Got Some Splainin’ to Do

In recent posts I mentioned I was becoming increasingly optimistic regarding future opportunity. Does this mean a sharp decline in stock prices is imminent? I wish I knew, but I don’t. As a bottom-up investor focused on small cap equity analysis and valuation, I remain unqualified to time markets. Regardless of my inability to determine when the bids disappear and the current cycle ends, recent market trends have been encouraging.

When I recommended returning capital in 2016, interest rates were near 0%, inflation was subdued, and global central banks were buying over $2,000,000,000,000 a year in assets (that’s a lot of zeros!). The investment environment has changed considerably since then. A growing number of objective and subjective variables that influence asset prices are in motion, with most indicating the current market cycle’s clock is once again ticking.

Objectively, inflation and interest rates are on the rise. The 2-year U.S. Treasury continues to move higher, reaching 2.95% last week, or up approximately 230 bps from its 2016 lows. Short-term Treasuries have suddenly become very competitive relative to normalized earnings yields of equities and other risk assets.

While some investors point to an improving economy (bullish) to explain rising interest rates, increasing wage pressure and inflation (bearish) have also contributed. From a bottom-up perspective, signs of inflation have been building noticeably over the past year. Labor availability/shortages, wage growth, and company responses (higher prices), are finally beginning to show up in the government data. Given these trends, and barring a consequential decline in asset prices, I believe the Federal Reserve will be forced to continue increasing rates and unwinding their bloated balance sheet. With the ECB in the process of ending QE and the Bank of Japan questioning the effectiveness of its asset purchases, the days of unlimited central bank bids may finally be coming to an end (at least for now).

In addition to influencing monetary policy, inflation is beginning to affect demand in certain industries. For example, several homebuilders recently blamed affordability (asset inflation), higher building costs, and rising mortgage rates as possible reasons for the recent slowdown in demand. While it’s too early to determine if the slowdown in housing (along with other interest sensitive industries) will accelerate, early indications suggest some spillover into corporate earnings could be expected.

In addition to objective variables, such as inflation, interest rates, quantitative tightening, and earnings growth, there are subjective variables emerging that also appear to be influencing the markets. For example, investor sentiment weakened during the Q3 2018 earnings season as investors appeared to be in a less forgiving mood. There are many examples of investors punishing stocks 10-20% in response to lower than expected operating results. For most of this cycle, that wasn’t the case. In fact, I remember many instances when poor results were met with a yawn and in some cases shareholders were actually rewarded!

There are many possible reasons why investors and stocks are behaving differently at this stage of the market cycle. In addition to variables already discussed, sometimes it’s as simple as markets getting tired and falling on their own weight. At higher market caps, and without the price insensitive bid from global central bankers, it’s likely becoming more difficult to muscle asset prices higher.

Another theory I’ve considered relates to the natural rotation of capital that occurs throughout a market cycle. As a portfolio manager who has generated some very good and very bad relative returns, I’ve seen my share of capital inflows and outflows. Inflows often occur after periods of strong performance, while outflows typically occur after periods of poor performance. As I’ve noted in the past, I’ve often been hired when I should have been fired and fired when I should have been hired.

The rotation of capital away from underperforming managers and towards managers with strong performance is nothing new. Chasing top performing managers isn’t much different than investors crowding into the best performing stocks. Similar to stock cycles, the capital transition cycle eventually runs its course as the number of managers remaining to pull capital from dwindles. I call it capital allocation capitulation – when asset allocators give up on a set of managers, style (includes active vs. passive), or asset class. I’ll never forget 1999 when many value managers I respected stepped down or were fired. By early 2000, there weren’t many disciplined value managers still in business! The capital transition cycle was complete, just as the market cycle was about to turn.

Based on the duration of the current market cycle, along with its elevated valuations, I believe a tremendous amount of capital has already been transitioned away from lagging managers. After a raging ten year bull market, many managers unable or unwilling to keep up with their benchmarks and peers have likely been replaced. And even if they’re still around, their assets under management (AUM) have certainly declined. As the market cycle ages, so does the capital transition cycle. Eventually capital becomes concentrated, breadth narrows, and the funds winning the AUM game become increasingly crowded in the “best” securities.

Near the later stages of a market cycle, portfolio managers who apply thorough bottom-up analysis and have strict valuation disciplines, may find it difficult owning the best performing securities. As a result, it is not unusual for disciplined active managers to lag during periods of significant asset inflation and overvaluation. As such, I believe it’s rational to assume much of the capital rotation this cycle has moved away from disciplined active managers and into funds and ETFs that are less analytically rigorous and valuation sensitive.

And this finally gets back to a theory of mine as to why certain stocks are beginning to act differently, especially after reporting weaker than expected operating results. As a portfolio manager, holding a stock that has a large unrealized loss isn’t easy. It requires a tremendous amount of research, analysis, and conviction. It also requires frequent and detailed communication with clients – expect to be grilled during the next quarterly meeting! 🙂

One way to avoid having to defend positions with losses (and time required to know positions well), is to refuse holding them. Why go through the pain when you can simply sell? For funds and managers that are less likely to have the necessary process, discipline, and conviction to defend losing positions, selling can be a tempting and easy solution. And that’s the foundation of my theory. As the current capital transition cycle matures, fewer portfolio managers and investment strategies remain that are willing or able to defend losing positions. As a result, I believe the capital transition cycle has contributed to the rising number of price gaps lower as stocks that require “some splainin’ to do” are sold and forgotten (easy) instead of held and defended (hard).

For patient absolute return investors, the recent shift in investor behavior has been refreshing and encouraging. As capital has moved away from disciplined active managers and into funds or ETFs that have little loyalty or conviction in individual holdings, I’m hopeful the current “gap down” phenomenon in equities increases in frequency and magnitude.