Dennis C. Butler, President
of all guest columns written by Dennis C. Butler, CFA
vents in recent years, both in the U.S. and abroad, have brought home to many people the transitoriness of many of our long-established and seemingly permanent political institutions. Surprisingly fragile, their continued existence depends on the interest and active support of us all, as well as the goodwill of those in positions of authority and responsibility. In continental Europe emotional debates about immigration threaten the stability of even the most stable and economically powerful countries. Britain’s “Brexit” battle has created governmental disfunction and weakened a constitutional order dating back centuries. In the U.S., “tweets” spread doubt about even the clearest constitutional strictures, while determined factions, as feared by the Founders, hijack and render ineffective the checks and balances the Founders put in place to prevent their aggrandizing power. We have no doubt that ancient Rome at its height truly did seem “eternal” to those who lived at the time, as did the many empires that have since come and gone to the denizens of those long-disappeared polities. Indeed, it seems, counterintuitively, that the more entrenched and powerful the political entity, the more vulnerable it is to internal doubt and disruption.
One explanation for why this might be the case was neatly summarized in a recent Financial Times piece dealing with the chaos engulfing Britain over the “Brexit” matter: “insouciance about history can induce blindness,” it warned. The relative stability of British political institutions over centuries has imbued a feeling of “it can’t happen here” among citizens, leading to confidence that the country’s political traditions will continue even as events undermine them. Worryingly, it even induces a willingness to entertain risky ventures (as Brexit is turning out to be), under the assumption that things “cannot get worse,” or reach a point where the political and institutional structures cannot recover from the blows. Those who have lived under less stable regimes are not fooled by this way of thinking because they know how damaging — even dangerous — institutional breakdown can be. If an illusion of stability based on past experience is serving to mask real instability in the present, people who have known only a benign political order could be in for a shock.
A similar phenomenon takes place in the economic sphere. Described by the late economist Hyman Minsky, extended periods of growth and well-being encourage risk-taking as parties relax their guards and increasingly feel that continuing prosperity will bail them out of marginal endeavors or outright poor decisions. For example, debt may come to be viewed more favorably as a prescription for increasing margins and profits, under the assumption that future profit growth will make repayment less burdensome for borrowers. (We frequently see this thought process at work in the markets for low-grade bonds). Such choices and the rising “animal spirits” that accompany them can continue for a long time without consequence, but just because nothing untoward happens does not mean the risk is not there. Debts must be repaid eventually. Burdens grown large increase the possibility of a “Minsky Moment” at the point when unexpected losses or those frightful “black swans” (totally unexpected macroeconomic discontinuities) upset the speculative cart. In extreme cases, we get crises, as in 2008-2009.
Stock markets exhibit these cycles of risk as well, as anyone who has experienced the last ten years of market behavior has witnessed. At first indiscriminately dumped in a fit of risk-aversion, avoided for years as painful memories lingered, then finally embraced enthusiastically as the averages reached new heights, equity investments since the Financial Crisis have followed a familiar pattern. Too risky during a crisis when valuations are historically low, high priced stocks are embraced as the only game in town, indiscriminately, too, as index funds (which permit wagers on the market as a whole, or at least the securities represented by the particular index) have become seemingly too easy a choice to avoid. Fundamentally, these moves represented a misperception of risk as being high during market collapses, and low as prices reach new highs. Yet, when you think of it, this doesn’t make sense. After all, during the collapse of 2008-2009, someone was buying all of those dumped shares! And those investors subsequently enjoyed one of the longest bull markets in history.
Have we now reached another Minsky Moment, when risks in the system have reached a point where they outweigh the potential rewards? Steep equity declines at the end of 2018, and nervousness in August could be indicative of a susceptibility to disruption. Extreme valuations of sovereign debt (exemplified by the negative interest rates offered by a number of countries) and narrow “spreads” across the entire bond market appear to us to be dangerous signs of “insouciance.” Nothing is for eternity, or, as a wise market observer one noted, “a bull market is not a financial institution.” Whether it is political systems or economic activities, all are social constructs rather than immutable laws of nature.
We experienced a fleeting moment of liminality several weeks ago when an influential business organization, counting among its membership the leaders of 180 major U.S. companies, unexpectedly declared that it was abandoning the decades-long view that a company’s sole purpose was to “enhance shareholder value.” Companies make business decisions that impact a wider spectrum of “stakeholders” — employees, customers, communities, etc. — and henceforth, the group said, corporate decision-makers should consider the needs of these other players to a greater extent than they had in the past.
The warm and fuzzy feelings produced by this announcement dissipated quickly when we saw that it came from a CEO — the head of a large banking institution — known for accepting a large bonus while the firm’s shareholders took a multi-billion dollar hit due to the activities of a rogue employee. We doubt this greedy behavior will instill confidence among the non-shareholder stakeholders that their interests will be carefully looked after. Talk about inclusiveness is nice, but actions, and, better yet, structural reforms of compensation schemes, are necessary before real change will take place.
Commentators also pointed to another seemingly unmovable obstacle in the way of the benefiting-all-stakeholders concept: institutional investors. Subject to their own incentives, these asset managers look to short-term share-price movements as absolution for their disturbing tendency to disregard business fundamentals in favor of following stock market winners. Pressures from large institutional holders strongly influence managements; even executives who have tried to take a more inclusive view of their responsibilities, and include long-term goals in their decision-making, have been shown the door for upsetting the institutional shareholder base.
In short, as long as the bonus culture and incentives that focus attention on short-term share price gains remain, we expect little change in corporate or investor behavior.
Rotation, rotation, rotation. Unlike real estate, where a favorable fixed location positively impacts a property’s value, financial markets can be subject to sudden shifts of the ground that upset investment strategies and lay waste to hitherto profitable trades, while making disappointing commitments suddenly appear prescient. Such a shift occurred in August when massive amounts of capital “rotated” from the few investment stratagems that have been working well this year (including “momentum” and “growth”) and also moved away from popular economic sectors (such as interest-rate sensitive utilities, real estate, and some consumer goods), to unloved areas of the markets, e.g. “value” stocks and issues with smaller market capitalizations. New interest rate cuts appear to have catalyzed these investor moves, but excessive interest in the favored stocks also likely pushed many market participants to reduce their exposure to expensive market segments.
Internal stock market convulsions were accompanied by massive money flows into the presumed refuge of bonds, bringing yields on some U.S. treasury securities to record lows, and expanding the universe of securities offering negative yields up to about $20 trillion. This move proved to be fleeting as September saw a fixed-income sell-off. Some concerns that spooked the markets — trade, currency moves, economic data — proved not as bad as anticipated, reducing the flight-to-safety fears of just a few weeks before.
After the dust settled, the markets remained just as elevated as before. The third quarter ended with modest gains in the popular averages. Year-to-date market moves, at around 20% positive, were well above average, reflecting strength in the shares of companies in a few highly-prized industries at a time of low rates and modest economic growth, and illustrating once again the futility of agonizing over periodic financial market hiccups. More importantly, the indexes — and most stocks — remain in or near record territory, making advantageous investment a rare occurrence at this time.. ________________________________
Dennis C. Butler, CFA, is president of Centre Street Cambridge Corporation, investment counsel. He has been a practitioner in the investment field for over 33 years and has been published in Barron’s. He holds an MBA from Wharton and a BA in History from Brown University. His quarterly newsletter can be found at www.businessforum.com/cscc.html.
“Current low valuations reward the long-term view”, an article by Dennis Butler, appears in the May 7, 2009 issue of the Financial Times (page 28). “Intelligent Individual Investor”, an article by Dennis Butler, appears in the December 2, 2008 issue of NYSSA News, a magazine published by the New Yorks Society of Security Analsysts, Inc. “Benjamin Graham in Perspective”, an article by Dennis Butler, appears in the Summer 2006 issue of Financial History, a magazine published by the Museum of American Finance in New York City. To correspond with him directly and /or to obtain a reprint of his featured articles, “Gold Coffin?” in Barron’s (March 23, 1998, Volume LXXVIII, No. 12, page 62) or “What Speculation?” in Barron’s (September 15, 1997, Volume LXXVII, No. 37, page 58), he may be contacted at:
Dennis C. Butler
Centre Street Cambridge Corporation
Post Office Box 390085
Cambridge, Massachusetts 02139
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Revised: October 18, 2019 TAF
© Copyright 2019 Dennis C. Butler, All Rights Reserved