Byron Wien: Comparing Risk and Opportunity
Every year in August I organize four lunches for serious investors on successive Fridays in eastern Long Island. There are different groups of 25–30 people at each one and many of the great names of the hedge fund, real estate and private equity world attend, along with some academics and government folk. I lead a discussion for the better part of two hours and, in the past, I would follow the same basic agenda at each one. This year I varied the approach: I took a hard look at who was attending and created agendas that took advantage of the knowledge and experience of the participants.
The one issue that dominated the discussion at all four of the lunches was whether or not we were in the late stages of the business cycle as well as the bull market. This recovery began in June 2009 and the bull market began in March of that year. So we are more than 100 months into the period of equity appreciation and close to that in terms of economic expansion. Howard Marks of Oaktree, one of the most insightful thinkers in the money management business, has written a 22-page paper on the risks facing investors, and he concludes that this is a time for caution because of the condition of asymmetry: the potential rewards are not sufficient to justify the uncertainties and stretched valuation of equities. Opportunities are limited because of price. One investor recalled the “Rule of 20” from what now seems like ancient times: the combination of inflation and price earnings ratios should be no more than 20. On that basis, the market is a little more than fully priced but not egregiously overvalued.
Looking at historical price earnings ratios, the market certainty appears to be fully valued, even assuming earnings continue to come in better than expected. Equities seemed priced for perfection. Greed was winning over fear. Historical multiples, however, were established in a higher interest rate environment where the 10-year U.S. Treasury was yielding 5% to 7%, versus just over 2% as it is today. Stocks compete with bonds as an investment. Current interest rates can support a higher multiple, perhaps as much as 30x, but few observers want to stick their necks out that far. While the market is always vulnerable to a 10% correction, bear markets are usually associated with a recession and there is no serious downturn in sight for the economy.
The Federal Reserve has been moving from an accommodative monetary policy to a more restrictive posture, with two increases in the federal funds rate behind it and the prospect of at least one more. The Fed balance sheet has swollen from $1 trillion in 2008 to $4.5 trillion today. The Fed has indicated, however, that it will start shrinking it now. The European Central Bank is also talking about tapering its balance sheet expansion and, as a result, liquidity will not be as favorable for financial assets as it has been since 2008. Nonetheless, other potential impediments to equity appreciation are not currently negative: investors are optimistic but not euphoric, inventories are not excessive, unemployment is declining rather than rising, leading indicators are making new highs and inflation is modest. Accordingly, we could be several years away from the next recession or bear market.
More recently, the markets have been buffeted by North Korea’s nuclear threat. A military confrontation in the Far East is certainly high on the list of potential risks. For the third lunch, I arranged for Orville Schell, a scholar at the Asia Society, to speak to the group about possible policy alternatives. I have followed his work since I first started going to China in the 1980s and his analysis of the evolution of the country from its underdeveloped economic condition at the time of Mao’s death in 1976 to the second largest economy in the world has always been helpful. Although there is no shortage of op-ed pundits writing about diplomatic policy initiatives that should be pressed on North Korea, Schell’s recommendations are very specific: cut off food and oil shipments, stop air travel from Chinese airports and eliminate rail transportation to the country.
While most agree that a severe response is called for, these moves would cripple North Korea and add to the suffering of its people. The popular view is that China would not implement such harsh sanctions on its neighbor with whom it does a lot of business. China wants to avoid a risk regime change that might lead to a combined North and South Korea. In the event of a war, it fears that immigrants would flood into China. It also wants a quasi-communist buffer between it and democratic South Korea. Schell’s argument is clear: the Chinese have two major objectives. The first is to become the largest economy in the world. They are likely to reach that point sometime in the 2030s, even if growth there slows to 4%. The second goal is to play a major role in international geopolitics. If China took steps that forced North Korea to scale back or stop its nuclear weapons development program, this would catapult it to a highly respected position among leaders throughout the world. China also does not want a nuclear capability in the hands of an unpredictable dictator on its borders. It wants to avoid a conflict that interrupts its growth. These factors may induce China to become the key player in diminishing the North Korean threat. One person close to the Chinese situation pointed out that no significant policy move is likely to happen before the meeting of the People’s Congress this fall. Xi Jinping will seek to use the meeting to solidify his power. Any major decisions are likely to occur after the meeting is concluded.
The other major risk is a possible serious policy error coming out of the White House. Those attending who are close to the president affirmed that there is a new mood of discipline in the West Wing since John Kelly became chief of staff. The president remains unpredictable, but the organizational chaos that existed before Kelly took over has been transformed by his leadership. Steve Bannon’s departure is a good sign that the White House is becoming more disciplined.
One other potential danger that investors seem too complacent about is Exchange Traded Funds. While most know these instruments as a great convenience in getting or reducing exposure to sectors or asset classes, they may prove to be less liquid than their participants believe and could destabilize the financial markets. Most owners of ETFs don’t know what’s in them. What happens when everyone wants to get out at the same time? The corporate bond market is also a risk. Investors are so hungry for yield that companies are able to issue bonds with few or none of the covenants that provide default protection or early warning signals of brewing problems. The fact that Argentina, with its checkered financial history, could issue 100-year bonds is an example of an easy money atmosphere in the debt markets.
The strong performance of the FAANG stocks (Facebook, Amazon, Apple, Netflix and Google) is also an indication of unappreciated risk. While these companies are delivering superior operating performance, they account for a major part of the rise of the Standard & Poor’s 500 (33% in the first six months of 2017). We have seen a strong equity market in the United States so far this year, but it has been a narrow market. One risk is that the government picks on several of the more successful companies as it has attacked past winners like IBM and Microsoft because of their dominance in technology. This could put Amazon and Google in danger in for years to come.
Some questioned whether the ease with which private equity firms raise money, and the large uncommitted capital they have in place, may also suggest that they will pay too much for new investments. But the private equity leaders who attended argued that they were in no hurry to employ that cash and they were still seeing attractive opportunities. The sharp rise in the value of Bitcoin, an alternative currency without the backing of a sovereign nation, was also viewed as a sign of the dangerous speculative mood in the financial markets.
There was a general feeling that the real overvaluations were in the bond market. If the economy continues to grow at even 2%, interest rates will rise but they would remain at historically low levels because of modest inflation and all the liquidity that was created since 2008. The investors did agree that there were more opportunities in Europe and the emerging markets than in the United States right now. A favorable surprise this year has been the economic strength of Europe. Whereas a year ago the possible break-up of the European Union was actively discussed by investors, the Brexit vote has brought the countries closer together. Emmanuel Macron’s election in France has been a positive with increased cooperation between France and Germany. A knowledgeable United Kingdom investor said that Brexit implementation was moving slowly and may not happen at all. One participant was worried about the new regulatory environment in Europe and how that might restrict the ability of the banks there to lend.
One prominent financial leader had the view that the rise in the equity market in the United States since the election may be a result of investors recognizing that there is a more business-friendly attitude in Washington. While Trump has not been able to achieve his pro-business agenda of cutting taxes and improving infrastructure, he represents a sharp contrast to Hillary Clinton, who would have increased taxes and added to the regulatory burdens of American businesses. There was a view that infrastructure projects were largely in the hands of the states and would, despite the president’s recent executive order, be slow to get going because of local regulations. The consensus was that Trump will be unlikely to achieve true tax reform during the next year, but that corporate taxes will be cut to something like 25%. A repatriation tax of 10% will be enacted but only $1.5 trillion of the $2.5 trillion of American cash in offshore accounts will come back to the U.S. The rest will be invested in opportunities abroad. Most of the money that does come back will be paid out in dividends or used for stock buybacks. With operating rates at 77%, there is plenty of spare capacity and not much need for new plants and equipment.
One investor was worried to the extent that the rise in the S&P 500 is linked to S&P 500 earnings this year coming in so much better than originally expected (an 11% gain versus January estimates of 6%). He said that companies were able to save money by borrowing at low interest rates and that earnings were overstated as a result. If you assign a higher multiple (because of low interest rates) to inflated earnings, you may be asking for trouble. Against this view was the observation that growth was reasonably strong everywhere – the U.S., Europe, Asia and the emerging markets. Moreover, this favorable business environment looked to be in place for a while. Stocks may appear fully priced at current multiples of 2017 earnings, but if you go out two years, the same companies at present prices could only be selling at 15 times what their earnings would be then.
Other topics that have generally not been given enough consideration include the troubled finances of state and local governments in the U.S. as well as the dangers to the federal budget deficit if interest rates were to rise sharply. The decline in oil prices was also putting Saudi Arabia, Algeria and Nigeria in a difficult financial position. These countries cannot provide the support and services their populations expect at the present world price of oil. Those close to the energy industry believe the price of oil will range from $50 to $60 a barrel for the next several years as a result of a combination of increased production from hydraulic fracking in the U.S., large existing inventories of crude that need to be worked off, greater exports from Iran and Iraq and substitution by alternatives and natural gas. That’s not enough to meet the budget needs of the major exporting countries.
There was a discussion of how two major industries – retail and automobiles – were going through major secular changes because of technology. Online buying is having a major impact on the retail industry and this is being reflected in real estate values. The real estate people believe that a good location is a recruiting tool for a company. This favors California, Denver, New York and a few other places. Attraction to New York is further refined because young people want to live downtown, and commercial rents in the meatpacking district are now exceeding those on Park Avenue. Manhattan is tilting west. Rental apartments are now in equilibrium, but here is some chaos in the condo market.
The auto industry is being transformed by electric and/or hybrid cars, and driverless cars and trucks, when they come, will compound the problems. This will be seen not only among auto manufacturers but also in the sales and service component of the industry. One critic of the electric car argued that there were few charging stations, boosting the battery took too long and the cost of electricity to do the charging diminished the saving on gasoline.
There was general agreement that both inflation and productivity were understated. Housing is a big part of the inflation calculation and, for most of the country, housing costs have been rising modestly. The prices of services like healthcare and lifestyle-supporting needs used by everyone, such as haircare and cleaning services, have risen sharply but don’t show up in the numbers. As for productivity, the measurement techniques were developed in the 1950s when the U.S. was more of a manufacturing economy. Now with services and knowledge-based industries so important, the historical measurement approaches, which underestimate the impact of computer software developments, understate productivity improvements. Time spent posting and reading posts on Facebook during working hours, however, detracts from productivity. One technology person pointed out, though, that the video games of today are intensely interactive and represent a learning experience for the kids playing them. This is in sharp contrast to the passive watching of television by previous generations.
We talked a bit about inequality and agreed the problem was likely to become worse because of globalization and technology. One investor was optimistic, however, because of the positive impact machine learning was making in improving the outlook of disadvantaged Americans and educational opportunities in the emerging markets. Another pointed out that 60% of the jobs held in 1980 don’t exist today and still unemployment is down to 4.3%. On-demand services, such as Uber, are creating jobs, but technology displacing workers is a problem throughout the world.
Even though there was an apprehensive mood at the lunches few were buying gold as a safeguard. In spite of the strong performance of the Japanese economy this year and the rise in its stock market, the group remained wary of Japan. There was no clear consensus on why the dollar was weak, but a lack of confidence in the new administration in Washington was clearly a factor in spite of strong U.S. growth and a rising stock market. One of the lunches was decidedly bearish. Overall, a vote on market performance between now and year-end showed that 60% believed it would be higher in spite of the caution expressed in the discussion.
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