By Patrick Morris
With a dramatic increase in bond volatility and an uptick in fund redemptions in the past few months, the question is, what is a smart investor to do? What happens when the Federal Reserve and perhaps the other central banks (Japan, European Central Bank) decide to stop the inflows of cheap money? The smart investor can still be well positioned when the music stops and liquidity shifts. Accepting that bonds will take a beating, there is still good news. There are many sectors and assets that will outperform in this time of flux.
Unfortunately history is a terrible guide in the current environment since there are no modern examples of such a dramatic central bank intervention in an economy of the United States' size and maturity. Active managers have been fighting the Fed for several years with little luck outperforming based on fundamental principals of finance. For example, it would seem pretty logical that a company with strong profits and cash flow and low debt would be a more logical investment choice than an unprofitable debt burdened one. But you would be incorrect in assuming that high quality is a good investment if your goal is to perform in line with the market, or in the case of many managers to outperform the market.
Although the high quality subset has worked reasonably well, the big gains have come from companies that don’t just use debt, but require it. The market is full of stocks that have soared based on the availability of low-cost or no-cost money. One only has to tune into the mainstream financial media to see the names and faces of companies and CEOs that flaunt the new paradigm of negative margin growth. This concept is not that dissimilar to the Internet companies of the late '90s that focused the business model on growth at any cost in order to gain market share. The source of liquidity or new money is quite different, but the effect is the same: hold your nose and buy, buy, buy the speculative momentum names that are the ‘new’ economy. But like the ‘90s, these new paradigm companies are likely to run into insurmountable problems if interest rates begin to rise dramatically and the availability of new financing in the bond market closes off.
It is important to remember that there is also the profound difference between the equity that was raised in the ‘90s and the debt that is being accumulated in the 2008-2013 period. The principal difference being the expectation that debt is more secure than equity. It is, after all, higher up the ladder in the case of a bankruptcy, but that payback on bad debt is based on the liquidation of assets to recover money for bondholders. What if the company has very few hard assets or is bloated with worthless inventory? Equity investors are generally more comfortable with the risk associated with a 100% loss (not that any equity investor is ‘comfortable’ with losses of that magnitude) while bond investors assume that there is always some guarantee of value no matter what the outcome.
By pumping trillions of dollars into the new economy, the Fed has been giving an implied backstop in the form of perpetual refinancing at lower and lower rates. In some ways the policy has been effective. We cannot know for certain what the outcome of the 2008 collapse would have been if not for the dramatic actions taken in the U.S., but what probably frightens policymakers is the concept that when the Fed stops buying debt the economy will tumble to the lows that it could have reached five years ago. So the pump has to stay on…for now.
Historically the Fed has had a tendency to overshoot in both directions, either intervening too much or not enough. The long history of policy decisions paints a picture of a reactive, not a proactive, Fed. The pendulum will swing in one direction or the other and the Fed will try to set policies that accommodate growth but limit inflation. The tactful art of changing policies is one that is increasingly difficult as more and more market participants scrutinize every single word in statements and official Fed minutes. Today we live in a good-news-is-bad-news environment as market participants try to anticipate the Fed's next move. Paradoxically, the Fed needs to anticipate the next move in the market so there is a sort of circular logic to the whole thing. This bizarre phenomenon is based on the fact that if the economy recovers to say 3.5% growth and 6-6.5% unemployment, the Fed will take the opportunity to stop buying bonds. No more buying means dramatically higher rates, less availability of funds and an end to the party, so to speak. Of course, very bad news is still bad news since it means that the Fed policy is failing and we are just $17 trillion poorer now. In effect, the Fed needs the current policy to work, or policy makers would need to find a different way to stimulate growth, perhaps via massive tax cuts, but in this environment it is unclear where those cuts would come from. So now we need just enough bad news to keep our richest uncle, Uncle Sam, at the table pouring liquidity into the system.
When the music does stop, what will happen and, more importantly, how can investors avoid losing money or actually make money? Our research suggests that moving into higher quality equities is the best trade in the market and that carrying only short-term debt, but not money market funds, is the way to go. The logic being that the equity in certain companies is a ‘safer’ bet than either the debt, which is priced unattractively on AAA and AA paper or money market funds that have been chasing yield. As a side note, money market funds have been chasing return by taking increasingly risky bets in such assets as high-yield European bank debt. It would seem logical that these instruments are terrifically susceptible to a collapse of the European Union or a change in European Central Bank policy. That money market funds may be allowed to have a floating value means that $1 is not guaranteed to be $1 anymore.
Jeremy Siegel stated that returns can be very unstable in the short run but very stable in the long run. This is the concept of regression to the mean. The instability or variability of returns in the current market would suggest that ‘quality’ as an investment should either have significantly higher returns moving forward, or that low quality should have significantly lower and probably negative returns. At the time of writing, the quality spread, or the difference between the two is a shocking 1000 basis points, or 10%. This is an historical high and by no means a short-term blip. We are pushing the limits of regression and moving toward an entirely new calculation of ‘average’. Thinking back on the go-go ‘90s or the housing bubble, the length of time that things are out of whack is generally an indication of how hard the whack is going to be coming in the other direction. Since we do have some historical context given the multitude of times that investors have been asked to throw out reason in favor of a new normal, I think it is better to focus on regression not recalculation at this stage of the cycle.
Try as we might we cannot predict exactly when or exactly how the unwinding of the Fed effect will happen. Nor can we predict with any certainty the precise trigger event that will mark the end of the era, but we know that it is coming. Should we be running and not walking to the door? The short answer is yes. Always get out of the crowd if you smell smoke, because once you see the fire it is too late. The exit will get crowded and unfortunately a lot of people will get hurt. The best way to move may be to cash, but in terms of investing, cash is not your friend. Actually in an inflationary environment cash loses value and can lose that value quite quickly. Therefore we advocate playing the quality spread. Bet on cash flow, earnings and low debt. Exposure to equities is a good thing, not a bad thing and a risk-balanced portfolio of assets is more appropriate than a direction risk best. By this I mean to encourage a rotation away from highly speculative growth at any price equities, high-yield and duration-linked products, toward risk-managed alternatives.
It is always hard to make decisions in the market. Every market environment is different and there is a certain connection that people have to their money that causes tremendous angst in betting against the current trend or fad. If you have made good returns on the Fed policy, take the profits and de-risk ahead of a very uncertain Q4. If the past few years have passed your portfolio by, we would urge you to fight the temptation to chase the market. The best lesson we can take from history is that of the poor bedraggled value manager in the late ‘90s. Having looked foolish for years, the value managers had to keep repeating the mantra that the Nasdaq was overvalued and that the Internet bubble was going to burst. Ultimately a large number of those managers either shifted their investment style or went away completely. However, if you bought value in 2000, by 2007 you were more than vindicated. In today’s high stakes game of musical chairs, the quality investor will still have a seat at the table when the music stops.
Patrick Morris is the chief executive officer of Hagin Investment Management, a quantitative hedge fund in New York.
See also: The flight to crap is on borrowed wings / Regulatory balance is key for functioning markets