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Terry Smith vs Andrew Monk - will it be different this time?

By Tom Winnifrith | Thursday 29 June 2017


Base rates are going to stay low forever so current (inflated) equity market valuations are justifiable. In other words "it will be different this time". I don't believe that and neither does Andrew Monk of VSA. But the great Terry Smith argues it might be...who are we to argue with Terry?

Monk contemplates this in his morning email today and it merits a wider audience. Over to the Monkey who writes:

Now yesterday I mentioned how the younger generation had never seen a rate rise ………….but then I was sent a piece by the great Terry Smith suggesting they still may not see one for a while

As I am sure you know, the late Sir John Templeton said that the four most dangerous words in investment were “This time it’s different” (there are actually five words in that sentence but being an American he thought “it’s” is one word). Sage advice one might think but investing on the basis of mean reversion to averages which have applied for quite long periods of time can lead to some egregious mistakes:

Until the early 1960s, for example, equities routinely had a dividend yield above that of bonds - the "yield gap" then became a "reverse yield gap" and, instead of mean reverting as most experienced investors at the time expected, it just kept going.

At the beginning of the 1980s US Treasuries were popularly known as “certificates of confiscation”. In the event, were one brave enough to have correctly postulated an inflationary “regime change” then the 16% or so yields available represented astonishing value. The longer you had been in the market the more your expectations had been conditioned by the sixties and seventies and the harder it was to recognise the new regime, which, of course, might have been derailed by the same factors that were responsible for the preceding inflationary decades.

Something similar happened at the end of the 1990s. The US economy was widely believed to be able to grow at 5% or 6% in real terms and TIIPS prospectively yielded 4.6% real - in any inflation environment. To suggest negative real rates on inflation linked government bonds would have been to attract ridicule.

Eventually, of course, people get used to the new regime. By 1980 no one was arguing for a “yield gap”. The irony is that the longer you have been operating in a market, the harder it is to accept that the regime has changed. There is the inevitable belief that all your experience of the last decade or two or more will be proven correct when mean reversion occurs.

My theory has long been that the events of the credit bubble and financial crisis have led to us being in conditions for which the closest historical parallel is the Long Depression of 1873-96. If I am correct, fairly obviously we are less than halfway through if the timeline proves to be similar and given that I cannot see that any of the fundamental problems which caused the crisis have been addressed I can’t see why that shouldn’t be the case. In this case the post financial crash low yield, low growth, high valuation environment might be another example of an investment regime change which will contradict the mean reversion theories.

I would suggest that the central case against owning high quality equities at this point and these valuations remains that it will all end in tears when rates rise (and rate rises are the cause of these sort of events) as a result of a cyclical recovery. Well if you can spot a cyclical recovery at the moment you either have better vision than me or you need vision correction. If as a result of an absence of a cyclical recovery, short US rates peak at 1.25-1.50% which looks increasingly likely and long rates at 2.75% then I would suggest that equities on a yield of 2.75% and a free cash flow yield of 4.40% (Nestle) which can deliver any growth (I would estimate at 4.5% p.a. for Nestle) may continue to look like good relative value. And in the end all value is relative.

The question is have equity bulls fallen into the trap of ignoring mean reversion of valuations or are bears refusing to recognise a fundamental regime change of the type that has happened in the past? I don’t know the answer, but I increasingly suspect the latter. From a behavioural standpoint I also suspect it is only when the bears cave in and accept that it is different this time that valuations and markets will become a danger and at the moment I see no sign of that.

This last para from Smith is the key


We now see that Carney is considering a rate rise and that people are re considering Draghi comments from earlier in the week and moving to my thinking – which is rates will slowly rise , QE will stop and a more normalised world will exist

So maybe I am right and Terry is wrong

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