“Nobody goes there anymore. It’s too crowded.”

Yogi Berra

 

I began my career at RBC Dominion Securities as an Investment Advisor 19 years ago next month. In that time, we have seen overly optimistic markets and excessively pessimistic ones and everything in between. Markets rarely reflect the “true” value of anything or any enterprise but simply swing from one extreme to the other, passing through “fair value” in each direction. Warren Buffett has said that in the short term, markets are a “voting machine” and only over the longer term are they any good at valuing enterprises. Billion dollar moves in a company’s value over a small bit of news is the norm.

Every now and then, markets seem to fall victim to consensus thinking on various issues. Lately, markets seem convinced that global central bankers are infallible because printing money (QE) has driven down interest rates and driven up asset prices (real estate, stocks and bonds etc.) without causing wage or price inflation (so far). Debt doesn’t really matter because interest rates will remain low forever. Interest rates will remain low forever because there is simply too much debt for rates to go much higher (sounds like something Yogi Berra would have said). The risk of inflation reasserting itself ever again is non-existent but if it ever does make an appearance, central bankers will move aggressively to raise interest rates. And so on.

Right now, there is a massive consensus as it relates to the USD and commodity prices (which are priced in USD and move inversely to the dollar). The whole world is convinced that the USD will continue to rocket higher even though it is already up 20% over the last year. After all, the US Federal Reserve has been talking for over 2 years about raising overnight rates from their 0% anchor. As incredible as it sounds, the Federal Reserve has not raised interest rates for 9 years and has kept overnight rates at 0% for over 6 years! Clearly the American economy is not in outright crisis and hasn’t been for many years so (practically) free money is not really warranted. But it is hard to take away the punchbowl especially when the party has been going on for this long. So, yes, US interest rates will most likely be increased sometime over the next 6 months. But how high can they go when almost every other country is lowering interest rates?

Europe just started down the road of Quantitative Easing earlier this year. Japan has been implementing massive QE efforts now for several years. Quantitative Easing is all about driving interest rates down (and respective currencies) by creating money and buying up bonds which in turn drives up other asset prices and hopefully inflation. So how will the USA be able to raise interest rates beyond a couple of token increases when the rest of the world (including Canada) has been lowering interest rates? If they normalize too quickly, the USD will really soar and the American economy will struggle to stay out of recession as exports collapse. At the moment, the market seems to believe that the USA will be able to raise rates in isolation and a soaring USD is a certainty. This is why commodity prices have been collapsing lately as one large consensus about an ever-strengthening USD has been built.

Lower commodity prices are deflationary and the whole world has been printing unfathomable quantities of money in an attempt to create inflation and after all this time and all of these trillions, I am not so sure central bankers are going to abandon the game plan. There is a big question (in my mind at least) as to how all this plays out but at the moment, commodity prices have plunged about 14% this year and with some broad commodity indexes back to 2002 levels (which were lower than during the financial crisis when the markets were in chaos). Many commodity stocks are at levels not seen since the tech-wreck almost 15 years ago. Of course, the Canadian stock market has been ravaged lately since almost half of the index is comprised of commodity stocks.

All of these various global QE programs have pumped the markets full of liquidity and has created pockets of extreme optimism and pessimism. The “fast money” (like hedge funds) have sold short every commodity play and crowded into fewer and fewer momentum names. These are the names that keep going up because of engineered earnings (through acquisitions) and story stocks that have lots of potential but no earnings (like biotech). For example, the most valuable company in Canada now is Valeant Pharmaceuticals which is an acquisition machine that has completed something like 160 acquisitions over the last 7 years. The CEO has amassed a $3 billion net worth by doing larger and larger deals. Does it sound reasonable to anyone that this can continue? Whenever a company unseats Royal Bank (or even challenges it for top spot) it usually ends in tears (Nortel, RIM, Potash are some notable examples). Meanwhile, Amazon makes a couple of pennies per share and the stock goes up over 10% and is now worth more than Walmart. Netflix is worth almost twice as much as CBS. Shake Shack, a hamburger chain in the USA that has less than 70 locations went public earlier this year and was trading at a valuation that rivaled Wendy’s even though Wendy’s has almost 100 times more stores and 12 times the revenue.

These pockets of extreme optimism and pessimism seem familiar. The difference this time is that the overall market is not trading at expensive valuations. In 2000, the US stock markets indices were trading at over 35 times earnings and are now trading around 18 times. Not cheap but not rich either so I don’t want to sound overly negative. But I think the pockets of extremes valuations (both high and low) will reverse course hopefully sooner than later. I have said all along that there will be unintended consequences to printing money and manipulating asset prices. So far it has not played out the way that I expected with hamburgers being worth more than tangible “things”. I still believe that valuations matter and ultimately, price inflation (not asset inflation) remains the key objective of central bankers as it is the most desirable way to deal with record government debt levels in a lower growth global economy. At some point, I still think we end up with more inflation than we want but with massive government debts, reporting actual inflation will be a challenge. We may never see reported inflation again but the markets will.