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Violence, Underperformance and Bubbles

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“Violence is the last refuge of the incompetent.” - Isaac Asimov


The horrific and cowardly terrorist attacks by the Islamic State targeting first a Russian jetliner on October 31, followed by the attack in Paris on the eve of Friday, November 13, shook the civilized world and was rightly condemned across the board. Sadly, despite what some leaders have characterized as “shocking,” these brutal, barbaric acts of violence have become more common since 9/11 and less of a surprise to many of us. Nevertheless, global markets pretty much shrugged off these “unforeseen,” negative events as it appears investors are more focused on stepped up central bank liquidity programs rather than geopolitical risks and the possible implications associated.


It is probable that investors have taken note of the quick bounce back in financial markets post previous terrorist events and have chosen to focus instead on the Federal Reserve “getting on with it,” i.e. tightening monetary policy with the idea that the overall magnitude and duration of this rate hiking cycle will be insignificant by historical standards. In addition, Europe and Japan appear committed to maintaining easy policy which, people believe will be supportive of asset prices even if the U.S. is pulling back a bit.


From our side of the world, market pricing along the U.S. Treasury bond curve is consistent with a modest amount of interest rate tightening which of course is music to the equity market’s ears. And so, the music keeps playing, and investors continue on dancing. Or, said another way, It doesn’t pay to fight the Fed.


But all is not rosy in U.S. stocks according to Strategas Research, as market breadth, which is a measurement of the number of stocks advancing versus declining has been very narrow throughout 2015 and may point to signs of a less than healthy market.


John Authers, of the Financial Times, who is one of the more astute financial market commentators writing for the popular press, recently addressed this divergence in his Long View column on November 27, “Fangs and Nifty Nine power US equities.” He defines the Fangs as Facebook, Amazon, Netflix and Google while the Nifty Nine are the Fangs + Priceline, Ebay, Starbucks, Microsoft and Salesforce. His team crunched the numbers and found that although the S&P 500 index was up about 1% on the year at the time of the study, an equal weighted version of the index was down slightly on the year at -0.20% (Figure 1). But the main finding was that when they stripped out the Fangs and Nifty Nine stocks mentioned above, the returns from these two groupings were around 60% year to date (Figure 2). This is extraordinary given that most US stocks are down on the year. Adding to the trickiness of making the above concentrated bet is the fact that collectively, the Fangs and Nifty Nine have a Price/Earnings ratio of 45 which is double that of the S&P 500. In other words, the very richly priced assets continue to get richer.


It has been a frustrating year for investors indeed, as diversified portfolios have not held up. Over the past month multiple financial sources have highlighted that aside from a small number of sectors, much of the U.S. stock market has not performed well this year, while medium to long term Treasury bonds are down modestly and credit has sold off. Commodity prices are also down and international equity investments for the most part are lower when measured in U.S. dollar terms. But don’t go running for the hills. The monetary juice that has enabled this six and a half year equity bull market may not be going away anytime soon, and I suspect that U.S. stocks as well as their international developed market brethren have room to run higher, that is, until we are undeniably in bubble market territory.


What is undeniable bubble market territory? For this, I will borrow the definition given by Jeremy Grantham of GMO, an asset management firm, as market values that are two standard deviations from the mean. Based on this metric, Mr. Grantham has the S&P 500 somewhere between 2250 and 2400 depending on what starting point is used to mine the data. Assuming the S&P 500 is approximately 2050, this implies that the index could rise between 10-17% before we would have achieved bubble territory. For those readers that prefer stock market valuation metrics such as the Shiller P/E ratio or the Q ratio, I can confirm upon quick inspection that their deviations are approximately in the same ballpark as Mr. Grantham’s analysis.


How to play this then? Stick to one’s long-term objectives utilizing an acceptable, yet comfortable amount of risk. Given that this bull market is surely getting closer to it’s finale, I believe it wise to scale back on certain risk assets (think technology and growth stocks in general). Despite their low yields consider a higher allocation to US Treasury bonds and alternative investments, both of which offer diversification benefits and in the case of Treasuries are good portfolio stabilizers should things get ugly. Finally, in addition to allocating more of one’s equity slice to both U.S. value stocks and preferreds for those seeking dividends, serious consideration should be given to adding exposure in U.S. dollar terms to Japan’s Nikkei 225 (one of the few international developed markets that performed this year), which currently stands at 19,522 and is still almost 50% below it’s all time high of 38,916, made on December 29, 1989.


Lastly, and on a more personal note, I would like to send out my deepest condolences to the families, friends and citizens that have been affected by the recent terrorist violence. I cannot fathom what motivates individuals to commit such atrocities against mankind. Those that steal our loved one’s away from us and rationalize this act based on some outlandish philosophical belief have clearly forgotten what binds us together as beings on this earth. At the end of the day, we all hope to love and be loved.



Sincerely,

Justin Kobe, CFA Founder & Portfolio Manager

Securities and Advisory Services offered by Protected Investors of America, an SEC Registered Investment Advisor. Member FINRA/SIPC. The views expressed in this commentary are the personal views of Justin Kobe of Pacificus Capital Management and do not necessarily reflect the views of Protected Investors of America. There is no assurance that the investment process will consistently lead to successful investing. This commentary does not constitute an offer to sell any securities or the solicitation of an offer to purchase any securities. Fixed income securities are subject to interest rate, inflation, credit and default risk. The bond market is volatile. As interest rates rise, bond prices usually fall, and vice versa. The return of principal is not guaranteed, and prices may decline if an issuer fails to make timely payments or its credit strength weakens.


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