A Fool's Market?

“In the short run, the market is a voting machine, but in the long run, it is a weighing machine.” (attributable to either Warren Buffett or Benjamin Graham)

The old adage that in a rising tide all boats float feels an apt description for today's market.  In our race to new highs we carry along a series of assets that in a "normal" market would not fare as well.

Yet, as I have said before, there is no point standing in front of speeding trains...regardless of whether or not there is an engineer steering the locomotive.

Today we are bombarded about other higher yielding opportunities.  Seminars abound about investing in ICOs.  Margin and leverage have come back into the vernacular as investors see nothing but a bull market ahead (despite the recent pickup in volatility).

I laugh as I watch ICOs now being packaged as portfolios and utilizing the same distribution systems normally left to conventional investments.  I described this recently to the press as “trying to move an automobile through a slaughter house”.  Conceptually, on a white board it should work, but the industrial machinery will break down.

So, to quote one to my favorite movies “Mascots”: “Those that can’t do teach.  And those that can’t teach, teach gym.  And those that can't teach gym, teach drivers ed." (Video link here)

From an investment practitioner’s perspective, we seem to be in drivers ed, which begs the question:

Are we in a fool’s market?

In order to make money does one have to be completely IRRATIONAL to make successful investments?

Sadly, when looking at the market tape, it appears more and more that irrationality rules the day.

We can look no further than the American Presidency to see this at play with government policy. 

Joe Kennedy’s old quote was to sell stocks when the shoe shine boy tells you to “buy”.  Now, I hear folks readily rolling out Nixon’s “mad man theory” as a rationale for today’s environment. 

Has the general populace decided that Nash’s Nobel prize winning work is now the explanation?

Possibly.  Our search for an investment narrative continues as behaviorally we all need an explanation (Look no further than the terrific book Sapiens for more such explanations).

When I look at valuations today, it is clear that what is cheap on a relative basis is Asia.  Extending that analysis further, I could also make the case for emerging markets.

But, that is on a relative basis, in a market absolutely (pardon the pun) over-valued.

I had coffee with David Kuo, CEO of Motley Fool for Asia this week, and he reminded me of the old Warren Buffett quote: “I’d be a bum with a tin cup if the markets were always efficient”.

Yet, how should investors protect themselves with regards to valuations?  It is by any measure, an expensive market.

David's words were prescient again:

"Over the long term, the value of a company will be determined by the profit and cash flow it is able to generate.

Consequently, one must be able to estimate with some degree of cynicism the profit and cash that the company is capable of producing from now to eternity.

Discount it back to today with a healthy dose of growth skepticism for a generous margin of error. The bigger the margin of error, the greater the margin of safety."

Focusing on a relative basis, Asia certainly looks cheap.  Specifically, Asia and emerging markets look cheap.

I spoke recently with Yoojeong Oh, Investment Manager – Equites Asia for Aberdeen.  She and her team manage two portfolios that I like to follow: The Aberdeen Global – Asia Pacific Equity Fund and The Aberdeen Global – Asian Smaller Companies Fund.  You can click on either hyperlink to learn specifically more about each fund.

Now full disclosure to my new readers.  I may be slightly biased with Aberdeen, as you all know that deep down I am a value investor at heart.

But, as a “data guy”, the data is clear.  On a relative basis, Asia and EM are cheap.  Here were some of UnHedged’s questions to Yoojeong Oh of Aberdeen:

UnHedged: When looking at the Asian markets, should investors now look more carefully at domestic growth?

Yoojeong Oh:  We have been very much positioned towards domestic growth.  Our funds have been underweighted in markets like Taiwan and Korea where they are more export driven and dependent.  There is a much stronger story following the demographic story, the population story, the growing middle class, and rising incomes.  You can see that in India with a growing local consumer base and much less exposure to the US dollar.

We have always wanted to be positioned towards the growth of the Asian consumer in our funds.  This has served us well over longer time horizons (our average holding period is 5 years).  When you look at growth prospects in Asia, using the IMF growth expectations for Asia, there is a concern that China is going to slow, its growth is still quite high on a global relative basis.  In SE Asia we are still seeing good growth rates, and see no need to overweight on firms driven by exports.

UnHedged:  That’s interesting that the consumer story in Asia is now developing for investors to follow.  But this begs an interesting question, given relative valuations, aren’t Asian equities still cheap?

Yoojeong Oh:  If investors were to look at valuations across the region on a P/E and P/B basis, they would find confirmation of that lower relative valuation.  Across the globe, all valuations are at historically higher levels, or premium, than average, but as you look across geographies, we are still looking at valuations that are reasonable in Asia. 

Asia’s outperformed MSCI World by almost 17%, and we are still seeing better earnings growth which is supporting forward multiples as well.

UnHedged:  Let’s expand on that for a second.  One could argue that the US is very focused on PE expansion.  Is it the same for Asian equities?  Or is there true growth?

Yoojeong Oh:  There are some risks in the Asian markets that we do need to be mindful of.  The US’ tax reform could provide investors with an incentive to re-allocate more to US equities versus their Asian counterparts.  In addition, if rates are increasing there is also that as a compelling feature for investors to consider.

But as investors look closer to US stocks versus Asian, there are some key subtleties.  When looking at US corporates they use buy-backs which helps their earnings per share.  The components of share price momentum in Asia are quite different, it is earnings growth.  investors have not seen that as much in the US markets.  In Japan and Europe, investors would note more of foreign exchange as a contributor to share prices.

These are all quite different compared to Asia where it has been driven primarily by top line growth which has fed into earnings growth

UnHedged:  Should fund investors be concerned about currency risk in light of an implied US policy tilt towards a weaker US dollar?

Yoojeong Oh:  There will obviously be companies that have currency risk in regards to their raw materials, but we rely on the companies to hedge that risk themselves.  We have chosen to focus mostly on those companies that will benefit from home consumer demand growth in the fast growing south East Asian economies, we have less exposure to the export driven companies found in North Asia and this makes the fund less exposed to US currency moves. We do however monitor our holdings' abilities to hedge this risk themselves at the stock level.

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As we look at Yoojeong’s comments above we can see that if we agree that Asia looks cheap, investors stand to gain.  Key to that will be for investors to incorporate the “margin of safety” that David Kuo emphasized. 

I personally believe that as the market continues its march forward, irrespective of the speeding locomotive, investors will inevitably tilt and overweight to Asia.

I am speaking again later this month at a closed door event for UBS management on March 27th.  While I cannot invite you, I expect I will have several other new speaking engagements shortly.  My last talk for the Mortgage Innovation Summit with the RFI Group in Sydney was terrific and the feedback was great.

Lastly, book wise, I am really enjoying The Gatekeepers by Chris Whipple.  I strongly recommend it for the readers who are real policy wonks!

Have a great week ahead!

Teledyne, Capital Allocation and Asian Equities

I am enjoying reading the book The Outsiders this week and highly recommend it (click here to get a copy). 

The author, William Thorndike, highlights the little-known CEOs (Warren Buffett being an exception) who outperformed the overall market by undergoing a discipline seen as “renegade” and “innovative.’  Ironically, in most cases, that approach meant doing nothing, and waiting for the right opportunity to present itself.

Thorndike, highlights Teledyne’s CEO Singleton, who achieved extraordinary above market returns over 20+ years at the helm.  What was his key to success as an investor?  Consistency and a pragmatic approach to capital allocation. 

How does that approach serve us in today’s market?

On the face of it, nothing has changed.  I always like using Marty Zweig’s quote: “Don’t fight the Fed.”  You and I can pontificate forever about Fed policy, but at the end of the day, it is a decision we have no control over. 

What we need to pay attention to is what the Fed says it will do.  In that regard, the Fed has been quite unambiguous.  The Fed has been explicitly clear that any indication of wage growth would require their immediate focus to help stem off inflation.

What did the markets do? 

Violently sell-off and begin pricing in a potential fourth rate increase.

In the days of old prior Fed Chair Volcker was clear regarding his focus on the monetary supply numbers, and he was entirely consistent with his approach to wring out inflation.  Today, with Chairman Powell’s continuation of Yellen’s mandate, market participants should expect the same.

However, as stated before, the Fed has their hands full.  They have four major concerns:

1.     The advent of wage growth

2.     More US debt

3.     Quantitative tightening

4.     Fed tightening

The Fed Chairmen has his work quite cut out for him as he needs to balance a strict anti-inflation policy as he unwinds a massive QE balance sheet and an Administration h**l bent on massive fiscal stimulus (as noted by The Economist).

I recommend we error on giving the Fed Chair the benefit of the doubt, and assume the Chair will manage this anti-inflationary process.

Where does that leave us with regards to Singleton’s approach on capital allocation in today’s market? 

We have to seek returns where we, as investors, can best obtain them.

From a relative standpoint, we can see this quite clearly in Asia. 

To my American readers, this may seem like sacrilege, but I prefer to rely on the data.  The data tells us several clear things that the American investor is ignoring:

·       Asia is not as dependent on the American consumer

·       The rise and independence of the Asian consumer

·       The strong local GDP growth story in Asia

Finally, living in Singapore and as a “local” investor, I can take issue with the term “emerging market.”  Markets here do not fit the Wikipedia definition:

In the 1970s, "less developed countries" (LDCs) was the common term for markets that were less "developed" (by objective or subjective measures) than the developed countries such as the United States, Japan, and those in Western Europe. These markets were supposed to provide greater potential for profit but also more risk from various factors like patent infringement. This term was replaced by emerging market. The term is misleading in that there is no guarantee that a country will move from "less developed" to "more developed"; although that is the general trend in the world, countries can also move from "more developed" to "less developed".

I personally believe that we have an interesting “informational arbitrage” in front of us today in the Asian markets.

The ignorant investor may conclude that the emerging markets present a higher degree of risk than is appropriate, hence limiting their allocation.

The smart investor would recognize the “developed” aspect of these markets (again my apologies to all those I know in Singapore for the phrasing), and understand that the investment risk factor is in fact lower than priced in the market. 

In some textbooks, they refer to an investors home bias, or the proclivity to invest in markets and companies they understand.  But let’s be candid, is British American Tobacco really only a British company?  I think not.

As investors, we should be rational and let our natural “home bias” not interfere with our investment decisions.

That said, Asia is cheap relative to the “developed” world.

In the coming weeks, I intend to highlight this opportunity in Asia.  I will have the opportunity to review both the equity and fixed income markets.  Alongside that I anticipate we will inevitably cover commodities and foreign exchange.

We’ll have the opportunity to meet some of Asia’s leading portfolio managers, economists, and investors.

My objective, is for all investors to see the fallacy of the "emerging markets" and recognize Asia growth story for the investment reality that it is.

My Keynote in Sydney!

In late February 21-23, I will be speaking at RFI’s Mortgage Innovation Summit Event in Sydney.  If you are in town, let me know and it would be good to get caught up then!  The link to the event is here.

Where to now?

(Or to paraphrase Clint Eastwood’s Dirty Harry: “A government’s got to know its limitations”) 

The past week has certainly accomplished what market pundits had long since called for: volatility. 

Volatility that was generated by four straightforward catalysts: 

1. The advent of wage growth

2. More US debt 

3. Quantitative tightening 

4. Fed tightening 

While we can talk at length about valuation, it was really last Friday’s Non-Farm payroll number's wage data that provoked the market (especially Treasuries) into the epiphany that the Fed, and rates, were the biggest risks to the economy going forward.   

We saw wage growth of 2.9% which we have not seen for some time! 

However, now that these risks have been highlighted, I would prefer to focus our attention and discussion to what lay ahead.  For the sake of some narcissistic vanity, I have included here the link to my CNBC broadcast during the market correction (Troise CNBC link here). 

Whilst we can fear the Fed, I would prefer to believe that the Fed will ultimately manage the economy through this phase of growth.  And, that is an important statement…this is growth we are managing now.  The world’s economies are now growing in unison for the first time since the GFC.  So the fear isn’t recessionary, but rather a worry about inflation. 

In the midst of all of this, the US Administration threatens shutdown.  In the midst of all of this, the US Administration (and the Tea Party) throw away any previous adherence/belief on deficit reduction.  Instead, the US keeps adding to its debt load.  (How has the USA done historically?  Click here) 

Begging the question…how does the US intend to pay for all of this?  Or, another way to view the dilemma, who is going to lend the US the cash? 

This question is worth focusing on further as it will define, and explain the stock market’s sentiment in the months and years ahead. 

How much money are we talking about near term?  The US Treasury is planning to borrow $955 billion in FY 2018.  Who has the appetite to buy this? 

It basically boils down to several possible market participants: 

• American savers 

• Institutional investors 

• Sovereigns (i.e. China, Japan, OPEC, etc.) 

As we look at each, we can conclude that a debt shortfall at current rate interest rate levels is inevitable. 

American savers have been virtually non-existent.  We sacrificed a generation of senior citizens in the GFC to low yields to foster QE and the asset bubble.  Now to hope that Americans will double down when they need a 34,000 DJIA level to retire is too optimistic.  My view is that Americans will be reticent to fund the debt and will instead double down on other asset classes (#NoCoin) 

Institutional investors, like US pension plans, have the same dilemma.  Ideally, the yield curve would be positively sloped (the carry trade), but it isn’t there yet to the degree necessary today.  In addition, given the extraordinary amount of pension shortfalls, most US pensions are facing the same dilemma that US savers are: they need the “8% equity return” of old. 

Leaving us with sovereigns.  This gets interesting when we compare this to US foreign policy, the US dollar, and the underlying dynamics of energy. 

China is trying to diversify away from US dollars.  Keep in mind, that due to the trade deficit, the US is paying them in dollars, and for the Chinese, the easiest asset to buy is US Treasuries.  Even if they buy assets elsewhere, the dollars ultimately have to be used by someone.  The Chinese don’t like this dependency on the US and as such have begun several initiatives to mitigate that risk.  Their One Belt, One Road initiative portends their move away from US dollars.   

To top it off, Asia has less of a need for the US consumer.  In the past, exports to the US were a key driver.  But now the Asian economies have far more autonomy than their Western counterparts seem to be acknowledging. 

NOTE:  In the next few weeks I will be sharing with you some data (and fantastic portfolio manager interviews!), where the smart money has now seen that the Asian consumer has finally arrived.  Asia isn’t as export driven as before…which does not bode well for the US debt problem. 

OPEC, another reliable buyer of US debt has its own issues.  Not the least of which is US energy independence. To oversimplify it, if the US isn’t buying large amounts of oil with dollars, then OPEC has no rationale to buy the same amount of US Treasuries.   

In fact, as we look at the holders of the US debt worldwide (link here), we can conclude that the US has to provide an “incentive” to buyers of its debt to make up for the shortfall. 

How best to do that?  Higher rates. 

Who has realized this?  The market(s).  Hence the sell off and increase in volatility. 

I am sorry that I do not have a more optimistic message, but this is the reality that we face in the markets today.   

It has been over ten years since we have seen a market like this.  Investors, traders and market participants have gotten used to low rates for far too long and many are ill-prepared with how best to deal with it. 

In the weeks ahead I will spend more time on this, and will provide you a roadmap for navigating this market environment. 

My Keynote in Sydney! 

In late February 21-23, I will be speaking at RFI’s Mortgage Innovation Summit Event in Sydney.  If you are in town, let me know and it would be good to get caught up then!  The link to the event is here. 

1987 Deja Vu

1987: Déjà vu

Last time I wrote, I compared the US Administration’s economic policy as “throwing the kitchen sink” at the US economic malaise.

In fact, the US has done just that.

A tax package that benefits corporations, and provides very little for the middle class it was meant to help.  That same tax package will not generate the revenue necessary for the deficit to recover, and the US debt will balloon as a consequence.

To add to the US dilemma, to help spur manufacturing growth, US policy makers are now talking down the US dollar.  As Secretary Mnuchin stated, this is good for manufacturers as it makes their goods cheaper for export.

Regulators are under increasing pressure by the Administration to loosen regulations.  This will allow banks to lend again to a US consumer, who while spending more, is saving less.  We need look no further than the recent data from the US Commerce Department to see the similarity to 2005 when we last saw the US consumer on a leverage binge.  That ended well for no one.

The clock is ticking for the US as it plans one last manufacturing “hurrah”…the infrastructure bonds.  This is on top of the $441 billion of borrowing announced this quarter.  It is ironic that the USA is planning more debt as the Federal Reserve begins stepping back from its QE policy.  Less demand and more debt means one thing: higher yields.

When did we last see these factors appear?  Look to the months prior to the Crash of 1987.  Like today, we saw a sell-off in bonds alongside a weakening dollar.

While I hate standing in front of market freight trains (regardless of their speed), it is clear that the market is showing the signs for investors to be concerned.  Sadly, the euphoria of rising stocks in tandem with Bitcoin may have sedated investors that this is not déjà vu, but rather the new normal (again).

Singapore & Sydney!

Excited to speak on Monday February 5th at GIC for their event with the FWA on FinTech Disruption.  I will be speaking with my good friends at Synpulse Management Consulting.

In late February 21-23, I will be speaking at RFI’s Mortgage Innovation Summit Event in Sydney.  If you are in town, let me know and it would be good to get caught up then!  The link to the event is here.

Trump's Kitchen Sink

This past week a colleague of mine shared with me the 2007 UC Berkeley commencement address presented by Professor Tom Sargent Nobel Laureate of New York University.  The commencement address was less than 350 words and was able to be completed within five minutes.  In addition to the 12 economic points presented by Professor Sargent #8 was most interesting in regard to the behavior of governments:

#8. Governments and voters respond to incentives too. That is why governments sometimes default on loans and other promises that they have made.

For the past eight years we have witnessed firsthand, the effects of combined monetary and fiscal stimuli.  Yet, as we look at the variables that are available to us today in order to stimulate growth, the US government is faced with an interesting predicament. During the Obama administration, we had a deadlocked Congress; therefore, the only institutional entity within the US government that could affect the economy was the US Federal Reserve.

Through a progressive policy of quantitative easing the Federal Reserve was able to create an environment where the immediate outcome was directly higher asset prices.  In addition, by keeping yields so low, the Fed made fixed income investments so low in return, that any investor had to buy equities.  Alongside the Federal Reserve you also had the BOJ, the ECB and the PBOC as other Central Bank buyers on the markets                

Now each central bank, in their own declarative policy statements, have begun to signal the end of QE; thus paring back their balance sheets.

In light of the absence of QE, that what other policy tools remain in order to stimulate growth?  Fiscal policy.

If we sideline our initial concerns about the individual in the office of the executive branch in the United States, and instead focus on the institution of Congress, we find ourselves in a position where Congress can implement several variables that would have the effect of continuing the market rally.   

The first of which is exactly what we just saw in regard to the tax package just passed by Congress. Ironically, whilst the tax package is of no real economic benefit to those who voted Trump into office, it does however provide significant economic benefit to the corporations that withheld cash reserves overseas in order not to pay US corporate tax rates. Case in point is the recent repatriation of over $350 billion in reserves held over seas by Apple which are now being brought back to the United States for a tax bill of over $35 billion.     

Yet we all seem to miss a very, very obvious fact... Apple is not the last company to make a move such as this.  At the same time Apple now has to consider the use of proceeds from all of the ample cash it is now coming into the US economic system.

Apple’s Treasury team will be faced with the classic decision affecting all corporate entities: how best to deploy the capital?  Regardless of which percentage is allocated to where we can safely assume that a certain percentage of the capital base will be deployed back into the US equity and fixed income markets.

That same conclusion can be drawn with each corporate entity going through the same repatriation that Apple just went through

Let’s extend the simple variable framework a little bit further. There are some more levers that the United States government also has had its disposal.

It is anticipated that given the still low yields in the fixed income market that the USA will go through substantive infrastructure fund raise in order to rebuild much of America’s declining roads and highways (look no further than the NYC rail system!)  In addition to supporting the financial services industry, this bond issuance will have the consequence of creating jobs and providing support to the US manufacturing base.

Last, we have a loosening of the regulatory framework.  After the US crisis, many argued that US regulations were too stringent and did not benefit the US consumer. If there is any relief of regulations, the impact to consumer debt could be staggering.  But, the near term benefit, would be increased consumer spending.  So, while having no real wage growth, Wall Street can extend further credit to a US consumer already in deep debt.

These several variables: lower taxes, bond issuance, and lower regulations portend a market rally fueled by debt.  We have one last silver bullet to add: the US dollar.

A lower dollar means cheaper US exports.

But, as a means of explicit policy, I doubt we will hear Treasury Secretary Mnuchin publicly espouse a lower dollar.  However, our Twitter User-In-Chief is an altogether different variable/manipulator.

All of this means, that the US is literally throwing the “kitchen sink” at this problem.  Barring a market shock, the US equity market should continue to rally until the Fed takes the punch bowl away!

On that note, let me share Professor Sargent’s other commencement point that is quite insightful relative to what I have written:

#10. When a government spends, its citizens eventually pay, either today or tomorrow, either through explicit taxes or implicit ones like inflation.

*PS: I have not forgotten my fixed income write-up.  Soon to come!