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Management team

Is it time to stop dancing?

September 2017

I run an internal blog for the Sentry sales team. The following is one of my posts from a week or so ago:

Must be late cycle; Bitcoin, hot emerging markets inflows ($1.8 billion into EM ETFs last week), 100-year Argentina bonds now this from Grant’s Interest Rate Observer:

“One example of the current zeitgeist: last week, the Republic of Tajikistan priced its first-ever sale of U.S. dollar bonds, placing $500 million in 10-year debt at 7.125%, compared to early-yield indications at or above 8% thanks to blistering demand (the issue was more than six times oversubscribed). Reporters at Bloomberg had a look at the prospectus, noting that:

The document, which begins with a map to help investors locate the country, devotes 10 pages to laying out the risks involved in investing in Tajikistan. These include lack of democracy and potential for social unrest, a banking crisis and economic reliance on Russia. It also notes that ‘one of the highest-volume illegal drug trafficking routes in the world’ runs through the country.”

It prompted a question from Jamie Wile, one of our District Vice-Presidents on the sales team:

Sandy, for the cycle to end, we typically need a recession. Do you think the yield curve is at risk?

This was my reply:

The former CEO of CITI, Chuck Prince, said: “As long as the music is playing, you’ve got to get up and dance. We’re still dancing.” Late cycle can last a long time. Equities can still go up despite a flat yield curve. In late-cycle phases, you get behaviours like Bitcoin: concepts win while value-orientated investors tend to lag. Could this structured product fly early cycle when investors are risk averse?

In further answer to Jamie’s question, consider the slope of the yield curve with market peaks and recessions. We know the Fed is trying to normalize rates to get wiggle room for the next downturn. In normalizing, the yield curve has flattened to where it was a year ago in the middle of an earnings recession. It has a long way to go before it flattens completely. None of the past 10 recessions occurred with a positively sloping yield curve. Not to say that it can’t happen, but recessions come from central-bank-induced credit contraction. That is not currently happening, nor is it desired.

You can get more than one interim peak in a cycle. This cycle I am showing a peak in April 2011 prior to a 19.4% decline for the S&P 500 Index (SPX). Over the same time frame, the S&P 500 Equal Weight Index (SPW) was down 23% and the Russell 2000 (RTY) was down 29.6%. For the average investor, this was a bear market. I also show a market peak in May 2015. It was a 14.2% drawdown for the SPX. The SPW was down 18% and the Russell 2000 was down 26.4%. Once again, for the average investor, this was a bear market. We are not in ‘year eight’ of an uninterrupted uptrend. We are in ‘year two’ of this market leg.

In my opinion, the 2011 baby bear market was the last gasp of the credit crisis and the last bear in the 2000 to 2011 secular bear market. The old highs from 2000 and 2007 were not eclipsed until Q1 2013. During the second half of 2011, European banks with operations in New York experienced a liquidity crisis that led to the climax of the European sovereign debt crisis in 2012. How soon we forget. Now we are financing Tajikistan at yields that Italy reached six years ago.  

Earnings bode well for the dance

In my view, we are in the early years of a secular bull market with the broad market following the long-term slope of 7%. The driver of that slope is earnings.

When you look at the driving force behind stock markets (i.e., corporate earnings), Q4 2011 experienced a minor downtick of 2.9% – the first decline since 2009. The 2015/2016 downturn was due to an earnings recession that brought with it a minor bear market. SPX reported earnings peaked at $29.262 for Q3 2014 and declined to $24.729 in Q1 2016 (Source: Bloomberg L.P.). This was an earnings decline of 15.5%. The market declined 15.2% because it had no fuel. Earnings are now recovering and – if you believe in estimates – are looking to accelerate. Annualize the Q4 2017 estimate of $35 and you get earnings of $140 and a PE of 17.9 ($2,500 / $140). Not cheap but, in my opinion, clearly not in bubble territory.

Not only are earnings in the U.S. recovering but, according to Barclay’s, the most synchronized global expansion in years is taking place.

Some market players are still dancing

As the last credit cycle was maturing, CITI and Prince decreased credit quality and increased leverage to maximize current period returns. Their asset of choice was mortgage-backed securities. NINJA (No Income, No Job, no Assets) mortgages had about as good a credit quality as financing Argentina for 100 years and giving credit to Tajikistan. According to the Wall Street Journal, “Argentina has defaulted on its external debt seven times and on its domestic debt five times since independence almost 200 years ago, putting it somewhere in the middle of the historical ranks of the world’s serial defaulters.” Tajikistan has no credit history. (Source:

Argentina currently has a credit rating of B (stable) from Standard & Poor’s. Tajikistan: B-. These are not quality credits. But you can get a greater than 7% coupon on the bonds. If prime brokerage lenders will let you leverage your position, you can generate double-digit returns. Game on! This is a late-cycle behaviour to extend credit to weak borrowers and add leverage to the mix. Prince may be retired but there are market players who are “still dancing.”

How long does it last? No one knows. What I do know is that compounding at 2% doubles your money over 36 years. Compounding at 4% takes 18 years to double while at 6%, it takes 12 years. Over multiple decades since 1954, the S&P 500 has grown earnings at more than a 6% clip and we are below trend with earnings growth returning. In 2016, reported earnings touched the five-year average; that is typically a symptom of a cyclical trough in earnings.

I do know that the slope of the earnings chart is replicated by the slope of the S&P 500 chart going back to the early 1930s. Equities, as an asset class, deliver earnings to the owners of a business through dividends, share buybacks and growth. The asset class serves as an effective inflation hedge and compounding vehicle if you manage your risk exposure correctly. Overpaying for these characteristics (as in 2000) is a risk and recognizing extreme value (as in 2009) is an opportunity.

With all the talk of a potential tightening in December, it is worth passing on some results from past tightening cycles. The first thing to keep in mind about equity prices is they follow equity earnings.

In the aftermath of the 1990 recession, earnings stagnated into 1994. Reporting standards were greatly different then. Impaired assets would remain on the books for a much longer time, which resulted in write-offs that occurred well after the recession. Earnings began to accelerate in 1995 and the market took off: it had fuel. When did the tightening cycle begin? Early 1994.

The market began to roll over in 2000 before earnings rolled over during the brief 2001 recession. The recovery of earnings growth in 2003 led to a sustained bull market. This time, the slope of the market was lower than the slope of earnings. The earnings grew faster than the market leading to benign market multiple behaviour. When did the tightening cycle begin? Mid 2004.

The market recovery from deeply oversold conditions in 2009 was in advance of the earnings recovery. The rapid growth in earnings in the first few years of this cycle was not “bought into” by market participants leading to the market being really cheap into 2013. The subsequent slope of the market was steeper than the slope of earnings and more recently has accelerated, leading to multiple expansion.

The earnings recovery from the 2015/16 earnings recession has the same slope as the market, keeping multiples within reason.

So how does the stock market respond to Federal Reserve tightening cycles? The market ignores them until the earnings show signs of turning. The best signal to “get out of Dodge” is when the Fed starts easing. I believe we are a long way from that point.

For a very long time, the underlying thesis to our investment management approach has been fundamental business analysis. We want an adequate return on our invested capital while minimizing the risk to that invested capital. It involves balance-sheet analysis; financial leverage magnifies operating leverage. We are prepared to pay a reasonable price for achievable growth targets; we do not invest in drill holes and dreams. The goal? To preserve and grow the savings of our clients in a rational manner. In a slow-growth world, it is hard to replace lost capital. So don’t expose it to excessive risk. Is financing Argentina and Tajikistan risky? We’ll see.

From a cyclical point of view, the U.S. is in an established tightening cycle, Canada has tightened twice, the U.K. is making noises re: starting a tightening cycle and the E.U. is trying to find a way to taper its asset purchases. All are indicative of a re-pricing of credit. So far there is no indication that re-pricing is affecting U.S. loan growth – consumer loans declined in 2015 but have returned to a roughly 6% annual growth rate – or lending standards (moderate issues in sub-prime auto, prime borrowers unaffected). Each of the major economic blocks continues to favour economic growth and income growth. In my opinion, each of the major blocks is trying to reach target inflation rates that remain stubbornly unachieved.

Remember income growth drives growth in tax revenues which fund their spending ambitions. They are trying to get away from abnormal interest-rate policies and back to “neutral rates” that make sense for their economies. Think long cycle. The cure for economic stagnation is loose rather than tight monetary conditions. Think long cycle.

Pick your dance partner wisely

I am still in “buy the dips” mode. It’s not yet time to put the defensive specialists on the ice but it is the time when you might want to take some of your floaters (i.e., offence-only players) off the ice and make sure the players you are using are strong two-way players (i.e., can play offence and defence). You want to participate in the economic returns going forward but not to such a degree that you place yourself at risk of catastrophic loss if the economy stumbles. “Outperforming” over the long term may require “underperforming” when the dancing gets a bit heated. That leads into a diatribe on the meaning of “performance.” But I’ll leave that for another day.


The opinions expressed in this piece are solely the author’s and are not to be used or construed as investment advice or as an endorsement or recommendation of any entity or security discussed.

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