Market Musings Blog

For the last ten years at least, investment managers who analyze stocks looking for value have had a tough time performing well. It’s becoming easy to wonder if value investing doesn’t ‘work’ any more. Jeremy Grantham has mused that large companies growing ever larger gain economic power at the expense of competitors, permanently, breaking the mean reversion that typically happens when a company is out of favor, fixes itself, and then appreciates. Others believe that with computers choosing stocks to an ever greater degree, small forays from fair value are rapidly arbitraged away. Too, an argument can be made that the Fed’s easy money policies have confused price discovery and distorted capital flows in many areas of the economy, possibly even perpetuating our low-growth environment. When growth is scarce, investors pay ever more for it, rejecting slow growers in favor of faster growth. Finally, with indexing so popular, money flows to the largest companies, boosting their values at the expense of other stocks. All of these may be true to some extent – for now.

But on a more ominous note for investors of all stripes, the willingness to pay ever more for companies that do not make much if any money is sounding quite a lot like 1999, the pinnacle of technology valuations that held for over fifteen years. Back then, tech stocks surged into early 2000, then fell like a rock. The Nasdaq did not recover its peak valuation until mid 2015. Countless stocks have never regained the prices of those days, despite experiencing recent record earnings. Cisco Systems, Intel, Qualcomm, and Verisign are all well below their prices of late 1999-early 2000. (Interestingly, IBM – a stock that the market loves to hate right now – is well above its peak of 1999.) In another eerie commonality, the Fed was beginning to tighten back in 1999. Here is what David Bianco, chief equity strategist at Deutsche Bank, wrote in 2013 about that time frame:

“The yield curve didn’t invert until March of 2000, however 1999 was feared to be late in the cycle by many investors despite low inflation given that it was eight years since the last recession. The popular debate at the time was whether or not the business cycle had been tamed and elongated versus history. The PE of the S&P 500 climbed to 20 and higher, which contributed to a correction in 7/99-10/99, but the market rebounded and rallied strongly into year-end as the economy displayed health with unemployment falling further and dipping under 4% in early 2000. However, 2000 brought signs of excessive investment in technology and telecom. A demanding PE and a hard rolling over of profits on a business spending recession started a bear market exacerbated by 9/11/2001.” (My emphasis added.)

Does that sound familiar?

The 2000-2002 time frame marked a redemption for value investors, who had been squeezed for years until then. Value investing entered a halcyon period, which lasted for several years. Investigating market history as we’ve done here reminds us: The more things change, the more they stay the same.

Anyone invested in the municipal bond market should keep an eye on Puerto Rico which declared a special form of bankruptcy allowed to it by Congress in a special law passed a couple of years ago. The territory, where population has been declining for decades, borrowed a virtual boatload of money in the last ten years, propelled by a very irresponsible government. The net result is an enormous and growing debt load per person – and since Puerto Ricans are US citizens, all they need to do to escape this debt is to move to the mainland, which they are doing in droves. Of course, this exacerbates the debt load for those remaining.

Some 45% of Puerto Ricans live in poverty. No, that is not a typo. And most of the rest of its citizens work for the government, which now has to go on a drastic diet, so you can see what’s coming down the pike. Not anything good.

Investors in municipal debt are sometimes – rarely, but sometimes – stung by default events like Puerto Rico’s. Usually, except for very small niche-y situations, these train wrecks are thoroughly visible long before they happen, as was Puerto Rico’s. The normal course of events – if there is a normal – is that the claims of creditors, including bond holders, are settled by the courts. While case law is slender in this arena, lessons from Detroit, Vallejo, and others teach us that anything can happen in court. Basically, once a municipal bankruptcy occurs, you can bet that the return on your bonds is very likely to experience a severe haircut. Even when bond indentures establish a claim that appears to be prior over another claim, if there isn’t enough money, there isn’t enough money and everyone is going to experience pain.

Among the claimants, too, are pensioners, current workers, and vendors. None of these parties may directly own bonds, but they will be sharing the same pot of money as bond holders, and will find themselves reluctant participants in the court process.

The events in Puerto Rico are particularly noteworthy not just for the outcome on the island – the court case will also add to law that may be used by Hartford Connecticut, which is well on its way to its own special train wreck, and possibly Illinois, which is becoming intractable. We shall see what happens.

Only a few months ago, bond gurus were saying we are finally on trend to higher interest rates, and now, here we are under 3% on the thirty year bond again, at the lowest yield of 2017 so far. The picture is muddled by the rocketship surge in rates immediately post-election, but what’s clear is that that surge did not take us past the old high in rates back in 2015. Almost like clockwork, every time the ‘talking heads’ leap to the ‘rising rates’ side, rates confound them by falling.

Whither now? We look at interest rates as a product not of the Fed – who only controls the shortest maturities – but of inexorable economic trends that affect much of the developed world. These trends include aging populations and high and rising debts. Add to that a demand for longer bonds that derives from regulations and business management at banks, pension funds, and insurance companies, and you have a brew that encourages low rates. Unfortunately, that also means economic growth will remain low – not something politicians want to hear.

Often, we’ll hear from clients about articles in the media on market and economic topics, which we find to be wildly wrong, nonsensical, or speculative at best. This post is a reminder that journalists are not economists; they are not equity or fixed income analysts; and they rarely report in an unbiased way.

The elements of good financial reporting include:

• the facts, ma’am, definitely the facts, from verifiable sources
• reasonable grounding in basic economic theory such as supply and demand, social goods, pricing theories and so forth
• lack of bias, examination of several points of view

Some sources we like for financial news include:

• Reuters, market section http://www.reuters.com/finance/markets
• Bloomberg https://www.bloomberg.com/markets
• St Louis Federal Reseve for data https://fred.stlouisfed.org/
• The Wall Street Journal
• Some subscription services such as Value Line, Morningstar, and The Economist can be good sources of more specific information, such as company reports, global economic trends, and so forth
• Barron’s

This is by no means a complete list, but these sources will get you started!

Last week, President Trump signed an order asking for a review of the Dodd Frank regulatory law. This law, about 24,000 pages of regulations evolving over multiple years, has commonly been vilified for holding back the economic recovery after the credit crisis. Some effects of Dodd Frank have been very evident such as a significant decline in the number of community banks, which do not have the resources to deal with this cumbersome regulation; and more fees for customers as banks try to recoup costs. Other effects are less obvious to the lay person. They include a sharp rise in deposits and lending activities at the nation’s five largest banks, which have consolidated their positions into even larger institutions; and a similarly sharp rise in the unregulated ‘shadow banking’ system. Some small businesses were frozen out of the credit markets; many mortgage borrowers are now shocked at the pickiness of banks, and at how long it now takes to get a loan. We’ve had clients sign as many as three loan extensions while banks try to gather the information they need to make a simple home loan.

Benefits of Dodd Frank are even more obscure. They include better transparency for certain interbank transactions, derivatives trading, and a clearer path for more regulation since reporting requirements under Dodd Frank spiked.

The main point of the legislation – to protect the banking system against ‘too big to fail’ – has not been tested. Thus, success is difficult to determine. However, we will note that since the first bank was formed in this country, there have been numerous ‘banking crises’ – some of which were really, and some of which were really not – and ever increasing regulations. Somehow we have never managed to repeal banking crises, and I am not optimistic that Dodd Frank has done it, either.

The executive order contains language ordering a review, with an eye to diminishing the regulations at some point in the future. This review could take months or years. In the meantime, bank stocks have become pretty frisky, rallying strongly for this and other reasons. Due to overreach by regulators, banks are often told which loans they can and cannot make. Rules have also required banks to apply to regulators in order to hike dividends or buy back shares. These factors have left banks with capital far in excess of regulatory requirements, money that is simply lying fallow, and not a minute sum. CitiGroup itself is estimated to have over $25 billion of excess capital. This capital could go to loans, if regulations were eased, or dividends and share buybacks.

Should banks have the opportunity to use this dormant capital, earnings could increase, but more importantly, the capital could goose the economy. Unfortunately, as much as Main Street loves to hate banks, you cannot have a healthy, productive economy without healthy, active banks lending money. That’s why banks exist.

It remains to be seen whether Trump’s order will lead to anything, but the signs are hopeful.