August 11, 2014
Low and Expanding Risk Premiums are the Root of Abrupt Market Losses
Through the recurrent bubbles and collapses of recent decades, I’ve often discussed what I call the Iron Law of Finance: Every long-term security is nothing more than a claim on some expected future stream of cash that will be delivered into the hands of investors over time. For a given stream of expected future cash payments, the higher the price investors pay today for that stream of cash, the lower the long-term return they will achieve on their investment over time.
The past several years of quantitative easing and zero interest rate policy have not bent that Iron Law at all. As prices have advanced, prospective future returns have declined, and the “risk premiums” priced into risky securities have become compressed. Based on the valuation measures most strongly correlated with actual subsequent total returns (and those correlations are near or above 90%), we continue to estimate that the S&P 500 will achieve zero or negative nominal total returns over horizons of 8 years or less, and only about 2% annually over the coming decade. See Ockham’s Razor and The Market Cycle to review some of these measures and the associated arithmetic.
What quantitative easing has done is to exploit the discomfort that investors have with earning nothing on safe investments, making them feel forced to extend their risk profile in search of positive expected returns. The problem is that there is little arithmetic involved in that decision. For example, if a “normal” level of short-term interest rates is 4% and investors expect 3-4 more years of zero interest rate policy, it’s reasonable for stock prices to be valued today at levels that are about 12-16% above historically normal valuations (3-4 years x 4%). The higher prices would in turn be associated with equity returns also being about 4% lower than “normal” over that 3-4 year period. This would be a justified response. One can demonstrate the arithmetic quite simply using any discounted cash flow approach, and it holds for stocks, bonds, and other long-term securities. [Geek's Note: The Dornbusch exchange rate model reflects the same considerations].
However, if investors are so uncomfortable with zero interest rates on safe investments that they drive security prices far higher than 12-16% above historical valuation norms (and at present, stocks are more than double those norms on the most reliable measures), they’re doing something beyond what’s justified by interest rates. Instead, what happens is that the risk premium – the compensation for bearing uncertainty, volatility, and risk of extreme loss – also becomes compressed. We can quantify the impact that zero interest rates should have on stock valuations, and it would take decades of zero interest rate policy to justify current stock valuations on the basis of low interest rates. What we’re seeing here – make no mistake about it – is not a rational, justified, quantifiable response to lower interest rates, but rather a historic compression of risk premiums across every risky asset class, particularly equities, leveraged loans, and junk bonds.
My impression is that today’s near-absence of risk premiums is both unintentional and poorly appreciated. That is, investors have pushed up prices, but they still expect future returns on risky assets to be positive. Indeed, because all of this yield seeking has driven a persistent uptrend in speculative assets in recent years, investors seem to believe that “QE just makes prices go up” in a way that ensures a permanent future of diagonally escalating prices. Meanwhile, though QE has fostered an enormous speculative misallocation of capital, a recent Fed survey finds that the majority of Americans feel no better off compared with 5 years ago.
We increasingly see carry being confused with expected return. Carry is the difference between the annual yield of a security and money market interest rates. For example, in a world where short-term interest rates are zero, Wall Street acts as if a 2% dividend yield on equities, or a 5% junk bond yield is enough to make these securities appropriate even for investors with short horizons, not factoring in any compensation for risk or likely capital losses. This is the same thinking that contributed to the housing bubble and subsequent collapse. Banks, hedge funds, and other financial players borrowed massively to accumulate subprime mortgage-backed securities, attempting to “leverage the spread” between the higher yielding and increasingly risky mortgage debt and the lower yield that they paid to depositors and other funding sources.
We shudder at how much risk is being delivered – knowingly or not – to investors who plan to retire even a year from now. Barron’s published an article on target-term funds last month with this gem (italics mine): “JPMorgan's 2015 target-term fund has a 42% equity allocation, below that of its peers. Its fund holds emerging-market equity and debt, junk bonds, and commodities.”
On the subject of junk debt, in the first two quarters of 2014, European high yield bond issuance outstripped U.S. issuance for the first time in history, with 77% of the total represented by Greece, Ireland, Italy, Portugal, and Spain. This issuance has been enabled by the “reach for yield” provoked by zero interest rate policy. The discomfort of investors with zero interest rates allows weak borrowers – in the words of the Financial Times – “to harness strong investor demand.” The chart below shows the volume of proceeds and number of new issues of global high yield debt in recent quarters (source: Thomson Reuters). Meanwhile, Bloomberg reports that pension funds, squeezed for sources of safe return, have been abandoning their investment grade policies to invest in higher yielding junk bonds. Rather than thinking in terms of valuation and risk, they are focused on the carry they hope to earn because the default environment seems "benign" at the moment. This is just the housing bubble replicated in a different class of securities. It will end badly.
Raghuram Rajan, the governor of the Reserve Bank of India and among the few economists who foresaw the last financial crisis, warned last week that "some of our macroeconomists are not recognizing the overall build-up of risks. We are taking a greater chance of having another crash at a time when the world is less capable of bearing the cost. Investors say 'we will stay with the trade because central banks are willing to provide easy money and I can see that easy money continuing into the foreseeable future.' It's the same old story. They add 'I will get out before everyone else gets out.' They put the trades on even though they know what will happen as everyone attempts to exit positions at the same time."
While we’re already observing cracks in market internals in the form of breakdowns in small cap stocks, high yield bond prices, market breadth, and other areas, it’s not clear yet whether the risk preferences of investors have shifted durably. As we saw in multiple early selloffs and recoveries near the 2007, 2000, and 1929 bull market peaks (the only peaks that rival the present one), the “buy the dip” mentality can introduce periodic recovery attempts even in markets that are quite precarious from a full cycle perspective. Still, it's helpful to be aware of how compressed risk premiums unwind. They rarely do so in one fell swoop, but they also rarely do so gradually and diagonally. Compressed risk premiums normalize in spikes.
As a market cycle completes and a bull market gives way to a bear market, you’ll notice an increasing tendency for negative day-to-day news stories to be associated with market “reactions” that seem completely out of proportion. The key to understanding these reactions, as I observed at the 2007 peak, is to recognize that abrupt market weakness is generally the result of low risk premiums being pressed higher. Low and expanding risk premiums are at the root of nearly every abrupt market loss. Day-to-day news stories are merely opportunities for depressed risk premiums to shift up toward more normal levels, but the normalization itself is inevitable, and the spike in risk premiums (decline in prices) need not be proportional or “justifiable” by the news at all. Remember this because when investors see the market plunging on news items that seem like “nothing,” they’re often tempted to buy into what clearly seems to be an overreaction. We saw this throughout the 2000-2002 plunge as well as the 2007-2009 plunge.
As I’ve frequently observed, the strongest expected market return/risk profile is associated with a material retreat in valuations that is then joined by an early improvement across a wide range of market internals. These opportunities occur in every market cycle, and we have no doubt that we will observe them over the completion of the present cycle and in those that follow. In contrast, when risk premiums are historically compressed and showing early signs of normalizing even moderately, a great deal of downside damage is likely to follow. Some of it will be on virtually no news at all, because that normalization is baked in the cake, and is independent of interest rates. All that’s required is for investors to begin to remember that risky securities actually involve risk. In that environment, selling begets selling.
Remember: this outcome is baked in the cake because prices are already elevated and risk premiums are already compressed. Every episode of compressed risk premiums in history has been followed by a series of spikes that restore them to normal levels. It may be possible for monetary policy to drag the process out by helping to punctuate the selloffs with renewed speculation, but there’s no way to defer this process permanently. Nor would the effort be constructive, because the only thing that compressed risk premiums do is to misallocate scarce savings to unproductive uses, allowing weak borrowers to harness strong demand. We don’t believe that risk has been permanently removed from risky assets. The belief that it has is itself the greatest risk that investors face here.
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