I had a very interesting conversation with an experienced value investor last week. We talked about a variety of topics, but one question he asked me really stood out and I continue to think about today. Has the investment landscape changed permanently? It certainly feels that way. However, we need to be careful in declaring so, as the history of financial markets is littered with “this time is different” corpses.
This is an important topic for me and for thousands in the investment management industry. If things have permanently changed, there is little need for fundamental research and experienced investment judgement. Instead of continuing to follow my 300-name possible buy list and organizing my thoughts on this blog, maybe I should be in trade school learning how to wire a house, or even better, make an irresistible pizza!
I touched on this subject in an earlier post, “If You Think Nobody Cares About You, Try Missing a Couple Payments.” In the post I wrote, “I don’t know what to call allocating capital in these markets, but I’m reluctant to call it investing. That’s a shame given the extraordinary amount of human capital being consumed by the investment management industry. If central banks fix asset prices how is this investing? If this isn’t investing, what is it? And if we all know prices are fixed and artificial, why are so many playing along?”
Is this investing? It’s a very relevant question in today’s financial world. Is buying a bond with a negative yield investing? By definition it is not. Investing is defined as committing capital with the expectation of receiving an income or gain. Assuming a negative yielding bond is held to maturity there is no expectation of receiving income, only losses. It is not investing (I’m sure you didn’t need me to tell you that!).
I have a different definition of investing. To me investing is much broader than simply committing capital to make a profit. It’s a process. A lot goes on from the time I discover an investment idea, perform due diligence, and make the purchase and eventual sale. For me, and for thousands of fundamental-based investors, it’s a long and thorough bottom-up process with a healthy mixture of critical thinking and subjectivity. Over this long process, I build an understanding of a business and develop an opinion of its intrinsic value. I then compare my opinion of the business’s worth to its market price. Seems simple enough, right?
I suppose it is. And I suppose the investment process as it relates to determining an asset’s intrinsic value hasn’t changed, but what about the purchase and sale portion of the process? The purchase and sale portion of my investment process often relies on changing fundamentals to create opportunity (purchase) and drive the investment’s price to my calculated valuation (sale). Let’s assume market prices are not allowed to fluctuate based on fundamentals. Instead, policy makers interfere and asset prices are set to levels they deem appropriate, not by market participants. In such an environment, market participants are price takers, not price makers, and fundamentals become less relevant. Is this still investing? Not as I define it.
In my opinion, the prices investors are now taking do not accurately reflect the true risks underlying a variety of investments, ranging from “risk-free” government bonds to small cap stocks. Risks, along with other fundamental variables, are becoming less of a factor in determining asset prices. As fundamentals decline in importance, the value investors place on the perceived safety of central bank price fixing, along with their reassurances that financial instability will not be tolerated, is growing. This new and intrusive investment variable, the central bank backstop, is difficult to value as the exact premium for its perceived “safety” is unknowable. Nonetheless, I believe it’s having a significant impact on how investors view and justify inflated asset prices.
This time is not different, but the cycle is…
I believe the pricing mechanism in financial markets is broken and asset prices are currently artificially inflated. Simply put, the prices of stocks and bonds would not be where they are today without central bank intervention. I don’t see how this is debatable. Whether asset prices are directly or indirectly set by central banks could be up for debate, but in my opinion, financial markets are not functioning properly and are not moving freely.
As I’ve attempted to illustrate in previous posts, asset prices are not properly responding to fundamentals, which is further evidence markets are malfunctioning. Despite this, I’m optimistic free markets will return with fundamentals and valuations eventually retaking the throne of what’s most important. When free markets return and valuations normalize, I believe asset prices and opportunities will improve considerably. It is why I continue to follow the companies on my possible buy list and remain engaged with the financial markets – I’m waiting for what I call “The Great Normalization”. Although I believe free markets will return, I do not know when the normalization process begins, or how long this period of artificial asset prices lasts.
It’s understandable why so many believe the investment environment has changed permanently. Central banks appear to be in complete control as every little hiccup in the market is met with decisive verbal or real countermeasures. It really does feel different this time. But don’t all asset bubbles feel different? The often cited Irving Fisher quote from 1929, “Stock prices have reached what looks like a permanently high plateau” is often ridiculed, but how different is this quote from the actions most investors are taking today?
Since investors are willing to pay current prices for stocks and bonds, they must believe something has permanently changed. Investors can’t believe stocks and bonds are good investments while also believing interest rates, profits, and valuations are going to normalize. When normalization occurs, investors will most likely incur significant losses. Therefore, buying assets at current prices implies investors believe rates will not normalize and valuations will remain well above historical norms. In other words, today’s investors are making the same assumption as Irving Fisher in 1929, that this time is different (ironically in 1929 the cycle was eight years old – sounds familiar!).
While I don’t believe things have permanently changed, I am aware that this cycle is different than past cycles – there has never been this type of coordinated monetary policy response. The last cycle (2003-2008) was just a good old-fashioned credit bubble. There was a limit to how far it could grow before it burst. For example, a bank’s balance sheet can go from 10x leverage to 20x leverage and maybe even 30x leverage, but its leverage can’t expand indefinitely. A central bank’s balance sheet is entirely different. In theory, a central bank’s balance sheet can expand indefinitely as there is no limit to the amount of money it can create to purchase assets.
Central banks’ unlimited purchasing power is reassuring to many, but for others (like myself) it’s extremely unsettling. Instead of raising taxes or cutting spending, why not print money to pay for the next need of the moment? It starts slowly and picks up speed as politicians and policy makers figure out an endless supply of “money” and crowd appeasement is literally a keystroke away. How will this power not be abused? And how has it not already been abused? How much debt has already been monetized globally to fund government deficits and spending? I believe it’s around $12 trillion and growing considering the ECB and BOJ continue to monetize stocks and bonds.
Monetary policy uncertainty and risk premiums
While the consequences of eight years of emergency monetary policies as it relates to asset inflation is clear, there are other consequences that are less obvious. One is the large number of investors that were once obsessed with bottom-up fundamental analysis, are now experts in central bank policy (this was another interesting topic of conversation I had with the experienced value investor). How can we all be experts on something that has never happened before? While we should acknowledge the influence central banks are having on financial markets, how can any of us know exactly how things unfold and what the ultimate consequences of these extreme monetary policies will be?
I argue we don’t know and we can’t know. And this includes the central bankers themselves! As such, shouldn’t the biggest uncertainty facing investors today (global monetary policy) be a reason to require a higher return on assets, not less. Considering we have never experienced these sort of monetary experiments before, along with the fact that whenever it has been tried by an individual country it’s ended badly, why are investors paying record prices for stocks and accepting record low yields on bonds? In effect, the investment environment is more uncertain today (risk higher) due to global monetary policies, not less. Can anyone name one instance when monetizing debt was successfully implemented and exited from? As a newly unemployed person, I’m open-minded to the wonders of money printing. If monetizing debt and helicopter drops work, let’s get on with it so we can all retire!
The last credit and economic cycle was very different than today’s central bank driven cycle. An investor could locate the eventual problems by following the debt (the mortgage debt trail led to the banking system). This time is different as a lot of the government debt that has been created has been monetized and is on central banks balance sheets. Central bank policies have depressed risk free rates and inflated asset prices. Instead of following the debt this cycle, I believe it’s more important to follow the asset inflation.
In my opinion, areas of accumulated asset inflation is where the risks of this cycle are centered. Instead of the banking sector catching most of the heat when this cycle ends, I believe it will be fully invested mutual funds, ETFs, pension funds, hedge funds, private equity funds, and any other financial vehicle that is underpricing risk and holding a pile of inflated assets.
When investors determine central bank policies are ineffective or counterproductive, the unlimited central banker bid will disappear. When that occurs, how will set prices respond when they become unset? I’ve managed small cap stocks for 20 years and I know what it’s like when the bid goes away. It’s not pretty. People panic. Large investors who need to get out drive prices down until they find a sizable bid. Before that bid can be found, there is a large air pocket. How all of these funds locked and loaded in risk assets will be able to find buyers during the next market liquidation is beyond me, especially given the sharp increase in ETFs and index fund investing.
In the meantime, investors aren’t very concerned. In fact, many investors are pressing their bets. According to a recent Bloomberg article, “Professional speculators are making record bets in volatility markets that U.S. stocks will keep rallying.” The volatility index VIX traded near 11 last week. Another Bloomberg article quoted a trader as saying the VIX dropping below 11 by end of month is “very possible” in a market that central banks built “with lower rates and asset buying and money.” The investor also said, “It’s a “Field of Dreams” market because “if you build it, they will come”; “central banks built it” and “investors have come”.
Is this investing?