During a stock market
phase when stock prices rise and conventional thinking suggests that the
economy is in weak shape, pundits may explain that the market is climbing a “Wall
of Worries.” Another way to phrase this phenomenon is that market prices are
narrowing their discount of future better prices. After all, the market for
future dividends and earnings is what today’s prices are meant to be about.
Since the break in 2008,
many of the markets around the world have been assessing the chances of further
declines due to potentially large financial failures, deep economic recessions
(some said depressions) and political turmoil. These are challenges that make
governing difficult to impossible and inhibit the ability to address the
long-term structural deficits facing many “developed” societies. Five years
after the markets’ bottoms, on the surface we have experienced no major
financial failures in part due to the shifting of financial leverage from the
private and commercial sectors to the government sector. This feat of
legerdemain was done by artificially lowering interest rates by ignoring credit
concerns. Removing the impact of deleveraged debt from the surface economy
reduced the strains on the economy. In addition, a number of the major
governments went through an election which did not produce panic selling by
disappointed investors. In the mind of
investors, institutions and individuals, if market prices didn’t go down, they
should go up. One rationally might disagree with this “logic,” but in truth
that is what happened.
Newer
risks
If the old worries did
not cause a double or triple dip in market prices, then as one comic book
character queried years ago, “What me worry?” As a professional investor that
is exactly why I am getting a bit concerned. In my most conservative accounts
that enjoyed a good 2012 (and 2013 looks positive), I am beginning to address
our stock/bond ratios. Stocks have done well and they now account for way above
normal asset class guidelines as a percent of the total accounts. The concern
is that when the periodic declines hit the stock market, potential gains from
fixed income holdings will not be large enough to hold the value of the account
to a comfortable level.
Analytically I see at
least three potential concerns that could get worse and put sharp pressure on
prices. My concerns are for the potential permanent loss of capital which I
call risk; which is quite different from the variability of prices or
volatility which many consultants and academics mistakenly call risks. My three areas of concerns which could lead
to permanent loss of capital are:
1. As
regular readers of these posts have learned, I believe the fixed income markets
with their more limited potential returns than the equity markets can send important
early warning messages to stock and equity fund buyers. I particularly pay
attention to High Current Yield or if you prefer the more pejorative term,
“junk bonds,” which in effect are stocks with coupons and maturities. According
to Moody’s,* the yield
spread from low grade paper to higher quality bonds is larger than at past
bottoms. Mutual fund investors, despite being warned, have been pouring money
into High Yield Bond funds. What is of particular concern to me is that a good
bit of this money is going into what is called “covenant lite” bonds that don’t
have the usual protective covenants. My fear is that the combination of
somewhat imprudent investors piling into funds with significant covenant lite
bonds could lead to serious disappointment, which in turn could lead to massive
redemptions. Often if a corporation’s low quality bonds drop it can hurt the
firm’s stock prices as well.
*Disclosure:
My financial services private fund
has a long position in Moody’s
2. There
are surface signs of complacency toward the stock market with relatively low
volumes of transactions, particularly by public investors. The VIX measure of the
presumed fear of option price declines is flat and near its lows for the year.
The structure of capital markets around the world has changed over the last
couple of decades by removing the shock-absorbing middlemen as well as agency
brokers, replacing them with dealers who have little, if any, responsibilities
for an orderly market. Thus a sudden surge of market orders could stampede a
market in either direction creating a significant impact.
3. I
am increasingly concerned about the spirit of integrity in the marketplaces
around the world, but primarily in the US. I have already mentioned the growth
of covenant lite bonds that may have been sold to unaware individuals and
institutional investors. Another tendency that is bothering me is a practice of
taking publicly traded firms private in a management buyout. To me the only
justification for the relatively low price being offered for Dell is that is
the cost to remove the present management, which has presided over more than a
50% drop in the price of its shares. We must take better care of our investors
if we want to have viable markets.
Please share your
thoughts on any of these topics by emailing me.
_________
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