Posts by the Contributor
President & CEO
Masood Vojdani began his career in the financial services industry in 1981. From the outset, he was driven by the vision of a firm that was different from the industry status quo. At the heart... Full Bio
Pundits who follow financial markets are always ready to supply a narrative to the crisis of the day. “Stocks fell today because of X” is how the story usually goes, although “X,” whatever it may be, is likely only a strand of a larger fabric. These days market-watchers are focused on Turkey, and the “X” factor giving the story a human face is one Andrew Brunson, a North Carolina pastor who for the past two decades or so has lived in Turkey, ministering to a small flock of Turkish Protestants. Brunson was caught up in a 2016 political backlash following an attempted military coup, and has been detained on charges of collaboration (unfounded, he claims) against the Erdogan regime ever since.
Earlier this month the Trump administration anticipated Brunson’s release after protracted negotiations. Instead, the pastor was placed under arrest. The US responded with a new round of sanctions, including a 50 percent levy on imported steel. Team Erdogan dug its heels in. The currency collapsed and – voila! – the summer of 2018 now has its official crisis. For investors, the pressing question is whether this is an isolated event, or a larger peril with the potential to turn into a 1997-style contagion.
Shades of 1997
Once seen as the next likely candidate to join the European Union and pursue the traditional path to prosperity by linking in to the global economy, Turkey instead has become a dictatorship under Erdogan. Possessed of a less than perfect understanding of macroeconomics, Erdogan has doggedly refused to address the country’s currency crisis by raising interest rates, the normal course of action. Facing down external borrowing needs of $238 billion over the next twelve months, the regime improbably imagines relief coming from comrades-in-arms such as China, Russia and Qatar. These are Turkey-specific problems.
But currency woes are anything but local-only. Almost all major emerging markets currencies are having a terrible time of things in 2018. The chart below shows four of them, including the Turkish lira.
From this standpoint, the situation looks less like a simple tempest on the Bosphorus, and more like the summer of 1997. That was when Thailand, under speculative attack from foreign exchange traders, floated its currency and sparked a region-wide cataclysm of devaluations and stock market collapses. One of the issues contributing to the mess in 1997 was the vulnerability of countries with large amounts of dollar-denominated external debt – a falling currency makes it increasingly difficult to service interest and principal payments on this debt.
This is an issue of relevance today as well; indeed, countries with the largest non-local debt exposures have been hit hardest alongside the lira (see, for example, the South African rand in the above chart). Another theme of 1997 was current account deficits, a particularly important data point for countries where exports play a central role in growth strategies. That has been the driving force behind India’s currency woes this year (also shown above). High oil prices (a key import item) have raised India’s trade deficit to its highest level in five years. And, of course, the specter of a trade war looms over all countries active in global trade.
Sleepless in Shanghai
Arguably the biggest difference between 1997 and today is the role of China in the world’s economy. Back then the country was still in the early stages of the boom that spawned the great commodities supercycle of the 2000s. Now it is the world’s second-largest economy (and the largest when measured in purchasing power parity terms). China is currently dealing with its own growth challenges – very different from those facing trade deficit-challenged economies like India or near-basket cases like Turkey, but concerning nonetheless. The Shanghai and Shenzhen stock markets have been in bear market territory for much of the summer. China’s biggest challenge is managing the transition of its economy from the fixed investment and infrastructure strategy that powered those supercycle years into a more balanced, consumer-oriented market. That is the right thing to do – the infrastructure approach is not sustainable for the long term – but concerns about the transition persist even while the country putatively continues to hit its GDP growth targets.
So how much contagion risk is there? The main problem as we see it is not that the detention of a pastor in Turkey could bring down the global economy. It is that all these strands – debt exposures, trade deficits, growth concerns, trade war rhetoric – are percolating to the surface at the same time. The story is not as systemic as that of the ’97 currency crisis, where the same one or two problems could be ascribed to all the countries suffering the drawdowns. But with all of these strands front and center at the same time, we cannot rule out the potential for broader repercussions.
The ’97 crisis had only a limited impact on developed markets. US stocks paused only briefly before resuming their manically bullish late-1990s ways. So far, neither turmoil in Turkey nor sleepless nights in Shanghai are having much impact on things here at home. A little more volatility here and there, but stocks within striking distance of January’s record high for the S&P 500 (and still setting new highs when it comes to NASDAQ). But we’re closing in on the always-important fourth quarter, and need to be fully cognizant of all the different narratives, positive and negative, competing for attention as the lead theme.
The languid dog days of August are truly upon us. Risk asset markets would seem to be feeling the soul-draining humidity as much as runners and cyclists slogging through day after day of relentlessly damp blankets of heat while training for fall goal races. The S&P 500 hovers just below its January record high, while volatility has resumed last year’s deep slumber. The 10-year Treasury yield casts a sleepy glance every now and then at the 3 percent level, yawns and goes supine again somewhere around 2.95 percent.
Random headlines make a splash on these days where nothing much from macroeconomic or corporate earnings data releases manage to perk up investor attention. This week’s little diversion came – as seemingly all diversions in 2018 must come – from Twitter and specifically from the account of Elon Musk, founder of Tesla, as he mused about the likelihood of taking his $60 billion enterprise private. Now, once upon a time a major strategic undertaking like taking a public company private would have simmered under the radar in boardrooms and hushed discussions with bankers, lawyers and advisors before proceeding in an orderly fashion into the public domain. But such are the times in which we live.
Mind The (Listing) Gap
While Musk’s method of communication may have been unusual (and quite possibly illegal), the decision itself – to take a public company private – is anything but an anomaly. Our interest piqued, we went hunting for some data on the subject and came across a 2017 Credit Suisse paper entitled “The Incredible Shrinking Universe of U.S. Stocks” with some eye-opening facts and figures. The universe of publicly traded equities – i.e. shares of common stock traded on an accredited stock exchange, compliant with SEC disclosure and transparency regulations, and available for purchase by any institutional or retail investor – has radically diminished over the past several decades.
Here’s a good illustration of what this means in practical terms. How many stocks do you think make up the Wilshire 5000 Total Market Index? Ah – you were about to say “5,000, of course!” but then realized it must be a trick question if we’re asking it. Indeed, this bellwether index launched in 1970 to represent the “total US stock market” does not consist of 5,000 companies. It consists of 3,486 companies as of June 30, 2018. Why? Because that is roughly how many publicly traded companies exist in the United States. In 1976 there were about 4,800 companies with publicly traded stock, and in 1998 that number soared to more than 7,500. The Wilshire 5000 reached its peak holdings with 7,562 names on July 31 of that year.
Where Did They All Go?
Why are there so many fewer listed companies now, and how much does it actually matter from the standpoint of an investor seeking to capture as wide a swath of global wealth as possible through portfolio diversification? The answer to the first question is relatively straightforward. The second – not so much.
The main reason why there are fewer companies on stock exchanges in 2018 than there were in 1998 or 1978 is twofold. First, mergers & acquisitions (M&A) activity has gone gangbusters over this period, and has been the main driver for delisting (a company, when acquired, naturally retires its stock ticker at the signing ceremony). Second, initial public offering (IPO) activity has fallen. If M&A is the main way that a company falls off the stock exchange, then IPOs are the main source for new supply. According to the Credit Suisse report we noted above, the average number of IPOs every year from 1976 to 2000 was 282. From 2000 to the present the average annual number was a mere 114.
Long story short – M&A fever has raged while the IPO market has slumbered. This in itself is unusual. Historically, strong equity markets tended to encourage both M&A and IPOs. That makes sense – companies feeling flush look to bulk up by taking out competitors or to buy their way into new industries, while start-up founders want to cash in with the high valuations available in bull markets. But that positive correlation no longer holds. From 1976 to 2000 the correlation between M&A and IPO activity was 0.87 (1.0 being perfect positive correlation). From 2007 to 2016, the correlation is actually negative: minus 0.08. Those start-up founders apparently have other, more enticing options for cashing in.
The Changing Market For Private Capital
And indeed, those alternatives exist. Probably the most noteworthy, in terms of explaining the diminished attractiveness of IPOs, is the growth of late-stage venture capital / private equity. Venture capital used to be concentrated in the early years of a start-up company’s history, with the VCs motivated to get their investments through successive funding rounds and out the door into the public markets via IPO as fast as possible. Now there is a whole distinct asset class of late-stage private investors. This includes most of the major mutual fund families, like Fidelity and BlackRock, that operate dedicated late stage private equity funds. This asset class provides a level of liquidity that previously could be found only in public markets. For example, late stage private deals allow start-up founders and their employees to cash out some of their stock and options – again, reducing the natural pressure to go public.
The Implications for Asset Allocation
So the story about how we wound up with so many fewer public companies is relatively easy to understand. But that second question we posed a few paragraphs ago remains outstanding. Is the long term investor with a diversified portfolio missing out on a major asset class exposure by not being invested in private equity?
This is a question we take seriously: after all, our primary job is to construct portfolios with a prudent level of diversification aligned with each client’s specific investment objectives and risk considerations. The data thus far are somewhat inconclusive, with attendant benefits and costs.
For example, while there may be fewer publicly traded companies out there, the total market capitalization of the US stock market is more than 1.35 times the value of US real gross domestic product (GDP). By comparison, total market cap in 1976 was just 0.47 times GDP, and in the late 1990s, when the number of listed firms peaked, it was 1.05 times. The collective profits of all listed firms today is close to 9 percent of GDP versus 7 percent in 1976. And share volume – hence liquidity – is at record levels today.
For investors there are other potential downsides to owning private equity, including reduced transparency and less consistent, available data for performance benchmarking. On the other hand, it is not possible to simply dismiss the reality of a new structure to the US capital market and the existence of distinct new asset classes large enough to demand consideration, if not inclusion, for long term diversified portfolios. We will have more to say about this in the coming weeks and months.
Sentiment travels quickly in the hyperkinetic world of the global capital markets. Just a week ago, the talk of the town was all about the Great Rotation. After weeks, months…nay, years! of underperformance, value stocks looked poised to unseat the great megatrend in growth stocks.
Remember one week ago? Facebook tanked as investors found reasons aplenty not to like the company’s earnings report, which suggested that stupendous revenue growth in the mid-40s would turn into not-quite-as-stupendous revenue growth in the mid-20s, and fat profit margins in the mid-40s would become somewhat less obese (though still hefty) profit margins in the low 30s. Facebook’s woes came on the heels of an earlier subdued outlook by Netflix and was followed by more downbeat headlines from Twitter (apparently being the official platform for the communication of US government policy doesn’t add much in the way of monetary value…). Suddenly FAANG nation (and its fellow travelers like Twitter) was in trouble! Rotation to value in three…two…one…
Blessed Be The Fruit
And then there was Apple, and the $1 trillion market capitalization that swiftly dispatched away all that talk of a Great Rotation from growth to value. As the chart below shows, growth (in green) has recovered quite nicely, thank you, in the space of the past three days.
The only thing financial pundits love more than talking about a market rotation is talking about big round numbers, and they don’t get bigger or rounder than $1 trillion. Value rotation, we hardly knew ye!
The Unsolved Mystery of Value Investing
Now, the fact that we have to bide our time for awhile longer before value stocks come back into favor does not do anything to solve the big mystery of what, in the name of all that is good and wholesome, ever happened to value stocks in the first place. After all, the “value effect” is supposed to be one of the fixtures of long term investing. The value effect holds that investing in stocks whose market price is lower than their fundamental value pays off. Over time, you are more likely to perform well by buying and holding out-of-favor names that are mispriced by the market than you are by getting into a hot growth name that everyone else is chasing.
The logic behind the value effect seems impeccably tight. But the numbers tell a different story. Over the last thirty years, the value segment of the Russell 3000 stock index, a broad measure of US stocks, actually underperformed the broader index. Not by much – the Russell 3000 Value returned an average annual 10.38 percent compared to 10.53 percent for the Russell 3000. But still – that’s a 30 year span of time, nearly one third of a century. And the numbers don’t improve. The value index underperformed growth over most time periods since then, with the gap between them increasing. Over the last five years a growth investor outperformed her value counterpart by more than 5 percent on an annual average basis.
The Software That Ate the World
The value conundrum is occupying quite a bit of our research brainpower here at MV Financial and we plan to come out with a more in-depth research piece on the topic some time in the coming weeks. One way of looking at the mystery is supplied by Marc Andreessen, the Silicon Valley venture capitalist and founder of Netscape (hi, kids! That was a browser we used back in the days when we used to dial into our AOL accounts. See “hissing modems”…). Back in 2011 Andreessen penned an article called “Why Software Is Eating the World.” The premise was that software platforms were encroaching into the central business value propositions of practically every industry sector, with the lion’s share of rewards falling to those companies most adept and developing and deploying technology solutions for their markets.
At the time Andreessen’s article was dismissed by many as so much Valley technobabble, but it has stood the test of time. Just look at what happens on any given day when, say, Amazon threatens to enter the retail pharmaceutical business or buys Whole Foods. Competitive industry dynamics these days do appear to be about little else than the deft execution of hard-to-imitate software platforms.
If Andreessen’s thesis is behind the growth stock megatrend, then investors will not be too happy when the FAANG sharks and their extended court of growth stock pilot fish do run out of upside. The result may be less an orderly reversion to mean while value stocks run for a while, and more a winding down of this historically long bull market. We are not suggesting that this is imminent, but it does bear watching. Meanwhile, detective work on the Case of the Missing Value Effect will continue apace.
They say numbers don’t lie, right? So what to make of the 4.1 percent real growth rate in US gross domestic product (GDP) from the first to the second quarter of the year? We feel quite comfortable in predicting that the narrative of today’s news cycle will be anything but unified. Depending on what news source you turn to for a first take on today’s Bureau of Economic Analysis release, you may be told that this quarterly number is in fact the dawning of the Age of Aquarius, when peace will guide the planets and love will steer the stars (hi, kids! ask your parents…). Or, alternatively, that 4.1 percent really isn’t 4.1 percent at all, but a fictitious sugar high delivered on a transitory pile of soybeans, never to be seen again.
As usual, the reality is somewhere between delusional happy talk and delusional apocalypse-now talk. Here’s an actual picture of GDP growth over the full cycle of the economic recovery that began in the middle of 2009. We show both the quarter-to-quarter rate of growth and the somewhat smoother year-on-year growth trend.
Something Old, Something New
The best way, in our opinion, to interpret the current trend in GDP growth is to ascribe much of it to factors that have been underway for some time. Consumer spending is by far the largest single component of GDP, accounting for more than 70 percent of the total, and Americans have continued to not disappoint in their purchasing predilections. Fixed private sector investment – both residential and commercial – also reflects continuing confidence by homeowners and businesses alike. The mix will change in any given quarter – nonresidential construction and intellectual property investment were key drivers this quarter while residential investment declined – but the overall trend has stayed positive. This is the “something old” – a continuation of the modest but steady growth that has characterized recent years.
The “something new” shows up in an usual jump in US exports, which grew by 9.3 percent overall and which was dominated by certain categories of goods. Enter the “soybeans” meme. It appears that other countries have been stockpiling various products from the US which they expect to jump in price on account of the new tariff regime. Those bags and bags of soya beans from Iowa really were a second quarter phenomenon, were mostly related to China, and have mostly stopped with the implementation of the first wave of tariffs imposed by Beijing on US products earlier this month.
Looking beyond the quirks of any given quarter – and as the above chart shows, these numbers do bounce around considerably – the longer term question is how much of this growth is sustainable. The average annual rate of GDP growth since the second quarter of 2009 has been 2.4 percent. Many economists argue that even that number is too high – remember that for a good chunk of this time much of the growth came courtesy of direct monetary intervention by the Federal Reserve, which is no longer in effect. The fiscal stimulus put in place at the end of last year – windfall tax cuts to US businesses – may have the effect of elevating fixed investment above trend levels for a few more quarters, but that has the longer-term implications of significantly higher deficits and thus borrowing costs. This could be a particularly thorny problem if it converges with a sustained period of higher interest rates as the Fed tries to “normalize” borrowing rates.
There has not been much in the way of market reaction to today’s GDP release – partly because the number was largely in line with consensus estimates and thus already baked into stock prices. Investment sentiment around GDP appears largely dominated by the “something old” theme – different quarter, same trends – while ascribing little in the way of impactful news to either transitory short term phenomena like soya bean exports or the longer term borrowing implications of the fiscal stimulus. This way of looking at what is arguably the economy’s lead headline number also assumes that the trade tensions are mostly smoke and mirrors and will not metastasize into an all-out hot war (which view got some support this week with a surprisingly docile outcome of trade talks between the US and the EU).
What has some observers feeling blue, even when most data point to continued growth in the economy and with corporate sales and earnings, is that this recovery cycle is already long by historical standards. We have discussed this in other recent commentaries, usually with the caveat that every cycle is different and that recoveries don’t end because they pass some arbitrary calendar milestone. We do not think we are in for some super-long period of above-trend growth. Neither, however, do we see a compelling case for an imminent winding down of this cycle.
Stock prices rise and fall on account of all sorts of influencing factors on any given day. For the time being, at least, the overarching economic narrative does not give us much cause to be feeling blue.
Something interesting happened earlier this week – well, interesting for those who like to read meaning into round numbers. The number in question is 2, as in 2.0 percent, as in the yield on the 3-month US Treasury bill reached on July 18, the first time this widely used proxy for “cash” breached 2 percent since before the 2008 recession. The practical impact of this round-number event, though, is that it extends a trend underway since April; namely, that the yield on cash is now greater than the dividend yield on large cap stocks. The chart below shows the spread between the S&P 500 dividend yield and the 3-month T-bill over the past 5 years. After a yawning chasm for much of the post-recovery period when interest rates were held close to zero, the Fed’s monetary tightening program begun in late 2015 has now closed and reversed the dividend-cash spread.
Meet the New Spread, Same As the Old Spread
There is nothing unusual about cash returns exceeding the dividend yield; it is usually a feature of a recovery cycle. For example, over the course of the growth cycle from 2003-07 the yield on the 3-month Treasury bill was 3.0 percent, compared to a dividend yield on the S&P 500 of 1.7 percent. As we have often noted in these commentaries, though, this most recent growth cycle has been profoundly different. When short term rates started trending up at the end of 2015 the recovery was already five years old. It’s unheard of for interest rates to stay so far below dividend yields until nine years into the recovery.
But, of course, this was no accident. Rates were kept low in order to stimulate risk appetite after the 2008 financial crisis. Essentially, the Fed induced investors to move into riskier assets by making it as economically unattractive as possible to invest in risk-free securities. The European Central Bank of course went even further – they made investors actually pay – via negative interest rates – for the “privilege” of holding Eurozone credit obligations.
Welcome to the Jungle
Now that investors can actually get something in the way of a return on their cash allocations, however modest, market pundits are raising the chatter volume on whether this signals a potential cyclical drift out of equities into safer investments (similar to the very much related concerns about the yield curve we addressed last week). Another way to put the concern is this: can equities and other assets with higher risk properties still be attractive without the explicit inducement by monetary authorities? We’re back in the market jungle and ready to test the survival skills of common shares in the wild, goes this train of thought.
As with any other observation made without the assistance of a fully functioning crystal ball, the answer to that question is “it depends.” What it depends on, primarily, is the other component of value in a share of common stock beyond dividends: capital appreciation. In the chart above, the capital appreciation variable is the dotted crimson line representing the price appreciation in the S&P 500 over this five year period. While getting close to 2 percent each year from dividends, investors enjoyed substantial capital gains as well.
What the spread reversal between cash and dividends does more than anything else is to put paid to the “TINA” mantra – There Is No Alternative (to investing in stocks and other risk assets). The calculus is different now. An investor with modest risk appetite will need to be convinced that the dotted red line in that chart above has more room to move upwards. The dividend component of total return is no longer free money – there is now an alternative to that with a slightly better yield and less risk. The rest will have to come from capital appreciation.
Now, we have argued in recent commentaries that the growth cycle appears durable, given the continuity in macro growth trends and corporate sales & earnings. The numbers still would appear supportive of further capital appreciation. But we also expect that the change in the TINA equation will have an effect on capital flows at the margins. Whatever money is still on the sidelines may be less inclined to come into the market. At the very least, investors on the sidelines skeptical of how much longer the bull has to run will have a better reason to stay put in cash. If enough of them do so it can become a self-fulfilling trend.
The transition from summer to fall is always an interesting time in markets, as a consensus starts to form around what the driving trends of the fourth quarter will be. There’s enough at play right now to make the stakes particularly high this year.