Anyone who enjoys sushi knows mackerel is one of the more pungent items you can order. It can have an overwhelming odor when inspecting up close before consuming. But as a good fisherman will attest, from afar, rotten mackerel can look quite appealing when glittering in the moonlight.
Bond and stock markets in the US and globally are reminiscent John Randolph’s age old adage of rotten mackerel in the moonlight. Based on the past 10 years of performance, these markets appear to be wonderful investments that never under-deliver lofty expectations. The Dow Jones Industrial 10-year performance is all glittery and shiny, up around 125% over that period. And long-term US bond yields hover at incredibly low levels typically reserved for periods of severe financial crisis or recessions. However, looking closer at the attribution over the last 10 years, these markets do not pass the smell test. Both have significant under-acknowledged and under-appreciated risks and large potential losses from revisions to mean valuations - these markets appear to be rotten.
Backward looking metrics, such as past performance, leaves out the attributes that are necessary to have a road-map as to where your journey will lead to next. Focuses on value metrics help keep investors grounded in forward looking expectations and help avoid disappointing and catastrophic results that most claim ignorance when experienced.
Using the Dow Jones Industrial Index as an example, history shows it is common for the price to earnings ratio (P/E ratio) to drop to the high single digits in times of economic stress. Currently the P/E ratio is around 18.5. This means the price should be expected to drop by around 50% to get to a high single digit P/E ratio assuming no changes in earnings during the next downturn. The drop could be expected to be worse if earnings decrease as well.
And taking a step back, think about what a P/E ratio of 18.5 means. At current earnings, it takes 18 and a half years for the earnings to equal the current valuation of the stock price. That’s quite a while and only makes sense if you expect significant earnings growth along the way. Needless to say after the longest expansion in the history of the US, that may be an unrealistic expectation over the short to medium term.
The bond market is not even close to being any better. Typically, long-term bonds in the US trade between 2 to 3 percent above the rate of inflation. As inflation is trending towards 3%, long-term bond yields should be closer to 6% than the current 3%. A reversion to this mean value could lead to a price mark-to-market loss of over 50%! And with such limited spare capacity in the US, low unemployment levels, wage growth picking up, a budding trade war and above trend growing economy, inflation is poised to go higher, not lower.
Looking backwards on history, it’s easy to see how the markets got to such current lofty levels. The central banks around the world have pursued hyperactive monetary policies to limit the duration of the financial crisis of 2008. They moved interest rates to zero or lower and flooding the systems with cash by purchasing trillions of bonds through quantitative easing programs. However, instead of pulling back on such unprecedented accommodation once the crisis had passed, they bent to political and social pressures to do as much as they could as long as they could regardless of the long term costs.
When such easy monetary policy is pursued, growth is stolen from future years and benefits are front-loaded. This leaves the economy in a tougher position in the future. Now that the recently enacted tax cut benefits are filtering through the system over the next two to three years and the Federal reserve has begun to remove accommodation, the economy is in for some tough conditions in a couple of years, maybe sooner. But the backwards looking metrics that encourage investments in overvalued traditional markets are blissfully ignorant to these factors.
The system motivating the masses is dysfunctional with its broken reliance on highlighting past performance. It benefits the large established funds to hold onto assets in overvalued asset classes longer than they should. Focus on past performance has a significant detrimental impact on the masses that are forced into poor risk/ return trade-offs. The masses feel the need to invest their savings and are largely limited on their investment selections to a few traditional overvalued asset classes. A focus on value would show the richening of these asset classes has attributed to a significant amount of the return, not economic performance. That would make limiting participation in these sectors an easy decision. Especially when cash is now a viable substitute offering some interest income.
Both the bond and stock market have had unprecedented drivers over the last 10 years that will not repeat in the future. Do not expect the next 10 years to even close to resemble the last 10 years. The start of 10 years ago began with a financial crisis and markets at historically cheap levels. Over the last 10 years, valuations have expanded to historically lofty levels.
When bitcoin was trading around 20,000 at the beginning of this year I was warning of the significant imbedded downside of an asset with little intrinsic value trading at such lofty levels. However, based on the past meteoric performance, even seasoned financial professionals were hopping onboard at the top of the emotional craze. The psychological pressure of witnessing significant wealth created by others – even if it will be fleeting – makes investors act in a way that leads to deep regret soon after. Not even 8 months later, bitcoin is the up close, visible rotting mackerel, a real-time warning to all of how quickly overvalued markets can wrack up significant losses.
My strong advice is to avoid these markets that have priced in all the good news. All that remains are significant downside risks from an eventual repricing of regret. If you have no access to other non-mainstream, non-traditional investments (such as investing in your own business or a private businesses and avoid paying such lofty premiums common in the publicly traded markets), that present good value, look into consuming your money in a pleasing and satisfying way. Skip the mackerel and indulge in a good Sake with maybe a sweet and pleasant smelling yellowfin tuna sashimi. There is no regret that comes along with good sushi.
by Michael Carino, Greenwich Endeavors, 9/12/18
Michael Carino is the CEO of Greenwich Endeavors, a financial specialist and a hedge fund portfolio manager, trader and owner of more than 20 years. He typically has positions that benefit from a normalized bond market, higher yields and value investments.