July of 2016 to June of
2018 may have been a turning point. Interest rates started rising to meet
commercial demand for loans, even before the political conventions. Three weeks
ago we began seeing that tech-led Growth funds were no longer the weekly mutual
fund leaders, value is now leading. In a gross oversimplification some people
divide equities between growth and value. According to a table in the weekend
edition of The Wall Street Journal, looking only at the sectors within the
S&P 500, note the following weekly performance:
Utilities +2.25%
Telecom Serv +1.18%
Real Estate +1.06%
Energy +1.03%
vs.
Information Tech -2.19%
Financials -1.93%
Consumer Discretion -1.87%
Health Care -1.79%
One could choose to
ignore very short-term performance results, which is normally wise. However, a
glance at the charts of the three major stock indices might well suggest that
there is a potential warning in the near-term data. Both the Dow Jones
Industrial Average (DJIA) and the Standard & Poor's 500 (S&P500) are
showing reversal patterns and the NASDAQ Composite (NASDAQ) could be as well.
Clearly something has changed and this could be labeled sentiment. The American
Association of Individual Investors (AAII) conducts a sample survey of its
members which can be quite volatile and the sample may not be representative
enough. Nevertheless, it is worth noting that in a three week period, bullish
responses dropped 37% to 28.4% of the sample and bearish responses rose 88% to
a reading of 40.8% of the responses. (The causes for the sentiment shift will
be discussed below.)
A
Positive for Value
While some may disagree
with me, I believe from a low level the increase in interest rates is a
positive for those who are looking for value. The search for value is much more
difficult than the search for growth in rising revenues and earnings. While
many value advocates speak of intrinsic value, what they really mean is what
price a knowledgeable buyer for the company would pay. Therefore, value is a
derivative of the price of a transaction. Value-oriented investors attempt to
arbitrage the difference between the current price and a future expected
transaction price. If one believes in the commonality of assets, a similar
transaction price for some could establish value or at least be indicative of
it.
Rarely have I found
complete commonality of individual assets and thus an adjusted price becomes
the theoretical price, with the buyer really determining the value. Most buyers
want to earn a premium over their cost of capital and therefore higher interest
rates drive acquisition prices. Commercial interest rates imply that they have
imbedded within them a credit cushion for bad debts particularly for commercial
loans as distinct from borrowings by governments. Thus, in late June and early
July of 2016, after the end of an undeclared recession started to raise
commercial interest rates, buyers could foresee the profitable use of loans.
Thus the beginnings of a new expansion started.
Cash
Flows
One of the first tasks
we learned from Professor David Dodd was to reconstruct financial statements so
that they could be used by investors instead of creditors. To me the single
most valuable statement for determining value was the Cash Flow statement,
which is rarely commented upon by the pundits. Recently, when I looked at one
of these documents it became clear to me that the proper reconstruction is
dependent very much on the intended use by a potential acquirer of a company.
Acquirers could be quick liquidators, passive investors, a buyer of talent,
customers, patent seekers, or others desiring excess capacity and unique
assets. In some cases the acquirer may want to remove capacity from the market.
The following is a brief list of items found on the cash flow statement that
should be handled differently depending on the user: depreciation/depletion
policies, property, plant and equipment, acquisition or disposals, repurchase
of company stock, repayment of debt, and dividends.
As a practical matter
value is not only dependent on interest rates, but on the willingness of others
to extend credit to businesses and individuals. Currently, we are seeing a
surge in the willingness to offer credit, which is a counter-force to the
central banks wanting to raise the price of money. I am concerned that the
pressure to offer credit may lead to narrower profit margins, resulting in
lower than appropriate reserves.
Stability
Leads to Instability
At some point this over-extension
of credit creates a vulnerability which could create a major distortion of risk
and lead to a recession. Right now credit reserves look to be stable; however,
please remember a quote from Hyman Minsky, “Stability leads to instability. The
more stable things become and the longer they are stable, the more unstable
they will be when the crisis hits.” Instability could mark the end of the
current phase, making investing for value problematic.
Shifting
Sentiments
I have already noted
the somewhat dramatic shift in market sentiment. Many will attribute it to the
troubled trade discussions. I personally believe the shift away from the tech-driven
growth favorites was overdue. At least on a temporary basis, some retrenchment
was to be expected in terms of excessively large positions.
In dealing with short–term
trade movements it may be worthwhile to focus on July 3rd and July 6th. The first date is another example of the
media-political-academic complex wrapping history to their own needs and
ignoring the real motivations of the principals. On July 3rd, 1863
the final day of the Battle of Gettysburg was fought. Robert E. Lee, probably
the smartest American general, sacrificed some of his best troops in charges up
a hill to breakthrough the Union lines. Most history books state that if he had
won the day he would have pivoted and attacked Washington DC, likely resulting
in the desired end of the war.
Looking at a map and
understanding where the Union’s economic strength lay, as well as what was
happening in Vicksburg on the very same date, shows me a different set of
plans. If the Confederate forces had broken through in southern Pennsylvania
they would not have pivoted, but instead headed north to disrupt the rail and
other east-west train traffic. This would have isolated economic parts of the
North and could have taken some pressure off the battle of Vicksburg, which was about to fall to Sherman, leading to the
destruction of the South’s war making capability on Sherman’s march to the sea.
Bearing in mind another
example of the general public being misinformed, we may be seeing a similar
mistake in terms of perceptions of the trade/security issues we are now facing.
On July 6 the scheduled implementation of the Trump tariffs is meant to happen.
To my mind the trade issues are not the real focus of the current US Administration,
security is.
For whatever it is worth I do not expect anything of significance to happen on July 6.
For whatever it is worth I do not expect anything of significance to happen on July 6.
What do you think on
the switch to value and the trade and security issues?
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