What lurks beneath

Last week saw the conviction of both bulls and bears tested. Job creation in the US exceeded expectations in June and investors bid the S&P 500 to yet another high. Bulls probably took succor from Janet Yellen’s mid-week promise not to use the blunt instrument of interest rate rises to prick any irrational exuberance. Yet, earlier in the week, bears must have looked approvingly at a Bank for International Settlements report which intoned gravely against the risk from “euphoric capital markets” and made a call for tighter monetary policy.

Let us address the key issues for investors raised in the BIS report.

1) Are financial markets expensive? At the very least, they are not cheap. Those assets for which we have a working model tend to be slightly above their average valuation level. Looking across the spectrum, markets vary between being on their fair value mean to being one standard deviation overvalued. The only asset which is “cheap” is the US dollar.

2) Do bear markets always start from an overvalued level? Not at all. The last two bear markets (defined as a decline of more than 10% over a six month period) which started in 2007 and 2010 occurred when prices were below an average valuation level. This is not uncommon.

So, our first reaction to the BIS comments is that we could have a bear market, but it will not arise because of extreme valuations as was the case in 1962, 1987 and 2000.

The bigger issue raised by the BIS was whether central banks’ constant manipulation of interest rates creates false sense of security among market participants. Here, we are in full agreement. One problem is that more and more money is managed via indexation, which is just a form of momentum buying. And since index money is not allocated on the basis of the marginal return on invested capital but rather according to market cap, the result is large-scale capital misallocation. As such, it is a form of socialism, and we all know how effective this system is at allocating capital.

Adding fuel to fire has been the Federal Reserve’s zero interest rate policy. Back in 2011, we argued that sustained low rates would result not in growth, but capital misallocation. We wrote that ZIRP would cause a rise in asset prices, but not an increase in the national inventory of capital. And the result would be a structural decline in productivity and a huge rise in the Gini coefficient (the rich getting richer, the poor getting poorer).

The point was that while high interest rates impede growth, low rates achieve exactly the same. What is needed is a market determined cost of capital which is elemental to capitalism.

Markets are now engaged is a momentum game with investors convinced that central banks in the US and Europe can avert big asset price declines. That was not such a dangerous proposition for investors back in 2011 and 2012 when shares were cheap. Back then, we advised investors to be 100% invested in equities even though we hated the policies. The problem is that investors are now skating on much thinner ice, which is why since 2013 we have advised an equity position hedged by a long dated zero coupon bond. Such a balanced portfolio has strongly outperformed so far this year, and we recommend to stick with it.

What is worrying is that bonds have outperformed both equities and a balanced portfolio for six months and no one seems to care.