A Bubble in "Safe Assets?"
Bloomberg recently published an article on a report by Seth Masters, the chief investment officer of Bernstein Global Wealth Management, entitled “Desperately Seeking Safety.” Masters argues that bonds, gold and "safe" stocks are all "dangerously overpriced." To be sure, we at least partly disagree with this thesis on the grounds that first of all, one cannot simply regard all these assets as belonging to the same class. The temptation to do so stems mainly from the fact that they have risen in parallel for a long time due to specific historical circumstances. However, if we look back to the 1970s, we can see that these assets can often take completely different paths. It all depends on the precise type of economic and market upheaval the world is experiencing.
Moreover, the pricing of these assets reflects the ongoing uncertainty in a world that is in the grip of the lunacy of policymakers who have seemingly lost all sense of perspective and are engaged in a huge gamble. This essential fundamental backdrop has not changed for the better lately, but for the worse. Masters has to assume that these crazy policies will somehow "work" all of sudden in order for his argument to fully stand up.
However, we do in principle agree with a number of points he makes – such as the fact that one's future returns are highly dependent on where in a price cycle one buys, and that any asset can become too expensive at some point. We also agree with him that massive stock buybacks don't produce better or "safer" stocks.
In fact, it is our experience that stock buybacks usually surge at precisely the wrong moment, leaving balance sheets precariously overstretched when the time comes in which balance sheet strength might be highly desirable.
We want to briefly look at a particular aspect of the "safety bubble" here, namely its expression in the stock market. Below are three randomly chosen long-term charts of stocks that are usually considered nigh "recession-proof" and are deemed highly reliable dividend payers.
Johnson & Johnson – a stock that is widely regarded as "recession-proof."
Procter & Gamble – the same holds for this stock.
Wal-Mart also belongs to the class of "safe stocks."
It is no secret what is driving the buying in these stocks – it is the aforementioned uncertainty that is the main motive behind it. Investors are still seeking "safe havens" and stocks like the ones depicted above fit the bill. However, the incessant buying over recent years has undoubtedly reduced the margin of error associated with owning these stocks. They may be "safe," but how safe can they really be once they have become this expensive? With regard to this, Masters certainly has a point.
As an aside to all of this, gold is obviously also no longer the bargain it was in 1999/2000 and bonds no doubt look overstretched as well. The main difference between gold, bonds and the stock market is that the former two are assets that according to recent surveys are hated with a passion by investors, while stocks are currently getting more love than ever before in history.
Who Is Buying?
In the above context, we have come across another very interesting recent article in the WSJ that may at least partly explain who it is that is so desperately paying up for "safe stocks." Apart from deluded central bankers, bond funds are increasingly straying from their reservation and are piling into equities. Bond funds, writes the WSJ, are "running low on bonds" these days.
"The number of bond funds that own stocks has surged to its highest point in at least 18 years, another sign that typically conservative investors are taking bigger risks to boost returns.
Regulators generally allow funds to hold a mix of assets, but the scale of bond funds' shift into stocks is unusual, fund experts said, and could expose investors to unexpected losses. In all, 352 mutual funds that are classified by Morningstar Inc. as bond funds held stocks as of their last reporting date, up from 312 at the end of 2012 and 283 in the first quarter of 2012, according to the investment-research firm.
The rush into stocks illustrates the dilemma bond investors face. The bond market has rallied for much of the last 30 years, and yields, which move in the opposite direction of prices, stand near record lows.
When bond-fund managers buy stocks, "They're reaching for yield," in the form of dividends, said Russ Wermers, a finance professor at the University of Maryland who studies mutual funds.”
"Reaching for yield" rarely works out well. We are not sure when that phrase was originally coined, but it became incredibly popular in 2006 and 2007 to describe the rush into all sorts of "structured products" like ABS, CDOs, CPDOs, high-yield bonds, PIK bonds and so forth.
As noted above in the WSJ article, this rush into equities by bond funds "could expose investors to unexpected losses." We would actually rephrase that: it will expose them to unexpected losses with near certainty.
Bond funds holding equities – an 18-year high (chart via the WSJ)
What this once again demonstrates is that intervention by central banks is creating incentives for many institutional investors to take inordinate risks in the name of preserving the purchasing power of the savings that have been entrusted to them. This is inter alia a symptom of what happens when central banks are holding interest rates well below their natural level. In the real economy, malinvestment of capital occurs on a grand scale, while investors are increasingly taking risks they would usually shy away from.
This is of course a declared goal of current central bank policy: namely to encourage risk taking, whether or not it is sensible. The problem is that the gains of today are absolutely certain to become the losses of tomorrow for investors taking the bait, as the echo bubble created by loose monetary policy is fated to turn into a major bust once the boom has played out. When the tide is going out, a great many naked swimmers will be revealed.
This time we believe that the coming bust will shatter the last bastion of investor faith: the illusion that central banks are omnipotent and can "fix" the economy and markets by waving their "magic wand" in the form of the printing press.
Charts by: Finviz, WSJ