Regular readers of "A Dash" understand our definition of the fundamentals. Whatever happens is eventually translated into forward earnings expectations and interest rates. Mr. Market offers the investor a daily choice between bonds and stocks.
This concept is a strong fundamental approach which is widely shared among savvy market professionals. While most dodge arguments by avoiding the term "Fed Model" to describe what they are doing, they are frequently quoted as comparing stock yields to bond yields. While we acknowledge some shortcomings in the simple version of the Fed Model, we have written extensively about its usefulness. It is a method for documenting periods of over-valuation and danger, as well as the current multi-year period of under-valuation of US equities when compared to bonds. Anyone who does a rigorous comparison of forward earnings with interest rates reaches a sound conclusion.
A Solid Foundation
The economic news has been quite good. GDP for the second quarter showed solid growth, without as much inventory build as some expected. That augurs well for future growth. The Fed's favorite inflation measure, the PCE deflator, remains below 2% year-over-year, within the "comfort zone." Corporate earnings have vastly exceeded expectations on a cap-weighted basis for the S&P 500 -- 14% growth so far this season. The comparison to the ten-year treasury note has improved as yields declined well below 5%.
For the investment manager or individual investor focused on fundamentals, this is all good news.
What Went Wrong?
First, there were some investors and hedge funds that (unwisely) made major leveraged bets on subprime mortgages. As these funds were forced to meet obligations, they experienced forced selling -- good paper, since there was a market for that, along with the bad, for which the market disappeared. This led to a general repricing of corporate debt obligations.
Second, this repricing of risk made financing for private equity deals in the pipeline much less attractive, commanding higher interest rates. For banks holding this paper there is a dilemma. They can hold it at a below-market rate, or seek to sell it while accepting a one-time loss. This will play out over the next six weeks or so.
The Market Reaction
Most market participants, even the big-name people one sees quoted in the financial press or on TV, mistakenly think in binary terms. Something bad happens. No one can get a good handle on quantification. Buyers step away. Many pundits predict the worst. Each new data point is cited as evidence of a complete collapse of the market.
This is not how economics works, and it is not how markets work -- given time. It is just the natural process of fear.
Predicting Periods of Fear
It would be nice if we could predict exactly when these periods of fear will hit. There are always some who succeed, because on any given day people make predictions -- both ways! In practice, most managers and pundits who had a bearish stance for the last week also missed the rally over the last year (or longer).
There are many buffers in the market. It is a marginal process, responding to new pricing. It is not like flipping a light switch. This may be the single most important concept for the individual investor to grasp in times of stress. It is difficult, because the existence of a problem is obvious. It is the quantification that is elusive.
- Banks will work with homeowners to restructure loans, and the decline in interest rates will help. No one wants defaults.
- New pools of capital will emerge as existing subprime loans are marked down. We are already seeing this.
- Banks holding paper on existing deals may choose to hold it because the corporations (unlike mortgage holders) are not in imminent danger of default). If they see better opportunities, they may choose to sell these assets and take a loss. That is their business.
The Private Equity Fallacy
Some market observers have argued that stocks have been artificially supported by private equity investment. They see an end to private equity and a market crash. We see two problems with this viewpoint.
- The undervaluation of stocks with respect to bonds is apparent to anyone, not just private equity firms. That this condition has persisted for years is the result of ongoing skepticism about the future of corporate earnings. That viewpoint has been wrong for years, and is wrong again this quarter. Corporate stock buybacks are one indicator. These buybacks were at record levels last week. Private equity activity has actively exploited this yield gap.
- Private equity will resume activity after Labor Day. It is an unfortunate coincidence of timing that these issues have arisen during a normal seasonal lull in investment banking activity. The forces behind private equity investing are powerful and continuing. Pension funds, universities, and even foreign governments are allocating capital to such funds. There is a long list of companies with strong balance sheets and low stock prices. While some deals may no longer be attractive, we expect to see plenty of private equity and M&A activity in September.
This is yet another example of where a long-term individual investor, watching CNBC, reading the Wall Street Journal, or visiting various market blogs can actually be punished for doing homework.
What has happened in the last week has little to do with the valuation of most stocks. We find many attractive buys on our "watch list", and we have added to our positions.