August 19, 2016
A Tale of Two Markets
A startling divergence between equity and fixed income markets has developed. The trend toward
increasing stock market values combined with declining interest rates has been going on for some
time but became quite marked in 2014 and 2015.
Modern financial theory tells us that the markets (particularly large stock markets) are “efficient”,
meaning that prices are rational and reflect all information available to market participants.
Therefore, there is no long-term advantage to trying to predict the markets – a view which has
led, among other things, to the rise of the low cost index fund industry.
While this theory might be largely correct most of the time, when it isn’t (and market prices are
“wrong”), dramatic price adjustments can follow. That possibility is important for us to keep in
mind in our role as risk managers, given that these two supposedly-rational markets are currently
telling us vastly different things.
Stock Market and Current Valuations
We believe that over long periods of time, increases in stock market prices should closely mirror
advances in corporate earnings. Higher earnings make stocks more valuable; without increases
in earnings, a rising stock market merely reflects higher multiples of earnings, book value, or cash
flow. In other words, higher stock prices in the absence of higher earnings means stocks are more
expensive, and therefore likely more risky.
Why would someone be willing to pay 20x annual earnings for a basket of stocks today, whereas
a few years ago they might have been only willing to pay 15x or 18x? Generally speaking, stocks
command a higher multiple when the expectation of future earnings growth is better. It would be
rational for an investor to pay a higher valuation for a group of stocks, if she thought their earnings
were going to grow at 10% annually, compared to a group that is only growing at 5% annually.
While any competent investment analyst will evaluate a stock not only on the basis of where
earnings are now, but where they are expected to be over the next several years, it is exceedingly
difficult to accurately estimate earnings much beyond the next 2-3 years. Therefore, paying
increasingly higher prices for stocks based upon aggressive assumptions about future earnings
growth can be perilous.
Chart l below shows the history of US GDP, corporate earnings, and stock market (S&P) levels
over the past 10 years. One can see that earnings dropped from 2007 to 2009, but stock prices
dropped even more, and had additional smaller downturns in 2011 and 2012. Since 2012,
however, stock prices have increased much more than earnings resulting in higher valuations as
investors sought return in an environment of low yields. Recent investor enthusiasm and the
search for return has driven US stock indices to both all-time high prices, and valuations
significantly above average historic metrics.
While current lofty stock valuations may reflect a number of factors (including easy money and
the relative dearth of attractive investment options), “efficient market” theory would imply that
investors have a sanguine outlook on economic and earnings growth.
Page 1 of 4 August 19, 2016
Chart 1
Bond Market Yields
The bond market is sending us a very different signal. Chart 2 below shows the percentage of
developed country sovereign bond yields that are either (a) below 1% (now more than half the
total bonds outstanding) or (b) less than ZERO (nearly 30%). Both of these figures are
unprecedented.
Chart 2
So what would cause a supposedly rational investor to accept a negative yield on bonds for up to
– an almost inconceivable – ten years (in the case of German bunds)? The only plausible
explanations are that they think that yields will become more negative (causing bond prices to
rise), or they think that other alternatives are worse.
Page 2 of 4 August 19, 2016
The first time in modern history when investors voluntarily accepted negative bond yields was
during the worst of the 2008 meltdown, when there were serious concerns about a global financial
system collapse. During that period, for a few weeks, rates on very short-term US Treasury bills
went slightly negative, as investors preferred the safety of US Treasury debt over the risk of putting
money in a bank that might fail. The situation was short-lived and the negative rates went away
after the worst of the crisis had passed.
Now, we think that the risk of a financial system meltdown is very low, given supportive monetary
policy and improved bank capital ratios (particularly in the US); accordingly, extraordinarily easy
monetary policy has replaced investor panic as the primary driver of low (or negative) rates. In
any case, the bottom line is that for someone to willingly accept a long term negative return on a
bond, they must expect that yields will not improve any time soon. Such a view is consistent with
an expectation of poor long term economic growth, potential deflation, and continued central
bank action to keep interest rates low.
Which to Believe - Stocks or Bonds?
The bond market is telling us that, for the foreseeable future, growth is going to be weak, and
economic conditions poor. The equity markets, now at all-time highs and with very robust
valuations, are telling us just the reverse. When markets are sending seemingly contradictory
messages, as we believe is now the case, we are inclined to become cautious. Experience tells us
that when the stock market and the bond market disagree about economic prospects, it is usually
the bond market that turns out to be correct.
In either case, the dramatic divergence between the signals being sent by those two markets
increases our assessment of the risk in the markets, and leads us to our current defensive stance.
We currently have a significant underweight to equities across our portfolios, partially offset by
an overweight to high yield bonds (which remain relatively attractive). Our allocation to
investment grade bonds (predominantly corporate rather than sovereign) is quite short in
duration, in order to reduce exposure to the risk of loss due to rising rates.
If the stock market is “correct”, and happy days are right around the corner, then we will likely
miss out on a bit of upside. However, if the bond market is correct, and we are in a slow-to-no
growth environment for months or years to come, then stocks appear meaningfully overpriced.
In that instance, our client portfolios will likely avoid a considerable portion of the potential
downside as stock prices adjust to economic and earnings reality.
Given our assessment of the relative risks and opportunities, right now we are more than happy
to err on the side of caution. As always, however, we will watch markets closely and assess further
developments.
Thank you for your trust and support. Please feel free to contact any of us with questions or to
discuss our views, your portfolio, or a prospective relationship with our firm.
David B. Kantor
Partner and Chief Investment Officer
Page 3 of 4 August 19, 2016
Disclosures
The information contained within this letter is strictly for information purposes and should in no way be construed as
investment advice or recommendations. Investment recommendations are made only to clients of Santa Fe Advisors, LLC
on an individual basis. The views expressed in this document are those of Santa Fe Advisors as of the date of this letter. Our
views are subject to change at any time based upon market or other conditions and Santa Fe Advisors has no responsibility
to update such views. This material is being furnished on a confidential basis, is not intended for public use or distribution,
and is not to be reproduced or distributed to others without the prior consent of Santa Fe Advisors.
Chart 1
Source: BlackRock Investment Institute, S&P and U.S. Bureau of Economic Analysis. June 2016.
Notes: The chart shows the percentage change since the peak of the last equity cycle in October 2007 for
S&P 500 total returns, trailing earnings per share and U.S. nominal gross domestic product (GDP) growth.
Chart 2
Source: BlackRock Investment Institute, J.P. Morgan and Thomson Reuters, June 2016. Notes: The chart
is based on the J.P. Morgan Global Developed Government Bond Index. Areas show the proportion of bonds
in the index with yields in each range.
Page 4 of 4