As we are all well aware, central banks have been, through quantitative easing, suppressing interest rates since the GFC. Consequently, monetary policy has fueled unprecedented flows of institutional and private capital into real estate, private equity and stocks.
History holds some valuable lessons. The consequences of last time this was attempted is explained in the classic book, Lords of Finance: The Bankers Who Broke the World. Its author Liaquat Ahamed offers us the following reminder:
“The quartet of central bankers did in fact succeed in keeping the world economy going but they were only able to do so by holding U.S. interest rates down and by keeping Germany afloat on borrowed money. It was a system that was bound to come to a crashing end. Indeed, it held the seeds of its own destruction. Eventually the policy of keeping U.S. interest rates low to shore up the international exchanges precipitated a bubble in the U.S. stock market. By 1927, the Fed was thus torn between two conflicting objectives: to keep propping up Europe or to control speculation on Wall Street. It tried to do both and achieved neither. Its attempts to curb speculation were too halfhearted to bring stocks back to earth but powerful enough to cause a collapse in lending to Germany, driving most of central Europe into depression setting in train deflationary forces throughout the rest of the world. Eventually in the last week of October 1929, the bubble burst, plunging the United States into its own recession. The U.S. stock market bubble thus had a double effect. On the way up, it created a squeeze in international credit that drove Germany and other parts of the world into recession. And on the way down, it shook the U.S. economy.”
Elsewhere, and the world’s largest hedge fund Bridgewater Associates, with US$160 billion under management, said: “We are bearish on financial assets as the U.S. economy progresses toward the late cycle, liquidity has been removed, and the markets are pricing in a continuation of recent conditions despite the changing backdrop.”
We have previously reported that the majority of the debt accumulated since 2010 by US non-financial corporates has been used for unproductive purposes, specifically financial engineering such as earnings-per-share-boosting stock buybacks, special dividends and mergers and acquisitions (at inflated prices). Swapping equity for debt through buybacks has, almost without doubt, inflated the equity market while simultaneously misdirecting capital away from productive purposes. By way of example, U.S. banks collectively returned 99 per cent of net earnings to shareholders via buybacks and dividends. In other words, the jaws between prices and reality have widened.
Bridgewater again; “2019 is setting up to be a dangerous year, as the fiscal stimulus rolls off while the impact of the Fed’s tightening will be peaking,” and “…since asset markets lead the economy, for investors the danger is already here.”
Finally, Warren Buffett’s Berkshire Hathaway is now holding US$116 billion in cash, which is a quarter of the company’s market capitalisation. Why? In the latest annual report Buffett wrote that an attractive price is “a requirement that proved to be a barrier to virtually all deals we reviewed in 2017.”
Figure 1. Buffett’s Cash
This is an important observation because, as one commentator noted Buffett has enough cash on hand to acquire 450 of the S&P 500 companies outright. Yet he did not buy any of them. Nor did he reduce the cash position to expose himself to more shares of any S&P 500 components. He has chosen cash in the form of short-term Treasuries.
History, the world’s biggest hedge fund and the portfolio of the world’s most successful investor are all telling us something.
At Montgomery, we’re listening and our mandates allow us to do something about it.
In our long-only funds, which include The Montgomery Fund, The Montgomery Global Fund, Montgomery Global Equities Fund (ASX:MOGL) and The Montgomery [Private] Fund, we have the ability to hold cash. Across our domestic and global funds cash weightings remain at relatively high levels.
Even though we’d prefer not to hold cash for long periods of time, it does provide us with an option over lower prices should they transpire. Indeed, higher cash levels have, thus far, enabled the funds to capture more of the upside in rising markets, than the downside during declining markets.
In our Global Long/Short fund, The Montaka Global Fund, the ‘net’ market exposure is just 35 per cent.
Our desire to preserve capital remains a priority with the aim to take advantage of value as and when it presents.
As an aside it is interesting to note that buybacks were illegal in the US prior to 1982 because the Securities and Exchange Commission regarded them as manipulation.