What’s the fuss with macro?
I am certainly not an advocate of market timing and I agree with the notion that trying to profit from timing market peaks and bottoms is a fool’s errand. As Buffett says Macro is important but unknowable so focus on the knowable i.e. focus on company fundamentals for the businesses you own.
However, that said, adding a macro overlay to your investing playbook is something completely different and something that I am certainly guilty of. What exactly do I mean by having a macro overlay to my strategy?
Ignore At Your Own Peril
Now while some of the factors listed below may not have a meaningful impact on the underlying business prospects of your portfolio holdings especially in the short term, collectively macro factors including those mentioned below will undoubtedly impact corporate earnings, asset prices, and market multiples, especially in the longer term.
So while you can never exactly time a crash or a trough in the markets, one can certainly prepare by asking oneself the following questions:
- What is the growth outlook for the economy (US, China, OECD, Emerging Markets, Global)?
- Where in the cycle is the underlying economy? Contrary to popular belief economies don’t run in a linear way. The sine-wave pattern is what one needs to keep in mind.
- Where are we in the credit cycle (both short term and long term)?
- What is the outlook for inflation since this is one of the primary determinants of monetary policy?
- Are interest rates likely headed higher or lower, based on the outlook for things like the economy, job growth, and inflation?
- Is the central bank likely to tighten liquidity or create it by unconventional means like the Fed’s series of QE programs following the Great Financial Crisis of 2008?
The above is by no means an exhaustive list but you get the picture.
My Portfolio Management Strategy
Inspired by Warren Buffett’s teachings I my stock selection criteria revolves around discovering world-class businesses that by virtue of their superior business model, brand excellence and capable management, possess a demonstrable and durable competitive position allowing them to compound earnings and cash flow per share at an extraordinary rate today and far into the future – also commonly known as compounders.
The final and perhaps the most important piece of the puzzle is, of course, price. Companies that fulfill the above criteria are a rare breed and are unsurprisingly seldom priced cheap. One has to be ready to take advantage of those rare occasions when Mr. Market gives us the opportunity to snap up shares in such companies at an attractive valuation.
Please bear in mind that these magical companies are not easy to find, nor cheap to buy, and the strategy requires a predisposition on behalf of the investor to seek long-term alpha as opposed to short-term speculative returns. As Buffett says: “Time is the friend of the wonderful company, the enemy of the mediocre”. You can read some of my earlier articles which articulate at length the specific criteria I use for stock selection.
Price, price, price
That said, even a world-class company can prove to be losing investment if one pays too expensive a price for it. As a classic example, please see the chart below for Coca Cola (KO) between 2000 when the stock traded at $32 at an EV to FCF multiple of 60x, and by early 2006, the stock was at $20 and traded at less than 18x on an EV to FCF basis – a loss of ~40%. This is for a world-class company such as KO. This exemplifies why value investors including myself don’t like paying high multiples.
Another equally important aspect of portfolio management is to have an objective decision-making process with regards to selling a position when it becomes too expensive. So allow me to share with you two examples of stocks that I have very recently decided to sell, not because the prospects of the underlying business have changed or deteriorated but because they have simply become too expensive or in other words trade at a premium to my estimate of their intrinsic value. Remember that my macro overlay helps me in that decision since equity valuations are generally high and macro risk remains elevated as I explain below. But, for now, back to the sell-decision examples:
Mastercard
First up, MA one of my all-time favorite businesses and one that I have written about on Seeking Alpha here. This is a stock that I bought for $50 at an EV to FCF multiple of ~18x back in 2013. As you can see, it currently trades at $220 which is 4.4x my cost price, but the multiple has exploded from sub-20x to almost 40x EV/FCF.
Verisign
Another example is VRSN, also a world-class business and a prized stock that I proudly held for a long time. Similar story to MA. I bought back in early 2013 for ~$40 at an unbelievably cheap valuation of under 10x EV to FCF. Fast forward to today, it trades at an all-time high of $175 (4.4x my cost price), but the valuation has sky-rocketed from less than 10x to 33x EV to FCF. Again, I sold a week or so ago for the same reasons I mentioned above for MA.
My Mantra
Remember time, not timing, is the key to successful long-term investing! The above two charts more than exemplify that absolute priceless bit of advice from Buffett himself.
So, what exactly is a macro overlay?
In other words, what am I proposing? It is that, in my opinion, not to incorporate macro factors into the matrix of how one positions the portfolio is risky at best and reckless at worst. By positioning I mean things like asset allocation (fixed income, equities, real estate, commodities, and chaos hedges like precious metals etc.), taking profits or adding to/new positions, increasing or decreasing allocation to cash as dry powder, deciding on net exposure being net-long or net-short depending upon whether my outlook is bearish or bullish – one can deploy instruments like short positions in equities/indices, buying puts on stocks/indices, go long volatility etc. if one is trending bearish for example.
I combine that with the basic criteria of whether quality businesses, the type of stocks that I like to own, are available to buy at valuations that I would be happy to pay. This broadly means paying less than 15x EV to FCF for buy decisions and more than 30x EV to FCF for sell decisions (generally speaking).
Current macro landscape as I see it
So the logical next step is to list some of the macro conditions that currently exist or remain on the horizon. The below list is in no particular order except for the top few:
- The prospect of Quantitative Tightening (QT) by the Federal Reserve, in other words, the unwinding of their balance sheet or the reversal of Quantitative Easing
- The prospect of the Federal Reserve continuing to raise interest rates
- Growth in the world’s largest economy is now showing signs of a slowdown
- The world’s second-largest economy, namely China slowing in a more pronounced manner than is manifest today
- The prospect of a trade war between the United States and China getting more aggressive
- The explosion of household debt levels in the US including student loans, auto loans (in particular sub-prime auto loans), credit card debt – please see my earlier post on this
- The record levels (highest in history) of corporate debt in the US. For the record, I consider this factor as the most likely culprit that will trigger the next crisis in the US that could potentially spill over globally. The issue at the core is:
- a record amount of corporate debt issued since 2008;
- the record amount of low-quality debt – consider this: BBB rated debt (the lowest notch in the investment grade or IG universe) now constitutes more than 50% of the IG universe; and
- the record amount of debt coming due for refinancing in the next 24 months
- Record levels of corporate stock buybacks which have played a huge role in keeping market multiples high will decrease as corporate balance sheets are forced to de-lever and/or the prospects of legislation against buybacks gain traction
- Algorithmic trading and passive instruments like index funds and ETFs which now according to some estimates constitute 80% of daily trading volumes can cause outsized stock moves and cause a cascading effect on stock declines in times of market stress
- The European Central Bank has also wrapped up its bond-buying program (ECB’s version of QE) since last summer. This clearly adds to the global liquidity being sucked from the system and as a result may help dampen asset prices around the globe. I believe the ECB is quite likely to rethink and/or reverse this policy given the ongoing rapid deterioration of the Eurozone economy
- The US economy is still the healthiest in the developed world and amongst the largest economies of the world. Moreover, the USD is undoubtedly still the unchallenged reserve currency of the world which has resulted in USD strength. Overlay that with the fact that a record amount of USD denominated debt in the emerging world (including China) is coming due for refinancing in the next 12 to 24 months. This may cause an unexpected shortage of US dollars and may result in emerging market currency, debt, and stock market stress
- The Eurozone economy continues its rapid slowdown with Italy already in recession and Germany very close to entering one. France and Spain follow closely behind
- The situation with European banks (be it Spanish, Italian or the German kind) worsening with the economies slowing, populism on the rise and unemployment increasing
- See below the chart for Deutsche Bank stock from 2007 to date – systemic riskanyone? Too Big To Fail?
- The Brexit conundrum and its impact on the UK economy
- S&P 500 constituents’ margins potentially having peaked in 2018 and there are increasing prospects of a looming earnings recession with earnings growth expectations rapidly being revised downwards
- The Australian housing bubble is deflating as we speak. This could have huge ramifications for the seemingly invincible Australian economy, as well as the Australian banking system
- And finally what I consider to be the gorilla in the room is the aging and retirement profile of the baby-boomer generation in the US. There are an estimated 75 million baby-boomers with an average age of 65. In other words anywhere between 10,000 and 15,000 baby-boomers enter retirement every single day. This cohort also happens to be the one with the largest exposure to the US equity markets. With volatility increasing, the economy late in the cycle and the bull market at ten years old is now tired and expensive. Combined with all the above factors, the slightest hint of a looming recession in the US (probability of which seems to grow with recent economic data) could result in a major drawdown in the asset markets, in particular, the equity markets and see a life-changing reversal of fortunes for an average baby-boomer on the verge of retirement.
Raoul Pal, founder of Real Vision, the author of Global Macro Investor, and certainly one of the best macro thinkers of this generation has written and talked about this extensively. He has even produced documentaries about the topic only to make his concerns public and to warn as many people as possible before millions potentially lose the prospect of a respectable retirement.
I would urge everyone to watch this short documentary titled “The Coming Retirement Crisis” produced by Raoul Pal on behalf of Real Vision Television.
Does the Fed care about asset prices?
If I were to focus on just one of the above factors I have listed, Quantitative Tightening or the unwinding of the Fed’s balance sheet would perhaps be the one I’d watch most closely. There is not an iota of doubt in my mind that stability in markets and asset prices generally is a priority for the Fed (as it is for other major central banks) even though they are not likely to admit as such in a million years.
Here is how the Fed Chairman Jerome Powell responded to a question regarding the Fed’s balance sheet in his post-FOMC press conference on December 19:
HEATHER LONG. Hi, Heather Long from the Washington Post. Today, the Fed lowered its expectations for interest rate increases. Given that, I’m wondering if the Fed has had any discussion of altering the course of balance sheet normalization and if you could give us any insight on what might lead the FOMC to alter that balance sheet normalization in 2019.
CHAIRMAN POWELL. Sure. If you go back some years, I think we-people who were working at the Fed in 2013 and ’14 took away the lesson that the markets could be very sensitive to news about the size of the balance sheet, the pace of asset purchases, the pace of runoff, and things like that. So we thought carefully about this, on how to normalize policy, and came to the view that we would effectively have the balance sheet runoff on automatic pilot and use monetary policy, rate policy, to adjust to incoming data. And I think that has been a good decision. I think that the runoff of the balance sheet has been smooth and has served its purpose. And I don’t see us changing that. And I do think that we will continue to use monetary policy, which is to say rate policy, as the active tool of monetary policy.
That day the S&P 500 closed down 40 points or 1.6%. You can see the price action on the S&P 500 from 1 December 2018 to date in the chart below. The equity volatility index jumped from 16 on December 3rd to 36 by Christmas Eve:
As seen in this report titled “US Fed’s Powell Seeks to Reassure Markets”, the tone at the US Central Bank had completely changed by the first week of January 2019:
There is “no pre-set path for policy and particularly with the muted inflation themes coming in we will be patient as we see how the economy evolves,” Mr. Powell said.
And the Fed is “prepared to adjust policy quickly and flexibly” to support the economy, he added…
“We’re listening carefully…to the message that markets are sending and we’ll be taking those downside risks into account as we make policy going forward,” he said
And by the 30th of January when the first post-FOMC press conference of 2019 was held, the “Fed pivot” was formally announced to the world:
“In light of global economic and financial developments and muted inflation pressures, the Committee will be patient as it determines … the target range for the federal funds rate.”
In addition, the case for raising rates has weakened somewhat…
Let me now turn to balance sheet normalization…
The normalization of the size of the portfolio will be completed sooner, and with a larger balance sheet, than in previous estimates…
The Committee is now evaluating the appropriate timing for the end of balance sheet runoff. This decision will likely be part of a plan for gradually reaching our ultimate balance sheet goals while … avoiding unnecessary market disruption…
While the federal funds rate would remain our active tool of policy in a wide range of scenarios, we recognize that the economy could again present conditions in which federal funds rate policy is not sufficient. In those cases, the FOMC would be prepared to use its full range of tools, including balance sheet policy.
So, where do I stand today?
Given the plethora of macro headwinds, as I see them, it is my humble opinion that the risks are skewed to the downside or at the very least, there is limited upside relative to
Conclusion
In conclusion, blending a thorough value investing methodology and philosophy with a macro overlay helps me in deciding my intermediate-term investing playbook, make asset-allocation decisions, decide on net exposure and cash percentage levels, as well as selecting appropriate instruments for when I have a bearish outlook based on a combination of market valuation and the macro environment. I hope readers come to a similar conclusion.