Investing is an inherently risky business with lots of uncertainties. At any given moment there are numerous questions the answers to which are not only unknown but unknowable. The future is not predictable and history can, at best, only act as a guide. Although rare, paradigm shifts do occur and one must always question whether it truly is different this time. I think it was Bertrand Russell who said that it's a healthy thing to "hang a question mark on the things you have long taken for granted". So we spend a lot of time around here asking questions. Here are the ones we are asking today:
- Are we in another tech bubble and if - when - it deflates, will it affect the rest of the market or the economy? I don't believe the current valuations of all tech stocks are in a bubble like they were in 1999 but that was a bubble for the agesת and it offers little comfort to an investor to say we haven't reached that type of extreme. I do believe that we are seeing behavior that in the past has signaled excess. The bidding for acquisitions, particularly in the fickle world of social media, is at least approaching the absurd. The valuations of private tech companies, as reported by the media, also seem based more on how much they might fetch from the greater fools who inhabit the public markets than anything like revenues and earnings. IPOs for tech companies have been coming fast and furious over the last year and one can't help but wonder if the venture capital folks know something the rest of us don't. Could a crash in tech stocks affect the entire market or more importantly the economy as a whole? For the market, the obvious answer in the short term is noת since we've already seen a big correction in some of the high flyers with little impact on the market as a whole. In the long term the answer is likely, but not assuredly, yes. The consequences for the economy are much harder to figure. Failure and losing capital on bad ideas is part of the capitalist process. It is only when capital is wasted on an epic scale (housing bubble) that dire consequences are certain.
- Does the recent slide in small cap stocks portend something ominous about the market as a whole? Will the S&P 500 follow smaller stocks lower into a true correction or-- God forbid-- a bear market? Is the small cap slide saying something about the domestic economy from which larger companies are insulated? There have been times in the past when small caps underperformed and it meant exactly nothing. There are other times when small caps have been the canary in the coal mine for a correction or bear market. Which is it this time? I don't know the answer but the question nags at me. Large caps aren't cheap either (fairly valued, overvalued or significantly overvalued seem to be the only options at present) but they aren't anywhere near the excesses seen in the Russell 2000.
- What is the UץץS bond market trying to tell us? Long term Treasury yields have been falling all year despite expectations of the opposite based on continued Fed tapering. We saw similar behavior in the long end of the curve the last time the Fed entered a tightening cycle. From 2004 to 2006ת the Fed funds rate rose 425 basis points while the 10 year Treasury only rose about 100 basis points. That didn't turn out too well, but maybe there are reasons long term interest rates should remain well behaved. Is innovation creating a long term deflationary wave? Is globalization doing the same? Or is the long end of the Treasury market signaling weak growth ahead? The 10 year Treasury yield generally tracks the rate of nominal GDP growth pretty well and if that remains true in the future as it has in the past, we better hope for some really low inflation or real growth is going to disappoint in a major way.
- Is the tapering of QE actually a tightening of monetary policy along the lines of previous cycles? Since the early 80s, every business cycle has ended with the Fed funds rate at a lower level. The 1990 recession was preceded by a Fed tightening cycle that took rates from 6% to 10%. Before the 2000 recession rates peaked at 6.5%. 2007 saw rates only get to 5.25% before the economy succumbed to recession. Now we're at 0% and the Fed has utilized QE since they can't cut rates anymore. Is QE the equivalent of negative rates? If so, will the economy be negatively affected when rates are back to zero again (in other words, when QE is over)? Or will somewhere south of full tapering get the job done? Or will rates have to rise off the zero bound before the economy rolls over? Can the economy handle higher interest rates? I'm not sure but the performance of the economy last year when long term rates spiked on taper talk would not seem to be a good sign.
- Can Emerging Market economies continue to grow if U.S. growth continues to disappoint? Can China successfully shift to internal consumption growth and away from export and capital spending growth? There has been a lot of ink spilled about the expanding middle classes of what are now called emerging markets. To what degree were these middle class expansions merely a function of the growth of China's exports to the developed world? How much of the growth in these economies was due to positive changes in economic policy and how much was due to capital inflows fleeing a weak dollar feeding credit expansion? Will the end of QE mean a return of those capital flows? I tend to think the age of treating emerging markets as an asset class are coming to an end. Countries that have used the Chinese boom as an opportunity to change their economies for the better can still advance while those that wasted the opportunity will fall back to their previous states. Despite their well publicized recent problems, I tend to think of China in the former category but then going from awful economic policies to merely bad ones is the easy part of the climb.
- Can profit margins for U.S. companies continue at levels well beyond the historical norm? That might be the most important question for anyone invested in the S&P 500. If margins can stay at these levels then valuations are stretched but not extreme. If not, then valuations are at levels that in the past have preceded some pretty awful long term returns. In a truly competitive global economy, high margins should get competed away but we've seen both peak and trough margins rise for U.S. companies since the early 90s. Part of that is because U.S. multinationals have taken advantage of the globalization of labor and cut their labor costs. Part of it is also probably due to the concentration of corporate profits in the finance sector, which requires less capital input than other industries. And part of it too is the favoritism shown to large companies, particularly finance related ones, in that time. One thing of which I'm certain is that profit margins will shrink in the next recession so maybe we should forget about the secular trends for now and concentrate on the cyclical ones.
- Are low yields in risky credit signaling confidence in future growth or just a reach for yield that will end badly? Junk bond yields are at all time lows and the spread between risky, less risky and risk free is miniscule. In short, one is not being compensated much for each new increment of risk. It is axiomatic to say that low spreads are followed by higher ones, but how low is too low? At what point does the risk outweigh any potential rewards? Personally, I think we passed that point a long time ago but junk bonds have just kept on rising.
- What do European bond yields say about the European economy? One of the greatest trades on the planet the last couple of years has been to purchase the debt of the peripheral European countries once known as the PIIGS. Spain and Italy bonds are now trading at all time low yields and even Greece is borrowing at rates that offer little reward for investing in a country that is a serial defaulter. German Bunds trade at a yield even lower than U.S. Treasuries. Are these low bond yields a warning about deflation in Europe or front running an expected launch of ECB QE? Or is it an indication that these countries are really working through their problems? If they are working through their problems or if the ECB launches QE, wouldn't that mean these bonds should have higher yields from better growth or higher inflation expectations?
- Where is the U.S. dollar headed? The U.S. dollar has been remarkably stable - at least if one looks at the trade weighted dollar index - the last few years. Like anything else, stability generally precedes instability so what direction will the next big move be? The direction of the dollar has wide implications from commodities to real estate to stocks.
- Have we reached peak inequality? The publishing of Piketty's book, Capital In The 21st Century, may mark the top in worrying about inequality and the divide between the returns to capital and labor. If the arbitrage of global labor has reached a peak - and rising wages in China point in that direction - then it may be that labor is about to gain the upper hand. The pressure to raise the minimum wage might be another indication that labor is getting its mojo back. If that is true, profit margins may also be peaking and as I said earlier, that probably isn't a good thing for stock investors.
- Are stock buybacks reaching a peak? In the past, high levels of stock buybacks have not been a good sign of future stock market returns. The last peak was in 2008 and 2009 marked the low point. Corporate executives seem to be better at timing the purchase or sale of their own stock holdings than they are at deciding when to buy company shares with shareholder cash. I also wonder how much longer companies can keep putting off capital spending to fund these purchases.
- Has leverage reached another peak? Everyone, it seems, is aware of the record margin debt outstanding but there are other danger signs as well. Goldman Sachs just granted a loan to Steve Cohen backed by his art collection. I highly doubt he is the only one and the art market appears to be softening a bit based on the latest auction results. Add in the pile of debt being incurred for leveraged buyouts, stock buybacks and dividends and corporate America is looking highly leveraged. In addition, HELOC originations were up over 40% in the first quarter and cash out refinancings were up 25%. Americans appear to have learned little from the bursting of the housing bubble.
- And what about housing? Mortgage originations have plummeted since last year and the private equity purchasing of surburbia appears to have run its course. There are pockets of housing mania again in the Bay area and maybe Miami again where preconstruction condo sales are again robust. Prices have risen to the point where young, first time buyers can't afford the downpayment or the monthly payments. Renting is the new black for a lot of people, so maybe apartment construction can continue to expand but with population growth waning and residential investment subtracting from GDP for two straight quarters, we may be near the end of this cycle. How will that affect the overall economy?
We have spent countless hours debating these questions and have come to our own conclusions (yours may be different; that's what makes a market). Profit margins will revert to the mean even if it is one that is rising on a secular basis. Bond yields are not speaking in tongues and the growth outlook has gotten worse recently, if not dire. There are areas of the market that are priced at levels we think are irrational with junk bonds, leveraged loans and social media stocks leading the pack. Tapering is tightening, but we don't know the level of rates that will prove lethal to growth except to say it is less than the last cycle. Emerging markets as a group will not decouple from Chinese and U.S. growth (although there will be exceptions). Housing is probably peaking for the cycle. Stock buybacks are no better timed this cycle than last. In other words, we don't see a paradigm shift; it isn't different this time.