Forbes Family Trust Gives Forbes Readers the Real Deal
I recently caught up with James McGrath, co-chairman of the investment committee for Forbes Family Trust. I serve as Vice Chairman of Forbes Family Trust. We discussed how he feels after the first half of 2017, The Federal Reserve and interest rates, developments he is tracking, quant investing and his final thoughts on where Forbes readers can find value in the current environment. This was our interview:
Forbes: Halfway through 2017, how do you feel about the markets?
McGrath: We’ve been very happy with the way our portfolios have performed. Through the end of June, world equities were up almost 12% (that’s just for half the year), and most other asset classes performed well. It wasn’t all smooth sailing, however. International equities were even stronger than the than the US, where large cap was better than small cap. Bonds did well: 10-year treasury rates fell from 2.45% to 2.3%, so longer duration bonds did better. Within hybrid securities, convertible bonds were especially strong, but we do note that almost 50% of converts are tech issues, so pay attention to what you are buying. Two notable blemishes: oil fell 20% this year; commodities fell with it, but both started to rebound in June. Managed futures, an alternative strategy, fared very poorly in June, putting it into the red for the year.
July has been good, too, with additional strength in international equities, particularly emerging markets, and gains in commodities, infrastructure, and other yield producing assets.
Forbes: What about interest rates? How do we make sense of the Federal Reserve?
McGrath: Everyone’s crystal ball on rates is a little murky. Did anyone expect long rates to be lower now than at the start of the year? The yield curve has flattened, as long rates came down, and the Fed has increased the Fed Funds target. Where do we go from here? Inflation is a big driver of longer duration bond yields, but it has been tame. On the short end? We are seeing some different signals there. A poll of the FOMC suggests higher, faster, whereas the futures market is more sanguine. We tend to favor the market indications, as they’ve been more accurate over time. What do they indicate? The FOMC is looking at 3% Fed Funds rates two+ years from now, but the futures market is roughly half of that level. This would be our baseline assumption.
Back to bonds—while rates are still low, it is also the case that the duration of the Barclays Aggregate Index (a broad market index of US bonds) has crossed 6 years, which is much higher than its average of around 4.8 over the past 30 years. If rates go higher, those rate moves will have a bigger impact on bond prices.
One more thing about rates: higher rates may be bad for bonds, but not necessarily for stocks. In fact, history suggests that there is a positive relationship between rate increases and stock returns when 10-year yields are below 5% (such as today). The intuition is fairly easy to fathom. Such relatively low rates are consistent with a relatively benign inflation environment, but increasing rates, given certain assumptions, are suggestive of a strengthening economy, a good combination of factors for equities. That’s what we see.
Forbes: What are developments you are watching?
McGrath: In short, a lot! But, just to highlight a few. Washington is vexing. With Republicans firmly in charge of Congress and the Executive, the healthcare imbroglio has not impressed us. We haven’t been focused on healthcare as much as hoping for wider tax reform, but the way they’ve gone about things in DC hasn’t been encouraging. We feel that there is an incredible opportunity here and we would hate to see it squandered.
Two other things we are watching: volatility and employment.
We’ve seen some volatility this year, but it has dissipated so quickly. And these spikes were just into the upper teens, which were average levels of a few years ago. Now, the VIX index (a widely quoted measure of equity volatility) is settled in below 10, which is an incredible record low. That said, we don’t think the VIX is necessarily predictive of anything, but historically, low volatility has been associated with tight credit spreads (very much the case today) and higher, sustained volatility with market sell-offs.
The employment situation is interesting. The unemployment rate has fallen to a level many people hadn’t expected—below the 5% many economists have regarded as the threshold for inflation to ignite. The intuition is that once employment gets low enough, employers have to start fighting over employees, pushing up wages. But, we seem to be in a strange place. Anecdotally, we are seeing help wanted signs, postings, etc., suggesting that certain employers are struggling to find people. Unemployment is very low, but wages, and inflation more broadly? Not budging. Average hourly earnings have crept up ever so slightly—a 2.5% increase over the past year. Outside wages, falling energy and food prices (we mentioned oil already; food prices have also fallen—18 months in a row), have done a lot to keep inflation on the back foot.
Getting back to those help wanted ads: it now takes 31 days to fill an open job in America, which is more than twice the time required in 2009. One of the small business trade groups just reported that 33% of all small business owners couldn’t fill a job in the prior month, which is the highest number since November 2000. In April, there were over 6MM US job openings, a record, which is equivalent to 1.2 unemployed workers per opening. That’s up from 5.6MM last year. On the heels of the financial crisis, there were six unemployed workers per job opening. We’ve come a long way.
At the same time, we’ve been mindful of the so-called labor force participation rate—the amount of people that could be working who are or who are actively trying to find work. For a whole host of reasons, that number has been historically low. Part of it may be older workers retiring, but another big part has been the chronically unemployed—folks whose skills don’t allow them to compete effectively for the wages they desire. So, they eventually stop looking.
The situation is complex. In our view, there is ever more bifurcation in the employment market. Just today, we were discussing the NBA-like salaries Silicon Valley interns have been commanding. Reports are that interns (college kids, with raw skills at best) are pulling down $7,000 to $8,000 per month salaries, crazy perks, and sometimes housing allowances on top of that.
In summary, labor markets are tight, some highly educated workers can command high salaries, but broadly speaking, due to lower labor force participation, skill mismatches, and other factors, wage hikes are slow, and a lot of jobs are unfilled. There will be more to say on this in the months and quarters to come.
Forbes: Changing tack… We’ve started to hear a lot more about so-called “quant investing”. What sort of impact could that have?
McGrath: Absolutely. Quant investing is all the rage now, but we worry about the hoopla. Ultimately, “quant investing” is as useful and descriptive a term as “hedge fund”, meaning not much. Back in the day, when hedge funds were as rare as an Inverted Jenny stamp, when Alfred Winslow Jones, Warren Buffet, Ed Thorpe, and other were running their early investment partnerships, their unique structures and novel approaches meant that they were able to exploit inefficiencies that 99% of other investors wouldn’t. Because of the specialized approach and obscurity, an investor in a generic “hedge fund” was probably getting something more than decent. Today, however, with 9,000 hedge funds and $3TT invested across the space, arguably buying an average hedge fund is not a recipe for outsized returns.
So, getting back to “quants”. We’ve always been partial to investment approaches that are systematic, repeatable, and data-driven. Those are our starting points. We’ve admired select quantitative managers since the early 1990s. We feel that certain funds may continue to maintain an edge, but they may not always. Many of the techniques they have leveraged to great effect—particularly machine learning, signal processing, and natural language interpretation—are quickly being commoditized, with science fiction-like functionality of five years ago now available through open source libraries.
My point is that there are a lot of ways to stand out from the crowd. If the crowd is using newspaper headlines, hem lengths, insider transactions, or today—big data, genetic algorithms, deep learning, etc.—it doesn’t matter how simple or sophisticated the approach if everyone is doing it. According to Google Trends, the interest in “Data Science”, a few years ago just a blip in searches, now exceeds interest in hedge funds by a wide margin.
We can see some of this playing out in another area: managed futures are a type of systematic strategy, which we believe can be useful to portfolios, but which also has few barriers to entry. Assets deployed to the space have tripled since 2010, to $300BN. At the same time, roughly half of those assets are controlled by the top 10 managers, which have 95% correlations to one another. Yes, smart people, a good strategy, but cause for concern if everyone is doing the same thing.
We recall how HFT traders were being regarded as the new financial barbarians just a few years ago. Today? Not really. Innovation happens quickly, and financial markets are some of the most fecund petri dishes in the world.
For our part, we are redoubling our efforts to identify strategies that aren’t easily commoditized, from managers who are charting their own course. Inevitably, there will be other well-intentioned crazes in asset management in years to come. We expect to be looking elsewhere once Michael Lewis gets around to writing a book about them.
Forbes: Any final thoughts? Are we still able to find value in these markets?
McGrath: We think so, but investors need to be diligent and patient.
We’ve seen the gyrations in tech this year, but a lot of the broader market’s recent strength has been due to this sector. The largest companies in the S&P500 are Apple, Alphabet (Google), Microsoft, Amazon, and Facebook. These five firms make up 12.5% of the S&P; their performance has had an outsized impact on the broader index.
The story is similar globally. International equities have also seen tech mega caps responsible for outsized gains. In China, Alibaba, Asia’s eBay, climbed 60%, while gaming platform company Tencent, and WeChat, China’s largest social network, are both up more than 40%. The former two companies are among the top 5 constituents in the MSCI Asia Ex Japan Index, which is already up an impressive 20% in 2017. Tech has continued to move strongly higher in July as well.
We are seeing more value elsewhere. In particular, international equities still look good to us. On a forward basis, the S&P500 is trading at a 17.5X P/E ratio, which is somewhat higher than its 20-year average of 16X. Reasonable, decent value, but not cheap. Stocks outside the US? It is a different story. They are at a 14.1X forward P/E, which is lower than the 14.7X average, and offer a 3.2% dividend yield on top of that.
MLPs struggled a bit earlier in the year, but we see a strong tailwind and good fundamentals for certain issues, particularly those running midstream or transmission assets (pipelines and such.) While the current administration hasn’t accomplished many of their audacious goals, a lot of what they are doing with domestic energy production is flying under the radar.
US crude exports averaged a record 1.3 MM Bbls/day at the end of May, but the rest of the world isn’t keeping pace. Global oil demand growth is strong at 1.4 MM Bbls/day and shows price elasticity (demand increases as prices fall.) US production costs, whether in shale or conventional extraction, continue to fall, while other major players, such as Venezuela, are literally falling apart. The story is similar with natural gas.
In a yield-starved market, MLPs stand tall. Representative yields are around 7% with expected distribution growth rate over the next year almost 7%, implying nearly 14% forward-looking total returns. This for an asset class that is still 45% below 2014 highs.
So, yes—there is some value, if you know where to look.