My last post (‘Welcome to the Floating World…’) talked about some of my habitual concerns regarding the markets & my portfolio…and consequently, I couldn’t help but highlight an inherent contradiction of my portfolio:
If I worry so much, how come my entire portfolio’s invested in stocks..?!
The answer’s simple: I have been & continue to be resoundingly bullish on the markets. Except it’s really not that simple…because this immediately highlights another obvious contradiction of my portfolio:
If I’m so bullish, how come my portfolio’s invested so defensively..?!
To illustrate, let’s revisit my Top Tips for 2015 post – which actually listed my Top 10 portfolio holdings (as of year-end 2014). Here they are:
I’d classify eight of these holdings into three (overlapping) categories: Deep value, special situations & (mostly) uncorrelated stocks (vs. the economy, or even the market). Which leaves just two holdings that can be described as growth (or high beta) stocks/funds: Fortress Investment Group (FIG:US) & VinaCapital Vietnam Opportunity Fund (VOF:LN). Granted, a defensive portfolio mix helps me sleep at night, as I’ve boasted before – but in light of my bullish market view, I have to ask if this is really an unnecessary luxury…or maybe even a bloody hindrance?
And in reality, my market view shouldn’t necessarily be that relevant anyway – return to my recent Stock Picking…Art, or Science?! series (esp. Part IV), and we’re reminded that consistent portfolio diversification isn’t just about geographical & asset allocation. Take another look at my Top 10 holdings table – again we see an inherent contradiction of my portfolio:
If I’m so concerned about diversification, how come my portfolio’s so lacking in large cap/growth stocks..?!
[Interestingly, the two growth stocks/funds I identified are actually my largest market cap holdings. My other holdings’ average market cap is just $84 million.]
Actually, I do have an answer, but it isn’t really a good one: I’m not averse to large cap/growth stocks. [I’ve owned Starbucks (SBUX:US) in the past, for example, to name just one of many!] But when I’m bullish, I personally tend to gravitate towards deep value & special situation stocks. Which is, admittedly, somewhat bizarre…as most bullish investors will tend to focus on buying large cap and/or small speculative growth stocks instead!
However, my reasoning probably isn’t so different – the more bullish I get, the more rapidly I expect deep value stocks to be revalued in the market (or be acquired), and/or special situation catalysts to deliver substantial value & upside. Unfortunately, this thinking’s no better really than some newbie growth investor assuming he’ll be making an easy 20-30% a year. And it’s a great reminder that a more formal stock picking process is essential, esp. in terms of genuine portfolio diversification, when/if you realise you need to ward off & stamp out such unconscious investing biases…
Bigger picture though, the underlying answer to my questions is more disturbing – in reality, the inherent contradictions of my portfolio reflect my continued anxiety over the contradictory prospects of the (developed) economies vs. the markets themselves. [And the same is true of the equity market vs. the bond market – in the end, how can they both be right…!?]
Astonishingly, almost seven years after the climax of the financial crisis, we’re still stumbling along nursing a potentially fragile global recovery. Which is a terrifying reminder of the underlying economic reality since then – in the absence of trillions of monetary (& fiscal) stimulus, and the bond & equity market rallies they’ve induced, quite obviously something more like (or even worse than) Japan’s lost decade (or two) would otherwise have been on the cards (& might still be)…
The marked divergence in performance we see here, for example, may not seem entirely relevant for some readers, but it’s intended more as an invitation really to consider more relevant/local examples for themselves…
Barring a few exceptions, I believe we’re now seeing a similar demarcation around the world: Two-tier markets where small(er) cap/value stocks may end up towed along in their wake, but mostly they’ll be left in the dust by large cap stocks, where investor flows/gains are now increasingly concentrated. Which reflects a similar two-tier attitude to risk: In the real world, investors remain risk-averse towards the majority of companies/stocks in the developed world, which face a world beset by surplus capacity & high costs, fragile & uncertain economic growth, an intractable welfare class & an over-stretched and disillusioned middle class, and governments over-burdened by massive debt & future entitlements. But at the other end of the spectrum, in the floating world, investors are increasingly risk-agnostic about buying the biggest & best blue-chips – which are the primary beneficiaries of a world awash in a central bank tsunami of liquidity & quantitative easing. [And investors’ insatiable appetite for income (at any price) is a similar & related phenomenon].
As I stressed in my last post, we’re now willing/unwilling participants in what’s proven to be a completely unprecedented experiment in money (& liquidity) creation. [In terms of size…otherwise, it’s an all too familiar exercise in currency debasement, which still fools people after thousands of years!]. Which puts us in uncharted territory, where perhaps we’re not even aware we’re lost… So how on earth can we hope to have any real idea (or assurance) of the ultimate impact & end-game for the developed economies/markets?! [Charlie Munger certainly admits he doesn’t!]
But I’m reminded here of Steve Drobny’s Currency Specialist interview (from the excellent ‘Inside the House of Money’), to which I keep returning in the past year. In just a few paragraphs, it offers some hugely insightful perspective about the (current) role of central banks – to summarise:
They control the price of money, and everything else is a function of the price of money*. And there’s really only one central bank, the US Fed – so they set the price of money. They can use monetary policy to drive people out the risk curve…from deposits to government bonds, to corporate bonds, to property, to equities (& even to commodities), while foreign exchange is the fan at the end of this curve. By default, they also control the price of liquidity & volatility.
[*Buffett’s quote from my last post is worth repeating: ‘Everything is a function of interest rates. Interest rates are like gravity.’]
So, call it quantitative easing, call it money printing, or why don’t we just call it the greatest price-fixing experiment the world’s ever seen…
Which leads me to suspect we may actually be repeating a specific history here – well, if not repeating, at least rhyming. We’ve essentially traveled full circle back to the
halcyon days of global government price controls/fixing – except this time ’round we’ve achieved it on a far grander scale, in effect compressing decades into mere years. And now we’re leaving the late ’60s again & heading into the early ’70s – and just as people discovered then, an illusory world of fixed rates, price controls & apparent economic/market stability can’t fend off an eventual & inevitable reckoning with the painful underlying reality….
So, what are the market implications?
Well, I believe the popularity of the Nifty Fifty in that late 60s/early 70s period may prove very relevant. They were a select group of large-cap stocks which offered what brokers & investors perceived to be an irresistible mix of quality, growth & dividends – that made them ‘one decision’ stocks, which investors would ‘buy & never sell’. Such an aura of invincibility was, of course, self-reinforcing…as they climbed ever higher, more & more investors came to believe & invest in them, until an average 40-50 P/E was considered entirely normal!
Fast forward to today, and we have trillions of central bank liquidity sloshing ’round still seeking a home, but the banking system still remains pretty hesitant about balance sheet expansion. We have global bond investors facing up to near zero & even negative yields. And we have prudent savers who have generally missed out on the post-crisis global equity rally, and who now can’t earn any kind of return on their savings. Out of choice, or simple necessity, this represents a huge wall of money that’s slowly but surely being forced to take the plunge into the equity market.
Because it’s searching for a better home…the modern-day equivalent of the Nifty Fifty. The bluest of blue chips in the major developed markets are the obvious & only real target for them – familiar large cap stocks which offer predictable (& increasing) dividends, and/or predictable (& higher than average) growth. Of course, we’re already seeing this phenomenon in terms of investor sentiment & the markets…and conversely, small cap/value stocks are now being generally neglected as far too difficult & illiquid a proposition for most such buyers.
But after rallying for six years now, blue chips certainly don’t look cheap any longer (but they’re not exorbitantly priced either). And if the underlying economic reality & prospects for the developed markets are (in fact) that gloomy, how can we really hope to see markets keep marching steadily higher? Ah but, isn’t that always the question…and when it comes to a potential bubble, I’m not sure anybody really cares anyway!? Because let’s not forget – a bubble definitely isn’t built on logic, and it certainly seems like we’re already adapting to a pretty illogical world.
When the alternative is a zero/negative return, a rock-solid dividend stock begins to look cheap at just about any price. And anyway, for such stocks, investors will ultimately be happy to fool themselves by raising their future growth expectations to justify increasingly elevated valuations. [We’re already seeing this with food stocks, for example – see my recent Four Mystery Horsemen post)]. And in a world of anaemic GDP growth & stagnant consumer incomes, stocks which offer the promise of predictable and/or accelerated growth can be priced even more stratospherically. Of course, the bubble really starts inflating when easy and continued gains on such stocks confirms & reinforces investors’ belief in their investment thesis, and then their investment genius, and eventually in their rightful investment entitlement to continued & assured gains… And the real world may do little to threaten to this scenario:
– I doubt there’s much possibility for the central banks to ever meaningfully reduce their balance sheets – only the ECB’s managed a (temporary) shrinkage to date (& it was probably unintentional)…and um, look how that turned out!? Otherwise, the Fed & the BoJ clearly don’t give a shit about the potential currency debasement implications of their actions, while the PBoC is obviously driven primarily by ideological considerations. Anyway, if such unprecedented monetary stimulus was absolutely necessary to reflate the global economy (as every government/central bank has insisted), how exactly would they argue a withdrawal of this stimulus wouldn’t have an equal & opposite deflationary impact?!
– And GDP growth may not matter so much… On the downside, we all know there’s a global central bank ‘put’ underwriting the markets – so if the global economy (or the markets themselves) take a turn for the worse, why worry, the central banks are there to save us yet again. After all, they haven’t come this far to suddenly give up now – in for a penny, in for a few trillion more, I say… 😉 And any upside surprise in growth (leaving aside how ersatz it might be, or not) is likely to be greeted with delight by investors ultimately, and could well prompt a potential step-change in corporate earnings expectations & valuations.
– Finally, we should consider rates…a subject of intense focus in the last week or two, with the recent reversal in bond yields. Frankly, I don’t think they matter a damn: Take note of where bond yields have actually ranged in the past few years – now if they manage to reach those levels again, why should that suddenly spell disaster for the markets? And if short term rates march higher by, for example, 100 bps (and there’s really only one place that might happen in the next year or two..!), why on earth should that meaningfully affect corporate earnings or investment decisions?!
In the end, rising yields (in their current context) aren’t so very different from the other myriad positive & negative facts, figures & opinions investors encounter every single day – and most of the time, they tend to end up serving the prevailing bullish or bearish market trend, i.e. facts are
cherry-picked made to fit the trend. [Which is why technical analysis often appears to predict the news…it doesn’t, it simply reflects and predicts prevailing market sentiment & trend(s)]. So if investors are genuinely bullish (or in actual bubble mode), and esp. when they don’t perceive a realistic alternative, real & imagined risks may have little impact in terms of potentially slowing down or reversing the equity market.
And again, remember what I’m arguing here isn’t that a coming (?) bubble is logical, I’m simply arguing that it could easily happen…and that it could also prove to be an entirely unprecedented bubble. Right now though, we’re missing some of the more obvious signs/confirmation of a full-blown bubble, so this investment scenario will remain a working hypothesis for the moment. But meanwhile, barring an occasional lurch or two, we should continue to feel pretty damn good about the markets…as David Tepper observed last week:
Next: So, what are the implications for my portfolio?