A few days ago, Stanley Druckenmiller (Trades, Portfolio) made headlines with his comments that the risk/reward ratio in stocks is not looking very good. Since then, the full interview he gave to the Economic Club of New York has become available.
In this article, I will analyze where he was coming from when he made these comments and what this could mean for the market going forward.
Why are valuations where they are right now?
Druckenmiller believes that in the short run, valuations are determined by liquidity rather than earnings. In other words, the amount of free capital that investors have and are willing to spend to buy assets means more than the ability of those assets to generate future cash flow. This explains current stock valuations, as the market seems to believe that the Federal Reserve will be able to support asset prices through the current economic lockdowns and that shareholders will emerge on the other side relatively unscathed.
Druckenmiller believes that at their current valuations, stocks don’t present a particularly attractive risk/reward ratio. The global central banks can inject liquidity to keep capital flowing easily around the financial system, but they can’t fix insolvency. They can’t rescue every company from bankruptcy in the long run. Druckenmiller believes that this presents a problem both for shareholders of exposed businesses, such as hotel operators and cruise lines, and also for sectors with secondary exposure like the banking sector. If you are a bank that has loaned a lot of money to a cruise ship operator, what will happen to your earnings if that operator files for bankruptcy and defaults on its debt?
Backed into a corner
Druckenmiller does credit the Federal Reserve for its actions since mid-March, giving them an "A++." However, he thinks that it had backed itself into a corner by pursuing easy monetary policy over the course of the last few years, which has left it with "too few bullets to fire" today. He thinks that the U.S. central bank really didn’t need to start cutting rates again in early 2019 with unemployment running at record lows just because inflation was running at slightly less than the target 2%, especially given the level of leverage in the economy:
“We went into [the crisis] with a $1.4 trillion government deficit with full employment, we’ve never seen anything like it. Corporations took their borrowing from $6 trillion to $10 trillion - in my opinion, this was all the result of free money despite many chances to normalise from 2012 to 2020. So because there was free money, they had to do a lot more in March than they would otherwise have had to do.”
Thus, Druckenmiller seems to think that the Fed was extremely aggressive in fixing a problem that it created in the first place. It’s hard to avert bankruptcies by just lending more money, and yet this is the situation that we are in. Once an economy becomes dependent on easy borrowing, it is very difficult to wean it off.
Disclosure: The author owns no stocks mentioned.
Read more here:
- Seth Klarman: Reducing Portfolio Risk
- Howard Marks: Why We Need Recessions and Bankruptcies
- Warren Buffett: How to Read Annual Reports
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