This just in: You can’t take the same actions as everyone else and expect to outperform.
Non consensus ideas have to be lonely. By definition, non-consensus ideas that are popular, widely held or intuitively obvious are an oxymoron.
I’m convinced that everything that’s important in investing is counterintuitive, and everything that is obvious is wrong.
Unconventional behavior is the only road to superior investment results, but it isn’t for everyone.
Howard Marks, Oaktree Capital, Dare To Be Different, II
I’ve spent my entire career swimming up the contrarian tributary of the investment stream. It isn’t, as Marks points out, easy to do. It is a natural, human instinct to seek out the comfort of the crowd and in many of life’s endeavors it works out just fine. Investing, however, is different. If you want to produce superior results over the long term, there are times when you have to venture outside the consensus. It is impossible to perform better than the crowd if you are merely doing what everyone else is doing. Anyone reading these weekly commentaries for the last year surely knows that I am not a fan of stocks at current valuations. In fact, I haven’t been a fan since early last year, right before a rather large multiple expansion that carried the averages to new all time highs. Which brings me to another Marks quote: “Being too far ahead of your time is indistinguishable from being wrong.”
The things that turned me cautious on stocks last year have not changed except for the worse. Valuations are higher than they were a year ago, as most of last year’s rally was a product of multiple expansion. Earnings were up about 7% last year while the S&P 500 gained 30%. The economy continued its plodding expansion with GDP rising 1.9%. As the year progressed and interest rates spiked on the Fed’s hints at tapering, some sectors of the economy, notably real estate, started to exhibit reduced activity levels and growth rates. While inventory additions did goose growth in the 3rd and 4th quarters, we now appear to be repeating the pattern of last year with 1st quarter growth falling substantially as the inventories are worked back down. And yes, yes, all you forecasters out there, weather did have a negative impact in the quarter. How much is a matter of debate that only time and higher temperatures will resolve. We’ll see.
So far, I haven’t seen much in the economic data to convince me that the economy is accelerating as expected by almost everyone. We did get blips higher in some of the manufacturing data last week with both the Richmond and KC Fed’s surveys showing expansion. Durable goods also rebounded a bit but it is still within the context of a slowdown in growth and at levels that in the past have preceded recession (see here). On the negative side, real estate reports continue to worsen. Existing home sales – which actually don’t have much impact on economic growth – were down again, 7.5% year over year. New home sales – which do have an impact on growth through construction – were even worse, down 13.3% year over year. Based on traffic patterns at new home builders down roughly a third over last year, I wouldn’t expect to see a surge there any time soon. The fact is that the economic data continues the recent pattern of being decidedly mixed with no clear trend overall except the one we’ve been in since the beginning of this expansion – weak, unsatisfying growth.
For those who hope foreign profits will bail out the multinationals of the S&P 500, there is some hope with Eurozone PMIs sitting at three month highs and Draghi’s hand on the printing press. On the other hand, China’s reading continues to fall into the contraction zone at 48.3. Japan could be another source of hope but the failure to follow through with structural reforms after last year’s big Yen devaluation leaves nothing other than more Yen printing as support for an economy that continues to struggle. The growing current account deficit will probably continue to pressure the Yen regardless of BOJ actions but devaluation is not the answer to Japan’s problems. That leaves emerging markets as a potential source of growth but their fate is at least somewhat dependent on whether China can engineer a soft landing from one of the biggest – if not the biggest – credit bubbles in the history of the world. Good luck with that.
Meanwhile, in markets, financial engineering is expanding at a rate that real engineers can only envy. Easy credit and low interest rates have revved up the M&A market with a spate of deals announced last week to add to the already frantic pace. The global value of M&A in the first quarter was 36% higher than the same period in 2013 and if this keeps up will surpass the previous record of 2007. A takeover boom is classic end of cycle behavior as companies turn to deals to keep earnings growing. The deals are being accomplished with increasingly dodgy debt, short on covenants and long on risk to the holders. Just last week the biggest junk bond deal in history was floated for French cable company Numericable to buy Vivendi’s mobile business. $11 billion was raised in both Euros and Dollars with the 10 year dollar tranche yielding just 6.5%. And demand was such that the size of the deal was expanded to satiate the buyers.
And it makes sense that companies would turn to mergers to try and keep earnings rising since the organic form of earnings and sales growth appears to have peaked. Earnings this quarter will be down year over year and sales are not any better. US companies are continuing to buy back stock but that can only do so much for EPS and incurring debt to do it looks increasingly risky. Apple did announce an increase in their buyback plans last week but Apple is a special case with a lot of cash and very little debt. The same can’t be said – anymore – about corporate America as a whole with cash as a % of debt at just 19%. Net debt is now about 15% above 2007 levels. There may have been some de-leveraging somewhere but it wasn’t at the corporate level.
So with all that as background, it is interesting to me that the consensus concerning markets has moved to an extreme rarely seen. Of the 67 economists who participated in a recent Bloomberg poll not one of them believes that interest rates will be lower 6 months from now. Every single one of them believes the rate on the 10 Year Treasury note will be higher in the next six months. A separate poll of economists found not a single one expects the economy to contract which is at least consistent with their view of bonds. Now that is a consensus. From a group that almost universally failed to predict the last downturn.
Further evidence of extreme sentiment can be found in the most recent Barron’s poll of US money managers. 71% believe that equities will be higher in the next 12 months. The consensus about US large cap equities is even more extreme with 89% self reporting as bullish on that asset class. Meanwhile their views on US Treasuries mirrors their view on stocks with only 11% bullish. 81% expect the housing recovery to continue over the next year – despite some pretty convincing evidence to the contrary – and 59% believe the dollar will rise against the Euro. Oh, and by the way, over 70% of these managers claim to be beating the S&P 500 this year. Wall Street meets Lake Woebegone.
If you are over allocated to stocks and your bond allocations have withered with the rise in the S&P or you are holding short dated paper because rates just have to rise or your bond allocation is full of junk, you are firmly in the consensus – an extreme one at that – right now. That may continue to work out in the short term, but over the long term you are going to have to get outside your comfort zone and away from the consensus to do better than average. Can you be a contrarian? Can you dare to be different?
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