Let’s start with the idea that inflation is not fleeting, as hoped, but rather it’s becoming embedded in the economy. In our recent newsletter, we discussed the events leading to scarcity, and, we argued, they appear to be driven more by structural causes than by the money-supply. (Money supply has played a large role, but we think it merely amplified the underlying structural issues.) We sit in an unstable position, then, if you believe history is to be respected.

The chart above highlights this instability. The green line shows the long-term historical relationship between inflation and interest rates. The purple line depicts the same relation only for the period encompassing the pandemic. Even if you believe inflation (shown as “core CPI,” on the x axis) is only temporarily elevated, it still argues for a 200bps adjustment in the 10-year Treasury note—from its current 1.8% interest rate to something around 4%. (As an aside, interest rates on mortgages are traditionally tied to the 10-year Treasury interest rate. Could you imagine a world where mortgages were in the 5% to 6% range?)

The distortion is, as has been well-publicized, driven by the world’s central banks pushing down rates. They do so by purchasing government bonds as a means of propping up prices, which lowers interest rates. Their influence is demonstrated in the declining share of sovereign debt held in the hands of private investors, who traditionally are the natural buyers of fixed income instruments.

Global central banks outside the U.S. have been about the only buyers of sovereign debt for the past decade, blurring the distinction between central banks and political bodies. This suggests one of two paths: that central banks will stop buying sovereign debt, letting the private markets once again control the price of that debt and letting risk-free rates move to market-determined levels; or, that political will wins, central banks lose their independence, currencies risk their value retention and inflation continues to run hot.

Central banks, through their massive buying of debt, have created a blackhole in risk-free rates, drawing all income-producing vehicles into that hole. If central banks need to give up on an easy monetary environment to fight inflation, rates across all income-producing products will increase, leaving little opportunity for fixed-income instruments to appreciate. This has some market strategists arguing that more equity within a portfolio is necessary. However, in our view, that comes with its own set of risks.

The first among such risks is over-valuation.

No matter what metric you choose to measure equity values now, we are seeing historically high valuations. The above chart highlights the CAPE (cyclically adjusted price to earnings) ratio, which is horrible at predicting timing, but good at demonstrating severity when (not if) market participants return their focus to values-based investing. While it is true that the future might be different in unknowable respects from the past, the last 100 years of data should humble us all. The chart below looks at 10-year forward returns versus experienced CAPE. All 10-year forward returns from valuation levels near what we are seeing today have been negative. This is also true for 5-year forward returns. (These last two charts should look familiar because we have presented earlier versions before, and they continue to become even more extreme with updated data.) Extremes typically last longer than many expect, but that doesn’t make them any less extreme.

We are not arguing to avoid equities completely. Instead, we are highlighting the need for caution. The 10-year returns following high CAPE periods of the past come mostly from the dotcom bubble, and a few data points are from the late-1960’s. Many of us are not old enough to remember the 1970’s—the period that returned to valuation sensitivity, but a lot of us remember the 2000’s quite well. We do not see the same disparities in valuations as we did during the dotcom period. The dotcom bubble was localized in technology and communication companies, and during that period one could buy tobacco company stocks with double-digit dividend yields and industrial companies at single-digit earnings multiples (i.e., really, really cheap). Not today. The low interest rate environment and the central bank blackhole have brought almost every asset category to historically high valuations.

We sometimes hear that low interest rates drive a lower risk premium and therefore a higher normalized valuation level. But this has only been true over the past 40 years, in the presence of low inflation when rates were normalizing after the Volker period. If inflation persists and rates move higher, history suggests rather that valuations will drop, even for growth companies, a phenomenon the U.S. experienced in the 1970’s.

If inflation picks up, the graph below does not auger well for valuation levels. A negative relationship between P/E (price to earnings valuation) and inflation has existed for the last 100 years. The higher inflation is, the lower the valuation multiples are that the markets will pay for equities.

The question comes down to the path investors take to get to those lower valuations. In some cases, it is through companies growing their earnings into a more reasonable valuation. In others, it will be a resetting of prices to reflect a more modest growth in earnings. The latter is already showing itself in those companies that benefited from the pandemic as some of the benefactors have seen drops of 50-80% from their highs. No matter which, history suggests that the path taken will not be without volatility.

Conclusion

Though valuations can become anchored, making any normalization to historical averages take time, we suspect we will see periods that resemble the shorter corrections (i.e., one- to three-quarter long corrections, not multi-year ones) we have experienced over the past 10 years. Our suspicion lies in the complacency within the investment markets. This complacency has led to high leverage as many believe that central banks will defend assets prices rather than follow their overarching mandate to protect price stability.

If that is not the case and central banks prioritize price stability above all else, it will put significant pressure on those that have leveraged bets to the contrary with the result being margin calls. Correlations of all assets drive towards one when margin is called, fear takes hold, and people run for the exits.

We sit with a 20% allocation to cash across our strategies, expecting better opportunities to move back into a fully invested position.

We have repeatedly said we are concerned about the perceived insouciance (adjective; free of concern) of the investment community regarding valuation and growth forecasts. With both equity and fixed income markets priced to perfection, according to historical norms, and optimism in an unperturbed growth outlook, the strong momentum of world markets leaves us not in the carefree camp.

The research group of Deutsche Bank runs a monthly survey of institutional investors, gauging their top concerns. The chart below shows that inflation concerns were prominent in May and June as economies around the world re-opened and supply chains were struggling to keep up with demand. Increased caseloads from the delta-variant became everyone’s chief concern in July, however, as worries revived that we would need to revisit past pandemic protocols. (We hope not because our weight is only now moving back to pre-pandemic levels.)

The delta variant appears to be more infectious than the 2020 variants with it too early to understand its severity, leading to concern that our economy’s re-opening process could slow or stall. Thankfully, the vaccines being used in the U.S. and Europe seem to maintain their effectiveness in the face of the delta variant. The chart below is a nice way of seeing just how protective these vaccines, with the risk of dying from Covid dropping by at least an order of magnitude once jabbed.

As vaccination rates among adults in most of the developed world reached well above 60%, perambulating (verb; to stroll) without concern was becoming increasingly prevalent. However, the delta variant’s spread has us checking ourselves. And a slowdown in the re-opening process might be a factor in recent drops in several types of financing activity, including credit impulse and corporate debt.

Credit impulse—a measure of financing activity relative to the size of the economy—is showing a worrisome deceleration. We have seen a significant reduction in financing activity in the U.S. and Europe and, most recently, in China. Some of it may be due to the reduction in fiscal stimulus, as well as supply chains getting back to normal. We are monitoring to see if the burst in economic activity is followed by a bust.This fear has its roots in the high level of debt held at the corporate level. The record level of leverage in the corporate sector has increased the cost of servicing it even with interest rates being so low. The cost of debt is consuming almost 50% of corporate income. Another slowdown could be unpleasant for those already finding it hard to operate.

The concerns we at Auour have do not appear to be shared by others; analysts have shared very optimistic updates for the long-term growth of the firms they cover. In fact, the consensus estimate for the average growth of the S&P 500 aggregate earnings stands at over 20% (per year for the next five years). Keep in mind that history has not been kind to the average analyst’s forecasting ability, though. Their estimates track the strength of the equity market, as seen below, rather than predicting the future success of the firms.

The ebullience (not an AWOTD, but it should be) of the analysts is one thing, but pricing investor optimism into the fastest growing companies is another. The next graph highlights the extreme optimism residing within the equity markets. It shows aggregate market value of the most expensive companies surpassing that seen during the dotcom period. The total value of those companies equals about $4.5 trillion, or 10% of the total value of the U.S. equity market.

The level of optimism about the future growth of a new company, industry, or investment theme can turn into fear quickly. We are seeing that now in the Chinese equity markets, specifically the Chinese internet space. The chart below shows the dramatic underperformance of the overall Chinese equity markets relative to the global index (MSCI All Country World Index), with it underperforming by 30% since the start of the year.

The slide in the Chinese stock market started in February of this year but has accelerated recently as the communist party considers turning the fast-growing online tutoring companies into non-profit entities—banning any for-profit operations. The communications out of the ruling party would suggest this is not furphy (noun; false report). China, for all the opportunities it offers as a market, continues to remind investors that companies exist at the pleasure of the communist party, not the other way around. The graph below highlights the magnitude of the drop within the Chinese technology space relative to their U.S.-domiciled brethren.

We will end with one last graph showing the maximum drop investors had experienced in each year going back to 1980. Last year was on a par with some of the worst. Will that be an isolated occurrence, or is it a sign of increased volatility within markets? We stay in the camp that believes we are going to experience higher levels of volatility, which argues for a strategy to dampen the volatility while we wait for better opportunity.

I have spent the last 18 years as an individual focused on determining the value of various investment assets.  Over that time, it has become crystal clear that over short and possibly even intermediate time periods, value is in the eye of the beholder.  As with any freely traded asset, the current value is derived from the current participants in the trade.  It may not be clear what is driving their thoughts on the underlying value but what is clear, at least to me, is that it is decided by their current priorities, their assumptions around the future, and most importantly their emotional state.  Because of this, there are too many variables to derive a single stable number that represents the value of an asset.

That’s why Auour has adopted, as many participants have, a belief that the value of an asset is more a spectrum of values.  By looking at the varying drivers of a company, asset class, or market, one can gain a level of understanding of the range of values an asset carries.  And with this information, an analysis on the potential return (to the high end of the spectrum) and the potential risk (to the low end of the spectrum) can be performed and used to form an investment decision.

Its a respect for the various outcomes and an appreciation for the current market participants’ needs that can assist in discovering opportunities and risks.  By having a longer term investment horizon, our focus on the material drivers to valuation provides us the opportunity to weather storms with more confidence and take advantage of discontinuities as they occur.