After Half-Term Ponderings: Where Our Man stands

Our Man has raised a lot of cash in the portfolio over the last couple of months, largely as a result of the exiting most of his Treasury Bond positions as yields fell sharply (and prices rose).  This, of course, leads to the question…what’s he going to do with it?   To get to the bottom of this, it would help to know what Our Man’s baseline macro views and expectations are as well as where and when he’s looking to take some risk.

While there has been positive news in recent weeks, it has done little to diminish Our Man’s bearish mindset.  Unfortunately, despite the talk and the plans, Our Man believes we’ve reached the point where the size of the problems we face is beyond the scope of the politicians and central bankers to solve.  As regular readers will know, Our Man believes we’re in a balance sheet recession; there are no simple and easy solutions to a debt-driven crisis.  Thus while the talk is about just how massive and impressive the latest European bailout plan is, to Our Man it is merely reminiscent of Paulson’s bazooka talk in the Summer of 2008.  The mere idea of leveraging Germany, France et al’s commitments to the bailout fund fails to acknowledge the simple premise that this is not a liquidity issue but a solvency one, and that the problem of excess debt cannot be solved by the issuance of (and increase in) more debt.  So, while more banks will be bailed out (without debt holders being haircut) and there’s the possibility of QE3 from the FED or some minor stimulus program in the US, once more the moves will only solve an imaginary counter-factual (if we’d not done this, then things would be worse) without encroaching on the real world issues. 

For equity investors, the long-term impact of the steady increase in leverage (especially since the 1980’s at the household level) has helped smooth economic cycles and led to numerous distortions in the market.  Furthermore, whenever the economy slows down, politicians & central bankers have become accustomed to using measures that foster an increase in debt (think lowering interest rates so you can refinance your home, or take out a loan, more easily) as their policy of choice.  The problem now is that despite record low interest rates and ample liquidity (thanks to the Fed’s rate cuts, Quantitative Easing, Operation Twist, etc) loan growth continues to be stagnant; there is no demand!  This lack of demand and the deleveraging, through both default and increased saving (i.e. reduced consumption), is something that equity investors should pay attention to. 

In the longer-term, as Our Man has mentioned before, with interest rates losing their potency (now we’re stuck at 0% rates) and demand stagnant, it becomes less likely that policy makers will be able to smooth the economic cycle.  As such, we should expect the choppier growth of recent years rather than the consistent economic cycles we’ve become accustomed to.  Furthermore, the disinflationary tendencies of a balance sheet recession mean that pricing power is likely to be more curtailed (no demand means it’s harder to push price increases through).  Combining these factors, means that over time Our Man is expecting stocks to exhibit greater cyclicality (as the magnitude of the cycles becomes more pronounced) and also to exhibit greater volatility (as the cycles become less smooth and more choppy).  These are, of course, the enemies of the buy-and-hold and value-driven investor.  The volatility affects the investor’s ability to hold his position from point A to point B, and means that the flight-path becomes as important as the destination.  The increased cyclicality will lead to a derating of equities as a greater risk premium should be introduced by investors to account for the more cyclical nature of equities but also due to investors’ long-term expectations proving overly ambitious (due to the deflationary/disinflationary environment limiting pricing power).

In the short-run, none of this would matter if stocks were at low valuations and margins were at or near cyclical lows.  Sadly, as the recent Chartology posts showed, neither is the case.  Now, certainly the use CAPE (or Shiller P/E’s) isn’t flawless, but like other long-term measures of valuation (e.g. Tobin’s Q), it does have a strong historical track record of long-term success.  So why does Our Man use the CAPE?  Well, it’s cyclically-adjusted…the Earnings part of the equation has been smoothed for a cycle, meaning the margins are those that reflect a full cycle (not a point in time) and that the figure takes into account the write-offs that inevitably come from the irrational exuberance of the peak.  Bear these factors in mind, when you next hear a Wall Street talking head say the market is cheap based on forward earnings (or even more egregiously forward operating earnings, which pretend we live in a fairytale world and ignore all the write-offs/etc).  Not only is the analyst assuming that the margins (currently at a record high) will persist at their current level infinitely, they’re not even using the actual earnings but their projections of the future which they then compare to a historical norm (i.e. the market’s average Price-to-(trailing) Earnings, or PE, is 15)!

So, in short; the underlying major issues are not being tackled by the politicians/central bankers, equities are going to be more cyclical & volatile (and thus de-rated, or trade at lower multiples) in the future, and they’re also currently trading at high valuations at a time when they have close to record high margins.  I think it is clear that Our Man’s bearishness remains undimmed.  However, with the increased cash and limited exposure in the portfolio, this bearish is not currently being expressed in any major way.  When will that change?  How will he express it?  Those, my friends, are questions for the next post.