September 19, 2013
“This will not end well” was our reaction to the Federal Reserve’s announcement that they will not taper their current efforts at quantitative easing. Equity valuations will continue to delink from reality while idle money will finally feel compelled to leave the sidelines and chase performance. We are now in the final act but we have no idea when the shows ends. All we know is that this will end in tears as a massive amount of capital is misallocated, and then justifiably purged. As allocators of capital, what do we do? Do we capitulate and play the game of relative valuations and relative performance? Of course not, but now we assume the increasing pressures of business risk and professional risk that Jeremy Grantham at GMO describes so eloquently.
Our nation’s central bank has essentially painted themselves into the proverbial corner. The market had already priced in the beginning of the end of the central bank’s extraordinary monetary stimulus, but now the market and all of its self-proclaimed expert prognosticators will continue playing the game of parsing each economic data point to determine the future intentions of the central bank. Sadly, the “machines” are programmed to trade each economic data point and technical level in the market to a degree that far, far exceeds the market of 2007. These black boxes advertise themselves as deep sources of market liquidity but the reality is that the liquidity is a mile wide but only an inch deep. We suspect that just as quickly as the market marches higher on monetary stimulus and manufactured news headlines, the reverse will prove true when the final act ends.
The current environment is similar to 2007 in that valuations are stretched but today is definitely different than 2007. The overnight lending rate was 5.25% in 2007, the Federal Reserve’s balance sheet was $800 billion, and the total federal debt outstanding was roughly $9 trillion. Today, the overnight lending rate is 0% – 0.25% with the Federal Reserve’s balance sheet approaching $4 trillion and US federal debt at $17 trillion and quickly growing. Meaning, there are few if any remaining conventional fiscal or monetary instruments to fight any shock to the economic system. In 2008, the “bad” debt shifted to the government’s balance sheet while corporations and individuals repaired their balance sheets. Today, the government’s balance sheet appears increasingly hobbled and yet the current environment is fostering malinvestments that will once again damage corporate and individual balance sheets. In 2007, after-tax corporate profit margins averaged 7% and top line revenue growth averaged around 7%, but today profit margins are closer to 10% and revenue growth is stalling at 2%.
How do you justify higher equity valuations if profit margins are more likely to contract than expand and revenue growth is stalling? Why naturally you discount those future cash flows by a lower cost of capital! But to my eye, the Federal Reserve appears to be slowly losing control of the bond market – interest rates are separating from the raw pressure of central bank interventions. We know why this will end badly, we just don’t know when.
The opinions expressed are those of the Castle Focus Fund’s portfolio manager and are not a recommendation for the purchase or sale of any security.
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