In our previous posts, we (1) reviewed the valuation of the Market based on CAPE and forward operating earning estimates for the S&P 500, which are two indicators that provide a general estimate that the Market appears expensive; and (2) we noted that our anecdotal evidence is indicating that there appears to be fewer undervalued companies in the current environment and in some cases free cash flow is not keeping pace with earnings. In the following, we will take a brief look at general investor sentiment.
Sentiment: The Search for Yield
Market participants and the main stream media seem to be very bullish and this worries us. With such sentiment, investment decisions tend to ignore risk and are primarily motivated by high return possibilities. At present, one frequently heard cliché is “the search for yield.” A phrase that emphasizes only returns. While most of our opinion has been focused on the equity market, a great example of this return-only sentiment comes from James Murren, the chief executive officer of MGM Resorts International, when in an October interview he said, “The bond market will get better. People are going to start to have a more positive outlook toward 2011. They’re going to be searching for yield and they’re going to go down the rating scale and that’s going to benefit companies like us.”
The current environment benefits non-investment grade companies like MGM Resorts International that need to issue more debt and can due to investors need for yield. Yet, Murren fails to mention that MGM’s junk bonds come with large risk of default and that is why they are trading at a high yield. To illustrate this general risk of default, here are a few statistics from the U.S. Municipal Bond Fairness Act of 2008 on cumulative historic default rates:
(1) For all non-investment grade corporate bonds the default rate is 31.37% for those bonds evaluated by Moody’s and 42.35% for those bonds evaluated by S&P.
(2) For corporate bonds rated in the Caa-C/CCC-C ranges the default rate is 69.18% for those bonds evaluated by Moody’s and 69.19% for those bonds evaluated by S&P.
The reader should note that MGM just issued $500 million of bonds rated CCC+ on October 25, 2010. Given MGM’s credit ratings and the fact that the economy is still extremely fragile, MGM and other non-investment grade companies should be having trouble finding investors, but they are not. Non-investment grade corporate debt has been issued at historically high levels during 2010. Investors are so desperate for a return that they are risking their hard earned money on an opportunity that has approximately 69% probability of failure. To be clear, while the risk/reward of these investments are unappealing to us, it’s the ease and the magnitude at which companies are able to issue their junk debt that makes us uneasy. We believe it is easy to see our concern.
Sentiment: Institutional and Individual Investors Bullish
While the above was an example of the sentiment in the debt markets, sentiment in the equity markets is very similar. The general sentiment at both the institutional and the individual investor level remains very bullish.
At the institutional level, according to the Investment Company Institute, mutual funds as of October 2010 were holding approximately 3.6% of their assets as cash, which is near historical lows (please look at this chart from ZeroHedge). Such a low percentage of cash holdings is a sign that the mutual funds are very bullish and nearly fully invested.
One argument we’ve seen defending this statistic is that asset prices have increased while cash balances have remained stable, thus only on a percentage basis have cash balances declined. This argument is irrelevant, in most cases, relative levels are more important in portfolio management than absolute levels. Mutual funds participate in rebalancing activities all the time, to take some positions that have gone up in value and liquidate a portion to cash is not a hard act, nor is it unusual. We believe that this statistic indicates that mutual funds remain bullish as they continue to “search for yield,” and do so in a manner that is not protective of the capital being entrusted to them.
In our opinion, very low cash levels indicate a mentality that ignores risk and searches for yield. Cash is a very valuable position in a portfolio and offers the portfolio manager the chance to buy assets at low prices if there is a dip, or rather a downturn in prices.
For instance, assume we are observing a mutual fund that is long-only (which most are) and its portfolio manager is fully invested in an asset class. If prices for the asset class drop, then most of fund’s assets will drop in value and hurt his returns. With no cash he cannot buy into the asset class at these lower prices, without realizing some of his current losses. One should note that the asset class will likely experience increased prices in the future as markets tend to be cyclical, thus allowing the mutual fund to make up some of its losses. However, mathematically, the mutual fund’s initial positions have to increase in price at a greater rate than they declined in price to fully offset the losses, which can be a tall order as the Market is still not at its pre-crisis levels.
Nevertheless, a larger relative cash position allows the fund to hold a position that did not decrease with its other investments. With the fund’s target asset class priced lower, the fund can use its cash balance to buy the asset class at reduced prices. When prices of the asset class increase, the new positions acquired with cash will mitigate the losses experienced during the downturn. In this way, we believe holding a cash balance of at least 5% of assets is imperative, especially for long-only funds which cannot short to hedge against losses. Holding a cash position is responsible and a policy that portfolio managers implement when focused on both returns and risk.
Furthermore, one popular argument by a few institutional investors to justify the current bullish sentiment in the market is that the Federal Reserve (the “Fed”) will not allow the Market to drop substantially. Basically, do not fight the Fed. David Tepper, a very well respected and successful hedge fund manager, was on CNBC at the end of September expressing this view that the Fed will continue to increase liquidity in the various markets via quantitative easing in order to keep asset prices afloat even if the economy experiences a slow recovery or enters into another recession. Thus, the Fed’s intervention has put a floor on how far asset prices may drop in the future and provides investors with some protection.
This argument depends on quantitative easing being an effective tool and that remains extremely debatable (and outside the scope of this piece). Moreover, this argument bears a very strong resemblance to the notion, which has repeatedly come up during the 20th century, that the U.S. has managed to overcome the downward fluctuations of the business cycle (a piece to consider on this topic). As we know, every time that claim has been made by someone, it has been proven incorrect. Besides having history on our side, we do not believe that the Fed is large enough to successfully implement a floor on Market prices during a period of panic and fear. Furthermore, the Fed’s balance sheet is already loaded with risk assets and its tools at this point in the game are rather limited. Through out the history of equity markets regulators have continued to implement rules and laws to prevent bubbles and downturns, yet we still experience them. As long as greed and fear exist as human emotions, market and business cycles will continue to persist.
On the individual level, we have noticed the same bullish sentiment that has been seen at the institutional level. This bullishness of individual investors is illustrated in the chart below, which depicts the weekly results of the American Association of Individual Investors (“AAII”) individual investors’ sentiment survey. The period covered in the chart begins 1/6/2005 and ends 11/24/2010.
Historically, there have been instances where very bullish sentiment preceded significant Market downturns. We believe the current bullishness is not justified by the current risks, which will be detailed on Friday, and the operating fundamentals of the companies. As seen above, market participants appear too focused on returns and not on the preservation of capital. Nevertheless, such optimism does not guarantee a downturn in the very near future, but it is another reason to be cautious, especially if the Market’s price continues to increase.
To be continued on Friday with more analysis on risks and some basic steps one can take to protect himself.
Disclosure: No Positions