Context – the circumstances that form the setting for an event, statement or idea, and in terms of which it can be fully understood and addressed.
Perspective – a particular attitude toward or way of regarding something; a point of view.
Walter Russell Mead, the Wall Street Journal Global View columnist once heard Henry Kissinger asked what he saw as the most important trends in the Cold War era. He answered with one sentence that contained more substance than most books published in the field; “You must never forget that the unification of Germany is more important than the development of the European Union, that the fall of the Soviet Union is more important than the unification of Germany, and that the rise of India and China is more important than the fall of the Soviet Union.”
Later when Mead asked Kissinger for advice on how to present his column he answered with one word, “context”.
It is easy in today’s world to get caught up in the minute by minute, hour by hour news. Almost all of it is dissipated in the ether like sweat on your brow during a 105 degree Arizona summer day. The question is rarely what is the news of today, but how does it relate to the bigger picture and contribute to providing a rational and constructive perspective.
“History doesn’t repeat itself, but it often rhymes.” – Mark Twain
Cyclicality is nature. Cycles are the inevitable undercurrent defining the bigger picture. Whether it is spiritual, philosophical, political, economic, relationships, or weather everything is in a state of change. Often change is similar in its formation and some historical perspective of related issues provides clues to the future.
Having context and understanding the bigger picture lends itself to rationality in uncertainty. It helps to moderate fear in uncertainty. It provides a better informed and healthier perspective.
Perspective is the culmination of the past, the present and the future. It is what bridges the present and the future. It is the intellect that forms our plans for the future and is the thing that modifies our behavior as circumstances occur.
Recent volatility in the financial markets (circumstance) has begun to awaken the animal spirits again. The news is filled with “market crash”, “bear markets”, “inflation with a vengeance”, “bond market bubbles”, “debt implosions”, and a host of other newsworthy hyperboles. What is the context of the current economic and market situation and how does it relate to our perspective in planning for the future?
In assessing cycles relevant to the economy and markets, three areas are noteworthy of close inspection; the credit cycle, the change in valuations of asset prices relevant and the psychology of markets.
The credit cycle is the engine of the broader economic cycle. All other aspects of the economy are exacerbated by the leverage and de-leveraging of the credit cycle. Economies prosper and providers of capital thrive by having more capital money to lend. The atmosphere is confident and risks appear manageable. Risk aversion is generally non-existent.
During this period banks (and other intermediaries) lend more money. They compete against others by lowering rates and easing the standards against which they loan money. For example, leading up to the financial crisis some lenders were loaning in excess of 100% of the value of real estate without regard to income and the ability to pay back loans. Enough said.
The cycle is reversed when lenders become risk averse. They provide less capital, the cost of funding rises and their restrictions on lending become much more stringent. This exacerbates a contraction in the economy and less risk taking is undertaken.
Where are we today in the credit cycle? In our opinion, we are nearer the end than the beginning of the current credit cycle and economic expansion. If it were a baseball game we might be in the 7th or 8th inning. Rates have begun to rise and are likely to raise many more times before they contract.
A significant amount of debt has been replaced or added in the business sector. Consumer debt has been on the increase, whether it is student loans, auto loans or credit card debt.
Bank capital and lending standards have been significantly improved since the late 2000’s period. However, there have been a growing number of well capitalized pools of capital outside the traditional banking system. These pools have been more aggressive in their lending standards and may be a source of financial reckoning.
Leverage is one of, if not the most, destructive attributes of the financial system. Acute attention to the credit cycle is imperative to understanding where the risks are in the economy. That is true for the US and the global economy at large.
Where are we in the valuation cycle? Asset prices cycle from cheap to expensive. During the epicenter of the financial crisis you could buy the public equity markets cheaper at single digit PE valuations; i.e. 6, 7, 8 times earnings. Today nine years later you are paying a more expensive high teens PE valuation; i.e. 18 times earnings.
It is difficult to find undervalued assets in today’s landscape. Public equities, real estate, private equity, etc., appear to be selling at higher than average historical multiples. An expanding economy, favorable credit conditions and low interest rates providing little competition for risk adverse investments have driven cash to steadily bid up the prices for equity assets. This cycle is long in the tooth and special attention should be given to risk management.
Where are we in the psychology cycle? The psychology and behavioral aspects of the economy and markets are intuitive, but they are real and need to be assessed regularly. The following quote from John Templeton helps to provide a gauge for the cycle and context of the emotions of the market.
"Bull markets are born on pessimism, grow on skepticism, mature on optimism and die of euphoria." John Templeton
Investors would be wise to imagine a pendulum or maybe a clock that is marked with these attributes. Pessimism is highlighted by investors’ inference that all bad news will go on definitely. Prices drop below fair value and buyers are non-existent; late 2000 to early 2003, 2007 to the first half of 2009.
Skepticism grows as the most courageous and rational begin to buy value in the markets. It is driven by optimistic investors who recognize undervalued assets and the inevitability of cycles.
Optimism develops when both the news sources report ‘things are better’ and investors slower to recognize valuations and who are less likely to buy ‘when there is blood in the streets’ begin to invest in the markets.
Euphoria is when luxury items are flying off the shelves and showrooms. Uber drivers are proclaiming their latest financial win. And when the last investors, the late adopters, finally commit their capital to the markets because, ‘it is doing so well’.
In our opinion, we are well into the optimism point in the psychology cycle. It does not ‘feel’ like nor are valuations similar to the technology bull market peak in the late 2000’s. It does not ‘feel’ nor appear to have the excesses of the real estate bubble peak and corresponding leverage of the mid 2000’s. However, another significant move up in prices; e.g. 20% in a short period of time; e.g. 12-18 months would begin feel like and rhyme with bubbles of the past.
We leave you with this…
Predictions are a speculative venture. Planning is a rational exercise.
Risk avoidance is a timing decision. Risk management is a thoughtful plan of understanding, recognizing and controlling risk.
It is extremely difficult to do the right thing consistently. It is impossible to consistently do the right thing at the right time.
To provide some context and perspective regarding our investment planning and strategy, we continue to balance assets along the risk spectrum and manage with a bias to reduced risk today. We continue to search out value among asset classes with a bias in equities toward the high quality, international and emerging markets. In fixed income we have a bias to short duration and flexibility. We are hedging with cash for investment opportunity. And we are investing with the intellectual capital in all areas that we believe have taken advantage of the inefficiencies over time.
Views expressed are not necessarily those of Raymond James and are subject to change without notice. Information provided is general in nature, and is not a complete statement of all information necessary for making an investment decision, and is not a recommendation or a solicitation to buy or sell any security. Past performance is not indicative of future results. There is no assurance these trends will continue or that forecasts mentioned will occur. Investing always involves risk and you may incur a profit or loss. No investment strategy can guarantee success.
S&P 500 intra-year chart - Returns are based on price index only and do not include dividends. Intra-year drops refer to the largest market drops from a peak to a trough during the year. For illustrative purposes only. Returns shown are calendar year returns from 1980 to 2017, over which time period the average annual return was 8.8%. Guide to the Markets – U.S. Data are as of December 31, 2017
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