Interim Commentary: The Price of Safety
When it comes to the financial markets, unfortunately, nothing is free; indeed, truly idealistic capitalist markets correctly price all major aspects of investments: earnings, growth, liquidity, risk, and safety. Many of these have values which move in tandem, such as earnings and growth, while others are diametrically linked, such as risk and safety. Risky assets should compensate for risk through tighter valuations and greater potential upside, while perceived safety commands a premium and lower prospective returns; this concept is a key crux to the art of investment analysis. The market bubbles of 2001 and 2008 were primary examples of how risk, in and of itself, can become fundamentally mispriced, and result in financial crises. The causes and drivers of these bubbles have been well-documented, and the resulting effect has been an investing public which is acutely aware of risk compensation. However, a more difficult situation to recognize and comprehend, is when an investor is confronted with an apparent mispricing of perceived safety. I emphasize perceived in the previous sentence, as no investment is truly 100% risk-free. We believe that such a situation is currently developing within the so-called ‘defensive’ sectors of equities, and plan on adjusting client portfolios accordingly, where warranted.
Whether an equity is ‘defensive’ or not will typically depend on who you speak to, however, the general consensus for the definition is a stock which exhibits steady earnings and revenue generation, which are relatively insulated from fluctuations in economic activity. The thought process is that these companies will out-perform in times of economic weakness, while the growth and earnings of capital-dependant, high multiple growth stocks will collapse in contrast. Additionally, they will also typically carry decent dividend yields which attract investors further. Despite a lack of volatility in their earnings and revenues, however, defensive stocks also typically exhibit low earnings growth, and thus tend to trade at lower multiples. As a refresher course, a valuation multiple, such as a Price/Earnings multiple, is often used as a proxy for expected future growth, and as such, are justifiably higher for high growth equities. That being said, we believe we have entered into a precarious period of time when defensive stocks are much more over-valued, relative to their own history, than their growth stock peers. Exhibit 1 below, which we came across through our friends at Bonners and Partners, aptly displays this observance.
Further comments from Steven Wood of New York-based GreenWood Investors explains that defensive stocks are currently trading at an average Price/Earnings valuation of 23 times, which is actually higher than their higher growth ‘high beta’ peers. Defensive stocks are often referred to as being ‘low beta’, because the movements in their stock prices are not thought to be closely linked to the movements in the overall market. Interestingly, however, further analysis of relative stock performance during market crashes actually revealed that, although the earnings and revenues of defensive stocks was less effected during a crash, their multiples actually compressed much farther and thus their stock prices also crashed. Alternatively, growth stocks saw their earnings decline farther, but their price multiples held stronger, and thus their stock prices actually performed better. This leads us to the conclusion that ostensibly safe defensive stocks are not the haven many believe them to be, especially when they are trading at such elevated levels relative to their own history. It should also be noted that the metric of beta is inherently flawed, as it is inextricably linked to the data and time period used to calculate it, which is inevitably backward looking and sometimes comprised of small sample sizes or from scenarios not indicative of the likely future layout. As such, a stock exhibiting a low beta may not be a great indicator of how it will perform under significantly strained conditions; during severe corrections, effectively, most stocks (outside of precious metals) will exhibit high betas and see their stock prices suffer. In order to truly protect capital, investors need to incorporate precious metals allocations as well as a healthy mix of investments outside of the traditional stock market, such as alternative investments, private investments, and alternative fixed income.
As we stated previously, we are becoming increasingly concerned of the pricing of all key fundamentals of the market, namely earnings, revenues, risk, and now safety; although we are not predicting an immediate crash, we believe it to be prudent to begin shifting increased allocations to asset classes which are truly outside of the stock market. Given that we do not believe an immediate crash, however, the risk is that we are early with our asset shifts and that we miss further upside in the market. In order to explore this further, we compiled Exhibit 2 below, which charts the performance of moving in and out of the market ‘early’, versus buying and holding through crashes.
Exhibit 2 shows the performance of the S&P 500 index since the beginning of 1990 (blue line), charted against a ‘Buy and Hold’ strategy (red line), as well as a more prudent ‘Early Exit’ strategy (green line). The Buy and Hold strategy is self-explanatory; it shows the performance of an investment of $1,000 if you were to buy an S&P 500 ETF in 1990 and hold it until now. In such a scenario, this investment would be worth approximately $6,400 today. Alternatively, the Early Exit strategy models the performance of an investment of $1,000, if the funds were completely liquidated mid-1999 and mid-2006, over a year prior to the eventual market crashes. Leading up to both crashes, an investor would have ‘missed’ upside of 36% in 2001 and 25% in 2008. This may seem damaging, but the Early Exit strategy would have resulted in a current investment value of over $9,100, or over 40% larger than the Buy and Hold strategy. Although timing market swings exactly is nearly impossible, we believe that this study validates the idea that being early is better than riding the market while ignoring worrisome red flags. Avoiding major capital loss is the primary role of a financial advisor, and we believe that an ‘Early Exit’ strategy is the best way to protect our investors, should the current prevailing red flags persist. At 7% growth per year, a portfolio will double its value in 10 years; however, if 50% of its value is lost, it will need to experience a 100% gain in order to only regain lost capital.
A notable exception to the performance of equities during market crashes is, as previously mentioned, the precious metals space. To date, precious metals stocks have been the best performers in the market, and we continue to believe in their ability to provide ‘portfolio insurance’, as well as their relative attractiveness from a fundamental value perspective. For reference, Exhibit 3 below charts the performance of the GLD, the primary Gold equity ETF, versus the performance of the S&P 500, since the inception of the GLD in late 2004.
As can be seen in Exhibit 3 the precious metal equities, and gold specifically, tend to maintain their value through periods of market turbulence. Due to this fact, as well as our belief that the stocks themselves still offer compelling value, despite great performance as of late, we would likely not be exiting precious metal stocks as part of any Early Exit strategy.
We also believe that the fixed income market is exhibiting signs of an inherent mispricing of both risk and safety, with traditional government bonds being the main culprit. Exhibit 4 below, which we referenced many times as of late, is a great start to this discussion.
Exhibit 4 displays the contraction of global fixed income yields, and the disappearance of any government product yielding above 5%, and scarce product yielding above 2%. Indeed, approximately 75% of global bonds are being offered at less than 2%. We do not believe products such as this to be either safe or prudent investments. Profiting meaningfully via fixed income has become a game of capital gains and trading; they have essentially blurred the line that differentiates them from equities. By purchasing a 1%-yielding bond, an investor must bet on rates moving even lower, when they will be able to subsequently trade the bond and experience capital gains. If rates were to move higher, investors would experience large mark-to-market losses. Of course, investors will inevitably receive back their capital, but the compensation via yield in the mean-time is a pittance. Not to mention, for example, with a 1%-yielding bond, if inflation averages above that level over the term of the bond, the investor will have lost money in real terms. In summary, the potential reward of investing in fixed income is low, with rock-bottom interest rates and the necessity to trade, and the risks are high due to likely higher rates and possible inflation moving forward. We do not view this as a strong risk-reward profile, and we think that traditional fixed income is not providing its historical role of safety and income any longer.
As a result, many of you will have heard of our upcoming Debt Fund, which is comprised of several ‘alternative debt’ and fixed income products outside of the traditional paradigm. This product is being designed to fulfill the role which we believe traditional bonds have vacated: the role of low capital risk and a livable income distribution. In reference to our earlier discussion on what we view as an increasingly risky equity market, we believe it to be prudent to shift funds out of equities and fixed income, and into our Debt Fund. If you would like to learn more about our upcoming Debt Fund, please do not hesitate to call us. There is also a full webinar on our website, under the video tab, which details our vision for the investment.
MacNicol & Associates Asset Management Inc.