The Inherent Contradictions of My Portfolio (or Who’s The Greater Fool..?) (Part II)

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blue chips, bubbles, bullish, China, don't fight the Fed, Europe, floating world, Greece, Japan, Nifty Fifty, quantitative easing, US

OK, I posted Part I a month ago (and here’s its prequel, Welcome to the Floating World…), so you may want to skim those posts again. [Especially as the world’s changed so much since then…what with the bond markets going crazy, Greece staying crazy, etc. 😉 ] To briefly summarise:

The central banks ‘control the price of money, and everything else is a function of the price of money‘, and post-crisis they embarked upon the greatest price-fixing experiment ever – an echo/amplification of the entire era leading up to the late ’60s/early ’70s. Consequently, sustained near-zero rates has meant there’s a wall of money that’s slowly but surely being forced into the equity market. And just like the early ’70s, investors have & will continue to exhibit a distinct preference for Nifty Fifty stocks, i.e. large cap/blue chip companies which guarantee (or at least offer the illusion of) predictable quality & growth in an uncertain economic & fiscal environment. Small & mid cap stocks may be neglected accordingly, but will probably end up getting dragged higher regardless.

As for liquidity, central banks will basically find it impossible to reverse the explosion in their respective balance sheets…Pandora’s Box is now open. And GDP growth may prove irrelevant – since positive/accelerating growth is likely to underpin/encourage market sentiment & valuations, whereas weak/negative growth will simply elicit fresh expectations of central bank stimulus. Most of all, regardless of potential rate increases (or bond market volatility), the absolute level of yields means stocks will arguably remain cheap at any price…

But I really don’t have to make the argument: If/when this bull market keeps marching higher, I have no doubt we’ll be spoon-fed all the erudite & compelling arguments we need to justify it, ’til investors can no longer help themselves & inevitably turn the market into a self-reinforcing bubble. I’m not saying this is necessarily a logical process (what bubble is?!) – but I am saying it could easily happen, plus I’m also saying it could well turn out to be unprecedented…

 [Again, it’s worth remembering two recent & very relevant quotes:

Buffett – ‘Everything is a function of interest rates. Interest rates are like gravity.’

Tepper – ‘Don’t fight four Feds!’]

So, what are the implications for my portfolio?

OK, first we really need to ponder the major markets themselves – let’s focus specifically on the ‘four Feds’ here:

US:   I don’t necessarily evaluate markets primarily in terms of respective P/Es, but the US is an obvious global benchmark for many investors, so we should specifically highlight the S&P is currently trading on an estimated 18 P/E. Which is closely bounded by a 16 P/E Dow & a 19 P/E Nasdaq. At first glance, none of those ratios look cheap…but none of them look too expensive either. Except that conclusion’s guided by our historical experience, and reflects what seems like an increasingly prevailing market notion – that the crisis is already fading in our memories & the world’s making its way back to (a new) normal. But when you consider the historical range of stock P/Es vs. bond yields, we’ve obviously traveled far into uncharted territory at this point. A place where just about any market P/E can be readily justified, as long as investors want it to be…

For the moment though, the US market’s still learning a new derivative – the Yellen collar. Sure, we can absolutely rely on her to keep writing the Fed put, but now we also have a Fed call on rates that’s capping the market. [To be cynical, the Fed’s new-found enthusiasm to raise rates isn’t really about economic orthodoxy…it’s more to do with Yellen’s desire to prove she’s got some stones. But more seriously (& scarily), it’s because the Fed now recognises it urgently needs to start reloading its elephant gun (with far higher rates, and I’m not at all sure that’s actually possible), so it will have some ammunition for the next crisis/recession]. This fear & uncertainty re potential rate rises will likely keep the market range-bound in the near term – I wouldn’t be at all surprised to see the S&P remain locked in a 2,000-2,200 range for the next 6-12 months, at least:

And the same is probably true of the buck…in spite of all those strong dollar headlines you keep reading, its year-long rally actually ended 2-3 months ago as the market (& now the Fed) became more dovish about the near term outlook for US GDP growth & rates. Here’s the Dollar Index for the past year:

[However, the dollar still enjoys substantial net gains – a macro factor analysts tend to under-estimate, so I suspect the negative impact probably hasn’t been fully discounted into earnings forecasts for more internationally focused US companies.]

But looking ahead, I think we’ll need to experience at least one or two rate hikes before the market actually gets over its fear of flying. Fortunately, rate rises have clearly been well flagged, there’s much less risk & leverage outstanding across the financial system (though absolute bond yields & duration still imply plenty of pain for the foolish), and higher money market rates (and/or bond yields, at any conceivable level) shouldn’t inflict any meaningful negative impact on corporate earnings/investment plans. Therefore, the potential importance of rate rises will likely depend far more on any resulting impact to investor sentiment…

If the US economy can actually develop/sustain some real growth momentum, it’s going to be a perfect excuse for the market to keep marching higher. And it’s worth remembering, in more normal times, the market’s often managed to rally anyway for at least 12-18 months after rates begin rising. Because growth ultimately trumps higher rates…but in this instance we’d still enjoy low rates, in absolute terms, coupled with higher growth expectations! On the other hand, there’s always the lurking possibility of a semi-permanent near-zero/QE environment (hello, Japan Part II) – but then the wall of money still hasn’t got a viable alternative, the Nifty Fifty argument still holds, and valuations keep ratcheting higher.

Maybe the most problematic scenario for the US market would actually be a (weak) Goldilocks economy, which leaves the market adrift & stuck with the Yellen collar. But don’t forget all that prior Fed stimulus is still going to be out there sloshing about, and we actually have three other ‘Feds’ who remain hard at work – so even in this scenario, I suspect the US market can still forge its way higher, albeit at a more hesitant & painful pace…

Europe:   Europe has far out-paced the US market this year, esp. in the first quarter, which has helped to close more of the valuation gap – it now trades at around a 10-15% discount to the US market, in P/E terms. Conventional wisdom would argue this seems more than reasonable, considering their relative growth rates & the continuing Greek crisis…but I’m not sure this perspective stands up under closer scrutiny.

I mean, where’s the actual ‘growth gap’?! 2015 GDP growth forecasts are now hovering around 1.5% for Europe, vs. 1.9% for US – clearly that’s far too close to call! The US obviously caused/entered the crisis first, so not surprisingly it’s now a year or two ahead of Europe in this current cycle of economic/financial recovery – with a Fed debating interest rate rises, vs. an ECB which is only now embarking on its most aggressive monetary/liquidity stimulus programme yet. Noting these relative positions, and recalling markets discount the future, which side of the pond really offers better momentum & upside right now for investors?!

Maybe the head should say Europe, but for many investors the US will instinctively remain their gut-call… Ironically, this investor preference might just prove my case – because it obviously reflects a general belief in & endorsement of the (apparent) success of the Fed’s QE programme(s). But logically, if that’s the case, the same investors should also believe the ECB will be equally successful & that Europe’s ultimately on the same trajectory as the US. Given that free sneak peek into the future, and Europe’s currently trailing position vs. the US, who wouldn’t want to belly-up for a big bet on Europe instead?!

As for Greece, it’s a side-show…who’d really notice if it disappeared? Its economy & equity market are mere rounding errors. And everybody & their dog knows Greece’s debt burden is untenable – any eventual debt write-off, restructuring, rescheduling, recouponing, etc. will come as no surprise to anybody, and surely the market’s discounted it more than adequately already. Not to mention the majority of the debt is no longer in private hands anyway. As for the Greeks themselves, don’t forget they defiantly voted for Syriza & all it implies – if that includes the road to hell, so be it…

And tolerating/funding Greece’s intransigence & profligacy clearly undermines the euro as a stable currency, and creates what might prove a far more dangerous & expensive future moral hazard – I’d bet my bottom dollar a Greek exit (or more appropriately, an ejection) from the Eurozone would ultimately underwrite a euro rally. Probably the only serious risk a Grexit presents is its potential impact on other weaker/peripheral Eurozone nations…though that’s nothing new either. But at that point, a clear line in the sand would then exist – nations would have a prudent set of fiscal standards to live up to, and be rewarded (or punished) accordingly. And Greece vs. Ireland (say) would offer two wildly different real-world scenarios to choose from – I think any fool can make the right choice there. Well, except for a politician maybe…

And speaking of, politicians are classic suckers for sunk costs – maybe Tsipras really has blinked first in the last couple of days, but I’m sure Germany et al. will otherwise just end up muddling their way through this with more delays, compromises & concessions. Whatever it takes really to keep Greece in the Eurozone, in return for at least some kind of bloody pretence it’s a responsible member. [Like Charlie Munger says: ‘You shouldn’t create a partnership with your drunken, shiftless brother in law’ in the first place, because you’re never gonna be able to cut him loose…] And it’s ludicrous to presume the IMF, for example, would actually announce an immediate default if they don’t receive payment from Greece on June-30th. So in the end, what matters most is the ECB’s ongoing stimulus programme, and the US has already drawn a precise road-map for the European market & economy to keep marching higher on the back of that…

Japan:   After rallying almost 150% in just two & a half years, you’d think Japan would look a little over-stretched now – in fact, it’s still the cheapest market. [And maybe the best Ben Graham-type market in the world, if you can’t resist that sort of thing…] Of course, investor sentiment’s improved accordingly – concern about the fate of the yen & Japan’s debt burden has abated for now, and Shinzo Abe has generated new expectations of meaningful change and progress in terms of corporate regulation, shareholder value & governance, and investor activism.

For the moment, a more relaxed attitude to the macro risks makes sense – after a 60% rally in the USD/JPY (over the same two & a half years, obviously a key driver of the equity market), it’s not surprising the authorities are now seeking a more stable currency. [Recent comments came after the market’s attempt to break clear of the key 125.00 level, which might have prompted a new rally to 140.00 (or even 150.00)]. As for shorting JGBs, that remains a real widow-maker of a trade (even Kyle Bass seems to have backed off now). And in reality, Japan’s (dire) fiscal situation will continue to defy economic logic – because at this point, Japan’s debt burden isn’t just its own problem any longer, it’s fast becoming everybody’s problem…

I mean, picture some kind of Japanese debt/currency apocalypse…now try to actually imagine what the hell’s happening with the rest of the world in that scenario. Quite the vision of hell, eh?! And it’s obviously a scenario the developed world must avoid at all costs. Which may well offer a bit of a silver lining, actually – because I expect Japan will ultimately be promoted as the global poster child for sensible & sustainable 150-200%+ debt-to-GDP management. Bizarre as this new paradigm sounds, it’s an obvious & necessary expedient for the US & Europe – after all, isn’t Japan’s current fate their inevitable destination also?! Just like Bernanke was a Depression scholar, I won’t be at all surprised to see a future Fed Chair touting his/her scholarship regarding Japan’s finances. And Japan’s skilful harnessing of its domestic savers/savings will attract widespread acclamation – after all, we can eventually expect to see a US President once again telling Americans their patriotic duty is to actually save money, all to fund an ever-increasing US debt & entitlement burden.

As for this glorious new dawn promised to investors, in terms of corporate governance & shareholder value, I think the jury’s still out. Yes, it all sounds a lot more promising this time ’round, but don’t forget we’ve heard this story any number of times before. The same applies for shareholder activism…a couple of swallows doesn’t necessarily a summer make. Sure, Dan Loeb appears to have scored a rapid & impressive success with Fanuc (6954:JP) – so rapid, I have to wonder if they were already considering a more shareholder-friendly stance – but people seem to have forgotten he also recently suffered a far more typical activist failure with Sony (6758:JP) (albeit, he exited with a gain). However, it’s still an excellent reminder of the substantial underlying intrinsic value & upside embedded in the Japanese market (which still needs to be unlocked), in terms of the obvious potential for improving corporate margins, return on equity & capital allocation. [This is obviously still true of Europe also (vs. the US, say), though obviously to a much lesser degree].

China:   Wow, look at that bull market fly…am I really going to argue here the Chinese market’s going to keep marching higher?! Well, I can’t disagree, there’s obviously a lot of froth & exuberance in the market right now – in internet/social media stocks, for example, except that’s no different really than the same mini-bubble we’re seeing in the US. But let’s try take a broader perspective here…

First, it depends on which China stocks & markets you’re looking at – ignore the speculative junk, there’s plenty of cheap stocks still available in the domestic markets. Admittedly, some may be lumbering SOEs, but who says they can’t grab a fair (or unfair) share of the Chinese growth pie? Or maybe they’re stocks you wouldn’t dream of touching with a barge pole…but let’s not kid ourselves here, how confident are you really about any individual Chinese stock/company/management team?! And when we think of China, we really should consider Greater China – there’s plenty of value still going begging in Chinese (exposed) companies listed in Hong Kong, Singapore, Taiwan, etc. [And obviously the major Macau stocks are looking pretty bombed now].

And longer-term, the past year’s market rally really doesn’t look so off base… Take a look at this long term chart of the Shanghai Composite, for example:

As of last year, investors had endured two bear markets & one bull market, leaving the index back at square one after nearly a decade & a half. And if we look back all the way to 1992, today’s index level suggests an obvious long term performance trend-line…unfortunately, a trend that’s actually compounded a mere 6.8% pa. Yup, bet you don’t see that being touted in any China fund’s marketing literature!? You know that China growth slowdown we’ve all been talking about…seems to me the Chinese market’s actually been discounting it for the past couple of decades!

So a China bull market that many now find perplexing doesn’t really surprise me all that much – particularly when  it’s essentially been government endorsed… This represents a huge about-face for the Communist Party – historically, it’s been fearful of speculation by small investors (for obvious reasons), so the government was generally quick to subdue any signs of over-exuberance. But over the years, with China’s increasing affluence & (continued) high savings rate, an increasingly huge pool of savings has been sloshing ’round looking for a home. With no foreign outlets available to the average saver, and a moribund domestic equity market (which was a relatively modest/declining % of GDP anyway), this savings pool was mere fodder for a banking sector that continued to shovel money into property/construction & other unproductive loans. The trust fund boom did appear to offer a solution, but ended up funding the same assets in even more speculative fashion…

So it was inevitable the government would eventually condone/encourage more general & active stock market investment. They may have let the genie out of the bottle a little recently, but big picture they’ll hopefully stay on plan – this is certainly not the right time to ‘fight the Fed’. Ideally, much of the speculative froth we now see will be gradually absorbed via new/follow-on stock offerings – to be used for more productive investment than the banking system, and which will also help to actually de-leverage companies & the banks. We’ll also see more foreign access granted – the Shanghai-HK (& the Shenzen-HK) Stock Connect are really just the beginning – which should also alleviate pressure, and also accelerate China’s long journey to full convertibility (& potential trade/reserve currency status).

This will go hand-in-hand with more dramatic changes in government policy in the years ahead. With the developed markets likely mired in slow growth, and with China having reached its Lewis inflection point, cheap/booming exports can’t necessarily be relied upon any longer to be the primary driver of the Chinese economic miracle. The domestic market will need take up the slack, and we can be sure it will…the Party can obviously pull more levers than most governments, but the main determinant & driver of success will be a sustained decline in the national savings rate & a concurrent rise in consumer spending.

To date, however, the Chinese people have proved to be annoyingly thrifty – how dare they..!? Which implies we may ultimately see something more like a US/European-style entitlement scam framework evolve in China, encouraging citizens to spend, spend, spend because a healthy & comfortable future’s now guaranteed by the state. [Most emerging/frontier markets can still avail themselves of this fiscal legerdemain – always easy to make financial promises that mightn’t come due for decades, in return for spending & taxes today! Hopefully, they make a better job of it than the West…]. And as difficult as it is for the Party (with revolution still a living memory), I expect we may also see a gradual shift to a more vibrant (American) form of domestic political control: That is, far less government anxiety & attention re perceived domestic threats, and a re-focusing of national attention on perceived (or even real) foreign enemies instead.

In the end, we should probably have more faith in the Party’s will to maintain/continue economic growth. I find it odd some of the economists now lauding the ‘recovery’ of the West are also announcing the end of the Chinese growth miracle. Surely it’s obvious the Party’s political will & economic/fiscal firepower dwarfs that of the West, esp. when it comes to ensuring success in what it continues to view as a life or death compact…jobs & growth, in return for continued Party control. Yes, the growth rate will fall short of historical levels, but will remain far ahead of the West & will obviously be pitched at a level which can continue to nourish & maintain the Party-People compact. And sure, it will be accompanied by the occasional speculative wobbles & bubbles, but I remain optimistic about the long term future & potential of (Greater) China stocks.

OK, that’s enough from me for now – hopefully this adds some interesting (& speculative) insights, both near term and/or long term, to my investment thesis: We’re in a bull market, which just might transform itself into a bubble, and even ultimately become the mother of all bubbles… This is obviously an evolving thesis – which I must highlight, is designed to be constantly questioned and re-evaluated based on new data & developments, and certainly not a thesis to be simply adopted & defended to the death with all kinds of confirmation bias. And I could keep on surveying the rest of the investment universe here, but if I’m any way correct, I expect a majority of the action & investor/fund flows will become increasingly focused on large cap high quality/growth stocks across these four markets – in effect, a new global Nifty Fifty. But I’ll also consider other markets & asset classes in a follow-up post, which will specifically (& finally) ask:

So, what are the implications for MY portfolio?

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