How the Broken Global Capital Structure Presents Opportunities for Individual Investors
Buying risk assets based on a long-term thesis is the rarest activity in finance right now, which is exactly why investors should be doing it.
It's time to buy and hold individual equities again.
I believe the swoon in early August of last year represented, for US equities, not just the end of the 2000-2011 secular bear market, but the beginning of a new secular bull. There are many reasons for this, but if I could use only one argument, it would be the lofty equity risk premium (ERP), which I first highlighted back in November (see Trust Record-High Earnings, Not Depression-Level Consumer Sentiment). I want to spend a little time explaining why ERP remains so high.
Before 2008, banks and other purchasers of fixed income securities had plenty of options when they wanted to buy highly-rated assets as collateral or income. In addition to treasuries, there were agencies and mortgage-backed securities (MBSs), all kinds of sovereign debt, and structured products that Moody's and S&P had rated highly. Credit spreads were fairly tight but with the 10-year Treasury yield trading between 4.5-5%, and core inflation between 2-2.5%, investors were still earning a positive real return on AA- and AAA-rated assets.
Enter the crisis. The demand for and supply of structured products evaporated. The Fed started buying agencies and MBSs, and soon thereafter Treasuries. European sovereigns were downgraded. All of a sudden, there was a shortage of “safe” assets, defined as the primary reserve currencies, the dollar and the euro, roughly $13 trillion less than we would have projected five years ago.
At the same time, baby boomers have been aging and moving money out of stocks and into bonds. Because of the European crisis, global investors have been moving money out of Europe and into the safety of government bonds in the US, UK, Japan, and Germany. Institutional investors and pension funds, battered after two 50% bear markets in a decade, have piled onto the trend. Simply put, there is more demand for Treasuries than there is supply at a reasonable price, and as a result, with core inflation at 2.2%, 10-year Treasuries yield less than 1.8%, for a real yield of around negative 45bps. This doesn't mean Treasury yields will rise any time soon – the acute demand for Treasuries could last for years – but the asset class isn't an appealing place to put new investible assets.
Similarly, equities have been impacted by their own set of forces. Because of the losses suffered in 2008 and the boomer demographic shift mentioned above, investors have pulled money out of the asset class even as prices have moved higher, reducing the demand for equities and pushing down P/E ratios as earnings rise and prices fail to keep pace.
While the asset allocation mix of individual investors may be mostly a function of demographics and recent performance, corporations are more sensitive to the relative cost of debt and equity. As debt costs have fallen and equity costs have risen (represented by the rising ERP), net equity issuance on the part of corporations has dried up, with many large cap corporations now using a large portion of their earnings for stock buybacks.
Those investors who have stayed in equities have been swayed by the “risk on, risk off” environment of the past several years, and have moved out of actively-managed strategies and into passive ones, as recommended by many professionals. This is sensible for individuals, who for the most part should not be picking stocks, but irrational in the aggregate, as there are fewer and fewer dollars seeking relative value in individual companies.
The bottom line is, we are in an environment where equities as an asset class are as cheap relative to Treasuries as they've ever been. However, for demographic reasons baby boomers continue to sell them while Millennials don't yet have enough assets to buy them. Into the void has stepped corporations, which are doing enough buying to offset boomer selling. Fixed income yields may well stay depressed for many years, as they did during the 1940s and 1950s. Those investors remaining in equities are sticking with ETFs and index funds, not wanting to take idiosyncratic company risk. As investor interest in equities has waned, liquidity has dried up, exacerbating price moves from macro headlines. This could last for the better part of the decade.
There has never been a better environment for fundamentally-driven money managers who have a long-term time horizon. It's not about being bullish or bearish. As Peter Thiel said, “To understand businesses and startups in 2012, you have to do the truly contrarian thing: You have to think for yourself.” Buying risk assets based on a long-term thesis is the rarest activity in finance right now, which is exactly why investors should be doing it.
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