This guest commentary was written by our friend Joseph Calhoun from Alhambra Investment Partners. This is part two of Calhoun's piece. Click here to read the first part, "Are Snapchat Investors On Peyote?"
Stock market sentiment, by some measures, is at its most bullish in 30 years. If you need confirmation of this unrelenting bullishness look no further than the fund flow data. Equity index ETFs have attracted $83 billion in new money just since the beginning of the year and that is on top of the surge we saw immediately after the election.
Heck, over $8 billion flowed in on the just the day after Trump’s Congressional speech. Trump supporters are bullish and putting their money where their votes were. They’re betting on Trump’s ability to make a deal with Congress and get his agenda passed. I don’t know the odds on that bet but it isn’t a sure thing.
This bull market from the beginning has been one that has defied convention, pushed along by an accommodative monetary policy and optimistic central bank “forward guidance” about a better economic future that refuses to arrive.
The stock market and the economy parted company long ago as earnings growth slowed, then turned negative and stocks continued to climb regardless. S&P 500 earnings growth has been negative the last three years, a mere 0.5% over the last 5 and less than 1% per year for the last 10.
And yet, stock prices are at all time highs and show no sign of slowing now.
S&P 500 index funds (ETFs) are the nifty fifty of this era, buy and forget, no actual thought required. This bull market isn’t about fundamentals; the passive mantra is buy and hold no matter what. If you’ve been a bull and stayed the course, you’ve done quite well and haven’t even had your will tested with a decent correction. It’s been easy, a SNAP one might say, just to stay long the index. Diversification has been for suckers, prudence an impediment, experience a detriment.
The Wall Street Journal had an article the other day about Paul Tudor Jones reducing his fees – again. Active managers, especially hedge fund managers, those former masters of the universe, have had a tough time of it lately. The most interesting part of the article though was the comment section.
The overwhelming opinion was that Jones was just another Wall Street hack sucking fees out of customers and he’s only reducing them because he’s desperate to keep them and their fees. This is a man whose fund has averaged over 17% per annum after fees for over 30 years. With one down year – 2008 – of 4% over the entire span.
In his spare time he founded and helped fund the Robin Hood Foundation. And he’s a billionaire; he isn’t desperate about anything. This guy did not start dumb and he hasn’t gotten any dumber because he’s underperformed the stock market the last couple of years. The comments are a perfect reflection of the hubris that is born in a bull market:
"Why pay 1.75 percent when you can buy an index fund at Vanguard or Fidelity for a fraction of 1% and probably beat the hedge fund. Hedge Funds are over rated. They tend to cater to Wealthy people who can afford to lose money.
Those old hedge fund returns came from easy insider trading and fake values on derivative positions. They were never real. Wow, what a bargain."
Buffett exposed these charlatans again in his most recent annual letter.
It should be required reading for anyone thinking about investing in hedge funds. This idea that investing is easy, that it only requires a superficial knowledge, that anyone can do it, is one that develops in every bull market – remember those stories in the late 90s about people quitting real jobs to day-trade?
I will not defend hedge fund fees here as I too think most of them are not deserved. A few good managers such as Jones can and do deserve every penny they earn. But this idea that hedge funds or actively managed mutual funds are not earning their keep because they aren’t keeping up with the S&P 500 is ridiculous.
Alpha, earning a risk-adjusted return in excess of a benchmark, is not something that is earned in a runaway bull market and it surely isn’t only in relation to the S&P 500 or some other equity index. Expecting a hedge fund to keep up with the market on the way up while also hedging the downside – they are called hedge funds for a reason – is wildly unrealistic.
The reason to hold non-correlated or low correlation assets is for what they do when stocks aren’t ripping higher on a daily basis. Alpha is earned in bear markets so if you have recently embraced the passive movement because no one has earned any the last 8 years or so, well you’ve just bought a fallacy.
Now before the passive mafia jumps all over me, let me just say that I have no problem with a passive approach. We use passive approaches with some of our accounts. And even actively managed accounts start with an underlying base, passive portfolio. All I’m saying is that passive is not the same thing as easy or simple. Putting together a passive approach requires some serious thought because in a sense, there is no such thing as passive.
- What assets do you include in your passive portfolio?
- How do you adjust the allocation if your risk tolerance changes?
- Heck, how do you know that your risk tolerance has changed?
- Do you have international assets?
- What about emerging markets?
- Bonds? What duration? Corporate, junk or government? What about non-US bonds?
- Commodities? Gold?
- How often do you rebalance?
Anyone who has ridden this US bull market the last 8 years by owning US stocks and bonds as their passive portfolio has probably been pretty happy. They might have chosen that portfolio for all the wrong reasons but that hasn’t mattered; they got lucky and good for them.
But that doesn’t prove that investing is easy and we don’t need the Paul Tudor Jones’s of the world. In fact, to me it means we need the Paul Tudor Jones’s of the world that much more right now. Investing successfully is not easy but boy it sure seems so right before it gets really difficult.
This feeling of over-optimism is most apparent in the belief about future economic growth, about the potential of Trump’s policies. In his speech the other night the President said:
"Everything that is broken in our country can be fixed. Every problem can be solved.”
I too believe our problems are fixable and I’ve said so in the past. But saying that every problem can be solved is not the same as solving them.
The stock market is pricing in a policy nirvana that is bound to be disappointed.
Just to take one example, expectations regarding corporate tax reform seem entirely unrealistic based on the potential outcome. One can only assume from stock prices that investors believe that cutting corporate taxes will be highly beneficial to corporate earnings. If you just look at the statutory rate of 35% and believe that will be reduced to 20% by Mr. Trump’s plan, then bidding up stocks because the difference ends up in shareholders pockets seems reasonable.
If you look at the actual tax rate of the S&P 500 you get a different picture. That rate last year was just 26% and over the trailing twelve months just a bit over 20%. So, if the plan is to cut the rate but reduce deductions then even if you assume he gets the rate to 20% the cut is not that significant. And I think expecting the rate to fall all the way to 20% is probably unrealistic to boot. But either way, corporate tax reform isn’t likely to impact corporate earnings nearly as much as stock prices seem to imply.
Not only that but corporate tax reform is being tied to reform of the individual code as well. In fact, it probably can’t be any other way since so much of American business is structured via pass-through vehicles. If you want to cut business taxes in most cases that means you have to cut individual tax rates.
That’s fine but makes getting a package that is acceptable, one that can get through Congress that much harder. It seems likely too that the only way Trump’s tax cut plans can get enacted is through budget reconciliation because Republicans don’t have anywhere near 60 votes in the Senate. That means whatever emerges has to be deficit neutral over a 10 year window.
There is also a debate coming on trade – tied to the tax reform debate in the form of the border adjustable tax – the outcome of which is probably more consequential than any change in any other tax rate.
That border adjustable tax is another popular, mass delusion. Republicans have embraced their protectionist roots, their inner Hoover showing through. (I recently saw Wilbur Ross praised as the best Commerce Secretary since Hoover – and it was meant as a compliment).
Whether that is due to an intellectual insight or a desire to maintain their newfound populist power is something I’ll let others debate but the support of this tax by formerly staunch free traders is maybe a hint. Martin Feldstein has written two editorials for the WSJ supporting the tax. Much was made of his assertion that the US Dollar would appreciate sufficiently to offset the impact of the tax.
No mention was made of how that might affect the many trillions of dollar denominated debt in the world. The supporters of the tax also find themselves saying things that anyone with a modicum of common sense knows can’t possibly be true in the real world. Feldstein says in the last editorial:
"Here’s why the dollar would rise: Without a change in the currency’s value, the border adjustment would cause imports to fall and exports to rise, reducing the overall U.S. trade deficit. But it is a fundamental fact of economics that the size of a country’s trade deficit equals the difference between national investment and national saving. Since the border-adjustment tax would not alter either investment or saving, there must be no change in the trade deficit. What would happen instead is a 25% increase in the dollar relative to other currencies, enough to offset the tax on imports and the subsidy on exports."
Even from a theory standpoint, if the BAT is a consumption tax – and I don’t see how it could be anything else – then investment and saving will be affected. Indeed, unless there is something wrong with my hearing, changing investment and saving is what this and all other tax reform is about.
So, while Mr. Feldstein’s articles have been characterized as supporting the tax maybe we’re wrong about that. His assertion that the dollar will rise is premised on the idea that the trade deficit won’t change. So, if the trade deficit won’t change, why are we doing this again? Isn’t cutting the trade deficit what Trump promised to do? Maybe, rather than endorsing the tax, Mr. Feldstein is actually issuing a warning, telling the administration sotto voce, that it won’t work. If so, it’d be nice if he didn’t make it in such a veiled fashion.
To invest today as if you know what policy will look like in a year – or longer – is the height of hubris.
Even if you knew exactly how policy would change, predicting the real world impact is impossible.
- If the package includes the BAT and the dollar does rise 25% what’s the impact on the global economy?
- What is the impact on foreign economies with large dollar debts?
- What’s the impact on US corporation’s balance sheets who own significant foreign assets?
- Is there a significant dollar hedge against the BAT right now (long dollars to protect against a big rise)? Or is one building?
- What if the BAT isn’t part of the package? How does that affect the dollar?
- Does it fall as hedges are unwound?
- How does that impact US inflation?
- How will monetary policy change in response, not just here but Europe, Japan and China as well?
I could keep going but I’m sure you get the point. In the real world ceteris is not paribus. And there is an almost infinite number of variables to consider.
Investing in this uncertain world is not easy but it isn’t impossible
The passive approach that so many today endorse is one way to address the lack of knowledge about the future. Success in that style requires, more than anything, that one know thyself. You have to construct a portfolio that you can maintain no matter what the market does. The only way a passive approach works over the long term is if you stick to it. You need to think about worst case scenarios and make sure you can ride them out.
You can also take an active approach but you better have a process to follow. There is always a certain amount of improvisation and subjective decision making as an active investor but you need to minimize it. Your process needs to incorporate a number of different variables and not depend on one signal.
Valuation is just one factor and tells you little about near term returns. Momentum is just one factor and tells you little about long term returns. Economic variables are subject to big revisions so find market based indicators to confirm your macro outlook. And like the passive approach, an active approach must be something you can stick to when it isn’t working exactly as you would like. If the process is sound, it will work in the end but only if you stick to it.
But above all, to be a successful investor you need to be aware of market sentiment. Successful investing, passive, active or some combination, is, more than anything, about avoiding big mistakes. You have to avoid letting your emotion about a market trend overwhelm your common sense and asset allocation plan.
Buy low, sell high should really be Don’t Sell Low and Don’t Buy High. It isn’t nearly as catchy but it is more important. Right now, stocks seem like a literal no-brainer. We’ve moved beyond “buy the dip” to “you aren’t going to get a dip so you better just buy now”.
But today’s market values are based on some big, very optimistic assumptions. Getting from today’s economy to the one the stock market is predicting may be possible but it surely won’t be easy. Warren Buffett says you never know whose been swimming naked until the tide goes out. All I’m saying is you might want to slip on the swim trunks.
EDITOR'S NOTE
This is a Hedgeye Guest Contributor piece written by Joseph Calhoun, CEO of Alhambra Investment Partners. Prior to founding Alhamra Investment Management in 2006, Calhoun was a Director of Investments at Oppenheimer & Co. and before that proudly served in the U.S. Navy’s nuclear submarine service for 8 years (1983-1990). This piece does not necessarily reflect the opinion of Hedgeye.
