Gone With the Wind
<November 4, 2021>
A CEO once told me that he liked to put his company’s sails up when the wind wasn’t blowing. He was referring to his preference to invest in anticipation of demand, instead of waiting for demand to hit and being unprepared.
With supply and labor shortages spreading throughout the economy, many companies appear to have been caught off guard by today’s strong winds. For most of the current market cycle, short-term interest rates have been pegged near 0%, while quantitative easing has kept long-term rates artificially depressed. Ultra-low interest rates have starved investors for yield, causing shareholders to urge companies to return capital through stock buybacks and dividends. Ironically, monetary policy meant to encourage investment via low rates has caused many companies to reduce investment and return capital to shareholders. Instead of putting their sails up in anticipation of demand, many businesses have underinvested and are currently unable to meet demand.
As corporate America has been caught with its sails down, investors remain committed to chasing returns and assuming risk—their sails are wide open! According to data from the Federal Reserve, investors’ allocation to equities has reached a new record, surpassing the previous high set during the tech bubble. Of course, the tech bubble eventually popped with the Nasdaq and S&P 500 collapsing 78% and 49%, respectively (peak to trough). Equity allocations were also elevated during the housing bubble, with the S&P 500 declining 57% from peak to trough. Investors’ allocation to equities eventually bottomed in 2009 along with stock prices. In hindsight, investors would have been better served having their sails down near bubble peaks and their sails up after the bubbles burst.
For much of the current market cycle, investors have been rewarded for maintaining a high equity allocation and risk profile. In fact, remaining aggressively positioned in most asset classes has worked, as investors have ridden the strong and consistent monetary winds emanating from the Federal Reserve.
Over the past year, gains have been particularly impressive, inflating a variety of risk assets to cycle highs. Interesting fact: over the past year, the size of the cryptocurrency market ($2.6 trillion) has eclipsed the entire U.S. high yield market ($1.5 trillion)! We’re so old we remember when junk bonds would outperform when investors were clamoring for risk. These days they barely make it on the performance leaderboard!
With asset prices soaring, we’ve made the difficult and contrarian decision to lower our sails and reduce risk. Based on current prices, we believe investors are dismissing the substantial risk associated with extraordinarily expensive valuations combined with unsustainable monetary and fiscal policies.
After comparing our calculated business valuations to current equity prices, we see little reason why stocks could not have similar declines to those experienced after the technology and housing bubbles popped. In fact, given current valuations and the unstable foundation on which they stand (ability to maintain monetary accommodation in an inflationary environment), we believe the potential downside in equity prices has never been greater.
With valuations and potential losses so high, why do so many investors remain committed to historically overpriced equities? Over our careers we’ve learned that selling what is working is much harder than buying what is not. Whether it’s greed, ego (I’m right!), or adrenaline, we’re not certain—we just know selling a rapidly appreciating asset is hard and is possibly one of the most difficult decisions an investor can make. And placing the proceeds in cash yielding 0% makes the decision even more difficult! That said, based on the valuations of our opportunity set, this is exactly what we have been doing since stocks rebounded sharply from their 2020 COVID-induced lows.
In addition to the emotional challenge of selling an appreciating asset, many professional investors are forced to remain fully invested regardless of price and risk. Portfolio managers focused on relative returns often have investment mandates that limit their ability to navigate through a full market cycle. Mandates can restrict managers on how much cash they can hold or how far they can deviate from the composition of their benchmark. In effect, they are trapped in the relative return race, striving to beat their benchmarks and peers without looking different. How a portfolio manager can outperform without looking different remains a mystery to us!
Relative return managers are often judged on an annual, quarterly, weekly, and daily basis. There are even managers that monitor their portfolios and measure relative performance minute by minute! We believe the obsession with relative returns, and the associated pressure placed on careers, significantly influences an asset allocator’s incentives and behavior. When prices are rising sharply, the last thing a relative return manager wants to do is put down their sails! They must keep up or risk losing clients, assets, and their jobs.
Throughout our careers, we have never allowed the threat of losing assets under management drive our decision making. We’ve managed a little and we’ve managed a lot. Regardless of the level of assets we manage, our process and discipline does not change. We are committed to refusing to allow career and business risk influence our decision making. As absolute return investors, our decisions are based on one simple concept. Are we being adequately compensated for risk assumed? If we are, our sails will go up. If we are not, our sails will go down and they will stay down until opportunities return, as they always have.
With the winds in our investment universe picking up, we have lowered our sails and will wait for valuations to once again compensate us for risk assumed. As we watch our competitors zoom by—riding the winds of easy money and seemingly endless asset inflation—we are reminded of the lessons learned navigating through past market cycles and periods of significant overvaluation. As absolute return investors, staying afloat to make it to the finish line (full cycle) is extremely important to us. As with sailing—breaking a mast, capsizing a boat, or losing passengers—absolute return investors must avoid fatal mistakes that cannot be reversed or overcome. In our opinion, sails wide open in the current investment environment qualifies as one of those mistakes. And if we are right, many of today’s large unrealized gains may turn out to be as fleeting as the winds responsible for their rise.
The Palm Valley Capital Fund can be purchased directly from U.S. Bank or through these fund platforms.
Index performance is not indicative of a fund’s performance. It is not possible to invest directly in an index. Past performance does not guarantee future results. Current performance of the Fund can be obtained by calling 904-747-2345.
There is no guarantee that a particular investment strategy will be successful. Opinions expressed are subject to change at any time, are not guaranteed, and should not be considered investment advice.
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Mutual fund investing involves risk. Principal loss is possible. The Palm Valley Capital Fund invests in smaller sized companies, which involve additional risks such as limited liquidity and greater volatility than large capitalization companies. The ability of the Fund to meet its investment objective may be limited to the extent it holds assets in cash (or cash equivalents) or is otherwise uninvested.
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The Palm Valley Capital Fund is distributed by Quasar Distributors, LLC.
Wilshire 5000: The Wilshire 5000 Total Market Index is a broad-based market capitalization-weighted index composed of 3,451 publicly traded companies.
Cyrptocurrency: A collection of binary data which is designed to work as a medium of value or exchange wherein individual coin ownership records are stored in a ledger.
Junk bonds: Corporate bonds that are not rated investment grade. They tend to provide higher coupons but are considered lower quality and higher risk corporate bonds.
Real rates: interest rates minus the rate of inflation.
Quantitative easing (QE): a form of unconventional monetary policy in which a central bank purchases longer-term securities from the open market in order to increase the money supply and encourage lending and investment.