Things Everybody Knows…

It ain’t so much the things we don’t know that get us into trouble. It’s the things we know that just ain’t so.

Mark Twain

Mark Twain probably wasn’t thinking of investors when he wrote those words, but truer ones have rarely been written. Investors routinely become overconfident in their assessment of economic and market conditions. They assume that recent trends will extend far into the future. They take positions based on assumptions that either aren’t true and sometimes can’t possibly be true or are true now but won’t be for long. Those who believed that the economy and markets had entered a “new paradigm” back in the late 90s were assuming a growth rate for technology companies that was, in some cases, literally impossible. As Herb Stein once said, things that can’t go on forever, won’t and the new paradigm turned out to look a lot like the old one.

The tech stock mania at the end of the last century was an extreme example but we are social animals with a need for the comfort of the crowd so markets often price in a future that won’t or can’t happen. One would think that burned once, investors would learn but the real estate boom quickly followed on the heels of the tech bust proving that while children may learn from their mistakes, adult investors seem uniquely prone to repeating them again and again. In truth, we see these cases of market/investor overconfidence all the time, just not usually to the extreme seen in the recent tech or real estate booms. Alpha is found in those areas where a trend has been taken beyond the level supported by fundamentals, to a price that incorporates and extrapolates too much of the past and present into the future.

For the alpha seeking investor then, finding trends that have been taken too far, that are near a reversal is key. Momentum investors, those who surf the established, existing trends, must find a way to exit those trends before the crowd. Momentum assets can take on a life of their own, running far beyond what you think they should, and providing great rewards right up to the point of reversal when the risks suddenly become obvious, large and realized quickly. Value investors, those who search for new market trends, must find a way to enter assets at cheap prices that don’t become cheaper or exit assets at prices that are dear but not so dear they take on momentum style risk. Neither practice is easy which is why alpha – true alpha – is so hard to come by.

But, unless one is satisfied with taking the passive investing route – one that I believe will be a lot harder to stay on in a world of low returns – then search one must for these anomalies, these trends that are vulnerable to reversal just when the crowd becomes too comfortable. There are plenty of individual stories that are vulnerable to reality – Amazon (O:AMZN) can ramp up profits whenever they want so the stock isn’t really expensive, Tesla is more than just an unprofitable car company, Netflix (O:NFLX) is worth more than twice what CBS is – but several big picture beliefs also appear to be past their sell by dates:

• The US dollar will continue to rise; the euro is headed for par against the dollar.
• Long term US interest rates will rise.
• US corporate balance sheets healthier than they’ve ever been.
• Emerging market growth is dependent on Chinese growth.

The overwhelming consensus is that the US dollar will keep rising as US growth and interest rates continue to diverge with the rest of the world. The European economy is deemed to be so much worse than the US that capital will continue to flee the continent pushing the euro down to par with the dollar. There are, I think, potential errors in this thinking. The difference in growth rates is not as extreme as most assume and the trend is convergence not divergence. Year over year Eurozone growth bottomed in the 4th quarter of 2012 at just 0.35%. It has trended higher since, hitting 2.77% in Q2 2015, although the rate has fallen back somewhat since. US growth, year over year, has ranged from the expansion high of 3.1% in Q3 2010 to a low of 0.90% in Q2 2013. The most recent change was 2.17%. The difference in growth rates between the two areas just isn’t that great and it is getting smaller.

There are also areas in Europe that are doing much better than most people are aware. Spain just reported 3.4% growth in Q3 up from 3.2% the quarter before. Household spending was up 3.5% and investment 6.5%. They are still running a budget deficit but tax receipts were up 6.1% while spending was up 3%. They also added 433,000 jobs in 2014 and are on trend to add 600,000 this year. That in a country with a population of less than 50 million people. Yes, Spain still has a lot of problems – unemployment is still over 20% – but there is no denying that the trend is in a positive direction and largely under the radar of most investors.

The US may also be approaching a cyclical inflection. While Janet Yellen and the FOMC seem intent on hiking rates based on the labor market – a lagging indicator – there is plenty of evidence that the economy is already slowing. The manufacturing/industrial side of the economy could easily be characterized as in recession right now. And that is at a time when auto sales and production are near cyclical highs. Wholesale and retail inventories are already well above the levels at the beginning of the last recession so absent a surge in sales, production probably won’t be picking up soon. For now, the service side of the economy continues to expand and keep total growth in the recent range but the two are not entirely disconnected; much of what happens on the service side is dependent on the manufacturing side.

Also of concern is that US corporate balance sheets are not, as so many presume, in very good shape right now. Debt is actually quite low relative to equity but that is a measure based on current equity prices; debt isn’t low, equity prices are high. Corporate debt as a % of GDP is once again approaching the highs set in 2001 and 2008. The total amount of debt on corporate balance sheets is more than double what it was before the last crisis. If one normalizes earnings – something that may be happening already with earnings down for three quarters in a row – leverage is much greater now than it was in 2007.

Those deteriorating balance sheets are behind the rising credit spreads we’ve been witnessing since the summer of 2014. Contrary to popular belief, it isn’t just energy companies that are having problems. Credit downgrades have been rising for months, now outnumbering upgrades and it is across a variety of industries including energy, retail, media and materials companies. Lower rated credits are performing the worst – not surprisingly – but spreads have widened across all credit ratings. And woe to the bondholder of an issuer who issues a profit warning. With little liquidity in the bond market, any whiff of trouble is taking prices down in big steps, double digit markdowns not uncommon.

Emerging markets are another area of too much agreement among investors. Most seem to think that these markets are just proxies for commodities but that is only true in one sense. Lower EM growth is definitely associated with strong dollar periods and since commodity prices are inversely correlated with the dollar the usual assumption is that the slower growth is due to lower commodity prices. That is certainly true in some instances – Brazil comes to mind – but it is far from universal. Of equal or greater importance are capital flows. When the US economy is weak and US real interest rates are low or negative, capital flows to emerging markets. When the dollar is strong the reverse happens, starving these growing economies of much needed capital.

To the extent that the consensus about US growth is wrong, it could also be wrong about emerging market growth. If the dollar pulls back because US growth disappoints, capital may flow back to emerging markets where real interest rates are still quite a bit higher than the US. Commodity prices should stabilize as well, relieving some of the pressure on the commodity producing countries. Of course, that assumes that the US does not enter recession but merely slows to a growth rate less than expected. If the US enters recession, the rest of the world is not going to escape damage; there is no decoupling in either direction anymore. I would also point out that emerging markets are not all created equal. Some of them benefit from lower commodity prices and growth in many of these countries has held up well to date. I think we forget sometimes that most of the emerging world is still growing pretty rapidly relative to the US.

There is no way to know what the future holds. About the only thing we can be sure of is that it probably won’t look like we expect. There will be unexpected events, black swans in the popular lexicon. Economic policies and geopolitical events will have unintended consequences that we can’t predict. The consensus is right most of the time but the longer trend, the greater the consensus, the more likely it is to reverse and surprise a lot of people. We may be at such an extreme now. Forward looking indicators such as inflation expectations and stock prices are pointing to a potential disappointment for those expecting better US growth, higher interest rates and a rising dollar. There would not seem to be much profit left in the consensus view.

I don’t spend a lot of time worrying about the things I can’t possibly know. It is more often the things we think we know for sure that get us in trouble. That Twain quote at the top of this commentary is a good example. It is credited to Twain almost every time I see it and it is rarely questioned. There’s just one thing wrong with that – Twain didn’t say it. It’s actually a cleaned up version of something Josh Billings – a contemporary of Twain’s – said: “You’d better not kno so much than know so many things that ain’t so.” Never assume that the accepted wisdom is wise.