David Tepper Says Market Isn't a Bubble: His Thoughts on Valuation, Tapering, Airlines & More

After the Robin Hood Investors Conference last week, Appaloosa Management founder David Tepper sat down with Bloomberg TV to talk about the markets.

On market valuation: He does not think we're in a bubble now as he compared P/E multiples over the last 5 years to the 5-year period running up to the 2000 bubble.  Stocks now have seen little change in multiples, while stocks back then saw huge multiple expansion.

On airlines:  "Our big play versus the market is the airlines.  We're the biggest holder of many of these airlines." 

On his 2014 investing approach: "We'll probably stay long.  We recently put on a treasury short, to hedge ourselves against the equity markets.  Little bit scared of tapering... higher rates... though rates won't go that high."

On to be worried about: "I would be worried if I was a long/short guy and not long enough, that's what I'd be worried about.  But I'm not worried, because I am long.  But if I'm a L/S guy who can only go 60% long ... the biggest risk for the market is you'll have multiple expansion, higher growth, 10% earnings growth next year, and you'll have another year of 20-30% (performance)."

On J.C. Penney (JCP): "It was a tiny position... a trade and we're done."

On Twitter (TWTR):  They would have held Twitter longer, but they had a price target in the $40's and so when the stock hit that in the first days of trading, he exited.  "It's a discipline."

On Citigroup (C):  "Citi still has some pretty good upside, we think it can make 7 bucks a share."

On his performance this year:  "I think gross we're in the 40's (%)."

On tapering:  He does think it's time to start tapering. He also said: "There can be a short-term negative reaction.  But if you're tapering, it's because there's stronger underlying US growth.  And if there's growth, there's going to be higher P/E multiples and the market should be higher.  If the market goes down, that's great, it'll be one more opportunity that people will be come and buy."

On what a lower Japanese Yen means: "It means higher P/E multiples in Japanese companies, straight out.  That's the way it works, because they're such exporters. So when you have a weaker yen, you have higher earnings."

'I can't look at myself in the mirror': Hendry reveals why he has turned bullish

Eclectica hedge fund manager Hugh Hendry has said he has been forced to leave his bearish outlook behind as he faces up to a market “which only makes sense through the prism of trends”.

Speaking at Harrington Cooper's 2013 conference this morning, Hendry (pictured) said he is no longer fighting the "two-way feedback loop" which is continuing to boost risk assets.
That centres on the currency war being played out between the US and China, in which US QE prompts dollar-denominated investment to head to China, and China fights the resulting upwards pressure on its currency by manufacturing an investment boom.
Hendry said this creates a "global supply glut", leading to falling US inflation expectations (as this supply far outweights US domestic demand) - which in turn prompts the Federal Reserve to loosen policy once again.
"I can no longer say I am bearish. When markets become parabolic, the people who exist within them are trend followers, because the guys who are qualitative have got taken out," Hendry said.
"I have been prepared to underperform for the fun of being proved right when markets crash. But that could be in three-and-a-half-years' time."
"I cannot look at myself in the mirror; everything I have believed in I have had to reject. This environment only makes sense through the prism of trends."
Opportunities
Hendry said he is looking for ‘auto-correlations' that benefit from this feedback loop.
Though he first began turning more positive on the likes of US and Japanese equities last year, Hendry suggested this morning the current environment created more counter-intuitive opportunities.
"This applies to European banks, Greek equities, Spanish equities. You have got to be in things that are trending," he said.
The manager's Eclectica Absolute Macro fund had a 64% value at risk equity allocation in September, up from 45% in August, with December 2013 Japanese TOPIX index futures his biggest single holding on a VaR basis.
Addressing attendees this morning, Hendry said his comments would take on a "confessional" tone, and admitted his performance over the past year had been "at best, mediocre".
Hendry's CF Eclectica Absolute Macro fund has lost 2.6% in the nine months to 30 September, according to the firm.
Risks to his reputation
The manager acknowledged his changing stance may be viewed by some investors as a 'top of the market' signal, but said he is not concerned by the prospect of a crash.
"I may be providing a public utility here, as the last bear to capitulate. You are well within your rights to say ‘sell'. The S&P 500 is up 30% over the past year: I wish I had thought this last year."
"Crashing is the least of my concerns. I can deal with that, but I cannot risk my reputation because we are in this virtuous loop where the market is trending."
Hendry said he retains a degree of safety within his portfolio by hedging out his bullishness through trades such as high beta US stocks versus emerging market stocks.
"There is the constant danger that Western bankers turn bullish again, start leveraging up, and we see money go into productive assets, not financial assets," he said.
"If that happens and the Fed does tighten policy [as a result], it will just be really bad news for emerging markets."

Hugh Hendry Capitulates....

Hugh Hendry is one of the brightest, most entertaining of the long-standing bears and this week he’s grudgingly flipped bullish.

 ”I can no longer say I am bearish. When markets become parabolic, the people who exist within them are trend followers, because the guys who are qualitative have got taken out,”

“I have been prepared to underperform for the fun of being proved right when markets crash. But that could be in three-and-a-half-years’ time.”

“I cannot look at myself in the mirror; everything I have believed in I have had to reject. This environment only makes sense through the prism of trends.”

“I may be providing a public utility here, as the last bear to capitulate. You are well within your rights to say ‘sell’. The S&P 500 is up 30% over the past year: I wish I had thought this last year.”

“Crashing is the least of my concerns. I can deal with that, but I cannot risk my reputation because we are in this virtuous loop where the market is trending.”

The Looming Bond Fund Crash

Two charts in a recent presentation by Citi’s credit product strategist, Matt King, tell the story of a structural fault line in the financial markets. King illustrates how the assets of US mutual funds invested in investment grade and high-yield debt have trebled since 2008, from $300 to $900 billion, reflecting investors’ increasingly desperate search for interest income in low­-rate environment. But the infrastructure supporting bond trading has weakened. The banks that act as intermediaries between the bond market’s buyers and sellers have seen their holdings drop from $286 billion to $69 billion—by 76 percent—to levels last seen in 2002. And King reminds us that bond prices are much more prone to jumps and “cliff effects” than share prices: as an example, note the 2006-08 behaviour of Lehman Brothers’ equity and of the company’s 2016 euro-denominated bond (illustrated in the chart below). Lehman’s share price declined steadily over the two-year period leading up to the company’s insolvency as investors factored in its deteriorating prospects: but Lehman bondholders didn’t face up to the worst until right at the end, at which point bond prices went from 70 to near-zero in an instant. This kind of behaviour places an automatic strain on the relationship between bond funds—which promise instant liquidity and continuous pricing—and the underlying bond asset class. Meanwhile, the underlying liquidity of the bond market has deteriorated since Lehman went bust. Efforts at forcing bond trading into a central, exchange-like format haven’t worked. The market still relies on a dealer-centric, capital-intensive transaction model. And the dealers’ capacity to hold bonds has been steadily eroded since 2008 due to restrictions on proprietary trading and higher regulatory charges for inventory. When an asset manager wants to buy or sell bonds he typically asks several dealers via a so-called request-for-quote (RFQ) process. Dealers and clients are aware of each other’s identity all the way from the initial request through to post-trade clearing and settlement. Bond dealing is fragile and rests on trust (in particular that pre-trade disclosure of an asset manager’s intentions won’t be abused). Dealers are under no obligation to buy or sell bonds they don’t want and investors fear that prices could move against them. Meanwhile most bonds see little, if any trading at all. Investors have little idea of the real price of individual bonds until they test the market. Dealers’ daily price “runs” (lists) are indicative, non-binding and often biased to reflect their trading preference. In bonds, there’s no deep, transparent, anonymised market of the type we find on most stock exchanges (equities are usually traded via a so-called “central limit order book” or CLOB). Add this fundamental difference in market conduct between bonds and equities to the way many bonds are currently owned and there’s a particular problem, say Larry Tabb and Will Rhode, authors of a recent study (“US Corporate Bond Trading 2013: In Search Of a New Market Structure”—the study itself carries a hefty subscription fee, but you can read an interesting debate on the topic on the Tabb Group’s website, for which registration is required). “The low levels of dealer capital would probably be fine if all bond inventories were held by individual investors, who are less likely to liquidate their holdings in the event of a rate rise,” say Tabb and Rhode. “However, retail investors’ bond holdings are increasingly sitting in mutual funds and ETFs. Packaged fixed income products such as ETFs and mutual funds are perceived to be much more liquid and easy to sell than the bonds themselves. However, the truth is that redemptions will force bond managers to sell the underlying bonds….What concerns dealers and asset managers alike is the fact that an interest rate rise causes investors to liquidate fixed income funds…causing a flood of bonds to hit the market at a time when there is little dealer liquidity to absorb the shock.” You won’t find the managers of corporate bond funds or ETFs advertising this risk, except indirectly; last year asset manager M&G acted to slow inflows into its corporate bond fund, though the firm explained this at the time as a policy to help the manager invest funds more easily, rather than as a precautionary measure against potential redemption pressures. But we saw a dress rehearsal of chaotic bond fund redemptions in June this year when the Fed hinted it might raise rates. The ensuing market disruption then caused the US central bank to backtrack rapidly. The risk of large-scale bond fund runs remains. “I know first-hand that not only the buy-side but the sell-side is scared,” says Larry Tabb. Many buy-side firms have made efforts to overcome the structural imbalance in bond trading. There have been several initiatives to start trading networks involving the big investment firms. But so far these have all failed to reach critical mass. Asset managers are also reluctant to reclassify themselves as bond dealers, for fear of incurring heavier regulation. As a result, funds still rely largely on bank dealers to enter and exit positions. And in its study Tabb reveals an impasse between the buy-side and sell-side when it comes to the future direction of corporate bond trading. 100 percent of asset management firms support the development of an anonymised, all-to-all central limit order book trading system for bonds, Tabb reports. But almost none of the dealers are prepared to back this, Tabb’s findings show. “Why would we provide liquidity for the whole Street?” an unnamed sell-side respondent asked Tabb. “I have a limited amount of balance sheet. Why would I care if XYZ bank wants to get out of a position?” There’s a dangerous and increasing imbalance in the markets: a rising pile of debt held by funds promising instantaneous liquidity; and a bridge for those seeking to exit their positions that is capable of carrying less and less weight. It’s hard to argue against the measures taken post-crisis to make banks safer. But the imbalance between bond fund inventory and dealer capacity is getting steadily worse. For the time being the cracks are being papered over by government intervention in the form of near-zero interest rates and quantitative easing, which keep the yield hunt going. Experience, though, tells us that when a market accident is waiting to happen it eventually does.

Ray Dalio's team is concerned...

Ray Dalio's team is concerned about something else - "we're not worried about whether the Fed is going to hit or release the gas pedal, we're worried about whether there's much gas left in the tank and what will happen if there isn't."

Excerpted via Bridgewater Daily Observations,

In the old days central banks moved interest rates to run monetary policy. By watching the flows, we could see how lowering interest rates stimulated the economy by 1) reducing debt service burdens which improved cash flows and spending, 2) making it easier to buy items marked on credit because the monthly payments declined, which raised demand (initially for interest rate sensitive items like durable goods and housing) and 3) producing a positive wealth effect because the lower interest rate would raise the present value of most investment assets (and we saw how raising interest rates has had the opposite effect).

All that changed when interest rates hit 0%; "printing money" (QE) replaced interest-rate changes. Because central banks can only buy financial assets, quantitative easing drove up the prices of financial assets and did not have as broad of an effect on the economy. The Fed's ability to stimulate the economy became increasingly reliant on those who experience the increased wealth trickling it down to spending and incomes, which happened in decreasing degrees (for logical reasons, given who owned the assets and their decreasing marginal propensities to consume).

As shown in the charts below, the marginal effects of wealth increases on economic activity have been declining significantly. The Fed's dilemma is that its policy is creating a financial market bubble that is large relative to the pickup in the economy that it is producing. If it were targeting asset prices, it would tighten monetary policy to curtail the emerging bubble, whereas if it were targeting economic conditions, it would have a slight easing bias.In other words, 1) the Fed is faced with a difficult choice, and 2) it is losing its effectiveness.

We expect this limit to worsen. As the Fed pushes asset prices higher and prospective asset returns lower, and cash yields can't decline, the spread between the prospective returns of risky assets and those of safe assets (i.e. risk premia) will shrink at the same time as the riskiness of risky assets will not decline, changing the reward-to-risk ratio in a way that will make it more difficult to push asset prices higher and create a wealth effect.

Said differently, at higher prices and lower expected returns the compensation for taking risk will be too small to get investors to bid prices up and drive prospective returns down further. If that were to happen, it would become difficult for the Fed to produce much more of a wealth effect. If that were the case at the same time as the trickling down of the wealth effect to spending continues to diminish, which seems likely, the Fed's power to affect the economy would be greatly reduced.

...

...we think that US monetary policy is nearing a new test that will require wisdom and creativity along the lines of that which was required to deal with those problems. 

The basic issue is that quantitative easing is a much less effective tool when asset prices are high and thus have low expected returns than it is for managing financial crises.  That's because QE stimulates the economy by (1) offsetting a panic by providing cash to the financial system when there's a need for cash, and (2) by raising asset prices, and driving money from the assets they buy into demand and investment, creating a higher level of future economic activity.  So, the policy was particularly wise and most effective (in the sense of impact per dollar) at the height of the financial crisis when there was both a desperate need for cash and when extremely depressed asset prices were heavily weighing on demand and investment. 

Now, there is a flood of liquidity and asset prices are high relative to underlying fundamentals.  So the impact of additional asset price increases on demand is much less (as high asset prices and low future returns make assets more interchangeable with cash). 

Quantitative easing today is driving asset prices to unsustainable levels, without stimulating much additional activity.  That leaves a much clearer tradeoff between driving up asset prices today and lowering future returns (the price of which will be paid in the future).  During the crisis period, that was much less the case, because pulling forward returns from the future (i.e.,  raising prices) was then also creating future earnings growth (by helping to normalize the economy). 

The dilemma the Fed faces now is that the tools currently at its disposal are pretty much used up, in that interest rates are at zero and US asset prices have been driven up to levels that imply very low levels of returns relative to the risk, so there is very little ability to stimulate from here if needed.  So the Fed will either need to accept that outcome, or come up with new ideas to stimulate conditions.

We think the question around the effectiveness of continued QE (and not the tapering, which gets all the headlines) is the big deal.  Given the way the Fed has said it will act, any tapering will be in response to changes in US conditions, and any deterioration that occurs because of the Fed pulling back would just be met by a reacceleration of that stimulation.  So the degree and pace of tapering will for the most part be a reflection and not a driver of conditions, and won't matter that much.  What will matter much more is the efficacy of Fed stimulation going forward. 

In other words, we're not worried about whether the Fed is going to hit or release the gas pedal, we're worried about whether there's much gas left in the tank and what will happen if there isn't.

SOCGEN: In A Few Months, The Stock Market Will Drop 15%, Then Go Nowhere For Years

Nearly all of Wall Street is optimistic about the prospects for the stock market in the coming years.

Monday, the S&P 500 closed at 1676. The median 2014 year-end target for the index among Wall Street equity strategists, according to a poll by Bloomberg, is 1900 — 13% above today's levels.

Thus, a new report from Société Générale's asset allocation team — which calls for a 15% correction in the stock market in the first quarter of next year, followed by a multi-year journey back to where the index sits today — may come as a bit of a shock.

SG Cross Asset Research/Global Asset Allocation

SocGen's new S&P 500 price targets.

In the report — titled "S&P 500: -15% in sight, then the big sleep" — SocGen's global head of asset allocation, Alain Bokobza, explains how an unwind of easy money policies at the Federal Reserve and ongoing dysfunction in Washington will cause the stock market to languish.

"Strategically, we advise investors to switch into eurozone and Japanese equities, where economic policy is much clearer, monetary policy very loose and positioning is low," says Bokobza.

The strategist lays out the case in the report:

Between now and the end of the year, any decline in the S&P 500 is likely to be limited given that the Fed is still injecting liquidity. We expect the S&P to be at 1600 by year-end, in line with our technical analyst’s forecast (1560+/-10pts).

SG economists expect the January FOMC meeting to be the most likely timeframe for tapering. They look for the first move to be $20bn (instead of the $5-10bn previously expected by the market).

We expect the drop to accelerate at the start of 2014 as the market starts pricing in the end of asset purchases (i.e. well before the market’s Fed tapering expectation). The S&P 500 should dip to 1450 on our estimates, down c.15% from the peak.

Keep in mind the S&P 500 fell by -16% after QE1 stopped and by -17% after the end of QE2.

From Q2 2014, the S&P 500 should start to recover slowly after a technical rebound (c.+7%), as 'Growth' returns to the forefront. We see the S&P 500 at 1600 by the end of the year, so 2014 should be rather flat.

In the two to three years that follow, the U.S. equity index should remain relatively flat, burdened by higher yields (rate hikes in mid-2015), a higher U.S. dollar and limited earnings growth (Return on Equity is already high), but supported by better economic prospects and a new shareholder value cycle, staving off a bear market.

The SocGen report calls Fed tightening "a cap on the U.S. equity market," pointing to liquidity as "the main driver of U.S. equities since 2008."

Simply put, stocks will not be able to handle higher interest rates.

"U.S. equities have been able to absorb the recent increase in the [10-year] bond yield without panic thanks to a high equity risk premium," says Bokobza. "The U.S. equity risk has dropped from 6.8% to 4.7% over the last 10 months. According to our proprietary risk premium model, U.S. equities can absorb only c.80 [basis points] more; i.e., a bond yield of around 3.4% (to normalise our risk premium at its long-term average)."

The surge in long-term interest rates that accompanied a big sell-off in the Treasury market this summer as investors anticipated a tapering of quantitative easing did not weigh much on the stock market, but the 10-year yield only made it to 3.0%.

Datastream, SG Cross Asset Research/Global Asset Allocation

Note: Red line = linear regression. Return on Equity = 12-month forward earnings/current book value.

SocGen says the U.S. stock market — along with Switzerland's — is the most expensive in the entire world, as the chart at left illustrates.

"We continue to find some value in U.S. equities, but we particularly like financial sectors," writes Bokobza. "The rest of the market is now back to pre-crisis levels, trading at 3.2x book value. Over the last 30 years, the only period non-financial U.S. stocks traded higher was during the dot-com bubble (1997-2001), when markets entered into a period of 'irrational exuberance'."

From a fundamental standpoint, SocGen argues that it's becoming increasingly difficult for companies to deliver on earnings expectations.

"While the profitability of U.S. companies is already relatively high, earnings momentum remains in negative territory and is decreasing," says Bokobza. "It will be increasingly difficult for U.S. companies to beat consensus expectations. Last year earnings growth expectations for 2012 and 2013 were revised down sharply from the double-digit level. The consensus expects 10% earnings growth for 2014 and 2015."

But what about the Great Rotation?

"There is more money in U.S. equities now than in 2007 (not the case for European equities)," writes Bokobza. "Everyone has found good reasons to buy U.S. equities, even if some of those reasons are incompatible with one another: economic recovery, monetary stimulus, energy revolution, safe haven area or simply a lack of alternatives."

"After gaining 170% since March 2009, we believe that U.S. equities are a tired and crowded asset now."

EPFR, SG Cross Asset Research/Global Asset Allocation

Jeff Gundlach's Presentation at Invest For Kids Chicago

•    FDR is a parallel to Obama.  Government – federal, state, and local – costs too much…  New Deal
•    FDR inauguration in a banking panic
•    FDR blamed bankers immediately
•    FDR sent congress a record numbers of bills
•    FDR “try something” & the new slogan is “whatever it takes”
•    Record corporate profits – will they catch the attention of the tax man?
•    FDR raised the marginal tax rate to 100% (500,000 equivalent in today’s dollars)
•    Dynamite shack – sounds like quantitative easing
o    For now the dynamite keeps getting stuffed into the plastic shack
•    Synonym for early is wrong
•    Interest rates are low but don’t have to rise in the near term
•    FDR confiscated gold and the Fed now explains things are “the policy”
•    Speculation at the expense of savers
•    US margin debt is borrowing at the purpose of speculation – mirrors S&P 500
•    Currently alarmingly high
•    Lunch atop a skyscraper
•    Amazon with no earnings, Netflix, Tesla
•    Advice: do not get sucked in to QE and remember ocean of liquidity and risk manage accordingly 

As Third Point Does Well, Loeb to Return Money to Investors

The billionaire investor Daniel S. Loeb will return as much as $1.4 billion to investors in his Third Point hedge fund at the end of the year for the first time in its 18-year history.

Mr. Loeb, who started Third Point in 1995 with just $3.3 million in capital, told investors on Tuesday that its assets under management had grown to $14 billion, buoyed by strong performance from its flagship Partners fund and its Ultra fund.

The hedge fund will return around 10 percent of its capital by the end of the year, “in an effort to moderate this growth,” according to its Third Quarter Investor Letter reviewed by DealBook.

Third Point is following in the footsteps of some of the industry’s largest fund managers as they return money to investors or close their doors to new investors.

In April, Seth A. Klarman of Baupost told investors that he would return some of their money, “unless the opportunity set increases dramatically later this year.” It will be the second time in 31 years that Baupost has returned money to investors. Earlier this year, D.E. Shaw decided to stop taking new investors in its Oculus, Heliant and Composite funds.

Hedge funds have seen more than $45 billion of investor money flow into the industry this year, according to BarclayHedge and TrimTabs, yet their returns have continued to lag a soaring stock market in the United States.

Third Point, one of the industry’s top performers this year, has gained 18 percent in the first nine months of 2013, compared with a 19.8 percent gain on the Standard & Poor’s 500-stock index.

In his letter on Tuesday, Mr. Loeb also gave investors an update on some of Third Point’s recent investments.

Third Point bought a stake in Nokia over the third quarter after Microsoft announced it would acquire the Finnish mobile phone company for about $7.2 billion in an all-cash deal, Mr. Loeb said.

Citing an estimate that Nokia would be left with 8 billion euros of net cash following the transaction, he said “we expect a meaningful portion of the excess will be distributed to shareholders in coming quarters.”

Shares in Nokia rose 3.1 percent on Tuesday to $7.37.

Mr. Loeb also weighed in on Japan, where Third Point’s investment in Japanese equities “contributed significantly to 2013 returns.” Referring to a series of reforms under Prime Minister Shinzo Abe, Mr. Loeb said, “We believe Premier Abe has the best chance in over a generation to enact the reforms.”

“If he acts on these initiatives, we will be eager buyers of additional Japanese stocks,” he added.

Mr. Loeb, who has a reputation as an activist investor with a poison pen, did not mention some of his most recent activist campaigns.

Third Point’s bet on the Japanese giant Sony was absent from the letter. In June, Mr. Loeb sent a letter to Sony’s board, urging it to spin off part of its entertainment business. One month later, Mr. Loeb dialed down the tough tone and said he would continue to follow Sony’s progress and reassess his view before the company’s annual meeting next year. At the time, Third Point held a 7 percent stake in the company through ordinary stock and so-called cash-settled swaps.

Also absent from the investor letter was Mr. Loeb’s 9.3 percent investment in Sotheby’s.

On Oct. 2, Mr. Loeb called for the chief executive of the auction house to step down, accusing Sotheby’s of a “crisis of management” that has created “dysfunctional divisions.”

The new reality of international bonds

The infographic below shows how international fixed income instruments have grown to become the largest investable asset class—larger than domestic stocks, international stocks, and domestic bonds. Vanguard believes that foreign bonds can diversify a traditional portfolio in much the same way that foreign stocks do, by helping to offset the risks presented by U.S.-based investments.