"What you see, what you do not see"
Another month has passed. Another rally has come. After only a short break in September, markets are strong again. Notwithstanding some random stock specific bad news, the reporting season proved generally better than expected both sides of the Atlantic. The Fed managed to start the tapering process without disturbing the “equity bulls”: a masterpiece of communication tactic. The ECB seems to me in a “catatonic state” and would never touch rates or sell bonds any time soon. So, we are left with nothing to worry about from now until the Santa Klaus arrival. Time will tell. It was during this market ebullient up-moves that I got some days off. I went to Florence with my family. The weather was nice, the food excellent and the city never disappoints art lovers like me. I had a very good time indeed. I really enjoyed visiting the Uffizi, the famous art gallery with the works of universally acclaimed artists of the Italian renaissance such as Botticelli, Michelangelo, Leonardo and Raffaello. However, I was particularly impressed by a small painting of a less famous artist, the double portrait of the Urbino dukes, Federico da Montefeltro and Battista Sforza, by Piero della Francesca. You are excused if you do not know it, I did not know it either until some days ago, so here is the link:
I indulged quite a lot watching the unusual profile of Federico da Montefeltro, his hieratic face of a pride warrior of the fifteenth century. Not many people know that Piero della Francesca carefully chose this pose because Federico was wounded during a battle, and he missed most of the right side of his face. This explains why he painted only his left side. However, photoshop was not available at the time, and Piero could not avoid revealing, at least, some of the truth. That is why Federico’s nose appears so weird with an impressive “step shape”. It is not a mistake. It was Federico’s real profile due to injuries inflicted by rivals. To me, this is a life lesson: keep a focus on what you see, but also on what you do not see. Watching this painting, what you see is an exquisite piece of art; what you do not see is the real story behind the main character. Both are equally important and fascinating. Let’s try to apply this approach to current financial markets. What do we see? We see equity indices registering new records at historically high valuations and credit spreads close to all-time lows. Risk markets thrive in the current narrative from the central banks that inflation is somewhat more persistent than expected but, nonetheless, temporary. Political hesitations are just bumps down the road: sustained fiscal spending is here to stay. We see government bonds also behaving “quite well” given the numbers of reported inflation and the initiation of “tightening” exercised by several central banks. Currencies are well behaved too. Commodities are through the roof. Even gold is getting marginally better, not too hot, not too cold. Speculative excesses in market niches or enthusiasm in cryptos are signals that market sentiment is positive and retail participation is strong. The missing piece is EM but, I guess, given that everything else is booming, we can live with that. In a nutshell, we see strong markets. So, the very important question is what we do not see? Well, by definition, if you do not see it, you cannot describe it. Then, a better question is: what is going on already today, under the market skin, that will be evident 5-10 years down the road but we are not factoring in? There are many things we could list, ranging from geopolitical risks to economic and social consequences of current state of affairs. However, I believe that most striking characteristics of the financial world today is the absence of any perceived likelihood of mean reversion processes whatsoever. I look at any asset class and the implied message I get is: “it is going to be this way forever, so price it accordingly”. This approach paid handsomely in recent years and “success breeds success”. Anyway, in the effort of listing a couple of things that we might not see today and be evident tomorrow I will choose one for bonds and one for equities. The one for bonds is the evidence of loss of purchasing power. 2021 most likely will be one of the rare years of nominal negative returns for the average bond investor, at least in a while. Should this continue in 2022 I guess some bond vigilantes might start getting nervous. We have been accepting negative real rates as long as nominal returns were positive. It all comes down to inflation expectations. Yeah, I know, this is not very new and in everybody’s mind. At the end of the day, nobody understands inflation. I do not. Central banks do not. When central banks affirm inflation is temporary, I do not believe them. Period. QE was supposed to be transitory too… in 2009. Despite this, bond markets price negative real rates for decades to come. To me this is an impossibility. This is the reason why we should factor some risk that current low expectations are simply too low. I do not see this happening at all. As far as equities, I think there is another implausible scenario discounted in markets right now. Let’s say, for argument’s sake, that yields are going to stay low and liquidity abundant for a very long time. This means that the cost of capital is going to stay close to zero for long. If this happens, why should we believe that today’s stock market winners are going to be tomorrow’s ones? If “financial barriers to entry” are non-existent, the Tobin q ratio (market value/replacement cost) should be much closer to one. This should be especially true for technology driven businesses when competition is just one click away or in the business-to-business segments. With low rates forever, the average valuations in these competitive segments should actually be lower, not higher. I do not see this happening either. These kinds of businesses sport record valuations of many multiples of sales (let’s keep the profit question for another commentary). At an extreme, I can rationalize such premiums for companies that already reached a size that could justify additional intangible value derived from network effects and high substitution costs. These are the megacaps of today. It does not make sure they are great investments, but they should be able to live long enough to return you money back. However, there is a “big belly” of the market of many hundreds of “unicorns” and “concept stocks” where I simply cannot understand what the market is implying. My feeling is that we are generally given not enough credit to the new generations. People in their 20s today are digital native and very creative. The internet is an impressive accelerator of human potential, now more than ever. There must be a significant number of youngsters that “connect the dots”, they are the successful entrepreneurs of tomorrow. Given the assumption that capital will continue flowing forever, do we really believe this young generation is not going to be a fierce competitor to the current existing “unproven” businesses? Again, I do not see anyone afraid of this.
A final suggestion, watch behind the painting for a surprise.
Peppe Ganci, CFA