This special guest commentary was written by Christopher Whalen. It was originally posted on The Institutional Risk Analyst.
“Markets go up on an escalator, they come down on an elevator. This is the most hideously overvalued market in history.”
-David Stockman
Last week’s action by the Fed was an effort to restore normalcy, but in the context of extraordinary action by the central bank. When you tell markets that the risk free rate is zero, it has profound implications for the cost of debt and equity, and resulting in different asset allocation decisions. Ending this regime also has profound implications for investors and markets.
In the wake of the financial crisis, some investors found comfort in the fact that when risk free interest rates are at or near zero, the discounted future value of equity securities was theoretically infinite. Markets seem to have validated this view. But to us the real question is this: If a company or country has excessive and growing amounts of debt outstanding against existing assets, what is the value of the equity? The short answer is non-zero and declining. But hold that thought.
Reading through Grant’s Interest Rate Observer over the weekend, we were struck by the item on China Evergrande Group (ERGNF), a real estate development company and industrial conglomerate that has reported negative free cash flow since 2006, but has made it up in volume so to speak. The stock is up over 200% this year, Grant’s reports. The real estate conglomerate has its hands into all manner of businesses and seems to typify the China construction craze.
Grant’s recalled an earlier observation by a US Texas real estate manager in the 1980s, something to the effect that real estate is not a cash flow business, but rather an asset appreciation business – until you can no longer service the debt. We can recall hearing similar cautionary comments about the dangers of leverage from Kevork S. Hovnanian years ago, when he spoke about holding on to some of his land investments in South Jersey for decades and with no debt.
How the Fed's QE impacted Amazon...
Today the idea of investment without leverage draws ridicule, partly because unlevered returns in most industry sectors are down in single digits. The observation from the unknown Texas real estate man three decades ago pretty much sums up the state of the US economy. This week as The IRAheads for Leen’s Lodge in Grand Lake Stream for some Spring fishing, we see bubbles in the water just about everywhere, but little in the way of revenue growth.
Empty retail locations are multiplying across Manhattan. Earnings in sectors like financials are up on cost cutting and share repurchases, but supported by little else. Asset prices for all manner of investments have risen by double digit rates or more, but income – that is cash flow – seems wanting.
As in the early 2000s, the Fed has squeezed credit spreads and thereby gunned asset prices, but to little effect in terms of employment or especially income. QE did not work, notes FT Advisors. While some of our fishing partners believe that tight spreads are always a benefit to the economy, when spreads fail to differentiate relative credit risk, then eventually equity must be restored via a little old fashioned deflation – right?
Consider the case of Amazon (AMZN). Here’s a company with relatively little debt and fewer profits, but high revenue and equity market growth rates. The company has less than $2 billion in net working capital supporting $140 billion or so in revenue, but trades at 3x sales and 21x book value. Moody’s has AMZN at “BBB+” based upon improving debt service cover for its $20 billion in long term and lease obligations.
One of the fabulous FAANG stocks – this after Facebook (FB), Apple (AAPL), Amazon, Netflix (NFLX) and Google (GOOG) -- AMZN last week announced the acquisition of Whole Foods Market (WFM) for $13.7 billion. The consideration to be paid, in cash of note, is a rounding error compared with the $472 billion market cap of AMZN.
And like AMZN, WFM is a low or no margin business as well, thus the pairing seems entirely appropriate -- but is also enormously disruptive. AMZN + WFM adds to the financial black hole created in retailing by AMZN. The combination of AMZN and WFM is seen as bringing the deflationary apocalypse for the retail food sector, one of the more vulnerable parts of the US economy. Jim Cramer of CNBC says "AMZN is a deflationary force. Fed needs to think about it."
True, but the more interesting question is how the massive expansion of debt orchestrated by the Fed since 2008 and particularly with QE after 2012 has impacted equity market valuations for stocks such as AMZN, as shown in the chart below.
By pulling trillions of dollars worth of duration out of the US financial markets via quantitative easing (QE), the Federal Open Market Committee has shifted risk preferences for both debt and equity. The net result is a series of debt-fueled bubbles in various asset classes, but none larger and more problematic than in large cap US equities. In order to “normalize” the credit markets, the Fed must be willing to let the equity and debt markets adjust in the short-run – by no means a given. With the toppy state of equity market valuations, the components of FAANG may be in for some significant downside.
Part of the reason that the FOMC remains so clearly hesitant about reducing the size of its balance sheet is the well-informed suspicion that the Street will be unable to absorb the increase in volatility that will accompany true market normalization.
Since much of the market in US Treasury debt and agency mortgage paper such as GNMAs is controlled by foreign central banks, the free float is small. Dealer inventories are minimal, thanks to the Volcker Rule. The end of portfolio reinvestment and even modest sales will increase both longer yields and market volatility.
For those of us who have been critical of Fed policy since the end of QE1 in 2012, the return of more normal levels of volatility would be a positive sign that the central bank finally is willing to allow markets to once again price risk. But the downside is that the fiscal situation in the US and overseas could see yields on government debt rise dramatically once investors fully appreciate that the days of QE are ended.
Having redefined “normal” based upon the extraordinary environment maintained by the FOMC since 2012, the Yellen Fed is now faced with its greatest test, namely allowing the financial markets to engage in price discovery without overt government support. We’ve been talking for years about the financial implications of the Fed’s portfolio and how trillions in duration negatively influences yields and spreads, but credit also impacts equities.
At the same time, mounting levels of public and private debt call into question whether investors can really invest in equities for the longer term without an assumption of more or less continuous QE. Where would stocks like AMZN and WFM be trading in the absence of QE? Just as a zero percent risk free rate suggests an infinite valuation for equities, the end to official market manipulation by the Fed suggests an equal adjustment in market valuations as we walk back from extraordinary to normal.
EDITOR'S NOTE
This Hedgeye Guest Contributor piece was written by Christopher Whalen, author of the new book Ford Men and chairman of Whalen Global Advisors. Over the past three decades, he has worked for financial firms including Bear, Stearns & Co., Prudential Securities, Tangent Capital Partners and Carrington. This piece does not necessarily reflect the opinion of Hedgeye.
