Coming Out - As a Bear!Wednesday August 05, 2015 15:49
Increasingly concerned about the markets, I’ve taken more aggressive action than in 2007, the last time I soured on the equity markets. Let me explain why and what I’m doing to try to profit from what may lie ahead. I started to get concerned about the markets in 2014, when I heard of a couple of investment advisers that increased their allocation to the stock market because they were losing clients for not keeping up with the averages.
Earlier this year, as the market kept marching upward, I decided that buying put options on equities wouldn’t give me the kind of protection I was looking for. So I liquidated most of my equity holdings. We also shut down our equity strategy for the firm.
Of late, I’ve taken it a step further, starting to build an outright short position on the market. In the long-run, this may be losing proposition, but right now, I am rather concerned about traditional asset allocation.
Fallacy of traditional asset allocation The media has touted quotes of me saying things like, "Investors may want to allocate at least 20% of their portfolio to alternatives [to have a meaningful impact on their portfolio]."Â The context of this quote is that because many (certainly not all!) alternative investments have a lower volatility than equities, they won’t make much of a dent on investors’ portfolios unless they represent a substantial portion of one’s investment. Sure, I said that. And I believe in what I said. Yet, I’m also embarrassed by it. I’m embarrassed because while this is a perfectly fine statement in a normal market, it may be hogwash when a crash is looming. If you have a theoretical traditional "60/40" portfolio (60% stocks, 40% bonds), and we suppose stocks plunge 20% while bonds rise 2%, you have a theoretical return of -11.2%. Now let’s suppose you add a 20% allocation of alternatives to the theoretical mix (48% stocks, 32% bonds, 20% alternatives) and let’s suppose alternatives rise by 5%: you reduce your losses to -7.96%. But what if you don’t really feel great about losing less than others; think the stock market will plunge by more than 20%; and that bonds won’t provide the refuge you are looking for? What about 100% alternatives? Part of the challenge is, of course, that alternatives provide no assurance of providing 5% return or any positive return when the market crashes; in fact, many alternative investments faired poorly in 2008, as low liquidity made it difficult for investors to execute some strategies.
Why? Scholars and pundits alike say diversification pays off in the long-run, so why should one deviate from a traditional asset allocation. So why even suggest to deviate and look for alternatives? The reason is that modern portfolio theory, the theory traditional asset allocation is based on, relies on the fact that market prices reflect rational expectations. In the opinion of your humble observer, market prices have increasingly been reflecting the perceived next move of policy makers, most notably those of central bankers. And it’s one thing for central bankers to buy assets, in the process pushing prices higher; it’s an entirely different story for central bankers trying to extricate themselves from what they have created, which is what we believe they may be attempting. The common theme of central bank action around the world is that risk premia have been compressed, meaning risky assets don’t trade at much of a discount versus "risk-free" assets, notably:
- Junk bonds and peripheral government bonds (bonds of Spain, Portugal, Italy, etc.) trade at a low discount versus US or German bonds; and
- Stocks have been climbing relentlessly on the backdrop of low volatility.
When volatility is low and asset prices rise, buyers are attracted that don’t fully appreciate the underlying risks. Should volatility rise, these investors might flee their investments, saying they didn’t sign up for this. Differently said, central banks have fostered complacency, but fear may well be coming back. At least as importantly, these assets are still risky, but have not suddenly become safe. When investors realize this, they might react violently. This can be seen most easily when darlings on Wall Street miss earnings, but might also happen when central banks change course or any currently unforeseen event changes risk appetite in the market.
Relevant with regards to my concern over a more severe correction is that it is complacency that drove the tech bubble to ever new highs in the nineties; and it was similar complacency that drove housing into the stratosphere ahead of 2008. Bubbles are created when investors have the illusion that there’s no or little risk with the strategy they are pursuing, bidding up asset prices.
Did I mention that I’m concerned about stocks and bonds? That may not make sense to some, as bonds are the historic refuge when stocks tank, but just as stock and bond prices have both been rising, it is possible for both of them to fall simultaneously.
Why now? Historically, it’s difficult to say when markets top, when bubbles burst. In my analysis, relevant is the rise of volatility, i.e. the return of fear. With hindsight, we will attribute that fear to a specific event, but to me, it’s secondary whether it is concerns about China, Greece, the Fed, Ebola, or what not. Remember that the market has been climbing a wall of worries? Well, similarly, the market can fall on good news or bad news. The question is what will get investors to think the glass is now half empty rather than half full.
As such, it’s difficult to get the timing right. It was in December 1996 that former Fed Chair Greenspan warned about irrational exuberance, yet the markets continued to rally until the spring of 2000.
I don’t claim to have a crystal ball, either. But I do know that if we have a severe correction, I prefer to be early than late: the time to prepare one’s portfolio for what may be ahead is before it happens. That’s why I explained I’m taking increasingly aggressive steps to protect myself, at this stage "starting to build" a short position. I can’t know for certain where my analysis will take me in the future, but should the market continue to climb, I don’t see that as a failure, but as a potential opportunity to increase my short position.
Part of the reason I’m willing to short the market is because, aside from the potential expansion of risk premia as the Fed is trying to engineer an exit, there are other red flags that suggest to me a more pronounced downturn may come sooner rather than later:
- Glass half empty. In our analysis, the market has increasingly been reacting negatively to news. We see little sign of a market climbing a wall of worries.
- In our analysis, market breadth has deteriorated. It was last in the late 90s that the Nasdaq reached new highs, but the number of shares reaching new lows on a fifty-two week basis exceeded those reaching new highs. In plain English, few stocks are driving rallies, a sign of a market that’s tired.
- Stale revenue. Too many firms, in our assessment, don’t have revenue growth.
- P/E ratios. All else equal, low interest rates warrant higher price-to-earnings (P/E) ratios as future earnings are discounted at a lower rate. As interest rates rise, we expect "multiple compression", i.e. lower P/E ratios.
- Share buybacks. Earnings per share for many businesses move higher despite stale revenue or higher costs because of share buybacks. As many firms borrow money to buy back shares, buybacks may become much less attractive as rates rise. They’ll have the additional headwind that they’ll then have to pay higher interest on the money they borrowed to buy back their shares.
- Whisper numbers are back. Some tech stocks get burned for not making "whisper numbers," i.e. elevated expectations that go beyond what analysts have forecast. Investors expect that optimistic expectations are beat, a recipe for disappointment.
- The strong dollar. The strong dollar is another headwind, as well as a great excuse when companies miss earnings, masking underlying weakness.
- Global slowdown. In our analysis China is slowing down; many firms that have tried to sell to the ever more affluent Chinese middle class may be facing headwinds.
- Valuation. We don’t think stocks or bonds are cheap. We list this last, as everyone has his or her own preferred measure of valuation (in bull markets, investors are very creative in how they justify valuations). All I would like to add here is that any pundit that tells you "stocks can go up 10% from here" has no clue what he or she is talking about â€“ in my experience, that’s what pundits say if they have stocks to sell.
The biggest argument -- and one I take very seriously -- as to why none of the above means the market is going to fall is that the above points are rather obvious. The question is when will the market start to care about any or all of the above.
Note that I believe the Fed will raise rates, but will "remain behind the curve." That is, we believe the Fed will be rather slow in raising rates, keeping real rates (i.e. interest rates net of inflation) near zero, if not negative. The Fed is well aware of past "temper tantrums" which contributes to its reluctance to raise rates. As such, it’s well possible that risk premia may not expand rapidly, thus keeping complacency alive and well. However, my base case scenario is that the Fed’s gradual approach will still get risk premia to rise, thereby toppling the markets. More so, Fed Chair Yellen has not experienced a major correction as Fed Chair; as such, she may well be late to succumbing the pleas of the market to back off. But given that much of the recovery may be based on Fed induced asset price inflation, a deflating of asset prices may cause significant headwinds to economic growth. As a result, I expect volatile Fed policy going forward; a Fed insider would more likely call it "fine tuning" of policy rather than volatile -- you choose.
How to profit? So what is one to make of this? Again, we can’t give specific investment advice here, but I can tell you that for myself:
- I have eliminated most of my equity exposure;
- I have started to build a short position in stocks;
- I wouldn’t touch bonds with a broom stick;
- Aside from cash in U.S. dollar and hard currencies, I focus on alternative investments.
What alternatives? A commonly cited alternative is gold. The price of gold, over the long run, has had a low correlation to equities and bonds. Having said that, gold has been most out of favor. Well, that’s part of the reason I like gold, as so many other things are in favor. As I indicated before, I don’t expect real interest rates to move up much; it’s high real interest rates that are the key competitor to gold. More so, our analysis suggests the dollar rally over the past year might have been extreme. In fact, I would not be surprised if, in a year from now, the U.S. would be on a flatter tightening path than some other central banks. Differently said, we see the greenback as vulnerable. Long-term, we like gold because we don't think the U.S., Europe or Japan can afford positive real interest rates a decade from now.
Talking about out of favor stocks, I have recently bought some gold miners. Again, just like anything else in here, this isn’t an investment recommendation. Importantly, gold miners come with their own set of risks -- they are certainly not safe. Beyond that, I have dedicated much of what I have available to invest to my home turf, the currency markets. The beauty of the currency market, in our assessment anyway, is that one can design a portfolio that has a low correlation to other asset classes. In a "long/short" currency portfolio that takes a relative position of, say, the Swedish krona versus the Euro, the returns generated are highly unlikely to be correlated to equity returns. That’s exactly what I’m looking for. And as the liquidity in the currency space is high, I don’t have the same fear I would have with many other alternatives. As always, I’m putting my money where my mouth is; amongst others, as a firm, we have built out our infrastructure, so we can offer long/short currency overlay services to institutional investors; we think that if/when markets plunge, they’ll be scrambling to learn more about services such as the ones we have been building.
Of course there are other alternatives. They all have their own pros and cons, they have their own risk profiles. Note that there’s no easy answer should this analysis be right. And there’s certainly no assurance I’ll come out as a winner. But I firmly believe that just as former Fed Chair Bernanke talked about his toolbox, investors should consider having a toolbox. I’m ready for a bear market. Are you?
President & CIO of Merk Investments
Manager of the Merk Funds