Thursday 16 February 2017

Why I worry more about a melt-up than a melt-down

Most stock market investors worry incessantly about the risk of a potential market melt down. I don’t. I worry about the risk of a market melt up. To be clear, this is absolutely not a prediction. But it is a risk factor I worry about, and think other investors should worry more about too.

For anyone trying to grow their capital; make a living off their investments; or build a business around managing (and making money for) other investors, the absolute worst thing that could happen would be if markets everywhere were to surge and become (and remain) extremely expensive. Imagine, for instance, a world in which stocks traded at 50x earnings. It would be extremely hard to make money in markets. If you invested, you would be offered a poultry 2% earnings yield in exchange for considerable risks. I would likely have to give up and return all the money I was managing to my investors. I’d be out of business.

Sound far fetched? It probably is. But only probably. Consider that we have already reached that situation in the bond market. You cannot invest money in most bond markets today and make a reasonable return (the risk-free return has been recast as return-free risk). In addition, we are at or are approaching that point in many real estate markets as well. In many capital cities today, you’re lucky to be able to get more than a 4% gross rental yield on residential real estate (25x sales). After costs (including property management) and tax, that’s somewhere in the order of 40x earnings. Stocks are currently one of the last bastions of reasonable returns. But there is no inevitability that that situation will persist. Opportunity does not exist just because it is needed or desired.

If markets were to melt up to 50x, it would feel good for a while (if you were invested). However, your future stream of dividends would not have increased, so in truth you would be no wealthier, and furthermore, you would be confronted with the reality of poor reinvestment returns on dividends and corporate stock buybacks. In the long run, this would make you worse rather than better off, despite feeling wealthier in the short run. Conversely, if markets were to melt down and trade at cheap levels, it would feel painful for a while. But you would be better off long term. Bond investors understand reinvestment risk, but most stock investors do not seem too. But it works the same way for stocks as it does for bonds. 

If you’re invested, you are hedged somewhat against the risk of a melt up (a risk most people don’t identify). You can lock in a reasonable return at today’s reasonable prices, and would suffer only on the reinvestment side (an unhedgeable risk). The disaster situation would be to be sitting in cash while watching markets surge all the way to 50x. What would you do then – particularly if the alternative was zero (or negative) rates in the bank? You'd be pretty much stuffed. If you kept holding cash, you'd have to settle for watching your capital slowly dwindle, and if you capitulated and invested, you would risk a major and permanent loss of capital if markets eventually did resettle at lower levels. I have never seen anyone worry about this risk. But they should. 

Why a melt-up to 50x isn’t impossible

Think 50x is impossible? Why is it? As noted, we have already reached that situation in the bond market. Bond yields today are at levels many would have deemed impossible not so long ago, and a whole asset class – indeed the biggest asset class in the world – has in the process been rendered uninvestable for investors seeking reasonable risk-adjusted returns.

One ongoing result of very low interest rates has been a growing desperation for returns, and this has been manifesting in more and more money finding its way into other asset classes, including not just property, but also index funds and ‘alternatives’, such as private equity. This has been pushing up equity valuations for a while now. But this dynamic could well continue to a degree that is much more extreme than we have witnessed thus far. As Bill Miller has pointed out, although not cheap in absolute terms, stocks are still incredibly cheap relative to bonds. A giant equity bubble from here is not impossible.

This is the point where many readers will wish to retort that the low bond yields and rising equity valuations we have seen in recent years have merely been a cyclical symptom of excessive central bank stimulation, and that we are already in the 7th inning of that asset pricing distortion. Bond yields and inflation are apparently starting to rise (although we don't know yet if that is cyclical or structural). It’s a cycle like any other and I'm getting carried away. 

That view is probably right, but only probably, because there are, in my submission, other factors that have been driving a growing excess of liquidity, and the resultant falling interest rates and rising asset prices, besides central bank policies. Indeed, the ability to blame central banks for any and all bubble-ish behavior may have created a blind spot in markets, and resulted in investors overlooking the other contributory factors I discuss below. After all, rates that are ‘too low’ are supposed to end in inflation, not deflation. So far they haven’t - in almost a decade - resulted in inflation, which suggests rates may not have been too low after all.

What are those other factors? In short, a combination of a growing supply of savings/capital, and falling demand for the usage of those savings (elaborated on further below) that together mean that the scarcity of capital has been falling - particularly now that the middle class' ability to absorb those savings via borrowing for real estate speculation has come to an end (and least in Europe and the US; it has yet to in NZ, Australia, and Canada), 

If capital is indeed becoming less scarce, it has important implications for asset prices and future investment returns. Scarcity is the foundation of returns in capitalism – whether to labour or capital. Unskilled labour is not scarce, so it doesn’t earn very much, even if it creates a lot of economic value. There is no value capture. Skilled labour, by comparison, is more scarce so it earns more. Companies that produce something other companies can’t make high returns, while those that produce something others can easily replicate make relatively little. Scarcity (for something of value) and economic returns go hand-in-hand. 

The provision of capital ought not be any exception in this regard. Historically, capital has been scarce (sometimes more than others), and high returns/interest rates have therefore been required to ration it to its most productive uses. However, there is no guaranty that will continue. There is no rule of the universe that says capital is entitled to a decent return (or any return), let alone one in accordance with 100-year averages. For capital to earn 100-year average returns, it needs to be as scarce as it has been, on average, during the past 100-years. Simply assuming future returns will be the same as historical returns (or, equivalently, that asset prices will average the same level as they have historically) is nothing more than an article of faith. 

This is a major problem I have, incidentally, with GMO & Grantham’s models – they assume the cost of capital is always the same and never changes (not to mention academic models, which assume the ‘market risk premium’ is always the same, due to some mystical universal law on par with a Newtonian law of physics). GMO’s market valuations and views are always based on long term return averages, and there is never any discussion of whether the price of capital might have changed. And if the price of capital has fallen, then the market's fair valuation has risen. Intriguingly, the S&P 500 has been materially above GMO's fair valuation estimate for most of the past 25 years. One wonders when enough time may have elapsed for them to revisit some of their basic assumptions.

Indeed, when you think about it, why should an index fund holder be able to lie on a beach all day and earn 10% a year? If the world needs savings, sure, that’s fine, but if it does not, then those savings ought to earn a materially lower return, if any return at all. And that is the direction the world has been going in.

Why might capital be getting less scarce?

There are several reasons why capital may be getting less scarce that have little to do with central banks. Some of these are likely merely cyclical, but some may also prove to be structural.

The world (or the developed world at least) is heading into something of post-industrial era, where a lot of tangible capital is no longer needed to drive growth in productivity. Innovation is instead happening in technology, software, and services, etc, while incremental consumer demand is for relatively intangible services/experiences/entertainment, rather than 'stuff'. These two factors are together reducing the demand for new tangible capital stock.

In bygone eras, economic growth was capital intensive. The industrial revolution required significant heavy investment in factories, railroads, electricity networks, and the like, to supply an under-serviced and growing middle class with a wide range of consumer goods and capital-intensive services (e.g. electricity). But the information/technological/services revolution we are currently in the midst of is relatively ‘capital light’. This can be readily observed from the balance sheets of the Googles and Facebooks of this world. These businesses don’t have or need a lot of fixed assets.

A lot of commentators have in recent years bemoaned low levels of corporate investment and a putative ‘secular stagnation’. Why, it is asked, are corporations not investing, and instead buying back record amounts of stock and/or paying higher dividends? Are management incentives distorted; is growth on a structurally lower trajectory; or is capitalism just plain broken?

In my view, that is all ivory-tower nonsense. We live in a time of quite radical productivity growth and innovation. The growing power of technology is all around us. The only place it is invisible is in the productivity statistics - in my opinion because rapid productivity growth is deflationary, and because new technologies are now resulting in whole industries being demonetized. Wikipedia is better than Encyclopedia Brittanica, for instance, and has made the world a better place. But the GDP numbers would tell you we are all worse off and less productive because of it.

In addition, from where I'm sitting, capitalism is still working. Uber is disrupting taxis. Amazon is disrupting retail. And Neflix is disrupting the traditional media industry. If companies were choosing to forego promising growth opportunities to finance buy-backs, others companies would seize them, and eventually supplant the former incumbents. How any serious economist or economic commentator can fail to see that is beyond me.

I would argue that a lot of investment/innovation has in fact been happening. It's just that the investment is happening more and more at the opex line, not the capex line. R&D and investment in software development and systems automation, for instance, are generally human-capital intensive rather than tangible-capital-intensive, and are usually wholly or partially expensed. A lot of that sort of investment is happening. However, corporations are investing less and less in hard assets because there are comparatively limited opportunities or need for them to do so vis-à-vis the past – particularly with slowing population growth. In short, the ways in which capital can be usefully deployed has been declining, and it is probably structural.

Meanwhile, savings are at elevated levels, and have been for quite some time. This may be for merely cyclical reasons, but it could be partly or wholly due to structural reasons as well. One of the reasons is that wealth and income inequality have been rising rapidly over the past 30 years (something that could be cyclical, structural, or both). The more one earns, the higher one’s propensity to save, and wealthy individuals seldom consume their capital (as opposed to a portion - usually small - of the returns from their capital). Consequently, rising inequality has been increasing the world's private-sector savings stockpile. In addition, savings-heavy economies such as China have been integrated into the world economy over the past several decades, which has further added to the world's savings surplus (which was arguably a major contributor to the build up of economic imbalances prior to the GFC).

In short, there is a case to be made that capital is becoming less and less scarce, and hence returns are shrinking, and this initially manifests in the form of a surge in the price of existing assets, as valuation multiples of existing earnings streams rise. It is not impossible that this dynamic still has a lot further to run, and at worst, could result in a stock price melt up.

Don’t despair (yet)

I am already feeling the pain. Since I left my prior occupation to manage money for a living, I have made about 5-6% a month compound for seven months in a row. I should be celebrating right? I’m not.

I’m not managing much money yet, and I’m making money way too fast. I would rather make a more sustainable 2% a month, than an unsustainable 5-6%. Some of my returns have been from stock picking, to be sure, but some have been from rising markets and shrinking value dispersion (the cheapest stocks/markets/industries in the world, where I am heavily invested, have been sharply outperforming). Markets are going up fast and stocks are getting more expensive. If this continues for several more years, it won’t be long before I won’t be able to sustain even 10% a year returns, let alone 50%. I’ll have to give money back to my investors, and I’ll be out of business.

However, there is no need to despair just yet:

*Firstly, the above probably won’t happen. I am not only not predicting a melt up to 50x, but I'm not even arguing it's likely. I’m just saying its possible. Lots of things could change and forestall the above. E.g. politics can and probably will change at some point and start to redistribute wealth. That will lower the world’s savings glut. That happened in the 1970s in the US and lead to inflation and wealth destruction on a large scale (but large gains to labour). Developed market real wage deflation due to the offshoring of labour to cheap developing markets has likely already run its course, and protectionism could also raise developed world labour (and goods & services) prices. Baby boomers in coming years will also start to retire in larger numbers and become net dissavers rather than net savers, also reducing the savings glut. Fiscal deficits may rise further or fail to fall alongside falling private sector savings. And central banks might see the light and cease (or even reverse) stimulatory policies at some point (although I have absolutely no faith in central bankers to do the right thing). If some or all of these things happen, the world's savings glut could quickly vanish.

*Secondly, there is a difference between risk capital and risk-averse capital. The world is currently drowning in risk-averse capital, so it earns nothing. But the world has a considerably smaller excess of risk capital (e.g. capital willing to invest in volatile stock markets). That is why there is still a return offered for bearing risk in the stock market (albeit a shrinking one). There will probably always be a reasonable risk premium attached to volatile assets because most investors scare easily and/or cannot afford to sustain large losses.

*Thirdly, even if the above is a meta-trend, there will still be short term panics/crashes. The above dynamic has been a trend that has now been in place since the early 1980s, when interest rates peaked in the high teens. They have - as a general trend - been falling ever since, and stock price multiples have been rising. This meta-trend did not, however, stop the GFC (Global Financial Crisis) from occurring and stocks being given away in early 2009, nor the 1987 stock market crash, nor the 2000-02 'tech wreck'. A mini-panic happened in early 2016 as well. Cyclical risk busts will very likely still happen from time to time.

*Fourthly, even if stock prices are expensive in the aggregate, there will likely always be pockets of fear, panic, and undervaluation. Stocks in Russia were being given away at 3x earnings as recently as early 2016. I made a bundle in Russia in 2016, and with stocks still being very cheap there despite having doubled already, I expect to make further gains there in 2017 as well. All things commodities were also at extraordinary low prices 12 months ago, while European and US financials were being given away for much of 2016 as well (I made a bundle in these sectors also). Market inefficiency will always be with us, and consequently idiosyncratic opportunities will always exist for the savvy stock-picker. They just might be rarer and tougher to find.

*Lastly, and potentially most promisingly, 5/7ths of the world (I’m excluding China deliberately) still live in relatively capital starved poor countries that are under-industrialised, and need plenty of fixed asset investment. If these countries can get their act together (and in the aggregate they slowly have been over time), there will be plenty of opportunities for capital deployment in these markets. 

We stock market investors will probably be ok. But only probably.