Markets Collapse: Economic Sanctions on Russia, Argentina Defaults…Again
publication date: Jul 31, 2014
author/source: Valuentum Analysts
Dow Jones falls over 300 points Thursday on Argentina default and economic sanctions on Russia. The very idea that we don’t know which hedge funds will be hurt by recent global economic activity, how leveraged these hedge funds are to global currencies and equities, and whether Russian president Vladimir Putin will respond in kind to economic sanctions means conservative investors are taking money off the table. Is it finally time to lock in profits after one of the best stock-market runs of all time from the March 2009 lows?
First, the EU and US impose economic sanctions on Russia. Next, Argentina defaults on its debt for the second time in 12 years, bringing back memories of the infamous collapse of hedge fund Long Term Capital Management (LTCM) in the late 1990s. The hedge fund, whose board of directors included some of the brightest minds in finance including Myron Scholes and Robert Merton, succumbed to the compounding dynamics of the 1997 Asian financial crisis and the 1998 Russian financial crisis. Major emerging economies also fell in the crisis in the late 1990s, including Argentina.
All of this should sound familiar if one’s imagination can extrapolate recent headlines. In this light, one can probably understand why the stock markets swooned today, despite what we would describe to be generally sanguine second-quarter results thus far this reporting season. But to the point on readers’ minds: Is there going to be another LTCM-style event where an ultra-leveraged hedge fund fails as a result of swings in the currency markets (brought about by deteriorating sovereign credit quality), subsequently damaging global equity prices, including those in the US?
But that may not be the correct question to ask.
Quite simply, it may just not matter. The markets have had one of the best runs in stock market history since the doldrums of the bottom in March 2009, and some investors are simply ready to take profits off the table. Russia sanctions, the Argentine default, and memories of LTCM are about as good of excuses as any. Conservative investors may simply see no reason to take on additional risk in light of a fully-valued (and perhaps frothy) stock market.
So, how are we thinking about all of this? Well, perhaps unsurprisingly, many of our thoughts today aren’t much different than those of a couple weeks ago. Let’s go back to the June interview with Brian Nelson to help frame all of the recent market activity:
Valuentum: Brian, thanks for joining us today.
Nelson: It’s my pleasure.
Valuentum: So the markets continue to make all-time highs. What are you telling investors?
Nelson: That depends. If you’re going to be in the market for more than 10 years, then you don’t have much to worry about. For long-term investors that are decades away from retirement and have absolutely no liquidity or income needs from their investments, one particular event resonates in my mind as to why they should have a full risk allocation to stocks. That event is the stock-market recovery from the Financial Crisis of 2008-2009 -- which is the worst financial event of our generation.
In just 5 or so years after the credit crunch, the markets have completely replenished losses and then some. This is simply amazing. There’s little doubt in my mind that, for investors that plan to be in the market for 10 years or longer, their risk exposure should be all stocks. I don’t think we have a stronger historical case than the stock-market recovery from the Great Recession for this view. It was simply a cataclysmic time period, and yet, here we are at all-time highs in the stock market again.
Valuentum: But what about near-retirees or those in retirement that have income needs?
Nelson: The answer is much more complex. With market valuations as they are and with dividend growth stocks in favor bargains have become harder to find. Within the next five years, it’s my view that near-retirees or retirees should expect a retracement in the markets to levels below where they are today. That said, we could hit 2000 on the S&P 500 (SPY) before we fall back. You can pick your own index, but I think you get my view of the potential trajectory investors should expect. We’ve stated previously that 1670-1680 is a more appropriate valuation for S&P 500 stocks (price is different than value).
The market is a forward-looking, discounting mechanism, and today, optimism about the future and liquidity is running wild. That means that today we have higher embedded long-term growth rates and lower embedded discount rates in stock prices. Over the next 5 years or so, we’ll likely see these two valuation drivers move against investors, as growth rates will be normalized following the recovery and interest rates likely approach longer-term averages. This isn’t anything to get too panicky about, but preparing for such a price trajectory will be important for near-retirees and those in retirement, especially if these investors have the opportunity to pursue alternative vehicles that may preserve capital while providing necessary income needs. If investors need to sell within the next 5 years or so, some profit taking could be a prudent idea.
Valuentum: Fascinating. If you believe the market will be lower in five years, why invest in it at all?
Nelson: I think this is where investors are sometimes too smart for their own good. Tactical moves in the stock market to tweak weightings here and there to reflect broader near-term market expectations can make sense at times, but strategic moves (or pulling all of one’s money out of a certain asset class) often turns out to be too aggressive. Many investors, us included, believe the stock market is starting to overshoot to the upside on the basis of traditional valuation metrics like the forward PE ratio, for example.
However, the very core of the Valuentum process embraces the understanding that markets undershoot and overshoot intrinsic value all the time. We’d only grow more pessimistic on the markets when they reveal a sustained move lower, confirming that momentum dynamics have soured. Selling at intrinsic value or higher often means missing out on continued pricing upside. This is how many value investors truncate their gains. Many pure value investors have already moved to the sidelines, missing most of the strong performance of 2013 and 2014.
Another important point is the concept of alpha. Though we expect the market to be lower within the next 5 years, we expect to outperform that nominal expected performance in the Best Ideas portfolio…