“Many that are fallen shall be redeemed, and many shall fall that are now in honor.”
Horace 20 B.C.
During the late 1990’s, tech stocks reached valuations that nobody could explain. While most people saw the dynamically changing marketplace and felt the extraordinary impact of the internet, traditional valuation metrics such as P/E ratios, book values etc. did not seem to matter. Value investing dramatically underperformed growth investing during this period. Many of the most successful investors in history such as Warren Buffett, Julian Robertson, George Soros etc., were believed to be out of touch with the “new economy.” Of course we all know how this bubble ended.
Tech stocks got crushed while value investors generated fantastic returns even during the bear market.
In my opinion, today there are parallels to the 1990’s in the overvaluation of bonds and bond-like investments such as utilities and telecom. On the opposite side is the severe undervaluation of stocks that are hurt by low interest rates such as banks and insurance companies. These trade at levels that are honestly beyond the scope of any rational financial analysis.
Life, Liberty and the Pursuit of Yield
The aftermath of the Brexit vote has, as expected, brought heightened volatility and uncertainty. We are living in extraordinary times for investors. As you can see from the chart above, the 10-year Treasury bond is now at an all-time low level, going back to 1790 when Treasury Secretary Alexander Hamilton borrowed money under the rules of the new U.S. Constitution.
If you think about all the wars, recessions, and global crises since then, it is unbelievable to think of where we are at today.
Inflation expectations are so low that the market seems to believe that the best days for the global economy are far in the past. I don’t believe that to be the case and when sentiment does change in a more positive direction, the impact should be quite severe. Inflation is all about expectations. Let’s say the new U.S. President and Congress proclaimed that they were going to take advantage of these record-low rates to issue as much 100-year debt as is possible and invest in infrastructure. In addition, let’s say that we lowered tax rates to get businesses coming to the United States as opposed to leaving via inversions. I believe you’d see inflation expectations ratchet materially higher and global growth would accelerate.
While today’s pessimism reigns supreme, things can change in an instant!
Over the last few weeks I’ve been reading Ron Chernow’s book on George Washington, which obviously has increasing significance after recently celebrating America’s 240th anniversary this July 4th. Prior to the battles of Princeton and Trenton, things looked as bleak as can be for the fledgling rebels. Many lacked clothes, food, and ammunition. Washington was going to lose a large percentage of his army in the next month, as there wasn’t a permanent army, so enlistments had to be renewed each year. Recent losses had decimated morale and many questioned whether Washington was the right man for the job. The battles of Princeton and Trenton changed sentiment so dramatically that the course of history was invariably altered.
I wouldn’t bet against global growth for the long-term, which is what market participants are doing when they are locking in ten and twenty-year government bonds at negative rates.
What is bizarre is that U.S. Treasury yields tell us less about what is going on in the United States than what they tell us about what is going on in Europe and Japan. On Wednesday, Japan’s 20-year government bond yield fell below zero for the first time. The 10-year Japanese government bond yield also fell, hitting a record low of minus 0.275%. The total of sovereign debt with negative yields jumped to $11.7 trillion as of June 27, up $1.3 trillion from the end of May, according to Fitch ratings. The risk of loss for investors in bonds is greater than it has ever been. If you invert the current 10-year Treasury bond yield of 1.37%, you get a price to earnings ratio of 73, which is very much in line with glamor stocks in the late 1990s. Remember that bonds have no potential for earnings growth and are not adjusted for inflation. This market has been distorted by quantitative easing on a level that we have never seen before. Monetary policy has taken precedent over prudent fiscal policies and the results have been very negative for savers and retirees.
Low yields have distorted equity markets and other asset classes in dynamic ways. The best performing sectors have been the most expensive with some of the worst growth prospects, such as utilities and telecom stocks. Utilities are up 21.9% this year and offer a 3.3% dividend yield. The price to earnings ratio for the industry is around 23, which is far higher than historical averages. The outlook for the industry is quite a bit more negative than prices reflect if you look at the surge in alternative energy development. Alternative energy now accounts for about 13% of electricity generation in the United States, according to the EIA, with wind power jumping by one-third in the last 12 months. This is forcing utilities to shut down old plants, which obviously can carry heavy costs. This is a trend that does not look likely to end anytime soon, but market participants are only focusing on the fact that these stocks have been up and currently offer a decent yield. This type of thinking is what creates the atmosphere for major permanent losses of capital.
The Biggest Driver of Good Times at Utilities is Low Interest Rates
While low interest rates have been a major boost to companies, the impact will have less and less of an impact moving forward. Most of the expensive debt has already been refinanced lower, although the housing and mortgage market should continue to benefit and that should provide a nice ballast to the U.S. economy.
Credit conditions are sound despite some small issues in auto and student loans, which shouldn’t be systemic by any means. Low interest rates have reduced net interest margins and investment income for financial institutions across the globe. The reality is that net interest income has been a lot more resilient than most market participants understand for the big U.S. banks. These banks are winning deposit share and increasing loan growth. This means that the expansion of their loan/deposit ratio has been able to offset and even supersede the decline in net interest margins. \
Current stock prices do not reflect fundamental values. This is the biggest disconnect between price and value we have seen since 2011 and there is a lot less risk to the Financial System than there was then, as banks have built the strongest balance sheets in their history.
As frustrating as the last year and a half have been for investors, the key is staying patient and true to the process.
Remember what happened to those that thought the seemingly good times in the late 90’s would last forever? When fundamentals stop being the lynchpin of sound investment decisions, permanent losses follow. We will be rewarded for buying when there is blood in the streets, while avoiding the areas that are filling fast with herds of sheep.
The fundamentals of our companies are improving at a very reasonable rate and valuations could not be better.
At some point, the market will come around and agree.
What is to come
Potential catalysts are:
- This Friday’s jobs report
- Corporate earnings
- The November election which could reduce uncertainty.
- In addition, we should see some type of resolution in Europe to boost capital for Italian banks, which are struggling with too many nonperforming loans.
I don’t expect the Brexit to have a massive financial impact long-term, but it certainly doesn’t help in the short-term.
Focusing on day to day price movement is a very arbitrary and non-productive process. When you invest in stocks, you are by definition taking a longer-term approach. History has proven that this process has been rewarded time and time again and today’s opportunities are considerable.