There is little use of studying economics to be honest but one thing I did learn which continues to help me is this: Capital should always be allocated to the "marginal cost of capital".
What's interesting in this context is that the stock market in its most simple form is really an Input-Output black box: In goes "cost of capital" – out comes "profit". I don't think anyone will disagree that long- and medium term it's the profit which both explains and drives stocks best.
The most profitable companies get the best stock returns: Philip Can Dorn, MarketWatch: (See the listed companies in link left)
The conclusion reads
This brings me to the "dilemma" of today's market: The marginal cost of capital is significantly higher. My own Marginal Cost of Capital chart (50% US, 25% Germany & Japan 10Y yields) is up from -3.0 Z-score to +1.0 since low in late January – a significant move by any standard.
The average cost of capital has risen 55 bps and 65 bps earlier this month!
Of course there is a delay in time from rising rates to profit – the "black box" takes 6-9 month to process the changes in input prices (cost of capital) but it increasingly clear that should the stock market continues up, and the consensus is more positive than any time before, it will entirely be driven by increase in multiples.
The credit cycle peaked in March/April last year and now the cost of capital has been rising since January (six month) which means by September/October the full impact will be felt on profit. There is also some good reasons to expect buy-back programs to lose some steam as the continued aggressive buy backs are mostly funded not from free cash flow created but new net lending meaning we are getting "worse" quality earnings on top of rising input costs.
I note that several people love to comment that I am always "negative" on stocks, that may be the case when journalists quote me, but in terms of money managed I am neutral – not long, not short – I have not done a stock index deal in more than six months and I maintain my equity exposure at the required 25% mainly through mining and commodities now.
Here is my "official" view on S&P-500 dating back from February 2015:
Far from "bearish" I guess…..
The credit cycle also peaked a while back:
The real peak was in April 2013, with a new "lower" peak in April 2014 – The above chart shows US high Yield (HYG) vs. YoY return in the S&P500. The correlation seems reasonable…..
But let's look a more charts and marginal cost of capital:
Leveraged loans – high risk credit lending is also coming off.. again peak was April 2014-ish….
In more liquid assets – the 10 and 30Y generic US yield and the 30 Y average Mortgage rates looks like this:
You can ignore these rises in capital cost at your peril but I would warn that this is NOT going away – we can discuss Fed next move in 3D, 50 colors and with conviction but the cost of capital is rising already even before Fed is starting its "normalization". Fed is now priced to go most likely in December, but I remain with September as December becomes political with Primaries and US elections. The data should be "good enough" – not great but trend will be rising (from very low)
The strategy for most assets remains one of wait-and-see to me: I keep recommending the few people who wants advise to bring back their stock portfolios to January 2013 level – keep the profit in "slush fund" to be used later. There are too many unknowns to proceed full steam ahead – the tax of "volatility" in now again increasing:
The "catalyst" for change is the first Fed move- It will be full blown "margin call" – if you add my models plus FED consensus together with the "prediction" made in February all of the sudden looks interesting…..What is clear is that the market "expected return remains zero over 3, 5,and 7 years… have you play that soon becomes a an exercise in capital preservations.
Safe travels,
Steen
PS: Greece- to be honest I don't see Greece going away – everyone is losing now, the whole debate is being defined by emotions not long term solutions. Greece will fail again, only because they have no interest in changing their ways. They are in economic and political Catch-22.
Med venlig hilsen | Best regards
Steen Jakobsen | Chief Investment Officer
Saxo Bank A/S | Philip Heymans Allé 15 | DK-2900 Hellerup
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