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Yes, We Are In Another Tech Bubble

Technology has touched our lives in so many ways, and especially so for investors. Not only has technology provided ever-better tools by which to research and monitor investments, but tech stocks have also provided outsized opportunities to grow portfolios. It’s no wonder that so many investors develop a strong affinity for tech.

Just as glorious as tech can be on the way up, however, it can be absolutely crushing on the way down. Now that tech stocks have become such large positions in major US stock indexes as well as in many individual portfolios, it is especially important to consider what lies ahead. Does tech still have room to run or has it turned down? What should you do with tech?

For starters, recent earnings reports indicate that something has changed that deserves attention. Bellwethers such as Amazon, Alphabet and Apple all beat earnings estimates by a wide margin. All reported strong revenue growth. And yet all three stocks fell in the high single digits after they reported. At minimum, it has become clear that technology stocks no longer provide an uninterrupted ride up.

These are the kinds of earnings reports that can leave investors befuddled as to what is driving the stocks. Michael MacKenzie gave his take in the Financial Times late in October [here]:

“The latest fright came from US technology giants Amazon and Alphabet after their revenue misses last week. Both are highly successful companies but the immediate market reaction to their results suggested how wary investors are of any sign that their growth trajectories might be flattening.”

Flattening growth trajectories may not seem like such a big deal, but they do provide a peak into the often-tenuous association between perception and reality for technology. Indeed, this relationship has puzzled economists as much as investors. A famous example arose out of the environment of slowing productivity growth in the 1970s and 1980s [here] which happened despite the rapid development of information technology at the time. The seeming paradox prompted economist Robert Solow to quip [here],

You can see the computer age everywhere but in the productivity statistics.”

The computer age eventually did show up in the productivity statistics, but it took a protracted and circuitous route there. The technologist and futurist, Roy Amara, captured the essence of that route with a fairly simple statement [here]:

“We tend to overestimate the effect of a technology in the short run and underestimate the effect in the long run.” Although that assertion seems innocuous enough, it has powerful implications. Science writer Matt Ridley [here] went so far as to call it the “only one really clever thing” that stands out among “a great many foolish things that have been said about the future.”

Gartner elaborated on the concept by describing what they called “the hype cycle” (shown below).

The cycle is “characterized by the ‘peak of inflated expectations’ followed by the ‘trough of disillusionment’.” It shows how the effects of technology get overestimated in the short run because of inflated expectations and underestimated in the long run because of disillusionment.

Amara’s law/ the hype cycle

Source: Wikipedia [here]

Ridley provides a useful depiction of the cycle:

“Along comes an invention or a discovery and soon we are wildly excited about the imminent possibilities that it opens up for flying to the stars or tuning our children’s piano-playing genes. Then, about ten years go by and nothing much seems to happen. Soon the “whatever happened to …” cynics are starting to say the whole thing was hype and we’ve been duped. Which turns out to be just the inflexion point when the technology turns ubiquitous and disruptive.”

Amara’s law describes the dotcom boom and bust of the late 1990s and early 2000s to a tee. It all started with user-friendly web browsers and growing internet access that showed great promise. That promise lent itself to progressively greater expectations which led to progressively greater speculation. When things turned down in early 2000, however, it was a long way down with many companies such as the e-tailer Pets.com and the communications company Worldcom actually going under. When it was all said and done, the internet did prove to be a massively disruptive force, but not without a lot of busted stocks along the way.

How do expectations routinely become so inflated? Part of the answer is that we have a natural tendency to adhere to simple stories rather than do the hard work of analyzing situations. Time constraints often exacerbate this tendency. But part of the answer is also that many management teams are essentially tasked with the effort of inflating expectations. A recent Harvard Business Review article [here] (h/t Grants Interest Rate Observer, November 2, 2018) provides revealing insights from interviews with CFOs and senior investment banking analysts of leading technology companies.

For example, one of the key insights is that “Financial capital is assumed to be virtually unlimited.” While this defies finance and economics theory and probably sounds ludicrous to most any industrial company executive, it passes as conventional wisdom for tech companies. For the last several years anyway, it has also largely proven to be true for both public tech-oriented companies like Netflix and Tesla as well as private companies like Uber and WeWork.

According to the findings, tech executives,

“…believe that they can always raise financial capital to meet their funding shortfall or use company stock or options to pay for acquisitions and employee wages.”

An important implication of this capital availability is,

“The CEO’s principal aim therefore is not necessarily to judiciously allocate financial capital but to allocate precious scientific and human resources to the most promising projects …”

Another key insight is, “Risk is now considered a feature, not a bug.” Again, this defies academic theory and empirical evidence for most industrial company managers. Tech executives, however, prefer to, “chase risky projects that have lottery-like payoffs. An idea with uncertain prospects but with at least some conceivable chance of reaching a billion dollars in revenue is considered far more valuable than a project with net present value of few hundred million dollars but no chance of massive upside.”

Finally, because technology stocks provide a significant valuation challenge, many tech CFOs view it as an excuse to abdicate responsibility for providing useful financial information. “[C]ompanies see little value in disclosing the details of their current and planned projects in their financial disclosures.” Worse, “accounting is no longer considered a value-added function.” One CFO went so far as to note “that the CPA certification is considered a disqualification for a top finance position [in their company].”

While some of this way of thinking seems to be endemic to the tech industry, there is also evidence that an environment of persistently low rates is a contributing factor. As the FT mentions [here], “When money is constantly cheap and available everything seems straightforward. Markets go up whatever happens, leaving investors free to tell any story they like about why. It is easy to believe that tech companies with profits in the low millions are worth many billions.”

John Hussman also describes the impact of low rates [here]:

“The heart of the matter, and the key to navigating this brave new world of extraordinary monetary and fiscal interventions, is to recognize that while 1) valuations still inform us about long-term and full-cycle market prospects, and; 2) market internals still inform us about the inclination of investors toward speculation or risk-aversion, the fact is that; 3) we can no longer rely on well-defined limits to speculation, as we could in previous market cycles across history.”

In other words, low rates unleash natural limits to speculation and pave the way for inflated expectations to become even more so. This means that the hype cycle gets amplified, but it also means that the cycle gets extended. After all, for as long as executives do not care about “judiciously allocating capital”, it takes longer for technology to sustainably find its place in the real economy. This may help explain why the profusion of technology the last several years has also coincided with declining productivity growth.

One important implication of Amara’s law is that there are two distinctly different ways to make money in tech stocks. One is to identify promising technology ideas or stocks or platforms relatively early on and to ride the wave of ever-inflating expectations. This is a high risk but high reward proposition.

Another way is to apply a traditional value approach that seeks to buy securities at a low enough price relative to intrinsic value to ensure a margin of safety. This can be done when disillusionment with the technology or the stock is so great as to overshoot realistic expectations on the downside.

Applying value investing to tech stocks comes with its own hazards, however. For one, several factors can obscure sustainable levels of demand for new technologies. Most technologies are ultimately also affected by cyclical forces, incentives to inflate expectations can promote unsustainable activity such as vendor financing, and debt can be used to boost revenue growth through acquisitions.

Further, once a tech stock turns decidedly down, the corporate culture can change substantially. The company can lose its cachet with its most valuable resource — its employees. Some may become disillusioned and even embarrassed to be associated with the company. When the stock stops going up, the wealth creation machine of employee stock options also turns off. Those who have already made their fortunes no longer have a good reason to hang around and often set off on their own. It can be a long way down to the bottom.

As a result, many investors opt for riding the wave of ever-inflating expectations. The key to succeeding with this approach is to identify, at least approximately, the inflection point between peak inflated expectations and the transition to disillusionment.

Rusty Guinn from Second Foundation Partners provides an excellent case study of this process with the example of Tesla Motors [here]. From late 2016 through May 2017 the narrative surrounding Tesla was all about growth and other issues were perceived as being in service to that goal. Guinn captures the essence of the narrative:

“We need capital, but we need it to launch our exciting new product, to grow our factory production, to expand into exciting Semi and Solar brands.” In this narrative, “there were threats, but always on the periphery.”

Guinn also shows how the narrative evolved, however, by describing a phase that he calls “Transitioning Tesla”. Guinn notes how the stories about Tesla started changing in the summer of 2017:

“But gone was the center of gravity around management guidance and growth capital. In its place, the cluster of topics permeating most stories about Tesla was now about vehicle deliveries.”

This meant the narrative shifted to something like, “The Model 3 launch is exciting AND the performance of these cars is amazing, BUT Tesla is having delivery problems AND can they actually make them AND what does Wall Street think about all this?” As Guinn describes, “The narrative was still positive, but it was no longer stable.” More importantly, he warns, “This is what it looks like when the narrative breaks.”

The third phase of Tesla’s narrative, “Broken Tesla”, started around August 2017 and has continued through to the present. Guinn describes,

“The growing concern about production and vehicle deliveries entered the nucleus of the narrative about Tesla Motors in late summer 2017 and propagated. The stories about production shortfalls now began to mention canceled reservations. The efforts to increase production also resulted in some quality control issues and employee complaints, all of which started to make their way into those same articles.”

Finally, Guinn concludes, “Once that happened, a new narrative formed: Tesla is a visionary company, sure, but one that doesn’t seem to have any idea how to (1) make cars, (2) sell cars or (3) run a real company that can make money doing either.” Once this happens, there is very little to inhibit the downward path of disillusionment.

Taken together, these analyses can be used by investors and advisors alike to help make difficult decisions about tech positions. Several parts of the market depend on the fragile foundations of growth narratives including many of the largest tech companies, over one-third of Russell 2000 index constituents that don’t make money, and some of the most over-hyped technologies such as artificial intelligence and cryptocurrencies.

One common mistake that should be avoided is to react to changing conditions by modifying the investment thesis. For example, a stock that has been owned for its growth potential starts slowing down. Rather than recognizing the evidence as potentially indicative of a critical inflection point, investors often react by rationalizing in order to avoid selling. Growth is still good. The technology is disruptive. It’s a great company. All these things may be true, but it won’t matter. Growth is about narrative and not numbers. If the narrative is broken and you don’t sell, you can lose a lot of money. Don’t get distracted.

In addition, it is important to recognize that any company-specific considerations will also be exacerbated by an elemental change in the overall investment landscape. As the FT also noted, “But this month [October] can be recognised as the point at which the market shifts from being driven by liquidity to being driven by fundamentals.” This turning point has significant implications for the hype cycle: “Turn off the liquidity taps at the world’s central banks and so does the ability of the market to believe seven impossible things before breakfast.”

Yet another important challenge in dealing with tech stocks that have appreciated substantially is dealing with the tax consequences. Huge gains can mean huge tax bills. In the effort to avoid a potentially complicated and painful tax situation, it is all-too-easy to forego the sale of stocks that have run the course of inflated expectations.

As Eric Cinnamond highlights [here], this is just as big of a problem for fiduciaries as for individuals:

“The recent market decline is putting a growing number of portfolio managers in a difficult situation. The further the market falls, the greater the pressure on managers to avoid sending clients a tax bill.”

Don’t let tax considerations supersede investment decisions.

So how do the original examples of Amazon, Alphabet and Apple fit into this? What, if anything, should investors infer from their quarterly earnings and the subsequent market reactions?

There are good reasons to be cautious. For one, all the above considerations apply. Further, growth has been an important part of the narrative of each of these companies and any transition to lower growth does fundamentally affect the investment thesis. In addition, successful companies bear the burden of ever-increasing hurdles to growth as John Hussman describes [here]:

“But as companies become dominant players in mature sectors, their growth slows enormously.”

“Specifically,” he elaborates, “growth rates are always a declining function of market penetration.” Finally, he warns,

“Investors should, but rarely do, anticipate the enormous growth deceleration that occurs once tiny companies in emerging industries become behemoths in mature industries.”

For the big tech stocks, wobbles from the earnings reports look like important warning signs.

In sum, tech stocks create unique opportunities and risks for investors. Due to the prominent role of inflated expectations in so many technology investments, however, tech also poses special challenges for long term investors. Whether exposure exists in the form of individual stocks or by way of major indexes, it is important to know that many technology stocks are run more like lottery tickets than as a sustainable streams of cash flows. Risk may be perceived as a feature by some tech CFOs, but it is a bug for long term investment portfolios.

Finally, tech presents such an interesting analytical challenge because the hype cycle can cause perceptions to deviate substantially from the reality of development, adoption and diffusion. Ridley describes a useful general approach: “The only sensible course is to be wary of the initial hype but wary too of the later scepticism.” Long term investors won’t mind a winding road but they need to make sure it can get them to where they are going.

Give Me An “L” For Liquidity

After a rocky first quarter markets posted a solid second quarter and improved steadily through the third quarter. The US economy is currently rolling along at a pretty healthy pace as GDP grew at 4.2% in the second quarter and earnings have been strong. Unemployment clocked in at 3.7% for September which is incredibly low by historical standards. Indications of inflation are starting to creep into wages, materials, and transportation and many manufacturers have been able to offset them by raising prices. Through the lens of economics, investors are in good shape.

It wasn’t that long ago, however, that investors looked past a feeble economic recovery and took cheer in the large volumes of liquidity major central banks around the world infused to support financial assets. Now the time has come to reverse course. As the Economist states [here] in no uncertain terms,

“Central banks are pitiless executioners of long-lived booms and monetary policy has shifted.”

Investors who view these conditions exclusively through the lens of economics risk misreading this pivotal event: global liquidity is falling and will bring asset prices down with it.

Liquidity is one of those finance topics that often gets bandied about but it is often not well understood. It seems innocuous enough but it is critical to a functioning economy. In short, it basically boils down to cash. When there is more cash floating around in an economic system, it is easier to buy things. Conversely, when there is less, it is harder to buy things.

Chris Cole from Artemis Capital Management has his own views as to why investors often overlook liquidity [here]. He draws an analogy between fish and investors. Because fish live in water, they don’t even notice it. Because investors have been living in a sea of liquidity, they don’t even notice it. As he notes,

“The last decade we’ve seen central banks supply liquidity, providing an artificial bid underneath markets.”

Another aspect of liquidity that can cause it to be under appreciated is that it is qualitatively different at scale. A drop of water may be annoying, but it rarely causes harm. A tsunami is life-threatening. Conversely, a brief delay in getting a drink of water may leave one slightly parched, but an extended stay in the desert can also be life-threatening. We have a tendency to take water (and liquidity) for granted until confronted with extreme conditions.

One person who does not take liquidity for granted is Stanley Druckenmiller. In an overview of his uniquely successful approach to investing on Realvision [here], he describes,

“But everything for me has never been about earnings. It’s never been about politics. It’s always about liquidity.”

Not earnings or politics, but liquidity. 

While not yet extreme, the liquidity environment is changing noticeably. Druckenmiller notes,

“we’ll [the Fed will] be shrinking our balance sheet $50 billion a month,” and, “at the same time, the ECB will stop buying bonds.”

Cole describes the same phenomenon in his terms,

“Now water is being drained from the pond as the Fed, ECB, and Bank of Japan shrink their balance sheets and raise interest rates.” 

Michael Howell of CrossBorder Capital, a research firm focusing on global money flows, summarizes the situation in a Realvision interview [here]:

“In terms of global liquidity, it’s currently falling at the fastest rate that we’ve seen since 2008 …”

For some investors, the decrease in liquidity is setting off alarms. Druckenmiller points out,

“It’s going to be the shrinkage of liquidity that triggers this thing.” He goes on, “And my assumption is one of these hikes- I don’t know which one- is going to trigger this thing. And I am on triple red alert because we’re not only in the time frame, we’re in the part …” He continues, “There’s no more euro ECB money spilling over into the US equity market at the end of the year …”

Or, as Zerohedge reported [here],

“We have previously discussed the market’s mounting technical and structural problems – we believe these are a direct result of the increasingly hostile monetary backdrop (i.e., there is no longer enough excess liquidity to keep all the plates in the air).”

As the Economist notes,

“Shifts in America’s monetary stance echo around global markets,” and there is certainly evidence this is happening. Cole notes, “The first signs of stress from quantitative tightening are now emerging in credit, international equity, and currency markets. Financial and sovereign credits are weakening and global cross asset correlations are increasing.” 

Howell also chimes in, 

“You’re also seeing emerging markets central banks being forced to tighten because of the upward shock to the US  dollar.” He concludes, “Emerging market currencies are very fragile. And emerging markets stock markets are falling out of bed. These are all classic symptoms of a tightening liquidity environment.”

The governor of the Reserve Bank of India, Urjit Patel, highlighted these issues when he wrote that “Emerging markets face a dollar double whammy” in the Financial Times [here]. He describes, “The upheaval stems from the coincidence of two significant events: the Fed’s long-awaited moves to trim its balance sheet and a substantial increase in issuing US Treasuries to pay for tax cuts.” He claims that if the Fed does not recalibrate the shrinkage of its balance sheet, “Treasuries will absorb such a large share of dollar liquidity that a crisis in the rest of the dollar bond markets is inevitable.”

Although there is evidence that liquidity is tightening, it has not done so uniformly yet. The Economist describes,

“The integration of the global financial system has turned national financial systems into a vast single sea of money that rises and falls with changes in saving and investment around the world.”

As a result, there are a lot of crosscurrents that confound simple analysis.

For example, Zerohedge reports [here],

“When ‘QT’ [quantitative tightening] started in September of 2017, outstanding Fed credit initially kept growing well into 2018, largely because reverse repos with US banks ran off faster than securities held by the Fed decreased …” The story continues, “The markets evidently never ‘missed’ the liquidity tied up in these reverse repos, not least because high quality treasury collateral serves as a kind of secondary medium of exchange in repo markets, where it supports all kinds of other transactions.” 

Flows of capital into US markets have also temporarily concealed tighter conditions. Howell highlights “the huge amounts of money of flight capital that have come into the US over the last four years” and quantifies it as “something like $4 trillion.”

But the turning tides of liquidity that have been so noticeable abroad are now also starting to wash up on US shores, as John Dizard demonstrates in the FT [here]. When rates are higher in the US, foreign investors can buy US Treasuries and hedge out the currency risk. He notes, “This made it possible for non-US institutions to hold large bond positions that paid a positive rate of interest without incurring foreign exchange risk.” However, by the end of September, “the interbank market’s cross-currency ‘basis swap’ for euros to US dollars rose by 30 basis points and the cost of yen-dollar basis swaps went up by 46 bp.” Dizard summarizes the likely consequences:

“That was the end of foreigners paying for the US economic expansion. It also probably marked the end of the housing recovery.”

Additional factors further muddy the mix. Repatriation flows have disguised the decline in liquidity but will only do so temporarily. Further, China has historically been a large buyer of US assets., but that is changing too. As Howell notes, “China has shown no appetite for buying further US dollar assets over the last 18 months.” He concludes,

“We think they’ve now stopped. And they’re redeploying their foreign exchange reserves into Central Asia in terms of real infrastructure spending.”

Bill Blain points to yet another factor in his analysis of liquidity in Zerohedge [here]. He notes,

“What’s happened since Lehman’s demise has been a massive transfer of risk from the banking sector – which means, so the regulators tell us, that banks are now safer. Marvellous [sic]. Where did that risk go? Into the non-bank financial sector.”

Almost as if on cue, the FT reported on liquidity issues at a shadow bank in India [here]: “The banks’ woes have meant India has come to rely for credit growth increasingly on its shadow banking sector. Non-bank lenders accounted for 40 per cent of loan growth in the past year, according to Nomura, funding their expansion by relying heavily on the short-term debt market.”

This case serves as a useful warning signal for investors because it is reflective of the global expansion of shadow banking and because it demonstrates the kind of pro-cyclical and mismatched funding that caused so many problems during the financial crisis.

In sum, although various transient factors have created some noise, the overall signal is fairly clear. Zerohedge reports [here],

“With net Fed credit actually decreasing, an important threshold has been crossed. The effect on excess liquidity is more pronounced, which definitely poses a big risk for overextended financial markets.”

Whether or not the big risk is immediate or not is open for some interpretation. As Druckenmiller puts it, “we’re kind of at that stage of the cycle where bombs are going off,” which suggests the time is now. However, he implicitly suggests developed market investors still have some time when he says,

“And until the bombs go off in the developed markets, you would think the tightening will continue.”

Problems for developed markets are on the way though, as liquidity is likely to get a lot worse. Cole says,

“Expect a crisis to occur between 2019 and 2021 when a drought caused by dust storms of debt refinancing, quantitative tightening, and poor demographics causes liquidity to evaporate.” He also warns, “[Y]ou should be VERY worried about how the bigger implicit short volatility trade affects liquidity in the overall market… THAT is the systemic risk.”

If it is still hard to imagine how a subtle and abstract thing like liquidity could overwhelm demonstrably strong economic results, perhaps a lesson from history can provide a useful illustration.

In Ken Burns’ Vietnam War documentary, Donald Gregg from the CIA captures the strategic perspective of the war:

“We should have seen it as the end of the colonial era in southeast Asia, which it really was. But instead we saw it in Cold War terms and we saw it as a — a defeat for the free world — that was related to the rise of China — and it was a total misreading of a pivotal event — which cost us very dearly.” 

In other words, the subtle and abstract force of independence from colonial rule ultimately proved to be an incredibly powerful one in Vietnam. Many people wanted to believe something else and that led to very costly decisions.

Liquidity is playing the same role for investors today and investors who believe otherwise are also likely to suffer. The important lesson is that long-term investors don’t need to worry about getting all the day-to-day cross-currents just right. But they do need to appreciate the gravity of declining liquidity.

A recent story in P&I [here] articulated the challenge well: 

“Investors also must be more aware. Few recognize when conditions that could lead to a crisis are brewing, and those who do often misjudge the timing and fail to act to protect themselves and their clients from the full impact of the storm.” More specifically, “The best laid plans for protecting investment gains, and even the corpus of a portfolio, could fail if attention is not paid to the likely shortage of liquidity” 

This isn’t to say it will be easy to do or that the message will be uniformly broadcast. For example, after the significant market losses in the second week of October, the FT reports [here] that Vanguard notified clients via a tweet:

“You know the drill. In face of market volatility, keep calm and stay the course.”

“Keeping calm” is certainly good advice; it is even harder to make good decisions when one is wildly emotional and/or impulsive. However, “staying the course” makes some dubious assumptions. 

If a market decline is just a random bout of volatility then it doesn’t make sense to change course. But when liquidity is declining and Druckenmiller sees “bombs going off” and Cole expects “a crisis to occur between 2019 and 2021,” a market decline has very different information content.  

Staying the course would also make sense if your exposure to stocks is low and your investment horizon is very long, but the numbers say just the opposite. As Zerohedge reports [here],

“Outside of the 2000 dotcom bubble, U.S. households have never had more of their assets invested in the stock market.”

Further, as Gallup documents [here], the 65 and older demographic, the one presumably with the shortest investment horizon, has actually slightly increased their stock holdings. As Bill Blain comments,

“You’ve got a whole market of buy-side investors who think liquidity and government largesse is unlimited.” 

Investors reluctant to heed the warnings on liquidity can consider one more argument — which comes from Druckenmiller’s own actions. As he puts it,

“I also have bear-itis, because I made– my highest absolute returns were all in bear markets. I think my average return in bear markets was well over 50%.”

Based on what he is seeing now, he is ready to pounce:

“I … kind of had this scenario that the first half would be fine, but then by July, August, you’d start to discount the shrinking of the balance sheet. I just didn’t see how that rate of change would not be a challenge for equities … and that’s because margins are at an all time record. We’re at the top of the valuation on any measures you look, except against interest rates …”

So, investors inclined to dismiss concerns about liquidity and who would be hurt if stocks should go down a lot, should know that on the other side is Stanley Druckenmiller, with an itchy trigger finger, ready to put his money where his mouth is.

Wrapping up, it is difficult to capture just how fundamentally important liquidity is to investing, but Chris Cole probably does it as well as anyone: 

“When you are a fish swimming in a pond with less and less water, you had best pay attention to the currents.”

So let’s hear it for liquidity: It is a powerful force that can boost portfolios and one that can diminish them just as easily. 

Do You Believe In Magic

Like so many things, magic can have different meanings. Many times, it is regarded as something special that defies easy explanation. Sometimes it also includes elements of nostalgia as in the Lovin’ Spoonful’s “It makes you feel happy like an old-time movie.” Positive, serendipitous experiences are often described as mystical, remarkable, or “magical”.

But magic can also have negative connotations. Common phrases such as “sleight of hand” and “smoke and mirrors” emphasize the misdirection of our attention, often for the purpose of gaining advantage. Increasingly, these types of “magic” infest investment analyses and financial statements and in doing so, belie underlying fundamentals. Just as hope is not a strategy, belief is not an investment plan.

One of the great lessons of history is that it is not so much periodic downturns that can cause problems for long term investment plans so much as it is specious beliefs about supporting fundamentals that can really wreak havoc. Often, we have decent information in front of us but we get distracted and focus on, and believe, something else.

In the tech bust of 2000, for example, investors learned that some companies inflated revenues through vendor financing. Some backdated options to retain high levels of compensation for key staff. Many used alternative metrics such as growth in “eyeballs” to embellish visions of growth while de-emphasizing real progress and costs.

Similar phenomena existed in the financial crisis of 2008. Exceptionally low interest rates boosted mortgage originations above sustainable levels. “No income, no assets” (NINA) mortgages allowed a large number of people to take out mortgages who were wholly unqualified to do so. Structured credit products boosted growth by creating a perception of manageable risk.

In both cases, there was a period of time during which people thought they were wealthier than they actually were, because they had not yet learned of the deceptions. Renown economist John Kenneth Galbraith thought enough of this phenomenon to develop a theory about it. John Kay describes it [here]: “Embezzlement, Galbraith observed, has the property that ‘weeks, months, or years elapse between the commission of the crime and its discovery. This is the period, incidentally, when the embezzler has his gain and the man who has been embezzled feels no loss. There is a net increase in psychic wealth.’ Galbraith described that increase in wealth as ‘the bezzle’.”

Charlie Munger went on to expand and generalize the theory: “This psychic wealth can be created without illegality: mistake or self-delusion is enough.” Kay notes that “Munger coined the term ‘febezzle,’ or ‘functionally equivalent bezzle,’ to describe the wealth that exists in the interval between the creation and the destruction of the illusion.”

As any magician knows, there are lots of ways to create illusions. For better and worse, the current investment landscape is riddled with them. One of the most common is to create a story about a stock or an industry. Investment “stories” are nothing new. In the late 1990s and early 2000s the story was that the internet was going to transform our lives and create enormous growth. In the financial crisis of 2008 the story was that low rates and low inflation created a “goldilocks” environment for global growth. Both stories, shall we say, overlooked some relevant factors.

New stories are popping up almost as reliably as weeds after summer rains. Zerohedge highlighted [here], “Back in December 2017 it was ‘blockchain.’ Now, the shortcut to market cap riches, and a flurry of speculative buying, is simply mentioning one word: ‘cannabis’.” If you are curious what a story stock looks like, take a look at the price action of cannabis company TLRY over the last month. After you do, try formulating an argument that the market prices reflect only fundamental information and no illusion.

Daniel Davies, author of Lying for Money, points out one overlooked, but highly relevant aspect of the cannabis story [here]: “Despite the “bright future of legalized pot”, he says, “The US Securities and Exchange Commission has already prosecuted several companies which appeared to be less interested in selling weed to the public and more interested in selling stock owned by the founders for cash.” As is often the case, the whole story is often more complicated and less alluring.

Stories are conjured about more than just exciting new stocks and industries, however. Sometimes they define a narrative about the economy or the market as a whole. One such story describes the economy as finally getting back on track and resuming its historical growth trajectory of 3 – 4%. It’s a nice, appealing story with significant tones of nostalgia.

It is also a story that is less than entirely realistic, however. The FT cites JPMorgan analysis [here]: “Jacked up on tax cuts, a $1.3tn spending bill, easy monetary policy and a weakening dollar, Wall Street and the US economy have enjoyed their own version of a ‘sugar high’.”

John Hussman describes how the discrepancy between real growth and perceived growth arises [here]: “The reason investors imagine that growth is running so much higher than 2-3% annually is that Wall Street and financial news gurgles about quarterly figures and year-over-year comparisons without placing them into a longer-term perspective.” He explains, “The way to ‘reconcile’ the likely 1.4% structural growth rate of GDP with the 4% second quarter growth rate of real GDP is to observe that one is an expected multi-year average and the other is the annualized figure for a single quarter, where a good portion of that figure was driven by soybean exports in anticipation of tariffs.”

Further, he reveals that fundamental drivers have actually languished during the huge run-up in the market: “[W]hen we measure peak-to-peak across economic cycles, annual S&P 500 earnings growth has averaged less than 3% annually since 2007, while S&P 500 revenue growth has averaged less than 2% annually.”

Tax cuts provide an especially interesting component of the investment landscape. Not only did the cuts in corporate tax rates quickly and substantially increase earnings estimates in financial models, they also provided a powerful signal to many investors that finally there is a business-friendly administration in the White House.

The reality, again, is more complicated and less sanguine, however. For one, the tax cuts came along with higher fiscal deficits, the cost of which will be borne in the future. Secondly, and importantly, the tax cuts did not come as a singular benefit but rather as part of a “package” of public policy.

The FT reported [here]: “At a meeting in Beijing late last year, US business executives tried to explain their concerns about imposing tariffs on Chinese exports to a group of visiting Trump administration officials.” It continued, “The meeting was held after President Donald Trump’s state visit to Beijing and the congressional passage of a large tax cut for corporate America. The executives, who had expected a polite exchange of views, were shocked by the officials’ robust response. One of the attendees reported that they were told, “your companies just got a big tax cut and things are going to get a lot tougher with China — fall in line”.

The attendee summarized, “The message we are getting from DC is ‘you’re just going to have to buck up and deal with it’.” Lest this be perceived as a one-off misunderstanding, it is completely consistent with Steve Bannon’s analysis of the situation reported [here], “Donald Trump may be flexible on so much stuff, but the hill he’s willing to die on is China.”

While “story stocks” and “tax cuts” and record growth” tend to steal headlines, they aren’t the only things that can engender perceptions that differ from reality. Sometimes the most powerful sources of misunderstanding are also the most mundane — because they garner so little attention.

While accounting in general is often overlooked because the subject is dry and technical, it also provides the measures and rules of the game by which financial endeavors are evaluated. But those rules, their enforcement, and the economic landscape have changed considerably over the years.

One big issue is the increasing use of non-GAAP metrics in earnings presentations. As I discussed in a blog post [here], the vast majority of S&P 500 firms present non-GAAP metrics in their earnings releases. Further, as the FT reported, “Most of those non-GAAP numbers make the company look better. Last year a FactSet study found that the average difference between non-GAAP and GAAP profits reported by companies in the Dow Jones Industrial Average was 31 per cent, up from 12 per cent in 2014.” A key takeaway, I noted, is that “non-GAAP financial presentations can play a significant role in cleaving perception from underlying investment reality.”

Another issue is that intellectual capital presents special accounting challenges and is far more important to the economy today than it used to be. The Economist reports [here]: “Total goodwill for all listed firms world-wide is $8tn, according to Bloomberg. That compares to $14tn of physical assets. Dry? Yes. Irrelevant? Far from it.” Further, one-half of the top 500 European and top 500 American firms by market value “have a third or more of their book equity tied up in goodwill.”

The Economist also reports, “Just as the stock of goodwill sitting on balance-sheets has become vast, so have the write-downs. For the top 500 European and top 500 American firms by market value, cumulative goodwill write-offs over the past ten years amount to $690bn. There is a clear pattern of bosses blowing the bank at the top of the business cycle and then admitting their sins later.” Because “the process of impairment is horrendously subjective,” the numbers for reported assets have become less defensible.

In addition, investors need to be on the watch for even more than clever numbers games and accounting obfuscation. The reliability of corporate audits has also been declining for a variety of reasons — which should reduce investors’ confidence in them.

As the FT reports [here], the original purpose of audited numbers was “to assure investors that companies’ capital was not being abused by overoptimistic or fraudulent managers.” However, Sharon Bowles, former chair of the European Parliament’s economic and monetary affairs committee, assesses, “But the un-anchoring of auditing from verifiable fact has become endemic.”

An important part of the “un-anchoring” process involves the increasing acceptance of fair value accounting, which was implemented (ostensibly) to provide more useful information to investors: “From the 1990s, fair values started to supplant historical cost numbers in the balance sheet, first in the US and then, with the advent of IFRS accounting standards in 2005, across the EU. Banking assets held for trading started to be reassessed regularly at market valuations. Contracts were increasingly valued as discounted streams of income, stretching seamlessly into the future.” “The problem with fair value accounting,” according to one audit professional, “is that it’s very hard to differentiate between mark-to-market, mark-to-model and mark-to-myth.” Yet another case of diminished verifiability.

At the same time as the reliability of audited numbers was decreasing, so too was the accountability for the audits. “[A]uditing firms have used their lobbying power to erase ever more of the discretion and judgment involved in what they do. Hence the explosion of ‘tick box’ rules designed to achieve mechanistic ‘neutral’ outcomes.” Professor Karthik Ramanna calls it a process “that is tantamount to a stealthy ‘socialisation or collectivisation of the risks of audit’.” In other words, don’t expect auditing firms to pay when their work fails, expect investors to pay.

To make matters worse, “There is also the perception that the dominant Big Four, which are now profit-hungry professional services conglomerates, are not that worried about audit quality anyway.” Erik Gordon, a professor at the University of Michigan Ross School of Business, highlights, “They have been able to do better with low quality than with high quality work.”

Jean-Marie Eveillaird, who accumulated an impressive record as an investment professional, summarized the effects of accounting changes in a RealVisionTV interview [here]: “[M]ost accounting numbers are estimates. And indeed, what happened in the ’90s, where there are a number … of chief financial officers decided that- with the help of some shop lawyers- decided that you could observe the letter of the regulations, and at the same time betray the spirit of the regulations, and you wouldn’t go to jail for that.”

In sum, there are a lot of different ways in which illusions about financial performance can be created and many have been getting progressively worse. Notably, they don’t even include the examples of intentional wrongdoing such as the Enron or Madoff frauds. Munger is right, “psychic wealth can be created without illegality: mistake or self-delusion is enough.”

The one thing all these examples have in common is that they are all essentially category errors. As Ben Hunt tells us [here]: “What’s a category error? It’s calling something by the wrong name.” In particular, a Type 1 category error is also called a false positive.

One opportunity for investors is pretty straightforward: Just don’t carelessly and uncritically accept a story as real fundamental information. Don’t call a narrative a fact. Don’t assign 100% value to numbers enshrouded with uncertainty. As Davies highlighted in regard to cannabis investors, “What they are not doing is asking the basic questions of securities analysts.” So ask the basic questions.

Davies also provides some useful clues as to when investors should be on special alert: “The way to identify a story-stock craze — overblown enthusiasm for a sector where there is a good tale to tell about its future — is if the justification for buying into the new hot venture is big on vision and short on detail.” For example, is the earnings presentation dominated by bullet points describing qualitative achievements or by revenue and earnings numbers accompanied by substantive explanations? If you are going to get involved with a story, a useful rule of thumb is: “the time to buy is either when very few people have heard the story, or when everyone has heard it and everyone hates it.”

In addition, the concept of the febezzle presents a fairly useful model for thinking about investment risk. Asset valuations can be thought of as being comprised of two separate components: One is based on fundamentals and reflects intrinsic value while the other is based on the febezzle and reflects illusory, or psychic, wealth. An important consequence of this is that when the illusion is shattered, the febezzle element vanishes and there is virtually nothing to prevent a quick adjustment to intrinsic value. In other words, the febezzle is much more of a binary (either/or) function than a linear one.

This matters for long term investors who are most concerned about creating a very high probability of achieving their long-term investment goals. Not only does the febezzle component subject their portfolios to sudden, substantial, and effectively permanent drawdowns, but it also defies conventional investment analysis. It is exceptionally hard to confirm that a popular illusion is being shattered, especially before everyone else does.

One signal of change, however, is volatility. Using language that closely parallels “destruction of the illusion,” Chris Cole, from Artemis Capital Management, explains [here], “Volatility is always the failure of medium… the crumpling of a reality we thought we knew to a new truth.” In this context, the absurdly low volatility of 2017 was ripe breeding ground for illusions. Investors believed. Higher volatility in 2018, however, suggests that some of those beliefs are becoming increasingly fragile.

Perhaps the greatest illusion of all is the belief that continued market strength confirms strongly improving fundamentals. While recent economic performance has been good, Cole rejects this view and offers an alternative explanation: “When the market is dominated by passive players prices are driven by flows rather than fundamentals.” In other words, strong market performance mainly means that more people are piling into passive funds. By doing so, they have the dangerously intoxicating effect of propagating the illusion of commensurate fundamental strength.

None of this is to suggest that stock fundamentals are strong or weak, per se. Rather, it is to suggest that, for several reasons, stock prices do not comport well with the reality of underlying fundamentals; there is less than meets the eye. As Ben Hunt warns, “It’s the Type 1 [false positive] errors that are most likely to kill you. Both in life and in investing.” If calling something real when it is not can kill you, it is hard to understand why so many people are so tolerant of mistakes and self-delusion when it comes to their investments. The question is simple: Can you handle the truth, or do you believe in magic?

The Most Important Asset Class In The World

Here we are, ten years after the bankruptcy of Lehman Brothers, and one would be hard pressed to find evidence of meaningful lessons learned.

“As long as the music is playing, you’ve got to get up and dance,” – Chuck Prince, Citigroup

Chuck’s utterance now sounds more like a quaint remembrance than a stark reminder. Ben Bernanke’s proclamation also sounds more like an “oopsie” than a dangerous misjudgment by a top official.

“We believe the effect of the troubles in the subprime sector on the broader housing market will be limited and we do not expect significant spillovers …” 

One of the most pernicious aspects of the financial crisis for many investors was that it seemed to come out of nowhere. US housing prices had never declined in a big way and subprime was too small to show up on the radar. Nonetheless, the stage was set by rapid growth in credit and high levels of debt. Today, eerily similar underlying conditions exist in the Chinese residential real estate market. Indeed, a lot of investors might be surprised to hear it called the most important asset class in the world.

China certainly qualifies as important based on rapid credit growth and high levels of debt. The IMF’s Sally Chen and Joong Shik Kang concluded [here],

“China’s credit boom is one of the largest and longest in history. Historical precedents of ‘safe’ credit booms of such magnitude and speed are few and far from comforting.”

The July 27, 2018 edition of Grants Interest Rate Observer assesses,

“Following a decade of credit-fueled stimulus, China’s banking system is the most bloated in the world.”

Jim Chanos, the well-known short seller, adds his own take on RealvisionTV [here], “So comparing Japan [in the late 1980s] to China, I would say Japan was a piker compared to where China is today. China has taken that model and put it on steroids.”

One of the lessons that was laid bare from the financial crisis of 2008 (and from Japan in the 1980s) was the degree to which easily available credit can inflate asset prices. This is especially true of real estate since it is so often financed (at least partially) with debt. The cheaper and easier credit is to attain, the easier it is to buy homes (or any real estate), and the higher prices go.

These excesses provide the foundation for one of the bigger (short) positions of Jim Chanos. He describes:

“China is building 20 million apartment flats a year. It needs about 6 to 8 to cover both urban migration and depreciation of existing stock. So 60% of that 25% is simply being built for speculative purposes, for investment purposes. And that’s 15% of China’s GDP of $12 trillion. Put another way, it’s about $2 trillion. That $2 trillion is 3% of global GDP.”

And so I can’t stress enough of just how important that number is and that activity is to global growth, to commodity demand, and a variety of different things. It [Chinese residential real estate] is the single most important asset class in the world.”

Chanos is not the only one who sees building for “speculative purposes” as an impending problem. Leland Miller, CEO of China Beige Book, describes in another RealvisionTV interview [here],

“The heart of the Chinese model is malinvestment. It’s about building up non-performing loans and figuring out what to do with them.”

The WSJ’s Walter Russell Mead captured the same phenomenon [here],

“Chinese leaders know that their country suffers from massive over-investment in construction and manufacturing, [and] that its real-estate market is a bubble that makes the Dutch tulip frenzy look restrained. Chinese debt is the foundation of the system.”

Increasingly too, household debt is becoming a problem. As the Financial Times reports [here], apparently China’s young consumers have:

“…rejected the thrifty habits of their elders and become used to spending with borrowed money. Outstanding consumer loans — used to buy cars, holidays, household renovations and other household goods — grew nearly 40 per cent last year to Rmb6.8tn, according to the Chinese investment bank CICC. Consumer loans pushed household borrowing to Rmb33tn by the end of 2017, equivalent of 40 per cent of gross domestic product. The ratio has more than doubled since 2011.”

Again, there are striking parallels to the financial crisis in the US. As Atif Mian and Amir Sufi report in their book, House of Debt, “When it comes to the Great Recession, one important fact jumps out: The United States witnessed a dramatic rise in household debt between 2000 and 2007—the total amount doubled in these seven years to $14 trillion, and the household debt-to-income ratio skyrocketed from 1.4 to 2.1.”

The inevitable consequence of unsustainable increases in household debt is that eventually those households will have to cut spending. When they do, “the bottom line is that very serious adjustments in the economy are required … Wages need to fall, and workers need to switch into new industries. Frictions in this reallocation process translate the spending decline into large job losses.”

In addition, just as the composition of consumers of debt affects the ultimate adjustment process, so too does the composition of its providers. For example, debt provided outside of the conventional banking system, such as from shadow banks, is not subject to the same reporting or reserve requirements.

Once again, the landscape of Chinese debt is problematic. Russell Napier states,

“The surge in non-bank lending in China has clearly played a key role in the rise of the country’s debt to GDP ratio and also its asset prices.”

Zerohedge adds [here] that the Chinese central government has become “alarmed at its [shadow banking’s] vast scale, and potential for corruption.”

Further, nebulous practices are not confined to the “shadows” in China. The FT reports [here],

“These [small] banks are quite vague and blurry when it comes to investment receivables … There’s so much massaging of the balance sheet, and they won’t tell you about their internal manoeuvrings.”

As it happens, “Problems at small banks matter because their role in China’s financial system is growing.” While China surpassed the eurozone last year to become the world’s largest banking system, “small and mid-sized banks have more than doubled their share of total Chinese banking assets to 43 per cent in the past decade.”

Nor is the lack of transparency confined to the financial system; it also extends to the entire economy. Miller describes,

“We’re constantly asked about how good Chinese data are. Is it all bad? It’s all bad, but it’s bad and different variations.” 

Chanos shared his opinion as well:

“As much as the macro stuff has intrigued me … what’s so interesting about China is the lower down you get, the more micro you get, the worse it looks, in that the companies don’t seem to be profitable, the accounting is a joke.”

Miller makes clear what the challenge is:

“[China] is the second largest economy in the world. This is probably the most mysterious big economy in the world. And people have been so willing to work on it based on guestimates.”

Normally, investors prefer certainty and discount uncertainty. The pervasive lack of discipline and due diligence echoes that of the structured debt products of the financial crisis.

Just as in the financial crisis, all of these excesses and shortcomings are likely to have consequences. Many of them will sound familiar [here]:

“[A] crisis of some kind is likely. The salient characteristics of a system liable to a crisis are high leverage, maturity mismatches, credit risk and opacity. China’s financial system has all these features.”

That said, the “flavor” of China’s crisis will depend on uniquely Chinese characteristics. Miller identifies an important one:

“I think the problem is that people didn’t understand that this is not a commercial financial system. That’s one of the major takeaways we stress all the time. This [China’s] is not a commercial financial system. What that means is when the Chinese are threatened, they can squash capital from one side of the economy to the other.”

In other words, China has substantial capability to manage liquidity and contagion risks.

As a result, according to Miller,

“We don’t spend a lot of time worrying about an acute crisis. If China falls and China does have the hard landing that a lot of people predicted, it’s not going to look like it did in the United States or in Europe. You have a state system, a state-led system in which almost all the counter-parties are either state banks or state companies. They’re not going to have the same freeze-up of credit that you did in some of these other Western economies.”

That said, there are still likely to be severe consequences. Miller reports,

“China has gotten themselves into a real difficult situation, because you have an enormous economy awash in credit that is leading to lesser and less productivity based on that capital. And that is why, rather than some sort of implosion, which could happen, or any type of miraculous continued prosperity indefinitely — we think that China’s economy is, for the most part, headed towards stasis.” More specifically he says, “So I think that we’re heading towards a Chinese economy which is going to slow down quite dramatically when we’re talking about 10, 15 years time.”

Indeed, it appears that process has started. As noted [here],

“Housing sales in China will peak this year and then begin a long-term decline, an inflection point that will drag on growth in the construction-heavy economy and hit global commodity demand, say economists.”

Throughout the process, Miller expects China to pursue a policy agenda designed to get the country “on a more sustainable track.” In particular, “that means cracking down on some of these bad debt problems, cracking down on shadow lending, becoming more transparent, injecting risk and failure into the system, and trying to build a stronger economy from that.” He is careful to note, however, “But it’s not easy.”

Neither will it be easy for investors to judge the puts and takes of various policy measures in a dynamic and opaque system. Henny Sender at the FT warns international investors [here]

“To take heed as Beijing continues a war against non-bank lenders and fintech companies that is tightening liquidity and spooking investors in mainland China.”

The FT also notes [here],

“New rules for recognising bad loans in China are set to obliterate regulatory capital at several banks” which will disproportionately affect small and mid-sized banks. Further, as reported [here], “the paring back of a state subsidy programme that provided Rmb2tn ($300bn) in cash support to homebuyers since 2014 is adding to structural factors weighing on the market.”

The good news is that investors can take several lessons from China and its residential real estate market. The first is that, like the US subprime market was, the Chinese real estate market is understated and under-appreciated. Perhaps it is because the numbers don’t seem that big. Perhaps it is because so few people have much clarity at all on what the numbers really are. Or perhaps it is just that people are making enough money that they don’t really care to look too hard. Regardless, just like with subprime in the US a decade ago, there are real problems.

Second, those problems will have consequences; investors should expect spillovers. As excesses in the country are unwound, the slowdown in Chinese economic growth will be felt around the world. China has driven global growth for at least a couple of decades. Further, residential real estate, with its strong economic multiplier and high degree of speculation, has been the rocket fuel for that growth. Reversal of those trends will feel like a substantial headwind. Further, lest US investors feel smug at the prospect of Chinese troubles, David Rosenberg warns [here],

“There is not a snowball’s chance in hell [the Chinese weakness] will not flow through to the US stock market.”

Where does all of this leave Chanos?

“Interestingly, we’re less short China now than we have been in eight years in our global portfolio. Because the rest of the world’s catching up. Although China’s been on a tear recently, Chinese stocks over the eight years are basically flat. And I’ve noticed that some of the other stocks have sort have tripled.”

Fundamentals are important, but so are prices paid.

A major complication of figuring out China will be determining the degree to which it’s domestic policy agenda influences actions on tariffs and trade and currency. Almost Daily Grants reported the findings of Anne Stevenson-Yang, co-founder of J Capital Research, on July 27, 2018:

“China’s credit-saturated economy … is the primary force behind the recent gyrations in FX. The reality is that China’s currency is most intimately connected, as with any currency, to the domestic economy – debt, asset prices, real estate prices, and efficiency gains and losses rather than just trade.”

In other words, don’t get distracted by the smaller stuff.

Despite all of these challenges, investors are not without tools to monitor the situation, however. Russell Napier reports [here],

“In general the copper price provides a good lead indicator to the market’s assumptions in relation to global growth. When it [the copper price] weighs the negative impact from an RMB devaluation and the positive impact from a Chinese reflation … the current indications are more negative for global growth than positive.”

The FT goes even further [here]:

“The metal [copper] is giving western investors a clear signal to sell risk assets or at least reduce their portfolio weighting.”

Perhaps the biggest lesson of all is that increasingly we live in a world of debt-fueled growth that shapes the investment proposition of financial assets. That means business cycles are increasingly overwhelmed by credit cycles. It means wider swings in financial assets — from euphoric highs to catastrophic lows. When the debt spigot turns off, it means the only “safe” assets are cash and precious metals. When the sparks fly, it’s hard to tell where they might land. And it means that whichever market has the highest debt and the fastest credit growth will be the “most important asset class in the world”.

Right now, that is Chinese residential real estate.

The Elephant In The Room: Share Repurchases

In a famous Indian parable [here] a group of blind men encounter an elephant. Since each blind man encounters a different part of the elephant (e.g., the tusk, the leg), there is a great deal of disagreement as to what the elephant is. The moral of the story is that “humans have a tendency to project their partial experiences as the whole truth.”

Projecting partial experiences as the whole truth has become standard practice in the arena of investing. Explanations for continued strength in stock prices range from strong economic growth to contained inflation to lower taxes to technology. It all depends on the partial experiences of the observer. There is, however, a different and yet dominant influence on stock prices that rarely gets the attention it deserves. That proverbial “elephant in the room” is share repurchases.

Of course no-one is claiming that economic factors are not critical determinants of share values — there is no disputing that. Actual prices, however, are determined by markets and as such, represent a form of competition between buyers and sellers. When buyers compete more aggressively, prices go up, and when sellers dominate the prices go down. In short, stock prices, like so many economic goods, are determined by supply and demand.

Based on this relationship and on recent positive price action, it is easy to infer that the bulls are winning. Further, it is tempting to associate this positive result with strong economic growth (at least in the US), low unemployment, low inflation, and lower corporate taxes. All of this feeds an alluring narrative: Finally, things are getting back to normal.

But the bears are not unworthy competitors. As John Authers reports in the Financial Times [here], trends in the expected return assumptions used by pension plans are a good indicator of sentiment towards the markets. Here the evidence is decidedly pessimistic: “Every single year of this young millennium, assumed pension returns have fallen — from 9.2 per cent in 2000 down to 6.5 per cent a year.” He adds that, “AQR publishes regular forecasts for five- to 10-year returns, and predicts real returns of 4 per cent on US equities and 4.7 per cent on emerging markets. Other assets would be weaker.” Other credible estimates are even lower.

As a result, there seems to be something of a paradox. Despite what seems to be a fairly evenly matched competition between bulls and bears, the market has continued to rise since its decline in February. Why would market prices keep going up even when it seems like supply and demand are pretty evenly matched?

The answer is partly illuminated by an old economics lesson. Markets do a pretty good job of determining prices based on the important assumption that there is a fairly diverse group of buyers and sellers and that each acts in its own economic self-interest. In real life, however, this is not always the case. In a prior blog post [here], for example, I pointed out that central banks have been buying significant quantities of stocks for purposes of public policy rather than as an effort to realize attractive financial returns.

While central banks have certainly distorted stock prices with their purchases, their impact pales in comparison to that of companies repurchasing their own shares. The scale has been mind boggling. As the FT notes [here],

“Between 2012 and 2015, US companies acquired $1.7tn of their own stock, according to Goldman Sachs.”

Calcbench also conducted a survey of common stock repurchases over 25 quarters of data through Q1 2018 [here] and calculated over $3 trillion was spent over that time.

By way of comparison, the $3 trillion amount comprises a significant 10% of the $30 trillion current value of the entire US stock market. Further, assuming repurchase trends continue through 2018, the FT reports [here],

“That would lift the total since 2010 to over $5tn, bigger than the Fed’s entire $4tn quantitative easing programme.”

Share repurchasing is not just notable for its massive scale, but also for its increasing trend. The FT reports [here],

“The almost $437bn in buyback plans announced in the three months to June 30 eclipsed the previous quarterly record of $242bn, which was set just three months earlier, according to TrimTabs, an investment research company.”

The FT also reports [here] that the latest annual estimate by Goldman Sachs is for “a record $1tn in share buybacks this year.”

As a result, share repurchases are doing a lot more than just “tipping the scales” of supply and demand. David Kostin, chief US equities strategist for Goldman Sachs summarized it best:

“[share] repurchases remain the largest source of demand for shares.”

Indeed, Bank of America observed [here],

“in the first half [of 2018], corporations were the only net buyers of stocks.”

Repeat: “the only net buyers of stocks.”

This highlights a startling characteristic of today’s market: It’s not even remotely a balanced competition between buyers and sellers. Kostin also observed that:

“most other ownership categories [households, mutual funds, pension funds] are net sellers of stocks.”

Bank of America reported that “institutions and hedge funds have been net sellers throughout 2018.” Harley Bassman summarized [here],

“In fact, away from Corporations purchasing equities (buy-backs or mergers), it is unclear who else is supporting the stock market against the relentless demographic tide of Baby Boomers rebalancing their portfolios away from equities and into bonds.”

One might expect corporations to be more judicious in their share repurchase activity, but that is not what the evidence suggests. Zerohedge reports [here],

“Corporations are not particularly price sensitive — buybacks tend to rise with the market”.

In addition, a report by Andrew Lapthorne of Societe Generale summarized in the FT [here] reached a similar conclusion:

“the correlation between a stock’s quality and its propensity to buy back stock is negative, and has been for most of the time since a brief period post-crisis.” In fact, he goes on to say, “Buybacks can be a ‘tell’ of a poorly run company, not just a company with few good growth opportunities.”

While the sheer volume of share repurchases has affected markets, its seasonal nature has had an impact as well. As noted [here]:

“August tends to be the most popular month for companies to execute their share repurchases, with the month accounting for 13 per cent of annual activity.”

Given typically low summer volumes, August share repurchases also increase the chances of producing a disproportionately beneficial impact on share prices.

In addition, seasonality of share repurchases also comes in another form. They tend to decline during the “blackout periods” before and immediately after companies report earnings. Chris Cole states bluntly on RealvisionTV [here]:

“I don’t think it’s any coincidence that the worst drawdowns in equity markets — we’re talking about the period in 2015 or January 2016 or this recent February drawdown — I don’t think it’s a coincidence that they’ve occurred during the five week share buyback blackout.”

Cole is not alone in this assessment; the same conclusion is also reached [here] and [here].

Another interesting feature of the share repurchase trend has been the degree to which it has been financed by debt. It so happens that the total amount of increase in corporate debt has almost perfectly coincided with the amount of share repurchases. This fact was highlighted by Zerohedge [here]:

“And as we first pointed out over two years ago, all net debt issuance in the 21st century has been used to pay for stock buybacks…”

An excellent example was provided by Horizon Kinetics [here] in their analysis of how

“The McDonald’s share price appreciated by 90% over 7 years.”

The explanation features two main components:

“One thing that happened is that McDonald’s P/E ratio expanded from 16.9x to 24.6x. That share-holders were willing to pay more for the same earnings accounted for about half of the stock return. Another thing that happened was that interest rates dropped; for 10-year Treasuries, from 4.08% at the beginning of 2008 to 2.30% at year-end 2015 (and to 1.77% now [Q1 2016]). This permitted McDonald’s to finance a massive share repurchase program that would have been unaffordable but for these artificially low rates, which is why its interest expense only rose by 22% even as its debt ballooned by over 6x this amount.”

Viewing market activity through the “lens” of share repurchase activity not only creates some extremely important implications for investors but also provides some clear prescriptions as well. For starters, since share purchase activity is dominated by price insensitive share repurchases, stock prices reveal little information content about underlying economics. This helps explain why neither inflation fears nor trade wars nor emerging market chaos nor increasing rates have been able to rein in stock prices to any great degree. This also explains how a great deal of pessimism about stocks can co-exist with rising prices and bullish narratives.

Another consequence of large scale share repurchase activity is that it has facilitated excessively high stock valuations. This creates a dangerous trap for investors. While high valuations may appear, superficially, to validate underlying economic strength, they are really just temporarily masking the darker reality of “the relentless demographic tide of Baby Boomers rebalancing their portfolios away from equities and into bonds.” In other words, despite appearances, there is likely to be a big drop in stocks in the not-too-distance future. After all, if conditions were really so good, why would market participants such as “institutions and hedge funds” be net sellers?

An important consequence of a market of artificially inflated prices is that it creates winners and losers by effectively transferring wealth. Artificially inflated prices today mean lower returns tomorrow. That is good for investors who want to sell today and bad for those who need to realize future returns in order to achieve investment goals.

One key group of beneficiaries includes retirees (and others) who have been rebalancing their portfolios away from stocks. They are benefiting from a remarkable coincidence of artificially inflated stock prices at exactly the same time they want to de-risk their portfolios. As luck would have it, there could hardly be a better time to cash out.

Of course corporate executives are also benefiting in the form of higher (share-based) compensation and an attractive opportunity to dispose of their share holdings. Zerohedge reported,

“there’s a dirty little secret lying just beneath the surface of this ‘different this time’ ramp in stocks. Insiders are dumping their shares to retail investors at an almost unprecedented manner…”

Grants Interest Rate Observer also reports in its June 15, 2018 edition that some repurchase announcements appear as if they are designed to create “cover” for insider selling:

“U.S. Securities and Exchange Commissioner Robert Jackson complained that management teams are using buybacks to pad their own income. According to number-crunching by SEC staff, insiders increase the amount of stock they sell by five times in the eight days following a share repurchase announcement.”

Unfortunately, just about everyone else loses. Artificially inflated prices force everyone with a longer investment horizon to make very difficult decisions on an ongoing basis. It forces people to determine whether factors such as large scale share repurchases will persist long enough to provide an attractive exit within the time frame of their investment horizons. Wait too long to sell and you face a big drawdown that could take a long time to recover from. Sell too soon and you aren’t earning the returns you need to meet retirement goals.

Younger investors are hurt because low expected returns on stocks discourages them from doing one of the best things they can do for themselves — start saving early. While such people still have plenty of time to save for retirement, every year prices are inflated and future returns are suppressed is one less year they have to reach their goals.

Perhaps the greatest risk is to investors who are nearing retirement or are recently retired and still have significant exposure to stocks. These investors run the risk of not selling stocks before prices drop down to more sustainable valuations. The risk here is of suffering a significant drawdown at exactly the wrong time. Such an event could either substantially defer retirement or redefine it altogether.

Because the consequences of diminished share repurchase activity are so severe, it behooves investors to monitor conditions that could cause such a change. The biggest factor is arguably the ability of companies to continue funding share repurchases at such high levels. With unemployment near record lows and profit margins near record highs [here], cash flows are more likely to get worse than better. It would be dangerous to extrapolate such favorable conditions very far into the future.

Harley Bassman also points out some debt-related factors to watch:

“So clearly higher rates driven by the FED could reduce buybacks funded by debt.”

Bassman also suggests that any twists in tax policy could also have a negative effect:

“if tax reform were to include a provision to reduce the tax advantage of corporate borrowing, that would raise the effective cost of debt, and may be the catalyst for reducing share buy-backs.” Bassman also hypothesizes, “or if the companies themselves reach up against a level where they may face downgrades or limits to their debt loads.”

The FT also reported a recent warning by BCA [here]:

“Dwindling balance sheet flexibility will become a serious constraint underscoring that the tailwind from buybacks is ending and could [change] into a headwind next year if cash flow does not recover.”

In addition to keeping an eye on what could cause share repurchases to decline, it also makes sense to keep an eye on when. Remembering that share repurchase activity is seasonal and tends to decline during blackout periods, late September, just before most third quarter earnings come out, will be a good time to observe what happens to stock prices when the impact of share repurchases is diminished.

In conclusion, most investors catch only glimpses of what happens in the markets if they catch anything at all. As result, much like the blind men and the elephant, it is easy to experience only partial truths rather than the greater whole. The challenge for investors is made even greater because self-interested market commentators don’t even need to lie in order to deceive; they can simply distract with agreeable narratives. Resist the tendency to extrapolate partial truths. Manage to your investment horizon. And focus on the things that count most by keeping your eyes on the “elephant in the room”. Right now that is share repurchases.