Whether Chicken Little is Right or Wrong, What Actions Should You Take Now?
Please do not cast me as Chicken Little screaming, “The sky is falling.” Nonetheless, there are several matters that give me pause at the moment.
Be Cautious About Creative Accounting
Investors are being asked to use a set of non-traditional metrics to value recent IPO’s, e.g., Uber and Lyft, and other companies. Haven’t we seen that movie before? Say in 1999 during the dot com bubble. Is this a good idea? Probably not.
The SEC and FASB have had an off- and on-relationship with non-traditional metrics. Query, is it time for them to take another look at whether sharper lines are needed around such metrics? If investors want to buy into them, fine, pay Elon Musk’s way to the moon. That said, there should be clear disclosures as to how such alleged-to-be-accounting metrics are devised, what they mean, and how they differ from formal accounting practices. Meanwhile, be critical of what you are being pitched. It may be another version of “this time is different.”
Pay Attention to Debt
Debt can be something of a stealthy force in the economy. For instance, an increasing share of Fannie Mae and Freddie Mac mortgage-backed securities have high and rising debt-to-income ratios. We have seen this movie before too, in 2008. It didn’t work out well the last time.
This is not just a matter of mortgage debt. Corporate debt is rising, particularly in the BBB tranches susceptible to downgrading (which requires that it be sold for legal-investment reasons, sometimes at fire-sale prices). Public debt is soaring, in the US, the UK, the EU, and Japan. The level of unfunded pension plan liabilities (which are not widely observed) is a serious matter that is not being addressed in a systematic way throughout the economy.
Some voices are warning of another crisis with some, or all, of the characteristics of both the sub-prime debt crisis and the EU public debt crisis. Moreover, as a result of low interest rates and legal restrictions imposed by Dodd-Frank, the Fed and other authorities have less leverage to address a crisis, should one arise, than they had last time around. At least one must say that an amber light is flashing in this realm.
Equity Valuations Matter
U.S. equity values are stretched. Gains in U.S. stocks have made them historically expensive relative to global equities. A recent article includes a chart of the ratio of the S&P500 to the MSCI ACWI ex-US monthly from 1994 to this May 14th. The lowest multiple on the chart was in June 1994 (3.1 times). The highest multiple was on May 14, 2019 (10.3 times). Maybe that makes sense – but maybe not.
In part, equity values are driven by low interest rates, which make it hard for investors to get a decent return on fixed income investments (which intersects with the prior section). Valuations are disquieting, especially at a time when political risks are manifold:
- Trade disruption between the US and China,
- Turmoil (potentially even the risk of war) in the Middle East,
- Instability in Eastern Europe,
- Political pressure on the Fed and the ECB to drive economic performance in the short-run,
- “Socialist” proposals on the left, and “new populist” proposals on the right, and
- Anti-corporate sentiment, e.g., Amazon’s unwarm reception in New York City.
What Should You Be Doing?
I do not know if, or when, the party is going to end. But the foregoing factors make me nervous. At the risk of returning to remarks in earlier articles, here is what I would suggest in the current environment:
- Be mindful of the degree to which valuations are stretched, to avoid unpleasant surprises.
- Have enough cash, plus assured sources of liquidity (e.g., expiring Treasuries), to cover a year’s spending, including:
- taxes (federal, state and local income, gift, real estate, etc.),
- current pledges and anticipated charitable commitments,
- capital expenditures (e.g., education, acquisition of non-investment personal-use assets, etc.),
- lifestyle maintenance, and
- alternative assets (venture capital, private equity and real assets) capital calls, without reliance on distributions — the disappointing experiences of Uber’s and Lyft’s initial public offerings could slow liquidity events.
- Review your long-term asset allocation targets. Be sure that they are suitable for your current and likely future circumstances. Consider doing that review with a trained professional.
- Rebalance back to your long-term asset allocation targets at least semiannually, reducing exposures that are above target and adding to exposures that are below target. I appreciate that there may be frictional considerations that inhibit your rebalancing, such as tax factors, age and health.
- When feasible (from the point of view of taxation and regulatory supervision) reduce outsized single asset exposure(s).
- Be prepared for potential unknown unknowns.
Please contact us if you would like to discuss any of the foregoing.
I gratefully acknowledge the thoughtful and important contributions of Reynolds Group’s board of advisors in the preparation of this article.
 Uber and Lyft Get Creative With Numbers, but Investors Aren’t Blind to the Losses, by Rolfe Winkler, Wall Street Journal, May 14, 2019 (also in the print edition May 15, 2019 at p. B-1)
 United States Securities and Exchange Commission
 Financial Accounting Standards Board
 Fannie and Freddie Back More Mortgages of Those Deeply in Debt, by Ben Eisen, Wall Street Journal, May 13, 2019 (also in the print edition on May 14, 2019 at p. B-1)
 Morgan Stanley Capital International
 All Country World Equity ex-USA Index
 Escalating Tariffs Test Investors’ Faith in U.S. Growth, by Amrith Ramkumar, Wall Street Journal, May 14, 2019 (also in the print edition on May 15, 2019 at p. B-1 under the headline “Shares Rebound, but Risks Persist”)