July 2005: If the News is So Bleak, Why Don’t the Investment Markets Reflect This?
It strikes us that getting the correct answer to this question will determine how effectively our current portfolio investment strategy will play out over the next 12-18 months. The geopolitical backdrop is fraught with potential eruptions which the sad news of terror attacks in London illustrates. Globalization continues to generate protectionist political sentiment in Washington, as well as with some of our trading “partners.” Hardly a day passes without an above-the-fold front page article about how badly things are going in Iraq and/or Afghanistan. The Fed continues its policy of raising short term interest rates, in its words until “more normal” borrowing costs are reached. Gas prices at the pump daily remind us that the specter of increasing inflation is upon us. The dollar, although year-to-date somewhat stronger, according to pundits must weaken over the long-term – particularly against many Asian currencies. Yet equity markets around the world have held narrowly at present levels, and fixed income security yields have not responded to the Fed’s pressure to increase rates. Why aren’t global financial markets behaving rationally? Isn’t it obvious what should be happening?
Globally, investment markets which after all are information discounting forums, more often are not driven by what’s “obvious.” We would be the first to admit to a sense of unease about the problems faced, as well as certain relative valuation imbalances in our own financial markets (more on this follows). However, underneath all this uncertainty exists understated and resilient economic strength. As mentioned in our last letter, world-wide GDP growth in 2004 was at its highest rate in nearly 30 years. This year, although the Eurozone economies are lagging slightly, already promises to be a reasonable encore. Preliminary indications are that inflationary pressures are abating and interest rates, instead of rising inexorably, may be for the moment leveling off. We don’t expect an ebullient, exuberant stock market ahead, but it’s hard to identify what might derail equity prices at today’s apparently realistic levels. There exist however, amongst certain asset classes, pockets of over-valuation which we hope the Fed, with careful deliberate policy actions, can arbitrage to a soft landing.
“It’s Different This Time”
Possibly four of the most expensive words in the English language. When investors take a trend to excess or the price of an asset class to an extreme, it is often driven by the belief that something has changed – that past paradigms have been rendered obsolete by new circumstances. Unfortunately, history tells us that financial markets are guided by the unseen hand of reversion-to-the-mean. Making the same mistakes over and over is a recurring investor trait – even when it is a new cast of players acting out a new asset class script. As Mark Twain noted, “History doesn’t repeat itself, but it rhymes.” The figure below shows some “bubbles” through the ages.
Today’s favorites – real estate, hedge funds, private equity – have replaced the darlings of last century – biotech of the early 1990s, or “TMT” (tech-media-telecom), dotcom and venture capital funds as the millennium approached. As investors who remember way back six years ago, the traditional standards for reasonable valuations didn’t apply to companies of the “new economy” because those companies’ products were changing the world. Consequently, because “it was different this time,” the Nasdaq 100 traded in March 2000 at 85 times projected earnings, while the 120 largest companies in the S&P 500 Index peaked at over 35 times expected earnings. We all know how that movie ended.
Real Estate
The media have opined incessantly about the U.S. housing market, but we believe there’s more to examine in a story of this significance. Housing bubble? No, according to Federal Reserve Chairman Alan Greenspan, although he has acknowledged that some local markets are showing “signs of froth.” But what about the economic fundamentals of today’s housing market – is it truly “different this time”? Will the market for housing stock build to the sky? There is evidence, at least in the greater Boston area, that housing stock turnover is slowing and prices are softening.
Let’s start with the bullish case: Isn’t real estate different from “risky” investments in the stock market? On the supply side, there is a limited inventory of land. Meanwhile, demand has been strong because of the growing number of households, as well as greater housing affordability due to historically low interest rates. Regarding prices, people need to live somewhere and home prices are “sticky” – that is, so long as owners can continue to afford mortgage payments, they will stay put until conditions improve rather than accepting lower prices and realizing losses. This explains why national average house prices have never fallen for a full year since modern housing statistics have been kept.
However, as mentioned above, cracks are forming in many local housing markets, with increasing evidence suggesting that economic fundamentals do not support today’s lofty valuation levels. U.S. census data show that while the number of new homes for sale (i.e., supply) continues to grow strongly, the rate of home non-ownership (i.e., a proxy for future demand) has declined sharply in recent years. This growing divergence of supply and demand may well play out in a situation where there are more homes being built than there are prospective buyers. For rational investors, this imbalance should be a warning signal of a deteriorating risk-reward trade-off in residential real-estate.
However, many investors do not behave rationally. The echoes of the dotcom frenzy are most evident in attitudes toward home buying today. Increasing numbers of home buyers are speculating on further price appreciation. Recent studies show that numerous investors are now willing to buy houses that they will rent out at a loss because they believe that home prices will keep rising. Hot demand leads builders to keep developing new, often marginal properties, with no end in sight. In some local markets “flippers” (today’s “day traders”) are buying and selling properties even before they are built (see websites like . HYPERLINK "http://www.condoflip.com" ..www.condoflip.com. for details). For example, in Miami up to half of original apartment buyers resell their units before occupying them, with many properties being traded two or three times before someone finally moves in. “South Florida is working off a totally new economic model” according to a Miami realtor quoted in the New York Times.
This “new economic model” is being fueled the old-fashioned way, with unprecedented liquidity (aka an excess of dollars or cheap credit) enabled by years of loose Fed monetary policy. There has been a frenzy of activity in mortgage lending, as until recently banks have enjoyed highly profitable lending conditions (in the form of a steep yield curve, or a large spread between short-term and long-term interest rates), allowing lenders to borrow at lower short rates and lend in the form of long-term mortgages. Further, creative marketing has led to a mushrooming in the variety of new mortgage products. For example, “E-Z” financing includes “interest-only” mortgages and “negative amortization loans” (whereby the buyer pays less than the interest due and the unpaid principal and interest is added on to the loan); or special “payment power” loans, which allow borrowers to defer monthly payments altogether twice a year.
Consumers have responded predictably to the lure of easy money. According to the National Association of Realtors, 42% of all first-time buyers in the U.S. (and 25% of all buyers) made no down payment on their home purchase in 2004. Can’t cover closing costs? No problem, take out a 105% loan. These trends are nationwide, but most pronounced in California where 60% of all mortgages are “interest-only” or “negative amortization,” up from 8% in 2002. The buyer wins when prices continue to escalate, since the home can be sold (or refinanced) before any principal has to be repaid. However, since these types of loans are usually adjustable-rate mortgages (ARMs), home buyers must stay ahead of the effects of rising interest rates. But no need for home buyers to worry about being overextended – it’s different this time.
Key here will be whether Mr. Greenspan can deflate real estate’s valuation bubble slowly through a gradual increase in borrowing rates and tighter lending standards. Much is at stake, since real estate (and related industries) has become a very significant sector of the economy and a key driver of growth. The Fed’s goal in raising short-term interest rates is to siphon off excess liquidity and to thereby set in motion market forces that will remove the tailwinds fanning this overheated sector. Higher mortgage rates will reduce housing affordability, while a flatter yield curve environment will make lending conditions less favorable. It is a tall order; a successful “soft landing” would be an historic first. Our bet is that Mr. Greenspan does not think it’s different this time.
Hedge Funds
The spectacular growth of hedge funds has not escaped the media glare either, but again it’s helpful to look deeper. Over 8,000 hedge funds manage at least $1 trillion in assets today, up from over 5,000 funds managing assets of $400 billion four years ago. Despite this growth, somehow many investors today are willing to believe that it’s possible to find thousands of new above-average managers capable of generating high returns with low risk in increasingly crowded markets. Is it really different this time? Or is the hedge fund market approaching its inevitable point of diminishing returns?
A disturbing trend is that (again) cheap credit (in the form of borrowed money or leverage) has been used increasingly to “pump up” slackening hedge fund returns. And no one really knows the amount of these borrowings, nor the collective risks assumed. Increasingly, high net worth investors have been jumping onboard the hedge fund bandwagon through “funds-of-funds.” For a fee, these managers (aggregators) provide broad exposure to a number of underlying hedge funds and strategies. Aside from the layering of fees and a general lack of transparency, leverage can be high – industry researchers note that 70% of hedge funds have the ability to use some amount of leverage, and many have debt levels of twice capital with some up to 5x.
For example, extensive leverage allowed UK hedge fund Bailey Coates to have $3 billion invested in the markets, even though the firm had only about $1.3 billion of investors’ money at the peak. In mid-June, this once high-flying firm announced it would shut down after racking up losses of nearly 25% this year on poor stock picks. This situation is not to be confused with that of Marin Capital Partners, a $1.7 billion convertible-bond hedge fund, which also threw in the towel this June due to “a lack of suitable investment opportunities” – that is, the fund’s managers concluded that prospective investments did not offer attractive risk-reward profiles (and the fund’s “high water mark” was likely out of reach, meaning the fund’s economic model was broken).
Are these funds, and other recent examples, the proverbial “canaries in the coal mine” signaling the peaking of the hedge fund bubble? Researchers at Morgan Stanley believe that last quarter may prove to have been the capital inflow peak, with private money coming in at half the rate of 2004. Time will tell, but investor redemptions seem likely to mount in the face of unsettled credit markets and lackluster hedge fund performance. If rates rise and credit becomes tighter, someone will stumble and get caught in losing positions. Our greatest concern for the equity markets is that of contagion – will hedge fund troubles spillover into other asset classes?
Private Equity
Another area showing “signs of froth” is private equity (pools of private capital raised to acquire companies in need of restructuring). Here, due perhaps to the private nature of these funds’ activities, the media coverage has not been so extensive. Nonetheless, investors should still be aware of what is occurring. Why? Managers are both raising “mega” funds ($8-10 billion) and also increasing their buying power in “club deals,” involving groups of funds. In raising capital, managers are asserting that scale matters and such enormous asset pools are needed to compete for the big deals, rather than what was addressable with the $1-3 billion “mega”-funds of a few years ago. Many investors have been suspending disbelief and pouring money into these new funds, convinced that past returns can be replicated. Somehow it’s different this time.
Five new funds have announced plans to spend over $50 billion of their investors’ capital (plus borrowed funds) on companies they intend to purchase. So much money chasing such deals is likely to not only dilute investors’ returns, but also have a sizable impact on both private and public markets. Indeed, so far in 2005 there have been several $5+ billion transactions (much larger than most previous private equity deals), some including publicly-traded companies. Recent large private equity deals like Sungard Data (at $11.3 billion, the largest LBO or leveraged buyout since 1989), Toys ‘R’ Us, and Neiman Marcus have also impacted public equity markets. How? High premium deals often breed speculative “event-driven” hedge fund activity and trigger related price volatility. Speculators typically apply the same [premium] valuation multiple used by the acquiring private equity fund in its deal to other peers of the acquired company, driving stock price levels above those justified by peer company fundamentals.
Meanwhile, investment-grade credit markets have also been buffeted by the “event risk” of these private equity-driven LBO and merger & acquisition moves. For example, news of extensive private equity firm interest in Hertz (which is being spun out by its parent Ford for approximately $5-6 billion) caused a sell-off in outstanding corporate bonds, as bondholders worried about the company’s balance sheet being saddled with debt. The knock-on effects of private equity “event risk” have caused corporate credit spreads to widen (particularly in the troubled auto-related sectors), increasing the cost of borrowing for those companies and dampening returns to investors.
Lessons for Investors
Years of loose monetary policy and accommodative credit by the Fed, in the form of low interest rates, have resulted in an abundance of U.S. banking system liquidity. Coupled with the “savings glut” of emerging Asia, many markets are awash in cheap capital. This capital is chasing a limited number of quality investment opportunities, causing asset values in some areas to be inflated well above levels justified by economic fundamentals. As these “bubbles” are forming, investors in those asset classes seem to be repeating common behavioral mistakes of the past, in effect telling themselves that “it’s different this time.”
The sobering conclusion is that prospective returns in the current environment are likely to be muted. Most financial assets (equities, fixed income, real estate, alternative asset classes) are relatively fully valued and there is generally a dearth of compelling re-investment opportunities. In terms used by financial theorists, the “Capital Market Line” is low and flat. This means that investors are faced with a quandary – either (a) accept returns lower than historical norms, or (b) take on high levels of risk to reach for higher returns. At present, many investors seem to be taking option (b) – that is, making risky investments because they can’t get the return they desire from safe ones.
This recent investor behavior, aside from being typical, is most concerning because individuals seem to be making these riskier (or at least less traditional) investments (in residential real estate, hedge funds, private equity, etc.) just when the prospective returns on those investments are the lowest they have ever been. This may be precisely the worst time to add risk in pursuit of more return in one’s own portfolio. Is it truly different this time? We think not.
Today’s Opportunities
Turning to the current market environment, markets today seem to be marking time while earnings and company fundamentals catch up with valuations. Given the plethora of daily economic and company data, we have been seeing both conflicting signals and different interpretations of the economic outlook by investors. The pessimistic bond market, as is often the case, has focused on the negative (e.g., rising rates and the adverse implications of a flat to inverted yield curve), while optimists in the equity markets have been hoping for a continuation in the current 2½ year old bull market (fueled by an end to Fed rate hikes and easing oil prices). Of course, financial markets daily respond to and adjust to new information – securities prices quickly reflect changes in oil prices, Fed monetary policy, inflation expectations, currency values, corporate profits, company developments, etc. However, today’s vastly differing schools of thought on the longer-term global economic outlook are influencing capital flows and seem to be constraining stock prices, resulting in range-bound markets and low short-term returns.
So what to do? In a word, play defense. That is, focus on minimizing risk (and preserving capital) rather than attempting to maximize return at this juncture. Well-diversified portfolios, constructed of high quality investments from a broad range of domestic and international asset classes, will likely deliver solid returns with lower levels of volatility. This may sound a lot like option (a) from above – it is. Particularly at times like these, defensive investing makes most sense.
TFC clients will note the steps taken since late 2004 to reduce portfolio risk by rebalancing portfolios – taking profits in the outperforming sectors of small-cap and value equities, and increasing the allocations to large-cap equities and quality growth. Successful long-term investors are usually aware of history – the tendency of markets to follow cycles and “revert-to-the-mean” – and they also maintain a healthy amount of skepticism when faced with speculative behavior (is it truly different this time?). You may miss the peak of a bull market, but you will likely preserve wealth and be a long-term survivor.
Please do not hesitate to call us if you have comments or questions.
Sincerely,
James L. Joslin
President