For any who are unfamiliar with the Greek tragic myth of Niobe, I highly recommend reading it in its entirety. The links to all of my quotes including the story of Niobe are cited at the end of the commentary. As one of the classic Greek stories of Hubris, I will do my best to condense it down to a few paragraphs. Niobe was a woman of great beauty and privilege. Tragically, her blessings were only matched by her pride. Niobe was most boastful as it related to her seven daughters and seven sons.
Her prideful disposition caused her to hold contempt for the fact that most of the women of her land gave praise to the Goddess Latona and not to her.
“And there she bore two children, who, compared with mine, are but as one to seven. Who denies my fortunate condition?—Who can doubt my future?—I am surely safe.
The wealth of my abundance is too strong for Fortune to assail me. Let her rage despoil me of large substance; yet so much would still be mine, for I have risen above the blight of apprehension. But, suppose a few of my fair children should be taken! Even so deprived, I could not be reduced to only two, as this Latona, who, might quite as well be childless.” 1
Naturally enraged, the Goddess had all of Niobe’s 14 children struck down and she was turned to stone, leaving her to forever mourn her loss alone.
“Childless— she crouched beside her slaughtered sons, her lifeless daughters, and her husband’s corpse. The breeze not even moved her fallen hair, a chill of marble spread upon her flesh, beneath her pale, set brows, her eyes moved not, her bitter tongue turned stiff in her hard jaws, her lovely veins congealed, and her stiff neck and rigid hands could neither bend nor move.— her limbs and body, all were changed to stone.
Yet ever would she weep: and as her tears were falling she was carried from the place, enveloped in a storm and mighty wind, far, to her native land, where fixed up on a mountain summit she dissolves in tears,—and to this day the marble drips with tears.” 1
I realize this may strike some as an odd introduction for our quarterly commentary. However, I hope that you can relate to my uneasy feeling of hubris surrounding this market. At DCM we are cognizant of the fact that there is not the unanimous belief that the market must go higher, which is something you would expect in a bubble. In fact, a great many are quite cautious with their forward guidance. With that said, it just seems that some of the bulls are so boastful, that unknowingly, they are asking for it, much like Niobe. Here are some gems from the past several weeks:
“We would encourage those professionals who love to hate Apple to book themselves a series of therapy appointments” 2 Neil Azous, Rareview Macro
It would appear that Neil is implying that anyone who disagrees with his bullish sentiment on Apple needs to get their head checked; seems like a pretty humble statement. More ironically is someone from a company named “Rareview” being bullish on Apple. Way to go out on a limb against sentiment there.
Steve Schwarzman, CEO of Blackstone, seems to feel the same way about his firm as Mr. Azous feels about Apple. The quotes below were taken from a single interview with CNBC.
“we are the most profitable money manager in the world”
“we have an economic model that doesn’t depend on one quarters earnings…It’s like an earnings machine… as we keep growing there are more and more assets that we can invest in, so we keep growing”3
Reporter’s Question: “When you look at those numbers though, do you ever get worried that there’s going to be a point at which size works against you. Even Warren Buffet has talked about the fact that he is now at a size and scale that for him to move his needle he has to really buy massive things. And has talked about the potential that his returns, long-term will ultimately as a result be lower. Is it the same or different for you?”
Answer: “It’s different and it’s different because we’re in different asset classes” 3
Sure sounds like Mr. Schwarzman believes the “earnings machine” that is Blackstone is impervious to the laws of large numbers. Who wouldn’t want to invest there?
The last batch of quotes comes from a Q & A with Stewart Butterfield CEO of Slack, who just raised $160,000,000 in capital at a valuation of $2.8 Billion. The company is just over a year old.
“Q: I’m surprised that you’re raising money, because last time we talked you said that you had enough money.
A: Do you have enough money?
Q: So do you think Slack is worth $3 billion?
A: It is, because people say it is.
Q: But the reason people outside of tech look at a story like a year-old company being valued at $3 billion is that they wonder, what if you’re wrong? What if your growth is an illusion and it won’t continue? Or what if there’s something else you’re missing? And not just you, but a whole bunch of other companies like you that have been raising money so fast. Do you worry about that — that there may be some kind of systemic problem?
A: Yes and no. As a citizen, I don’t think it would be a really bad thing in the end if all these investors lose a great deal of money, because it’s really not a very large percentage of the overall economy. I’m quoting Marc Andreessen here: The entire amount of V.C. funding that happened last year was $50 billion. That’s compared to the total market of share buybacks and dividends by public companies in the U.S. being $1 trillion. So it’s one-twentieth of the overall public market dynamics, which is a small percentage of the overall economy, so it’s not going to make a difference to most private citizens whether V.C.s lose a lot of money here.
It does make a difference to me personally in that sense that it matters what happens to our employees, partners and the investors that I work with directly.”
Pretty clearly, there’s a little smugness in his answers to the first two questions, although I kind of agree with his assessments. What I take issue with however, is when he quotes Marc Andreessen to say VC is a small percentage of the overall economy and it’s not going to make a difference. Although he’s on the right track by conceding that it matters what happens to his employees, he’s sadly mistaken in his implication that it won’t influence anyone outside of his inner circle. In particular he compares VC funding to dividends and buybacks from public companies. Insinuating that venture capital funding is the same as dividends and buybacks is simply inaccurate.
Buybacks and dividends are net negative factors for growth. Instead of money being reinvested in growing the respective businesses they are either being used to expand EPS or reward investors. Neither is going to improve GDP.
Venture Capital investments, a point he touches on, have a great influence on economic growth. They provide high paying jobs, which feed right into the local economies. Earlier in the Q&A he even concludes that the VC boom has caused a boom in commercial real estate prices.
The troubling thing about when these firms implode, is that they implode magnificently. Like for example, Secret, a company that raised capital at $100,000,000 valuation that went to zero astoundingly quickly. Those jobs, funded by VC are gone and so is the $3,000,000 each co-founder got for 16 months of work. http://techcrunch.com/2015/04/29/psst/#.plxaxd:l0zx
It’s also foolish to believe that the Venture Capital boom is only occurring in Silicon Valley. It is in fact spreading all over the country, fueled in large part by the cost to live in the Bay Area. Make no mistake, if this private equity bubble implodes it will have profound effects on local economies.
Remember in 2003 Subprime lending only accounted for a little more than 8% of all loans originated and didn’t really pose a systemic threat to the economy!
I suppose what shocks me the most about the fearlessness of the very successful individuals quoted above, is my belief that anyone who has been in the investing business for long knows that the market can humble you very quickly. Paul Tudor Jones perhaps put it best;
“Don’t be a hero. Don’t have an ego. Always question yourself and your ability. Don’t ever feel that you are very good. The second you do, you are dead.”
Risk management is the only thing that matters, especially when the risk free rate is essentially zero. Anyone who has taken a finance class knows the first thing you learn is that returns that are greater than the risk free rate are higher to compensate you for your higher risk or opportunity cost. Thus, one can conclude that essentially any return in today’s environment is fraught with risk.
With that in mind, I can resolutely say that anyone lacking fear in regards to this market is at least very naïve, if not entirely foolish. Make no mistake, the truly brilliant thinkers of our era are widely concerned. From Bill Gross to Jeremy Grantham to Mohamed Al Arian, even the folks at Bridgewater have at a minimum sounded concern in regards to expected long-term returns. Some have even flat out called for a top. Indeed, we agree that real returns over the next decade are likely to be exceptionally low.
So why do the lemmings think they’re invincible? There could be many reasons. The fed induced bull market, which is now in its seventh year, surely plays a large part. The easy gains have almost certainly put many in a cheap money coma, much like a drug addict with a permanent fix.
Hearing Janet Yellen comment on the unusually low levels of Capital Expenditures during her most recent speech was almost mind numbing for me. This “phenomena” is something we’ve been banging on the table about for the past 18 months or so if you’ve been reading the commentaries. In an expansionary environment, I would describe the fact that Capex is at its lowest level since the WWII era shocking. I’d like to ask Janet why she thinks this is the case. Better yet, I’d like to ask why the Board of any public company would invest in Capex when they can simply issue debt at 1-2% or less, buy back their own stock, collect substantially higher dividends and ride the Fed driven Equity Bull ever higher.
You might be asking yourself if I’m implying that low interest rate policy is doing the exact opposite of what it’s supposed to. Well, not exactly. Obviously, the reduction in Capex is net negative for growth. Perhaps not as intuitive, is that cheap money leads to more acquisitions, which typically result in job cuts. At first glance this appears to fly in the face of the Fed’s dual mandate, but the Fed no longer cares about the employment number. The unemployment rate has firmly nailed their stated unemployment target and yet we are pegged at the zero bound. Now the Fed has a single mandate; create inflation at any cost necessary.
Unfortunately for the Fed, the bear market in commodities is doing them no favors in that respect. Throw in the seemingly unified easy monetary policies of the rest of the world, AKA unspoken currency wars, and it becomes even more difficult to get inflation. The US being much closer to an interest rate hike than the majority of major central banks has caused the dollar to surge and therefore commodities traded in dollars have plummeted. From grains to energies to softs, almost no sector has been spared.
With that said, there are many signs of a bottom. The CRB index has finally put in some sort of a base. Hopefully it’s a bottom, because we’re testing lows last seen during the financial collapse. What is wrong with the global economy if world commodity prices are near decade lows despite worldwide money printing? I don’t know what’s wrong, but I do know it’s quite disturbing.
What should be of most concern for the Fed is whether they can return to normal before an uncontrolled inflationary event or without some sort of market dislocation. History has proven it is very difficult to control inflation and in that regard, the odds are stacked against the Fed.
Even if we escape the inflationary event, I would be very surprised if the Fed addicts continue to be satiated once the Spigot is pulled. There are just too many hurdles to get over in order to keep the party going. For example, our demographics alone could be too much to overcome. Indeed the aging baby boomers are going to be leaving the productive work force and there’s a much smaller group coming to replace them.
Furthermore, despite high employment and of course the stock market, it seems to me the economy is really not that strong. Much of the public market gains have been achieved through financial manipulation and fat trimming over the past seven years. As discussed earlier, the growth drivers such as Capital Expenditure we would like to see, are not present in quantities large enough to support a Fed addicted market when the cheap money is taken away.
In Fact, we’ve seen expansion in the cost of housing and education far outpace wage inflation. What will be the driver of growth going forward? Much like last quarter, we are somewhat unsure of what the dominant themes going forward will be, particularly, when central banks are not the only game in town. Secular stagnation, which I mentioned last commentary seems to be more and more a possibility. With that in mind, for this quarter we suggest the following:
- Covered Long Equity exposure unless a 5-10% correction provides solid buying opportunities
- Maintain fixed income exposure of 3-5 years, also covered.
- Maintain exposure to income producing commodities & assets like rental property that provide inflation hedges.