State And Main - ZIRP And Its Effect On Value

Includes: AGG, DIA, SPY
by: Bloodhound System

"Investing is the intersection of economics and psychology." Truer words may not have been written than those by Seth Klarman in his annual letter to limited partners of the Baupost funds.

We have noted for some time at the Bloodhound Exchange that government efforts (particularly the Fed) to maintain a balanced economy have created a skewed risk/return environment.

The Fed's ZIRP (Zero Interest Rate Policy) has created a ceiling (and essentially a floor) on the observed risk-free rate. The theory behind ZIRP is that low interest rates stimulate investment while allowing consumers and businesses to finance more easily and discourages banks from hoarding capital, equating to more production and lower unemployment. Lower rates have an added bonus of allowing the government to spend under Keynesian economic theory without the penalty of a burdensome interest carry.

However, as with most actions, there are also unintended consequences. Abnormally low rates cause investors to reach for yield and cause major distortions in fixed income investing. At some point, the Fed buying needs to stop, and the Treasury needs to find natural buyers for what they are selling. We have discussed in multiple posts about the potential of the bond market being in a bubble. Bubble or not, the risk/reward trade-off for fixed income buyers is not in their favor (see Bond Conundrum).

James Montier, author of 'The Little Book of Behavioral Investing' noted,

"William McChesney Martin was the longest-serving Federal Reserve Governor of all time. He is probably most famous for his observation that the central bank's role was to "take away the punch bowl just when the party is getting started." In contrast, Bernanke's Fed is acting like teenage boys on prom night: spiking the punch, handing out free drinks, hoping to get lucky, and encouraging everyone to view the market through beer goggles.

Although we think that stocks have a better comparative profile when combined with a long-term investment strategy, it should be noted that the effects of ZIRP are not limited to the bond market. If one were to use the old Fed Model, all stocks would be screaming value stocks today. The Fed Valuation Model is a simple method to sort out relative valuations between the bond versus stock markets. It, at one point, was acknowledged as one of the Fed's favorite tools to measure investor sentiment. If the 10-year Treasury interest rate was 5%, the P/E ratio would be 20x. Yet that metric today would imply a P/E of more than 50x. However, that model assumes a "guns" or "butter" trade-off between stocks and bonds. In fact, that measure shows the disequilibrium created by the interest rate environment.

From one aspect, the ZIRP policy has conceptually worked as it relates to financial assets. Stocks were up 12% in 2012. Bank stocks such as Bank of America (NYSE:BAC) doubled off their lows. The real estate market has signs of recovery. REITs returned 15%. However, in a general economic sense, ZIRP has failed to jump start GDP or improve the unemployment rate materially. As such, it has potentially distorted more than just bond values, but rather has created a disconnect with all value assets and their intrinsic properties.

Value investors seek to buy assets including equities below the intrinsic and relative value. Founded in 1982, Boston-based Baupost is one of the better known value-focused investment strategies. Klarman's market analysis isn't to find the next greatest thing, but rather that which trades below intrinsic value. He lays out the ultimate value investor's proposition, "we make no heroic assumptions in our analysis, hoping, instead, that by compounding multiple conservative assumptions, we will crease such a substantial margin of safety that a lot can go wrong without impairing our capital much or even at all." Their annual letter released last week voiced their own concerns.

"Investing today may well be harder than it has been at any time in our three decades of existence. [The Fed's] relentless interventions and manipulations have left few purchase targets. [The] underpinnings of our economy and financial system are so precarious that the un-abating risks of collapse dwarf all other factors.

As investors have become accustomed to sputtering economies and massive government intervention, episodic "risk-on" and "risk-off" behaviors drive the capital markets. Unexpected bad news means risk off. A stopgap solution to the crisis du jour is offered - i.e., a bailout, a rescue, a Band-Aid deal, QE(n) - and risk on resumes. We have been on a roller-coaster ride for the last four years and counting, with no meaningful recovery, no feasible solutions, and ineffectual leadership. Investors conditioned to the short-term trading mentality are increasingly ill prepared for policy changes. What will happen when the Fed declares, as it someday must, that the era of low interest rates is at an end? What if governments holding trillions of dollars of sovereign debt and other securities stop buying and begin to sell? Or if another serious crisis - economic, political, international - materializes and governments have insufficient ammunition to intervene? The content, though not the timing, of the next chapter in market history is quite predictable. Few will say they saw it coming, though, in fact, everyone could have seen it if they had only chosen to look."

Baupost's risk antennae are clearly up. Nevertheless, their December 31st 13-D filing suggest they still remain invested even though they have adjusted some of their bets. Almost 18% of their holdings are consumer cyclicals and only 1% are in consumer defensive names. Although they built a sizable stake in American International Group (AIG), they eliminating their stake in Hewlett-Packard (HPQ). HP is significant in that noted short-seller, Jim Chanos, came public with his bearish thesis on the company pointed to declining PC sales and labeled it a "value trap." Baupost also shifted their stake in Microsoft (MSFT) swapping stock for two million call options. That trade can have multiple objectives. On one hand, Baupost could be leveraging their potential return on MSFT, on the other, they could be minimizing exposure. It should also be noted that hedge funds are only required to release their long positions. Any short holdings, or increase of them, would be a mystery to an outsider.

We reflect on this in light of the minutes of the FOMC January 29-30 meeting. While assessing the outlook for growth and unemployment, the Committee's members debated the risk that ZIRP may be creating price bubbles for certain assets. The Committee was split with "many participants" expressing concerns on how long their bond purchase program can continue. The details of the split can be seen directly in the minutes [my emphasis]:

"Many participants also expressed some concerns about potential costs and risks arising from further asset purchases. Several participants discussed the possible complications that additional purchases could cause for the eventual withdrawal of policy accommodation, a few mentioned the prospect of inflationary risks, and some noted that further asset purchases could foster market behavior that could undermine financial stability. Several participants noted that a very large portfolio of long-duration assets would, under certain circumstances, expose the Federal Reserve to significant capital losses when these holdings were unwound, but others pointed to offsetting factors and one noted that losses would not impede the effective operation of monetary policy. A few also raised concerns about the potential effects of further asset purchases on the functioning of particular financial markets, although a couple of other participants noted that there had been little evidence to date of such effects…

A number of participants stated that an ongoing evaluation of the efficacy, costs, and risks of asset purchases might well lead the Committee to taper or end its purchases before it judged that a substantial improvement in the outlook for the labor market had occurred. Several others argued that the potential costs of reducing or ending asset purchases too soon were also significant, or that asset purchases should continue until a substantial improvement in the labor market outlook had occurred. A few participants noted examples of past instances in which policymakers had prematurely removed accommodation, with adverse effects on economic growth, employment, and price stability."

The Fed's balance sheet currently surpasses $3 trillion in assets, $2 trillion in Treasuries and $1 trillion in mortgage securities. They agreed to review their $85 billion-a-month bond buying program when they meet again March 19-20. At some point the Fed has to stop intervening, and the Treasury will need to seek natural buyers for what its selling - and theoretically may even need to compete against the Fed who just might be selling the same commodity. Then, and only then, will we have clarity on what it means to return to normal. Fixed income will likely bear the brunt, but certain other value investors are clearly becoming concerned.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.