A dozen developed market nations have issued about $17 trillion in negative-yielding bonds — m...
Treasuries, REITs & Utilities are Expensive for a Reason
09/05/2019 9:30 am EST
While the cost of any asset is always a consideration, it should not be a driver of a trade, says Landon Whaley.
A critical error we see time and time again in the professional analyst field and financial media (i.e. Old Institution) constitutes this week’s headline risk and comes courtesy of a Bloomberg Opinion piece by John Authers — It’s Too Expensive.
Authers references new research by Societe Generale, which shows that bonds and bond proxies (utilities and REITs) are expensive.
There is nothing more the Old Institution loves than a conversation about valuation. Specifically, they tout that high valuations increase risks to an asset class, while low valuations reduce drawdown risks.
While generally true — all things being equal, it is better to buy something on the cheap and sell it at inflated levels — he fails to ask why. Bonds prices are high, they have been on a tear. But why?
To be clear, we aren’t one of the many perma-bullish or perma-bearish research firms; we are perma-agnostic. We allow the data and our Gravitational Framework to tell us which bias to carry for a market, and when to be completely out of a given market.
The problem with the valuation argument is that equity and bond markets don’t correct or experience significant drawdowns because they get “expensive.” People don’t wake up one morning and suddenly decide that 20x earnings is too much to pay for the S&P 500 or that your Grand Pappy’s Treasuries are suddenly rich.
We are not implying that valuation, as a metric, isn’t useful as part of certain investment strategies. For instance, we acknowledge it was much better to get long Treasuries on Aug. 1 than on Sept. 1. What we are saying, however, is that using valuation or concepts of cheap and expensive to determine risk in a given market is like using the Super Bowl to anticipate the stock market’s future direction.
Back in the 1970s, Leonard Koppett figured out that the Super Bowl winner could accurately predict the future direction of the S&P 500. If the AFC won, the S&P would lose ground over the next 12 months. If the NFC (actually an original NFL team) won, the S&P would gain in the following year.
At the time Koppett discovered this supposed “connection,” the Super Bowl had accurately predicted the S&P direction 100% of the time. As of last year, this predictor of S&P returns has been right 40 out of 50 years—an 80% success rate!
Clearly, the Super Bowl has no real connection to the S&P 500, and this is just a coincidence. Similarly, valuation has no real connection to causing directional moves in markets—it can simply act as a downside (or upside) accelerant once the price movement begins for Fundamental Gravity reasons.
The Bottom Line
This op-ed is a reminder of why it’s critical to be data-dependent and process-driven in financial markets. Valuation is not, and should not be, a foundational component of an investment process. If you are bullish a sector, there is probably more opportunity if that sector is relatively under prices vs. overpriced but that should alter your outlook. It may mean that you missed some opportunity. But most market trends extend beyond what can reasonably be expected so you never want to be picking tops and bottoms during large trending moves.
Use the current Fundamental Gravity as the core of your asset allocation decisions and not only will you avoid nasty drawdowns in your portfolio, but more times than not, you’ll be perfectly positioned for the prevailing opportunity set.
The bottom line is I don’t care how rich utilities, REITs and Treasuries become, keep buying the damn dips until the Fundamental Gravity shifts.
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