Q2 2021 Mean Reversion
Clients of the Firm,
We are soon concluding the 2nd Quarter of 2021 and another good period for U.S. domestic equity performance. Travel is reopening in the United States and we expect robust consumer and energy demand to continue through at least the summer months. COVID-19 levels in the United States are persisting at low levels. While an increase in unvaccinated areas from variants is expected, we do not expect another national shutdown domestically with vaccination rates at very substantial levels. As life returns to a new normal in the United States, we can turn our attention to earnings and economics in the quest for successful investment outcomes.
Banks continued to perform well after Fed stress test results revealed excellent fundamentals and capital cushions. These results have enabled many major banks to increase their dividends and maintain or extend their share buyback programs. While the yield curve has steepened somewhat, absolute yields remain at historically low levels. Trading activity, investment banking and the slightly steeper yield curve have all been accretive to bank earnings. In addition, Federal stimulus has kept debt default rates low across the credit spectrum and loan loss reserves have been released accordingly.
We expect an eventual tapering of Fed accommodation near the end of 2021 or beginning of 2022. Our view is if economic growth, inflation and employment levels are substantially higher than expected, actual Fed tightening could be in the offing in 2022. This change would mean an increase in short-term rates to slow inflationary pressures. Moreover, a parallel shift in the yield curve would increase the prevailing interest rates for IG (investment grade) credit. If longer-term rates were to increase to levels consistent with the end of 2018, we would see the 10-year Treasury closer to 3% from the current 1.50% level.
There are many disparate views in the investment community as to how this yield increase would impact the different asset classes. Some opine that Fed tapering and short-term rate increases would increase the likelihood of slower longer term economic growth and thus result in lower interest rates for longer. Others believe that the absence of Fed tightening, amid the backdrop of the substantial increase in the M2 money supply, will result in substantial non-transitory inflation. This outcome would force the Fed to more aggressively tighten, resulting in significantly higher longer-term interest rates.
Our view continues to be closer to the latter opinion. With the current S&P 500 price to earnings ratio at around 21 times, the earnings yield premium is 3.18%. Therefore, equities continue to offer an earnings yield that substantially exceeds the rate of return of 10-year Treasury bonds. In addition, the yield spread between IG credit and the Treasury is a paltry 80 basis points (normally this spread is closer to 200 to 250 basis points). This spread compression makes IG corporate credit a particularly unappealing option, but a correction in bond prices could change this dynamic. Our recent approach has been to use short-term Treasury bonds and fund (money market) proxies for this risk exposure. This approach relies on a thesis of a future market reversion to the mean of prices and spreads for bonds and allows investors to avoid losing money on fixed income when that correction occurs. This strategy would likely change upon normalization of prices in the bond market. Our opinion is that patient waiting will help avoid near-term losses and provide liquidity to take advantage of lower prices and higher yields when that normalization occurs.
Recently, we have had many questions about Bitcoin as an investment. Currently, Bitcoin is part of a broader speculative trade that has taken root in markets. While promoted as a store of value or even a fiat currency alternative, Bitcoin and other block chain technologies are still experiencing rampant price speculation and the corresponding volatility that goes with that. In 2000, we witnessed a similar phenomenon with internet tech stocks. Even the most robust of companies that ended up becoming the current market leaders experienced massive price volatility and extreme valuation. Indeed, stock prices tried to pull forward earnings that were 10 even 20 years in the future into current prices. Again, as it has throughout history, mean reversion of prices ensued in the spring of 2001 and continued for a few years until prices corrected nearly 90% from peak to trough for many of these assets.
While the market was performing its function, trying to be a forward pricing mechanism, it was way ahead of itself on earnings realization. While the blockchain will likely be a future mechanism for money transfer, its broad adoption will be many years in the future as governments, central banks and our financial system adapt to new mechanics for financial transfers. Bitcoin may even be a winner in this process as it enjoys first mover advantage and a finite supply of minable coins. That said, pricing for the asset is volatile and valuation is near impossible as Bitcoin has no intrinsic value, tax base or hard asset backing it. Counterparties have agreed to use it as a tradeable instrument for an exchange of value. The merits of finite supply, the distributed ledger and the anonymity that goes with that made Bitcoin a compelling choice. Markets have adapted and exchanges have risen to accommodate investors and speculators interest in trading. Indeed, Wall Street and tech will look to profit off the facilitation of such trades and the high commissions that go along with that. Ultimately, price volatility and trading costs will need to normalize in order for Bitcoin to be successful as an exchange of value. We feel that time is in the relatively distant future and a likely price correction in the asset will eventually reflect that.
Benjamin Graham, noted value investor and mentor to Warren Buffett said, “Wall Street people learn nothing and forget everything.”. While said partially in jest, his words remind us that history tends to repeat itself in markets. We refer to this phenomenon as mean reversion. Speculative bubbles come and go as do bear markets and extreme pessimism events. The past year is unique in the sense that we have seen both extremes over a 15-month stanza. Mean reversions occur, and we know markets sometimes overshoot to the downside or upside. This is why we use a rational framework for investing that focuses on reasonable normative valuation as a standard for putting capital to work. Patience, discipline and method all combine to help us make rational decisions amid exuberance or fear.
Thank you for your continued confidence in our firm. We shall continue to keep you informed as market conditions develop.
Sincerely,
Peter C. Wernau, CEO
Wernau Asset Management
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