Here's What Keeps Me Up at Night
October 21, 2019
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Capital markets are discounting mechanisms of all available information. Asset prices trade based on the push and pull between investors with varying viewpoints about the underlying assets, future cash flows. In simple terms, the market is an aggregated view of investor expectations of future cash flows, and, consequently, risk. It's a signaling engine.
So let's look at a simple example. In July 2007, the structured credit market began to signal cash flow risk as prices started to discount significant default probabilities. Later in the year, and throughout 2008, the broader credit market was similarly discounting cash flow stress and ultimately bankruptcy. Yet over this time, equity investors ignored a significant signal from the bond market until after the collapse of Lehman Brothers in 2008. Is it possible we've witnessed a reverse over the last few years? Is it possible the bond market has missed the deflationary signal that the equity market has been sending? Let's explore.
The out performance of growth stocks over value stocks has been endlessly rehashed in recent years. Growth investors explain the out performance based on the superior future earnings power of technology firms; and, conversely, value investors explain it in a way as trend following, like in the case of the technology bubble of the late 1990's, and they expect mean reversion with value stocks eventually reasserting leadership. However, I'd like to offer a different perspective. Is it possible that growth stocks' unprecedented out performance over value for much of the last decade, has been signaling lower, if not zero, interest rates world wide? Perhaps bond investors, just like equity investors ahead of the global financial crisis, ignored the signal at their peril.
So let's go back to financial textbooks. In simple terms, the value of a company is a total value of property, plant, equipment, and the like, plus discounted cash flows. Using fixed income parlance, equities are very long duration assets. More specifically, growth companies are the longest duration equity asset because they generally reinvest cash flow back into the business rather than return it to shareholders over time. Whereas mature, cyclically-oriented value companies return capital more consistently to shareholders through dividends or buy-backs. So as a result, growth stocks have more duration than value stocks.
Despite unprecedented stimulus, inflation remains benign, perplexing central bankers and the bond market. Perhaps fixed income investors should stop looking at the symptom, which is low inflation, and consider what's happening across industries. If they did, they may see how technology has increased the supply of goods available for sale, it's created price transparency, and improved product quality awareness. All these factors have combined to spark price wars across sectors all over the world fueling disinflation. Which is why, in my opinion, interest rates may yet have further to fall.
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The views expressed are those of the speaker and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation to purchase any security or as a solicitation or investment advice from the Advisor.
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