Altus Insight January, 2016
The Altus Insight
Market news, commentary and relevant topics for today's alternative asset investor
Date: January 31, 2016
FR: Forrest Jinks
My friend: Is there going to be a recession?
My friend: Are you sure?
Me: 100% unequivocally positive.
Me: Who do you think I am, Nostradamus?
I really can tell you with 100% certainty that there is going to be a recession. But if no one on Wall Street or at the Federal Reserve can accurately predict a recession, even with their years of schooling and mountains of data (and the Federal Reserve is worse than pure chance at predicting them despite their years of schooling and legions of data – It’s true. Yes, almost unbelievable, but true), rest assured that my prediction would at best be a guess, although I may well likely be more accurate than the Fed.
But wait, there’s more. I am extremely confident that we are drastically more likely to go into a recession within the next seven years than we are to repeat the last seven years of (tepid) growth.
There is no question the stock market has gotten crushed thus far this year and sans drastic surprises to the upside, is likely to continue to have a rough go for a while. Even with the correction thus far, year to date stock prices are still historically overpriced, especially the so called FANG stocks (Facebook, Amazon, Netflix, and Google). Those four stocks were up 61% in 2015 while the broad based S&P 500 was basically flat. If, however, you take those four stocks out of the S&P 500 index, it would have been down 5%. A 5% decline may not seem that bad after the fruits of a few years of higher than average growth, but think about the impact of those four stocks on the index. Less than 1% of the index increased the performance by 5%. That is HUGE.
This year the stock market and the FANG stocks are down roughly the same percentage but the price to earnings (PE) ratios of those four stocks are out of this world, meaning per dollar of income earned they are priced far, far, far, above the S&P average (PE ratio is the inverse of cap rate). Thankfully, seeitmarket.com already did the calculations for me showing how much the earnings performance of these four companies would have to increase to bring their PE ratios into line with the S&P average. Brace yourself for the answer. 473% (Facebook), 5017% (Amazon), 1752% (Netflix), and 81% (Google). Almost makes Google seem like a steal.
The reason for pointing out these insane valuations and the these companies’ impact on the total S&P 500 performance is to raise the possibility that with any sort of meaningful correction to the valuation of these four stocks (and the handful of other similarly priced 2nd tier high performers) the S&P is likely in for a large, as in much bigger than we have already seen, correction. There could well be a bear market coming.
To be clear, a stock market correction does not cause a recession. There may be some level of correlation between the two but only a low level of direct causation. By some indicators we aren’t yet ready for a recession. For one, payrolls continue to be strong. Additionally, a recession is rarely not preceded by an inversion of the yield curve (where long term debt pays a lower rate of return than short term debt). [Editor’s Note: an inverted yield curve doesn’t always happen due to falling long term rates, it can also occur due to increasing short or midterm rates. This may already be happening with intermediate rates (2, 5, 7 year rates) increasing even while short and long term rates have stayed steady or dropped].
But…we rarely have been in a situation where first the Federal Reserve, and then major central banks across the world participated in such bout of economic manipulation. According to the Fed, our economy is strong enough for them to reverse course and start raising interest rates. In addition to everything else we have previously discussed about interest rates, the Fed is now dealing with an additional situation. The Fed openly touted its accommodative interest rate policy and quantitative easing as a way to increase asset (read stock and bond) prices so that the increase in asset prices would make people feel more wealthy so they would spend more in turn creating a benefit would trickle down through the economy. What happens when the wealth effect created by the accommodative policy is removed resulting in a fall in asset prices? Does that create the opposite of the wealth effect? And if the wealth effect that the Fed bragged about was responsible for the small amount of economic growth we experienced over the last handful of years should it follow that the opposite of the wealth effect would lead to a reduction in economic growth? If real growth is closer to the historical post recessionary average of 3 – 4%, maybe reduced growth is still enough to keep the economy chugging forward, but when real growth is averaging below 2% there isn’t much room for a slow down with forward momentum.
And there are other headwinds. China is obviously a big one. Emerging markets are struggling. Canada, our largest trading partner, is struggling. The dollar is strengthening (hurting imports), oil prices are plummeting, and now interest rates are supposedly going to rise.
Not so fast. Rarely does someone discussing economic possibilities get such rapid feedback as I did after the December Altus Insight discussing the Fed quandary around increasing interest rates. Within three days of the Insight being sent out I came across this article quoting voting Fed members as being concerned with the natural interest rate and that in their estimation the natural interest rate might be lower than their target rate which may hinder their ability for the rate raises to have the affect they were hoping for. DUH! The back pedaling continued here and here and here, often quoting voting Fed governors. It is not lost on the financial markets who have already adjusted pricing to indicate lower likelihood and severity of rate hikes than the Fed claimed, and the market reacted to, less than two months ago.
As previously mentioned, one of the headwinds to increasing rates is the strength of the US dollar. One drag on economic growth is the freefall in oil prices. Articles in the financial media continually point to oversupply of oil as the reason for the drop in prices and that is certainly a factor, but the strong dollar is unarguably also having a large impact. Oil prices have historically been priced in dollars and since a barrel of oil provides the same utility regardless of the price of that barrel, a stronger US dollar would push oil prices down while a weaker dollar would result in prices running to the upside. The Saudi Riyal is pegged to the USD so the effect of the stronger dollar can’t be seen in the Saudi/US exchange rate, only in the Saudi foreign reserves as they struggle to protect their currency value. Other oil producers aren’t so lucky with many of their currencies falling over 30% against the dollar over the last couple years. The Russian Ruble has fallen close to 60% and the Brazilian Real approximately 50% in the last 18 months alone. At $100/barrel, the price roughly 18 months ago, a 30% strengthening of the dollar would result in a barrel price of roughly $70, not an insignificant portion of the overall drop in prices. Watch the dollar strength, maybe even more so than the supply, for an indication that the price of oil may change directions.
If you remember back to when oil prices first started falling most analysts were predicting the lower oil prices would lead to increased economic growth. Why were they wrong (and more rhetorically, why are they now braying about how bad low oil prices are on the economy?)? The reality lies in where the money spent on oil was ending up. In 1990 the US imported ~55% of the 6.2 billion barrels it used. At that time if the price of oil was to drop from $100/barrel to $50/barrel the export countries would see a reduction of $170.5 Billion of revenue. Conversely, the US economy saw a corresponding benefit of $170.5 Billion of savings that could then be spent on other items or used for investment. This was partially offset by US producers taking a hit of $140 B, an overall $30.5 Billion benefit for the economy. For perspective, that equates to a .55% bump to the US GDP, before taking into account any benefits of the multiplier effect. Using the same 1990 usage as the baseline, based on today’s oil imports and using the same math as above, a fall from $100/barrel to $50/barrel creates a burden of $180 Billion on the US economy. This equates to roughly a 1% hit on the US economy. But really even that understates it, again due to the multiplier effect and because prices have fallen more than $50/barrel.
As long as oil producers are still operating in the black, it is only their profit that is reduced. All the costs of production and back office are still being covered. This means people are still being paid and auxiliary companies are still in operation (and paying their own employees). Once companies start operating in the red investment stops, or at least is severely curtailed, and people start losing their jobs. Lost jobs, especially the relatively high paying jobs in the oil industry, leads to a reverse multiplier effect and a large drag on the economy. The issue with the price of oil isn’t going away any time soon and I think we can safely expect it to have an increasingly negative effect on economic growth and the financial markets for the foreseeable future.
So now that we have gone through a long winding review of some of the issues facing the markets and the economies, maybe I am expecting economic turbulence in the relatively short term (9 – 18 months), and if not outright recession at least very slow growth.
I have been through two recessions in my professional life (and started in the midst of the prior real estate downturn). The first one (2001) did not affect me or my investments at all. Despite seeing it (meaning a real estate correction) coming, along with most people on the real estate “street” the second one (2007/2008) definitely did affect me. As I have shared in the past, we completely changed our investment strategy in anticipation of a drop in residential prices. Unfortunately we did not anticipate a 50% drop in prices nor the corollary effects that the ensuing Great Recession would have on other real estate prices.
Seeing the correction/recession coming wasn’t enough. Even doing something about it wasn’t enough. Knowledge is only as valuable as its application and in that case our proactive moves to counter the correction was a misapplication of knowledge. If we are indeed going into a financial markets bear market and a recession, where does knowing the likelihood of their occurrence put us? In one sense, 2008 was the first and only time that real estate prices have fallen country wide and often even during a financial downturn real estate prices aren’t largely impacted. The liquidity of market may decrease, but the overall effect is muted. I certainly don’t want to assume this will be the case this go around, but the possibility certainly has to be acknowledged. Additionally, even in 2008 the correct investment structure allowed people to skate through the downturn relatively unscathed. Sure, maybe their balance sheet wasn’t as robust as it had been previously but by comparison they were stronger than the rest of the investing world.
As has been previously discussed, we prefer income producing bread and butter properties with multiple tenants. The debt load isn’t nearly important to us as the debt coverage. Cash flow can cover a plethora of investing sins.
One thing I am sure of is that corrections in investment markets and downturns in the economy leads to opportunity. Recessions expose misallocated investment and in so being exposed provide opportunity for the next investor bold enough to take advantage of the opportunity when most of the investing world is hiding in fear. To be bold is difficult, but, and this is especially true in alternative assets, the bold can obtain incredible investment value. We are early in this cycle and already opportunity is starting to present itself. Next month I will discuss some possible areas of opportunity and some particular markets we are keeping an eye on.