Riding the Waves – Q2 2014 Letter
Posted on Thursday, July 10th, 2014
I think we aspire less to foresee the future and more to be a great contingency planner… you can respond very fast to what’s happening because you thought through all the possibilities, – Lloyd Blankfein
For years our mantra has been – build investing scenarios and trade accordingly. It is akin to the Boy Scout motto. Be prepared. Lloyd Blankfein, the Chief Executive Office of Goldman Sachs, states it very well in the above quote when he compares his firm to contingency planners. Indeed, he is correct in that we cannot predict the future but what we can do is prepare for it. In this preparation we are currently finding the lack of volatility to be very unsettling. Less and less volatility tells us we may be overdue for an approaching storm. Let’s take a look at the facts from the folks over at the Bespoke Investment Group. On June 17th they released this research note.
In fact, it has been two months (42 trading days) now since the S&P 500 last had a move up or down of 1% or more. To put that in perspective, you have to go back nearly 20 years to 1995 to find a period where the S&P 500 went longer without a move of that magnitude.
Since 1928, there have been 30 other streaks that lasted longer than 40 trading days. While extended streaks have been rare in the last twenty years, it hasn’t always been that way. For example, from the early 1950s through the early 1970s, there were numerous periods of extended calm in the market. In fact, the years 1963, 1964, and 1965 each saw streaks of more than 100 trading days without a 1% move (the 1965 streak ended in February 1966).
http://www.bespokeinvest.com/thinkbig/2014/6/17/1-moves.html
Could we be in for an extended period of calm in the markets as the one that took place from the early 1950’s until the inflation years of the early 1970’s? Perhaps, but we feel that the pace of change is accelerating in the Internet Era and too many high level officials have interests in seeing higher volatility. Let’s look at what some of those high level officials have been saying in recent months.
VOLATILITY – Resurgence?
Over the last two months we have seen a steady parade of Investment Bankers, CEO’s and Federal Reserve officials, both past and present, come to the microphone to argue that volatility must rise. For investment bankers and CEO’s of financial trading firms volatility is a must. Banks like CitiGroup, Goldman Sachs and JP Morgan need volatility in order to provide value to clients and make profits. Here is a partial list of the lineup of bankers preaching about the current lack of and need for volatility.
On May 7th of this year Jeremy Stein, in one of his last speeches as a Federal Reserve governor, warned that the central bank may face more bouts of market volatility as it winds down the most aggressive easing in its history.
Some investors may be “underestimating the degree of uncertainty about the future path of policy and are placing levered bets accordingly,” Stein said yesterday in a speech to the Money Marketeers of New York University. “So we may have some further bumps in the road as this all plays out.”
In response to an audience question, Stein said “it’s important that we not get goaded into thinking we’re responsible for minimizing market volatility.” -Bloomberg 5/7/14
We see this as a not so subtle shot across the bow. We take this as a warning that the Fed knows that volatility is coming as they exit from Quantitative Easing (QE) and that they want markets to be prepared. Stein’s answer to the audience’s question seems to intimate that given renewed volatility upon their exit the Fed may remain on the sidelines and allow greater volatility. A 10% correction could easily morph into a 20% correction as the Fed tries to remain on the sidelines in the event of a market retreat.
Comments from FOMC members carry different weights. New York Federal Reserve (NYFRB) President Bill Dudley’s comments carry more weight than most. While we believe that volatility will rise and that the Fed may be encouraged to sit on the sidelines at some point the Federal Reserve will intervene and backstop any market slide. In late May Dudley made comments that suggested that very same concept. Dudley volunteered that the Fed will be more aggressive in raising rates if markets allow and less aggressive if they do not. From that comment we believe that Dudley infers that the market will be calling the tune and the Fed will apply the brakes or the gas depending on the market’s reaction to Fed policy. Welcome to Goldilocks monetary policy. Not too hot. Not too cold.
Jon Hilsenrath is considered to be a mouthpiece for the Federal Reserve and is charged with helping get the committees thoughts and the correct perception of those thoughts into the mainstream. In a piece in the Wall Street Journal (WSJ) on June 3rd of this year Hilsenrath proffered a belief that Federal Reserve officials, looking out at mostly calm financial markets, are starting to wonder whether tranquility itself is something to worry about.
Other measures of risk aversion and market volatility show an especially striking sense of investor calm. The VIX, which tracks expected stock-market fluctuations based on options trading, has gone 74 straight weeks below its long-run average—a run of steadiness not seen since 2006 and 2007.
Moreover, the extra return that bond investors demand on investment-grade corporate debt over low-risk Treasury bonds, at one percentage point, hasn’t been this low since July 2007. The lower this “spread,” the less risk-averse are bond investors.
The worry at the Fed is that when investors become unafraid of risk, they start taking more of it, which could lead to trouble down the road.
By way of none other than Lloyd Blankfein, CEO of Goldman Sachs, comes his take on the lack of volatility.
While stock market volatility has dropped to a seven-year low as major indexes continuously rise to record highs, that blissful investing state can’t last forever, … The luxury of a steady, calm, quiet market” might continue for a period, but will ultimately halt,…
“At the end of the day, it’s not a normal condition to have interest rates at zero,”… “Eventually people will acknowledge higher [economic] growth. Money as a commodity will start to cost something again. . . . That in itself will produce a shock to the market.”– Lloyd Blankfein CNBC Interview June 11, 2014 http://www.cnbc.com/id/101749844
With great complacency comes the possibility that the market will be surprised by an exogenous event and given the degree of complacency the greater the impact of that event as investors are not positioned accordingly. If everyone is on one side of the boat when the wave hits the greater the chance that one or more get thrown overboard.
The central theme here is that investors should be expecting an increase in volatility as the Federal Reserve tries to exit its loose monetary policy. We expect trading bands to widen over the coming months as Fed officials warn of approaching volatility. The bankers are asking for it and the Fed is ready to let it happen. We intend to be prepared.
INFLATION VS DEFLATION The Debate Rages again
The inflation trade is making its way back to the forefront of investor’s minds in the aftermath of the Federal Open Market Committee meeting in June. In Chairwoman Janet Yellen’s press conference traders got the feeling that the FOMC is a bit too complacent when it comes to recent inflation statistics which seem to be heating up.
When inflation talk heats up we look to gold and the 10 Year US Treasury for clues. Traders bid up the inflation trade across asset classes as gold/silver rallied and Treasury yields rose while the yield curve steepened. Is inflation back? Gold bounced off of its lows very aggressively this week in the aftermath of the FOMC meeting. We may now be looking at the top end of that range to see if that can repel the gold bulls. $1400 is going to be a key number. Can it break out of its recent range of $1200-$1400? A break through $1400 on the upside would ignite a new round of short covering and perhaps foretell a move back into inflation trade winners. US 10 year Treasury yields are also up against resistance and at key levels. Over the course of the next quarter we will be keeping a close eye on gold and the 10 Year US Treasury. If investors begin to move back towards the inflation trade things could change quickly. A move towards rising inflation would push us to reduce bond holdings and garner a larger allocation towards precious metals and oil producers.
VALUATIONS
BIRINYI
Laszlo Birinyi called the bottom in stocks in March 2009 and has remained unabashedly optimistic ever since. Birinyi has an amazing track record and is considered the consummate bull. Last month he was quoted by the WSJ as saying that he felt that the bull market may be its last phase – the exuberance phase.
http://blogs.wsj.com/moneybeat/2014/05/27/laszlo-birinyi-sp-500-to-1970-this-year/
GRANTHAM
Another voice that we always stop and listen to is that of Jeremy Grantham founder of Grantham Mayo and manager of over $100 billion in assets. In an interview in Fortune Grantham and his crew over at GMO in Boston were asked about their extensive work on bubbles going back throughout investing history. Grantham’s research indicates that most bubbles go to at least two standard deviations above the market’s mean valuations. Grantham feels that a bubble in the overall market would not exist until the S&P 500 hit 2,350 although his models suggest negative returns over the next 7 years based on current valuations.
We do think the market is going to go higher because the Fed hasn’t ended its game, and it won’t stop playing until we are in old-fashioned bubble territory and it bursts, which usually happens at two standard deviations from the market’s mean. That would take us to 2,350 on the S&P 500, or roughly 25% from where we are now.
We invest our clients’ money based on our seven-year prediction. And over the next seven years, we think the market will have negative returns. The next bust will be unlike any other, because the Fed and other central banks around the world have taken on all this leverage that was out there and put it on their balance sheets. We have never had this before. Assets are overpriced generally. They will be cheap again. That’s how we will pay for this. It’s going to be very painful for investors.
Another note on current market valuations came to us just last week from JP Morgan that shows the current level of Price Earnings ratio of the S&P 500 based on trailing earnings. The latest numbers show that the market has only been more richly valued on this metric in 10% of its history. As you can see from the chart below that shows P/E levels since 1983 a good portion of that 10% happened between 1996 and 2007. That timeline encompasses the period that Alan Greenspan cited irrational exuberance in the stock market, the Internet Bubble and the Real Estate Bubble of 2007. Are we just in a phase in the market where Federal Reserve polices engender higher P/E ratios? Could markets go even higher? We think that the answer to both is yes but we must be prepared if the answer to those questions turns out to be no. Two things that money managers are taught from the time they can crawl and considered always dangerous to believe. 1. It is different this time. And 2. We are in a period of permanently higher price levels. It is never different and nothing is permanent.
RIDING THE WAVES OF VOLATILITY
The market continues to make new highs even as investors seem as reluctant as ever to buy those new highs. Small caps may hold the key to the market. We have noticed of late that investment managers have been piling into Mid Cap S&P stocks. That gives them the chance to catch up if they have been underperforming the market but are not fully exposed as they would be if they piled into small caps and their higher risk profile. While large caps have risen back to all time highs small caps have not quite confirmed that move. What we may be seeing here is that institutional investors are forced to invest client’s money and are placing that money into safer assets like mid and large cap stocks while a stealth bear market takes place underneath in small caps. When confusion reigns we turn our eyes to the bond market. The bond market is not playing along with a new high in equities as 10 Year US Treasury rates hover between 2.5 and 2.65%. It gives us reason to pause when equities seem to be ignoring clues emanating from bond market.
While we are not discounting that this could be a late stage market breakout, if small caps begin to fail and push down through recent lows the broader market may follow suit. For the time being investment managers are almost paralyzed in their decision making. While not being able to discredit the new highs in large caps managers are concerned by stock valuations, a lack of volatility and lack of confirmation of recent S&P 500 highs from small cap stocks.
BOY SCOUTS
The Federal Open Market Committee (FOMC) Minutes from the April 29-30 2014 meeting were released last month and the committee noted that a couple of participants felt that conditions in the leveraged loan market had become stretched. We were early into leveraged loans the past couple of years and that served us well. Some clients will now see a reduction in that area in the coming months as we wish to back away from any repercussions associated with a possible bubble in leveraged and covenant lite loans.
While officials and bankers are prepping the investing climate for volatility we continue to prepare our portfolios accordingly. While we do not know if the stock market is in a late stage breakout or breakdownwhat we can say, is that a major market top is likely to be preceded first by increasing volatility, or expanded trading ranges. We feel that battening down the hatches as we approach what is seasonally the weakest part of the market cycle is a prudent idea. Battening down the hatches would see us continuing to invest in less beta sensitive parts of the market including utilities and telecommunications while also maintaining exposure to inflation sensitive issues such as precious metals and oil in case inflation raises its head. We intend to be prepared for any and all outcomes as we are your contingency planner.
Blackthorn is an investment adviser registered in the state of Georgia. Blackthorn is primarily engaged in providing discretionary investment advisory services for high net worth individuals.
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