If you follow me on twitter, you have probably noticed me tweet “BUY CASH!” once in a while. It typically comes on a day when almost every asset class is down, hence the only thing being “bought” (via selling other assets) is cash.
I can’t believe I actually explained that! . Oh, and if you don’t already follow me on twitter, please rectify that.
Let me preface this post by saying this isn’t a forecast nor a recommendation, this is what I think has been happening over these last few weeks, and really intensifying this past Wednesday & Thursday.
In normal market environments, as my buddy @conorsen pointed out last week, there would have been a risk-on to risk-off mentality. Whether it’s based on specific headlines, sentiment, data etc. when market participants want to put “on” risk, they would shift from “safe assets” like Treasuries into “risky assets” like stocks. Within assets classes as well, from Treasuries into Junk Bonds – causing narrower spreads, or from defensive stocks into cyclical / high beta stocks. Vice versa when risking “off”.
What we’ve seen in the markets these last few weeks however, is that the correlation between assets have gone up. @TheStalwart posted this great article last week with a lot of interesting charts, including the following one from Miller Tabak depicting it quite clearly.
Many are struggling to understand why this is happening. I’ve watched interviews & read articles (including one in this week’s Barron’s from Bernstein Research,) where people are quoting data that shows equities performing well even periods when interest rates were rising.
Data (typically) doesn’t lie, and I would agree with it if this was a normal interest rate increasing environment, and I’m not talking about the size or speed of the increase. I’m referring to why rates have been rising.
It has become quite obvious - to me at least – that rates are not rising because of economic growth and/or higher inflation expectations. Interest rates are rising because they should have never been this low to begin with. Investors are simply allowing rates to get back – somewhat at least – to normal pre-QE/ZIRP levels.
I’ve seen many explanations as to why this is happening now, including the simple narrative, which would have you believe that the Fed controls everything. And now that they’re hinting that they’ll taper QE & eventually increase interest rates, investors ran to start pricing in the beginning of QE-less rates. They believe that the Fed was the only thing holding down rates.
Others, like Professor @AswathDamodaran who used a great metaphor in his recent post “Lessons from OZ”, believe that the Fed isn’t really in control, and in the end the markets will decide.
I continue to formulate my own opinion on the matter and think that there are multiple variables involved. A point that Felix Zulauf mentioned in last week’s Barron’s midyear roundtable really hit home. (emphases mine)
I still own physical gold. The price is making a medium-term bottom in the $1,300s. The downside isn’t dramatic from here, but we’ll need another global crisis for gold to start rising in earnest. The disappointing thing is that gold didn’t behave well, despite all the money-printing. The major forces in the world economy are still deflationary, not inflationary. The money isn’t flowing into the economic system. It is contained in the financial system and leading to bubbles — in bonds, emerging-market bonds, junk bonds, emerging-market currencies, and such.
Obviously this was referenced to gold, and it explains why gold prices have collapsed. The money that was printed – which the gold bugs thought would cause dollar debasement vs hard assets, and perhaps even hyperinflation - hasn’t flowed into the economic system. It all stayed in the financial system. And while this has helped the economy to a certain extent, the marginal benefit keeps on decreasing. The risks on the other hand keep on increasing.
Mr. Bernanke knows this. More importantly (as @AswathDamodaran would probably say), the market knows this. So perhaps there’s some sort of coming together, where market participants are realizing that the time to end QE is near, and although we’re in a deflationary environment, QE-less yields should be much higher.
Either way, the debate of why rates are increasing isn’t that important for this post. What is important, is the reason they are not. Rates are not increasing because of the economy growing. They are not increasing because inflation or the expectations of inflation has shown up out of nowhere.
If that was the case, you might very well have seen a great rotation (from bonds into stocks), or at least some sort of variation of a rotation from risk-off to risk-on. If rates were rising because of growth, the decline in Treasuries would have been coupled with an increase in the stock market. Or defensive stocks would have lost ground to cyclical / high beta names. (Early in this yield correction, there was some outperformance in high beta, but as i wrote in my recent “Macro Update” I think that stems from prior underperformance and the need to catch up.)
This is not what we have seen in this – so far – minor sell-off. Everything has been declining. There’s no risk-off happening. It’s all “buy cash”.
Investors are clearly beginning – and clearly only beginning – to price in a small portion of QE-less and eventually ZIRP-less markets.
Think about it for a second… Imagine you could walk into a bank and get a 2.5% 1-year CD. Imagine a 10-year Treasury bond was yielding 4% or 5%. What would happen to the risk-off investments? Let’s take a look…
At 4.5%, a 10-Year 1.7% US Treasury bond, purchased at par just a month or two ago would trade down to ~87 cents on the dollar!
Of course Treasuries are guaranteed, and if held to maturity you’re only exposing yourself to inflation & reinvestment risk. Uh huh.
How about your average low growth – 70% dividend payout – utility stock, which has been driven up because of the hunt for yield and now trades at 16x earning. It would probably fall back to a more typical 12x p/e for a nice 25% correction.
I’m sure the utility company has a consistent and stable business model. I’m sure they don’t need to rely on the next great product to fund their dividend either. But if you can lose 25% just to earn an extra few percent from a dividend, that’s not a great proposition from my vantage point.
On a related side note: I was shocked to read @htsfhickey in that same Barron’s midyear roundtable last week recommend a few gold miners (specifically $AEM). And not because gold and/or gold miners are volatile. It was just shocking to me that he highlighted the company’s 31 year dividend record and its 3% dividend as part of his thesis!
Dividends are important, and the more stable the company paying them is, the more important you should focus on them. IE – when buying a bond until maturity, the only returns you have (other than of course getting back your principle) are the interest payments. So when buying a bond, obviously, interest payments are key. Same with an equity and its dividend. If you buy a stock that hardly ever moves – up or down, then the dividend is crucial. However, the more volatile the stock price, the more irrelevant the dividend becomes. Gold miners have been, and probably will continue to be some of the most volatile stocks around.
Back to utilities – because of their huge returns the last couple of years thanks to the hunt for yield, they face a similar fate. Their dividends and consistency of their business model, has become and might continue to play second fiddle to the return of the stock. What the hunt for yield giveth, the flight from yield taketh away.
We wont even get into those mREITs, which until recently many investors sadly weren’t aware of their leverage or their holdings. In the above scenario, where ZIRP magically disappears, some of these mREITs would instantly be under water themselves.
In this environment the typical investments that you flee to when there’s a risk-off, might actually be more risky than the risky investment you’re fleeing from. (Such is the case so far in this decline with the $TLT down 11% vs S&P only 4.6%)
Some impeccable timing from my stream… As I was typing this post, @Fullcarry tweeted: “One month returns on some “safe” assets” along with the following graph
So what about the risk-on investments?
It’s really hard to measure the success of QE, and if I had to guess if it helped the economy (setting aside the costs for a moment), I would say it did, most definitely. But did it help they way people thought it would? I think the answer to that is a resounding no.
Look at a chart of the 10-year Treasury interest rates…
As you can see, when QE1 & QE2 were announced (11/25/08 & 8/27/10 (Jackson Hole)), Yields spiked… up, quite drastically as a matter of fact. And this was in the face on purchases that would have driven yields lower. This was because investors thought that QE would work and it would really stimulate the economy. Gold was driven higher for a similar reason. Investors thought QE money wouldn’t just stay on Wall Street, they thought it would flow out into Main Street.
Bottom line – QE has helped, mostly on and via Wall Street – propping up almost all assets, whether directly through the sellers of the MBS needing to buy other assets, or the retirees needing yield, bidding up anything and everything that had a dividend yields greater than the deflated CDs & bonds. All assets, real estate (Housing: Where QE Works) stocks, and yes, (nobody would have assumed this at QE1 & QE2 -) even bonds have been propped up by QE.
So now, if QE & ZIRP were gone tomorrow, what’s the fair value of all these risk-on propped-up assets? Has the economy improved? Undoubtedly. But I’m pretty certain that if QE & ZIRP disappeared tomorrow, most of these assets would be more fairly valued another 10-15% lower from today’s prices.
So during a “buy cash” decline, would you want to be invested in stocks over bonds? Would you want to be in cyclicals over defensives? They actually might do better (especially from a risk/reward perspective), but there aren’t many places to hide.
Having said all that, I do believe that if you’re forced to sell cash and put your money to work, there are places to invest and/or hide.
Event driven names with very little or no correlation to the overall market are the seemingly easiest choice. There are also plenty of fundamentally defensive companies – not sectors that are typically lower beta etc. – but firms that are trading at or near cash/asset levels with lots of optionally on the upside etc. These are areas where you can either calculate odds and make decisions based on specific idiosyncratic event-driven ideas, or where at least you have a margin of safety in owning assets at a discount to what they’re worth.
Again, this is what I think has been happening these past few weeks. Moving forward, the talk of tapering might taper, Bernanke might yet again convince himself that the QE benefits outweigh their risks, and we’re back to hunt for yield and QE4ever all over again.
The takeaway moving forward is to keep a close eye on the 10-year… That yield number should be the driving force of most assets classes. And keep in mind, the higher it goes, it most probably won’t cause a rotation to risk-on assets and drive investors to equities, rather it’s signaling that investors are beginning to price in – somewhat – the end of QE & eventually ZIRP, and in that case we’re heading back to reality, a reality that bulls may not want to face.