Comparing Risk and Opportunity

Every year in August I organize four lunches for serious investors on successive Fridays in eastern Long Island. There are different groups of 25–30 people at each one and many of the great names of the hedge fund, real estate and private equity world attend, along with some academics and government folk. I lead a discussion for the better part of two hours and, in the past, I would follow the same basic agenda at each one. This year I varied the approach: I took a hard look at who was attending and created agendas that took advantage of the knowledge and experience of the participants.

The one issue that dominated the discussion at all four of the lunches was whether or not we were in the late stages of the business cycle as well as the bull market. This recovery began in June 2009 and the bull market began in March of that year. So we are more than 100 months into the period of equity appreciation and close to that in terms of economic expansion. Howard Marks of Oaktree, one of the most insightful thinkers in the money management business, has written a 22-page paper on the risks facing investors, and he concludes that this is a time for caution because of the condition of asymmetry: the potential rewards are not sufficient to justify the uncertainties and stretched valuation of equities. Opportunities are limited because of price. One investor recalled the “Rule of 20” from what now seems like ancient times: the combination of inflation and price earnings ratios should be no more than 20. On that basis, the market is a little more than fully priced but not egregiously overvalued.

Looking at historical price earnings ratios, the market certainty appears to be fully valued, even assuming earnings continue to come in better than expected. Equities seemed priced for perfection. Greed was winning over fear. Historical multiples, however, were established in a higher interest rate environment where the 10-year U.S. Treasury was yielding 5% to 7%, versus just over 2% as it is today. Stocks compete with bonds as an investment. Current interest rates can support a higher multiple, perhaps as much as 30x, but few observers want to stick their necks out that far. While the market is always vulnerable to a 10% correction, bear markets are usually associated with a recession and there is no serious downturn in sight for the economy.

The Federal Reserve has been moving from an accommodative monetary policy to a more restrictive posture, with two increases in the federal funds rate behind it and the prospect of at least one more. The Fed balance sheet has swollen from $1 trillion in 2008 to $4.5 trillion today. The Fed has indicated, however, that it will start shrinking it now. The European Central Bank is also talking about tapering its balance sheet expansion and, as a result, liquidity will not be as favorable for financial assets as it has been since 2008. Nonetheless, other potential impediments to equity appreciation are not currently negative: investors are optimistic but not euphoric, inventories are not excessive, unemployment is declining rather than rising, leading indicators are making new highs and inflation is modest. Accordingly, we could be several years away from the next recession or bear market.

More recently, the markets have been buffeted by North Korea’s nuclear threat. A military confrontation in the Far East is certainly high on the list of potential risks. For the third lunch, I arranged for Orville Schell, a scholar at the Asia Society, to speak to the group about possible policy alternatives. I have followed his work since I first started going to China in the 1980s and his analysis of the evolution of the country from its underdeveloped economic condition at the time of Mao’s death in 1976 to the second largest economy in the world has always been helpful. Although there is no shortage of op-ed pundits writing about diplomatic policy initiatives that should be pressed on North Korea, Schell’s recommendations are very specific: cut off food and oil shipments, stop air travel from Chinese airports and eliminate rail transportation to the country.