be squashed with each successive decline to a new low. This is why it is said that a bear market ‘slides down a slope of hope’. Another old adage may be that ‘hope springs eternal’, and it usually does, but not at the bottom of a bear market. By then all hope has been abandoned and fear is the dominant sentiment, the vast majority of market participants know just how bad things are and fear that they will only get worse. This backdrop is what lays the foundation for a new cyclical bull market and the climb up the ‘wall of worry’.

Very few, if any, markets displayed anything like such an emotional extreme at their lows two months ago, not even in some of the very depressed European markets. The Spanish market has undoubtedly been amongst the worst performing stock markets since the initial rally after the global financial crisis. The IBEX at its recent low, just ten days ago, was down more than 50% from its 2010 recovery high and more than 60% from its all time high recorded in 2007 but in just the last two weeks that market, on the back of all the news induced hope, has rallied almost 20%. Again, this is not the type of reaction that is seen at the start of an enduring bull market. At bear market lows any good news is dismissed, bad news captures headlines and when the rally begins no one appears to know why the market is rising and the rise is dismissed as just a ‘dead cat bounce’. One only has to think back to March 9^th 2009 for a perfect example of this exact market reaction and response. That day the Dow soared almost 6%, with perfect hindsight we now know that this marked the end of the worst bear market in more than seventy years but very few thought so at the time. The Huffington Post described the move online:

“Wall Street snapped out of its stupor and posted its best performance of the year Tuesday, finding a badly needed glimmer of optimism in the most unlikely of places: Citigroup is actually managing to turn a profit. The 379-point gain for the Dow Jones industrials, a rally of almost 6 percent, was a welcome break from almost uninterrupted selling.”

It then went on to quash any excitement or enthusiasm that the move may have brought about;

“But just as almost nobody expects the banks to snap back to health, almost nobody thinks the market has hit its bottom.”

The rally continued for months and for months the general tone of media commentary was dismissive and bearish as the ‘wall of worry’ was ascended. A similar backdrop was seen in 2003 at the prior cyclical bear market trough. Unfortunately if everyone seemingly ‘knows’ why a market is rising it is more than likely a rally born out of hope not fear, and is therefore only a bear market rally.

What is perhaps most remarkable about the current market action, and sentiment backdrop, is that despite the increasing levels of frustration that are undoubtedly being felt by investors, still, any straw of hope, no matter how fragile, is immediately seized upon and markets rally for a few days or weeks. Reflecting this desire to be optimistic investor expectations for stock market returns remain elevated. Yahoo Finance recently conducted a poll of its readers asking which asset they believed would deliver the best return over the next twelve months. Despite all the frustration that is clearly out there the favourite asset class was the S&P500, beating gold, oil, emerging markets, corporate bonds and US treasuries. 27% favoured the S&P whilst only 4% picked US treasuries, this despite the fact, and contrary to the majority of economic forecasters, treasuries have been the best performing asset over the last one and two years.

But hope is a wonderful thing!

As described above, hope is a wonderful thing and it is human nature to cling to these straws of hope, but just because something is understandable, and even natural, it doesn’t mean it will result in a successful investment outcome. In fact going against ingrained and instinctive biases is far more likely, albeit uncomfortable, to result in success in the investment world. The unfortunate thing is that because behavioural biases are instinctive we humans find it very difficult to learn from past mistakes, and so, eventually, repeat the same mistake again and again. Sometimes the ‘eventually’ is not very long!

Over the last couple of years of the European debt crisis there have been numerous announcements of bailout packages, trillion euro ‘bazookas’, summit meetings and acronyms galore, and after each supposedly positive or constructive outcome European markets have rallied, presumably on the hope that whatever has just been announced will ‘fix’ the problem. Sometimes the rallies in the immediate aftermath of the news have been remarkable. The most recent rally in the Spanish IBEX, described earlier, began after ECB president Draghi’s comments in a Q and A session at an international investment conference held in London to celebrate the opening of the Olympics. He said that the ECB would "do whatever it takes to preserve the euro" and added, "believe me, it will be enough."

This sparked a one day surge in the IBEX on the 26th of July of 7% and initiated the current bounce. But similar reactions had been seen before, and not that long before. On the 29th of June when it was announced that European leaders had reached a ‘deal’ on European banks the IBEX closed nearly 6% higher than it had the prior day. Three weeks earlier, over the weekend of the 9th of June, it was announced that Spanish banks had sought a 100 billion euro bailout. This news was apparently ‘welcomed’ by the markets and on the Monday the IBEX rocketed about 6% higher soon after opening before fading later in the day.

What is remarkable is that all these supposedly good news stories still produce dramatic, albeit usually brief, rallies in a market that has already fallen so far and for so long. After so many ‘fixes’ that turned out to be nothing of the sort the willingness of the investing public to believe that Draghi could do ‘whatever it takes’ seems incredible. If he really could ‘fix’ the problem why has he waited for so long and seen so much damage done to European equity and debt markets?

The reality is that history has repeatedly shown that long term recoveries in markets come not as a result of governmental or central banking policies, but rather in spite of them. Markets eventually begin to recover when investor hope has been quashed and expectations are at rock bottom so that no matter how bad the news is it’s not as bad as the majority feared. They don’t recover when hope continues to bloom with each passing fix.

It is therefore unlikely that even the incredibly depressed Spanish market has yet reached the bottom of the current cyclical bear market. If a market that is already down more than 50% over the last couple of years hasn’t bottomed it is unlikely that a worthwhile buying opportunity exists in markets that are down substantially less, despite the frequent pronouncements as to how cheap some markets may be. As I have repeatedly stated over the years valuation tells an investor nothing about what direction a market is going to move in except over truly long term time frames and then only at historic extremes. The majority of markets, notably the US, that are being heralded as cheap are a very long way from being historically very cheap.

Could anything change this view?

When I was first asked this question I believe that the questioner was primarily interested in my shorter term cyclical view, that equity markets had to fall further and potentially challenge their 2009 lows before a new cyclical bull market could begin. However, in order to answer that question I think it is useful to consider the secular position of markets, in fact I believe it to be essential.

Secular bull markets last up to thirty or forty years and always take a market from an extremely low long term valuation to an extremely high valuation and secular bear markets do the reverse and tend to last about half as long as secular bull markets. There are no hard parameters as to just where a secular bull should end and a bear begin however, the chart below (produced by Smithers and Co, the firm headed by Andrew Smithers who, along with Stephen Wright, wrote the excellent and highly prescient book about, ‘Valuing Wall Street’ in 2000) illustrates two long term measures for valuation of the US equity market. Both have clearly swung from high to low several times over the last century, up swings have coincided with secular bull markets and down swings secular bear markets. The US market in 2000 was historically incredibly expensive, but even at the 2009 lows it was far from being historically cheap. I firmly believe that sometime over the next few years the US market will become historically cheap. That tells us nothing about what the market is going to do over the next few weeks or months but it does tell us that buying and holding will probably continue to be as frustrating an exercise as it has been over the last dozen years.

Given this there is little, barring an unprecedented surge in earnings and so collapse in valuations, that would change my secular view of the US and most developed country markets. A low valuation extreme still lies out there in the future, but this tells us little if anything about how this valuation extreme could be reached, a sudden crash could deliver such a valuation extreme or a grinding sideways market for several years could. This then raises the question of how my shorter term, cyclical view, could be wrong.

Like Jeremy Grantham I too would like the markets to get on with whatever they are going to do. My expectation had been for the major markets to follow a similar, if less extreme, path to the Spanish market and in so doing smash investor expectations and deliver another buying opportunity like those seen in 2003 and 2009. I still consider this the most likely outcome and so continue to believe a very cautious investment strategy is warranted, however, it is possible that the current frustration just continues. Any extension of the current rally would then just be part of an extended period of ever dampening oscillation around a sideways trend in the markets that may eventually produce the disinterest on the part of market participants and valuation extreme that are found at the end of a secular bear market.

This is not unlike what was experienced over the final few years of the last secular bear market in the US. After the market’s most severe decline since the thirties in 1974, when the Dow fell almost in half, the secular bear market was eight years old and only about half over. It rallied sharply from that low point and then over the last seven years of the secular bear market the Dow meandered in a far tighter trading range from about 750 to 1000 characterised by shorter and shallower cyclical bull and bear markets. Eventually, by August 1982 with the Dow at 776, the same level it had been at almost two decades earlier, and at the lowest valuation that had been seen for sixty years, the secular bear market ended and a new secular bull market that would last until 2000 began.

A similar resolution to the current secular bear market may occur, and whilst the cyclical damage may not be as severe as it could be frustration levels would undoubtedly rise and again caution would be warranted.

Is the ‘eye’ passing over again? Or Déjà vu (again)

In May of 2008 I titled Strategy Conclusions ‘The Eye of the Storm?’ as some normality appeared to have returned to markets after a miserable decline over the prior six or seven months. I wrote at the time;

“The dictionary definition of the eye of the storm or the eye of a hurricane goes something like, “a region of calm weather right in the middle of the storm or hurricane” and the danger to the inexperienced weather watcher is that the eye of a storm can result in a false sense of security or safety. It can feel like the worst is passed and that things can get back to normal, however, as the eye moves on the storm begins again with all its former fury, only just to add insult to injury the winds come from totally the opposite direction.”

“The eye of a storm is a very appropriate metaphor for what many investment markets are now experiencing. As I commented in last week’s Thoughts and Observation piece, it is highly unlikely that the worst is over, in fact the mere fact that so many commentators are declaring that the worst is now behind us should actually be taken as something of a contrary indicator, and a warning.”

Our caution at that time was eventually proven to be very well placed; the worst was far from behind us at that time and the worst effects of the Global Financial Crisis had still to be felt.

After the ‘eye’ has passed the second half of a hurricane is never the same as the first although the damage can be just as severe or worse, and so the metaphor played out in markets through the balance of 2008 and into early 2009. History never repeats itself and so it is not surprising that markets through the current cyclical bear market are behaving differently to those four years ago, but history does tend to echo or rhyme. One of those echoes can be seen in the relative lack of volatility currently, particularly in US markets. The VIX, or volatility index, has fallen to its lowest point in four months and is currently at about 15.5 having been close to twice that level just two months ago. In May of 2008, as the last ‘eye’ was passing over, the VIX fell to less than 16 having been a little more than twice that level two months earlier. There is a real possibility that the current calmness, and growing feeling that the worst may have been seen, is as misplaced as it was four years ago.

History doesn’t repeat but I was struck by an updated version of a chart that I used two years ago, it overlays the current secular bear markets in Europe and the US on the Japanese experience eleven years earlier.

The risk in junk, or the danger of ‘chasing yield’

The chart below shows the total return of investing in high yield (or junk) bonds in the US over the last fifteen years. Generally returns have been good, although 2008 was pretty miserable, and they have been particularly good so far this year.

This performance may be understandable, with treasury yields having fallen to historic lows recently it seems the world has been searching for (chasing) yield. As a result the spread, or premium, paid by high yield bonds over the most secure bonds, has narrowed, so pushing the price of junk bonds up even more than the rise seen in government bond prices. This hunger for yield is not only being felt by individual savers but by institutions too. CALPERS, the huge public employee pension fund manager in California recently announced that their fund return for the last twelve months was just 1% compared with their long term expected return of 7.75%, as a result they have reduced their expected return to 7.5%. Expectations on the part of all investors fall through a secular bear market and tend to trough some time after the secular bear market has ended. It would not be surprising to see substantially lower expectations than 7% by the time the current secular bear runs its course. In the meantime return of, rather than return on, will continue to be the most important issue for most investors and their investment capital. The risk in junk may not only be in the bond defaulting, there is now the risk that treasury yields may start to rise along with those very narrow spreads.

For a very long time I have proclaimed the virtues of long dated US treasury bonds, and anticipated that yields would go lower than virtually any economist was forecasting. I also didn’t expect long dated yields to rise until the consensus view had given up on looking for higher rates and accepted low rates for a very long time. In June I wrote;

“Until the fear of deflation and ever lower yields becomes widely embraced and discussed it is likely that further surprises on the downside in yields, not a sudden reversal to the upside, are in prospect.”

At the time ten year treasuries were yielding a little over 1.7%, over the next eight weeks yields plunged, briefly falling below 1.4%. As a result there has been an interesting shift in investor expectations and attitude. Two days ago Bloomberg ran the following story:

Treasury Bears Submit To Fed As Bond Optimism At High

Jay Mueller, who manages $3 billion of bonds for Wells Capital Management in Milwaukee, resisted buying Treasuries for four months, anticipating the Federal Reserve would drop its pledge to keep interest rate at a record low through late 2014. No more. With the economy growing at a 1.5 percent annual pace, the odds of a recession have risen to 60 percent, making 1 percent yields on 10-year notes a possibility, he said. Wells Capital’s parent, Wells Fargo & Co., boosted its Treasury holdings 32 percent to $11.5 billion in May alone, according to the latest data compiled by Bloomberg. “We’re in a low-rate environment for a long time, longer than I had thought,” Mueller said in a July 26 interview at Bloomberg headquarters in New York. “I’m finally throwing in the towel.” So are Pioneer Investment Management Inc., Pacific Investment Management Co., Federated Investors Inc., Northern Trust Global Investments and Columbia Management Investment Advisers LLC. They are adding to holdings of Treasuries as economic growth cools. Of the 20 firms that own the most Treasuries, 16 bought more U.S. government debt during their most-recent reporting periods, Bloomberg data show.

If treasury yields continue to rise, as they have over the last three weeks, and spreads start to widen junk bond returns will start to struggle.

Conclusions

Apart from the possibility of a final low having been seen in treasury yields little has changed over the last month, although it is probable that frustration levels have continued to grow. Hope continues to abound and so the danger of disappointment is high. Secular bear markets continue to roll on in most major equity markets of the world and within those secular bears the current cyclical bear markets have not displayed the kind of give up, or plunge in expectations, that one would expect to see at a cyclical trough. Cautious patience, avoiding frustration, will likely be the most valuable attributes as the current ‘eye’ passes over.

On a personal note my frustration levels have been elevated for reasons outside of the markets, we have spent the last three weeks downsizing now that we are ‘empty nesters’. We have sold our family home and moved to our house by the sea. De-cluttering a lifetime of accumulation in just three weeks is no easy task but I am delighted to say that it is now done. I would also like to say how delighted I have been with the level of interest shown in Strategy Thoughts since my departure from the bank, your comments and questions are always welcome. Finally if you have any friends, colleagues or clients who would like to receive Strategy Thoughts please forward their addresses to [email protected]

Kevin Armstrong

9^th August 2012

Disclaimer

The information presented in Kevin Armstrong’s Strategy Thoughts is provided for informational purposes only and is not to be considered as an offer or a solicitation to buy or sell particular securities. Information should not be interpreted as investment or personal investment advice or as an endorsement of individual securities. Always consult a financial adviser before making any investment decisions. The research herein does not have regard to specific investment objectives, financial situation and the particular needs of any specific individual who may read Kevin Armstrong’s Strategy Thoughts. The information is believed to be-but not guaranteed-to be accurate. Past performance is never a guarantee of future performance. Kevin Armstrong’s Strategy Thoughts nor its author accepts no responsibility for any losses or damages resulting from decisions made from or because of information within this publication. Investing and trading securities is always risky so you should do your own research before buying or selling securities.