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Geoff Gannon
Geoff Gannon

How to Get Extra Cautious About the Risks the Crowd Isn't Worried About Yet

The historical norm is for stocks to have lower P/Es than now, for a higher Fed Funds Rate and for higher inflation. The time to prepare for 'normal' is when it seems unlikely to happen soon

February 07, 2018 | About:

I believe the stock market is in a bubble. And I’m 100% invested. The two aren’t mutually exclusive. And it’s usually counterproductive to try to change someone’s mind about either of those two things. If you don’t believe we’re in a bubble – chances are I’m not going to be able to convince you otherwise. And if you believe the right thing to do when stocks are in a bubble is to go 100% to cash – chances are I won’t be able to convince you to stay in stocks despite your belief that we’re in a bubble. So, what can we do that can make an actual difference in process? What can we do to become better investors right now – without arguing about bubbles, market timing and so forth?

We can remember Warren Buffett’s quote, “Be greedy when others are fearful and fearful when others are greedy.” In other words, you should exercise more caution the less cautious your fellow investors are being. When everyone is being super cautious (like in the first months of 2009) – it’s actually okay for you to relax a little and just buy stocks without a whole lot of thought. But, when other investors are less cautious (like in 2017 and 2018) than they have been in years – you need to be cautious “for them.” You can’t count on caution being priced into the stocks you’re looking at. Instead, you need to be at your most cautious – your most selective – when the investors around you are at their least cautious.

So, what isn’t the market being cautious about?

When something is at an abnormal level for a long time, people get used to it. Investors in general – even many value investors – don’t just think of the Shiller P/E ratio as something that has a certain average and you are 90% or whatever over that long-term average. This may be the way GuruFocus’ page presents that information. But, it’s not the way most investors think. If the Shiller P/E suddenly goes to 25 after a decade where it never touched 20 – then people are worried that first year. But, if the Shiller P/E ratio stays at 25 or 30 or 35 for several years in a row – that level starts to feel normal.

Now, the Shiller P/E is, of course, elevated. And you can check GuruFocus’ page to see that. I think that means stocks are too expensive to buy indiscriminately. I would suggest you don’t keep any of your money in an index fund when those index funds are full of a diversified group of expensive stocks. But, I said this wouldn’t be an article about whether stocks are in a bubble or not. And, really, it isn’t. I wanted to use the example of the Shiller P/E ratio to move into discussing other numbers that are at quite unusual levels but which we’ve all gotten accustomed to being at such unusual levels over these last few years.

My analogy here is that people now say the Shiller P/E ratio “hasn’t worked.” And, in the medium-term and shorter, they’re right. It has said the market is too expensive to offer a good return for a long time. Now, if we look back at truly long-ago readings on the Shiller P/E ratio – it does work. For example, if we take 1999 and then check how stocks have performed in terms of annual returns over the last 19 years – the answer is pretty much in line with the idea that stocks were too expensive in 1999. I should point out I invested between 1999 and now and did fine. But, that’s in specific stocks. That’s not in an index fund. If I had owned an index fund in 1999, I would’ve done badly. Instead, I owned specific stocks that were a lot cheaper than the index.

Regardless, the Shiller P/E ratio did work back then. But, it hasn’t helped investors who have to decide whether stocks are too expensive in 2013, 2014, 2015, 2016 or 2017. The Shiller P/E in those years was high. But, returns have been good for a long time despite that. So, we can say the Shiller P/E “doesn’t work” if you are judging it over the last five years. But, it does work if you are judging it over the last 25 years.

That’s what I want to talk about. I want us to look for other numbers that we consider normal right now, because they’ve been at a certain level for the last five years – but that’s actually an abnormal level for the last 25 years.

Let’s start with interest rates. The Fed Funds Rate – which is an important rate for bank investors to think about – is at a little less than 1.5% as I write this. It has been at that level or below – and usually far, far below (like zero) – since just after the summer of 2008. So, we are talking about roughly one decade. The Fed Funds Rate is now at something close to a decade-long high. But, where was it in past decades?

One way to consider the “risk” that the Fed Funds Rate hits a certain level is to remember where it was just before we entered each previous recession. Very often, the Fed Funds Rate is at a high level going into a recession. The Fed then cuts rates during the recession and keeps them lower for some time after the recession. So, we can sort of test the historical record for exceptionally high Fed Funds years by looking at what the rate was just before a recession. Keep in mind: The Fed and investors had no idea a recession was about to happen whenever the rate was this high. But, we have the benefit of hindsight.

Going into the 2008 recession, the Fed Funds Rate was 5.25%. Going into the 2000 recession, the Fed Funds Rate was 6.50%. Going into the 1990 recession, the Fed Funds Rate was 8.25%. Going into the 1981 recession, the Fed Funds Rate was 19%. Going into the 1980 recession, the Fed Funds Rate was 14%. Going into the 1973 recession, the Fed Funds Rate was 10%. Going into the 1970 recession, the Fed Funds Rate was 9%. Going into the 1960 recession, the Fed Funds Rate was 4%. And going into the 1957 recession, the Fed Funds Rate was 3%.

Some investors – and some members of the Fed as well – don’t have projections for the Fed Funds Rate that reach 3% or higher. However, the most recent recession started with the Fed Funds Rate at over 5% and the oldest recession I looked back at (1957) had the Fed Funds Rate at 3%. It’s pretty common to trim the top and bottom reading you see in a historical series to omit the very highest and very lowest numbers. That would leave you with something like a historical range of 4% to 17% in the Fed Funds Rate on the eve of past recessions.

Now, every investor you ask would say that we will have another recession at some point. If you asked them exactly when they might tell you quite a few years from now. But, would every investor tell you that we will have a Fed Funds Rate of more than 3% at some point? More than 4%? More than 5%?

I’d say the historical records says “yes, we will” to all of those. You should expect to see a Fed Funds Rate of 3%, 4% and 5% sometime in your investing lifetime. And, if you feel pretty sure that something is going to happen during your investing lifetime – then you don’t want to be positioned today in such a way that you’re completely unprepared for that kind of risk.

What is being unprepared for those kinds of interest rates?

Obviously, owning bonds yourself. But, also owning any stock that owns long-term bonds. Some insurers have portfolios full of long-term bonds. Other don’t. A good example of an insurer that takes a ton of underwriting risk (it writes a lot of coverage relative to how much equity it has) is Progressive (NYSE:PGR). But, Progressive doesn’t take a lot of investment risk. The company had some bad experiences in that area. And now it likes to own short-term, high quality debt. That’s a lot like being tied to the Fed Funds Rate. So, if you were looking at insurers – one way to be cautious would be to consider avoiding insurers that own a lot of debt and especially long-term debt and prefer insurers that either don’t own debt or own very short-term debt that is much closer to just holding cash. So, one way to add a cautious “refinement” to your process today is to look for any insurers you own and see if there is danger on the asset side of their balance sheet.

Let’s look at the liabilities side. What do you want to avoid here? Well, companies with debt could be a problem. But, not all companies with debt are equal. Some companies with debt are financed through short-term bank debt including variable rate date that floats along with some interest rate level. Companies like that will have a harder and harder time meeting their interest payments as the Fed Fund Rate rises. Companies can re-finance debt to make it longer term. And they can enter into agreements that allow them to effectively turn a floating rate into a fixed rate (from their perspective). But, there are costs associated with doing any of these things. And you don’t want to assume they will be a lot of people willing to take the other side of such deals in the future. The future might not have credit as loose as the present. So, you should be a little extra cautious about companies like Hostess Brands (NASDAQ:TWNK) that are basically publicly traded LBOs and you should instead prefer companies like Kroger (NYSE:KR) that have a lot of debt – but it’s long-term fixed rate debt. Kroger is a good example of a company that is set up in a way that isn’t “optimal” in the present day but might be safer in the long-run. If a company tries to organize its finances so its optimizes the generation of earnings per share today – when interest rates are near 0% – then it will trade off long-run reliability for short-run efficiency. Hostess Brands has a very “efficient” balance sheet for this moment in time. But, Kroger has a very reliable balance sheet for the next decade or three. Kroger may not be a safe stock. But, if the stock is imperiled in the future it’s likely to be for operational (that is, competitive) reasons. If Amazon (AMZN) enters groceries in a big way and takes market share from Kroger and Aldi comes in and so on and so on…

That’s a risk. And you have to assess that risk. But, Kroger’s financial risks are lower because of how it borrows and because of how little it borrows versus how much property it owns. In good times – like today – investors aren’t so cautious that they’ll discriminate between the kind of debt Hostess has (riskier debt) versus the kind of debt Kroger has (safer debt).

And then there’s the less obvious “secondary effects.” What I’ve been telling you is that the time to prepare for a 3% or 4.5% Fed Funds Rate is when that rate is at 1.5%. Imagine a doubling, tripling or even quadrupling of the rate today – when others aren’t yet – in deciding how cautiously to construct your portfolio. If people are treating insurers with long-term bonds and insurers with short-term bonds as equally good stocks – you want to focus on the insurers with a lot of short-term bonds. Those are the safer assets. If investors are thinking of the debt on a stock like Hostess and the debt on a stock like Kroger as equally bad – you want to focus on the leveraged companies that are leveraged in a way that can be reliably maintained for decades to come.

That’s easy to see. Those are first level effects.

Now, we’re going to the second level to point out the way having very low interest rates for a very long time can distort other industries.

Let’s talk about America’s Car-Mart (NASDAQ:CRMT). This is a deep, deep subprime car lender. The company sells used cars (often quite old) to buyers in basically “rural cities.” What I mean by that is I live in Plano, Texas. This is a metropolitan area (Dallas-Fort Worth) with a lot of economic opportunity. Car-Mart has found markets like where I live uninviting. But, it has found markets like Durant, Oklahoma (about 75 miles from) here inviting. Durant is technically a city. It has 15,000 people living there. But, it’s part of a “micropolitan” area with only about 40,000 people in it. That’s very small. In fact, it’s rural.

So, I wrote a report on Car-Mart a couple years back. You can find it on my Focused Compounding website. I bring up that report because the thing I like about America’s Car-Mart is that it was a niche. It focused on cities where competition was unlikely to be (usually Southern “rural” cities) and it focused on customers with no real credit history (FICO scores wouldn’t be helpful). Most importantly from my perspective, it made loans that depended heavily on collections experience to get good results. In other words, if Car-Mart loans were securitized – the buyer of the security would have a much worse experience than Car-Mart would if it kept the loans on its books. Car-Mart would collect the loans much more aggressively. An absentee owner of the security would do badly. So, you don’t pool these loans and sell them as a package to investors.

I wouldn’t say there are “moats” in lending. But, I would say this seemed like a pretty small market where Car-Mart has more experience than others making the same loans.

The problem though is that interest rates stayed so low for so long, that some car sellers that normally focus on much higher income buyers have been pushing further and further into trying to get rather low income buyers into their cars. The reason they’ve been doing this is because of investor appetite for subprime car loans. It’s been really high because these loans are short-term and have high yields. Investors may be reluctant to hold truly long-term bonds (which have higher yields). But, they are also reluctant to hold short-term, high quality debt that yields nothing. So, they’ve been overeager to own low quality car loans for a couple years now.

That’s caused competition for Car-Mart. When my website co-founder Andrew Kuhn asked me to re-visit the stock on my website, I said I still liked the company just fine – but, I thought we were at about the worst time ever in terms of the quality of the loans being made in this industry.

In other words, it’ll get worse before it gets better.

So, I didn’t want to write about the stock. Now is not the time to get investors interested in Car-Mart. The time for that is after there have been really bad loan losses in the industry and lenders pull back.

We’re not at that point.

And that’s an unintended consequence of low interest rates. So, I wouldn’t encourage you to buy into Car-Mart or any of its competitors now. But, I would encourage you to learn about them now because there will come a point where investors are a lot less interested in owning risky car loans. That point will be when the Fed Funds Rate is closer to normal than it has been since 2009.

There are a lot of other macro numbers we could talk about here. I will leave you with just one more possible cautious refinement to your portfolio. Ask yourself how the businesses you own would do during a period of inflation. Everyone is talking about whether we will reach the Fed’s 2% a year inflation target. The truth is that since the Federal Reserve was created inflation has been about 3.2% a year – not 2% a year. The time to assume 3% inflation is when people are worried we’ll never even get to 2% inflation.

That isn’t being contrarian. It’s just assuming that a number that was “average” or “normal” in the past is within the realm of future possibilities even when we haven’t seen levels like that for years.

So, my advice is to look at your portfolio and imagine the Fed Funds Rate is 4% and the inflation rate is 3% right now. Would anything in your portfolio change? Would it be for the better or for the worse?

Make the changes today that position you in the best way for what has been historically normal. Don’t wait. It’s cheap to make those changes now. It’ll be expensive in the future. Your fellow investors will try to anticipate these changes once they see them happening. Instead of waiting to see the current trend move in that direction – look at the historical norm. What has inflation “normally” been throughout history? What has the Fed Funds Rate “normally” been throughout history. It isn’t overly cautious to prepare for “normal” right now.

So, look at your portfolio and see if you can make these extra cautious refinements…

Ask yourself: Do I own companies that own long-term bonds? Do I own companies that are financed with short-term floating rate debt? Do I own companies where the credit cycle influences competition? Do I own companies that would suffer from inflation?

Then, imagine we were living in a world where the Fed Funds Rate was two or three times higher than it is now and inflation was two or three times higher than it is now.

Would you still own the stocks you now own?

If the answer is yes, no refinements are needed. But, if the answer is no – then now is the time to make those extra cautious refinements to your portfolio. When there is no trend in that direction yet, it’s cheap and easy to make those refinements. When the trend is already headed in that direction – a lot of your fellow investors will have made the refinements I’m recommending. And the later you are in making those changes, the more expensive they’ll be to make.

Disclosures: Geoff owns NC, CFR and BWXT.

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