“Storms on the Horizon?”

Sydney M. Williams

Thought of the Day

“Storms on the Horizon?”

March 13, 2013

On Monday, the yield on the FINRA-Bloomberg index of High Yield Bonds hit 5.84% – close to the lowest yield on record, and only about fifty basis points above where the Thirty-year Treasury was selling in June of 2007. In late November 2008, the yield on that Index exceeded 25% – the highest since the Index was created. Normally, a positive move in bonds of that magnitude would be associated with a tremendous spurt in industrial and commercial activity. As we all know, that has not been the case. Instead, we are living in a strange “risk-on, risk-off” world that has as its principal source of momentum a Federal Reserve determined to keep interest rates at below normal levels. The bottom line: the Fed has done a lot for Wall Street, but not very much for Main Street.

While I have spent more than forty-five years toiling in the vineyards of Wall Street, I profess no expertise regarding bonds and very little about stocks. Years ago I learned ours can be a humbling profession. Macbeth’s three witches were far better predictors than most. Even the name Wall Street conjures images of tycoons in top hats, big cigars and fancy cars. Much of the President’s venom has been aimed at so-called “millionaires and billionaires” who populate its byways and boardrooms. This image has long been its bête noire. A hundred years ago, Ambrose Bierce incisively described Wall Street in The Devil’s Dictionary: “n, A symbol of sin for every devil to rebuke.”

Wall Street has had its share of con artists. Before Bernie Madoff, in 1940, Peter Schwed wrote a best-seller, Where are the Customer’s Yachts? The answer was obvious from the title. Just under thirty years ago, John Train’s Famous Financial Fiascos was published, which describes a dozen or so nefarious characters that have lurked along the fringes of markets for centuries. There have literally been hundreds of such books. Today, a firm called Power Trade, which I know nothing about, has a radio ad in which they highlight “Michael” who “went from a park bench to Park Avenue in a few short years” by learning to trade stocks. The ad claims he “cracked the stock market’s code” (whatever that is), “something your broker doesn’t want you to know.” When I hear ads like that I cringe and worry for our business. Caveat Emptor should be the watchword for all investors.

The Street is an easy place to mock, and there are certainly charlatans eager to separate a customer from his or her money. However, in my experience most people in the business are fair and honest. There are serious students of the market and there have been a few who have become very wealthy. At its core, Wall Street serves three critical roles. It provides the mechanism by which companies and governments can raise capital. It acts as a depository for the investment dollars of individuals and institutions. And third, it provides liquidity to buyers and sellers.

The market is persistently mystifying. Robert Shiller, the Yale economist, concluded his column in Sunday’s New York Times, “We can keep trying to understand it, but we’ll be puzzled again the next time…” He was writing about behavior, but his words apply to the way markets move. Stocks are inscrutable, which is part of their appeal. Much has been made of the fact that the S&P 500 has more than doubled in the past four years, while earnings have risen 57%. Over the same time, GDP, a more important number for Main Street, is up a mere seven percent. From my simplistic perspective there are two main reasons for that big rise in stock prices. One, stock prices in early 2009 were very depressed, having fallen just over 50% in the previous eighteen months, not surprisingly since it appeared that the world was about to end.

The second reason, however, is more pertinent to my real fears and that is the extraordinary actions taken by the Federal Reserve that first lowered Fed Fund’s rate four years ago to near zero and has kept the rate at that level. Subsequently, they have been active in purchasing Treasuries and Agencies, via multiple quantitative easing (QE) programs. The Fed’s actions have extended and accentuated what has been a thirty-year bull market in bonds. Lowering rates in the midst of the crisis was absolutely necessary. Keeping them at this level has become a matter for debate. Low interest rates are an aphrodisiac to borrowers and provide a false sense of confidence to lenders. These low rates for borrowers remind one of the doughboy song that emerged from World War I, one line of which went something like this: “How to you keep Johnnie down on the farm, once he has seen gay Paree?”

Stocks, in contrast to bonds, have been in a funk for a long time. Thirteen years ago the S&P 500 was selling at 1480, less than half a percent below where it is now. If it had simply tracked inflation, the Index today would be 1950, or 40% above where it now is. It was an expensive market in 2000, selling at 26X prospective earnings. Today, the Index is selling at 14X expected earnings. Earnings have risen 95% over the past thirteen years and dividends 87%. (The explanation as to why dividends have not done better, I believe, is due to banks having cut or eliminated them during the 2008 credit crisis.) Stocks are certainly more attractively priced than they were in 2000. But, again, predictions are tricky. It took sixteen years for stock prices to move meaningfully ahead of where they had been in 1966. And, of course, it famously took the Dow Jones a quarter century to pass the 1929 high. Regardless, investors should not be too shy. Over the past thirteen years, while stocks were essentially at a standstill, dividends increased at a compounded annual rate of 4.9 percent, while earnings have compounded at 5.3 percent.

Bonds are another matter. Over the past thirty years, but especially over the past ten to fifteen years, they have decidedly outperformed stocks. But the latter part of that bull move was due to onetime events - the QE programs. Tields are such today that no similar rally is possible; thus, with smalll but earnings and dividend increases, equities, over time, will play the tortoise to the bond's hare.

In the irritating, cutesy parlance of the day, we have been in a “risk-on/risk-off” market the last few years. (I smile when I hear commentators on CNBC soberly pronounce, with futures lower by a few points, that today looks to be a “risk-off” day.) At any rate, since the start of the year the yield on the Ten-year has risen from 1.76% to 2.02%, suggesting sellers of Treasuries are more aggressive than buyers. The opposite is true in the High-Yield market, despite 2012 having been a record year for issuance – a 38% increase over 2011. Since the start of the year, yields have declined, using the FINRA-Bloomberg High Yield Bond Index, from 6.77% to 5.84%, In other words, the price of Treasuries has fallen, while the price of high-yield bonds has risen. Bond vigilantes are on offense. Howard Marks, co-founder and chairman of Oaktree Capital Management, in a Barron’s, interview suggested we are only in the “fifth inning,” but he does caution that “rates have descended to levels that hardly compensate investors for the risks incurred.” James Grant, in his most recent “Interest Rate Observer,” noted that creative destruction may not be taking place as it should. The implication is that abnormally low rates are allowing inefficient businesses to remain open, creating the possibility that “Japanese ‘zombie’ companies” may clutter our industrial parks.

The late economist and Presidential advisor Herbert Stein once remarked: “If something cannot go on forever, it will stop.” None of us can predict when the turn will come in interest rates. We only know that it will. Fed Chairman Bernanke has suggested that he will continue to ease until unemployment gets toward 6.5%. However, markets generally, but not always, anticipate change. While no one really expected the economy to come roaring back after the credit collapse in 2008 – consumer balance sheets were way over extended – economic growth has been more anemic than most thought. The reason, in my opinion, can be traced to an absence of confidence. Two factors account for that – tax rates and regulation. Corporate taxes are too high (except for those like GE, for whom complexity works) and regulation, whether it is environmental or healthcare related, which has become too invasive, Diane Furchtgott-Roth, writing in the Wall Street Journal, recently noted: “The Senate Permanent Subcommittee on Investigations has estimated that American companies hold offshore around $1.7 trillion of earnings from foreign operations.” That represents about 11% of GDP. Not all of that money would come home, but some would, if tax rates were lowered and regulation eased.

So I sit at my desk, worried, perhaps unrealistically, about the world I see. It is not so much stocks that concern me. It is what happens when the thirty-year rally in interest rates ends. How will markets react when Mr. Bernanke has bought his last bond? Despite a gargantuan federal (and state and municipal) debt problem, there is little going on in Washington (or the affected states and cities) that provides comfort. At the same time, equity valuations, while not cheap, seem reasonable. More importantly, many companies are returning value to shareholders through increasing dividends and/or buying back shares. We are told not to worry about inflation, yet when a government becomes as deeply indebted as is ours, the incentive to pay future obligations with depreciated dollars is enticing. Thus far this year, the dollar has been reasonably strong. As to whether that reflects conviction in the U.S. or worries about the UK, Japan or Europe, I am unsure, but suspect the latter. No Western economy, other than Canada, looks particularly robust. Many have problems far bigger than that of ours. But markets look forward, not backward.

Storm is too strong a word for my fears, but having foul weather gear handy seems appropriate. Keep in mind that common sense, the rarest of commodities, is an investor’s best friend – in the stocks one buys and the prices one pays.