In human terms, risk involves exposure to some danger and the possibility of loss or injury. In finance and investing, risk is often viewed as the chance of an investment's actual return negatively differing from an expected outcome, including potential loss of some or all of an investment.
For many, this risk is assessed by considering historical performance and recent outcomes. This generally leads to poor investment results as many investors become complacent near tops and tend to run for the exits near bottoms. They buy high and sell low. Attempting to help investors, Warren Buffet has stated that one should be "Fearful when others are greedy and greedy when others are fearful." While this works in theory, there is no bell ringing to signal the tops or bottoms of markets. Fortunately, investing does not have to be binary. It is possible and prudent to view risk as a continuum and to allocate portfolios and invest accordingly, given your own assessment of the relative risk/return tradeoffs available in the market.
Last quarter we stated that "As always, there are clouds on the horizon; including potential trade issues with China, further military escalation with Iran, slowing economic growth domestically and abroad, and the beginning of a 15-month presidential election cycle." In the past three months, each of these clouds darkened. The President has proposed additional tariffs on China to take effect during the fourth quarter. Iran appears to have taken military action against our middle eastern ally Saudi Arabia. Industrial production continues to decline both domestically and abroad. Finally, presidential impeachment is being actively contemplated. The only significant offset to these growing risks is strong domestic employment, which combined with increased wages, has led to a very healthy consumer.
Seeing the approaching storm clouds, it would be easy to run for the hills. However, given our incremental approach, we believe the more practical course of action is to ensure that our clients are allocated correctly and that portfolio risk is moderated. What does this mean? To us, it means being willing to forgo full participation in the final stages of an equity bull market in order to preserve equity capital for when there is "blood in the streets." This is accomplished by holding more cash and by owning a portfolio of stocks with lower valuations and higher dividend yields than the market as a whole. Historically, this is a strategy that has served our clients well. While we are not attempting to call a top in the market, another piece of wisdom from Mr. Buffett comes to mind, "What the wise do in the beginning, fools do in the end."
This quote is also applicable to today's fixed income markets. Coming out of the recession in 2009, long dated government bonds around the world offered positive rates of interest. Even thirty-year Japanese bonds yielded 2.20%. The world still seemed risky, and thus investors demanded not merely a return of their capital but a return on their capital. Through the magic of quantitative easing and price insensitive buyers, the "risk-free" rate has been driven into the ground. There is now more than $15 trillion of government bonds that have a negative interest rate attached to them. This secular bull market in bonds is now approaching forty years!! To protect client capital in this environment, it is important to reduce the maturity length of portfolios and avoid credit risk. In both cases, the market does not compensate investors for taking additional risk. The spread between yields on junk bonds and US Treasury securities has narrowed from 800 basis points in 2010 to only 400 basis points today and the thirty-year Treasury bond now yields only 30 basis points more than the one month T-bill!! To mitigate these risks, we own more short term investment-grade corporate bonds, which should provide the opportunity to reinvest at higher rates when they become available.
Though we will not be able to call an exact top in the market, nor are we trying to, we can continually observe the market for signs of frothy activity. Recently, more and more examples of frothy activity are catching our attention.
An egregious example of fixed income mania is occurring in long-dated sovereign bonds. For example, Austria issued a 100-year bond in 2017 with a 2.10% coupon. It would seem lending money to any government for that long would be risky. However, in the past two years, yields have fallen on that bond to 0.70%, meaning the price of the bond has gone from $100 to $197!! Nevermind that the inflation rate in Austria is 1.5%, indicating an "owner" of this bond is losing 0.80% in purchasing power each year, they are making it up in price! As a reminder, yields can move higher and just might at some point over the next 98 years. If they merely moved back to 2%, this bond would fall 50% in price. This appetite for bonds is the result of continued price insensitive purchases of bonds by central banks around the world. It is particularly acute in Europe where the central bank has resumed purchases, and investors are hurrying to buy bonds in the hopes of selling them to the central bank at a higher price. In the global financial world that we live in, our bond market is not immune to the effects of this behavior. The resultant persistently low yields are one of the reasons why we believe our fixed income market has gotten considerably riskier.
In the equity markets, the mania has recently reversed, at least in the IPO market. Recent IPO quality has deteriorated and it appears as though investors may finally have said enough with the attempt to bring WeWork public. WeWork essentially is an office space rental company. They take out long term leases on buildings and then rent out space to other companies. This business model has been around for some time; however, WeWork had a captivating founder and a captivated investor in Softbank via their "VisionFund." Softbank initially invested in WeWork in August of 2017. That year, WeWork had $886 million in revenue and lost $993 million. Softbank invested $4.4 billion in the firm valuing it at $21 billion. In 2018, WeWork had revenue of $1.82 billion and managed to lose only $1.92 billion. That was good enough for Softbank. Over the last 18 months they invested an additional $6 billion into the firm ultimately valuing it at $47 billion. If that sounds crazy, it gets better. The company recently attempted to come public. Unfortunately for WeWork and Softbank, to come public you have to file an initial registration statement called an S1 detailing your business model and how you plan to use the capital you are attempting to raise. This document contained over thirty pages of risk disclosures, including potential self-dealing between founder and company, unusual accounting measures, and the promise to "change the world." The initial pricing for the IPO suggested a valuation in excess of $60 billion. As investors started to digest the filing, demand at that price disappeared. The pricing continued to fall. Even at $20 billion, there were no buyers causing the IPO to be shelved. What was once the next sure thing suddenly was being talked about as a potential bankruptcy due to their $40 billion in lease obligations and the short term nature of their rental agreements. It is said that you do not find out who is swimming naked until the tide goes out. In this corner of the market, it appears as though the tide is receding.
In July of 2007, Chuck Prince, then the CEO of Citigroup, infamously said, “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you've got to get up and dance. We're still dancing." In his case, the music continued playing for another year, but the volume was being turned down. Before it was all said and done, Citigroup had lost more than 95% of its equity value. While we like a good party, you will not find us on the dance floor after midnight. We will be sitting at a table, drinking water, and watching in wonderment.