When liquidity is awash, it isn’t time to chase performance!
Financial world seems divided. On one hand, we have treasury yields near multi-year lows with some even braving the negative side. On the other hand, equities never had it so good, hitting all time highs in many markets. Take the case of US markets. S&P is near all time high while ten year US yield was near multi-decade low just a couple of weeks ago, though has recovered since then. Contradicting signals, isn’t it?. One is hinting at flight to safety (risk-off) and other is pointing to reckless risk-taking. Negative yields in Japanese, German and Swiss bonds have only added to the puzzle.
In simple terms, negative or low yields in general mean increased risk perception (volatility and flight to safety) or expectation of weak growth in future (low interest rates in future). Of course, that doesn’t tally with the exuberant equities that are extrapolating extraordinary growth or betting on a much saner world. One of them, of course, is getting the future wrong. It is difficult to say which one. Bond king Bill Gross calls it a Supernova in bond markets waiting to be exploded. But he has been saying it for many years now with bond markets proving him wrong for long. Same is the case for bears on the equity side. Markets will eventually see reasons, but in short-term, it is anyone’s guess. As someone famous said, markets can remain irrational longer than you can remain solvent.
While this irrationality lasts, strange things happen. It gives rise to new breed of short-term flows that drives the distortion to devious levels. Some call it “Liquidity” and others call it smart “Carry-trade”. But these are short-term phenomena that vault the valuations to frenetic levels. Power of liquidity can never be questioned and it is unwise to fight liquidity.
That said, fundamentals have much less to inspire. Take the case of Q-1 earnings in India. The season is already midway. Nothing spectacular so far. If anything, it has been an disappointing start with lackluster results from IT behemoths and consumer staples. Woes in private sector banks have worsened with Axis bank’s asset troubles refusing to abate. With telecom expected to follow suit with its dwindling fortunes, earning season may not play to the sentiment of bulls. But that hasn’t stopped them from taking markets to new highs. When liquidity rules, fickle fundamentals hardly matter. When NBFCs are showcased as next sun risers, micro-finances as next master blasters and staffing companies are chased by 150+ times over-subscriptions (in IPOs), you know who rules.
What do long-term value investors do in such an irrational setting?. No prize for guessing. Stay away and sit tight. It is time for under-performance. By choosing not to chase liquidity/ momentum, one gives up on the short-term performance. In a way, short-term under-performance is the price, an investor pays for the long-term out-performance. Investing is often compared metaphorically to Marathon. As in Marathon, these are times to slow down the pace to get prepared for the longer haul. As Buffett quipped, the trait that builds durable success in investing is the ability to focus on process than on proceeds. No better time to remember this than now when greed meter is gyrating high.
Happy Value Investing!