At almost every market juncture it seems a seismic shift occurs. This decade long bull market has been defined by the outperformance of growth stocks1 and passive strategies.2 We think the cracks are beginning to show as the market shifts, marked by the cry of sick and dying unicorns. The recent poster child for this has been WeWork, though it could equally apply to many other companies.
The unicorn phenomenon has been one to watch in awe. These companies, which typically burn through huge sums of cash in an attempt to scale into something cool, and maybe even profitable, have earned the nickname of unicorn. Once these companies attempt to cash out via Initial Public Offerings (IPOs), they are finding a shift in sentiment. In our opinion, if there was one easily identifiable bubble in the equity world, it was not in the public markets, but rather in these overvalued rare and elusive investment opportunities losing hordes of money and requiring perpetual funding.
One could just imagine the valuation a banker would place on the value of multiple years of 9-digit losses if it were on our own personal balance sheet. The market has now seemed to wake up to the fact that no matter how cool the concept is, the purpose of a business is in fact to earn a profit for their shareholders, not transfer wealth away from them.
It appears that the market has started to acknowledge the fact that we invest to make profits, not scale losses. We are frankly glad to see this, as we believe valuations have become as distorted as the late 1990’s when value stocks had underperformed for so long that they were given up for dead.3 We think this may finally revert to long-term normalcy, or in investment parlance “reversion to the mean”.
Currently, we believe the biggest distortion in the market is the preponderance of negative interest rates globally. There is now over $14 Trillion in negative yielding debt worldwide, primarily in the sovereign debt of Japan and Europe, though it does include corporate debt.4 Though we are envious of the ability of a corporation to pay back less than they borrow, the circumstances that create this scenario are not economically favorable long-term. However, we can take advantage of the situation by owning some of these entities via stock exposure in Japan and Europe.
In financial calculations if you use a negative discount rate the value of a dividend paying and growing entity, like a common stock, would be infinity. Not that we believe that number would become accurate, but rather that this phenomenon strengthens our belief that equities are likely a very attractive hedge against negative interest rates.
It seems that everyone now “knows” that we are going to have a recession. That supposed knowledge will either become self-fulfilling or the occasional highly discounted event that never materializes. On Wall Street, typically things that are consensus never seem to come to fruition, or be profitable, as that “knowledge” is generally already reflected in security prices.
We do know that the economy is decelerating and that the yield curve has inverted for a meaningful amount of time, both typical precursors to a recession.5 But we also know that this has been the most tepid recovery on record, even though it has been the longest.6 We believe a short shallow recession is likely and would actually be a good thing. We would prefer to get it over with and start a new expansion clock, though that may require finishing an election cycle and concluding a trade war between the two largest global economies. Regardless, recessions are a normal and regular economic reality and not to be feared. Additionally, market bottoms are typically set before the recession is even recognized. We have often wondered if that was the message of last December’s sell-off?
The seasonal patterns of the 4th Quarter are among the best of the year, though not in 2018. At this point, when evaluating asset allocation, we find ourselves “pounding the table on neutral”. We are comfortable holding a bit of cash or short-term bonds for redeployment if we get volatility, but we would be very hesitant to step away from the equity market, as we see true value in the companies we own at current price levels.
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1. www.strategasrp.com – Undervaluation of Value Stocks is a Global Phenomenon
6. www.strategasrp.com – Strength of Economic Expansions