Monday, May 05, 2014
Edginess or Extrapolating The Unextrapolatable
Edginess. No, I am not referring to the one sought by my daughter by rolling her own and pushing boundaries (fortunately, for a parent, eschewing the tats, for now at least), but as in uneasiness, anxiety, disquietude, restiveness, worry, and an increasing sense of agitation of the type that George Soros wrote about in his journal as a feeling that gnaws at him from within his stomach.
I am becoming more aware of my growing agitation - and rather than let it gnaw away, I will try to dissect and articulate it in order to share with you for I've been sanguine about equity risk for what seems like a long time, certainly one of the longest periods I've held my pessimism in check. During this hiatus from my natural state, I've derided perma-bears through the recovery - through the Euro wobbles, US budget concerns, the ridiculous hyper-inflation/QE hysteria, and dismissed those both selling and wishing to buy tail risk insurance after the proverbial horse had bolted suggesting to those interested to heed Bob Litterman and SELL the insurance (SPX puts), rather than buy it. This is not because I am optimistic by nature, or otherwise bullishly inclined. Rather, it was because for much of the last five years - scarred investors were underweight despite, in plain english, things more or less continually improving on all fronts, albeit not fast enough for those in search of instant gratification. "Up" has been the path of least resistance. Housing/construction/ was diminished, and financials were so cratered, they are still, only now, getting back to something resembling normal index weights. Couple that with much of large-cap tech undemanding at close to single digit forward multiples and the risk, as PensionPulse's Leo Kolivakis presciently called, moved more clearly to the right. That was then. Over the past four year, investors have been squeezed in - and for the right reasons: absolute and relative valuations, cash-flows and earnings growth - all which have been more-than requited by their materialization, pwning the pessimists!!
Now, it no longer is obvious that investors are under-invested. Now it appears that they are, en masse reasonably allocated. In the process they've taken forward-looking returns from rather attractive levels with large implied equity-risk premia, down to levels which don't leave much margin for "shit happening". In the process, investors may very well have done too much of a good thing, inflating ratings (on a forward-looking basis) to pedestrian levels at best, or positively-unattractive ones - implying low to negative forward returns at worst. In itself, this situation doesn't mean imminent danger, and can continue - given positive sentiment, piss-poor alternatives, supportive monetary and fiscal policy, and the chance that underlying growth may continue unabated (and even accelerate) without undue inflationary pressures, keeping the ratings high as stock prices increase further. For the avoidance of doubt, this is not a bubble in the popular sense of the word. We have indisputably had phenomenal corporate earnings growth justifying and supporting the reversion back to the reasonable from ostensibly cheap crisis levels. In the process, investors have become comfortable increasing the rating of equities towards more historically-dubious levels, and in extrapolating forward, idiosyncratic boosters to earnings that I do not believe should be extrapolated.
Yes, I am gnawingly concerned about the blitheness with which many investors assume that major contributions to past earnings growth will replicate themselves going forward, an occurrence that often presages an intersection of bloated expectation with the spartan-ness of a wetter and colder reality.
Imagining a classical "T" account to conceptualize my edginess, I place these positive contributors to earnings growth since 2009 on the left-hand side of my construct:
* Sustained USD weakness. (USD weakness has flattered USD translated global sales and earnings)
* Constrained capex (Squeezing existing capital stock coincidental to prior capex depreciation rolling-off, dramatically boosts EPS; investors dazzled by and extrapolating EPS growth, but at CF level, multiples are getting heady. Eventually companies will have to re-invest which will hit both operating and bottom lines)
* ZIRPy interest rates. (Low rates have one-off refinancing benefits that benefit bottom line, and remain as long as ZIRP. Corp earnings now short put on rates for refi)
* Wafer-thin credit spreads. (Ditto above: one-off refinancing benefits to EPS but forward profile is left-skewed risk)
* Buybacks/share count squeeze. (Buybacks - whether from cash-flow or debt have materially goosed EPS over last five years. But, with capex needs increasing, and valuation ratings elevated Co's will find it increasingly difficult to justify maintaing/curtailing buybacks). Yet, only NOW in typical gamma negative behavior are co's leveraging up to buy back stock.)
* Wage restraint (Corporate pricing power coincident to falling real wages will not last forever. With economy hollowed, and jobs already offshored, one would not be remiss forecasting that we are at or near peak disparity. The wage squeeze has given Co's enormous operating leverage during the last five years of recovery. UK real wages ticked higher than inflation for first time in years, last print. In US, with @6.7% unemployment, the balance of power favoring Co's feels like it petering out. If so, this will hit operating and bottom-lines directly. With Piketty on top of best-seller list, one might also wonder whether this is another tell-tale of the end of the squeeze on labour. )
* Tax holidays/optimization. (Firms are increasingly keeping money offshore and borrowing onshore to buyback stock or pay divs rather than repatriate and pay tax); They consolidate overseas earnings gross of tax, but with increasing scrutiny of avoidance/minimization they will have to bite the bullet sooner or later; It looks like earnings have grown, but if you can't use them or return tim to shareholders without taking a hit, there appears to be an asymmetric outcome. At best, it is baked into the price; at worst investors have discounted potential liability over-stating realizable cash flows.
* Pension holidays. (Higher asset prices thanks to recovery have allowed firms to get actuarially onside and reduce DB plan contributions, in many cases reducing contributions that directly flatter both operating and bottom line earnings. Never mind that with asset prices high, the actuarial assumptions of most DB plans are unrealistically optimistic. With so many asset classes fully valued, and forward expected returns low - see GMO forecasts - such holidays will end. And in true to gamma-negative feedback loops, one need only imagine what might be required were asset prices to fall…).
And In fairness, one must take into account drivers on the other side of the "T" account that may continue to have legs such as:
* Pricing Power. (Increasing industry scale, concentration, oligpopoly have materially diminished competition, and created competitive moats that have buoyed both prices and margins across many industries. Toothless regulators, concentrated gain to collusion and diffuse pain make it unlikely that margin gains from such sources will reverse anytime soon. It remains more attractive to collude and bank immediate benefits with certainty than pay fines in the future, in which there is reasonable likelihood, it will go completely unpunished. )
* Productivity. (Benefits from IT and FA, after years of disappointment have finally gained traction. They can continue to surprise to the upside offsetting reversals in the above.)
* EM Growth. (Volume growth outside DMs has provided meaningful surprises, and may continue to pick-up slack resulting from other erstwhile disappointments).
Despite prolonged meditation, I make no claims that either side of the T-account is complete. But I suspect that if one took the combined income statement of the SPX, non-exptrapolatable growth boosts explain a large portion of the upside growth Co's have seen in both operating and top-line earnings. Analysts (both top down and bottom up) are well known for more or less extrapolating priors, but I surmise that at precisely the time these are getting harder to reproduce, or are on the cusp of reversing, the ratings are getting extended, and this is a recipe for concern - not because 17x or 18x earnings is an awful return in tame inflation environment - but because expectations are primed for more of the same dancing juice. This, and the gamma-negativity of some of the variables themselves has the potential to cause a more vicious negative feedback loop, inconsistent with a tame VIX, and extremely low historical vol., and for which markets are neither prepared nor positioned.
This is why I feel edginess, despite having been a committed "probability-adjusted optimist"… 'till now. With that said, I historically have been early….and what with parabolic-like pops as we saw in Feb/Mar, it is likely there'll be additional opps to temper exposure or put in place more attractive conditional hedges.