For twelve years, stock markets have been on the rise. Several indices are at or close to record highs. The big question for investors is when we’ll see a long-overdue, serious pullback. Since we all know that the stock market rally was based largely on expansionary (if not outright limitless) monetary inflation, the recent rise in yields has awoken investor concerns. We consider these concerns justified and critically important – this is not a time to be “swimming naked”. Are you familiar with self-doubt? I am. Frankly, it bugs me constantly. At times, it keeps me awake at night, particularly when it comes to the current state of financial markets. Are we correctly interpreting the key indicators, the economic data, the charts...? Are we getting the big picture right and have we properly positioned our client portfolios to participate in this (incredible) secular bull market, while still protecting them from an increasingly likely harsh market correction? Given how frothy and overstretched stock valuations seem at the moment, such a turn looks like the most probable response to too much cheap money, too much debt, too much government, too many artificially supported and distorted market forces.
It’s only when the tide goes out that you learn who has been swimming naked. ~ Warren Buffett
Stock markets know one way only – up, up and up...
I’m sure you are aware of and likely share these kinds of questions and doubts. If you’re an experienced investor, you know that the information we have, unfortunately, is always incomplete and partially erroneous. Therefore, our conclusions and decisions are not and can never be perfectly accurate and correct all the time. However, these days, so many investors seem to be entirely free of self-doubt, or at least this is what is reflected in financial markets. What is projected instead is absolute conviction, blind faith and overconfidence, perhaps neighboring on hubris.
Stock markets seem to know one direction only: Up! Corona pandemic and the worst global recession ever? Up! Record-shattering unemployment figures? Up! Governments spending tax dollars as if there was no tomorrow. Relief packages. Support loans. Infrastructure spending... UP, UP, UP! We are all very well aware that these market advances are built primarily on the back of one driving factor: monetary inflation, or as we like to call it, Cheap (if not FREE) Money. Contributions to S&P 500 cumulative change since April 2020
Source: Bloomberg, UBS
In support and in preparation of the expected economic recovery – the rebound from the corona-induced and temporary global recession – central banks and governments have been and continue to be willing to go all-in, keeping interest rates low and using the generally deflationary context to pump liquidity into the system at record levels. And investors are all too willing, after over a decade of interventionist “success”, to trust in the powers of these “economic gods and engineers”.
After all, until recently, official (CPI type) price inflation was nowhere to be found. The consensus has been that this will go on for a long time. The new economic theory of MMT (Modern Monetary Theory) has been widely accepted. Japanification, the decade-long economic malaise of Japan has become somewhat of a role model for the West: a long period of deflation, low or negative interest rates, growing debt, combined with slow growth and booming stock markets.
In fact, much of the economic data coming out of the US, as well as Europe, has been quite encouraging. However, recently, the bull market has started to stutter just a bit. The post-pandemic bull run has slowed down. The reason? Yields, and inflation expectations, have increased. Who could have seen that coming in an economic model built on and sustained by unlimited free cash?
Don’t be bamboozled by the positive news – RISKS ARE ON THE RISE
Clearly, as we have warned for the past few years, and as discussed in depth in our Special Report published last year, titled “On the Brink of a New Era - Are You Prepared?” , interest rates and bond yields will at some point start moving up. They can’t go much lower from here, particularly when a substantial portion of government papers are already in negative rate territory.
Higher yields spell disaster for the value of the mountains of fixed income held in portfolios, reserves, and balance sheets globally, many of them being used as collateral for other debt instruments and derivatives. But higher yields will not only damage bond prices. They will take away the free refinancing of debt for governments. And they will take away the free money gravy train that our economies and corporations have been become so addicted to.
The rise in bond yields and decline in bond prices devalues the pool of collateral bonds and works like a margin call at some point in time, which may force deleveraging and risk-off procedures. ~ Felix Zulauf
Therefore, yes, it is prudent for investors to consider the risk of a market blow off and be prepared for a meltdown. For reference, Bank of America’s Sell Side Indicator, which informs sell-side strategists how much of their portfolio should be allocated to equity, jumped up nearly a percentage point last month after a rise in January as well. Just a few days ago, Savita Subramanian of BofA Quant indicated that the last time the indicator had reached as strong a sell level was June 2007... What to do?
For some time now, at BFI, we have been actively building in downside protection in the standard investments strategies of many of our clients. This vastly boosted our performance in 2020 and we were not affected by the stark correction in stocks last spring. On the contrary, our puts on equities, which we had in place to protect against a market meltdown, increased our flexibility to stay in the markets and keep our stock position on the way back up.
However, since then, our downside protection has cost us some upside performance. It’s like an insurance policy that does not come for free. At times, I wonder whether we are too cautious. But then again, as discussed here, in our view, the probability of a harsh downturn in financial markets is substantial. Despite the positive economic numbers and the obvious willingness of governments and central banks to push monetary and fiscal support to the limit, the dangers are obvious and very serious.
Non-conventional investment strategies need to be considered in order to manage and limit these risks, but also to thrive in the period ahead. Alternative investments, commodities and very attentive risk management are just a few key elements of investment success as we head deeper into the world of free lunches and fairy tales...