How inconsistencies in the market resolve themselves can have a profound impact on future investment returns.Artur Marciniec
Anybody who is intelligent and who is not confused doesn't understand the situation very well.
There are always disconnects in the markets. Things that are out of whack with what we've come to expect. As Charlie Munger, Warren Buffett's investment partner points out in the quote above, there seems to be more than usual right now.
Of course, what's normal or unsustainable is a matter of opinion. It's also up for debate how disconnects resolve themselves. It's rarely simple. I'm going to highlight three very different ones that jump out at me right now.
Crisis? What crisis?
It's hard to miss the disconnect in the fixed income markets. The U.S. Federal Reserve is intent on fine-tuning an economy that is already behaving well – steady job growth, 5.3 per cent unemployment, strong auto sales and rising real estate markets. So the Fed is going after what I call "nice-to-haves." Things like even better economic growth and stronger employment.
In doing this fine-tuning, the Fed has brought out the heavy artillery – near-zero interest rates. After five years of economic recovery, they're using crisis-level rates to pursue nice-to-haves. The Fed is risking over-stimulating large portions of the economy (autos and housing for instance) and leaving no cushion for the next recession.
So which is it? Is the economy in a perilous state (in which case someone should inform the stock market), or are central bankers, in pursuing perfection, getting in the way of the natural path of an economic cycle?
Focusing on now
There are two ways corporations can give back money to shareholders – pay dividends or buy back shares. By buying back their own shares in the market, companies can enhance their earnings per share.
The U.S. market in particular has become dependent on share buybacks. It's almost expected of a company, no matter where its stock is trading. But we've now arrived at a point where the amount of capital being allocated to buybacks is equal to what corporations are spending on capital expenditures (new plant, equipment, technology and people). Managements have chosen, with encouragement from the market, to maximize profits today rather than tomorrow.
On a company by company basis, buybacks may indeed be the best thing to do for the long term, but in aggregate, can we shrink our way to wealth creation?
The other important thing to understand about share buybacks is that they're pro-cyclical. In good times, they're strong and as a result, support higher stock prices. When the economy is weak and markets are down, however, buybacks shrink dramatically as management teams preserve their cash and wait to see how things turn out. In other words, they enhance the market's cyclicality.
To the moon
Have you noticed how many new age companies are dependent on advertising for their revenue? What leading growth company isn't counting on ads to make their business model work?
The powerful tech and social media companies like Google (including YouTube), Facebook (Instagram) and Twitter generate most of their revenues from advertising, and we read every day about new companies that have built an app, website or game to deliver advertising.
The disconnect? Are there enough advertising dollars to support the established mediums (television, radio, newspapers, banner ads, billboards, sports sponsorships) and justify the valuations of the newcomers?
It seems almost certain that the conventional media will continue to lose market share. Dollars currently being spent on newspapers like The Globe and Mail or "The News at Six" will be re-allocated to shared photos, a tweet and Grand Theft Auto 22.
And if the new providers can improve advertising effectiveness through enhanced analytics and precise targeting – i.e. deliver more revenue per advertising dollar – it makes sense that the advertising pie will grow substantially. If Molson and McCain Foods get more bang for their buck, they'll spend more bucks.
But it seems to me, from an investment perspective, something has to give. The advertising pot is finite. Either conventional media will disappear more quickly than expected, or the total capitalization of the new media players will go through a correction. I'm betting on both.
How inconsistencies in the market resolve themselves can have a profound impact on future investment returns. If you believe they're unsustainable, then you need to understand how they will eventually re-connect.
Tom Bradley is president of Steadyhand Investment Funds Inc.