44.5% of companies have now revised their earnings expectations to the upside. These revisions are particularly heavy in the Energy and the Financials sector. It is early enough still that we will defer drawing any systemic conclusions from what we have seen so far in earnings season, but the revisions alone do already tell the story of earnings expectations a few months ago that were just way overdone in their downward guidance. Reality is setting in, and it looks better than the ancient history that was January.
Okay, I lied. I said I wanted to wait until later in the earnings season to elaborate, but it is worth noting that with 36% of the S&P 500 having reported (so 2/3rds still to go), the total expectation is now for no decline in Year-over-Year earnings growth (whereas projections were for a 2.5% decline just a matter of weeks ago). That downward slope in revisions has reversed, and that is the reason for market pricing in April- period.
Sentiment vs. Fundamentals
One of the most frustrating debates (for me) in all of finance is whether or not sentiment trumps fundamentals or vice versa. There ought not to be any debate about the fact that there are periods of time where sentiment completely overwhelms fundamentals, and that in the long run, the fundamentals win out. The fundamentals are understood in the context of investor sentiment - and the longer the timeline, the more "smoothing" of sentiment there is to interpret and apply the fundamentals. Legendary value investor, Ben Graham, addressed this subject with his famous line: "In the short run, markets are voting machines; in the long run, they are weighing machines." The relationship between time and the impact of fundamentals on asset performance is heavily correlated.
When you pray that past is not prologue
New home sales (single family) have picked up slowly but surely since 2010, recently arriving back to the level (and slightly above it) that represents the median level of home sales volume for the last fifty+ years. The rather significant event that took place from 2000-2007 where that level peaked far and above any precedent in history should not represent a new level to be re-achieved for anyone but the pathologically insane. The reason it not only is not necessary, but also that it is not good, for housing sales volume to re-achieve those levels is because there are not enough people that can afford such, and people buying something they can't afford is actually not good for the economy. Let me know if you need me to explain why that may be …
The Alternatives refresher we all need
What is the reason we incorporate "alternatives" in a client portfolio allocation? We create an "alternative" to equity market volatility (traditional assets) in the portfolio, so as to create "zigs and zags" that counteract one another, and pursue a better risk-adjusted result than we otherwise may find. Therefore, to have an "alternative" to equities, it behooves one to find "alternatives" that are actually alternative to equities. "High beta" in one's hedge fund portfolio may perform well if the beta is performing well, but it isn't an "alternative" to your equity beta to merely mirror it in another form. The objective in intelligent alternative investing is not to beat the market, but to non-correlate to the market - meaning, low beta. Seeing the recent tick-up in so many hedge funds' equity beta reinforces for us why selection is so, so important in alternative investing.
And another refresher?
The dispersion between managers in alternative asset classes like hedge funds, private equity, and real estate is simply massive - exponentially higher than the dispersion between long-only public equity managers. In other words, the manager selection means everything with alternatives, whereas in public equities the asset class itself may very well do the work. This categorical distinction is why blindly allocation to hedge funds is not the objective. Rather, thoughtful manager selection, due diligence, strategy oversight, and careful implementation is the key to alternative investing.
Real Estate vs. Stocks in Recession
I love this chart from JP Morgan Asset Management showing how high the correlation between real estate and stocks is during recessions. This chart points to one really clear exception: the tiny recession post-dotcom and post-9/11 in 2000/2001. There, correlations stayed very low, and that has caused many to suggest the two asset classes zig and zag against each other in recessionary times. History tells the opposite story, which forces me to prove my thesis with an empirical explanation. Simply put, the low rate environment and formation of the housing bubble were perfectly timed during that stock market recession and served as an outlier in which housing prices managed to rise even as the rest of the economy struggled. The collapse of underwriting standards, heavy securitization, infinite access to housing mortgage credit, and all the events that became the very kindling of our financial crisis also managed to, years earlier, help real estate skirt that one recession. An exception, not the rule!
Our Emerging Emerging Thesis
A tighter U.S. financial policy framework in 2018 combined with threats to global trade served to hit emerging markets with a one-two punch. And since both of those catalysts are theoretically in the opposite stage of where they were 6-12 months ago, it warrants a look at the asset class (from emerging markets stocks, to bonds, to currency). Monetary policy expectations are now much more accommodative, obviously, and while valuations are well of their lows of 4-5 months ago, remain competitive and attractive relative to other risk asset historical levels.
Getting QE right so we can get the next five years right
The consensus view when the Fed embarked upon quantitative easing a decade ago was that it risked creating inflation, as critics feared that the build-up of excess reserves was a backdoor way to monetize the debt, and that it would boost asset prices and economic activity, thereby boosting the price level. I have long argued that the majority of inflationistas were not so much getting something wrong, as not understanding what QE really was, to begin with.
The combination of zero-interest-rate-policy and three rounds of quantitative easing (QE) served not to increase the money supply and the price level, but rather to create a low cost of capital that depressed returns on savings, and stimulated corporate borrowing. This not only was not inflationary, but it was arguably disinflationary.
The problem is that the low cost of funds did more than stimulate economic activity in the corporate sector. It also enabled additional government spending that crowded out the private sector (a dis-inflationary activity). It benefited struggling companies which compressed the margins of their stronger competitors (a dis-inflationary activity). Debt is a drag on growth and dragging growth is dis-inflationary.
But more than anything else, the many years of aggressive monetary policy we saw post-crisis served to exacerbate mis-allocations of capital, and provide a deeper commitment to debt than we had before the crisis. The primary addicted patient may now be corporations or sovereign nations (as opposed to consumers and home borrowers), but the challenge is the same nonetheless. Our positioning ought not to be in trying to guess when we switch from deflation to inflation (something no one has done remotely well), but rather in finding investments driven by cash flows and pricing power, which weather either season well, and do not depend on monetary assistance to thrive.
Politics & Money: Beltway Bulls and Bears
- Did the Mueller report shock markets? Obviously not. Have I spoken enough about this? I'd say so [Fox Business - Cavuto Coast to Coast]. Will the aftermath of this report mean much to markets or the present political atmosphere? It appears those pre-disposed to disliking the President are more prone to do so now, and those pre-disposed to defending the President are more prone to do so now. It does not appear that many minds or perspectives are changed. Will the Democrats pursue impeachment? And if so, will that hurt them in 2020? The first question remains to be seen. The answer to the second question is as clear as can be to me.
- Former Vice President, Joe Biden, announced this week that he was entering the race for President in the very crowded Democratic primary field. Name recognition alone has him amongst the top of the field, and we will see in the weeks ahead how the early fundraising efforts go. Senator Biden is not necessarily as centrist and moderate as he is being portrayed, but of course, relative to many candidates in the primary field he is quite centrist (all things are relative, I suppose). To formulate a market perspective on a potential Biden presidency, it will take a little time to see how the campaign unfolds.
Chart of the Week
All risk assets have their value computed relative to a risk-free rate. What is it worth to me to take the risk in owning a given asset relative to the return I could get in some asset that does not have risk (i.e., a government treasury). In real estate, we look at "cap rates" to assess the income relative to the value that the asset produces, and the "cap rate spread" tells you how much more income you can get relative to the risk-free asset. Low cap rate spreads indicate very high valuations, and high cap rate spreads indicate low valuations. Spreads are a better tell than absolute cap rates, because the spread captures what matters - the income relative to something else - namely, the risk-free asset. A 7% cap rate may be quite low if a Treasury offered 6%, and a 5% cap rate may be quite high if the Treasury offered 1% (you get the idea). The Chart of the Week looks at historical cap rate spreads, and where things stand now.
“What matters isn’t what a person has or doesn’t have, but what he or she is afraid of losing.”
-- Nassim Taleb