Introduction
Last month I likened the recent relative calm evidenced in investment markets as being the ‘eye of a storm’ and questioned how much longer the relatively benign ‘eye’ would linger over markets that had been frustrating to both bulls and bears. Well, the ‘eye’, and the frustration, has continued for at least another month. At the same time volatility measures remain at historically low levels implying that ‘fear’ is not currently the prevalent emotion amongst investors.
In this month’s Strategy Thoughts I explore some of the attitudes that have emerged surrounding the presence, or lack, of fear in markets and the increasingly frequently heard term ‘tail risk’. I will also revisit a topic I have discussed on several occasions, the misplaced ‘hope’ that central bankers will fix things. The mere fact that this hope is still so present highlights that the longer term secular bear markets, in much of the developed world, still have some way to run.
Long time readers will know that I have little faith in market forecasts based upon economic forecasts (or perhaps extrapolations is a better description), markets have a far better record of forecasting the economy than the other way around and by the time changes in the economy are manifestly obvious in data those changes have already been reflected in markets. Nonetheless, an economic basis is the starting point that the majority cling to, each apparently hoping that not only will their economic prognosis be better than the majority’s but also that they will interpret what that prognosis may mean for markets correctly.
It is astounding that despite the manifestly obvious shortcomings of such an approach, through the tumult witnessed over the last twelve years, that still so many cling so firmly to it. It is like Pavlov’s famous dog, only food never comes when the bell rings but still they salivate in anticipation. These shortcomings have been explored in a couple of articles over the last month. It is also illustrative of this conditioned reflex that ‘expert’ forecasts of where the markets will end the year are almost all premised on some level of valuation based upon economic assumptions. As humans we all hate uncertainty, investing is obviously inherently uncertain and so we look for things to provide comfort amidst that uncertainty. Economic data and valuation levels can all be measured, and they can be particularly accurately measured retrospectively, unfortunately, neither are useful in forecasting market movements over time frames that the majority are interested in. That so many rely upon such measures over these time frames is understandable. The fact that so many do is what makes it feel so comfortable, we are after all herding animals, but that doesn’t mean it is the sensible or useful thing to do, no matter how comfortable it may feel.
‘Tail Risk’
During the great bull market of the eighties and nineties ‘tail risk’ was a term that was hardly discussed, back then diversification was seen as the answer for investors seeking protection from highly unlikely but potentially very damaging events. However, since the Global Financial Crisis (GFC) more and more investors are becoming aware that diversification doesn’t always deliver that protection; in times of severe crises correlations approach one, as they did in the second half of 2008. Discussion of the impact of tail risks has also been fuelled by the familiarity that most investors now have for ‘Black Swans’, a term originally coined for use in investment markets by Nassim Taleb and popularised in his hugely successful and remarkably prescient 2007 book, ‘The Black Swan’. Whilst all tail risks are not necessarily Black Swans it is probable that the effects of Black Swan events, that is hugely damaging (or hugely rewarding) but totally unforeseeable events, are eventually described as falling into the category of tail risks.
From a very long term (secular) perspective it is encouraging that attitudes have gone through something of a shift from those of the latter stages of the last secular bull market, it illustrates that some progress has been made through the current secular bear. Nonetheless, from a shorter term, cyclical, standpoint it is concerning that discussion of how large or small tail risks may be is growing.
Throughout the current secular bear market, that is from 2000 onwards, tail risks have been seen to be high at market troughs and low at market peaks. If one thinks about this for a while that is to be expected. The reason a market peaks is because the majority see little to be afraid of, as a result expectations become elevated setting up the preconditions for disappointment and so a decline in the markets. Similarly the reason markets bottom is because the majority are fearful that, despite things already being bad, they will likely get worse. This sets in place the potential for a positive surprise and so a rising, but disbelieved, market. Fear of tail risks or Black Swans is high at troughs and low at peaks.
This can be seen in the chart below:
The Chicago Board of Options Exchange who produce the VIX index, shown in the chart above overlaid on the S&P500, state that the VIX is a “key measure of market expectations of near term volatility conveyed by S&P500 stock index option prices.” Put another way, the VIX indicates market expectations of future stock price volatility, or risk. A high reading on the VIX implies expectations of risk are high and low readings that expectations of risk are low. What is obvious in the chart is that expectations of risk rise as the market falls, and fall as the market rises, with the result that it would appear to indicate that the market gets riskier the lower it gets and less risky the more it rises. This is obviously absurd. What does rise the more a market falls is the fear, on the part of investors, that things will get worse and what falls the more a market rises is that same previously misplaced fear.
Currently we hear that tail risk has fallen, this is highly unlikely, tail risks, like Black Swans, are always lurking in the background, unseen and unpredictable. What has fallen is investor fear of tail risks or Black Swans, just as it always does the more a market rises.
Two weeks ago, on the 17th August, the VIX traded at its lowest level since June 2007. Then markets had been in a very rewarding cyclical bull market for more than four years and in the conclusion to the July 2007 edition of Strategy Thoughts, written in late June, I wrote;
“The future is unlikely to be a neat continuation of what has been enjoyed by so many for so long, it is likely to be more challenging.”
As indicated by the level of the VIX back then levels of fear were very low, as they are now, but the tail risks and Black Swans were all lurking in the background and they certainly came out with a vengeance over the subsequent eighteen months as the entire world witnessed. Currently investors continue to favour living in hope rather than having to cope with fear.
The Hope continues!
Two months ago, in the July edition of Strategy Thoughts, I titled one section, ‘The other great Hope! Central Banks?’ At the time the ‘hope’ was rampant that central bankers the world over would ‘fix’ whatever was ailing the financial world. I wrote;
Whilst it may be understandable that we humans cling to and seek hope, it is remarkable that we just don’t seem to learn, even from the relatively recent past. There remains an abiding hope that central bankers will fix whatever the problem is, that they will do ‘whatever it takes’. These are sentiments that are often reported and in some quarters relied upon, what is most surprising is that that the same phrases continue to get trotted out and that the faith in the ‘almighty’ central banker is so strong.
This ‘hope’ has persisted as the current bear market rally, within the broader slide down the ‘slope of hope’, has continued. Most recently there was an almost overwhelming sentiment of hopeful expectation, on the part of most of the financial media, ahead of Ben Bernanke’s Jackson Hole speech, with the prevalent ‘hope’ being that the next round of QE would be announced and so provide the next leg up in financial markets. The actual outcome seems to have been that ‘frustration’, as I discussed at length last month, continues.
It was with some relief that at the beginning of last month I read the following article in the Wall Street Journal. It did a far better, and more entertaining job of illustrating the futility of investors hanging onto every central banker’s pronouncement than I could ever have done
The Music Men: The illusion that central banks alone can conjure faster growth.
WSJ 1st August 2012
“As the financial world breathlessly awaits word this week from the Federal Reserve and European Central Bank, we can’t help but think of "The Music Man." In that classic if now dated musical, the residents of an Iowa town are gulled by a huckster selling band equipment. They desperately want to believe in his power to solve their town’s delinquency problems, until they discover Harold Hill can’t play a note. Central bankers are today’s music men, the maestros we desperately want to believe can rescue the world economy by playing one more monetary tune. Buy more bonds and lift the stock market! cry the boys at Pimco and Goldman. Pay less for bank reserves! shout the Princeton professors. Promise to keep rates at near-zero until 2015—or 2016 or 2017—beg the politicians. And so Mario Draghi and Ben Bernanke will try to sell us 76 more trombones. Sooner or later we’ll discover that their money illusion can’t save an economy from its more fundamental problems, and that they may even be interfering with the faster growth they want.”
The article went on to illustrate that successive actions on the part of the Federal Reserve have had less and less impact, irrespective of however much credit chairman Bernanke wants to take. A similar theme was picked up by John Mauldin in his weekly ‘Thoughts from the frontline’ this week when he extensively quoted from a recent paper by William R White, chairman of the Economic Development and Review Committee at the OECD, which was published on the Dallas Federal Reserve website.
The paper’s conclusion began with;
“The case for ultra easy monetary policies has been well enough made to convince the central banks of most AMEs to follow such polices. They have succeeded thus far in avoiding a collapse of both the global economy and the financial system that supports it. Nevertheless, it is argued in this paper, that the capacity of such policies to stimulate “strong, sustainable and balanced growth” in the global economy is limited. Moreover, ultra easy monetary policies have a wide variety of undesirable medium term effects - the unintended consequences.”
The paper went on to finish with the following warning;
“What central banks have done is to buy time to allow governments to follow the policies that are more likely to lead to a resumption of “strong, sustainable and balanced” global growth. If governments do not use this time wisely, then the ongoing economic and financial crisis can only worsen as the unintended consequences of current monetary policies increasingly materialize.”
But for investors it is easier, and more comfortable, to belief that things can somehow painlessly revert to ‘normal’ at the hands of central bankers. Or at least what the majority, who have spent most of their investing careers enjoying the wonderfully rewarding and benign backdrop of rising equity markets throughout most of the eighties and nineties, believe to be normal. It is easier and more comfortable to believe that somehow the tech wreck and the GFC were the anomalies rather than the natural consequence, or price that has to be paid, after a wonderful ‘secular’ (very long term) almost two decade long bull market ends, as it did in 2000.
It’s the economy stupid, or is it?
As noted above, most investors seek to rationalise investment decisions based upon some economic outlook. This does at first blush appear a sensible approach, it at least provides some foundation even if, as already commented, the records of economic forecasters are questionable and the interpretations of what even correct forecasts will mean to markets is open to just as broad an error. It is not only me that is frustrated with the efforts of economists; the following headline appeared in the Guardian on the 6th June this year;
Why do we take economists so seriously?
They have no foresight, no hindsight, and little humanity. Are they really the best people to lead us out of this crisis?
They do provide comfort however, that there is some explanation as to why something happened, even if their crystal balls don’t work.
The fact that the straw of economic forecasting should not be clung to by investors was beautifully illustrated by Gerard Minack of Morgan Stanley Australia recently. In a piece titled ‘Mind the Gap’ he summarised the lack of connection between economic growth and stock market performance.
High-trend GDP growth still underpins some investors’ focus on EM equities. However, there’s no correlation – even over very long periods – between GDP growth and equity returns.
China-centered Asia has been the great economic success of the past two decades – yet regional equities have traded around a flat trend. Exhibit 1 shows the Asia ex-Japan MSCI index, in real US$ terms. (To be fair, the ‘flat trend’ glosses over several very significant rallies – and a couple of nasty bear markets.)
This is another example showing that economic growth and equity returns are unconnected. This is true over even very long periods. Exhibit 2 shows the correlation between equity returns and GDP (and GDP per capita) growth over periods of up to 105 years. Ironically, many of the correlations are negative. But the more important point to note is that the explanatory power is very low.
‘The explanatory power is very low’, how beautifully put. But still the majority want to invest where GDP forecasts are highest. It may provide comfort but it just doesn’t work.
The futility of hanging on every news release as a path to investment success has been known for decades. The legendary speculator Jesse Livermore wrote in ‘How to Trade Stocks’ in the early part of the last century;
“It is too difficult to match up world events or current events, or economic events with the movement of the stock market. This is true because the stock market always moves ahead of world events.”
“The market often moves contrary to apparent common sense and world events, as if it had a mind of its own, designed to fool most people, most of the time. Eventually the truth of why it moved as it did will emerge.”
“It is therefore foolish to try and anticipate the movement of the market based on current economic news and current events such as: The Purchasing Managers’ Report, the Balance of Payments, Consumer Price Index and the Unemployment figures, even the rumour of war, because these are already factored into the market.”
“After the market moved it would be rationalised in endless post mortems by the financial pundits and later when the dust had settled, the real economic, political and world events would eventually be brought into focus by historians as to the actual reasons why the market acted as it did. But, by that time it is too late to make any money.”(emphasis added)
Livermore and other great investors do not ignore economic and other news releases, but they do realise that the neat ‘cause and effect’ that so many would like to exist doesn’t. That is why one day a similar release to a previous one could result in exactly the opposite effect in the markets. It all depends upon what is already expected by the majority of market participants. To be a successful investor you do not have to do the impossible and forecast a Black Swan, however, what one should strive for is an understanding of not specifically what a surprise will be but in which direction it is most likely to occur. Will it be a positive surprise or a negative disappointment? These are what move a market, the expected has already been priced in.
Where’s the yield?’
One manifestation of the frustration that has grown out of the meandering, sideways moving markets of both the last couple of years and those of the last decade or more has been the search for yield. During the latter stages of the great bull market that culminated in 2000 no one was interested in yield, capital gains were the only game in town. After the miserable bear market from 2000 to 2003 attitudes began to change and for a while more secure returns from dividends and coupons became more sought after. Once the bull market of the mid 2000’s got into its stride however, and risk appetites grew, capital gains once again came back into vogue and only more risky higher yielding bonds were of interest given the low yields that were by then available from government bonds.
The danger of chasing yield was made horribly real for so many through the GFC and the collapse that was seen in junk bonds and other derivative products. Unfortunately, as so often happens as a terrible memory gradually fades, the same behaviours return and once again the appetite for chasing yields has returned with a vengeance.
This can be seen in the US in the surge of new funds that have flooded into junk bond and high yield exchange traded funds (ETF). Almost half of the more than $28 billion that is invested in this type of ETF has been invested in just the last twelve months. One of the largest such funds, with more than $11 billion in assets, is the Barclays Capital High Yield Bond. The surge in volume can be seen in the chart below, however, despite all this new money chasing the yield of a little over 7% the price has done nothing for two and half years. The real money was made by those brave investors that bought the fund when defaults were at record highs, back in 2009, when fear was also at a peak. Now, with dramatically lower default rates and far less fear, the damage any ‘tail event’ or ‘Black Swan’ might bring about is so much higher.
The old adage of ‘more money being lost chasing yield than at the point of a gun’ does not only apply to unsophisticated individuals. Major corporations succumb as well.
AFLAC chasing yield
For twenty years the share price of AFLAC (American Family Life Assurance Company) outperformed the market in a remarkably steady fashion year after year. It rose virtually without interruption until 2007. Understandably it fell through the GFC but then it bounced back and almost recouped all its lost value by early 2011, but since then it has lagged the market materially, down more than 20% while the overall market is up 5%.
Much of AFLAC’s revenue comes from selling supplemental life insurance, disability and sickness plans in Japan, but that is not the reason for the fall. Business has been fine, the problem, as outlined in Barron’s this weekend, is Europe;
“In a global world of abnormally low interest rates, AFLAC, like insurers and investors the world over, is desperate to invest in assets with good yields, to match its liabilities. Japanese long government bonds—a natural asset for a business that gets 75% of its revenue and 80% of its earnings in yen—yield a paltry 0.80%, even lower than their U.S. counterparts. So AFLAC turned to yen-denominated preferred stocks of European banks, among other issues, in order to improve the performance of its investment portfolio, now about $100 billion. The result: Since the European sovereign debt crisis began in 2010, "every time Europe sneezes, AFLAC stock catches cold," says Thomas Weary, chief investment officer of money-manager Lau Associates. Indeed, the results this year, good as they are, include an investment loss of $272 million or 58 cents per share in the second quarter. Much of that is from European assets, Weary adds.”
Chasing yield can be very harmful to your financial health no matter how sophisticated you are. Another reminder of this was highlighted in another Wall Street Journal article, this time on Royalty Trusts;
Will These Royal Yields Rule?
WSJ August 26th
“Investors reaching for yield should always bear in mind the warning label on stepladders: "DANGER. DO NOT STAND ON TOP STEP."Just look at what happened this past week to investors in several so-called royalty trusts. These instruments, which collect and distribute income from oil and gas or mining properties, are among the highest-yielding in the stock market, with payouts averaging 9%. But last Wednesday, the "unit," or share, price of Hugoton Royalty Trust fell 8% after it announced a cut in its dividend; on Tuesday, San Juan Basin Royalty Trust also cut it payout, knocking its shares down 5%. And Dominion Resources Black Warrior Trust fell 6% this past week after it declared a dividend cut the previous Friday. Many people—especially older, conservative investors hoping to rejuvenate their shrivelled bond portfolios—might not realize what they are buying when they invest in these rare, peculiar and suddenly popular instruments.”
The article finished with; "Those who stretch too far for yield will probably topple."
With government bonds the world over offering record, or close to record, low yields it is tempting to chase higher returns, but the reason there is a record issuance of junk (high yield) bonds currently is because it is great business, and cheap money for the issuer. Barron’s current yield column titled;
Orgy of Bond Issuance Continues
Concluded with;
“Investors reaching for yield by now have grown used to this unpleasant choice: Buy low-quality bonds when their yields are low and their prices are high, in the hope that the good times will continue, or invest in high-quality bonds at the risk that your cautious intentions will be undercut by rising rates. So far, investors haven’t really been hurt. This month’s new-bond deluge hints that the banks and issuers want to squeeze out every new bond they can right now, while the going is good, because it eventually won’t be.”
When the going stops being good it won’t be those issuers that have already issued that suffer, it will be those that have been on the buy side of the ‘orgy’.
It is probably timely to highlight once again, as I did in the February edition of Strategy Thoughts, that what is considered a yield worth chasing now may not actually be so attractive.
One of the sectors that has seemingly been continually touted by the business media, certainly in the US, has been the ‘high yielding’ utility stocks. The chart below is an update of a chart I originally used in February. It shows the very long term total return of the US utility sector, as well as two very long term indicators of valuation. The cyclically adjusted P/E ratio and the dividend yield. The secular bear, then bull, then bear and finally bull markets are very clear, as are the valuations at each of those inflection points.
As I pointed out seven months ago, the time to buy these utilities was when their yields were in double digits and their long term P/E’s were in single digits. Both those extraordinary opportunities came after the stocks had disappointed for a very long time and no one wanted to buy them, that is why they were so cheap. I concluded the comments back in February;
“Over the last couple of years the utilities index has delivered a very healthy total return and the price index has enjoyed a significant rise. This has merely been a cyclical bull market in a still unfolding secular bear market. It is interesting that there is currently a strong consensus view that high yielders, like utilities, should be a favoured destination for investors. This is understandable given the lack of yield elsewhere and the steady returns that have been delivered by utilities. That level of recognition however, is usually found near the peak of cyclical bull markets, eventually utilities will yield double digits once more and the P/E ratio will once again be in single digits. At that time no one will want to own them, that is why they will be so cheap, and a secular opportunity will once again be presenting itself.”
Whilst utilities may offer yields slightly higher than the rest of the market they are a very long way from offering historic valuations and are yields that should not be chased.
Quality
Older readers may remember Henry Kaufman from the seventies and eighties when he was Salomon Brothers Chief Economist and known as ‘Dr Doom’. Now in his mid eighties he continues as the head of the consulting firm Henry Kaufman and Co. He recently gave a brief interview with Barron’s and shared some of his views on the world and investing. I had a great deal of sympathy for many of his views and his outlook, although it would be fair to say that we look at markets from a quite different perspective. I thought it worthwhile sharing a few of this octogenarian’s observations;
“We are in no man’s land when it comes to economic policies to get the US and Japan out of their doldrums.’
He added that no ‘economic thinker’ had emerged who could galvanize our collective imaginations and show us the way out, and he lamented that such complacency existed about the supposed inevitability of the developing nations picking up the slack from the developed world;
‘There is a halo around the emerging nations that is not deserved. China isn’t working. India has significant problems.’
On the US he said;
‘We have a subdued economic recovery, only 100 or so large companies are cash rich. Small and medium sized companies, the backbone of the economy, have little access to credit’.
On low interest rates;
‘Few investors have benefited from this steep decline in interest rates.’
He noted that;
Much in financial markets and life is comparative. So while our politicians on both sides of the aisle continue to fail us I don’t think we can just cut taxes; we all have to make sacrifices. The US is still much better off than the EU and Japan. Our problems are not as great as China’s. In China, you can’t even be sure of the quality of the statistics.’
He concluded;
‘Try to keep an intermediate view and stay with quality.’
Throughout what remains of the secular bear market I still firmly believe that a focus upon quality will be invaluable. Obviously through each cyclical bull market there are periods where low quality investments rally hard, as was seen in junk bonds from the March 2009 low, however, they have usually fallen far further in the preceding cyclical bear market, and on balance will do poorly over the entire secular bear market.
Closing thought and conclusion
In addition to the ‘Music Men’ article in the Wall Street Journal last month, I was also amused by an column penned by Al Lewis, a regular columnist in the Wall Street Journal, on 26th August titled ‘50 shades of red ink’. The column was obviously playing on the huge literary smash ‘50 Shades of Grey’ but the focus, I am reliably assured, was quite different. It focussed on the necessity to ‘jump off the fiscal cliff’. Lewis wrote;
“So what do you call a recession followed by a faint recovery, followed by another recession? I’ve called it a depression. That’s why I am ready to take the jump. I would like to see the economy finally hit rock bottom so that it can finally begin to recover from its debt crisis on real terms. No more zombie banks. No more propped-up corporations. No more shadow real-estate inventories. No more funny money flowing into the stock market and pumping up prices. Free-market forces are really going to hurt. But the insane idea that we can avoid them, indefinitely, is bankrupting our nation. Call me an economic sadomasochist. I don’t care. I want leaders who are willing to borrow a line or two from "50 Shades of Grey," like, "I will punish you when you require it, and it will be painful." Feels good. Don’t it?”
The ‘majority’, as I described earlier, want things to go painlessly back to normal. Unfortunately that can’t happen, a price has to be paid and the vast excesses of the prior two decades or more need to be unwound. That can happen quickly and very painfully, as Lewis described, or slowly and frustratingly as they have so far for the last twelve years. Either way the ultimate resolution will be stock markets that are historically exceedingly cheap, expectations that are exceedingly low, and the prevalent attitude towards stocks by the ‘majority’ will by then be one of disgust and disinterest.
Markets are not there yet; the secular bear market, in much of the developed world, still has some way to go. In the meantime an acceptance of the frustrating nature of markets will be invaluable, as will a focus firstly upon ‘QUALITY’, as Dr Kaufman counselled, and secondly, on preserving capital rather than chasing capital gains or yield.
I have been surprised, and frustrated, how far the current rally has run but firmly believe that it is evidence of a decline in the investing ‘crowd’s’ perception of tail risks, not a sign that tail risks have actually diminished. I continue to look for positive surprises out of the US dollar and, as noted last month, believe that for those who have made money out of the decline in interest rates, through holding long dated high quality bonds, that the best returns have been seen.
The Two ‘Great Games’
Many of you know that in addition to investment markets another passion of mine is golf. What you may not know is just how closely the histories of the two ‘Great Games’, golf and investing, are intertwined. That is the focus of a book I have almost completed; ‘Bulls, Birdies, Bogeys and Bears, the remarkable and revealing relationship between Golf and Investment’. Not only does it provide a historical view of golf through an investor’s eye, or an investment market history from a golfer’s perspective, it also provides some predictive tools, particularly when it comes to the Ryder Cup.
If you would like a taste of the book a synopsis of one chapter was published in Hong Kong Golfer earlier this year; http://www.hkgolfer.com/money-matters/bulls-golden-bears-and-tiger . The book is to be published late this year, if you have an interest in an advance signed copy please email me at; [email protected]
Kevin Armstrong
4th September 2012
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