Since the extremely weak May jobs report, interest rates have plummeted across the globe. There are now over $10 trillion in bonds that are trading at negative interest rates. This is unprecedented as the buyers of these bonds are guaranteeing themselves losses if they hold until maturity. This has pushed asset prices up as savers are forced to broaden their risk horizons to obtain the yields necessary to fund their retirement needs. This search for yield has elevated the valuation of seemingly “conservative” investments, such as consumer staples and utilities, to levels that are 25-35% higher than historical averages. Most bubbles are built on a good idea that gets taken to extreme levels, pushing asset values far beyond intrinsic value. I believe that there is a very obvious bubble in bonds and also there are bubbles in consumer staples and utility stocks.
Brexit: “British exit” the process of whether Britain will leave the European Union
The other major concern influencing market is the possibility of the Brexit, which will be voted upon on June 23rd. While the betting odds still favor Britain staying in the EU, the polls say otherwise. The situation appears to be too close to call. While the impact of a Brexit shouldn’t be too significant for the companies that we own, the stock market hates uncertainty, so volatility between now and then is to be expected and that is in fact what we have seen of late.
Investment fundamentals staying strong
As far as our investments go, the fundamentals appear to continue to be strong. Today we received good news for AGO, MBIA and Ambac, as the U.S. Supreme Court rejected Puerto Rico’s appeal to reinstitute its voided Recovery Act. This basically assures that the PREPA restructuring deal will go through in which AGO and MBIA will likely take no losses on one of their worst Puerto Rico exposures. The PROMESA legislation was approved through the House and seems likely to pass through the Senate. While not ideal, this legislation should resolve a great deal of uncertainty and is far better than what many speculated would come out of Washington D.C.
The banks have taken a hit of late as interest rates have contracted, but actual fundamentals are quite strong. In recent industry updates, activities such as trading and investment banking revenues are up substantially.
Earnings should be quite strong overall for the sector and combined with the dirt cheap valuations, I’d expect earnings to be a good catalyst for us.
Another major event coming up is the release of the CCAR results where we will ultimately find out the amount of dividend and stock buyback increases the big banks have been approved for. Being that these big banks are overly capitalized, the fact that the majority of their earnings will ultimately be returned to shareholders over the next 3-5 years seems to be seriously underrated by market participants and analysts.
Outlook looks good
Summertime trading is often low in volume, so markets can move without anything fundamentally changing. The key is to not get too caught up in this sort of stuff. Almost all of our positions are covered at this stage in the game, so as we get closer to January we will see the full benefit of this strategy. Over the last week, volatility has spiked which increases all option prices but at expiration volatility goes to zero.
The fact is that if our stocks didn’t move one cent between now and mid-January when our options expire, our accounts would be considerably higher!
This is why we preach patience and I believe that as each quarter goes by, the intrinsic value of our investments will continue to grow. Once we get a little less pessimism, valuations should improve particularly for financials, which will lead to very strong investment gains. We’ve seen this before and we will see it again. Below is a WSJ article outlining a bit of current market conditions that you might enjoy: