"It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent." — Charlie Munger
Over the past couple of years, we have discussed a couple of driving forces in the market: our long-term view that inflation was a higher risk than many were prepared for, that a tug-of-war for market leadership was underway between value and momentum investing strategies, and that both of these forces were being exacerbated by massive fund flows into passive index funds.
Let's explore how each of these factors contributed to the steep sell-off over recent weeks.
We'll begin on the inflation front.
Since the recession of 2008-09, central banks around the world pursued a coordinated policy of money printing and suppressed interest rates. Over the past 10 years, the U.S. Federal Reserve, the European Central Bank and the Bank of Japan have printed over $13 trillion. That money was plowed into the purchase of government bonds, mortgage bonds and eventually corporate bonds.
As demand for these bonds went up, so did their prices. Since bond prices and yields have an inverted relationship, the higher prices meant the yields on those bonds fell to the floor. This why interest rates have been so low over the past several years.
These low interest rates have had a huge effect on the stock market. Initially, with lower debt costs, companies were more profitable. This helped drive the initial recovery. Then, companies began to use cheap debt to fuel stock buybacks, propelling share prices higher. As the pain of 2008-09 receded, investors began looking for income and higher yields.
With interest rates on bonds so low, many plowed into dividend-paying stocks as an income alternative — driving stocks even higher. Some central banks, like the Swiss National Bank, plowed their printed money directly into stocks — buying hundreds of billions of dollars of stocks through passive index funds like the S&P 500. With the rally in full go-go-mode, everyone wanted into the game, and momentum funds (more dollars chasing the fastest-rising stocks) dominated.
Alongside this interest rate suppression and impressive run in the stock market, the economy hummed along, growing in the 1.5 percent to 2 percent range throughout the recovery. But because of a combination of economic healing, reduced regulatory burden from the Trump administration and increased fiscal stimulus from recent tax cuts, the economy has stepped it up a notch.
The gross domestic product has grown above 2.5 percent for three straight quarters, and the Atlanta Federal Reserve is predicting first-quarter GDP to come in above 5 percent. Some of this was presaged by the recent jobs report that showed wages climbed nearly 3 percent in January.
This is a big deal. Growth is accelerating.
At the same time, central banks are beginning to unwind their bond buying programs. The U.S. Federal Reserve has hiked short-term rates five times in the last two years and is letting its massive bond portfolio slowly run off. The European Central Bank is winding down its bond buying program, and many believe it, too, will start raising short-term rates later this year.
These huge buyers of bonds are leaving the market. The unwinding of central bank stimulus combined with expectations of higher growth have driven interest rates higher.
If we focus on the interest rate environment over the last 18 months, we see that 10-year U.S. Treasury yields have risen from 1.4 percent to over 2.8 percent. Now, this is still an incredibly low level of rates, but on a relative basis, interest rates have doubled over the last 18 months.
This is an incredibly fast rate of change. We have warned investors for years to stay away from bonds because we knew that once inflation began to build and yields began to rise, bond prices could get crushed. After an initial jump in late 2016, rates were fairly stable for most of 2017.
This resulted in low levels of volatility and high levels of complacency that encouraged investors to plow money into passive indexes that chase companies whose prices have gone up the most. Hundreds of billions poured out of actively managed funds (often invested in the few pockets of value that remained) and were redirected into passive funds.
This depressed market volatility. The Chicago Board of Exchange Volatility Index (VIX) measures the implied volatility of future stock prices based on options' premiums in the market.
When people are fearful, and believe prices may fall a lot in the future, they pay high prices for options that protect against those price declines. This results in a high VIX. When investors are complacent, and think nothing bad can happen, the prices of those options fall and the VIX declines as well. According to Morgan Stanley, 2017 had the lowest level of volatility in stocks since 1964. This encouraged a lot of stupid behavior.
The most glaring example of this stupidity has to be the rise in "short-vol" exchange-traded funds and exchange-traded notes. Given the trends of lower volatility, investors poured money into ETFs and ETNs that made leveraged bets on low volatility.
One such fund, the Velocity Shares Daily Inverse VIX ETN (XIV), which was structured to rise as volatility fell or stayed low, soared from roughly $20 in early 2016 to nearly $150 by January 2018. This nearly 700 percent return encouraged lots of complacency and a bit of stupidity, as more and more people plowed into these funds, often with borrowed money.
January and early February were fascinating from a market mechanics perspective. The broader indices like the Dow Jones Industrial Average and S&P 500 surged nearly 8 percent in just a few weeks, and short-vol funds like the one above continued to race higher. But alongside these moves, the rise in interest rates accelerated, jumping from 2.4 percent to 2.85 percent in a few weeks.
This triggered a healthy correction in the market, which we typically see at least once a year but had been gleefully missing for a few years. When the market indices fell nearly 12 percent in a handful of days, the short-vol funds came unglued. The XIV plummeted to nearly $5, triggering a liquidation provision by the fund's sponsor, Credit Suisse. Investors may not walk away with much.
We encourage investors to stick to their knitting — seeking good companies with strong assets, run by capable managers, priced at bargain value with a steep margin of safety.
Often, this leads us away from what is popular and exciting. Sometimes, the bargains we focus on are snapped up quickly by other investors or acquiring companies. But typically, these bargains take a few years to generate the returns we expect. In the meantime, we try to avoid anything that can lead to catastrophic losses.
Bitcoin, short-vol ETFs, Tesla — they have all been great momentum trades when the world was awash with cheap (low-interest-rate) money. But none of these made sense from a value investing perspective.
Instead, value investors should continue to focus on companies with real cash flows or valuable assets and work with our portfolio companies to grow their earnings or harvest their assets through a sale to a strategic buyer.
By focusing on not being stupid, occasionally you look smart.
Jonathon Fite is a managing partner of KMF Investments, a Texas-based hedge fund. He is an adjunct professor with the College of Business at the University of North Texas. This column is provided for general interest only and should not be construed as a solicitation or personal investment advice. Comments may be sent to email@KMFInvestments.com.