May 2015: Think Negative Thoughts

Download: Coxe Strategy Journal: May 2015

Some day later in this century, a class studying “The Decline and Fall of Capitalism” will hear that within just 15 years, investors ran like rats in Hamelin following the Pied Piper into (1) technology stocks trading at 150-times earnings, (2) investment packages containing complex collections of mortgages on American homes at far above true market value rated Triple-A, and (3) zero coupon bonds priced above par.

A student will ask, “I can understand the first two, because real market value is subject to fads and over-enthusiasm, but buying a bond that absolutely promises a loss makes no sense at all.”

The professor will smile and say, “We rationalists would never have been hurt by any of those late-capitalism idiocies. All three of those financial disasters occurred because greedy speculators assumed they’d be able to sell those over-priced assets to bigger fools.”

This month we delve deeper into the implications of the Origin and Propagation of a New Species within Investment Zoology—Negative-Yielding Bonds.

Many European governments have reconfigured themselves into the financial equivalent of vampires, sucking in capital at negative cost.

Zero and negative-yield bonds are signs of bond market mania at a time when US equity prices are also trading close to all-time highs in valuation.

In contrast to the euro-excitement over those bizarre bonds, US bond markets have been, until recently, mostly dull and mildly positive. Funds flow into the US bond market because Treasury yields that would have seemed niggardly even three years ago look good compared to European bonds. Fed Fear continues to restrain bullishness, while the economy has not created fears for bond-buyers: for the second straight year, the US east of the Rockies struggled through a brutal winter of 19th Century temperatures. Equity investors bid prices mildly higher, arguing that last year, the economy sprang forward once Spring arrived, and that will happen again.

Oil has remained a big story for both bonds and stocks. After crude prices fell by more than 50%, they rallied strongly, despite unrestrained production by the Saudis, the Emirates, and the new member of the club of mega-producers—the USA.

We assume the Saudis and their allies will continue to supply oil markets heavily, at least until the Iran deal is settled on any terms other than capitulation to the Mullahs’ demands. If Iran triumphs, the Arabs will have even greater motivation to ensure that Iran cannot unload its 30 million barrels of oil from storage at high prices—and to restrain Iran’s income thereafter.

Meanwhile, China’s economy is weakening, but remains potent when compared with most OECD economies.

India’s economy is strengthening, albeit more slowly than its new Prime Minister expected. After decades of desultory performance labeled “The Hindu Rate of Growth,” a Hindu who takes his faith more seriously than did Nehru and his colleagues is delivering reforms to unshackle the nation’s millions of entrepreneurs.

The background to economic and financial concerns keeps darkening as wars and geopolitical risks keep increasing.

Until Putin invaded Ukraine, investors could concentrate on forecasting Earnings and Risks Per Share; wise investors will now also be looking at Earnings and Risks Per Scare.

Moreover, a bad bond idea doesn’t just threaten the bond market. It undermines the integrity of the stock market.

If the world still basked in the calm of the American-managed Post-Cold War Peace, bonds and stocks could correct without unleashing real Fear.

But America’s standing in the world is deteriorating, and its newly-ambitious rivals may overplay their hands as they seek to fill the vacuum Washington’s perceived fecklessness has created.

We have changed our long-established bullish call for bonds to Medium-to-High Risk. We argue that the onset of a bond bear market—which could be unfolding as we write—will impair the already-eroded foundations of stocks.

We recommend slashing bond durations and raising some cash from equities.