"The imaginary person out there -- Mr. Market -- he's kind of a drunken psycho. Some days he gets very enthused, some days he gets very depressed. And when he gets really enthused, you sell to him and if he gets depressed you buy from him. There's no moral taint attached to that."
-- Warren Buffett
(What follows is a compilation of some of my Real Money Pro Daily Diary articles over the last month combined with a recent letter to my investors at Seabreeze.)
We remain of the view that equities are overvalued.
Again, for emphasis, we are not Perma Bears. We are not Perma anything. Rather, we are realists whose guiding North Star resides in the unemotional calculus and assessment of upside reward vs. downside risk --with a strong consideration for a "margin of safety."
At my hedge fund, Seabreeze Partners, we are value investors.
Value investing is the discipline of buying securities at a significant discount from their current underlying values and holding them until more of their value is realized. The element of a bargain is the key to the process. Being a value investor means you look at the downside before looking at the upside -- starting the investment process from a position of fear:
Take the probability of loss times the amount of possible loss from the probability of gain times the amount of possible gain. That is what we're trying to do. It's imperfect, but that's what it's all about.
-- Warren Buffett
As I have recently noted in my Diary:
Before we start our brief assessment and critique of the markets, we wanted to emphasize that we strongly recognize American exceptionalism - the belief that the United States is distinctive, unique and exemplary compared to other countries around the world.
We also recognize the tendency for equities to rise over time -- and that, as such, long positions serve to generate wealth while, when appropriate, short positions protect wealth.
Nonetheless, when we evaluate the business cycle, inflation, interest rates, fiscal and monetary policy, the U.S. corporate profits outlook and other factors we remain of the view that equities provide little value at current levels.
Thinking about the macro environment and how it influences our proper risk posture falls squarely within our responsibilities as an investment manager."
Within the context of the recent rally, the key question we face today is not whether we should be net short in exposure -- but, based on our analysis, how short we should be.
That is not to write that we are filled with hubris of view and opinion as we recognize that markets may not trade relative to the reality that we see. This is especially the case with quant products and strategies that dominate and distort the investment terrain and with ODTE (zero days to expiration options) accounting for 60% of total option trading. History has taught us that we certainly don't have a concession on truth and that the only certainty is the lack of certainty. We constantly and dispassionately question and "test" our views through hard-hitting fundamental analysis.
Controlling Risk Is a Little Discussed Portfolio Management Skill
Given the continued and heightened regime of market volatility and the role of quant strategies in exaggerating short-term market moves, we are particularly conscious of controlling risk. Though possessing a negative market outlook, and being net short, we demonstrated good risk management and did not lose money in the unrelenting March-July market advance.Throughout the month of August and into September, my hedge fund has maintained our net short exposure.
Bracing for Reality
We believe, in the time ahead, markets now must face and brace for the weight of reality -- chiefly in the likely deterioration in fundamentals (slowing economic and corporate profit growth, prickly inflation and interest rates higher for longer) as we face the consequences of wrong-footed policy (monetary and fiscal) at a time in which valuations are elevated.
The markets started the summer as a voting machine in which FOMO (fear of missing out) and animal spirits dominated the investment landscape. In turn, stock prices were buoyed by machine/algos, which are at the foundation of momentum-based quant strategies and products.
However, by mid-August equities began to decline, appearing for a brief period in time to have ended the summer as a weighing machine. That drop was surprisingly short-lived as equities rebounded robustly over the last two weeks. Though September is still young, the market internals have notably deteriorated -- with small-caps and financials weakening conspicuously as overall market breadth sours.
Importantly, history also demonstrates that "price is not truth" as, at times, markets deviate from reality. We believe we are in one of those times.
In the 18th century, Genevan Jean-Jacques Rousseau wrote that "the world of reality has its limits; the world of imagination is boundless."
So was it in early 2000 (at the end of the dot.com boom), in the Fall of 2007 (at the beginning of The Great Financial Crisis) and (at a key market top) in late 2021.
To some degree it has also happened this year, in the March-July period when equity markets rallied violently (and P/E ratios rose from 15x to 21x), in the face of rising interest rates and a plethora of growing market challenges.
Another 18th century philosopher, France's Voltaire, said, "those who can make you believe absurdities, can make you commit atrocities."
Then there was Alfred E. Neuman - who made his debut in 1954 -- the freaky little kid that appeared on almost every Mad Magazine cover, who once cautioned, "In retrospect it becomes clear that hindsight is definitely overrated!"
As noted, we are now on market alert and positioned short - as another philosopher, my Grandma Koufax used to say, "Dougie, always look over your shoulder as the Cossacks may be coming."
The market's climb remains large tech top heavy and the bullish clarion call for a broadening in the market's rise has gone unheeded, with the small-cap Russell Index and financials stalling:
In terms of concentration there has never been more hedge fund exposure to large technology stocks in history - recently crossing 30% for the first time ever:
Market Participants Grow Complacent as Headwinds Multiply
Today our markets face the weight of reality as, among other headwinds, are:
* A U.S. economy, though still reasonably strong but imbalanced by the wealthy, those with large balance sheets (savings, real estate, equities), is about to be weighed down by a number of factors -- the exhaustion of excess consumer savings, a record affordability stretch which will likely deliver an imminent decline in the residential real estate markets (more on that this week), a massive loan reset cliff and the reemergence of inflation in gas and other energy products, etc.
* Inflation is likely to remain stubbornly elevated. With the base effects inflation comps grow more difficult. As well, the recent resumption of higher commodities prices (agriculture and energy-related) and continued pressure of wage inflation will weigh on the reported inflationary data.
Most notably, since June, the price of oil has advanced by +27%:
Then consider the recent UPS and American Airlines labor contract agreements and the upcoming UAW negotiations which we discussed fully in yesterday's opening missive, "Look For The Union Label":
Services inflation is at it again. Year-over-year, the "core services" PCE price index accelerated to 5.4%, the second worst since 1985, according to data by the Bureau of Economic Analysis, sharing that spot with January 2023. February had been the worst.
As noted in the body of this commentary, the Fed's job is far from done. Chairman Powell has been fretting about core services inflation for a year, and last Thursday he got what he worried about he'd get: an acceleration of core services inflation, especially in the red-hot "non-housing services":
Inflation, especially when sustained, is a voracious beast. Its cumulative and stacked impact cannot be understated as it eats up purchasing power and will likely contribute to what I have described as a likely extended period of "slugflation" (sluggish economic growth and elevated inflation). As an example, the following graph demonstrates the insane increase in the price of hospital services, college-related costs, medical care and childcare:
Here are some more worrisome data:
- The average payment on a new home is now at a record $2,750/month.
- The average house is now renting for a record $1,900/month.
- The average new car payment is now at a record $733/month.
- The average used car payment is now at a record $530/month.
- The average student loan payment will be $500/month when payments resume.
- The average gallon of gas is above $4.00 again.
- The average household credit card balance is now at a record $7,300.
- The average household will have $0 of excess savings by the end of this quarter.
How can the average person afford to live?
Two answers to the question are the depletion of excess consumer savings and the piling on of credit card debt (to over $1 trillion):
Not surprisingly, the yearly change in the credit card default rate is now at levels higher than in the Financial Crisis of 2007-09:
* A bulging deficit and endless rise in our nation's debt loads means that the service of U.S. debt will crowd out and dampen future economic growth.
The slow-motion crisis of debt and delusion that's been unwinding before our eyes for the last two decades is now accelerating because debt grows on an exponential rather than linear basis. Debt compounds if you don't pay it back and it compounds faster as it adds up. It's simple math -- actually it's compound math. We never hear a single serious word from any political or business leader about cutting debt. They figure they won't be around when the crisis comes to a boil.
The gigantic US government debt is now approaching $33 trillion, amid a tsunami of issuance of Treasury securities to fund the mind-blowing government deficits and roll over maturing securities. At the same time, the Fed has hiked its policy rates where borrowing with short-term Treasury bills costs the government now close to 5.5% in interest, and borrowing longer-term costs over 4%.
But the higher interest rates that the government pays now apply only to the new Treasury securities to fund the new deficits and to replace maturing securities with lower rates. The securities issued years ago will cost the government whatever coupon interest they came with until they mature.
The average interest rate that the government is paying on all its interest-bearing debt has been ticking up gradually from the historic low point of 1.57% in February 2022 to 2.84% in July. And it will continue to rise as new securities with higher interest rates take on a larger share:
Unfortunately our country is not alone as every major government in the world is engaged in a race to the economic bottom and nobody is willing to acknowledge that a race to the bottom only ends in one place -- the bottom!
* A Federal Reserve will be forced to stay higher for longer, with an elevated neutral rate than previously assumed, in order to maintain price stability.
* The Fed's stated and current Quantitative Tightening will serve to reduce overall market liquidity and will likely add pressure to a possible (further) interest rate rise - to levels above consensus expectations.
* An unprecedented level of partisanship in Washington, DC reduces the timely address of legislation surrounding critical issues - structural labor, energy, geopolitical challenges/threats and, notably -- as discussed above -- our national deficit and debt load -- that our country faces.
* Rising geopolitical risk around the world and the absence of cooperation between the largest trading countries -- in an ever more interconnected world.
* Deglobalization is a threat to corporate profits and margins, the general level of inflation and is likely to be punishing to market valuations.
* Still relatively high price earnings ratios.
Finally, one of the most formidable headwinds to equities is high interest rates - not only from the standpoint of an alternative to equities but also as a dampener to price earnings ratios - as the risk-free rate of return is a key ingredient to discounted cash flow valuation models.
- High interest rates provide provides equity-like returns with little risk or volatility.
- A paper-thin equity risk premium (the difference between the S&P's earnings yield and the risk-free interest rate) - at the lowest level since 2006 - suggests that credit is more attractive than equity:
- The 1- year U.S. Treasury note yields 5.529% compared to the S&P dividend yield of only 1.55% - that's the largest gap in nearly two decades:
S&P Dividend Yield
- Moreover, the aperture between valuations and real interest rates has also rarely been so wide. Here is a comparison of the S&P 500 Index's forward price/earnings ratio versus the inverted real yield (adjusted for inflation) of 10-year U.S. Treasuries:
* And the case for value investing...
No wise pilot, no matter how great his talent and experience, fails to use his checklist.
-- Charlie Munger
To summarize... prickly inflation, coupled with a U.S. economic slowdown, a looming recession in Europe and the foundering economy of the engine of global growth - China - argue in favor of slugflation.
Given our checklist of fundamental and valuation concerns, coupled with the advice from Rousseau, Voltaire, Alfred E. Neuman, Warren Buffett, Charlie Munger and Grandma Koufax, we are maintaining our net short exposure as we are finding more attractive shorts than longs.
In closing, Ben Graham (the father of value investing) described the role of value, mathematics, patience and the importance of investing unemotionally, and not chasing price momentum, in these quotes -- which represent the watchwords of our investing faith:
Buy not on optimism, but on arithmetic.
You must never delude yourself into thinking that you're investing when you're speculating.
Individuals who cannot master their emotions are ill-suited to profit from the investment process.
Buy when most people, including experts, are pessimistic, and sell when they are actively optimistic.
The market is a pendulum that forever swings between unsustainable optimism (which makes stocks too expensive) and unjustified pessimism (which makes them too cheap).
The intelligent investor is a realist who sells to optimists and buys from pessimists.
If you are shopping for common stocks, choose them the way you would buy groceries, not the way you would buy perfume.
While value is in the eyes of the beholder, we remain convinced that, in the fullness of time, equities will decline to attractive levels for purchase.
Finally, we continue to be concerned with the impact of a changed market structure - in which leveraged quantitative products and strategies (e.g., risk parity) may adversely impact our markets much like portfolio insurance was responsible for the October 1987 stock market fall.
Apropos to the evolving change away from active investing strategies to a leveraged long pool of passive investing strategies - The Oracle of Omaha also once proclaimed that, "the stock market is filled with individuals who know the price of everything, but the value of nothing."
Buffett's quote has never been so true as in 2023.
(This commentary originally appeared on Real Money Pro on September 6. Click here to learn about this dynamic market information service for active traders and to receive Doug Kass's Daily Diary and columns from Paul Price, Bret Jensen and others.)