nless you happen to be among those people who
are dependent on the cash flow from fixed-income investments to support
your lifestyle, what’s not to like about how business activity and the
financial markets have been performing so far this year? Not only is the
economy chugging along at a reasonable rate of growth, it has entered
its 121st consecutive month of growth, thereby becoming the longest
expansion since 1854. Stock averages are up, extending the bull market
further into its tenth year, and June was a particularly good month with
the Dow Jones Industrials having their best June since 1938, the S&P 500
the strongest since 1955, and the best since 2000 for the NASDAQ. Oil
prices are relatively stable despite rumblings in the Middle East.
Interest rates are lower, reducing the cost of home mortgages and other
borrowings. Jobs remain plentiful and incomes are rising, all while
inflation remains surprisingly subdued. Although the income-starved may
grumble, the flip side of lower interest rates is higher bond prices, so
for those for whom “total return” (income plus price change) is
important, such as fund managers, it has been a good year to own bonds,
especially those issued by governments, as rates on about $12.5 trillion
of sovereign debt have once again plumbed sub-zero depths. Indeed, for
the first time since 1995, both equities and long-term government bonds
posted double-digit returns during the first half of 2019.
This is mostly good news, especially for owners
of real and financial assets, but since we are paid to, among other
things, think the unthinkable — such as the possibility that markets might
go down as well as up
—
we are naturally inclined to be on the lookout for
signs of potential trouble. For example, the simultaneous strength in
stocks and long-term bonds would generally not be the case; economic
growth tends to favor stocks, while lifting inflation and interest
rates, which is bad for bonds. This leads us to suspect that one of
these markets may be subject to a painful adjustment as events unfold
going forward. You don’t have to look too far to find other trends that
should be of concern (or interest) if you are a long-term investor. We
discuss some of these below.
Desperate people do desperate things, and there
are few places where this human trait is more dangerous, or more easily
implemented, than in the investment business. To see this principle at
work, let’s review a little history. Interest rates in the U.S. peaked
in the early 1980s, when short-term government debt traded at yields
approaching 20%. Since then rates have been on a long-term downward
trajectory, which seemingly bottomed during the past decade or so, when
at times some U.S. treasury paper yielded practically zero (the U.S. has
not experienced negative yields as yet). Investors who had become
accustomed to the unusually high yields prevailing at the dawn of the
great bond bull market in 1982 were inconvenienced as rates fell;
already in the 1980s one heard complaints about too-low yields, although
by today’s standards they were exceedingly generous.
The continuing decline in interest rates during
the ensuing decades fed “reaching for yield” behaviors, whereby some
investors, striving to maintain their accustomed income streams, took on
additional risk, either credit (“junk” or “high yield”) or price
(long-term bonds), or both. In addition, central bank policies,
culminating in “quantitative easing” during the 2008 financial crisis
and its aftermath, flooded the financial system with money that made its
way into pools of income-seeking capital, thereby creating tremendous
demand for securities to produce that income. The market for newly
issued “junk” bonds was fueled by investors seeking yield, and new
instruments were created, such as “derivatives,” that fed directly off
the fact that too much money was seeking alternatives to the meager
offerings found in the conventional places. The financial crisis was at
least partly a result of “creative financing” in which mortgage
securities were cleverly repackaged to appeal to income-starved
investors who often were ignorant of the risks they were incurring.
Indeed, the vast demand for yield led Wall Street to set up an entire
ecosystem designed to accumulate risk and distribute it to parts
unknown.
Some of these new ways of losing money lost
favor after the blow-up in 2008, but in the decade since, the reach for
yield appears to have become even more desperate in the environment of
negative sovereign yields. The old standard
—
junk bonds
—
finds perennial
favor, and bank loans to risky, heavily indebted companies repackaged
into securities have attracted ready buyers. Derivative securities,
known to be at the heart of the financial crisis, are making a comeback
as well (although in safer forms compared to the earlier incarnation,
their promoters assure us).
Another striking development has been in
property. Long preferred by investors for its safety and relatively
stable income streams, the market for real estate has become
increasingly institutionalized and commoditized. In the aftermath of the
crisis, private equity firms (firms which manage large pools of capital
which they invest in private businesses) began to buy foreclosed
properties at bargain prices. Huge pools of income-seeking capital,
directed by such firms, have flowed into properties worldwide, driving
up prices and shrinking returns. Economic growth and increasing wealth
abroad have also led to an influx of foreign capital into real estate
markets, seeking stability and refuge from unpredictable political
systems. When outside capital flows into local markets, valuations are
often pushed up beyond what local residents can afford. These capital
inflows and structural market changes have created a wave of
speculation, as financial buyers move in, hoping for a quick profit by
“flipping” properties.
None of these trends necessarily foreshadow
immediate trouble for bonds or real estate, but they do indicate a
degree of complacency among those who are committing capital at
ever-lower expected rates of return (high prices). There seems to be a
high degree of comfort with the current state of affairs despite the
heightened level of risk it signals. Already in markets such as New York
City and London we are beginning to see the aftermath of excessive
optimism in high-end real estate, as tax changes and political disputes
upend expectations and puncture asset bubbles. In both markets,
dwellings developed in anticipation of future sales are going
unoccupied, and properties placed on the market sometimes have to be
marked down more than once to attract buyers.
Not to be overlooked, the stock market, too, is
showing signs of being overextended, even as the averages march higher.
Valuations are at the high end of their long-term ranges, but of greater
import is the fact that 2019’s healthy gains appear far less robust when
you look “under the hood” to find that a small number of stocks account
for an oversized portion of the rise. At one point in June the shares of
only four companies were responsible for 25% of the S&P 500’s
year-to-date rise. Fully one-third of the second quarter’s strength
could be attributed to five companies. As the market technicians like to
say, this is a “narrow” market, led by a small group of
high-market-value issues that move the averages.
While we are not normally very attuned to or
interested in such “market internals,” narrow advances such as this
catch our attention because they have in the past signaled subsequent
market weakness. The Dotcom period was the greatest recent example of
this phenomenon, and while the current market dynamics do not match the
extremity of that now two decade-old romp, they do deserve respect as
potential forerunners of turbulence. They also help to explain the
strength in the indexes at the same time the broader stock list is far
less robust.
Stock market operators also have their version
of “reaching for yield,” or “gain” in this case. During the financial
crisis it was possible to acquire the stocks of major companies very
cheaply; in fact, the entire market was as depressed as it had been for
many years, and simple index funds could have been purchased to
advantage at very reasonable prices. In the ensuing years such
commitments produced strong results. Returns like those are now hard to
come by, as the prices of most assets have become inflated. In hopes of
maintaining a record of good returns, some investment managers have
turned to obscure, unlisted securities (not traded in public markets)
from which they hope to profit when the issuing companies eventually go
public. Aside from the investment risk that such companies might fail,
there is also a liquidity risk in that the positions cannot be sold
easily. One British manager who had resorted to this strategy suffered
catastrophic damage when his funds did poorly and investors began to
demand their money back.
Our intent in these cautionary remarks is to be
neither a Chicken Little nor a Cassandra. The fact is, there are very
few times in this business when the markets are so obviously in your
favor that one can throw caution to the wind and make commitments with
confidence, knowing that the odds of good results are very high. Most of
the time the choices are not abundantly clear, which is why caution and
skepticism are good traits for the investor to possess. After the last
ten years of strong results and increasingly aggressive behavior in
certain corners of the investment world, we would encourage readers not
to entertain hopes for high expected returns going forward. We say this
not as a market forecast, but rather out of concern for preserving
capital. Conditions will change at some point, they always do; we may
even have another opportunity to throw caution to the wind, so to speak.
When the change occurs you do not want to be exposed to leveraged loans,
“unicorns,” or any of the currently popular Wall Street creations, since
they are usually the first to lose favor and suffer grievous losses. At
those times the “conventional places” may look very attractive indeed.
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