Confused by the Current Correction?

For those of you who may be shocked by the violence and velocity of the continuing market downdraft, the following excerpt from our Fund's 4Q19 Partner Letter may be informative:

"The Fund concluded 2019 with the most defensive posture in its history. Short positions comprised 35% of the portfolio, and 21% of the Fund was in cash. While we expect our shorts to correct based on position-specific factors, because they would also likely decline in the event of a market-wide downdraft, they serve a dual function, providing potential alpha as well a form of insurance should a broad-based correction occur.

Our conservative stance stands in sharp contrast to the prevailing market sentiment. Only 12 times since 1928 has the S&P 500 posted a better return than it did in 2019. And yet

Almost 40% of U.S. listed companies lost money during 2019, the highest percentage since the 1990s.

It’s clear that investors’ fear of missing out (“FOMO”) well exceeds their fear of losing their money. In terms of human nature, this is nothing unusual.  As behavioral economist Richard Thaler has observed, once we adapt to our environment, we tend to ignore it. Still, investors’ indifference to risk seems peculiar in light of recent history.

Since the turn of the millennium, U.S. stock investors have had their wealth cut in half not once but twice – first in 2000-02 and then in 2007-09. Having only recently emerged from those market massacres, you’d think they would be exceedingly gun-shy. But if anything, prices and spreads indicate that investors’ appetite for risk has never been higher. 

As shown above, during 2019 corporate profit growth stagnated, earnings per share declined (blue line), and earnings expectations for 2020 continued to fall as the year progressed (red line). Accordingly, all of the S&P 500’s approx. 30% gain last year derived from multiple expansion.

There’s no mystery as to cause and effect;

U.S. stocks rallied in 2019 because investors were willing to pay higher multiples for poorer quality earnings.

Declining interest rates certainly helped fuel the price run-up, but mammoth share buybacks bolstered both stock prices and earnings per share, which would have declined much more but for U.S. corporations purchasing $736 BN of their own stock during 2019. 

Buoyed by interest rates near or below the zero bound, the risk premia in most asset classes further compressed over the past year. By mid-December, U.S. double-B bonds were yielding just 3.51%, the lowest on record and just 164 basis points more than U.S. Treasuries. Moreover, the difference between double-B and triple-B bond yields collapsed to just 38 basis points, the smallest spread in at least 25 years, leaving no meaningful difference in yield between investment- and speculative-grade bonds.

With interest rates scraping 5,000-year lows, we entered the current decade exhibiting little apparent concern about debt sustainability in the sovereign or corporate categories.  

Gross public debt in America reached $23.18 TN in 2019. To put that in context, it took 192 years for government IOUs to reach $1 TN. It required just 5 months (from August 1, 2019) to add the newest trillion.

Foreign currency denominated debt in 30 large emerging markets hit a new high of $4.7 TN in 2019, more than double the level only a decade ago. As a result, repayments on EM foreign currency bonds and loans next year are projected to be almost $800 BN.  For the 3 years from 2020 through 2022, redemptions will total $2 TN.  Including local currency denominated debt falling due, the total rises to $10.7 TN, or approximately one-third of EM gross domestic product.

Perhaps inflation has gone the way of the Woolly Mammoth, and interest rates will remain low forever. That’s certainly what current bond yields are implying. But it’s an expectation not obviously supported by actual monetary policy since The Great Recession.

For over a decade central bankers have been making every effort – including such extreme, unconventional measures as quantitative easing – to create inflation. Last year, the Fed cut interest rates three times, reducing its target range for short-term borrowing costs from 1.75% to 1.5%.  Why cut rates three times in three months when unemployment is at a 50-year low? Because they’re worried about deflation – that is, not enough inflation.

Jim Bullard, president of the Federal Reserve Bank of St. Louis, recently stated in a speech, “If we did get some upward inflation pressure, at this point I think it would be a welcome development even if it pushed inflation above target for a time. . . so bring it on is what I would say." 

If that accurately reflects central bank sentiment, and the five-year trend in core inflation is in fact rising at the fastest pace in 30 years, why does perpetually subdued inflation seem like a safe bet?

It's a critical question, because the entire framework of asset prices is anchored to the expectation that inflation – and thus interest rates – will remain extraordinarily low. It’s axiomatic that  

Bond yields in fact must stay low in order for expected returns on other assets to remain low and prices to remain correspondingly high.

Fixed income investors are particularly exposed, given how little compensation they’re receiving for the interest rate risk they’re taking.

Consider the chart above, which illustrates the ratio of aggregate bond yields to their duration. This ratio, known as the Sherman Ratio, shows the amount of yield investors receive for each unit of duration. The smaller the number, the less interest rates need to rise before one’s cumulative interest income is wiped out. That ratio is close to its lowest level ever.

Accordingly, it would only take a relatively modest but unanticipated spike in interest rates to trigger significant losses for fixed income investors. Perhaps this is why investors continue to act as if rates will never normalize; the transition to higher interest rates is simply too gruesome to contemplate. Which begs an essential question:

What in this market is priced to protect investors?

One of the reasons we run a concentrated portfolio is because it enables us to avoid what we consider suspect while still retaining the ability to selectively exploit those extreme mispricings that offer a substantial margin of safety. This frequently leads us well away from the beaten path. But as always,

It’s not necessarily what you buy – it’s what you pay for it.

?Sources:

“This U.S. Stocks Melt-Up Rests on Faith in Low Rates,” Bloomberg, December 20, 2019, John Authers. In 2019, the S&P 500 gained 28.9%, or 31.5% including dividends.

“Pennies in the fiscal fuse box,” Grant’s Interest Rate Observer, Vol. 38, No. 1a, January 10, 2020.

“Emerging markets face wall of dollar debt,” The Financial Times, November 24, 2019, Caroline Grady. The $4.7 TN figure excludes the debts of the financial sector in order to avoid double counting.  

The team at Richard Bernstein Advisors provides an excellent discussion of this subject in “Investing for December 31, 2029 —The End of Globalization.” (https://rbadvisors.com/images/pdfs/RBA_Insights_Investing_for_2029_1219.pdf)

“This Is the Scariest Gauge for the Bond Market,” Bloomberg, January 9, 2020, Brian Chappatta. The Sherman Ratio is named after Jeffrey Sherman, Deputy CIO at DoubleLine Capital, who devised it.