Download ECONOMICS IS NOT ALWAYS ECONOMICAL

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ECONOMICS IS NOT ALWAYS ECONOMICAL
What creates a bubble? Many theories are utilized to define a term which has become all the
rage in the media. If I didn’t know any better, everything is in a bubble, from social media
companies to bio-technology, and even the use of the term bubble. So, how is it best to define
an investment bubble? Cliff Asness of AQR (Managing over $100 billion) has a great definition
of the term. He defines a bubble as when the expected returns of an asset become negative.
Who in their right mind would invest in something which would provide a negative return? The
answer is unfortunately, most of us. Examining the factors which can cause a bubble can help
us avoid those negative returns from when a bubble inevitably pops and can explain much of
the current market turmoil.
Determining Future Returns
In order to define if an asset class is in a bubble, we need to determine how reasonable it is for
those investments to have a negative return. As part of our investment process, we use
numerous indicators and techniques to determine the expected returns. In our opinion, the
valuation of the asset is the primary determinate of future returns. When investors purchase an
asset, they are paying for the expected future cash flows of that asset. The more they pay, the
lower their expected future return. With this basic concept in mind, one of our many indicators
we use is the value of the stock market to gross domestic product (GDP). The chart below is the
indicator for the US stock market since 1950:
Source: http://www.hussmanfunds.com/wmc/wmc151221.htm
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As of the end of 2015, the value of U.S. corporate equity was ~127% above its historical norm
and ~30% above its 20 year average. This indicates investors are paying well above historical
norms for equity securities. Our next step is extrapolating the data in determining possible
future returns for U.S. equity markets. The chart below demonstrates a 90%+ correlation of the
starting valuation of these assets versus their future 10 year returns. The current valuations are
now expecting a negative long term return from the U.S. stock market, which lay the
framework for a stock market bubble.
Source: http://thefelderreport.com/2015/04/27/its-going-to-take-a-major-bear-market-beforestocks-can-live-up-to-investors-lofty-expectations/
This is only one indicator and it cannot be viewed in a vacuum. We do see the U.S. stock market
as extremely weak and vulnerable heading into 2016, but it does not necessarily mean the
market will crash. The market could move “sideways” over the next few years - just as it did in
2015. These are conditions that we are watching with great focus and have de-risked portfolios,
when appropriate.
In our view, most bubbles are caused either through over-investment, or non-economic actors
playing a major role in determining the value of an asset. In the overinvestment scenario,
investors act with a herd mentality prioritized by the fear of missing out. The two most recent
stock market bubbles (dotcoms in 2000 & real estate in 2007), are great examples of the overinvestment thesis. In the non-economic actor scenario, there are people or organizations
whose motivation is to fulfill their agenda without regard for the return on investment. This
forces up the valuation of assets and in turn, creates a bubble.
Unraveling of a Bubble
The past few years have been harrowing times for investing in the stock markets of developing
countries and China. Many advisors and investors believe these countries possess tremendous
growth potential due to their young and growing populations. However, at Ganim Financial, we
have a different perspective which has paid off over the course of the last few years. Our
allocations to emerging markets have been extremely small, and our direct exposure to Chinese
markets has been zero. Using the framework outlined above, we determined it was likely that
China was in a credit bubble very similar to the experience of the United States during the
financial crisis. In addition, we determined that most emerging market economies were
dependent on China for their growth. The indexes representing these countries began
reflecting our thesis and the stock market performance of these countries have been awful. The
FTSE Emerging Market Index is down 23.08% and the FTSE China 50 Index is down 26.32% over
the past year ending on February 4th, 2016 (source: Morningstar Direct). This downtrend has
continued into 2016 (as of January 8th), and we believe it will persist in the coming months. At
present we are not purchasing shares, but we will become buyers when the risk/reward profile
of such of an investment is in our favor.
If we are correct in predicting a “bursting” of a credit bubble in China, the causes of this bubble
are far different from the excesses of our own credit bubble. This bubble is indicative of the
non-economic actor thesis, as mentioned above. In our opinion, when non-economic actors are
the root cause a bubble it causes markets to disconnect widely from reality.
One of the largest non-economic actors is the Chinese communist party. Through this system
the government dictates economic policy, and most large corporations and banks are state
owned. The agenda of the Chinese state is almost purely non-economic. The agenda of which is
economic growth, jobs, and stability rather than returning a profit. As a result, state owned
banks have over-extended credit to projects that will never be able to repay the debt. The
direct consequences can be seen by the numerous ghost malls and ghost cities throughout
China (View here). If the Chinese state focused on a profit motive, most of these projects would
not have been undertaken leaving a more sustainable and well balanced economy.
Compounding the above issue is the average Chinese citizen cannot invest abroad. In addition,
the Chinese stock market is small relative to the size of their economy. With limited outlets for
investment, most savings has been invested in real estate which further escalates the problem
of over-investment in infrastructure. The individuals here are investing for investments sake
just trying to earn a return above inflation without regard to the profit potential of the
investment.
This cycle will continue until the debts cannot be funded any further. China’s unique status as a
closed country has led to concerns about the integrity of its official growth numbers, which fail
to coincide with the global economy. The Chinese economic growth miracle has come to an end
or at least is on hold for the time being. We are not optimistic in the short to medium term on
the prospects of China turning around its economy.
Our Non-Economic Actors
One of the largest issues with global markets since the end of the global financial crisis is the
intervention of central banks. Historically, central bankers have played a large role but not to
this degree. An example is the U.S. Federal Reserve (The Fed). The Fed lowered interest rates to
0% at the depths of the worst financial crisis since the Great Depression. For 7 years, even as
the economy recovered, they have not increased rates until this past December. In addition,
they have been buying assets in order to help fuel an economic recovery. This is beyond
unprecedented and these actions could not have been fathomed only a decade ago. These
entities again, similar to Chinese authorities, are playing large roles in markets without the
regard for a return on investment. Their actions not only help perpetuate bubbles, but they add
another level of complexity to the most complex systems on this planet, in global financial
markets. It is becoming increasingly difficult to use known theory and historical norms in
determining the returns of investment assets.
An example of this increased complexity, is determining the action of these central banks in
response to current bubbles or crises. For example, if the Chinese central bank decides to
purchase non-performing loans from its banks through a Quantitative Easing (QE) program,
similar to what the U.S. Federal Reserve has done over the past 7 plus years, the effect might
lift their markets and emerging markets into another stock market boom. Numerous roadblocks
to implementation exist, but this course of action would completely change the returns for
these asset classes. It would negate the economic consequences of the overinvestment of these
countries, but only for a time.
A Good Bubble Forming?
Most bubbles have been terrific boons to society and long-term economic growth, but terrible
for investors. Historically, almost all of the modern technology we enjoy was an investment
bubble at some point. Over-investment stems from investors reaching for the stars on game
changing technology. Consider the investment bubbles that led to railroads, electricity, radio,
computers, cell phones, and the internet (Video Demonstration Here).
So where is the bubble forming? It all revolves around FANG, the new hot investment at the
moment. FANG stands for Facebook-Amazon-Netflix-Google (now renamed Alphabet). As of
November 13th, 2015, these 4 companies accounted for less than 9% of the market cap of the
S&P 500 index but accounted for 3.14% of the 3.18% of the gain on the year for the index.
Without FANG, the index would be negative on the year.
Patrick O’Shaughnessy, CFA (a financial blogger) ran an interesting experiment on FANG. The
goal was to determine how fast these companies would have to grow to justify their current
valuations. His assumptions, they are valued at the current valuation of the S&P 500 index (at
21.9 times earnings) and that their market cap grows at the historic long term U.S. corporate
growth rate (7%). The results are astonishing and are shown below with a comparison to Apple
(AAPL) as a comparison.
Source: http://investorfieldguide.com/fun-with-f-a-n-g/
This is a bubble in the making. The fear of missing out on companies exhibiting growth in a low
growth world is leading to over-investment in these companies. The expectation to maintain an
earnings growth rate of ~55% in the case of Amazon in our opinion is absurd. We could be
proven wrong, but the odds are definitely stacked against these companies maintaining the
average long-term corporate performance at these valuations. Will this be a bubble? I have a
feeling like we will soon find out.
What year is it? 1998? 2008?
Mark Twain famously said, “History doesn’t repeat itself, but it does rhyme.” This is especially
true when it comes to the stock market and investing. Comparing current market conditions
with past market cycles can help provide some clarity to the future. Recently, the hedge fund
legend George Soros recently stated that the current environment is reminiscent of 2008 when
the world suffered a financial crisis.
However, the current market environment could mimic 1998. There was an emerging market
crisis then as there is now. Russia had a credit crisis and defaulted on its debt. Stocks were
overvalued and remained so until the bubble burst in 2000. Recently I revisited accounts from
Marathon Capital (a favorite investment firm of mine, and I agree I need to find better reading
material), and was playing the game mad-libs (Madlibs Website). You could see history rhyme
by replacing “Russia” with “China”, or, you could replace “Amazon & Yahoo” with, well
“Amazon & Netflix.” Investors behave the same just as things are so different.
The lesson from 1998 is that even though valuations were high, just as they are today, they
could go ever higher. The key difference from then compared to now is debt. Debt levels have
never at this level of GDP. The consequence of these actions is that it makes markets less
resilient and more fragile. Since 1994, world GDP has grown at 5.3% per year, while total debt
has grown at 9.0% per year. This is an unsustainable equation and a reason to worry that future
gains will not materialize.
Source: http://www.oldschoolvalue.com/blog/investing-perspective/why-2016-could-be-a-badyear-for-the-markets/
Though the U.S. stock market seems to be overvalued, we are hopeful that the continued gains
in jobs can continue into the future, fostering further economic growth and deterring a bear
market. It is important to keep in mind that employment tends to be a lagging indicator and
confirms the past rather than forecasting the future.
We can foresee a scenario in which the U.S. economy performs well as job growth continues
putting pressure on corporate profit margins. This is a “goldilocks” scenario where excess debt
and valuations are paid off while the market does not increase much in value. During that time
period we could experience some significant volatility. We are still extremely cautious, as
anything can happen, but we see the U.S. economy as the most dynamic and innovative on the
planet, and so we are optimistic for the long term.
The Half Economic, Half Non-Economic Player – The CEO
Another major player has helped increase the valuation of the stock market: the CEO. After the
global financial crisis, corporate America slashed costs, became lean, and increased profit
margins to increase stock prices. Over the past seven years, this has greatly benefited
shareholders, and the compensation of most CEOs (Much of the compensation of CEOs is tied
to the stock price of the company they manage.) In the current low growth economic
environment, there are not many costs left to cut; and, therefore, CEOs have moved to buying
back stock using profits.
In addition, the current low interest rate environment has allowed companies to issue debt in
order to pay for these buybacks. This phenomenon was observed just before the financial crisis
(as shown below). This financial engineering puts future growth prospects at risk and drives up
the valuation of the company.
Oil – The Reverse Bubble
One of the biggest market moving news events was the collapse of the price of oil at the end of
2014. This trend is continuing and there are many reasons for it and even more consequences
to be aware of. For much of 2011-2014, oil traded around $100 per barrel. This allowed for
many high cost drilling projects to start in the United States and Canada. Production increased
dramatically (as shown below) and so did overinvestment in the sector.
Source: http://marketrealist.com/2015/07/game-changers-us-crude-oil-output-opecproduction/
These new projects threatened the Saudi Arabia’s and other traditional oil producing countries.
The Saudis are not concerned with limiting competition from U.S. producers, but also with
undermining the economy of their rival Iran. Many of these countries are low cost producers of
oil, requiring an oil price as low as $3 per barrel in order to turn a profit (in the case of Saudi
Arabia – see Breakeven Cost Calculator). Once we take into account the oil price needed to
balance their government budgets, that breakeven point balloons higher. According to the Wall
Street Journal (Article), the breakeven cost for Saudi Arabia would be approximately $106 per
barrel for their 2015 budget. Saudi Arabia took on the role of a non-economic actor, causing a
reverse bubble, when the nation decided to increase production in November 2014 to counter
competitors and to pursue its geopolitical agenda.
Closing Thoughts
So how do we get back to reasonable return expectations? This will take some determination
and some time. For the U.S., the Fed has started raising rates, which is a good thing. The sooner
we can “normalize” rates and not be in emergency mode, all the better. Hopefully the economy
will continue to grow, increasing jobs and wages which will in turn lead to greater spending by
consumers. The key is getting the growth outlook to improve. This will facilitate more capital
spending by corporations, increase competition for new sales growth, and lead to less spending
on buybacks by corporate America. Corporations could work through our excess valuations and
pay down debt. The traditional model of capitalism will flourish and not be dependent on the
role of non-economic actors such as central banks. This would be far more sustainable and lead
to a recreation of 1998, rather than 2008. If this “goldilocks” scenario is not achieved, we
believe similar to 2008 will yield its ugly head.
In addition, investors must keep a keen eye on the major non-economic actors and their
agendas. The decisions by these powerful players have less to do with profits and losses and
more to do with their desired outcome. These decisions can come from out of the blue and can
have a large impact on your portfolio.
What You Can Do
Building a diverse portfolio with numerous risk and return sources is the key to success. This
will allow your portfolio to be robust against changes in the world and actions taken by noneconomic actors. The traditional fixed income portion of a portfolio, traditionally used as a
buffer against losses, will not be as successful in this regard. The world has changed
dramatically since the global financial crisis and the reliance on traditional models needs to be
updated and forward looking.
Your portfolio should be customized for your needs and goals. You should understand what you
own and what could happen in a severe downturn. Once you know this, you should have a plan
for such a scenario. Remaining liquid, flexible, and calm will allow you to ride out the inevitable
storms that come your way.
In the end, make sure you are not risking dollar for cents. Remain focused on what you need to
accomplish and do not chase returns of recent high fliers.
The opinions expressed in this commentary are those of the author and may not necessarily
reflect those held by NFP Advisor Services, LLC This is for general information only and is not
intended to provide specific investment advice or recommendations for any individual. It is
suggested that you consult your financial professional, attorney, or tax advisor with regard to
your individual situation. Comments concerning the past performance are not intended to be
forward looking and should not be viewed as an indication of future results.
S&P 500 Index is an unmanaged group of securities considered to be representative of the stock
market in general. You cannot directly invest in the index.
FTSE China 50 Index is an unmanaged group of securities considered to be representative of the
Chinese stock market in general. You cannot directly invest in the index.
FTSE Emerging Market Index is an unmanaged group of securities considered to be
representative of emerging market stock markets in general. You cannot directly invest in the
index.
Using asset allocation and diversification as part of your investment strategy neither assures nor
guarantees better performance and cannot protect against loss of principal due to changing
market conditions.
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