It certainly was an interesting summer. From the Gaza strip through the Middle East and into the Ukraine, the global political landscape was rife with challenges and dilemmas. We look around the globe, and we see societies facing change on a scale that is unprecedented. While the financial ramifications are uncertain, we know that change is scary, and it is hard to predict who the clear winners will be, if there are any at all.
Against this backdrop, the financial markets have done… nothing. U.S. equities tried for a correction in early August, only to be stymied by reluctant buying two weeks later. Since then, the U.S. equity markets have progressed a couple of percentage points, but that gain has been tenuous as we saw last week.
The lack of strength across equities is notable. The large cap industrial index (Dow Industrials 30) has gained 4.6% this year against the S&P 500’s broader base with an 8.3% gain. [Note: The Dow has just 30 stocks in it and misses some key sectors that the S&P 500 represents with its 500 largest cap stocks.] But outside the U.S., the rest of the developed markets (namely Japan, The U.K., France, Switzerland and Germany) are flat for the year, kept out of the negative only by the dividends they generate. Their performance is anemic compared to the U.S. markets, and U.S. bonds have fared respectably at 4.0%.
Equities
As we have seen many times in the past, an extended bull market leads to some pretty odd behavior. Market bubbles, irrational exuberance, rising tides raising all boats: whatever you might be tempted to call these supposedly serendipitous trends, they have more to do with Fed policies than anything with financial fundamentals or dumb luck. We are seeing stock prices continue to climb in every situation, with individual companies getting valuations that induce acrophobia.
Amazon, one of the world’s largest online retailers, has yet to generate a consistent profit, but trades at a $150 billion valuation. On the other hand, Alibaba, which does generate a profit by selling just about everything online to everyone around the world, went public and pocketed $25 billion for its owners/investors; it now trades at 38-times the estimated earnings. Keep in mind that during the last equity bubble, Amazon hit a market capitalization high of $36 billion. Alibaba is now worth $220 billion.
The troubling aspect of the Alibaba IPO is the use of cash. When a company raises equity capital, such as with an IPO, it is generally expected that a large chunk of the new funds are used by the company while key investors are required to hold their stock for an extended period of time. This prevents the “pump and dump” incentive from those promoting the company to line their pockets at the expense of new investors. With Alibaba, up to half of the $25 billion that was raised in this IPO is going straight into the pocket of owners and past investors with no lockup period. The last time something this extreme happened during a bull market was the IPO of Blackstone. Back in 2007, they raised over $4.1 billion and the owners/investors were allowed to cash out immediately. That IPO coincided exactly with the top of the equity markets in 2007, and IPO investors have yet to see any gain on their investment after seven years.
But for all the crazy hype, the stock market has not gotten so out of hand that a correction would be as devastating as what we saw in 1999, when tech stocks lost 80% of their total value. As a reference point, the S&P500 is now trading at 18x earnings, which is notably above the historical average of 15x, but nothing close to the 30x that we saw in past bubbles.
Chart 1. Year-to-date performance of three major indices without dividends (S&P500 in green, Dow in blue, and EAFE in orange) shows significant divergence and points to the sluggish nature of equity returns. Dividends are the only thing that keeps the EAFE (Europe, Asia and Far East developed) index positive.
This market rationality is seen in the way that individual sectors of the S&P have moved. Technology shares are doing well, but high-risk, nominal profit companies have fared poorly this year as investors shun the exuberant behavior of the past. In fact, the Russell 2000 (a small cap index) is down -4.4% for the year, as opposed to Healthcare being up 16.5% this year to date. These numbers are a far cry from 1999 and the dot-com bubble, when serious economists were predicting Dow 50,000].
Fixed Income
A big challenge we might face is the fixed income market. The “bubble” factors are fairly stark. The Fed has kept interest rates below historical norms for years now, with short-term rates near zero and 10-year rates barely above inflation. The inference is bleak if you invest in a safe, secure instrument now, you will lose out to inflation. Putting money away guarantees that you’ll lose purchasing power.
That dynamic has led to reduced bond rates across every bond class as investors chase returns, and inflated bond prices are a result. The hope is that the bond market is able to absorb any movement in interest rates without creating any significant disruption. The actual unwinding of the monetary stimulus by the Fed and a return to conventional interest rate structures could be far messier.
Another issue we face today is the changing bond market. Unlike stocks, which are relatively uniform (everyone knows what a share of Apple stock represents), bonds have thousands of different structures. The number of active CUSIPS (a unique identifier for each security) vastly differs between stocks and bonds: there are 18,000 active U.S. common stock CUSIPs, versus millions of active bond CUSIPs. To make the point even clearer, the total value of the top 500 stocks represents nearly 80% of public US companies. You would need tens of hundreds of bond issues to match that number in bonds.
Bonds trade in a very complicated manner as well. Unlike stocks, which have several electronic markets that are synchronized and relatively uniform, the bond market has fewer market makers with less inventory today, and trades are often completed with a phone call – how old-fashioned! With a total market cap that is significantly larger than the stock market, any sizable disruption to the bond market could result in mayhem. [On a side note: the departure last week of a key manager from PIMCO, the largest bond manager in the U.S., caused Treasury prices to drop. While he was an important figure in the building of PIMCO, it is disconcerting to think that one person in the private sector can influence the bond market that much.]
Because of such a disparate market, individual investors and advisors rarely use individual bonds in portfolios, and instead rely on mutual funds and exchange-traded funds. These funds need to reflect the market price of bonds each day, even if the bonds won’t sell for many years. As a result, public bond fund pricing can be far more volatile than the value of the underlying assets, which we have seen can lead to redemptions and selling into an already thin market. Such activity could make for the perfect storm for an asset devaluation.
There are many ways to mitigate these risks in individual portfolios (start by using individual bonds and sticking to known risks), but many institutions will be affected differently based on how they use bond investing. For those who are “hold-to-maturity,” it would take a major disruption in the economy, with significant bond defaults, to impair portfolio values.
Most institutional investors, however, do not have the luxury to look past current prices and plan for the long-term hold. They must mark their portfolios each day, reflecting “market” prices that are often grossly misaligned with asset value. The ramifications can be disastrous, as we saw in 2008, when the marks on mortgage products brought many institutions to failure. This is not a prediction of what is to come, but rather an outline of the concerns that are shaking the markets right now.
Economic Overview
The other factors we focus on have maintained a steady state these past three months. Labor force participation rates are still at historic lows, making unemployment numbers look quite good despite anemic job growth. While the number of people filing for unemployment continues to drop, the workforce itself remains at levels we haven’t seen in decades, harking back to the period when women began to enter the workforce. As I have emphasized for many quarters, the quality of our job growth is poor. The U.S. economy has not brought folks back into the workforce from the recession, and many of the jobs that we do create have relatively stagnant wages. The dynamic creates further strain on the divergent social classes in America, while slowing down economic growth.
Chart 2. Workforce participation rates sit under 63% of the population, the lowest that is has been since women started to enter the workforce in historically large numbers. This trend undermines the notion that jobs growth in America is strong.
While slow, GDP growth in the U.S. does appears to be steady, in spite of the stalling economy we saw this past winter. The slow growth in Europe, combined with perceived weakness across the emerging market economies, has resulted in the U.S. looking like it is still the best place for equity investors. As I noted, the U.S. equity markets have substantially outperformed global markets, a trend that is interestingly based on this divergent economic picture.
The final piece of domestic activity that I closely monitor is real estate, which provided so many jobs in the last economic expansion. For good or bad, we are seeing slow but steady improvement in the housing sector, but not the sort of expansion necessary for stimulated economic growth. As an example, new home sales grew this summer to over 504,000 per year. This is a seemingly strong figure. That number, however, is less than half of where we were in 2005 when the real estate sector generated over 1,200,000 new single family home sales a year, even though our economy is 11% larger today. This might be good news, but we have a long way to go before the sector drives the economy forward.
Our view, whether looking at global politics, domestic wealth inequality, or equity market growth, is that we are facing a continued period of substantial change. The instability triggered by the global economic collapse in 2008 has not ended, and what we are experiencing right now is still based on extreme measures by central banks. When the global economy does eventually find its long-term footing, we will see a very different dynamic and balance of powers than we have ever seen. It is the change that creates panic, and so we at Vodia, focus our energies not only on the financial risks that are created by this change but the irrational market behavior it triggers.
All the best for an enjoyable fall.
Regards,
David B. Matias, CPA
Managing Principal
