The catch is, a boat this big doesn't exactly stop on a dime.
- Seaman Jones - Hunt for Red October
Whenever you find yourself on the side of the majority, it is time to pause and reflect.
- Mark Twain
The word of the year just might be paradox. In a normal year, the market is full of conflicting information and contradictory conclusions. 2018 and its historical asset valuations may set a new bar when it comes to investing paradox. A recent Bank of America Global Fund Manager survey shows a record high number of managers feel that stocks are overvalued, yet cash levels continue to fall. The upshot is that even though managers feel that markets are overvalued, they are forced to chase the market ever higher and deploy their cash holdings. An explanation for this data point is that managers act in this way in an effort to provide themselves with insurance against career risk. Chasing markets higher can be, in itself, just an effort to assuage investors who see the market returns and expect the same despite managers' historical models telling them to act more cautiously.
One data point that simply jumps off of the page from the fund manager survey is that close to 70% of fund managers believe that tax reform will lead to higher stocks in 2018. If 70% of managers feel that tax reform will lead to higher stock prices, and the stock market is a discounting mechanism, then shouldn't that idea already be factored into stock prices? In a world where for every buyer there is a seller, 70% is practical unanimity.
Here is yet another paradox. Low rates are a commonly ascribed reason as to why equity valuations are so high. Doesn't everyone expect rates to rise in 2018, including the Federal Open Market Committee (FOMC)? The FOMC itself has stated that it expects to raise rates three times in 2018. If it is widely expected that rates will rise and low rates are the reason for expensive equity valuations, then shouldn't equities be falling? We are left with the idea that the current market is in melt-up mode due to the twin engines of human psychology and market structure.
Current market structure is built on self-reinforcing algorithms engineered by computers. Computers run by market makers see buy orders and place other buy orders ahead of clients in order to implement more liquidity into the system. Market makers, by design, restrict themselves as to how much capital they put at risk. At a certain level, dictated by management, a market maker will cover their short or dispose of their long in order to manage risk. A high and rising market will lead to a market maker buying more, and a lower market will lead to a market maker dumping their position into a falling market. That leads to self-reinforcing loops. We now find ourselves in an era with lower volatility and grinding markets with self-reinforcing feedback. While we believe that the lower-volatility regime is partly a response to the lower human emotional component of investing, the emotions are still present and impactful. Investors currently find themselves chasing the market ever higher, as their models have told them to reduce their allocations to stocks, but yet, stocks push ever higher and clients demand higher returns. Hence, another self-reinforcing feedback loop.
"... algorithmic traders and institutional investors are a larger presence in various markets than previously, and the willingness of these institutions to support liquidity in stressful conditions is uncertain."
- Janet Yellen FOMC Chair Jackson Hole 8/25/17
We are currently seeing record low volatility with continued rising asset valuations, all while being in an era of experimental monetary policy attempted globally for the first time in history. After conducting their experiment of adding liquidity to ward off the greatest financial crisis since the Great Depression, central bankers have now begun to drain liquidity and lift interest rates.
Prices of bonds and stocks continue to advance further away from median historical valuations. That tells us that there is too much money in the system and it needs to be drained. The Fed and BIS (Bank of International Settlements) see that too, and are anxious to drain or, at the very least, stop adding liquidity. That tipping point of global central bank balance sheets draining liquidity instead of adding may happen sometime in the summer of 2018 if markets allow.
Central bankers have never attempted this before, and will now, in the next six months, begin to attempt the most difficult part of their act. In the face of this never-before-attempted trick by central bankers, we find investors are taking on even more risk. Are investors waiting to see who runs for the door first in an elaborate game of chicken? "Prices are still rising. I can't sell. I will miss out. I will get out before the other guy." It will be a small door when the music stops. It's like the boiled frog. A frog will jump out of a hot pot, but put him in a cool pot that slowly boils and he won't perceive the danger until it's too late. Investors are the frog as central banks slowly raise interest rates and drain liquidity. They won't know what hit them. Note the following quotes (courtesy of ZeroHedge) from Jerome Powell, the newly appointed Chair of the FOMC, from the FOMC Minutes in October of 2012.
[W]hen it is time for us (the Federal Reserve)to sell, or even to stop buying, the response could be quite strong; there is every reason to expect a strong response.
- Jerome Powell FOMC Committee Minutes October 2012
I think we are actually at a point of encouraging risk-taking, and that should give us pause. Investors really do understand now that we will be there to prevent serious losses. It is not that it is easy for them to make money but that they have every incentive to take more risk, and they are doing so.
- Jerome Powell FOMC Chair FOMC Minutes Oct 2012
Since the election of Donald Trump in November 2016, we have postulated that we were on the precipice of a melt-up in stocks. Since that time, we have seen the S&P 500 rally by over 28%. It was not the election of Trump that led to that thought process, it was an amalgamation of set points that had come together at that instant to provide the fuel for the rally. The election released the Animal Spirits of the market. We felt that investors would be spurred by the idea that deregulation, tax reform and infrastructure spending would lead an economy, which was primed and ready, to go to greater heights. But most importantly, the groundwork for this rally was put into place prior to the election by the members of the FOMC. What the FOMC had put into place was similar to kindling and gasoline looking for a spark, and that spark arrived in the form of tax reform and deregulation.
The above quote from Powell deserves to be read again. By engineering QE, the FOMC took steps to actually encourage risk-taking, and with that, the FOMC had created a moral hazard. Moral hazard is the idea that investors could, and should, count on the Federal Reserve to effectively bail them out if things went wrong. Investors have been trained to think that if there is a significant selloff in the market, then the Fed will add liquidity. Perhaps even begin a new round of QE if the sell-off is bad enough. That leads investors to think, "Why sell?" No one sells. The market just heads higher. People have adjusted to the new paradigm. Whenever the market gets in trouble, the Fed bails it out. 1987. 1998. 2001. 2007. 2011.2012. 2015. That has investors asking, "Why ever sell"?
The moral hazard of the Fed gave rise to what became known as The Greenspan Put. The put was the level in the market, which if the market ever fell to, the Federal Reserve would ride to the rescue, add liquidity and save the markets from themselves. The Federal Reserve gave no reason for investors not to take on risk, and substantial risk at that.
Another factor in the rise of animal spirits has been the parabolic rise in the price of Bitcoin and the mania surrounding it. It has helped drive investors to an extreme in bullishness anticipating future investing profits. Now, bullishness in itself is not bad, and in fact, an extreme level of bullishness can portend further gains, but we do believe that it sets markets up for difficult comparisons. Most major tops and bottoms in the market in recent years have what is seen as a negative divergence in its level of Relative Strength (RSI). We are currently seeing extreme levels of RSI in the broader market. Having hit this level of extreme bullishness, we should see some sort of sell-off or just a breather in markets' rise. Having had that breather, when we approach these levels again, comparisons become very difficult. If those levels of bullishness do not hit prior levels, investors may see that as a negative divergence and begin to take off risk. Bitcoin's parabolic rise is a sign of mania in markets, and caution should be paid. The FOMO - "Fear of Missing Out" - has investors, perhaps, getting in a little over their heads.
Giddy Up and Getting Giddy
We learn far more when we listen than when we talk, so when smart people talk we listen. David Swenson is the chief investment officer of the Yale Endowment. He is seen as the Michael Jordan of endowment investing. We have rarely seen interviews of him, but we came across this one in November of last year at the Council on Foreign Relations. He was interviewed by Robert Rubin, the former US Treasury Secretary and CEO of Goldman Sachs. My take on "uncorrelated assets" is that a good portion of what he is talking about is cash or cash-like instruments that do not move with the stock market.
Rubin: Did I hear you say that you have 32 percent now in uncorrelated assets?
Swensen: That's correct.
Rubin: More than you had in '08, when we were in recession?
Swensen: Slightly more, yeah.
Rubin: Do you think we're in recession, or what scares you that you really want to have a recession-level of cash?
Swensen: Yeah. So I'm not worried about the economy so much. I have no idea what economic performance is going to be over the next five or 10 years. What I'm concerned about is valuation. I think when you look at pretty much any asset class anywhere in the world, it feels expensive. And the handful of areas that I talked about where I thought there were opportunities are kind of niche-y-short-selling, Japan, I think there's some opportunities in China and India, although it's hard to call either of those markets screamingly cheap either. So it's really a question of valuation, not a question of economic fundamentals.
For now, we ride markets higher. We ride them higher with lower equity exposure and lower durations, but ride them we must, as our clients need a return on their assets to provide for current and future liabilities. But we grow in caution as giddy investors' confidence grows with their account balances. We are concerned because valuations are historically high, because interest rates are historically low. If we believe that asset valuations are a derivative of the risk-free interest rate, then shouldn't valuations be falling as interest rates are rising? Or, perhaps, valuations will just drop off a cliff when interest rates hit some theoretical number? Will it be 3% on the 10-year? 4%? 5%? No one knows this theoretical number, so is it not prudent to scale back your risk allocation given that higher interest rates are on the way? The frog is in the pot. The water is getting warmer. You cannot plan to get out before everyone else. We recalibrate our risk perspective. The trick is that human nature has us chasing higher and higher equity prices because we have fear of missing out.
The market is a massive naval ship running full steam ahead. It doesn't stop on a dime. The markets could continue to rage. We recalibrate and adjust our asset allocations because when turning points come, they will come quickly and seemingly come out of the blue. The Fed cannot react to every market twitch, and if they are truly dedicated to reducing their balance sheet, then they will have to raise their pain threshold, and that makes the Fed Put lower (and more painful) in terms of the level of the S&P 500. For now, we recalibrate, accept slightly lower rates of return and brace for a shock with non-correlated assets as our cushion.
We continue to believe that central bank purchases will dictate asset pricing, and while we can try and predict when asset flows will turn negative, we cannot predict when markets will react to that reversal in flow. For now, buy the dip still reigns, while volatility selling strategies are de rigueur. In a self-reinforcing loop, the current paradigm reflects an assumption of the continuance of the status quo, and trades built upon that will grow ever higher in AUM. That will make the break all the more painful and swift.
In economics, things take longer to happen than you think they will, and then they happen faster than you thought they could."
- Rudiger Dornbusch
Since November 2016, we have postulated that we were on the verge of an animal spirits-led melt-up, and we projected that much like 1987, we would see a 30-35% rally in markets before a letdown in prices. We may have underestimated the animal spirits. A strong 2017, followed by a strong start to 2018, could lead to further gains. We may also have underestimated current market structure, as it may be causing markets to have longer, less volatile regimes, and that regime change may become less and less frequent.
We feel that while we are in the late stages of a bull market, it is best to pull back on risk, and while late stages of bull markets can see spectacular returns, we nor anyone else knows when that comes to an end. So for now we are in it to win it, but just a little less in.
2018 has come in like a lion. We think that a correction in 2018 is likely, and how the Federal Reserve responds to that correction is likely to determine how long and how deep that correction is. Tax reform is priced in, and economic news has been positive. While those positives are now baked in the cake, disappointing actual results from tax reform could impact pricing. Also, impact could be felt from rising bond yields as investors seek safe haven in bonds over stocks. This week, the rate on the 2-year bill rose above that of the S&P 500 yield for the first time since 2008. Investors may begin to see bonds as an alternative to equities. If a correction should come, we would expect it to be sharp and scary, but it will set equities up for another leg higher in 2019 and beyond. We believe it is prudent to be a bit more conservatively positioned this late in the cycle and expect lower returns in order to be prepared to profit from others panic and flawed market structure.