“If there is one common theme to the vast range of the world’s financial crises, it is that excessive debt accumulated, whether by the government, banks, corporations, or consumers often poses greater systemic risks than it seems during a boom.” – Carmen Reinhardt
We are unapologetic college hoops aficionados and know so much about the game that we expect (but rarely achieve) success with our March madness bracket picks. Anecdotally, we will proffer the odds of your picks outperforming ours, even with no knowledge of the game at all, are substantial. Some interesting trivia for you: the odds of correctly picking the correct outcome of all 61 games is 1 in 9 quintillion if you simply flip a coin. If you know a bit about college hoops, your odds improve to 1 in 120 billion. You’ll have to consult an actuary if you need the math explained. That’s beyond our paygrade.
We use the aforementioned as a metaphor for the odds of a day trader unarmed with complex algorithms making 61 (the number of games played) profitable trades in a row. Even without an actuary, we will argue the odds are low! However we are listening to some remarkable stories of young traders with little-to-zero investment knowledge suggesting their odds are quite high. We’re not so sure. As John Bogle suggested, “Don’t confuse genius with a bull market.”
Last month we used a graph like the following to illustrate the extremes to which current equity prices are rising.
This chart shows us that the total market cap of US equities actually exceeds the total dollars used to measure GDP. Over the past decade, this condition has occurred numerous times – just not to this extreme. One should be cautioned however, about using any single data point for making short term investment decisions. Markets seldom behave in both the manner we expect and in the time period we expect. Just six months ago, pundits were warning of market meltdowns if Biden won the presidency. It hasn’t happened – yet. We’ve also been cautioned that a rise in interest rates would cause markets to tumble. The chart below illustrates that yields on ten-year treasury bonds have tripled over the past year. And yet no tumble – yet!
10-Year Treasury Rate Over The Last 12 Months Source: Ycharts
Year-to-date the victims of higher yields have been bond prices. This graph illustrates the rapid rise in yields for the ten-year US treasury bond over just the past 6 months.
Source: Financial Times
The next graph illustrates the drop in price for the same bond as rates have risen.
Ten-year bonds returned -5.5% for the first quarter 2021. The S&P returned 5%+ for the first quarter. Energy and financial shares dramatically outperformed and technology shares, though positive, trailed.
Here are comparative returns for each sector.
We had argued late last year that value shares, which had consistently underperformed growth shares, looked more promising. Indeed, a significant gap in performance has been closed. We like the irony embedded in the performance of energy and financial shares for the first quarter. The pundits were predicting dire times for both as the new government would trend toward more regulation. The markets clearly have their own opinion.
We are often asked about the bubble many see in the prices for investment assets, and when will the market correct some of the obvious speculative fervor. We will focus here, because we agree that speculation in markets from SPACs, to meme stocks, to high yield bonds, to crypto currencies, to technology shares seems excessive and leads us to ask the inevitable (and often foolish) questions – Is this time different? Do the measures we use to analyze and manage risks no longer apply? Can the collaboration of speculators in chat rooms turn the frog back into the prince?
We’ll add another question – Has the US government and its numerous agencies lost their collective minds? And yes, we believe that question to be rhetorical! It has been doing so for the entirety of the 21st century. If you do nothing else related to investments today, please click on the image below for a real-time look at the US debt.
Source: US Debt Clock.org
There is nothing remotely comforting about this if you believe in free market capitalism. If socialism or dictatorship is more to your liking, then you should be encouraged. The political truth the Debt Clock highlights is that both political parties together created this problem and neither seems to have a clue on how to return our country to a state of financial responsibility.
Like you, we are deluged with unsolicited advertising pushing advice on not paying back student loans, how to get the credit card companies to forgive your debt, how to negotiate a deal with the IRS, how to lower your mortgage balance, how to renege on your timeshare, how to sue most any company or person, etc, etc. Okay – so who will pay for all this forgiveness?! Somehow, the entity that has accrued an unmanageable debt has morphed into the saint, the lender AND the devil. Somehow big government has emerged as the problem solver and the taxpayer has emerged as the problem, i.e. in their view, the reason the debt clock is operating in overdrive is not that we spend too much, but that we tax too little!
We challenge you to provide a shred of evidence that either political party has a strategy to navigate our country back to making the same level of sound financial decisions for our country that they expect its citizens to make in their personal lives.
Undoubtedly, the dollars doled out during COVID have been used for consumption and for investments, and that’s good! But where do those dollars come from?
By now you understand that we think we have a macro problem with debt – but we still haven’t addressed the bubble question. The stock market bubble, if that is indeed what we are in or approaching, doesn’t have to correct. Perhaps it can remain expensive or irrational forever. We don’t know. If timing a pop in the bubble was possible, we would obviously take appropriate measures. That famous Keynes quote comes to mind – “ Markets can remain irrational longer than you can stay solvent.”
A couple of data points suggest the market is frothy. The following shows the percentage of Initial Public Offerings with no profits at time of IPO.
For whatever reason investors are just fine paying a lot for nothing.
The next chart shows the issuance in Special Acquisition Corporations (SPACs) shares.
SPACS are known as blank check companies. Investors fund the corporation today and some time in the future SPAC management will invest in a yet undetermined company. Investors pumped almost $70 billion into these shares in the first quarter. Investors are willing pay today for something that MIGHT happen tomorrow.
More market observations that fuel our caution include lofty price-to-sales and earnings ratios, complacency in the option markets, complacent in volatility measures, the GameStop (meme stock) phenomena and lofty levels of margin debt as shown below.
Source: Yardeni Research
In summary, we can’t find any asset class which looks inexpensive. Several including value, emerging markets and commodities at least look less expensive. (see Jan , Feb, March memos). Rates, though trending up, have a ways to go before making rotation from stocks to bonds all that attractive. Fiscal and monetary policy (which we view as moderately insane) continues to be supportive of asset inflation. The economy has been definitely on a tear over the first quarter and data suggests that trend to continue into the second.
Yes, we consider equity investments risky – just like they are on any other given day. Expecting markets to perform indefinitely as they have since April 2020 seems unreasonable. But so too does the timing of a correction unless you know exactly when it will occur. Our advice and posture include high quality over low, value over growth, some exposure to emerging, private equity where suitable, some liquidity for the possibility of some ugly days and quality with lower duration in bonds.
As for how our college basketball picks turned out this year? Well, first we should acknowledge the huge debt of gratitude owed to all those who helped ensure there was a “this year.” This is at least one example of our country’s ability to figure it out and carry on (though we’d like to see many more) and leads us to the second thing we’re grateful for…confidence that we’ll have the opportunity to do better next year.
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