Technically…

18117_JBLU_Technicals
Source: Morningstar Direct

Given how many smart people end up working in investment management, I am always surprised how siloed we can be. You tend to be a fundamental guy, OR a quant gal, OR a technician. Never all three. In my view there ought to be more interdisciplinary investment strategies. One reason there aren’t more of them is that capital allocators have a hard time underwriting strategies that don’t fit neatly into pre-established boxes (a subject for another post).

Personally, I don’t believe our world breaks down into neat little boxes, so I am interested in opportunities to integrate analytical techniques from different disciplines. To that end I have been studying up on how you might marry fundamental and technical analysis in a disciplined way. Typically a vast chasm of prejudice separates the two camps.

Fundamental Analyst:“Intrinsic value is what matters. Market price fluctuations are just noise to be ignored. Analyzing charts is like tossing chicken bones and reading the entrails of livestock to see the future. It is like trading based on ancient superstition.”

Technician:“Market prices are what matter. Market prices reflect supply and demand dynamics, as well as investor psychology. Prices are real and tangible, unlike some academic’s estimate of intrinsic value, which depends on “squishy” estimates of growth rates and discount rates.” 

What we have here are two people talking across each other. It is like two people arguing over whether hammers or screwdrivers are “better” tools. In reality hammers and screwdrivers are different tools with different use cases.

I don’t believe technical analysis is particularly useful over long time horizons. There is plenty of evidence that in the long run, stock prices track earnings and dividend growth. I also don’t believe fundamental analysis is particularly useful over short time periods. If you are placing a trade, it is supply and demand that impact your execution, not market price relative to intrinsic value.

Fundamental analysis is going to give you a better idea of whether a business will be a good investment for the next decade. Technical analysis is going to give you a better idea of why today’s price is moving up or down.

Now, I should be up front about the fact that I am not at all interested in chart patterns. I have no interest in scouring candlestick charts for head-and-shoulders or cups-and-handles or van-gogh’s-remaining-ear. As far as I’m concerned that really is like tossing chicken bones or reading animal entrails. I prefer to use simple technical indicators to get a sense of price momentum and investor psychology.

For the time being at least I have focused on three indicators:

Support/Resistance Lines: You can draw a support line across the lows on a chart and a resistance line across the highs. In my view (I certainly don’t claim to be an authority on technical analysis), these lines are rough indications of where valuation sensitive investors have acted to counter a stock’s momentum. The support line forms where valuation sensitive investors step in to buy the stock. The resistance line forms where they sell the stock.

Moving Averages: Moving averages quantify short-term price trends versus long-term price trends and are useful for visualizing momentum. It is generally a bullish sign when a shorter-term moving average crosses above a longer-term moving average and a bearish sign when a shorter-term moving average crosses below a longer-term moving average.

Money Flow Index: The money flow index is an indicator tracking volume-weighted price momentum. It is an oscillator that moves between a range of values. It is useful for understanding whether price momentum is overextended in either direction, and whether it might soon reverse. More on the calculation and interpretation of money flow index here.

I think of the support/resistance lines as marking out the upper and lower bounds for the market’s estimate of a stock’s intrinsic value. Fundamental investors enforce these boundaries by trading contra-momentum (they sell when they believe a stock is overvalued and buy when they believe a stock is undervalued). Inside those boundaries, a stock will tend to ping-pong back and forth until the fundamentals change unexpectedly or fundamental investors significantly alter their expectations. A variation on the latter is when the type of investor dominating a stock’s investor base transitions from value to growth investors or vice versa.

Thus, I would argue, if you are an investor with a high degree of confidence in your estimate of a stock’s intrinsic value, and that estimate differs significantly from market expectations, you may be able to profitably trade around momentum-driven price swings–the goal being to generate higher position-level IRRs than you would earn by simply buying and holding.

In a follow on post I will walk through a live case study from my own portfolio to make this more concrete.

Shenanigans! PIK Bond Edition

As follow on to my recent post on “return free risk” in the high yield market, here is a real gem via the FT:

One of Ireland’s richest entrepreneurs has embraced an aggressive new version of an already esoteric form of junk bond, highlighting the level of risk that debt investors are willing to tolerate as they seek higher yields in hot credit markets.

The $350m “super PIK,” or payment-in-kind bond, raised at the end of last week will pay a dividend to a group of shareholders in Ardagh Group, a one-time small Irish glass bottle maker that has grown in the past two decades into one of the world’s largest metal and glass packaging companies.

PIK refers to bonds or loans that can pay their interest with further debt rather than cash. This means the size of the debt can balloon quickly and leave lenders with steep losses if the underlying company is not able to handle the growing burden.

No, your eyes do not deceive you. The company raised a $350mn bond issue that gives it the option of paying coupons with IOUs instead of cash. So it can pay insiders a dividend.

While Ardagh listed on the New York Stock Exchange last year, 92 per cent of its shares are held privately, with its billionaire founder and chairman Paul Coulson the largest shareholder. It is these private shareholders that are receiving the dividend. “In plain terms, the use of proceeds is essentially providing a ‘margin loan’ to legacy shareholders,” noted analysts at credit research firm CreditSights.

Here is the cap structure, if you are interested in a quick round of Spot The Suckaz:

Ardagh_Cap_Structure
Source: FT

And where exactly did this boondoggle price?

Despite its risky structure, the PIK bond sale drew roughly $2.5bn of orders, said a person close to the deal. This allowed it to ultimately price with a yield of 8.75 per cent, below the 10 per cent initially marketed. An older PIK dollar-denominated deal sold by the company in 2017 currently trades with a yield of 6 per cent.

Yeah, I know, it’s all anecdotal evidence. You can’t time the market or the credit cycle. Blah, blah, blah. Nonetheless, I vaguely recall an old Warren Buffett saw… something about when to be fearful and when to be greedy…

Why We Are Allocating Capital On Autopilot

In recent posts (here and here) I explored my view that today’s markets are systematically mispricing risk. My analysis isn’t exactly rocket science. So why does this mispricing persist? Why does everyone shrug their shoulders and say, “well, there is no alternative,” versus simply dialing back their exposures or hedging out some of the tail risk? At the very least, investors could increase the discount rates used in their valuations to correct for ultra-low riskfree interest rates and build in a greater margin of safety.

So why don’t they?

I would argue that more than anything, it is business and political pressures that drive this behavior. Importantly, I don’t believe this mispricing of risk is irrational. Rather, I believe decisions that seem rational on a micro level have led to irrational behavior in the aggregate. Investors are simply behaving how they are incentivized to behave–as a herd.

Here are my reasons:

Institutional investors must remain  invested. If you are a mutual fund manager or a hedge fund manager or venture capitalist, good luck explaining to your investors why you are sitting on a portfolio that is 40% cash. Many investors are loathe to stick with a manager who sits on a cash hoard for an extended period. Particularly in a buoyant market where cash will drag on returns. There is a sound rationale for this: the investor is perfectly capable of allocating to cash or hedging market risk on his own. Why pay some asset manager fees to sit on cash? While this makes plenty of sense from a business perspective, it makes no sense at all to an investing purist. The purist takes risk when the market is rewarding her for it and pares risk when the market is not rewarding her for it. Portfolios should be positioned more aggressively when markets are dislocated and prices are bombed out. They should be positioned more conservatively when valuations are high and expected returns are low.

Institutional investors are afraid to look different from their peers. Career risk drives a great deal of behavior in financial markets. It is the reason so many mutual funds look so similar to their benchmarks. This positioning makes no sense to a purist concerned with absolute returns. Yet it is perfectly rational for the mutual fund manager who will be fired if he drops into the fourth quartile of performance for a trailing 3-year period. Likewise for pension funds and endowments with trustees who may be penalized politically for contrarian positioning.

All investors have return hurdles to meet. If you are an individual or pension fund there is a certain rate of return that will allow you to fund your projected future liabilities. If you are an endowment or foundation there is some spending rule governing portfolio withdrawals, usually based on long-run capital market expectations. Altering these hurdles is a big deal. Reducing expected returns means pensions and individuals will have to save more to fund future liabilities. Endowments and foundations may have to cut financial support for certain programs. This can be psychologically devastating for individuals and extremely embarrassing for institutions. It is a powerful incentive for investors to take a “glass half full” view of the future, even if it is ultimately self-deluding and counterproductive.

Perhaps the most significant advantage you can get in the markets is what Ben Carlson calls organizational alpha. Put simply, this is the flexibility to do what others can’t, or won’t, as a result of business and political pressure. It is the freedom to switch off the autopilot and deviate from the pre-established flight plan.

More On S&P 500 PE Ratios

As follow up to my last post regarding cost of equity and valuation multiples for the S&P 500, here is a chart showing the implied steady state PE versus the actual PE for the index since 1961.

118_Implied_vs_Actual_PE
Data & Calculation Sources: Aswath Damodaran & Michael Mauboussin

The actual multiple typically plots above the steady state estimate. This is to be expected since the market is typically assigning some value to future earnings growth, and for simplicity’s sake my steady state multiple calculation does not factor in future growth.

By calculating the steady state multiple in this way you can easily visualize how the market is valuing future growth at a point in time. When the actual multiple is far above the steady state multiple, as in the late 1990s, the market is assigning a high value to future growth. Obviously the value of future growth can swing around violently depending on investor sentiment. In fact, exploiting this tendency for the market to overvalue and undervalue future growth is the lynchpin of Ben Graham style value investing. If you buy a stock at a low steady state valuation, yet have correctly discerned there are future growth opportunities not reflected in the market price, you get a free call option on the future.

The impact of ultra-loose monetary policy shows up very clearly in this chart in 2009. The steady state multiple shoots up dramatically in 2009 as interest rates (and thus discount rates) hit historic lows. What is interesting to me about this chart is how long the actual multiple remained below the steady state multiple, almost as if the market “realized” the discount rate had been artificially manipulated and refused to play ball. Again, that speaks to the power of investor sentiment.

Superficially, it appears as though the market valuation has finally “caught up” with its steady state value and has room left to run (remember, the steady state model isn’t pricing any growth). However, as discussed in the previous post, the steady state multiple has risen due to a low discount rate. So what I think investors need to think long and hard about today is whether we are systematically mispricing risk (spoiler alert: I think we are).

That said, I don’t think investors are mispricing risk because they are stupid, or even because they are greedy. In fact, I think they are acting rationally in the face of unappealing alternatives. But that is a subject to explore in future posts.

It’s The Risk You Don’t See That Kills You

I want to share a chart I believe is of paramount importance to asset allocation and valuation in today’s environment. It graphs the implied cost of equity for the S&P 500 alongside the steady state earnings multiple that number implies. The underlying data is from NYU Professor Aswath Damodaran and the steady state calculation is taken from a paper by Credit Suisse’s Michael Mauboussin.

Professor Damodaran estimates the implied cost of equity for the market by solving for the discount rate that sets the present value of projected S&P 500 dividends equal to the current level of the index. There are plenty of quibbles you can raise with this simple model (as with all models it is a dramatic oversimplification of messy reality). However, I don’t believe quibbles diminish the key insight.

Namely: the implied valuation of the equity market moves inversely to its implied cost of equity. This should make intuitive sense to anyone who has ever discounted a cash flow. If you were wondering, the calculated correlation is around -.90.

Here is my chart:

118_Implied_Cost_Equity_SP
Data & Calculation Sources: Professor Aswath Damodaran & Michael Mauboussin

What this chart makes abundantly clear is that over the past thirty years the justified steady state multiple for the S&P 500 has crept steadily upward. Not so much because the risk premium has contracted but because the T-Bond rate (used as proxy for the riskfree rate of interest) has come down dramatically.

Now, that is a fairly superficial observation. Why does it matter?

Reason #1: A popular contrarian narrative in the markets is that central bankers have artificially suppressed interest rates, and that absent their interventions the “natural” rate of interest would be higher (implying a higher discount rate and thus lower sustainable valuation multiples). The key risk to this thesis is that low rates are not some exogenous happening imposed on the market by a bunch of cognac swilling technocrats, but rather a consequence of secular shifts in the global supply and demand for funds. Specifically, that these days there is a whole boatload of money out there that needs to be invested to fund future liabilities and too few attractive investment opportunities to absorb it all.

If low rates are actually a function of the supply and demand for funds, it doesn’t ultimately matter what central bankers intend do with monetary policy. Market forces will keep rates low and elevated valuations will remain justified.

Reason #2: Capital is allocated based on the opportunity set across asset classes. A 5% implied IRR on the S&P 500 may suck wind relative to “normalized” risk, but it is better than what you can expect in bonds. As long as equity looks like “the least bad alternative” valuations will remain elevated. If you are trying to short the market into this dynamic you are going to have a brutal go of it unless you are extremely fortunate in your timing. This is precisely why so many bearish investors have been wheeled out of the market on gurneys over the past 5 years.

Reason #3: By way of anecdotal evidence, sentiment is getting more and more bullish. Every day I am reading articles about the possibility of a market “melt-up.” If the market melts up it may narrow the implied risk premium and further reduce the implied discount rate. If this occurs, it leaves investors even more exposed to a double whammy: simultaneous spikes in both the riskfree interest rate and the risk premium. The years 1961 to 1980 on the chart give you an idea of how destructive a sustained increase in the discount rate can be to equity valuations.

My overall assessment of today’s markets is that perceived risk is low across the board. As a result investors are not generally being well-compensated for the real risks embedded in their portfolios.

Some Acknowledgements

This post is a synthesis of many arguments I have read over months and years. I therefore want to credit Josh Brown, John Hempton, Philosophical Economics, David Merkel and GMO for their tremendously insightful comments and analyses, which have helped me get to grips with the “real world” supply and demand fundamentals underlying today’s market valuations.

1Q18 Factor Performance

A while ago I created some charts to track factor performance in the US equity market. The data is from Ken French’s Data Library. As you might expect, it is the Fama French Five Factor data, as well as data for the North American Momentum Factor.

From an analytical point of view I always find it helpful to dis-aggregate investment returns, as this can offer a more nuanced picture of the fundamental drivers of equity market returns.

118_Market_Factor_Performance
Source: Ken French’s Data

Our first factor is Market. Looking at this chart it’s no wonder there has been a bull market in passive investing lately. Since May of 2014 simply being in the market has return a cumulative 45%. Getting market exposure as cheaply as possible has proven to be a great strategy over this time period.

118_Size_Factor_Performance
Source: Ken French’s Data

Next up is size. As a whole small companies have not generated much of a return premium in recent years.

118_Value_Factor_Performance
Source: Ken French’s Data

Value is a much beloved and storied factor and if you follow markets at all you have probably read plenty of material calling value investing into question lately.

118_Momentum_Factor_Performance
Source: Ken French’s Data

Momentum has taken investors on a wild ride in recent years. 2015 in particular was an exceptional year for momentum, driven in large part by internet technology and biotechnology stocks. Despite a vicious drawdown in late 2015 and early 2016 momentum is surging again on the back of bullish sentiment.

118_Profitability_Factor_Performance.PNG
Source: Ken French’s Data

Nothing to write home about in terms of operating profitability.

118_Investment_Factor_Performance
Source: Ken French’s Data

Investment is more or less the mirror image of the momentum chart. The investment factor is a bit counter intuitive in that it is measuring the premium associated with a conservative corporate investment policy. There have been a couple of inflection points in this chart and more recently investors seem to again prefer companies investing more aggressively in growth opportunities.

Finally, here is my updated chart of rolling factor returns back to 2000:

118_Rolling_Factor_Returns
Source: Ken French’s Data

Observations & Implications

The most significant takeaway from this data is that since the financial crisis, the best performing factor has been Market by a wide margin. I don’t believe it is an accident that strong Market factor performance coincides with both the trend toward passive investing and the extraordinarily low interest rate environment we have seen since the financial crisis. I suspect there is some degree of feedback loop in play here: low interest rates push up equity valuations which enhances broad market returns which is a tailwind for low-cost, market cap weighted equity funds (a.k.a index funds).

Furthermore, since the financial crisis several factors have shown muted performance versus their pre-crisis averages, notably Size and Value. This is a headwind for active mutual fund managers. Most of these managers run diversified portfolios where the factor exposures drive the majority of the variation in their returns. If they are good (or lucky) they will add some incremental return through security selection. Many managers also intentionally tilt their portfolios toward small stocks and value stocks. They have not been rewarded for these tilts in recent years.

The trillion dollar question here is whether Market factor dominance is a secular or cyclical trend. I am inclined to believe it is cyclical, albeit with a significant caveat.

My significant caveat is that Market factor dominance will last at least as long as global interest rates remain low. In this low rate environment the notion that There Is No Alternative forces capital that would otherwise be content to earn 5% annually in long-dated Treasury bonds into risk assets, pushing up valuations indiscriminately. Until investors with lower risk preferences determine they have viable investment alternatives, equity valuations will remain elevated across the board and the Market factor will perform well.

Sentiment seems quite bullish so far in 2018. This has animated the spirits of a number of investment managers. Yet here is the YTD data for the Treasury yield curve. The market is absolutely not pricing for significantly higher economic growth, inflation or interest rates over the very long term (20-30 years). I am not sure there is any actionable insight in this but it is a troubling disconnect.

118_Treasury_Curve
Source: treasury.gov

 

Return Free Risk: A Picture Book

Once upon a time there was an asset class called high yield debt. It consisted of all the lowest quality bonds issued by all the lowest quality companies. Companies like Frontier Communications and Sprint and Valeant Pharmaceuticals.

And yet, because There Is No Alternative but to buy risk assets these days, particularly for Yield-Starved Fixed Income Investors, in aggregate this debt traded at yields well below the historical average.

 

118_HY_Spreads

 

You see, what the Yield Starved Fixed Income Investors had forgotten was that high yield debt returns are (badly) negatively skewed.

 

118_HY_Loss_Potential

 

And so what the Yield Starved Fixed Income Investors had bought was return free risk.

 

118_Spred_Per_Turn_Leverage

 

118_Yield_Per_Turn_Leverage

(Charts from a presentation by Troob Capital Management)