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Financial Genius Is... a Bull Market - Tocqueville Asset Management

May 09, 2014 | About:
CanadianValue

Canadian Value

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Investors have a natural tendency to brag about their successes. Of course, it is a bit easier for individual investors, who don’t have to show proof of their financial exploits. Professional investors do have to show proof of performance, but they still have some leeway in choosing the period of time over which this performance is measured and the benchmarks (indices) against which it is compared.

Generally, however, even genuinely good investors routinely take credit for success during rising markets, only to blame other factors, such as governments or central bankers, when investment returns sour. That is not difficult, because whenever something goes wrong in the economy or the financial markets, there usually is no shortage of culprits to blame. The recent episode often referred to as the Great Recession (to indicate that it was less destructive than the Great Depression of the 1930s, but more destructive than other recessions since) is a good example. But in fact, I would argue that, as is often the case, we were all to blame – both individually and collectively.

One favorite candidate for blame is the Federal Reserve under Alan Greenspan, for (rightly) providing ample liquidity to the economy when it was deemed fragile, but failing to withdraw it once the economy strengthened. This could be justified by the fear of financial accidents like the bursting of the “tech” bubble in the early 2000s, but in retrospect it ultimately made things worse.

Another candidate for blame is the fiscal policy of the George W. Bush administration, which turned out to be a Republican version of Lyndon B. Johnson’s “guns and butter” policy: Tax cuts and the war in Iraq replaced welfare programs and the war in Vietnam, but both resulted in large budget deficits and rising government debt.

Unfortunately, money and deficits are like oil – lubricating oil, that is. They make everything feel easier in both the economy and the financial markets without fixing problems durably. With liquidity aplenty, and a tacit or imagined Fed policy of preventing any significant decline in investor wealth, the prices of real estate and financial assets kept rising, interrupted only by an occasional correction. People increasingly used financial leverage to purchase these assets and they seemed the smart ones; those who did not borrow were viewed as losers. The motto became, “Borrow if you can and borrow all you can.”

As always, of course, there were aggressive bankers ready to assist people wishing to commit financial suicide. This happened at two levels, which I separate for simplicity, although they often are joined at the hip: investment banking and commercial (traditional) banking.

Mortgage-backed securities had already been popular for some time. These bonds, using packages of mortgages as collateral, were paying higher coupons than traditional instruments; they were deemed to be very secure due to the broad diversification of risk. Unfortunately, as often happens, reckless copycats doomed an originally smart idea: The collateral evolved from good-quality mortgages to increasingly suspect packages mixing good and junk-quality ones.

Both the regulators and the rating agencies that are supposed to monitor the safety of bonds failed to supervise properly this evolution. Eventually, many junky packages of mortgages were routinely endorsed as AAA by the rating agencies, without any reaction from the regulators.

The attractiveness of the fees involved in packaging and selling these mortgage-backed securities made them a favorite product of the investment-banking industry, which aggressively sold them to large and small investors alike. The industry developed a voracious appetite for mortgages and, not surprisingly, the commercial banks’ lending departments were happy to oblige by becoming a lot looser in granting these mortgages. Note that this accommodative stance was made a lot easier by the commercial bankers’ knowledge that the mortgages would soon be resold to investment banks, so that the risk would not appear for long on the commercial banks’ books. (They would not appear for long on the investment-bank books either, since they would promptly be resold to the public.)

Many households could ill afford to service or repay the mortgages they were undertaking and, as it was later learned, many also lied about their incomes, their assets, or even their employment. But it appears that neither the bankers nor the mortgage originators (who are not bankers but agents who attract borrowers and process their applications) could have cared less. When responsibilities are shared too broadly, everyone assumes that someone else carries the greater obligations.

Did I forget anyone? My point is that in periods of speculative euphoria, such as this sub-prime lending craze, everyone feels richer and life seems easier. Even people like me, who did not borrow and did not even buy mortgage-backed securities, still benefited from the general – if artificial – prosperity. We just assumed that we were smart businesspersons, who took little risk but still made good profits – in business, in real estate, or in the stock market.

I am not religious, but I tend to take a moralistic view of life: When you sin, you eventually have to pay. In the recent bubble and its aftermath, I don’t mean to say that we all sinned, but to some extent we all indirectly benefited from the sins of others, even if ephemerally – through an easier business environment, higher stock prices, and appreciating real estate.

Life is more symmetrical than we at times would wish. If the people who actually sinned eventually have to pay the piper (through bankruptcy, economic hardship, unemployment, etc.), it is likely that people who did not sin but enjoyed the derivative benefits of sin will also suffer when the day of reckoning arrives. If we all become addicted to excess liquidity, whether we realize it fully or not, we will all suffer withdrawal symptoms when it dries up.

So, from my perspective, the question is not, “Will there be pain?” but rather, “When will there be pain, and how much of it?”

On the economic front, we already have suffered a serious and global recession and financial crisis, from which the recoveries have been slow, hesitant, and unevenly distributed. But it is fair to say that populations that depended on salaries and did not own financial assets (or real estate in major financial capitals like New York or London) have suffered more and longer than those that benefited from a rebound of the “wealth effect” associated with rising real estate and stock market values. However, the debate about the ultimate consequences of the Great Recession and financial crisis is far from closed.

The 19th-century French economist and politician Frederic Bastiat explained:

In the economic sphere an act, a habit, an institution, a law produces not only one effect, but a series of effects. Of these effects, the first alone is immediate; it appears simultaneously with its cause; it is seen. The other effects emerge only subsequently; they are not seen; we are fortunate if we foresee them. (Selected Essays on Political Economy, 1848)

As the lubricating effect of excessive money creation and large fiscal deficits eventually abates, it is possible that the hardship suffered by the owners of assets will materialize differently and more slowly than that heretofore experienced primarily by wage earners: in the form of higher taxation, crippling regulation, generally accelerating costs, and the like.

Most major markets have doubled or tripled in the past five years. We may have forgotten but, on a trailing 12-month basis, the price/earnings (P/E) ratio of the S&P 500 index reached a low of 8.8 in early 2009, and has since bounced back to around 15. The 2009 low was not quite at the level attained at major market bottoms in the past, but it was a single-digit reading nevertheless. So, one could argue (and many have) that a secular (long-cycle) low was reached five years ago. Maybe not, but even if a secular low was reached in 2009, the likelihood remains of shorter cycles ahead. Those last only a few years but can be quite painful nevertheless.

My view is that if a secular low was reached five years ago, it should not be too long before the next intermediate bear market starts (remember that we don’t need to see a recession to have a bear market). My experience of important market tops (1969, 1972, 1980, 1987, 1999 and 2007) is that they often take months developing, with divergences between various market measures, sectors, etc. appearing little by little. As they do, the quality of advances declines even as various benchmarks still reach new highs. Semantics aside, I get that feeling today, and so do a number of old market observers.

The longer it takes, the higher the market indexes go and the more “bears” (pessimists) capitulate, the more inclined I am to be stubborn, because it means we are getting closer to some kind of correction.

This is a way to restate my views, expressed in a few past papers:

I think stock and bond market investors have not yet fully paid the piper.

It is hard to say exactly when the reckoning will come, but the higher and the longer the market climbs the closer we get to that day.

A similar point can be made on valuation: the higher the price of stocks and bonds, the thinner the potential gain from further advances and the less attractive it is to remain bullish.

This being said, individual stock-picking based on thorough and common-sense-based analysis remains superior to macro considerations and market timing as an approach to investment. If we uncover an idea, we should start cautiously buying it, regardless of our market opinions.

Cash reserves remain the best dry powder to keep in anticipation of such occasions.

Many years of artificially low interest rates have eroded our reflexes and instincts. As far as the stock market is concerned, we may have a tendency to perceive as “normal” P/E ratios that really are high in historical context. We should be a bit parsimonious when calculating the valuation potential (and thus the gain potential) of individual securities.

François Sicart

5/5/2014

http://www.tocqueville.com/

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Canadian Value
http://valueinvestorcanada.blogspot.com/

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