For the past three years the dominant paradigm in investment markets has been “risk on, risk off”. You know – if it’s Tuesday it must be gold and the Japanese yen, but come Thursday animal spirits are back and it’s full-on into small caps and frontier equities. Over this time the market has seemed bipolar as it pinballed back and forth between riskier exposures and perceived safe havens.
Where have all the havens gone?
As we approach the midpoint of calendar year 2013 that paradigm seems to be fading fast. What’s missing is the safe haven, a designation that seems to apply to fewer and fewer asset types. Currencies and precious metals – well, in truth they were never all that safe to begin with, and the recent gyrations of gold and the yen provide a clear demonstration of this. But it’s the fixed income market – the traditional epicenter of safety and predictability – that is the real story today.
Volatility in the bond market
Consider the past week. After reaching a record high of 1669 on May 21 the S&P 500 has seen higher than average volatility and by the close of trading on May 30 the index was a bit less than 1% off the 5/21 high. That’s typically perfect weather for the risk-off flight to the safest of fixed income assets. Not this time. The yield on the 10-year Treasury note – a bellwether for interest rate trends – shot up from just under 1.95% on May 21 to 2.1% on May 30. The total return for IEF, an exchange traded fund (ETF) that tracks the Barclays 7-10 Year Treasury Index, was -1.4% for the same period. Risk here, risk there, risk everywhere.
Taste of things to come?
Now, a nine day calendar stretch is not the defining word on where markets are headed in the immediate future. We think it is more likely to be a small taste of a larger problem that we may be dealing with for some time to come. That problem has a name – interest rate risk. The thing about bond market macro trends is that they tend to be very long. Here’s a little history to make the point: since the 1950s we have had only two such macro trends.
From Cheap Money to Credit Crunch
In 1945 the 10-year Treasury reached a low of 1.7% - its lowest yield since, literally, the founding of the Republic after the Revolutionary War. This was a result of deliberate monetary engineering – sound familiar? – to finance America’s involvement in the Second World War. After the war policymakers realized they had to bring an end to the era of cheap money in light of inflationary pressures. This decision was formalized in the Treasury Accord of 1951. From that point interest rates began a long, steep climb that lasted 30 years until the 10-year yield, reflecting punitively harsh credit conditions, reached an all-time high of just under 16% in 1981.
From Credit Crunch to Cheap Money
Now, 32 years later, that yield is again just over 2% after plummeting below 1.5% in 2012. The Fed is still printing cheap money, but the minutes of recent Fed meetings make clear that this policy is under pressure. We don’t know when we will see “Treasury Accord 2.0” – when the policymakers decide they have to formally acknowledge changing course. It may be awhile yet. But this is the giant elephant in the room, and we believe it is going to present a major challenge to portfolio managers. This challenge will require an innovative, active and flexible approach to managing risk.
As of the market close on Wednesday of this week the S&P 500 had appreciated by more than 22% in price terms from November 15, 2012. What’s special about November 15? It was the date when the market pullback that began a couple months earlier reached its low point. From September 14 to November 15 of last year the S&P 500 lost 7.7%, bottomed out and began the steep, sustained climb leading to where we are today.
What Goes Up…
These ebbs and flows are what market analysts are looking at when they toss around terms like “correction”, “bull/bear cycle” or simply “pullback”. You’re hearing a lot of this these days, because when things go into the stratosphere the question on everyone’s mind is when they’re going to come back to earth – and how hard the landing will be.
We think it’s worth a look at the data. The question to ask is this: is the 22% run-up over the 180-plus days from November to May an extreme data point, one that is more likely than not to result in a huge pullback, even a technical correction of 10% or more? Or is it within the range of other bull runs? In questions like this context is everything.
The 181 days from November 15 to May 15 is certainly on the long side of bull runs. From the beginning of 1990 the average duration for an uptrend (i.e. from trough to peak) after a drop of 5% or more was 75 days, so our 181 day run as of May 15 is more than double the average. But it’s far from the longest – that would be a whopping 533 days, from December 1994 to May 1996.
What about in terms of how far we have soared? Well again, the average run-up after a 5%-plus contraction over this 23 year period was just under 14%, so our 22% return to May 15 is on the high end. But again, it’s not an outlier. That 533 day run in 1994-96 ran up a return of 52% to the peak. And even then the subsequent pullback was a fairly modest fall of -7.6% over a two month period before things turned up again – for another 209 days!
Growth or Gap?
We’re looking at data points from the 1990s as well as the more recent environment because we are in a sort of limbo between growth and gap market conditions. We’re clear of the previous records on the S&P 500 (1527 in 2000 and 1565 in 2007), but we’re not yet sure we’re going to clear those bars for once and all. So we need to pay attention to how bull and bear cycles work in both environments and factor that into how we keep ourselves positioned. The fear impulse – running for cover when most of the damage has already been done – is never a good idea, but it can be especially harmful in a growth environment where the losses are more likely to be brief and contained – and where traditional safe haven markets look particularly unappetizing. For now, as far as equity markets are concerned, no news is good news.
Tech has always been a bit different. Among the staid dark suits of other industry sectors like finance or manufacturing, tech likes to play the part of disruptive rebel. Tech companies live to upend the apple cart (as it were); to invent new paradigms that we all – whether willingly or led kicking and screaming – wind up incorporating into the rhythms of our lives.
In recent years the pinnacle of this Valhalla of disruptive technology gods was occupied by Steve Jobs. Jobs lived for the product launch and famously despised the quarterly earnings call with investors and analysts. His insouciance and a torrid streak of product wins vaulted Apple to the coveted title of “world’s most valuable company”, as measured by market capitalization, for a time.
Be Careful What You Wish For
Coveted, but precarious. John Chambers and Bill Gates could watch Apple’s ascendancy from the sidelines and say “been there, done that” – both Cisco Systems and Microsoft have worn the MVP crown in the not too distant past. They learned what every successful tech company learns sooner or later: there comes a time when you get out of bed, put on your Hermes tie and muted colors, and head to work with all your energies focused on pleasing those capricious money types who are staring laser-like at your earnings estimates, product shipments and top-line revenue guidance. That day came yesterday for Tim Cook and post-Jobs era Apple.
Pennies from Heaven
For most of us pennies are annoying bits of copper that we’re as liable to leave in the little tray at the checkout counter as we are to save them for a rainy day. In the world of quarterly earnings, though, pennies rule. Apple reported net earnings of $10.09 per share yesterday, which was exactly two pennies higher than analysts’ forecasts. Now that reflected a drop in net earnings of 17% over the last twelve months, which may sound dour. But the immediate reaction as financial pundits blogged and live-Tweeted the disclosure was ebullient. Apple beat estimates! By two whole pennies!
Cook then went on to unleash a torrent of pennies on his company’s shareholders, in the form of a pledge to return $100 billion to them in the form of share buybacks and a higher dividend between now and 2015. That’s a massive program and a radical departure from the Jobsian ways of hoarding as much capital as possible. Only Exxon Mobil has ever announced a bigger buyback program.
What About Changing the World?
What was missing from yesterday’s earnings call? Any frisson of excitement over an imminent product release to set the world on fire. Cook promised “lots of great stuff” in the fall and into next year, without providing any further detail. He wasn’t romancing his gadget-geek fan base, but rather showering love on the financial suits. He was doing, in short, what Gates and Chambers and any other tech visionary before him have always had to do – to realize that as the CEO of a company that is in a slowing growth paradigm he has to make the hard choices that will preserve shareholder value. It’s a tough pill for a disruptive tech guy to swallow, but swallow it he must.
Of Phoenixes and Ashes
For now, anyway. Apple may be at the crest of its S-curve now (i.e. in a phase of maturing growth) but it has already reinvented itself at least once and can plausibly do so again. Tech pundits are taking a second look at Microsoft these days, in ways more reminiscent of the mid-90s than the last five years. IBM is quietly entrenching itself as the king of predictive analytics, which may sound less sexy than a hi-res iPad but is slowly taking over more and more real estate in the land of business decision making. Contrary to F. Scott Fitzgerald’s observation, there are second acts in America – and in American tech.
“Safe haven” is the term we use to describe the things in our portfolios that help us sleep better at night. The imagery is rich – amidst the violent tempests of unruly seas there are quiet, sheltered harbors that protect us from Poseidon’s ravages. Or so the thinking goes. Here is a cautionary tale about safe havens and not-so-safe havens.
In the summer of 2011 asset markets were aboil with unusually high levels of volatility. The Eurozone was mired in the latest act of its Greek tragedy, and in the US our redoubtable government policymakers were speeding recklessly towards a possible default as they ineptly debated and negotiated what should have been a routine adjustment upwards of the debt ceiling. In this environment two asset classes found particular favor among haven-seeking investors: gold, and the Japanese yen.
The yen reached an all-time high – 76 yen to the dollar – in October of that year (consider that when the yen was first floated after the breakdown of the Bretton Woods agreement in 1971 its value was 360 to the dollar). Gold grazed the $1900 level at the same time – good enough for an all-time nominal high, though short of the real level of $2,470 (in today’s dollars) reached in January 1980. When stocks and non-precious metals commodities plunged, gold and the yen soared. How the mighty have fallen.
For the year 2013 to date the Japanese yen has plunged by 12% against the dollar, largely a function of the radically new easy money policy embarked on by Prime Minister Shinzo Abe and the new guard at the Bank of Japan. The yen is now around 98 to the dollar – it has fallen nearly 30% from that 2011 high point. Meanwhile gold is in freefall. It is down 10% just in the last week and has also given up more than 25% of its value since those “haven” days of 2011.
Herein lies the cautionary tale. A true safe haven is an asset that is hardwired to deliver predictable, stable returns over a decently long period of time. A government or AAA-rated corporate bond can – to the extent that anything can in our new financial order – be deemed a safe haven asset because if you hold it to maturity you will know exactly how much income you will receive, and when you will receive it, in all scenarios except for that of a default. As long as the US government or Procter & Gamble don’t go bankrupt there is no mystery about what these assets will deliver to you as cash flows.
But currencies and precious metals don’t work that way. They are traded in spot markets and futures markets based on the collective views of thousands of currency and commodity traders about the direction of Japanese interest rates, or the rate of new industrial complex developments in China, or the inflation forecast for Brazil. There is no inherent value – no floor below which these assets cannot fall. As the market cycle of the last eighteen months tells us, these fluctuations can be immense. They are not going to help us sleep better at night, and they are very clearly not safe havens. For asset allocation and portfolio selection purposes we should not treat them as such.
Investors as of late have been heartily cheering the rally in US equities that (at least until today’s bad reaction to the latest job numbers) has propelled the Dow Jones Industrial Average and the S&P 500 into all-time record high territory. Now, it often happens that when the animal spirits are let loose to run rampant in the land of blue chip US equities other riskier asset classes – like small caps and emerging markets – do even better. Often, but not always. Given that the S&P 500 has settled above its 200 day moving average for 304 of the last 314 trading days, you might think this would be a terrific environment for a traditionally riskier play like emerging markets. Not this time.
Emerging equities markets seem to be inhabiting some other spacetime realm entirely. The MSCI Emerging Markets index is down by more than 3% for the year to date. That’s right – it’s in absolute negative territory, and on a relative basis that’s more than 13% worse than the performance of the S&P 500 over the same time period. What are we to make of this?
One school of thought leads to still-troubled Europe. Emerging economies have more at stake in selling their goods and services to Europe’s households and businesses. This is less about the Eurozone financial crisis and more about good old fashioned supply and demand. Those GDP growth rates that have been so impressive in recent years among emerging markets are predicated on robust export markets. But demand in Europe – for many EM companies the most important export market – remains soft.
In a broader sense, though, it may be more about winners and losers in the global economy. The “winners” plausibly could be emerging markets households and US businesses. Average household income levels in the emerging world continue to grow briskly, and with that growth naturally comes increased consumer demand. But who supplies that demand? When you look at the financial reports of large US companies you get a glimpse of the answer: a very significant portion of the earnings growth that has been so impressive of late comes from…yes, sales in emerging markets.
So even if economic prospects for the growth engines are still strong, the main beneficiaries may not be the companies that make up their stock indexes. If GE and Cisco Systems and Procter & Gamble are enjoying explosive earnings from their sales in China, India and Brazil, that doesn’t add direct value to the Shanghai Composite or the Bombay Sensex or the Bovespa. It adds direct value to the S&P 500 and the Russell 1000. And for the moment that value gap – in equity market terms – is in the double digits.
And what of the S&P 500? As of this writing the intraday level for the index is down by a bit less than one percent, in the aftermath of a slew of below-expectations job data. Well, the index had gained more than 10% for the year to date, and when that happens some kind of correction is usually to be expected. Whether it turns into anything more than a brief pullback remains to be seen, but at this point the data signals are not flashing emergency red. Patience and discipline are the watchwords.