Dennis C. Butler, President
of all guest columns written by Dennis C. Butler, CFA
nless you happen to be among those people who are dependent on the cash flow from fixed-income investments to support your lifestyle, what’s not to like about how business activity and the financial markets have been performing so far this year? Not only is the economy chugging along at a reasonable rate of growth, it has entered its 121st consecutive month of growth, thereby becoming the longest expansion since 1854. Stock averages are up, extending the bull market further into its tenth year, and June was a particularly good month with the Dow Jones Industrials having their best June since 1938, the S&P 500 the strongest since 1955, and the best since 2000 for the NASDAQ. Oil prices are relatively stable despite rumblings in the Middle East. Interest rates are lower, reducing the cost of home mortgages and other borrowings. Jobs remain plentiful and incomes are rising, all while inflation remains surprisingly subdued. Although the income-starved may grumble, the flip side of lower interest rates is higher bond prices, so for those for whom “total return” (income plus price change) is important, such as fund managers, it has been a good year to own bonds, especially those issued by governments, as rates on about $12.5 trillion of sovereign debt have once again plumbed sub-zero depths. Indeed, for the first time since 1995, both equities and long-term government bonds posted double-digit returns during the first half of 2019.
This is mostly good news, especially for owners of real and financial assets, but since we are paid to, among other things, think the unthinkable — such as the possibility that markets might go down as well as up — we are naturally inclined to be on the lookout for signs of potential trouble. For example, the simultaneous strength in stocks and long-term bonds would generally not be the case; economic growth tends to favor stocks, while lifting inflation and interest rates, which is bad for bonds. This leads us to suspect that one of these markets may be subject to a painful adjustment as events unfold going forward. You don’t have to look too far to find other trends that should be of concern (or interest) if you are a long-term investor. We discuss some of these below.
Desperate people do desperate things, and there are few places where this human trait is more dangerous, or more easily implemented, than in the investment business. To see this principle at work, let’s review a little history. Interest rates in the U.S. peaked in the early 1980s, when short-term government debt traded at yields approaching 20%. Since then rates have been on a long-term downward trajectory, which seemingly bottomed during the past decade or so, when at times some U.S. treasury paper yielded practically zero (the U.S. has not experienced negative yields as yet). Investors who had become accustomed to the unusually high yields prevailing at the dawn of the great bond bull market in 1982 were inconvenienced as rates fell; already in the 1980s one heard complaints about too-low yields, although by today’s standards they were exceedingly generous.
The continuing decline in interest rates during the ensuing decades fed “reaching for yield” behaviors, whereby some investors, striving to maintain their accustomed income streams, took on additional risk, either credit (“junk” or “high yield”) or price (long-term bonds), or both. In addition, central bank policies, culminating in “quantitative easing” during the 2008 financial crisis and its aftermath, flooded the financial system with money that made its way into pools of income-seeking capital, thereby creating tremendous demand for securities to produce that income. The market for newly issued “junk” bonds was fueled by investors seeking yield, and new instruments were created, such as “derivatives,” that fed directly off the fact that too much money was seeking alternatives to the meager offerings found in the conventional places. The financial crisis was at least partly a result of “creative financing” in which mortgage securities were cleverly repackaged to appeal to income-starved investors who often were ignorant of the risks they were incurring. Indeed, the vast demand for yield led Wall Street to set up an entire ecosystem designed to accumulate risk and distribute it to parts unknown.
Some of these new ways of losing money lost favor after the blow-up in 2008, but in the decade since, the reach for yield appears to have become even more desperate in the environment of negative sovereign yields. The old standard — junk bonds — finds perennial favor, and bank loans to risky, heavily indebted companies repackaged into securities have attracted ready buyers. Derivative securities, known to be at the heart of the financial crisis, are making a comeback as well (although in safer forms compared to the earlier incarnation, their promoters assure us).
Another striking development has been in property. Long preferred by investors for its safety and relatively stable income streams, the market for real estate has become increasingly institutionalized and commoditized. In the aftermath of the crisis, private equity firms (firms which manage large pools of capital which they invest in private businesses) began to buy foreclosed properties at bargain prices. Huge pools of income-seeking capital, directed by such firms, have flowed into properties worldwide, driving up prices and shrinking returns. Economic growth and increasing wealth abroad have also led to an influx of foreign capital into real estate markets, seeking stability and refuge from unpredictable political systems. When outside capital flows into local markets, valuations are often pushed up beyond what local residents can afford. These capital inflows and structural market changes have created a wave of speculation, as financial buyers move in, hoping for a quick profit by “flipping” properties.
None of these trends necessarily foreshadow immediate trouble for bonds or real estate, but they do indicate a degree of complacency among those who are committing capital at ever-lower expected rates of return (high prices). There seems to be a high degree of comfort with the current state of affairs despite the heightened level of risk it signals. Already in markets such as New York City and London we are beginning to see the aftermath of excessive optimism in high-end real estate, as tax changes and political disputes upend expectations and puncture asset bubbles. In both markets, dwellings developed in anticipation of future sales are going unoccupied, and properties placed on the market sometimes have to be marked down more than once to attract buyers.
Not to be overlooked, the stock market, too, is showing signs of being overextended, even as the averages march higher. Valuations are at the high end of their long-term ranges, but of greater import is the fact that 2019’s healthy gains appear far less robust when you look “under the hood” to find that a small number of stocks account for an oversized portion of the rise. At one point in June the shares of only four companies were responsible for 25% of the S&P 500’s year-to-date rise. Fully one-third of the second quarter’s strength could be attributed to five companies. As the market technicians like to say, this is a “narrow” market, led by a small group of high-market-value issues that move the averages.
While we are not normally very attuned to or interested in such “market internals,” narrow advances such as this catch our attention because they have in the past signaled subsequent market weakness. The Dotcom period was the greatest recent example of this phenomenon, and while the current market dynamics do not match the extremity of that now two decade-old romp, they do deserve respect as potential forerunners of turbulence. They also help to explain the strength in the indexes at the same time the broader stock list is far less robust.
Stock market operators also have their version of “reaching for yield,” or “gain” in this case. During the financial crisis it was possible to acquire the stocks of major companies very cheaply; in fact, the entire market was as depressed as it had been for many years, and simple index funds could have been purchased to advantage at very reasonable prices. In the ensuing years such commitments produced strong results. Returns like those are now hard to come by, as the prices of most assets have become inflated. In hopes of maintaining a record of good returns, some investment managers have turned to obscure, unlisted securities (not traded in public markets) from which they hope to profit when the issuing companies eventually go public. Aside from the investment risk that such companies might fail, there is also a liquidity risk in that the positions cannot be sold easily. One British manager who had resorted to this strategy suffered catastrophic damage when his funds did poorly and investors began to demand their money back.
Our intent in these cautionary remarks is to be neither a Chicken Little nor a Cassandra. The fact is, there are very few times in this business when the markets are so obviously in your favor that one can throw caution to the wind and make commitments with confidence, knowing that the odds of good results are very high. Most of the time the choices are not abundantly clear, which is why caution and skepticism are good traits for the investor to possess. After the last ten years of strong results and increasingly aggressive behavior in certain corners of the investment world, we would encourage readers not to entertain hopes for high expected returns going forward. We say this not as a market forecast, but rather out of concern for preserving capital. Conditions will change at some point, they always do; we may even have another opportunity to throw caution to the wind, so to speak. When the change occurs you do not want to be exposed to leveraged loans, “unicorns,” or any of the currently popular Wall Street creations, since they are usually the first to lose favor and suffer grievous losses. At those times the “conventional places” may look very attractive indeed.
Dennis C. Butler, CFA, is president of Centre Street Cambridge Corporation, investment counsel. He has been a practitioner in the investment field for over 33 years and has been published in Barron’s. He holds an MBA from Wharton and a BA in History from Brown University. His quarterly newsletter can be found at www.businessforum.com/cscc.html.
“Current low valuations reward the long-term view”, an article by Dennis Butler, appears in the May 7, 2009 issue of the Financial Times (page 28). “Intelligent Individual Investor”, an article by Dennis Butler, appears in the December 2, 2008 issue of NYSSA News, a magazine published by the New Yorks Society of Security Analsysts, Inc. “Benjamin Graham in Perspective”, an article by Dennis Butler, appears in the Summer 2006 issue of Financial History, a magazine published by the Museum of American Finance in New York City. To correspond with him directly and /or to obtain a reprint of his featured articles, “Gold Coffin?” in Barron’s (March 23, 1998, Volume LXXVIII, No. 12, page 62) or “What Speculation?” in Barron’s (September 15, 1997, Volume LXXVII, No. 37, page 58), he may be contacted at:
Dennis C. Butler
Centre Street Cambridge Corporation
Post Office Box 390085
Cambridge, Massachusetts 02139
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© Copyright 2019 Dennis C. Butler, All Rights Reserved
Revised: July 10, 2019 TAF
© Copyright 2019 Dennis C. Butler, All Rights Reserved