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Landmines in the Field of Dreams

Whether the focus is on shares, property or other financial markets, we have entered an environment of low returns. Anyone believing they will see double-digit returns from stock market indices is not just optimistic but misguided. It is therefore more important than ever to find other avenues to generate alpha (the active return over an index). Every bit of alpha will be that much more valuable in a low return regime. Thanks to the many instances of structural industry declines and disruption, there is a rich vein of opportunities, for anyone with the right framework, to profit and add alpha from short selling. That is why we launched a global long/short fund last year and we will soon offer a similar structure in domestic equities.

Struggling to stimulate

In 2014, the low point for the S&P500 was 1782. Shortly afterwards, the reported earnings for the S&P500 was $106.00 per share (September quarter). Today, the S&P500 is almost 16% higher at 2066 but earnings have declined to $86.44 per share, a fall of 18.5%. It is true that in the short run the market is a voting machine, so factors other than earnings have clearly influenced the multiple of earnings investors have been willing to pay for a share. And right now, the market is willing to pay 24 times earnings. But in the long run, the market is a weighing machine and prices generally reflect underlying economic performance. Unless the trend in earnings reverses, share prices could be under pressure.

Clearly, quantitative easing (QE) is doing part of the job that was intended.

During the GFC, banks significantly reduced their lending, retaining excess reserves. The effect of this behaviour was a decline in the money multiplier (credit) and total money supply. Amid fear (thanks Japan) of deflation, the US Federal Reserve tried to increase demand for credit by reducing interest rates. High pre-existing debt levels, however, failed to spur spending rendering this conventional lever of monetary policy ineffective.

Quantitative easing commenced and as with cutting interest rates, its intent is to stimulate the economy by encouraging banks to provide more loans. And if it also convinces investors that the Fed is serious about fighting deflation it can raise confidence and economic activity.

Since the GFC, there has been a global drive to cut interest rates and purchases of bonds now exceed US$12 trillion, yet anaemic growth (or negative growth if you’re looking at S&P500 earnings) remains with us.

What QE has done is triggered the sort of reckless financial behaviour that presaged the GFC. Asset prices have soared but income growth has not.

Fundamentally, asset prices cannot remain detached from the fundamental drivers, in particular earnings. Either earnings must rise or asset prices must fall.

To the extent that there are always risks to earnings and growth, it is worth examining if any current facts suggest we should be more concerned or more sanguine.

The numbers are not pretty

In the US, a record $US947 billion of junk debt – euphemistically called ‘high-yield debt’ – matures by 2020 and in 2020 itself the highest ever amount of junk debt in history, $US400 billion, matures. By itself this fact is not something to be concerned about but other facts produce a reason to worry.

According to Moody’s Investor Services, there were 109 US junk-rated defaults in 2015, double the number in 2014 and the value was more than 30% higher. The number is expected to climb again in 2016. More importantly, the default rate for all US corporate issuers rated by Moody’s is expected to rise by a third to 2.1% this year – the highest rate since the GFC.

The number of stressed borrowers appears to be increasing and the stress is not confined to energy, oil and gas. Data shows that technology and telecoms carry the largest debt burdens and Moody’s Liquidity Stress Index has hit its highest level since December 2009 and recorded its largest one-month jump since March 2009 during the depths of the GFC.

Of course, maturing debt that remains unpaid causes defaults, which leads to job losses, declining consumer spending and broader impacts on economic growth, but maturing debt can be refinanced so the wall of maturities and rising stress doesn’t immediately lead to the conclusion current levels will get worse.

Moody’s also report a refunding index for three-year maturities. This index measures whether sufficient liquidity exists in the credit markets to refinance the coming debt maturities. Sadly, the index is also at levels only seen at the depths of the GFC in 2009.

The worries are not confined to shares. In my last column I ruminated on the possibility of a crash in the property market, concluding; “ ... the probability of a bargain is higher than the probability of prices running away from you. There’s no need to rush.” Since then, the media have been replete with observations that apartment prices are falling.

Across all markets, there are reasons for great caution, lower return expectations and looking for new sources of alpha.

 

Roger Montgomery is the Founder and Chief Investment Officer at The Montgomery Fund, and author of the bestseller ‘Value.able’. This article is for general educational purposes and does not consider the specific needs of any individual.

 

4 Comments
Stan
April 22, 2016

Warren, I fully agree with you, but to quote your earlier piece..
"Many investors are unnecessarily put off by the colloquialism ‘junk’ ".
Most of the bonds I currently hold are classified "junk",I just wish that writers such as Roger had available a more nuanced term to describe them.
To the uninformed reader they appear as either "OK or "not OK"!

Warren Bird
April 22, 2016

Stan, a couple of comments.

First, the distinction between investment grade and high yield bonds is not as simplistic as you think. It isn't that 'investment grade' is not risky, but high yield is very risky. The whole spectrum of ratings is a continuous one. Within investment grade there are several steps, with escalating risk from AAA down to BBB-. The rate of escalation of the probability of default is logarithmic, so that the gap between say AA- and A+ is larger than the gap between AAA and AA+. This also means that the jump from BBB- (the low end of the investment grade space) to BB+ (the top high yield rating) is large. However, it is not quite the seismic adjustment that you seem to think is the case.

Second, as I argued in "Why would you invest in junk?" http://cuffelinks.com.au/invest-junk/ the asset class of high yield bonds has delivered very strong returns over time despite the inherent riskiness of the individual securities within it. You get paid for the risk you take when you invest there.

Third, you can "trust" the system of credit ratings for corporate bonds. They have been in placed for nearly a century now and the relationship between the elements that credit analysts evaluate and the probability of a company defaulting is remarkably robust. A single-A rated credit has a small probability of default and the rate at which these rated entities do default through time aligns perfectly. That is, the vast majority don't default, but a small % do.

Also, it wasn't the rating of CDO's in general that was questionable, but the rating of CDO structures backed by sub-prime loans that was wrong. The ratings agencies covered themselves in the proverbial with their rating of those, which were premised on the assumption that house prices wouldn't go down. But most of their CDO ratings, like their company ratings, have been useful guides to default risk.

The question is, what are you trusting them to do? All that a credit rating ever has been and ever can be is an estimate of the probability that an entity will default on its debt obligations. It is not a recommendation to invest, and in particular it says nothing about the investment value of an investment. I think too many people think that a strong rating means that they can invest with no worries, when that is not the case. Even AAA rated assets have a non-zero probability of default. The ratings agency that assigns AAA is not saying 'invest in this, it's a great deal', they are simply saying that it's got a very, very small chance of blowing up over the next few years. They are not saying anything about whether the price you are paying is the right price, or whether the yield you are buying is a good rate of return.

So the good or bad that ratings are telling you about is only ever part of the story. It's not the ratings agencies fault if investors interpret the information they provide incorrectly.

Stan
April 22, 2016

While Chris Cuffe rightly challenges the simple binary classification of "growth" and "income", bonds are also binary, either "junk" or "investment grade"(with nothing between), depending on their position on the ratings agencies scale. These same agencies we can thank for the classification of CDO's that contributed to the GFC disaster, yet we still trust them to help us decide on which bonds are "good" or "bad" ?
Puzzling.

Alex
April 21, 2016

The US looks better than that to me. Confidence and economic activity have been raised significantly – so much so that the Fed stopped QE, is reversing QE progressively as bonds, notes and bills mature, has started to raise rates again – all while housing prices have recovered, unemployment has come down to below full employment levels and wages are rising.

 

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