The end of Q1 always brings out interesting insights from around the investing landscape. Quarterly Letters and the Milken Institutes’ Conference give the best and the brightest platforms from which to speak their collective investing minds.
From the Milken Institutes Global conference in Los Angeles comes a voice from the private equity world in the form of Josh Harris who is one of the founders of Apollo Global Management. Harris believes that deals are getting harder and harder to come by and that is due to over exuberant monetary policy from the Federal Reserve. Here is what Mr. Harris had to say.
The quantitative easing and the excess money and the low interest rates have driven pricing up of almost all financial assets to beyond what their intrinsic value might be.
So even though we can all chat about the benevolent growth environment that exists in the U.S. and to a lesser extent globally, the ability to make money and invest wisely on that is very, very challenging right now because you’re starting at a point in the valuation cycle that is very, very aggressive.
Almost every asset is overvalued.
He seems to have company with Daniel Loeb the founder of Third Point and one of the more successful hedge funds managers over the last 18 months.
Early optimism about the U.S. economy may have been “misplaced”, Third Point said on Thursday, adding that key sectors were showing “bubblelicious valuations” and were poised for more volatility in the months ahead.
In a letter to investors obtained by CNBC, the hedge fund said that Federal Reserve Chairman Janet Yellen’s shifting of monetary policy tightening was a contributing factor behind the market’s dour tone.
The correction, however, was “healthy”, said Daniel Loeb, Third Point’s chief, adding that the economy was beginning to accelerate after the punch of a brutal winter and heightening rate hike expectations. As the second quarter cranks up, “it now seems evident that investment performance will require a combination of good stock selection, patience, and deft trading,” he said. –CNBC May 1 2014
Another voice that we always stop and listen to is that of Jeremy Grantham founder of Grantham Mayo and manager of over $100 billion in assets. We spotted an interview of Jeremy Grantham brought to us from the folks over at Fortune. Grantham and his crew over at GMO in Boston have done extensive work on bubbles going back throughout investing history. He is very critical of the policies enacted by the Federal Reserve but goes on to note that most bubbles go to at least two standard deviations above the market’s mean valuations. For those of you scratching your heads trying to remember your college Stats 101 course Grantham feels that a bubble in the overall market would not exist until the S&P 500 hit 2,350 although his models suggest negative returns over the next 7 years based on current valuations.
Okay, but then I guess that means you think stocks are going higher? I thought I had read your prediction that the market would disappoint investors.
We do think the market is going to go higher because the Fed hasn’t ended its game, and it won’t stop playing until we are in old-fashioned bubble territory and it bursts, which usually happens at two standard deviations from the market’s mean. That would take us to 2,350 on the S&P 500, or roughly 25% from where we are now.
So are you putting your client’s money into the market?
We invest our clients’ money based on our seven-year prediction. And over the next seven years, we think the market will have negative returns. The next bust will be unlike any other, because the Fed and other central banks around the world have taken on all this leverage that was out there and put it on their balance sheets. We have never had this before. Assets are overpriced generally. They will be cheap again. That’s how we will pay for this. It’s going to be very painful for investors.
In Grantham’s GMO Q1 2014 Letter he goes one to quote the Presidential Cycle which you have heard us refer to from time to time. Grantham and his team note how its effects are seen worldwide and in fact the effect is even greater in the United Kingdom. He calls for more bumps in the road and volatility to increase as the Fed exits from QE. He sees Year 2 of the cycle to be negative but Year 3 is the best year of the cycle and very positive.
Here is the link to the entire letter. A great read if you have the time.
The central theme here is that investors seem to be expecting an increase in volatility as the Federal Reserve tries to exit its loose monetary policy. Even more directly comes another voice telling us to prepare for more volatility while the Fed winds down its purchasing in the open market. This time it comes straight from the FOMC and departing Fed Governor Jeremy Stein.
Jeremy Stein, in one of his last speeches as a Federal Reserve governor, warned that the central bank still may face more bouts of market volatility as it winds down the most aggressive easing in its history.
Some investors may be “underestimating the degree of uncertainty about the future path of policy and are placing levered bets accordingly,” Stein said yesterday in a speech to the Money Marketeers of New York University. “So we may have some further bumps in the road as this all plays out.”
In response to an audience question, Stein said “it’s important that we not get goaded into thinking we’re responsible for minimizing market volatility.” -Bloomberg 5/7/14
A not so subtle shot across the bow if you will. We will take that as a warning that the Fed knows that volatility is coming. Read that last line from Bloomberg again. The Fed knows volatility is coming and it appears that they do not intend to do anything about it. A 10% correction could easily morph into a 20% correction as the Fed tries desperately to remain on the sidelines in the event of a market retreat.
I think that I have depressed you enough. Remember though that there may be some light at the investing tunnel and no it is not a train. At least we hope. Volatility this summer and early fall as the Fed eliminates QE could lead to nice gains come spring time as the Presidential Cycle reasserts itself. Patience is a virtue. Small Caps continue to tumble and diverge from the broader market which is usually a warning sign. The 10 Year US Treasury keeps flirting with breaking through recent highs. That also could be signifying a weaker market. Treasuries and Gold continue to be our risk temperature gauge. Keep an eye on Small Caps and the 10 Year US Treasury.
The changing opportunity set over time means you will do well by reducing risk significantly when faced with a less favorable set of expected returns and increasing risk when looking at a particularly favorable set of asset valuations. -Ben Inker GMO Q1 2014
To learn more about us and Blackthorn Asset Management LLC visit our website at www.BlackthornAsset.com .
A pessimist sees the difficulty in every opportunity; an optimist sees the opportunity in every difficulty. – Winston Churchill
Disclosure: This blog is informational and is not a recommendation to buy or sell anything. If you are thinking about investing consider the risk. Everyone’s financial situation is different. Consult your financial advisor.