Buy low, sell high. It is one of the most abused of market axioms and says both quite a lot and nothing at all. Of course you need to buy assets when they are cheap and sell them when they are dear but low and high aren’t exact terms and are, like beauty, amorphous qualities assigned by each observer based on their unique tastes and biases. What appears cheap to an optimist can be labeled quite dear by the pessimist. I have only very rarely in my career been labeled a pessimist but if it is defined as seeing the entire universe of investable assets as ranging from merely pricey to absurdly expensive then my glass is most definitely half empty.
Thanks to the diligent efforts of the Federal Reserve, a conservative investor is today faced with a menu of difficult choices. US stocks at roughly 15 times earnings are not cheap relative to earnings growing at 5% or so unless economic growth is about to accelerate and profit margins can stay at generational highs. Treasury bonds offer yields that are less than the rate of inflation out to maturities well beyond 10 years. Corporate bonds are trading at low spreads to those same government bonds and for high quality issues an only slightly less negative real yield. Emerging market bonds, as Doug Terry points out nearby, are trading at yields reserved in the past for high quality developed markets. And high yield bonds are no longer any such thing.
I suppose we should not be surprised to find ourselves at this juncture. Ben Bernanke told us two years ago at Jackson Hole that he intended to raise asset prices and aid the economy through the “portfolio balance effect”. The whole idea behind QE, at least as articulated by Bernanke, is that as the Fed purchases Treasuries and Mortgages in the open market, the sellers of those assets will go out and buy something else such as a corporate bond. Bernanke believes that will lower the cost of borrowing for the corporation and have a stimulative impact on the economy. The first problem with this theory is that Bernanke has no control over what the seller actually buys. He might buy corporate bonds or he might buy junk bonds or he might buy Brazilian bonds thereby, I guess, stimulating the Brazilian economy. The second problem with the theory is that simply because corporations can borrow cheaply does not mean they will do so and spend the money wisely or in a way that creates long term growth. They might use it, for instance, to finance a takeover that only makes sense because the Fed has depressed interest rates.
If QE isn’t successful at raising future growth, then raising asset prices merely reduces the future returns available to investors today. So here we are almost 4 years since the first incarnation of QE and if this is success, I’d hate to see failure. Stocks have risen from the depths of the 2009 lows but a big portion of the rise was nothing more than a multiple expansion from roughly 9 times earnings to now 15 times. Economic growth has slowed significantly since the initial post crisis surge and is now running at roughly 2% per year. Does anyone believe that stocks have risen because expectations about future growth have improved? Or have stocks risen because people have responded as Bernanke expected them to by purchasing riskier assets?
The cause of our weak growth has been debated ad nauseum but whether monetary or fiscal, I see little reason to believe it is about to change for the better. QE and fiscal stimulus, as implemented by this administration, has not been an effective combination and seems very likely to get worse. The resolution of the fiscal cliff – or the illusion of resolution – raised taxes on almost every American. The headlines were about the marginal rate hikes on the higher incomes but the restoration of the payroll tax will have the larger effect. Now, as we approach the sequestration deadline, the President’s party has made it clear that if the Republicans want to avoid any of the spending cuts – defense for instance – they will have to agree to more tax hikes. Whether the Republicans make that tradeoff matters little. Either way, the fiscal picture tightens in the short term. The spending cuts would have a smaller impact on the economy (and a positive long term effect in my opinion) but either way GDP growth will be slower in the short term than it would have been with no fiscal change. Considering last week’s 4th quarter report, that makes investing in anything dependent on US economic growth a fairly high risk proposition in my opinion.
Unfortunately, bonds do not offer the easy alternative they normally would in such circumstances. Even after a recent sell off, bonds are expensive relative to inflation and especially potential inflation. Bernanke’s actions have raised inflation expectations and based on history it is hard to believe that he won’t eventually conjure higher prices and possibly much higher ones. In the short term, sentiment has turned very sour on bonds so a rally wouldn’t be a surprise but buying a long term bond right now is a bet on deflation that seems almost impossible in the context of an ever expanding Fed balance sheet.
Bernanke was correct to some degree in his expectations regarding QE. Investors did go out and bid up riskier assets. Unfortunately, it doesn’t appear that he was correct about what impact that would have on economic growth. Or at least he wasn’t correct given the current state of fiscal and regulatory policy. I find it hard to believe that anyone is out there buying stocks because they think fiscal and regulatory policy is about to improve dramatically which leaves nothing but the old Keynesian beauty contest as an explanation for the recent run up in stock prices. Stocks are rising right now because they are the most attractive of the available alternatives. They are also rising because the marginal buyer believes they will keep rising based primarily on the fact that they already have. These marginal buyers – think about those recent large mutual fund inflows – are setting the price of stocks right now. Not exactly confidence building is it?
Buy low, sell high is a two step process. You can’t do one without first doing the other. Given the “success” of Bernanke’s program to raise asset prices, you are too late to execute step one. And since asset prices, at least in recent times, seem to go down a lot faster than they go up, you sure don’t want to make the same mistake on step two.
For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, Joe Calhoun can be reached at: firstname.lastname@example.org or 786-249-3773.
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