Big Guns, Cheap Banks and Sweet Cash

It seems the hedge fund gurus are out in force of late talking about their view of the market. Ray Dalio of Bridgewater penned a piece in a recent edition of The Economist, and he was less than upbeat, to say the least. He wrote “The bond market is risky now and will get more so. Rarely do investors encounter a market that is so clearly overvalued and also so close to its clearly defined limits, as there is a limit to how low negative bond yields can go. Bonds will become a very bad deal as ­central banks try to push more money into them, and savers will decide to keep that money elsewhere. Right now, while a number of riskier assets look like good value compared with bonds and cash, they are not cheap given their risks. They all have low returns with typical volatility, and as people buy them, their reward-to-risk ratio will worsen. This will create a growing risk that savers will seek to escape financial assets and shift to gold and similar non-monetary preserves of wealth, especially as social and political ­tensions intensify.”

He added, “For those interested in studying analogous periods, I recommend looking at 1935-45, after the 1929-32 stock market and economic crashes, and following the great quantitative easings that caused stock prices and economic activity to rebound and led to “pushing on a string” in 1935. That was the last time that the global configuration of fund­amentals was broadly similar to what it is today.”

Being me, I went and looked. Driven by stimulus programs the market had risen from the bottom in 1932 through 1935 and continued to move higher until topping out in 1937. From here we fell by about 50% before bottoming. We didn’t recover the 1937 highs until 1945. Mr. Dalio doesn’t think a collapse is imminent but warns that the buying of risk assets by investors chasing return will continue to make them less attractive until the bubble does pop so to speak and a pullback in stocks and bonds become almost inevitable.

In a very rare occurrence, the whole of Seth Klarman’s annual shareholder letter was leaked, and he was not much more upbeat about things. He wrote to his investors saying “The steady drum beat of stock market gains (the S&P 500 index closed at record highs on eight different occasions between the election and year-end) casts a spell on market participants -no one wants to miss this ticket to paradise. As they piled in, investors were largely ignoring perilously high valuations. Goldman Sachs noted that the S&R 500, in aggregate, recently traded at the 85th percentile of its historical valuation over the last 40 years, while the median company in the S&P 500 had reached the 98th percentile of valuation. Respected investor Jeremy Grantham calculated this market as the third most expensive of the last century, behind only the markets of 1929 and 200, both of which ended disastrously for investors. David Rosenberg, the respected chief economist and strategist at Gluskin Sheff, a leading Canadian asset manager, noted that the U.S. stock market in early December was pricing in a whopping 30% earnings per share growth for 2017.”

David Einhorn of Greenlight Capital warns that we may see a reversal of the Main Street Wall Street disconnect at long last. He told his investors that “Since Election Day, the market appears to have changed its macroeconomic outlook and is re-evaluating the prospects for many companies accordingly. This change in tone has been favorable to our style, and we generated a good result in the quarter despite our low net exposure and a decline in gold. Rather than look backward, we’d like to share our views of what a Trump Presidency (TP) might look like and why we believe we are well-positioned for 2017. In short, we believe that the post-Great Recession easy money policies have been good for Wall Street but bad for Main Street. It’s possible that the TP reverses these policies, which would be good for Main Street but rough on Wall Street.”

He suggests that one of the strategies to prepare for a Trump Presidency is to short a basket of bubbles. He suggested “Bubble basket stocks mostly don’t have profits, which makes them unlikely to benefit from corporate tax cuts. Further, an accelerating economy should allow investors to find growth without needing to pay nosebleed prices for a narrow group of profitless top-line growth stocks. We think the basket is poised to further underperform with one caveat: There is a risk that Disney decides to star in the Internet Bubble 2.0 remake of the TWX/AOL deal by acquiring a profitless Netflix (NFLX) at the top. We suspect Disney won’t. Accordingly, NFLX merits a spot in the basket because its domestic market has matured; it risks an unfavorable change in net neutrality rules, and it has not demonstrated that its huge investment in original content has a positive return. We believe it doesn’t. NFLX is able to report that its U.S. streaming segment is highly profitable only by allocating a disproportionate amount of content amortization to its smaller and unprofitable international streaming segment.”

Daniel Loeb of Third Point reminded us that this is not the 1980s. He wrote to his investors saying “While markets are at highs, accelerating economic growth both in the U.S. and globally means that earnings should also rise for the first time in three years. The combination of higher nominal growth and lower tax rates could cause earnings to rise in the high single digits this year. Some observers highlight the parallels to the 1980s, but drawing too much from that comparison is dangerous because the starting levels are very different. Then, both interest rates and unemployment were high; now, both are low and likely moving higher. Debt as a function of GDP was 30%. It is now 80%. The median age in the U.S. was 30 then and is now 38. While this does not mean things cannot improve, particularly in 2017‐18, creating a virtuous cycle by following a 1980s blueprint is highly unlikely.

Mr. Loeb does make me happy with his thoughts on financial stocks, of which obviously we own a ton. He is quite bullish saying “In terms of fundamentals, rising rates in the U.S. have the obvious benefit of boosting net interest margins. But this is particularly true today because banks are sitting on more excess cash and liquidity than at any time in history. Indeed, with over $4 trillion of liquidity parked at the Fed, many banks do not need additional deposit inflows to fund loan growth for years to come – they already have the cash on hand to lend. This amplifies the benefits of rising rates as banks raise lending rates without a corresponding hike in deposit rates.” He further notes that “Our bank stocks trade at less than 10x earnings with high‐teens EPS growth ahead and at a small premium to tangible book value for returns that will expand into the mid‐teens.”

 

I don’t base my investments decisions on what the big guys are doing. However, the actions and opinions of investors who have made a lot of money over a very long time are certainly input factors into the decision making process. The limited number of safe and cheap opportunities is also a great reason for caution at current levels. I think that anyone willing to throw caution to the wind in what is a pricey market surrounded by uncertain conditions is being foolish. The market has been moving up for eight years now pretty much without a break in spite of a slow growth environment buoyed primarily by low interest rates. That may be changing, and I think that I grow fonder of my cash hoard with each passing day.

 

Moving onto more important things pitchers and catchers begin reporting on Monday and position players should all be in camp by the end of the week except the slackers on the Texas Rangers. Their position guys don’t show up until a week from Monday. I have started the data collection process for my season preview which is usually out sometime in mid to late March. I see that my wife has us heading out to the beach in Texas to visit her family in late March so I expect that’s when I will do it this year as the idea of combining baseball and beaches has a certain appeal. My track record predicting baseball seasons has been much better than my record predicting stock market movements. It is shaping up to be a very interesting season, and my Orioles look to be in it all year. I am signing up for my MLB TV package so if you see me walking along staring at my phone over the next eight months its not social media; it’s baseball!

Have a great week.

Cheers!
Tim
When approaching markets its probably best to emulate Bob Marley and use some