Many of the trends we have recognized over the past five years or so remained largely in place through the second quarter. The "narrative of the central banker" has persisted far longer than we ever thought possible and that has manifested itself in suppressed volatility. It has also created an open season for any security that can be even remotely associated with either growth or income.
Interestingly, with interest rates so low many investors have forsaken bonds as sources of "safe" income and instead have embraced stable dividend paying stocks. Likewise, given the obvious risks attendant when rates normalize, many investors have also looked to bonds more for their appreciation potential.
This unusual inversion of risk perceptions reminds us of the 2008 financial crisis in some important ways. At that time, the higher level tranches of mortgage debt seemed completely insulated from any minor rumblings in the subprime world. As housing prices fell, and fell hard, however, some of the greatest damage occurred in these "safer" tranches -- partly because their prices did not reflect the risk and partly because the risk models were enormously flawed. In a similar way, the gap between perception and reality regarding the risk of defensive stocks (as well as many others), seems to be especially wide today. We strongly suspect that after the next stock market disruption, a great number of income investors are going to be sorely disappointed in their "safe" dividend stocks.
This inversion also seems misplaced for other reasons. First, stocks have a lower claim to assets than debt and therefore, by definition, are riskier. It seems odd that so many investors seem so willing to overlook this hard reality. Second, to the extent that investors are concerned about the effects of rising rates, they should be at least as concerned about stocks. In regards to fixed income, investors are all too aware of the disproportionate losses long duration portfolios can suffer as rates rise. In regards to stocks, though, just the opposite is happening. Not only do stocks generally have much longer duration than bonds, but the types of stocks that have been performing best are also those with the longest duration, namely biotechs, tech stocks, quality stocks, and growth stocks. These are also the groups that will get hit hardest when rates start increasing.
With duration and other inherent stock risks underappreciated, the one risk that has been amplified in this environment has been exposure to economic growth. Those stocks that are perceived as having the most economic risk tend to get clipped when GDP forecasts are downgraded and don't recover commensurately when numbers improve in what distinctly looks like a downward ratcheting motion.
This is interesting not because we have high expectations for economic growth (we don't) but because the prices of these stocks discount much more dismal conditions than other stocks do. In short, market action is looking a lot like the tech boom of 1999 when the market hated industrial, energy and commodity stocks and considered most other stocks (wrongly, in hindsight) as being completely untethered from economic travails. It seems as if the market believes those old companies that actually make things (and produce cash flows!) are just too uncool and passe'.
It is no secret that this bizarre investment environment did not evolve on its own but rather is being absolutely dominated by the Fed's actions and communication. Since the second round of quantitative easing (QE2) was first floated back in 2010, the market has been dominated by one theme: don't fight the Fed. While such measures provide well known benefits in the short term, they also create several longer term consequences, many of which are derivative effects and cannot be known. What we do know is that measures taken by central banks have been at an unprecedented scale and that no central bank can create economic growth.
Ben Hunt addressed this scenario brilliantly in a recent piece entitled "Inherent Vice" [here]. He describes it as a "game of Chicken" and notes that "once you start looking for it, you will see it everywhere here in the Golden Age of the Central Banker." He describes the situation in terms of game theory: "You and James Dean are each driving your car towards the cliff’s edge, but unfortunately for both you and James there isn’t a single Nash equilibrium for this game."
By this, he means there is no single situation in which neither party prefers to change its game position. If there were, it would be easy to identify that equilibrium and predict an outcome. Since there isn't, however, it is impossible to gauge the outcomes of the "game". As Hunt concludes, "This is the inherent vice of the game of Chicken – it is impossible to predict the outcome of the game by looking at the fundamentals of the game."
Now let's suppose that James Dean represents the Fed (really, central bankers as a group), and you represent investors continuing to bid up stock prices. Who wins this game of Chicken? According to Hunt's analysis, it's impossible to know. What he does say is that it is not a game that works in anyone's favor. As he puts it, "Play the game enough times and it will break you. It’s un-insurable, plagued by inherent vice, and that means that it’s un-investable, too." His advice, which we consider to be good advice is: "There’s no shame in picking your battles, in recognizing what’s investable and what’s not."
Indeed, this highlights a view towards market risk that we discussed in our last blog and one that many investors seem to be missing. When the Fed began targeting asset prices as a matter of policy, it fundamentally changed the exercise of investing in stocks to a game of Chicken. In doing so, the exercise morphed into one that is "un-investable" and therefore one that more closely resembles gambling.
That change has been gradual but persistent. Jared Dillian characterized the situation nicely in a note [here]: "People get used to regimes. They get used to a certain state of affairs with a lack of volatility. They become complacent. Maybe they stop hedging. Maybe they allow themselves to have unbounded downside risk. Maybe they start gambling."
Gambling is also a topic Nassim Taleb discussed in his book, Fooled by Randomness. In Taleb's opinion, "'Gambler' is about the most derogatory term that could be used in my derivatives profession. As an aside, gambling to me is best defined as an activity where the agent gets a thrill when confronting a random outcome, regardless of whether he has the odds stacked in his favor or against him." The broader point is that for most investors, who are simply trying to benefit from the best returns to be had for a certain amount of risk, there is no room for gambling -- and no room for playing Chicken.
This game of Chicken has done more than changed the character of the investment environment, it has also changed the environment for investment services. Successful active investors have gotten there by developing a broad range of skills in analyzing fundamentals and valuations. Unfortunately, since "it is impossible to predict the outcome of the game by looking at the fundamentals of the game," these skills have been severely devalued. In their stead, aggressiveness and disregard for risk have been rewarded handsomely, much as in the runup to 2008. As a result, the Fed's game of Chicken has also affected investment management strategy by undermining the value of active management.
Jim Grant corroborated this effect in his newsletter by highlighting the recent "uniquely outsize returns to the S&P 500 index, in relation to measured risk". Grant conveyed the insights of Jeff deGraff, chairman and head technical analyst of Renaissance Macro Research, that "the last three years have been easier for the indexers than at any other point in time in the history of the data." This provides terrific context for the headwinds facing active managers the last few years.
How much longer do investors need to contend with this bizarre investment environment? Hunt provides us with some helpful guidance. "When does time run out in a game of Chicken? When you see competing Narratives of 'we have no choice' you’ve entered the death spiral phase of the game. That’s when it’s time to head for the hills, and quickly."
There are some indications this is happening. The notion that "there is no alternative" is a familiar refrain among some stock investors with the subtext being that "we have no choice." Indeed this position rings especially true for a number of large investor groups such as underfunded pensions plans desperately trying to catch up to their liabilities and investors needing income (ranging from individuals to foundations to family offices). Many central banks also seem compelled to buy stocks in order to induce "wealth effect" spending. Finally, companies are repurchasing record amounts of their own shares in what looks like an increasingly desperate effort to maintain earnings per share growth (and therefore executive compensation bonuses) despite slowing revenue growth. Notably, none of these motives are investment related.
On the other hand, we haven't yet seen indications from the Fed that it is embarking on an "all or nothing" campaign, especially given that it did finally phase out QE. We have seen indications from other central banks, however, that they may feel like they don’t have a choice. Japan has massively increased its quantitative easing program and shows no signs of slowing down. Sweden's Riksbank also just lowered rates to be even more negative and further increased its QE program. And we shouldn't forget China which is shifting into high gear in an increasingly desperate effort to stem losses in its stock market.
Finally, an extremely important aspect of the game of Chicken is that the outcome is determined not solely by the wills of the two drivers; it is also determined by the vehicles they are driving. In this sense, the spectacle of Chicken may well be distracting investors away from the more mundane, but incredibly relevant, condition of the economic "vehicle".
Debt and demographics are two forces we have reported on several times that are going to increasingly impede economic progress. These secular factors have been under appreciated in large part due to the cyclical "fireworks" surrounding the big market crashes in 2000 and 2008 and the subsequent recoveries. None of this changes the fact that they will increasingly be drags on economic growth for some time and that the effects cannot be forestalled indefinitely. Further, such challenges will be exacerbated periodically by a wide range of geopolitical risks.
Other actions have also concealed the underlying condition of the economic vehicle. Booming activity in mergers and acquisitions and record share repurchases have also masked deteriorating fundamentals. A recent post by zerohedge [here] highlights that last quarter, for the first time since 2007, dividends and share repurchases exceeded cash flows. In other words, companies are actually shrinking their investments in future growth. The conclusion, in short, is that there is a distinct possibility that this game of Chicken ends anticlimactically with the economic "car" simply unable to maintain speed and instead slowing down to sputter along at an embarrassingly slow pace.
We may already be seeing some indications of this slowing. The famous Dow Theory is predicated on the notion that industrial stocks and transportation stocks should move in tandem with divergences potentially signaling a correction. Recently transportation stocks have rolled over while the industrials remain near record highs. In many respects, this action mirrors the bifurcated performance we have witnessed between energy, commodity and other economically sensitive stocks, and the rest of the equity universe.
Although we see many risks in today’s investment environment, we are by no means fatalistic. Certainly for as long as this game of Chicken lasts, it makes sense to be especially careful in committing new money. That said, as the game resolves, it is quite likely that investors will find a number of attractively priced securities. Whether this happens in one dramatic event, gradually over time, or periodically over time, it argues for a more opportunistic or "active" way of investing. It is a great time to have dry powder available and a well-established process to evaluate opportunities as they arise.