Author: Scott Brown, CFA, Founding Partner
Based on 100 years of data and metrics that show valuations well over two times normal, this remains a time to focus on capital preservation if one is a long-only investor. Clinging to a buy-and-hold strategy may soon prove regrettable. Regardless, expecting anything more than very low returns over an investment horizon from current valuations is no different than buying a bond with a 0% yield to maturity and expecting it to return 10% per year.
Importantly, every investor should at least think about what it means that given stated policy changes at the central banks, there will be a positive $800 billion swing in net bond supply in 2018. That’s a lot of additional bonds for markets to take down as Quantitative Tightening takes over. In addition, in the U.S., borrowing at the federal level could increase by a few hundred billion dollars this year. All of that money must come from somewhere and will suck capital from the financial system.
We expect less pressure on yields than many bond bears predict because this added supply is also an incremental liquidity drain that will reduce future economic growth. Nonetheless, we are keeping dry powder for potential fixed-income bargains for now as we watch this dynamic unfold in coming months. It’s important to keep in mind that if bond prices were simply a function of marginal net supply, then why did rates fall during most of the last thirty years as government borrowing skyrocketed?
At the same time, equities should be negatively impacted by diminishing central bank liquidity. Already, Treasury yields are offering the sort of competition to dividend yields that has been absent for years. The pundits don’t mention that very often.
We recognize no matter how favorable our valuation math may be over the long-term, it does not work every year. As you know, we base our risk exposure on overall valuations, but we never feel that we are entitled to profits in our risk-controlled endeavor. We do know investors’ asset allocations should include a percentage devoted to strategies such as ours and that allocation should increase as markets rise. We firmly believe that value still matters. It is possible to take advantage of the greed of others if one is truly a dedicated and patient value investor.
We would suggest that hedged strategies will once again prove their merit as the cycle completes. We suspect that the market tone will switch from QE-driven revelry to a realization that major problems and ridiculous valuations have simply been ignored. Most importantly, we will continue to heed decades of data which indicates that hedge funds should continue to remain in capital preservation mode with a focus on downside profits because the risks of participating in a clear mania are simply too high.
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.