The following is excerpted from an investment update sent to clients on January 11, 2013.
A major part –- perhaps the most important part -- of investment success is to avoid the big losses. To that end it’s crucial to be aware of factors that could potentially cause significant, long-lasting account declines.
Below we will outline the three factors that we think pose the biggest risks to investors:
- Aggressive and untested monetary policy
- Bubble-like conditions in the bond market
- Overvaluation in the US stock market
Big Risk #1: Aggressive and Untested Monetary PolicyOur first major concern regards the highly aggressive and experimental policies being undertaken by the Federal Reserve and other global central banks.
Two charts serve to summarize the extraordinary nature of today’s monetary policy climate. The first shows the Federal funds rate (the widely-followed short-term policy rate the Fed announces after each meeting) adjusted for inflation:
When the real (inflation-adjusted) Fed funds rate is high, that signals restrictive monetary policy; when it’s low it signals stimulative policy. When it is negative, meaning that the funds rate is lower than inflation, that signals unusually stimulative and inflationary monetary policy.
The Fed funds rate is firmly negative – and has been for most of the past decade. Never before have real rates been so low for so long. The only precedent that even comes close is the early 1970s, a period that was followed by double-digit inflation and interest rates.
The second chart is even more concerning. It shows the amount of “money printing” being undertaken by the US, British, European, and Japanese1 central banks.
This chart does not even reflect the additional $1 trillion per year (roughly 35% of the current balance sheet size) that will be created going forward as a result of the Fed’s latest quantitative easing programs, which have no set end date.
Money creation on this scale is entirely unprecedented in the US, let alone globally , and it is taking place over the most permissive interest rate backdrop in our history.
There is no one on earth who knows for sure how these exceptionally novel policies will play out. What we do know is that in the past, highly expansionary monetary policy of this sort has had a very strong tendency to lead to higher inflation, higher interest rates, and reduced confidence in the currency being created. (In fact, we aren’t aware of any historical example in which money printing on the scale being undertaken by the US didn’t lead to serious inflation). The Fed maintains that it will reverse policy before any such consequences appear, but for reasons discussed at length in last quarter’s update, we think this is highly unlikely.
What this all suggests to us is that we face a significantly elevated risk of some combination of rising inflation, rising interest rates, and reduced confidence in the dollar (along with several other currencies) at some point in the future.
Moreover, given the dramatic and unprecedented aggressiveness of US monetary policy, we have to acknowledge the possibility that changes in inflation, rates, or dollar confidence could be equally dramatic and unprecedented.
Big Risk #2: Bubble-Like Conditions in the US Bond MarketOur second big concern revolves around what we see as a bubble in the US bond market.
We’ll begin with a historical graph of long-term bond rates2 in the United States, with the current level being represented by the red line:
Source: Bianco Research
Interest rates on long-term US bonds have very rarely been this low. Since bond prices move inversely to interest rates3, that means bonds are nearly the most expensive they’ve ever been.
Yet the fundamentals of our national debt situation are actually quite poor. Our federal debt and deficits have very rarely been higher, and as discussed earlier, inflation risks are unusually elevated due to highly stimulative monetary policy and money printing on an epic scale. The historical record suggests that both of these factors portend higher rates, and thus lower bond prices, at some point in the future. Therefore, it is our view that extremely high bond prices are occurring at a time when the fundamentals for bonds are unusually poor.
Despite this, investors have been absolutely piling into bonds:
source: JP Morgan
In short, investors are wildly enthusiastic for an asset class that, despite a serious deterioration in its fundamentals, has almost never been more expensive.
We think it’s fair to characterize the US bond market as bubble. Perhaps not one that is driven by the rampant greed that characterizes most bubbles, but certainly one that shares the classic bubble qualities of complacency, overconfidence, dismissiveness about risk, and facile rear-view mirror analysis – as well as a stampede into the asset just as it approaches its most expensive and riskiest levels ever.
Whether we apply the “bubble” designation or not, there are several reasons to believe that US bonds are at high risk for an abrupt re-pricing (prices lower, rates higher) at some point:
- The consensus view is that rates will start rising in a few years, yet investors have been snapping up longer-duration bonds that lock in current low yields for as much as 30 years or more. Why would they do this if they believe rates are set to start increasing in just 2 or 3 years? The likely answer is that many of them are simply trying to benefit from the slightly higher (than cash or short-term bond) rates now, with the plan to sell before rates go up. This raises the chances of a disorderly decline as everyone eventually tries to “head for the exits” before everyone else.
- A major contributor to the huge demand for bonds is their reputation as a “safe haven.” But we think this reputation is based less on an understanding of fundamentals and prospective risks than on the fact that bonds have done so well for so long. If this is true, then a decline in bond prices might be all it takes to undermine their safe-haven reputation and remove this source of demand, which could contribute to further price declines in a self-reinforcing manner.
- Because of the large size of our national debt, higher rates would lead to significant increases in the costs of servicing that debt. For example, if the cost to service the federal debt were to rise back to 5% (roughly the average level over the past decade), interest payments would take up 22% of all federal tax revenue! A sufficiently large increase in rates could start a vicious circle in which rising debt service costs lead to declining confidence in US Treasuries, which in turn lead to yet higher rates and debt service costs, and so on.
Many dismiss these worries with the argument that the Fed can print money to buy bonds, keeping long-term rates low indefinitely. The Fed certainly has shown a willingness and ability to buy bonds with newly created money; this would simply entail more of the same. The problem is that it would probably require money printing on an enormous scale (even by today’s standards) to fight a genuine investor exodus out of bonds. If investors were truly becoming worried about bonds, we doubt they’d take comfort in massive central bank money printing. Even if they did, the likely best-case scenario is that the Fed could keep yields down, but at a cost of substantially increased inflation risk. Put another way, the more the Fed mitigates Big Risk #2, the more they exacerbate Big Risk #1.
Unfortunately for investors trying to shield themselves from potential troubles in the bond market, it’s not enough to simply refrain from buying long-term US bonds (though that sure helps). A serious bond market decline could have major consequences not just for other markets, but for the economy as a whole -- all potential outcomes that should be protected against.
Big Risk #3: Overvaluation in the US stock marketOur final concern pertains to the US stock market, which continues to be significantly overpriced based on historically reliable indicators.
We’ve routinely discussed the overvaluation of US stocks, along with the fact that this state of affairs is a reliable predictor of poor long-term returns and a heightened risk of serious loss. Having covered this ground, we won’t go too deeply into it here. (Those who are interested in more detail are referred to this website article).
Instead, we will just show this chart of our favorite stock valuation measure (which has been shown to be the most predictive of long-term returns) going back over a century. The red line in the chart indicates the current level of valuation:
The chart shows that the US market has spent very little time at or above current valuations, with the exception of recent times in which stock prices were artificially propped up first by the biggest-ever stock bubble and then by biggest-ever housing bubble. In all instances in which stocks reached these valuations -- even the recent bubble-driven years -- severe stock market downturns have eventually ensued. Might it play out differently this time around? It’s possible. But the answer will only be known in hindsight, and in the meantime, history is telling us that there is an unusually high probability of a serious stock downturn at some point ahead.
Even if the worst is avoided and there isn’t an abrupt or serious decline, the market is priced at a level that has almost always led to poor long-term returns. This means that unless this time is different, US market-like investors are taking a lot of risk for very little potential reward.
It is important to note that our concern about the US stock market is heightened when we consider the prospects for rising inflation and interest rates -- both of which, it turns out, tend to be bad for stocks. If anything, prospects for the US stock market are even worse than valuations alone would suggest.
Avoiding the Big DeclinesWhile there will always be risk in the pursuit of investment returns, we think it’s very helpful to distinguish between run of the mill ups and downs, and the “Big Declines.”
Ups and downs are inevitable because investors tend to be emotional and short-term focused, and because the economic world is often full of surprises. We don’t think they can be avoided -- but that’s ok, because ups and downs are part of the process and are typically easy enough for value- and risk-conscious investors to recover from.
In contrast, the Big Declines are large and enduring and can take a very long time to recover from. They tend to be caused by significant overvaluation or serious macroeconomic imbalances that are usually identifiable in advance. It is critically important to avoid, or at least mitigate the impact of, the Big Declines.
The first step in doing that is to remain keenly focused on the overvaluation or macroeconomic issues that could potentially lead to such declines. We have outlined our three most serious “Big Risks” above.
Having identified the risks, we must then try to protect ourselves by avoiding at-risk assets or buying investments that we think will do well should the risks come to the fore.
This is where it often gets frustrating, because markets can ignore serious risks for a long time. Still, we think it’s important to get prepared ahead of time, because once markets do turn their focus to long-ignored issues, they often react in a very abrupt and violent manner. We’d rather protect ourselves too early than too late.
Nothing in the future is ever certain, but we believe there is compelling evidence that any or all of the three risks we discussed above – aggressive monetary policy, the bond bubble, and US stock overvaluation – stand a very good chance of seriously impacting markets at some point. Our efforts to avoid these potential negative outcomes have not helped us lately, which is frustrating, but that doesn’t make it any less important to protect against them. In the event that these Big Risks do lead to Big Declines, we expect we will be very glad we did.
Opportunities Current and FutureDespite everything we’ve written, we are not pessimists. We actually consider ourselves pretty optimistic on the big picture outcomes: humans will innovate, problems will be solved, economies will grow and prosper, and markets will offer good opportunities for value-conscious investors. Right now, though, we face an unusually serious set of issues to be grappled with, and we want to steer clear of any Big Declines they may cause.
Even as we wait for these risks to resolve themselves one way or another, there are opportunities in the markets.
Currently, we have exposure to international stock markets, which have substantially lower valuations on a historical basis – and thus, better potential returns and a lower risk of loss over the long-term – than the broad US stock market. As a bonus, many foreign countries have better demographic and fiscal prospects than the US, increasing the chance for better returns even beyond what the lower valuations would imply.
We also have an investment in the energy sector because we think energy has bullish long-term fundamentals and helps to protect against inflation risk. Our exposure to international and energy stocks should help us to participate in any further broad market gains, but to do so without the valuation risk that looms over the US stock market as a whole.
We have exposure to some areas that would actually benefit if our inflation or bond market concerns came to pass. We own global bonds and currencies from countries with sounder monetary and fiscal policies than the US. This asset class provides both income and the potential for capital gains that aren’t tied directly to global economic growth.
We are also in invested in the gold mining sector, which we have discussed at length previously (see here and here). We view our gold-related positions as a form of insurance against two of our three big risks — reckless monetary policy and the bond bubble — each of which put the value of cash itself at risk. While gold stocks have performed poorly lately, the fundamental case we outlined in our prior discussions has only gotten stronger, increasing the chances that the insurance they provide will be needed someday. The whims of investors can push gold stocks all over the place in the short term, but should the day come when markets finally start to recognize the huge risks we have described here, we expect we will be very thankful that we were invested in this asset class.
Even in this difficult climate, there are good investments to be found -- but perhaps more exciting are the opportunities still to come . Markets tend to ignore, then overreact. If that pattern continues, and any of the scenarios we’ve outlined do take place, we’d expect several asset classes to get a whole lot cheaper. More low-priced assets would mean more opportunities for robust investment returns with less vulnerability to Big Declines.
We are in a climate of unusually heightened risk, but that won’t be the case forever. We believe that once the issues outlined here have been resolved, we will reach a point where investing is simpler, less uncertain, and more profitable . Let’s get to that destination safely.
1 The chart of central bank reserves also shows that the Bank of Japan has printed money to a degree that is almost negligible compared to the US. This is one of the major reasons we believe it is a mistake to expect a Japan-like outcome in the US.
2 The interest rate chart is for US Treasuries, and among bonds, Treasuries are especially overpriced. But because interest rates throughout the overall US bond market tend to move up and down with Treasury rates, we feel we can safely generalize that major changes in the Treasury market would also be projected onto the US bond market in aggregate.
3 Many people find the inverse relationship between bond prices and interest rates to be counterintuitive; a helpful explanation can be found here.