The quote above is from one of my favorite comedians, Steven Wright. I’m not sure if he’s still performing, but he’s the dry humor guy with an extremely slow and unique delivery. He’s hilarious and his jokes are very clever. One of his jokes goes something like, “If you’re driving in space traveling at the speed of light and you turn your headlights on, does anything happen?” I remember this joke because when I first heard it instead of making me laugh, it made my head hurt! That’s exactly how I feel about financial markets these days and the global central bankers propping them up.
Over the weekend I thought some more about earnings season. Although it’s happened for several quarters now, I continue to be surprised stocks are holding up as well as they have. I’ll admit this market cycle has lasted longer than I expected. Given how expensive stocks have become, I believed once earnings began to decline, stocks that were priced for perfection would abruptly reverse once investors realized fundamentals were anything but perfect. After four consecutive quarters of earnings declines (soon to be five), that has not been the case.
While earnings season remains young, so far I’m not seeing sufficient evidence that would suggest a reinvigorated corporate earnings cycle. In fact according to FactSet, earnings for Q2 are expected to decline -5.5%. FactSet states, “If the index reports a decrease in earnings for the quarter, it will mark the first time the index has seen five consecutive quarters of year-over-year declines in earnings since Q3 2008 through Q3 2009.” The earnings cycle ended long ago, but the market cycle (second longest in history) marches on.
Why has there been such a large disconnect between fundamentals and valuations this cycle? We all know. It’s no secret global central banks have hijacked the financial markets with eight years of emergency monetary policies. Whether central banker policy is meant to create asset inflation, fund fiscal deficits, raise capital gains taxes, make 1-2x government debt to GDP affordable, or simply keep it together until the next policy maker comes into office, is all up for debate. What we do know is central banks have set interest rates and bond prices. This is undeniable. As a result, they have also interfered with the pricing mechanism of all asset prices. What asset class is not dependent on interest rates or their cost of capital? If the cost of capital of all asset classes is manipulated and untrue, isn’t information derived from asset prices misleading? I think so.
I have a love-hate relationship with the Federal Reserve and central banks. I despise their interventionist policies. I believe capitalism and free markets are wonderful concepts if allowed to function properly. Current monetary policies and the temporary suspension of free markets truly make me sad. Over the past twenty years I’ve witnessed some very serious monetary policy errors along with three Fed-induced asset bubbles. While I was also upset about monetary policies during the tech and housing bubbles, I acknowledge I benefited from these imprudent policies as the asset bubbles eventually popped, creating massive dislocations between price and value (opportunity). Given my current positioning, I again expect to benefit once the Fed’s third bubble in only 17 years pops.
While I’m looking forward to future opportunities, for now it’s steady as she goes for rising asset prices. According to a July 21 Bloomberg article, the S&P 500 enjoyed its fourth weekly gain last week. Although companies continue to beat their spoon-fed earnings estimates, I believe actual operating results have been insufficient to drive stock prices higher. In my opinion, stock prices continue their march higher because of relentless global central bank policy, not fundamentals.
The Bloomberg article points to the catalyst of the current rally, “Expectations for lower rates or additional bond buying had sparked a three-week rally in global equities that added more than $4.5 trillion in value.” So much for the negative impact of Brexit. Not only did the unexpected Brexit not harm investors, it provided them with a $4.5 trillion bonus for misjudging its likelihood! In effect, Brexit provided central bankers with cover to keep policies extremely easy. So now not only do we have the central banker “put” on risk assets, investors now also receive free call options! Simply amazing. I miss free markets and I miss investing.
I don’t know what to call allocating capital in these markets, but I’m reluctant to call it investing. That’s a shame given the extraordinary amount of human capital being consumed by the investment management industry. If central banks fix asset prices how is this investing? If this isn’t investing, what is it? And if we all know prices are fixed and artificial, why are so many playing along? Where are the bond vigilantes for goodness sake? If you’re not going to be a bond vigilante now, when?
Absolute return investors need not worry. They aren’t required to play the game. The best game to play now, in my opinion, is patience, discipline, and preparedness. When policies fail, free markets and investing will return, along with another round of wonderful opportunities. Until then, let ‘er rip Yellen, Draghi and Abe. The crazier heights policies and prices reach, the more opportunities in the future for those of us not playing along. A final quote from Steven Wright to sum up the current investment environment and market cycle, “The early bird gets the worm, but the second mouse gets the cheese.”