We continue to see policy normalization at the Fed as a fantasy. Even if rates in the short end of the curve were to increase by 100 basis points, the term “rate shock” would be a euphemism given the massive leverage in the system. Total public and private debt in the U.S. stands at nearly 350% of current GDP. Bear in mind that the housing market has already softened versus 2013 because of the increase in mortgage rates last year. Single-family construction resides near November 2012 levels. The news from Lumber Liquidators (LL) a few weeks back makes it quite clear that even home renovations have slowed as the company’s sales have cratered. Thanks for all that QE guys…NOT!
We currently find it quite difficult to identify companies with reasonable valuations. Leveraging corporate balance sheets to buy back stock is the direct result of exhaustive and exasperating QE. We see too many companies that have posted modest revenue growth as well as flattish earnings over the last three years, but have only grown earnings on a per share basis by buying back their own equity. Current, extreme valuations are especially risky considering the quirky financial engineering that has occurred in the absence of robust business improvements. Many of these companies have seen their stock prices rise 50-75% in the last year from levels that were not inexpensive. We have learned over the years to avoid cyclical stocks at 20 times peak earnings and 25 to 30 times normalized earnings because they can see their share prices cut in half (or worse) without much notice. Many are good companies, but trade at extremely expensive prices. We prefer these on the short side.
As measures of market complacency soar, we suspect faith in the Fed has likely been peaking. It is harder to shrink shares outstanding at these higher prices. At the same time, major issues remain unresolved across the globe. For instance, the current troubles at one of Portugal’s biggest banks, Banco Espirito Santo, make it all too clear that Europe is not “fixed.” Deutsche Bank has had to issue a big chunk of equity to raise capital even in the face of all the Euro bullishness. Additionally, the weakening economic data out of Japan (machine tool orders), China (exports), and Europe (industrial production) cannot be encouraging to those in favor of the grand central planning experiments.
This coming October, as the Fed is set to end a QE policy that has failed to benefit the real economy, investors are supposed to hold equities priced at all-time highs on the hope that sustainable GDP growth is right around the corner. Meanwhile, serious investors (like us) are only left to wonder who will buy stocks from all those participants whose only rationale for purchasing them in the first place was that the Fed was printing money. The tail does not wag the dog.
The Fed has made a gigantic mistake as it desperately tries to cover for a long record of foolish, ultra-easy policy. Like addicts looking for a quick fix, it has become fixated on the S&P 500. The Fed does not appear to realize that their self-inflicted economic malaise is structural. As a result, there is little it can do to help. Trying to encourage additional capacity expenditures and real estate development with low rates is not helpful over the long term; it simply creates more problems. In addition, many markets have become more distorted than we can ever recall. We see no easy way out for central bankers looking for escape hatches. Prudence dictates caution.
The views expressed on this blog are the opinions of the authors. This information is not intended as investment advice or to recommend the purchase or sale of securities. More information on Strategic Balance, LLC may be obtained by contacting investor relations.