10 Factors That Demand Cautious Investing in 2017
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SUMMARY: Investor optimism has taken off after the 2016 U.S. presidential election. Despite this enthusiasm, many facts today including - valuations, federal deficit spending, corporate debt and other factors - demand caution. As Howard Marks says, “We may never know where we're going, or when the tide will turn, but we had better have a good idea where we are.” Where we are today isn’t pretty.
The U.S. presidential election triggered a psychological shift in investors’ mindset. Change is often cause for enthusiasm, and at the close of 2016, U.S. equities raced to new highs. Despite the run up, however, there remain numerous reasons why investors need to remain cautious, and it has little to do with politics or who sits in the Oval Office.
1. Bull markets don’t last forever: In July, the economic recovery will be 8 years old; the longest recovery in U.S. history was 10 years. Could this current run break the record? Perhaps, but the odds of a recession grow larger as the recovery runs longer. Some optimistic money managers (who have not predicted past recessions) are using the argument, “we don’t see a recession coming.” The fact is, no one can forecast recessions with any precision. None other than John Manyard Keynes started his money management career trying to use “credit cycle theory” to time downturns, and it nearly bankrupted him, twice. Recognizing historical trends, investors need to act accordingly and remain cautious.
2. Trees don’t grow to the sky: Most valuation metrics are flashing “very expensive.” One might argue that low rates justify higher valuations. But consider this: almost never in U.S. history have you had similar valuations (red circles below) and not had to wait 10 or more years to push through to significant new highs. They only exception is 2007. While we never know where the current cycle will peak and an investor may be leaving money on the table in the short-term, that “dry powder” will become far more valuable when prices inevitably decrease. (This is probably why Berkshire Hathaway will soon reach $90 billion of cash on its balance sheet.)
For those who think long-term valuation metrics don’t matter, realize that the true trailing-12 month S&P 500 price-to-earnings ratio is roughly 25x*. The often-quoted lower multiples don’t include one-time expenses** (which always seem to reoccur). How prudent is it to ignore “bad stuff” in a benign economic environment? If you look at the value of equity and debt together, we are back to the all-time highs of 2000.
Stocks have value because when you own a share of stock, you have a “claim” on the firm’s earnings. A price-to-earnings ratio represents how many dollars you are paying for one dollar of profit. The historical average of this ratio in the United States is about 16x.
** Under U.S. accounting rules, there are types of losses you are able to take as a “one-time” event. When looking at an index like the S&P 500, these one-time events are, in fact, always occurring with many firms in the index and thus should be counted when valuing the index.
3. Trees don’t grow to the sky (Part 2) – If you look for the valuation of the Russell 2000 in the Wall Street Journal, you see this:
Note the “nil” in the Russell 2000 row. That is because true GAAP earnings of the index over the last 12 months have turned negative, verified by the nice folks at Birinyi Associates who supply the data to the WSJ. Looking to Bloomberg, we see a P/E of 48.6x (which includes “bad stuff”). Any data provider quoting a low-20s P/E for the Russell 2000 is most likely not including firms with negative earnings.
For example, the iShares website shows a P/E of 22x; however, they have a disclosure that “Negative P/E ratios are excluded from this calculation.” Given that a full 27% of firms in the Russell 2000 have negative earnings (Bloomberg), ignore these stratospheric ratios at your own risk. The Russell 2000 has never been more expensive in its entire history, which is not a good starting point for buying low and selling high.
4. The Federal government is already spending: A big part of the enthusiasm for President-elect Trump seems to draw from plans for deficit spending; that is, more infrastructure spending while reducing taxes. The problem is that the government is already overspending. While most people think our federal deficit was a little less than $600 billion for fiscal year 2016, the actual increase to the U.S. national debt last year was $1.4 trillion. The difference between these figures, explains Dr. Lacy Hunt, owes to accounting gimmicks. There is significant spending “off balance sheet,” which is an accountant’s way of saying “we’re just going to ignore it.” The reality, which is how much you need to borrow to finance all of your spending, is much higher. Given this budget-busting spending, how much tolerance will there be for even more deficit spending?
5. Too much debt in corporate America: There is about $1.7 trillion in cash and cash equivalents on corporate America’s balance sheet, but it is unevenly distributed. The top 25 companies control more than half of all that cash; a third is controlled by just five companies. When you consider that leverage for non-financial firms is at a multi-cycle high (chart below left), the firms not part of the top 25 club are extremely leveraged. Even more worrisome is how corporations have spent that money.
As the bottom left chart shows, dividends, buybacks and M&A (not included in the chart) have more than spent all the cash flow of firms. Doing M&A and buybacks at today’s valuations have a slim chance of working out well because these are essentially investments made at very high prices. What is more, since firms are not spending as much on productive things like factories, training and modernization, we are seeing anemic productivity growth (bottom right chart). When high-priced acquisitions and buybacks fail to be accretive to firms in the long-term, it means companies will have racked up a lot of debt that didn’t do them much good.
6. Investors are reaching for yield: As I wrote in “5 Reasons Why Reaching for Yield is Risky,” extreme central bank policies around the world have resulted in a low-yield environment. Yield-starved investors have turned to junk bonds to give them their fix. Junk debt is near all-time high prices, and issuance has more than doubled since the financial crisis. Credit binges are cyclical, and historically, the bigger the binge, the bigger the fall.
7. Some European banks are a mess and the European Project must change: While the United States spent almost $1 trillion recapitalizing its banks during the financial crisis, the European banks have been hobbling along. For some of these banks, it looks like they may have finally run out of road down which to kick the can. The European Monetary Union (EMU) has not been a success. An economy cannot have central planning for monetary policy with local fiscal spending and banking regulation. More fundamentally, different masses of people at very different places in their economic and cultural ideals cannot be managed in the same way. The EMU must break up, get closer together or a combination of the two, and this will impact the capital markets.
Texas Ratio measures the amount of non-performing assets and loans (including loans delinquent for more than 90 days) divided by the bank’s tangible equity, plus its loan loss reserve. Chart via Zerohedge.
For example, Italy’s debt-to-GDP is 132%, according to Eurostat. If the country has to recapitalize its struggling banks but is hamstrung by the EMU, this could antagonize the Italian voter base. And if that occurs and it starts to look like Italy is willing to leave the EMU, watch out. Capital markets will, to use a technical term, freak out. This scenario could play out in several European countries, where voter sentiment is already tipping towards leaving the European Union. As of June 2016, here are the numbers for European support:
8. Most developed nations have too much debt: This is the ultimate long-term worry. We know we cannot grow debt faster than our economy indefinitely, but just when do we reach that “bang” point (to use Roggoff and Reinhart terminology); that is, the point at which debt materially slows economic growth, and if taken too far, can cause a crisis. In their book, This Time It’s Different, the historical threshold identified is 90% debt-to-GDP—well below where advanced nations are currently.
9. Central Bankers continue to unleash amazing amounts of “medicine:” The pace of money printing globally has not slowed. The European Central Bank, the Bank of Japan and the People’s Bank of China continue to print money like the world is in crisis. One big question facing us today is what will be the side effects of all this “medicine?” The honest answer is nobody knows. As I wrote previously in “Central Bank Extreme Monetary Policies and Your Portfolio,” investors must be mindful of the interest rate exposure in their portfolio. As central banks around the world continue pumping new money into the system, we need to be cautious of the risk embedded in securities, since long duration holdings, like stocks, can be greatly affected by interest rates.
10. China continues to blow its real estate and credit bubble: China’s “wealth management products,” which some have compared to America’s subprime loans, have reached $4 trillion. The entire banking system of China is estimated to have reached a staggering $34 trillion, or more than three times their GDP. Few argue that there have been trillions wasted on unneeded real estate and misguided infrastructure projects. The numbers are so big now that it is hard to imagine China can continue adding debt at the pace they have been. Is 2017 the year they finally stop kicking the can down the road?
The Cost of Being Cautious
If you look at the first valuation chart at the top of this paper, it's quite obvious that there is an extremely high probability the next bear market trough will be significantly lower than where we are today. That means there are only two things aggressive investors can hope for in today’s environment:
- To earn income through dividends. Since the dividend rate on U.S. equities is lower than, say, an intermediate bond portfolio, there is no value added here. In fact, it’s a cost as you’re earning more income in the safer investment.
- Further capital gains, which are only helpful if they are "locked in" through rebalancing (selling) at some point before the next downturn. Let's assume this bull market has another 3 years and 25% upside to go. Given the extreme facts of the current situation, what would cause an investor to be conservative after this scenario happens, rather than now? The entire equity portfolio invested under an aggressive reasoning today will still be there when the downturn starts. An incredibly small percentage of investors will guess right and get defensive right before the downturn, but that is not a strategy. It’s luck. As Buffett likes to say, speculators are “Cinderella dancing in a ball room with no clocks.”
After the U.S. election, investor sentiment became very positive, very quickly. Here are a few data points cited by Economist David Rosenberg:
- Global growth expectations are at a 19-month high (net 57% from 35% in November).
- Inflation expectations have only been as high as they are today one other time in the past 20 years—a net 84% see inflation accelerating.
- Global profit expectations are at 6-year highs.
- Allocation to equities rose to a net 31% from an 8% overweight position last month.
- Only a net 7% (record low) believe large-caps will outperform small caps, despite the move we already have seen.
Yet, optimism about a new president historically fades. And besides, all this optimism does nothing to alleviate the global financial challenges we currently face. To be sure, markets cannot be timed. There’s no way of knowing whether a bear market is around the corner or off on the horizon.
As legendary investor Howard Marks says, “We may never know where we're going, or when the tide will turn, but we had better have a good idea where we are.” And where we are today strongly suggests the prudent investor should be cautious. In February 2009, I counseled my clients to buy stocks. This was far from clairvoyant. I had a simple rational: “If you’re not going to buy stocks when they’ve fallen 50%, when the heck are you ever going to buy stocks?” Similarly today, if an old, very expensive, highly leveraged stock market won’t make you cautious, what will?
- December 2016, Dshort.com
- Russell 2000, Wall Street Journal
- Congressional Budget office – through 2016
- Market Watch – America’s 25 Richest Companies
- May 2016, USA Today Markets
- Haver Analytics, Thomson Reuters, Barclay Research
- S&P Global Market Intelligence
- FactSet, Barclays Research
- The Economist Intelligence unit
- FRED, BofA Merrill Lynch
- May 2016, JP Morgan
- Bloomberg and Saxo Bank
- The Sun
- FAD Historical Public Debt Database and IMF Fiscal Monitor
- Citi Research, Haver
- Doubeline Funds