Might Financial Engineering Extend The Bull Market?

For both investing and the economy, cost of capital and return on invested capital (ROIC) are vital concepts. Generally speaking, investment capital will seek its highest return. This is partly what drives stock prices but it also is an important element in private investments and capital spending decisions by businesses.

The past several years have witnessed financial market anomalies not seen in many decades. One of those anomalies currently is the unusually wide disparity between the cost of debt capital and the cost of equity capital. Because of the long decline in interest rates, the cost of debt capital is now very low relative to the cost of equity capital.

Anomalies like this present capital opportunities. Specifically in this case, an arbitrage opportunity exists in which low cost debt can be used to boost shareholder returns (ROIC). How does this work? Say, for example, a large company has a current cost of debt capital of 2% and a cost of equity capital of 8-9%. It might make financial sense for this company to take on debt and use that capital to reduce equity capital through share buybacks. The result of this is higher ROIC.

The potential for exploiting the current debt/equity arbitrage has positive implications for the stock market and the economy. Why? First, it means that capital heretofore not invested in equities can come into the market via acquisitions and share buybacks; and second, capital is allocated more efficiently in the economy, an important benefit.

History repeats itself. We saw something like this in the early and mid-1980s. As interest rates (cost of debt capital) came down during the 1980/81 recession, it allowed strong companies to take on debt and acquire undervalued companies through leveraged buyouts (LBOs). This “financial engineering” process is occurring again and could be further fueled by this debt/equity arbitrage.

From a financial planning perspective, to the extent this arbitrage opportunity can continue over the next year or two, it reflects positively on stocks as an important vehicle for enabling clients to grow their financial assets, meet long-term financial goals, and keep up with inflation.

 

Twitter and Animal Spirits

It seems like our little “correction” appears to be over. The stock market indexes are all at or near all-time highs. Investors continue to remain comfortable with the “goldilocks” environment (not too hot, not too cold) for stocks: rising earnings, low inflation, and reduced fears over Federal Reserve policies. The situation in Syria? De-fused for now. Debt ceiling debate? It may get ugly for a while, but ultimately there will be a resolution to the debt ceiling.

Of greater concern of late is the “Twitter” and rising animal spirits. “New age” internet stocks, like Zillow, Netflix, and Facebook, have been on a tear lately, some of them up by over 200% in the last year. On top of this, Twitter, a social media company, recently announced it will go public. Why now? Twitter and its bankers sense the market is ready for it….the “animal spirits” of the market are ready and salivating for the next quick flip IPO.

Traditionally, when we talk about “animal spirits”, it refers to the human propensity for taking on more risk when things “look good”, when the market’s been up, and, oh yes, when it now seems OK to take on more risk. That smacks of “overconfidence” and overconfidence is a problem for the stock market.

While we suspect there is more upside for the stock market in the near term, the rising animal spirits may be an early warning sign that the market is no longer be “cheap” and that market “risk”, or volatility, may be increasing. From a financial planning perspective, the best way to protect retirement and investment portfolios from volatility is through appropriate asset allocation and diversification. Holding multiple asset classes in a portfolio reduces risk because different asset classes typically behave differently in different parts of a cycle (for example, bond prices usually go up when stocks go down). Sticking to a long-term financial and investment plan also lowers risk by reducing the temptation to “time” the market and buy or sell at the worst possible time in the cycle.

 

Three Terrible Days

Did you see this on the news? We were amused earlier this week when a commentator on a daily stock market program declared in horror that the stock market had been down three days in a row……Three days in a row!! Wow…...like it was the beginning of the apocalypse….or was it the beginning of a new, dreaded market correction? You know as well as I do that three days of a trend in the markets really doesn’t mean much. But it sounded so “daunting”. It perpetuates the “fear factor” and creates confusion. But, financial media know this is what keeps people watching and, of course, sells commercials.

Let’s look at what’s really happening. As bull stock markets go, the current one, which began in March 2009, has been pretty average or “normal”. There have been five corrections (market pullback) since March 2009 that have averaged about 13% and have lasted about 3.5 months. This is very much in line with the long-term averages. Corrections are normal and are healthy for the markets because they curb excesses and help maintain balance.

Granted, there have been some legitimate concerns lately about the potential for a correction based on a change in Federal Reserve policy and renewed debate over Federal debt ceiling. One thing we do know absolutely is that the market will correct again at some point. But we also know that the market has rebounded from every correction and bear market and that general stock market fundamentals remain sound.

So should you fear the coming correction or lay awake worrying about it? One of the best ways to protect an investment portfolio from inevitable pullbacks is through appropriate asset allocation and reasoned sector exposure. Holding multiple asset classes can help lower portfolio volatility and moderate losses in a correction. Reducing exposures to stocks and sectors that have performed extremely well is another way in which investors can mitigate the impact of a potential correction. The advice we give to clients is to develop a sound investment strategy or financial plan and stick to that strategy throughout the market vicissitudes. This helps to reduce the temptation to time the market and buy or sell at exactly the worst time.

Q3 Investment Committee Meeting Summary

We held our third quarter Investment Committee meeting on June 27. There was general agreement on a number of issues following our meeting, namely: we believe the U.S. economy continues in a slow but stable recovery; we believe inflationary pressures remain low; we continue to hold a positive view towards equities; we believe equity market leadership is shifting from a value/yield focus to growth; and general agreement that investor psychology toward interest rates is shifting to the view that a more sustained rise in rates is increasingly probable.   

Our longer-term view towards equities remains positive. We believe stocks should continue to perform well in a rising interest rate environment as long as 1) inflation remains moderate and 2) Fed policy remains gradualistic. We think leadership in stocks is shifting away from yield-oriented or value, to growth.  We think growth stocks can do better in a rising interest rate environment because of their perceived ability to grow both earnings and dividends at an above average pace.

Within equities, we meaningfully changed our allocation in favor of growth. We eliminated our holdings of higher yield stocks and added new positions in technology and dividend achiever stocks. These groups have the attributes of very large cash positions, attractive valuations, and large growing cash flows which place them in a position to grow dividends at an above average rate. We also increased allocations to small and mid-cap growth, which have historically delivered higher returns than large caps and we expect should do well in an environment that favors growth.

Within bonds, we reduced our exposure to intermediate bonds, slightly increased our exposure to short-term bonds, and repositioned our long-term bonds by substituting preferred stocks for long corporates. The preferreds provide a significant boost in yield and have demonstrated lower volatility. Our allocations to intermediate and long-term bonds are now at the low end of our allocation range while our allocation to short term bonds is neutral within our allocation range.  

Rising Interest Rate Concerns

Of increasing concern for the stock market of late has been anxious focus on the potential wind-down of the Federal Reserve’s long-standing monetary policy known as quantitative easing, or “QE”. QE has involved massive bond purchases by the Fed to keep interest rates low and stimulate economic growth. Some investors are concerned that ending this program would result in a rapid rise in interest rates which would be damaging for the valuations of financial assets, especially bonds.

While there is a clear and visible risk for bonds in a rising interest rate environment, history shows this is  not necessarily the case for stocks. Historically, stocks have been able to overcome rising interest rates and continue to appreciate in the face of rising interest rates. We recently analyzed seven (rising) interest rate cycles going back to 1967. What we found was that, on average over these seven rate cycles, the stock market was up 7.7% in the twelve months and up 17.7% in the twenty-four months following the bottom in rates. 

Why would stocks go up during a period of rising interest rates? There are several reasons for this:

1.       In most of the periods analyzed, the economy was either strong or recovering and, therefore, corporate earnings were rising.

2.       Stocks are viewed as a hedge against inflation because corporations can raise prices for their products and pass some of this on to investors via growth in earnings and dividends.

3.       Growth companies have greater potential to increase their book value faster than inflation and thereby provide better return potential relative to fixed income investments (i.e. bonds).

From a financial planning perspective, the analysis leads us to believe that this cycle should probably not be much different from earlier cycles. There may be a period of market “turbulence” or even a market correction as the Fed begins to taper its QE program; however, as of now, the economy appears to show little sign of recession, we believe corporate earnings will continue to grow, and we expect inflation will remain moderate. This leads us to conclude that equities, particularly growth stocks, should continue to remain an important component of a diversified portfolio.

Are The Skeptics Right ?

There are still plenty of people who are complete skeptics on the stock market and who still believe the market is going to crash. This is normal for this point in a secular bull market. Investor psychology has gone from a “total fear and loathing” phase in 2008/2009 to a “disbelief, distrust” phase more recently. And we are probably still a long way from the “euphoric stage”. To be fair, it is true that the market could crash at any time for some unforeseen reason or shock, but right now the financial fundamentals still look reasonable.

The fact that many people are still skeptical is actually bullish because of the lack of consensus. Once there is unanimity of opinion, it usually means we are at or near the end of the trend.  The market is kind of a “reverse psychology” animal: many times you have to “fight” the consensus to be successful and this is difficult to do. The ability to approach investing in a systematic and unemotional way is one of the key reasons why great investors like Warren Buffet do so well over long periods.

We all know the market goes through bull and bear phases; that is normal and predictable but these cycles trigger emotional responses. What causes these phases or cycles? Changes in the outlook for corporate profits has a significant bearing on stock prices. When the market perceives or is comfortable that corporate earnings will rise, it will bid the prices of stocks up in anticipation of improving earnings, as it has been doing for some time now. And vice versa, when the market anticipates or becomes concerned corporate profits may slow or decline (such as in a recession), it will bid the prices of stocks down.

Another key driver of stock prices is valuation. A lot of factors go into valuation, such as investor confidence, the outlook for the economy and inflation, Federal Reserve policy, health of foreign economies, geopolitical factors, energy prices, and a myriad other factors. Market cycles can be further exacerbated by “shocks”, such as financial bubbles (think “housing” in 2006/07) or bubbles within a market sector (think tulips in 1637, or technology in 2000). These “bubbles” create imbalances which are eventually normalized through severe market corrections.

So how do we deal with market cycles from a financial planning perspective? Like Warren Buffett, one way is to take “emotion” out of the process. This is accomplished through a sound financial plan. The plan acts as a long-term roadmap for both personal finances and investments and helps the client approach investments in a systematic and unemotional way.  A good plan will help a client “stay in the game” and avoid the temptation to make emotionally-based decisions at the worst possible time.

 

The “New Goldilocks”….. Not

In our last post, we discussed the “new goldilocks” economy. But it may be “goldilocks” for the wrong reason. Why? It may be “goldilocks” (not too hot, not too cold) for investors in financial assets (for a while anyway), but it remains a pretty cold bowl of lumpy porridge for many people who are either struggling to make ends meet or find a new job. The economy is operating well below its theoretical potential because of slow consumption and companies’ reluctance to ramp up new hiring because of this slow growth. In our last blog, we talked a bit about why, in this “new goldilocks” economy, money is shifting to equities from bonds in a search of higher yield. This is raising systematic risk because equities are inherently more volatile than bonds. To the extent more people are relying on higher volatility investments to provide more of their retirement income, the risk of many people falling short of requisite retirement capital is increased.

 So the point is, while it may be a “goldilocks” environment for stock investors right now, it is not “goldilocks” for the economy. We are still mired in a very slow growth environment which is part and parcel of a de-leveraging environment following a massive 30-year credit binge. It’s like a “hangover” and this is the “payback”. In the meantime, as long as global central banks maintain their super-easy money policies (which they appear to be doing), the “goldilocks” environment for stocks will also probably continue as excess liquidity is channeled into higher yielding equity securities.  But it does raise systematic risk and is unlike anything we’ve seen in the post-World War 2 environment. How does one protect themselves in this environment of increased systematic risk? Diversification of investment portfolios by both asset class and market sectors. Diversification provides the insulation or “shock absorber” when markets become more volatile or decline because assets that are not highly correlated to stocks may hold up better or actually increase when stocks decline. Diversification is probably the only “free lunch” in investing; it is one of the ways to obtain portfolio “insurance” without having to pay for expensive hedging or alternative investment strategies.