White Falcon started managing capital in the beginning of November. In this memo, we write about the current market environment, the path that got us here, and how we are navigating it and stewarding partner capital.
The investing landscape today has many of the classic attributes of a bubble. We arrive at this conclusion after analyzing valuations, flows, debt, and sentiment. Every one of these signals, in our view, is flashing red.
“There are two good standards for a bubble. One is boring statistics, and the other is an exciting behavioral frenzy” - Jeremy Grantham
To begin with, valuations, with the exception of a few sectors, are at one of their highest levels in history. The S&P 500 CAPE ratio or cyclically adjusted P/E, a valuation metric that smooths periodic fluctuations in earnings, is at 39.67x. It has a mean and median value of around 15-17x and has been higher than its current value only once before - in December 1999 when it was at 44.19x. We all know how that ended!
Second, according to Bank of America data, flows into equity markets are at all-time highs. In fact, investors poured more capital into equities this year than they have done in the last 19 years combined. Every investor is now in mode TINA – There Is No Alternative. Third, between margin debt (debt used to purchase equities), leveraged ETFs, carry trades, and options, leverage in the system has surpassed all past records. Not only do investors have the lowest cash levels in history but they have also borrowed and deployed capital in what is evidently an inflated market.
“There are old investors, and there are bold investors, but there are no old bold investors” - Howard Marks
Fourth, sentiment has been euphoric. There are many new investors in the market who have made and lost fortunes over the past year, thanks to the advent of zero commission trading, gamification of investing apps and narratives fueled by social media. We have seen frenzied speculation in not only meme stocks but also some larger capitalization stocks led by option dynamics. We have also seen alt coins and NFTs bid up on a single social media post. This behavior is eerily similar to that in previous bubbles such as in 1999 or 1929.
In fact, we are already seeing risk-off signals such as higher junk bond spreads, higher US dollar, emerging markets turmoil, and underlying divergences where equity indexes are only being supported by a few large stocks.
While the above conditions were present in each of the previous manias, they, by themselves, do not foretell an imminent end to the bull market. This is not a crash call. Rather, this analysis is an attempt to understand where we are in the cycle and to determine the best course of action going forward.
Before we elaborate on our positioning, we believe it is important to talk about the two factors that led us to the present situation: interest rates and central banks.
“In the absence of the gold standard, there is no way to protect savings from confiscation through inflation. There is no safe store of value”
- Alan Greenspan
Interest rates in the developed world have been on a downtrend since 1982. Any asset - be it a house or a business or a commercial building - is priced off of interest rates. The value of a business is the discounted sum of all the free cash flow it will produce over its lifetime. This value will be higher if we discount these cash flows at lower rates than if we demand a higher rate.
Moreover, central bank response to every succeeding crises over the last 30 years has been more powerful and absolute. This has given market participants an implicit assurance that in times of crises, and when asset prices fall, the central bank would engage in policies that would put a floor under asset prices. As a result, market participants started taking more and more risk. Why? The logic is as follows - in good times the market participants will make more money by taking greater risk and, if things go bad, they will be rescued by the central banks. ‘Buy the dip’ and ‘stonks only go up’ have become popular battle cries for most investors.
“Be fearful when others are greedy and be greedy when others are fearful”
- Warren Buffett
It is not our job or responsibility to judge whether what is happening in the economy or in the markets is right or wrong. We have a fiduciary responsibility to our partners to produce decent risk-adjusted returns. For this, we need to know and understand the rules of the game. We understand that, as long as disinflationary or deflationary impulses exist, the central banks have unlimited power and that there is an ultimate floor under asset prices. But, central banks' ability to support the market weakens if high inflation persists as an intervention with lower rates or more QE causes even more inflation.
Currently, reported inflation is running at above 4.5% in both the US and Canada. We do not have a definitive view of the persistency of this higher inflationary impulse but we recognize that market risks are elevated. Currently, the US 10-year bond yield is around 1.5% which means that bond investors are losing money on an real basis (after inflation). What if the bond investors revise their long-term inflation expectations upwards and decide they need 2.5% or 3% yields to compensate them for their risks? What would that mean for asset valuation and P/E ratios? What would that mean for businesses that are barely able to pay interest or businesses that are dependent on a constant inflow of capital? Crucially, what will be the second and third order consequences of any market accidents? It is worth remembering that almost all of the previous recessions and market accidents were triggered by central bank policy tightening and the central banks are currently in the process of tightening policy.
“I didn't get rich by buying stocks at a high price-earnings multiple in the midst of crazy speculative booms, and I'm not going to change.”
Due to the factors discussed above, we are cautious and maintain a defensive stance. What does this mean? Well, this simply means that,
We have increased our already high standards when we underwrite an investment
We are only focused on good quality businesses with strong balance sheets
We are investing in pockets of the market where valuations are still reasonable
We have initiated positions in hedges that will help protect the portfolio in a downturn
This caution has led us to have a high cash balance. We are not timing the market and these cash balances are a direct result of higher underwriting standards and smaller position sizes.