THE CRASH AND REBOUND OF TINA
2018 Corrected Many Excesses—The Crash of TINA
Q1 2019 Has Helped TINA Make A Comeback
Allen Gillespie, CFA®
Managing Partners of Investments
Mercer Treadwell, CFA®
Senior Vice President
David Lewis CFA®
Chief Financial Officer
- Monetary Policy: Neutral. The Federal Reserve has indicated its goal is to move from “accommodative” to “neutral.”
- Fiscal Policy: Checks and balances. One of the beautiful things about the American political system is the system of checks and balances. With a conservative populist Trump White House, a populist liberal House, and a nearly evenly split moderate Republican/Democrat Senate, we believe we are likely to see the American system of checks and balances at its finest.
- Watch the Yield Curve: Historically, the yield curve has a good track record as a leading economic indicator, and it leads other leading economic indicators like the stock market. The stock market, in turn is considered a leading indicator of the economy. The yield curve inverted in December and again in March.
- Deal Activity Accelerates. There has been a noticeable increase in mergers and acquisitions activity since the Federal Reserve’s interest rate pause. In our view, this materially improves the environment for arbitrage and value based strategies.
Q&A WITH THE RESEARCH TEAM
Q: Allen, you have called 2018 the CRASH of the TINA market, can you explain?
A: TINA, stands for “there is no alternative.” TINA was a term traders coined for the market when cash interest rates fell to zero. Since money literally returned nothing, people were forced by the Federal Reserve’s zero interest rate policies (ZIRP) to buy anything and everything that offered a yield or prospective return (i.e. stocks, bonds, real estate, bitcoin, etc.), as holding money was guaranteed to be a loosing position. The TINA effect caused investment valuations to reach some of the highest recorded levels in history.
Q: That sounds scary. Can you elaborate on the levels of valuation?
A: According to data from JP Morgan, entering 2018, equities were in the 99th percentile of valuations on many metrics. For example, on an enterprise value to sales basis, the median stock had never been more expensive, on a forward P/E basis the median stock was in the 97th percentile, on cash flow yield 98th, enterprise value to EBITDA 98th, price to book 99th, and price earning to growth 100th, but fortunately free cashflow yield was in the 55th percentile, so you get the idea. Things were not cheap. As a result of these types of valuations, I truly believed that the TINA bull market might end in another crash event, but more like 1987 than 2007/2008 or 2000-2002.
Q: You seem to have changed your mind, what changed?
A: In many ways, the markets did crash in 2018. The changes to equity valuations in 2018 were, in many respects, as large as the 41% correction that occurred during the 1987 stock market crash. It is just that the market got there a little differently. First, the Trump corporate tax cuts, which lowered tax rates from 34% to 20% increased the cashflows to investors. This increased cashflow, and thereby lowered valuations by about 20%, so that eliminated part of the problem. Secondly, companies generally performed well, so the basic earnings base in-creased; so that took care of another 5-10% of the valuation problem. Finally, stock pric-es had a pretty big decline in the fourth quarter, which further adjusted the valuations. By our estimates, 2018 was about a 40% valuation correction from the highs reached in September to the December 24th low, not too dissimilar to 1987.
Q: What should investors expect going forward?
A: On the monetary side, the Fed says it wants to be “neutral.” Politically, we have a populist Republican President, a populist liberal House, and an almost evenly split moderate Republican/Democrat Senate. You can then throw into the mix an almost completely flat yield-curve. It is a really bland sounding view, but the big macro picture looks neutral, and nothing is getting done.
Q: Mercer, if the big picture outlook is “neutral” – where are the opportunities?
A: We think a lot of the basics.
Cash and cash equivalents, now at least offer an alternative. Though for most risk assets, 2.5% is still not a significant hurdle rate. As a result, we would expect a more modest investment climate, but diversification and regular disciplined rebalancing is still a good plan. Just because most asset classes were negative in 2018 and cash was up, doesn’t mean clients should change long-term plans. Diversification works over time, not every time.
We also think there are some more tactical opportunities, specifically in strategies that have modest degrees of correlation to traditional assets. For example, 2017 was the worst year on record for insurance losses, so we think that creates an opportunity in re-insurance. There are also other trends that can be played through tactical positions that otherwise get mut-ed out in large diversified funds.
Q: Can you give us a more specific example?
A: We believe there is an opportunity in the financial sector because so many investors remember the financial crisis. Interestingly, we are seeing mergers and acquisitions in the space and in-creased dividends from many companies, but the stock market performance of the sector has been horrible. In fact, there is one manager we track, a true financial sector specialist, who was one of the best performing managers during the 2008 crisis. His recent performance has been down given his more constructive view on the space. We think that creates an opportunity. In addition, if the yield curve steepens, then we believe financials would be the biggest beneficiaries.
Q: Any other examples?
A: Based on our modelling, we believe arbitrage strategies offer an attractive risk-return premium above short-term interest rates. Given that we are seeing an uptick in major mergers and acquisitions activity, we would expect it to be a good investment climate for these less correlated strategies. A related strategy that is more directional in nature would be event managers. We have noticed a number of event trades occurring, related to corporate debt, due to both special situations (like the California wildfires), and due to last year’s rise in interest cost (like Kraft’s announcement that it will be lowering its dividend to paydown debt faster).
Q: Any final thoughts from the team?
A: We are always looking for ways to improve the investment program for our advisors and clients, so one of the goals we have set for ourselves this year is to improve our communication. This newsletter is an attempt to do that, and we are also very open to any feedback that will help us serve you better.
Last year was a year that many investors would like to forget. Most asset classes, apart from cash and cash equivalents, finished the year negative. While not a pleasant year, 2018 did correct many extreme excesses. The broad-based declines can largely be attributed to the fact that the Federal Reserve enhanced the attractiveness of cash. There is a saying on Wall Street: “money will go, where money is best treated.” By raising short-term interest rates throughout the year and treating cash “better,” the Fed shifted its policy stance from “accommodative” to “neutral.” In our estimation, the shift to “neutral” is a significant change in policy that alters the investment climate for the foreseeable future. The Federal Reserve has been “accommodative” for 10 years, so we suspect it will be “neutral” for a significant period (though maybe not 10 years) going forward.
The past year also brought political changes, as Democrats regained control of the House of Representatives, while Republicans held on to a slim majority in the Senate. While this was an unsatisfying result to those of a strong political persuasion, we believe checks and balances are a beautiful feature of the American political system. According to Ned Davis research, when a Republican President loses the House, stocks are largely flat over the subsequent twelve months. It appears the stock market, just like many American sports fans—does not like ties, but ties are better than losses. Many people remember when Auburn coach Pat Dye kicked a game tying field goal in the 1988 Sugar Bowl. Coach Dye’s actions are one of the reasons College Football today plays overtime.
THE INVERTED YIELD CURVE
The yield curve inverted in December and again in March. Historically, the yield curve has a good track record as a leading economic indicator. It can lead other leading economic indicators like the stock market. As a result, the FinTrust research team took a look at all of the yield curve inversions since the 1970s, as defined by five-year Treasury rates being below two-year Treasury rates. What the research team found was a mixed bag of good and bad information for equity investors.
Yield curve inversions have lasted from as short as a month to as long as a couple of years. We found the average length of a yield curve inversion was 7 months. This makes intuitive sense to us because recessions are defined as two quarters of negative Gross Domestic Product (GDP), hence the usefulness of the yield curve as an economic indicator. Naturally, we found that the longer the inversion is maintained by the market, the more se-vere any subsequent slowdown. For example, during the 2006/2007 period the yield curve was inverted for 19 months.
Our research found that stock market performance during yield curve inversions is reduced but still positive.
The yield curve is a leading indicator, and it leads other leading economic indicators like the stock market. Once the yield curve re-steepens, a much more challenging stock market frequently results. In short, the data suggest that the bond market leads the stock market and the stock market leads the economy. The equity market downturns of both 2001-2002 and 2008 occurred after the yield curve had steepened after being inverted for a long period.
We are continuing to monitor the yield curve and we would be increasing concerned should the yield curve remain inverted for six months or more or if the inversion becomes more pronounced in magnitude. After six months, we believe the bond market will have clearly forecasted a coming recession. Similarly, a severe inversion would suggest a more negative environment as well. Long-term investors should not overreact to business cycle data, but we would encourage investors to review what we call their ‘vertical risk’: financial plans, risk pro-files, and asset allocations. The FinTrust portfolio management team mainly considers horizontal risk moves, which shorten or extend risk within each respective asset class. A move between stocks and bonds would be a vertical risk shift, whereas a shift in allocation between large capitalization dividend paying value stocks and small capitalization growth stocks would be a horizontal shift.
Given our neutral view, we believe gradual reductions in risk posturing, systematic rebalancing, and less correlated strategies should be emphasized within portfolios.
QUICK TAKE: MAJOR ASSET CLASSES
Cash and Cash Equivalents
After nearly a decade of being below the inflation rate, cash and cash equivalents once again offer investors roughly the equivalent compensation as inflation. The Federal Reserve’s over-night rate currently sits at 2.4% while the last read on the CPI was 1.9%, but the twelve month average sits at 2.45%.
Investment Grade Fixed Income
Investment grade bond yields rose more or less in-line with the rise in short term interest rates during 2018, while spreads slightly increased after interest rates reached their December peak. Many are concerned about the large number of investment grade credits that sit just above the high yield category, as any downgrades could lead to forced selling by institutions. Consecutive down years are rare in the bond markets, and the bond market is currently pointing to-ward deteriorating conditions, but interest rates continue to be very low by historical standards. As a result, we think investment grade bonds still have a defensive roll to play, but they do not offer much in the long run.
Tactical Fixed Income
Historically, fixed income and equity arbitrage strategies earn a risk premium above cash yields. Over the last few years, when cash rates were very low, these strategies we not as attractive as more traditional credit and interest rate carry strategies. Now, however, given higher short term interest rates, the inverted nature of the yield curve, and the potential for credit spreads to widen, we believe event and fixed income and equity arbitrage related strategies offer a compelling risk return opportunity. We believe the return profile is reasonable and the risk profile is better than either duration or credit.
In December, the Dow Theory gave a sell signal, but it is not uncommon to see large secondary moves after the change in primary trend. According to Ned Davis Research, when a Republican President loses the House, stock returns are flat for the next year. Based on the yield curve and historical patterns, we are modestly constructive on equities but do not believe investors should chase the market as during the Quantitative Easing (QE) period that ran from 2009-2018. We also believe the neutral outlook in the US will lead investors to seek returns in international markets given their higher yields.
Nearly every strategy and asset class has underperformed domestic US equities during the fourth quarter of 2018, but we did see some evidence of money returning home to emerging markets on a country by country basis. Other tactical equity strategies, like long/short equity, have historically performed better when short-term interest rates are higher. The duration of long only equities has been estimated to be 30-50 years; so given that we are in an inverted yield curve environment, we believe tactical equity strategies are becoming increasingly attractive on a relative value basis.
ABOUT FINTRUST CAPITAL ADVISORS, LLC
Privately owned and independent, FinTrust Capital Advisors is a Southeastern based financial services firm that serves both personal wealth clients and corporate and institutional clients. Through strategic financial planning, investment management, and other fiduciary consulting, retirement plan consulting, research, capital markets, and other services concerning financial well-being. The FinTrust team of experienced professionals provides solutions to meet both individual and corporate client objectives.
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