Market Risk Overview:
The accelerating rise of the stock market marks the final stage of this ripping bull market. Interest rates are rising, and stocks are pushing peak valuations–market historians know these two conditions cannot coexist for a protracted period of time. If the October 19, 1987 stock market crash is the best historical comparable, many will suffer life changing financial losses when this rally ends. What is different about this bull market is the unprecedented global central bank intervention since the financial crisis of 2008-9 that have artificially created trillions in negative interest rates bonds globally. This month’s letter will explore the current market risks and sensible countermeasures..
The three-panel chart1 below displays the S&P 500, earnings and interest rates over the last 20 years. The colorful top panel shows the S&P 500 and the “Risk Premium”2(a reliable indicator comparing the earnings of the S&P to the 10-year US Treasury note.) The next panel down shows S&P 500 earnings3(current and expected) which have accelerated with the stock market, economy and new tax law. The S&P 500 is obviously extended, and while the earnings and economic acceleration support the market’s move, this acceleration cannot persist indefinitely. Inevitably, earnings will slow, and interest rates will rise to a point that ends this bull market. When this bull market ends is difficult to predict. What is not difficult to do is thoughtfully manage the risks in your portfolio of assets in the event of a 50% decline in the S&P 500 and/or rise to a 6% yield on the 10-year Treasury Note.
The unique factor in this bull market–which started in March 2009–is the unprecedented central bank accommodation through quantitative easing. “At the bond market peak in mid-2016, the total market value of negative-yielding bonds, including corporate and securitized debt, reached $12.2 trillion” according to Bloomberg4. With rising interest rates offering an increasingly compelling alternative to stocks, equity market investors will move their assets from stocks to bonds and trigger a stock market decline. On January 10th, bond legend Bill Gross wrote that bonds have entered a bear market5. We have cited the forecast6 of bond guru Jeffrey Gundlach, CEO of DoubleLine Capital, that long-term interest rates could rise to 6% by 2021. We do believe bonds are in a bear market and 10-year US Treasury Notes will rise to 6%. If and when this happens, this rise in rates will have a profound impact on bonds, stocks and real estate.
Below is a chart of the Constant 10-Year US Treasury7. What is noteworthy is that when rates have risen historically, they can rise sharply, which is inconsistent with the current Federal Reserve narrative of gradual tightening of Federal Funds.
The chart below shows the steep increase in the 10-year US Treasury rate from its July 2016 low of 1.37% to its current 2.73% rate.
The greatest risk from rising interest rates is losses on long term bonds. For example, in 1987, I had a client who had purchased $750,000 in 20-year 8% AAA Connecticut municipal bonds. When the bond bear market got into gear, this portfolio of insured and triple tax-free bonds started declining $100,000 a month! This unanticipated rise in rates ran counter to Wall Street’s consensus forecast. The bond decline was so sharp and surprising, we sold the bonds saying that we would buy them back when the dust had settled. This example illustrates how, if you are not prepared for a sharp decline on your long-term bonds or other assets, the financial losses can mount very quickly.
Unfortunately, many people own bond funds in retirement plans and elsewhere without a clear understanding of the maturity and risk. Bond funds advertise their “high” rates to attract investors. To get the highest yields bond fund managers will buy the longest term bonds and the riskiest securities to entice new investors. Many bond funds will use leverage to increase their yield, amplifying the interest rate risk; many less sophisticated investors are oblivious to this fact. When retired investors’ fixed income portfolios experience double digit losses, the lawyers will remind the investors of the interest rate risk disclosure in the small print at the back of the prospectus and their arbitration agreements. We sincerely believe in the months and years ahead, there is a very real risk that massive amounts of wealth will change hands abruptly and some8 people will ask why nobody warned them? Bill Gross did. Jeffrey Gundlach did and Income Growth Advisors did9.
Interest Rate Risk Reduction:
One of the great benefits of MLPs is that they are far less sensitive to rising interest rates than bonds. MLPs’ distributions grow which allows for their yields to rise in a rising rate environment. Consequently, MLPs will not decline as much as bonds but can offer yields several percentage points higher than bonds. Additionally, many MLP’s have PPI escalators, which will increase their distribution growth if commodity prices rise which seems likely. Individual MLP distribution growth rates can differ widely, but we can construct a portfolio where distribution growth is 10% or higher per year and has a tax advantaged 6 or 7% distribution yield. Consequently, shifting out of bonds into MLPs can help you preserve your principal and increase your income in a rising interest rate environment. Since we have entered an environment of rising rates that could continue for several years, a move out of bonds could have a meaningful impact on the retirement focused investor. Additionally, MLPs offer valuable estate planning benefits. MLPs, upon the owner’s death, can receive a stepped-up cost basis. Effectively MLPs can provide 10 to 20 years of attractive tax advantaged income that can then pass to your heirs potentially avoiding capital gains taxes!10 Consequently, we remain fervent advocates of MLP portfolios due to the cyclical recover in energy, their compelling combination of yield and distribution growth, lower interest rate risk profile and estate planning benefits.
Comparison to 1987 Stock Market Crash:
We believe the current market environment is very similar to that of 1987. In 1987, 30-year Treasury Bond yields rates rose from 6% to 10% by October. The Dow Industrials rallied 43% from 1,900 to 2,725, before it declined 22% in one day, October 19th!
Outside of bonds, another risk in the final stages of a bull market is the fear of missing out and drawing in investors at peak prices. Money seems so easy to make that people throw caution to the wind and end up buying stock that are fully valued or overvalued. These stock have typically had eye popping parabolic ascents because all the positive news for the last several years is already priced in and momentum chasing fast money push these stocks higher at an unsustainable rate of appreciation. Consider these two great American companies, The Boeing Company (BA) and The Home Depot, Inc. (HD) their 40 year charts look like charts of the Dow Industrial Average in 1929 and 1987 and the Nasdaq in the tech bubble.
Boeing and Home Depot are great businesses franchises that are built over the last forty years. Their parabolic moves and price appreciations since 2011 are unprecedentedly their 40 years history. If rate rises, their price appreciation experienced under the historically ultra-low interest rate environment can be gravely imperiled.
Concentrated Position Hedging:
Most of our client accounts are at Interactive Brokers Group, Inc. (IBKR). Aside from offering the lowest commissions on Wall Street, IBKR offers the lowest margin interest rates on Wall Street.
We offer customized concentrated stock positions hedging with Portfolio Margin11. For example, an executive can hedge $1,000,000 of a $5,000,000 concentrated position with a costless collar and use most of that $1,000,000 to invest in a portfolio of MLPs which earns 6% per year after management fees. After subtracting the approximately 2% margin interest, the executive can collect approximately $40,000 in additional income from the MLP portfolio and have effectively diversified his concentrated position without triggering a taxable event. Creating a growing tax advantaged stream of income makes sense for most people looking to retire. Combining the low margin rates with the attractive tax advantaged growing income stream makes great sense, to someone who has a disproportionate amount of money in a single stock position.
Rotating Out of Extended stocks:
Sectors shift in and out of favor. Those stocks in an out of favor sector are inexpensive and have less price risk than stocks that are in sectors that are in favor and have high valuations. Rotating out of the most extended stocks and into stocks which have been out of favor and whose fundamentals are improving is a good way to reduce portfolio risk in an expensive market like the current one.
Pharmaceuticals and biotechs are two sectors that have struggled in recent years due to presidential campaign pledges to cut pharmaceutical prices.
The chart below suggests that asset price appreciation will shift from financial assets to commodity assets, a logical consequence of infrastructure spending and the strengthening US and global economy. Industrial, materials, energy and agriculture stocks are logical beneficiaries of a shift to commodities. The improving US energy market is driving a fundamental improvement in energy stocks and a move into MLPs. Not only are MLPs an attractive alternative to bonds for income investors, MLPs are a logical sector to rotate into and out of extended stocks like many Dow Industrial stocks and FAANG stocks.
The circles in the chart12 above show the change in price of commodities versus the S&P 500. When these shifts occur, the change is often pronounced and swift.
MLPs are an out-of-favor sector, with attractive valuations and improving fundamentals. They offer good income, lower interest rate risk than bonds and distribution growth tied to the US energy sector. We believe the rotation is happening and the result is showing up in our investment result.
Our record investing is the sector is excellent. This month, our MLP returns were up 7.10%, and we outperformed both the Alerian and S&P Indexes. Our long term record is attractive versus these indices. With the severe decline in oil from 2014-2016 our performance along with the Alerian Index, dramatically underperformed the S&P 500. The underperformance was so pronounced we have argued that a mean reversion should occur and lead to MLPs and IGA’s MLP SMA performance outperforming. We believe that this reversion has commenced this month and should continue to demonstrate solid outperformance, particularly if the equity and bond markets struggle.
The table below shows IGA’s MLP SMA performance versus Alerian AMZX and S&P 500 SPY total return since 2000. Note the one year underperformance of IGA MLP SMAs of 35.77% and 8.06% outperformance to the S&P 500 since 2000.
IGA MLP SMA performance on a monthly compared with Alerian AMZX and S&P 500. Note solid outperformance of IGA MLP SMAs to S&P 500 in 2001 and 2002 (tech bubble crash) and in 2009 and 2010 (financial crisis). We have noted following major declines, MLPs are negatively correlated to the stock market as investors move to income generating assets like MLPs.
IGAs MLP SMAs in combination with a hedged concentrated stock position offers exceptional value in a potentially risky market environment.
Grantham’s Melt Up Scenario:
Jeremy Grantham co-founder and chief investment strategist of Grantham, Mayo, & van Otterloo (GMO), wrote a provocative piece in January suggesting the market could be subject to a massive melt up. The piece was summarized by Zero Hedge:
“79-year-old Jeremy Grantham has lived through – and successfully traded – a number of the market’s most extreme emotional moments. Infamous for his call in 2000 that stocks would trade lower in price for a decade, his latest letter is a shot across the bow warning of the beginning of the end for one of the longest bull markets in history.
Critically, he says the market’s next move could take stocks higher. Dramatically higher.
“As a historian of the great equity bubbles, I also recognize that we are currently showing signs of entering the blow-off or melt-up phase of this very long bull market,” the chief investment strategist for GMO in Boston which manages $74 billion, wrote in a letter to investors Wednesday.
Despite remarking that the current market is one of the highest-price in history, Grantham cited the recent acceleration of U.S. equity prices, a concentration of leadership in stocks and growing media coverage of events such as bitcoin’s surge and Amazon.com Inc.’s success as signs that the final phase of a bubble could be coming in the next six months to two years.
He warned investors to keep an eye on what is showing on television in restaurants.
“When most have talking heads yammering about Amazon, Tencent and bitcoin and not Patriot replays — just as late 1999 featured the latest in Pets.com — we are probably down to the last few months,” he wrote.
“Good luck. We’ll all need some.”
Grantham begins his letter with a warning: “brace yourself for a possible near-term melt-up“”13 Zero Hedge.
The article is a provocative departure from renowned bear’s often perspicacious cautionary views.
Citing several historic market bubbles, his analysis makes good sense, and is not a scenario we would casually discard; however, when considering the impact of rising rates on the stock market’s dramatic 1987 rise, the current rapid rise in bonds against a long history of low and declining rates may challenge the melt up scenario. In the present condition, the countervailing weight of higher interest rates could be systematically more problematic than in 1987 due to the wonderful innovations of Wall Street. One of the unforeseen consequences of the 2008-2009 market collapse was the degree of hidden risks in the portfolios of sophisticated financial institutions including Lehman Brothers, Bear Stearns and American International Group. If, as rates rise, hidden risks associated with derivatives, leverage, structured products and other innovations emerge, the downside risk could again become serious. It is also troubling to consider the downside of rising interest rates since rising rates could add to and exacerbate the huge federal deficit. Rising rates could lead to a negative feedback loop that results in 6% 10-year US Treasury yields well before 2021. If that unfolds, Grantham’s meltup scenario will be short lived. Could the market continue to go higher? Yes. Strong markets like this generally take a time to top.
Income Growth Advisors, LLC is open for business. As a great fan of Winston Churchill, I feel his sense of foreboding like Churchill when he put down his paintbrush in 1939 and said “it will be a long time until I pick these up again”. Churchill had full understanding of Adolf Hitler and the Nazi agenda, because before his political career, he was a soldier and a war correspondent and had seen decades of brutal wars. While Grantham could be dead on and the S&P 500 could jettison to 3700 and to valuation levels surpassing the 2000 bubble, we should not get drawn into the irrational exuberance. The prudent course of action is to evaluate your downside risks while carefully trying to make money in out of favor stocks and sectors.
Please let us know if you have any questions regarding this letter or your investments.
Tyson Halsey, CFA
- Chart from Portfolio123., quantitative software developed by consultants who worked for two top quantitative investment firms: Citadel and Driehaus.
- Risk Premium is the difference between the earnings yield of the S&P 500 (the p/e inverse) and the 10-year US Treasury yield.
- The earnings are a equal weighting of current earnings and estimated earnings, by Portfolio 123 with S&P data input.
- https://www.bloomberg.com/quicktake/negative-interest-rates March 21, 2016
- Barron’s Jeff Gundlach of DoubleLine Capital Markets November 21, 2016. https://www.barrons.com/articles/gundlach-bond-yields-could-hit-6-in-five-years-1478929496?mg=prod/accounts-barrons
- St. Louis Federal Reserve FRED.
- In the wake of the 2000 stock market bubble, Queen Elizabeth said, if everyone know the market was so overvalued, why didn’t anyone warn us?
- On 1/31/2018, Yahoo news noted that Renaissance Technologies the world’s most profitable hedge fund wrote in their year end letter that the market could be at risk of a significant correction due to many of the points we highlight. We did not plagiarize their thoughts. We have been writing this letter for a week when we read their warning. https://www.bloomberg.com/news/articles/2018-01-30/renaissance-hedge-fund-sees-significant-risk-of-correction
- We are not tax advisors, but the step up in cost basis can reduce an accrued capital gain liability which can be a high as your cost basis.
- Zero Hedge January 3, 2018 https://www.zerohedge.com/news/2018-01-03/jeremy-grantham-warns-brace-yourself-near-term-melt
- Chart from DoubleLine
- Chart from DoubleLine
- Zero Hedge January 3, 2018 https://www.zerohedge.com/news/2018-01-03/jeremy-grantham-warns-brace-yourself-near-term-melt