"When price discovery is blocked, trouble tends to follow."
This commentary was first published on 1st February 2021. Judge for yourself how its predictions have fared.
“Imagine, if you will, a person arriving in a town on an empty train, at the empty station, for the meagre, distanced and strictly limited funeral of an old friend.
He asks his way to the crematorium. The only available stranger replies: ‘Take the right fork at the dead cafe. Go past ten dead restaurants, three dead pubs, a dead shopping mall, a dead bookshop, two dead cinemas and a dead theatre.
Turn right at the dead museum, and right again at the dead gym. Cross the road when you get to the dead swimming pool. Walk through the first dead university. At the dead covered market, turn right until you reach the dead library.
Then take the empty bus up through the other dead university, through the dead suburb and past the dead school. Watch out for the dead surgery. At the roundabout, turn down the hill by the dead church and keep going for half a mile.
You can’t miss the crematorium, as it is one of the few places where there are any signs of life.’”
“The Financial Times has seen a copy of a letter written by Seth Klarman to his clients. Klarman is a legendary value investor, and value investors have not had a great time recently, not least because notions of value have been hopelessly muddled by the Fed’s interventions in the market. It is possible to make the case that those interventions were justified, particularly in March (and I would make it). However, judging by the FT report, I do not think Klarman would agree (“Mr Klarman criticised the Federal Reserve for slashing rates and flooding the financial system with money since the onset of the coronavirus pandemic”), but it is hard to argue with him about this:
The biggest problem with these unprecedented and sustained government and central bank interventions is that risks to capital become masked even as they mount.
The Fed’s policies and programmes “have directly contributed to exceptionally benign market conditions where nearly everything is bid up while downside volatility is truncated”, he added. “The market’s usual role in price discovery has effectively been suspended.”
When price discovery is blocked, trouble tends to follow. One of the many reasons for the disaster that engulfed the euro zone a decade ago was that the decision to replace a whole set of national currencies with one single currency seriously weakened the market’s ability to price country risk. If, say, well, Greece, had been pursuing reckless policies, this would previously have very quickly been picked up in the currency markets as the drachma came under pressure. And as a result, the markets would have been much more likely to put an accurate price on Greek risk. But with the drachma swapped for the euro, that warning signal was extinguished (between 2001–2007, the average spread between the yield on German and Greek ten-year government bonds was 27 basis points — 27!). Unhappiness ensued.
Somewhat similarly, by distorting the debt market in the way that it has, the Fed has (for now) destroyed the role that interest rates ought to play in signaling and thus pricing risk.
Mr Klarman said investors were now in a constant hunt for yield that was driving them to riskier corners of the market, including investment-grade corporate debt, private credit or junk bonds.
And there is another problem. If (fights break out) the value of a stock should be linked to the discounted value of the forecast future cash flows generated by a company, then ultra-low interest rates can justify a massive increase in the present value of those cash flows and thus the share price.
Low interest rates have made projected cash flows more valuable, [Klarman] said, a point many investors have unwisely used to justify valuations on companies that sit far above historic norms.
“The more distant the eventual pay-off, the more the present value rises,” he wrote. “When it comes to the value of cash flows, the vast and limitless future, yet to unfold, has gained considerable ground on the more firmly anchored present.”
The difficulty is that, for as long as the market is being distorted in the way that it is, what would normally be irrational investing is rational. The signs of an investment bubble (or bubbles) are all there, from the rise of SPACs (blank-check companies) to the surge in participation of retail investors (the latter doubtless helped by the combination of being stuck at home and the sheer ease of investment in the Internet age) to electric vehicle mania. But quite what, other than an abrupt change of direction from the Fed, will change that is not easy to say.
Then again, at moments such as this I cannot help remembering the wise words of Nathan Rothschild — “I never invest at the bottom, and I always sell too soon”– advice that is good for almost any investment market, but, perhaps, for bubbles in particular.”
Prediction: after years of extraordinary gains, 2021 will be the year when Big Tech goes into reverse. And if this stock market juggernaut stalls, the fallout will be terrific.
The death of value investing, cited by Andrew Stuttaford above, has been somewhat over-reported. We say this as the managers of a Benjamin Graham-style explicitly value-orientated fund, investing unconstrainedly and internationally in listed businesses generating significant cash flow, but trading on low earnings multiples and with little or no attendant debt. Last year, the fund in question, the VT Price Value Portfolio, returned 9.7% in 2020. The FTSE 100 index, by way of comparison, lost 14.3%. If outperforming the FTSE by 24% in a single calendar year equates to failure, we’d love to know what success looks like.
But it’s certainly true that most “value” strategies have, for some years now, substantially underperformed the only game in town, namely Big Tech in the US.
This correspondent having had front row seats to the first dotcom bubble, back in the late 1990s, working as a private client portfolio manager at Merrill Lynch, as we watch the latest surge by the biggest names in Big Tech, it seems to possess all the hallmarks of a classic, end-of-cycle, bubble at the point of bursting.
Bubbly anecdotes abound. US market analyst Evan Lorenz points out that two weeks ago, six penny stocks accounted for 18% of total US equity market turnover. When it surveyed its members on 13 January, the American Association of Individual Investors reported that precisely 100% of them were bullish. This incredible outcome turned out to be the product of a software glitch, but it looked perfectly plausible in the context of financial media news flow including, on 14 January, a story from news agency Reuters talking up the uses of astrology in timing bitcoin purchases.
But precise timing, as always, is impossible. So our question to you is straightforward. Are you more concerned with capital preservation, or with missing the last few percentage point returns from a hopelessly overvalued market ?
As Evan Lorenz concedes, he and his colleagues discussed the problems in US structured mortgage credit, for example, in minute detail back in September 2006; but the S&P 500 stock index rallied for another 13 months after that. That said, he believes – as we do – that “there remain cheap assets outside the 50 states – Japanese equities, for instance…” And in passing, let’s not forget the real elephant in the room, in the form of the $16.9 trillion of bonds globally that yields less than zero.
The major political event of the year to date, of course, has been the inauguration of Joe Biden as the 46th US president. This is, in our opinion, a disastrous development for US markets and for the US economy. Alasdair Macleod of Goldmoney shares this perspective, and predicts the following:
But our primary concern for 2021 is that Big Tech stocks (including Google/Alphabet, Facebook, and Twitter) will fall to earth, from a combination of rising regulatory oversight after their abysmal interference in the free speech process by effectively cancelling both Donald Trump and new media rivals to social media such as Parler, and from consumer and customer boycotts in response to the same developments.
Since Big Tech has been such a key driver of the bull market, any precipitous declines by the major players cannot but have knock-on effects on the rest of the stock market. Separately, if Alasdair Macleod is right, which we suspect he is, the bond market will also come under acute pressure from investors searching with an increasing sense of desperation for the exit. If the Fed is successful at keeping a lid on these developments, the only possible escape valve left is currency turmoil. So make sure you own gold. The inflationary impact of Bidenomics already make inflation hedges look like a shrewd investment for all investors for the year ahead.
As you may know, we also manage bespoke investment portfolios for private clients internationally. We would be delighted to help you too. Because of the current heightened market volatility we are offering a completely free financial review, with no strings attached, to see if our value-oriented approach might benefit your portfolio -with no obligation at all:
Tim Price is co-manager of the VT Price Value Portfolio and author of ‘Investing through the Looking Glass: a rational guide to irrational financial markets’. You can access a full archive of these weekly investment commentaries here. You can listen to our regular ‘State of the Markets’ podcasts, with Paul Rodriguez of ThinkTrading.com, here. Email us: firstname.lastname@example.org.
Price Value Partners manage investment portfolios for private clients. We also manage the VT Price Value Portfolio, an unconstrained global fund investing in Benjamin Graham-style value stocks and specialist managed funds.
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