The Smell of Dry Powder in the Morning

William Blake, the English poet once wrote, “In seed time learn, in harvest teach, in winter enjoy.” By Blake’s rule, fresh data suggest that the winter has set in with subzero temps and that there’s much to enjoy as private equity emerges from a record $73 billion in first-half buyout sales. In seed time they learned well one of the oldest lessons on the Street: Buy low, Sell high. It’s always wonderful when it works. The real question is what the kings of Wall Street have learned as they prepare to plant the next season’s crop? Will restraint rule the day? Or will the siren call of untapped fees be too much to resist, prices be damned?

News that private equity is cashing out is unabashedly good for investors. Limited partners, as private equity investors are known, agree to lock up their money for the better part of a decade in funds run by general partners. In exchange, limited partners rely on the promise of outsized returns when the companies that have been taken private are harvested via an initial public offering or a sale to another entity. Distributions, the crop harvested, is cash plus profits — and critically, net of generous fees.

According to a recent Triago report, fund managers distributed a record high $477 billion to their investors last year. That’s up 39 percent over 2013 and a shocking 215 percent above the six-year average.

This year’s distributions, an estimated $503 billion, are on track to surpass that of 2014. One trillion dollars over two years matters given the asset class totals $4 trillion in equity investments and commitments.

Did limited partners stuff their distributions under the mattress? Not hardly. In 2014, reinvestments and fresh commitments pushed annual funds raised to a post-crisis high of $438 billion. Not to be outdone, 2015 is shaping up to take out last year’s high with fundraising up 11.4 percent.

Traditional funds raised, when a limited partner commits to invest in a fund structure, tell only part of the story. Some $113 billion in new “shadow capital” commitments were also made last year through structures other than funds, such as co-investments, separate accounts and direct investments. Once again, 2015 is poised to unseat the record high for shadow capital commitments. Forget the post-crisis years which began in 2009. If the record paces hold for reinvestments, fresh funds and shadow capital commitments, 2015 could mark a historic high for new commitments to private equity.

The risk: there’s not a healthy enough fear of commitment moving forward. Despite record distributions, private equity is sitting atop a record heap of $1.2 trillion in dry powder, an industry term that captures committed capital that has yet to be deployed. It’s easy enough to comprehend why private equity is selling high. It’s much more difficult to explain how managers approach today’s investing landscape with the stated goal of buying low.

Judging by last year, the challenge is growing. In this year’s first quarter, the money called by fund managers to make new investments declined to the slowest annualized pace since 2009. The contrast between then and now is striking. In 2009, there was blood in the streets. The stock market was trading at its cheapest valuations since the early 1980s as the financial crisis raged on, taking down 200 victims that year alone among companies defaulting on their publicly-traded bonds. Today stocks are trading at over twice the valuation levels as 2009 thanks in part to the wide-open debt markets that have helped finance record share buybacks. As for defaults, though companies do fail to make due on their obligations from time to time, the quenchless thirst for yield largely prevents most companies from resorting to default. Such is the appetite for new issues of debt with any kind of a coupon.

The Federal Reserve’s zero-interest rate policy has done much more than facilitate record bond sales and share buybacks. Record low borrowing costs have also helped private equity cash out: bond sales for the express purpose of paying the company a one-time dividend were all the rage until last year when issuance fell off. That’s a good thing as piling debt onto an over-indebted company’s balance sheet tends to end badly for bondholders. On a more subtle level, the implicit floor under the stock market has allowed buyout firms to place 97 stock offerings in the three months to June, yet another record pace.

And yet, leveraged buyout volumes have fallen by 47 percent to $28.9 billion versus $54.1 billion a year ago. This suggests private equity firms recognize their weak position competing against merger-famished companies that are even more desperate to off-load some of their huge cash positions. The latest estimates places the global corporate cash cache at $4.2 trillion. If only easy money could get out of the way and in doing so lay the groundwork for investing this cash in organic growth and job creation rather than Monkeying With Your Balance Sheet 101!.

It stands to reason that leveraged loan volumes have fallen by 43 percent over the same time as the need to finance risky deals has cooled. Alongside the decline is a similar falloff in “covenant-lite” bond issues, in which bondholders are denied standard protections they’re given in a less frenzied issuance environment. Finally, bond sales by the weakest-credit issuers have fallen to half of last summer’s crazed pace. The reckless late-stage credit cycle behavior would appear to be ebbing.

It would be great news if this story ended there, on a prudent note. But the fact is, dry powder earmarked for buyouts is $450 billion. Meanwhile, debt issued to fund mergers and acquisitions is on the rise and approaching 2007’s peak levels. At some point, private equity may succumb to the gravitational pull of the credit cycle that has plenty of room left to run in no small part becausethe buyout kings have yet to unleash their purchasing power. The alternative would be returning committed capital to investors and foregoing the rich fees attached to it. The denial of the earth being round would soon follow.

All sarcasm aside, there’s never been evidence of humility in the DNA makeup of the self-proclaimed smartest guys in the room (the heads of private equity firms are the current titleholders – net worth is the yardstick that determines the reigning champions). Returning dry powder to limited partners would thus go against the very nature of the gentlemen who run what just 23 years ago was a cottage industry with $50 billion under management.

The alternative: spend the money, come what may in the pricing arena. After all, distributions enrich the general partners to a greater degree than their fee-laden limited partners. In other words, the kingpins of Wall Street have made so much money (the highest paid individual pocketed nearly $700 million last year alone) that they can afford to be price agnostic because they’re playing with someone else’s money.

Of course the Fed could step in and attempt to pull away the punch bowl. But that would too be out of character. The current generation of central bankers insists that their role is akin to that of a clean-up crew called in after the police have already been called by the neighbors.

It’s difficult to envision what the next harvest will yield. If the power of buyout capital is unleashed, knowing full well that private equity always juices their deal structures with leverage, then the current credit cycle has room left to run, and then some. As for the debt market’s cousin, the equity market, math dictates that the reduction in aggregate share count produced via buyouts will necessarily boost stock prices. Hence, despite lofty valuations, between corporations and private equity firms flush with cash, there may be more than enough buying power in the kitty to inflate both the bond and stock markets to untenable levels. The smell of dry powder in the morning may simply be too much to resist.

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Rational Exuberance?

“The mob will now and then see things in a right light” — Horace

If one dares make mention of overvaluation in the U.S. equity market, the derision incited takes one back in time to angry Roman mobs. Is it not plain, the masses shriek, based on a traditional price-to-earnings (P/E) ratio, that stocks are valued just a hair above their long-term average? Indeed, if you look back over the last 12 months of reported earnings, the current P/E of 20 is not alarmingly above its long-term average of 15. And that’s that.

But is that, that simple? At nearly 76 months, the current rally in stocks is surpassed in length by only two other stretches since 1932 – the 86-month run that ended in 1956 and the extraordinary 113-month era that culminated with the bursting of the Nasdaq bubble. Shouldn’t the current stock market rally prompt a rational investor to at least ask what underlying factors are driving the persistent trend? There’s no post-war economic surge that promises to produce the next Baby Boomer generation. Nor has a technology emerged that begins to compete with the advent of the world wide web? The shale revolution aside, the current rally has not been catalyzed by anything that appears set to alter the course of history.

Of course, stocks could have been so undervalued in March 2009 that they were simply poised to rise after a brutal and prolonged slump. The problem with this line of thinking is that history suggests otherwise. Stan Nabi, now the Chief Strategist “Emeritus” at Silvercrest once told a group of wet-behind-the-ears MBAs in training that there was one rule that never failed to deliver when it came to valuing stocks. Way back in 1996, when Greenspan was angsting about “irrational exuberance” and Nabi was still at Donaldson, Lufkin & Jenrette, Nabi said, “Stocks never emerge from a bear market until the Standard & Poor’s 500 is trading at a single-digit P/E multiple.”

There was little doubt in our minds as to Nabi’s credentials. He’d had the good fortune to study at Columbia University under the tutelage of Benjamin Graham, the father of value investing. It didn’t hurt that he’d attended Graham’s class with a young student named Warren Buffet. Suffice it to say, a long vigil began that day for one very impressionable market watcher for whom the wait has yet to end. The closest the market got to a single-digit P/E breach occurred in March 2009 when the S&P 500 troughed at the ominous level of 666, taking the P/E down to its most recent low of 13.3.

As for the true secular bottoms, ones that laid the groundwork for secular bull markets? The years 1921, 1931, 1942 and 1982 featured bear market troughs, when the P/E ratio did skid to a single digit. In some of these cases, P/E’s languished below 10 for prolonged periods prompting investors to cry “Uncle!” and abandon the despised asset class once and for all.

While there’s no doubt stocks had put deep fears into investors’ hearts by early 2009, they were nevertheless not the screaming bargain history suggested they could be. Maybe it was good enough that there was a gaping distance between 13.3 and 1929’s 32.6 to say nothing of December’s record high of 44. Maybe, but that reasoning just didn’t sit right with this market historian, especially from my perch within the halls of the Federal Reserve.

It’s undisputed that the financial crisis sparked by the subprime mortgage conflagration was the worst since the Great Depression. Why then, did stocks not react in kind, bleeding out until they too were trading at a single-digit P/E as they were in 1931? Could it be that interest rates, which had been slammed down to the zero bound three months prior, had a hand in halting history in its steps?

Few Fed insiders would deny that extraordinary measures undertaken in the heat of the financial crisis put a floor under asset prices of all kinds, including stocks, though such aims could never be uttered publicly by policymakers. Except for the fact that they were, on October 20, 1987 in a statement released by Alan Greenspan’s tightly-run Fed: “The Federal Reserve, consistent with its responsibilities as the nation’s central bank, affirmed today its readiness to serve as a source of liquidity to support the economic and financial system.”

The Fed intervened in the markets that very day bringing the fed funds rate down by a half-percentage point to just under seven percent. The stock market responded in kind, rallying as if on cue. Throughout the course of the next few months, The Fed repeatedly took overnight interest rates lower. Sometimes, as an added bonus the central bank would go so far as to give trading desks advance notice. How awesome was that, traders must have thought, the ability to position to profit before the fact.

Nobel Prize winner Robert Shiller has devised a twist of sorts on the traditional P/E ratio by comparing stock prices to the average inflation-adjusted earnings from the previous 10 years. The thinking behind this construct is corporate earnings can be affected by the bumps in the business cycle, which can render the traditional P/E ratio highly volatile. Smoothing out volatility to make any indicator less noisy and therefore more efficacious is intuitive enough. And yet, the Shiller ratio has become a target of stock market cheerleaders, many of whom have made a professional sport out of debunking his methodology. (Shiller’s measure suggests a higher current level of overvaluation than the more malleable, shorter-term P/E does, so what’s to like?)

To his credit, legendary investor Jeremy Grantham has not succumbed to attacking Shiller. Rather, he recently made an elegant observation with regard to the good professor’s full historic data set: The Shiller P/E averaged 14.0 times earnings from 1900 to July 1987; in the period that’s followed Greenspan’s taking the helm to present day, the Shiller P/E has averaged 24.4.

In other words, some element appears to have entered investors’ calculus that justifies paying prices that are markedly higher than they were before Black Monday, before Greenspan committed to provide liquidity to support the financial system. Years ago, investors even came up with a nickname to describe the effective floor placed under all risky asset prices since the Fed began making policy with an aim to mitigate losses: the “Greenspan Put.”

A put is a contract that allows the owner to profit if the price of an underlying security declines. If you own a put contract on the broad stock market, you make money as the stock market declines. To be sure, investors have changed with the times when it comes to the identity of the put’s benefactor. The current put is ever so originally called the “Yellen Put,” which replaced, of course, the “Bernanke Put.”

So which history should investors reference to judge the current value of the stock market — the pre-Greenspan era or that which followed? The former casts the current Shiller P/E of 27 as frothy, if not rich; the latter suggests investors are perfectly rational in their exuberance. After all, stocks are not nearly as overvalued today as they were in 1999. And more to the point, policymakers remain loathe to end an era, regardless of the damage it has wrought on the notion of price discovery.

The catch is that a put, as is the case with any contract, is not designed to be in effect in perpetuity. Then the question becomes, what happens if history eventually catches up with stocks, ultimately pushing valuations into single-digit P/E territory?  In that event, investors would rightly conclude that interventionist policymaking, while well-intentioned in name, was nevertheless destructive in the end.

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The Sin of Commission

To omit is to care-less. To commit is to care not. From the perspective of the populace and the financial markets, the question is whether the Federal Reserve has committed a sin of omission or commission when it comes to the thorny issue of inflation.

The subject of inflation has never been as complex as it is today. No doubt, an oversupply in countless industries, many of which would be more competitive if not for the ease with which inefficient operators can stay in business, pulls down traditional price gauges. This dynamic underlies the case for pronouncements that prices across the full spectrum are rising in benign fashion according to the metrics employed by those charged with safeguarding the dollar’s buying power. Economists deploy the term “hedonics” to shush-shush the whiners, ensuring the masses that their dollar buys so much more today than it did in prior times. The problem with this is the masses don’t necessarily need another cheap television, especially one that’s bound to break down. Last we checked, two of their most important needs– affordable education and health care–are not available at Walmart.

The (not) funny thing about inflation is that is doesn’t exist unless it pertains to something you need to buy, in which case inflation is a very real phenomenon, at least if you populate what is nostalgically known as the American middle class. Listen to any retiree and they will regale you with exact data points on the price of a pound of ground beef, their statin prescription, or a gallon of gasoline. Step down the demographic ladder to would-be empty nesters and they will tell you the pain in their budgets emanates from helping their children pay their rent, the cost to maintain their own home, and the fact that dining out, flying away or sleeping over at a hotel makes travel a thing of luxury, and therefore for many, also a thing of the past. Slide down one more rung on the age ladder and you arrive at the truly hard pressed — families whose high-schoolers live and die for an iAnything, or worse, those with offspring entering college. These folks are faced with some of the most difficult financial decisions of their lifetimes. Such is the reality of out-of-control higher education inflation, spurred on by the fact that student debt has become a profit center.

There is a distinct irony to easy monetary policy helping fuel the skyrocketing cost of a college education. Data on mortgage equity withdrawal (MEW) do not detail where the money goes, but the nearby graph suggests that during the housing boom, home equity withdrawal provided a potent support for tuition increases. Many of those bills are just now coming due as home equity lines of credit (HELOC) that were originated in the mid-2000s are nearing the end of the ten-year period over which only interest payments are made. (Never mind that Reatytrac recently reported that 56% of the 3.3 million open HELOCs in that $158 billion pipeline are “seriously underwater.”) After the bubble burst, the crash in house prices that began in 2006 put mortgage equity withdrawal into hibernation. Did that arrest the rise in tuition costs? Not hardly. Student debt added fuel to that fire.

Mortgage Equity Withdrawal

While there is no suggesting that student debt is a nouveau form of household debt, the fact that its growth took off in earnest in 2006 is anything but coincidental. Wage growth stagnating at the same time did nothing but exacerbate the budgetary dilemma of families. Something had to give and in the end the new source for the lack of wherewithal to fund higher education became student debt. The overall figures are widely reported but nevertheless breathtaking. There is even a student debt clock that has been designed by an educational website for MarketWatch which is modeled after the infamous National Debt Clock. Though it’s hard to fathom, student debt increases by $3,055 every second based on the growth rate in the nine years through 2015’s first quarter. The latest data point from the New York Fed placed total student debt at $1.2 trillion, a figure that has doubled since 2007 and surpasses both auto and credit card debt. Without doubt, cuts in public spending on higher education have not helped matters. The less the public can contribute, the more families have to.

Of course, there is a class of Americans who roundly applaud the Fed’s advancing an exclusionary definition of that scourge inflation and what it allows – the investors. Asset price inflation, whether speaking of stocks, bonds, commercial real estate and by extension, high-end residential real estate has been magnificent. The good news for the tony invitees to the rally’s party is asset price inflation is anything but benign and wholeheartedly welcome. The better news is measured inflation gives the Fed license to never remove the proverbial punch bowl. The catch is when the bubbles inflating all of these asset classes burst, the exit will not be wide enough to allow each and every investor who has been enriched since 2009 safe passage from paper to realized wealth. Perhaps then, the other kind of inflation, the one that is poorly measured but oh so critical, will make a difference, even to investors.

In the end, when the results of the grand experiment in easy monetary policy are in hand, history’s judges may determine that a more honest approach to measuring inflation was needed all along. If that is the case, the Fed’s sin will not be one of omission but rather that of commission.

 

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The Great Abdication

The business cycle is dead! Long live the business cycle!

Not too long ago, in a land not so far away, the business cycle was declared to be defeated. Policymakers at the Federal Reserve were credited with slaying the pesky beast that featured recessions as part of its nature. Such was the faith in the permanence of the business cycle’s demise that the era was given its own label, The Great Moderation, a perfect world in which inflation ran not too hot or too cold and profit growth was accepted as the steady state.

As is so often the case, reality rudely disturbed nirvana’s prospects. The Great Moderation devolved into the Great Recession precipitated by one of the most devastating financial crises in U.S. history. The veneer of calm advertised over the prior years was stripped away. In its stead, economists had to concede that an era of benign monetary policy had encouraged malinvestment, the scourge that Austrian Ludwig von Mises warned of in the early 20th century. An overabundance of debt, if left unchecked, inevitably leads to the misallocation of resources. In the case of the first years of the 2000s, the target was, of course, the housing market.

The hope today is that the current era of easy monetary policy will have no deep economic ramifications. Such thinking, though, may prove to be naive. It goes without saying that the heat of the financial crisis merited a monumental response on policymakers’ part. That said, the most glaring outgrowth has been politicians’ exploiting low interest rates to their benefit. While it’s conceivable that well-intentioned central bankers want no part in encouraging Congressional malfeasance, the fact remains that the lack of action on politicians’ part would not have been possible absent the Fed’s allowing Congress to abdicate its responsibilities to the manna of easy money.

Of course, we all appear to have been spoiled over the last 25 years. A funny thing happened when the Fed placed a floor under stock prices with assurances that investors’ pain and suffering would be mitigated – recessions faded from the norm. Over the past 25 years, the economy has contracted one-fourth as often as it did in the 25 years that preceded this benign era. Hence the illusion of prosperity, one that has rendered investors complacent to the point of being comatose. That’s what happens when entire industries are able to run with more capacity than demand validates simply because the credit to remain in operation is there for the taking. To take but one example, capacity utilization is at 78.1 percent, shy of the 30-year average of 79.6 percent some six years into the current recovery. The downside is that the cathartic cleansing that takes place when recession is allowed to play out all the way to the bitter end of a bankruptcy cycle never occurs – winners and losers alike stay in business.

The savvy fellows in the C-suites are not blind to reduced competitiveness. As such they are remiss to expand their core businesses too much, that is, until the time they can truly assess the operating environment in a post-easy money world. The tricky part is that the credit is still there for the taking. What’s to be done? In the words of one of the wisest owls on Wall Street, UBS’s Art Cashin, such environments raise the not-so-fine art of financial engineering to a “botox state”. It’s no secret that companies have been gorging themselves on share buybacks and mergers and acquisitions, non-productive but highly lucrative endeavors. When combined the results are magnificent – costs are cut, profits juiced and bonus season becomes the most wonderful time of the year.

The insult added to the economic injury is the players who are compelled to underwrite the not-so-virtuous cycle. Broken pension accounting and incentives continue to force the hands of the individuals tasked with allocating the portfolios underlying the nation’s $18 trillion in public pension obligations. One of the least discussed consequences of easy monetary policy is the damage wrought on the nation’s pension system. Not only have low interest rates compounded underfunded statuses, they have driven pension assets into riskier and less liquid investments than anything prudence would dictate. The catalyst is the perverse rate of return assumptions that are wholly disconnected from reality. Averaging 7.75 percent, these bogeys have forced allocations into credit plays, many of which are caged in the least liquid corners of the debt markets. The irony is that many pensions have sought to diversify away from their bloated equity holdings by seeking out what they perceive to be the traditional safe harbor of fixed income investments, much of which flows straight back into the stock market via debt-financed share buybacks and M&A.

All retirees’ security is thus at risk when the massive overvaluation in fixed income and equity markets eventually rights itself. Pension math, however, will forestall the day of reckoning in the financial markets given the demographic surge in retiring beneficiaries that require states and municipalities to top off pensions’ coffers. Pensions will thus dig themselves into a deeper grave than they would otherwise by buying the credit craze more time.

Meanwhile, would-be retirees who don’t have the safety of promised pensions continue to be punished by low interest rates. The past seven years have criminalized conservative cash savings. The Swiss Re report quantified what U.S. savers have lost in interest income at $470 billion, while debtors had an easier time. It’s no coincidence that the average 401k balance for a household nearing retirement will only cover two years based on the nation’s median income. Nor is it any wonder that the labor force participation rate for those aged 55 and older has increased by three percentage points over the past decade. If only they were all earning what they did in their prime years.

And the lesson to be learned when making ends meet is simply not feasible? That would be the tried and true economic offset, the magic behind the miracle of our consuming nation, which for too long now has been debt that pulls forward the demand that should have to wait. Despite the collapse in mortgages, overall household debt remains elevated; it isn’t that far below its pre-recession level, and households are now splurging on cars as lending standards have caved. Even credit card borrowing is making a comeback – the average household’s credit card balance of $7,177 is the highest in six years. Meanwhile, student debt is scaling record heights as families struggle to keep pace with the most egregious inflation plaguing household budgets, that of higher education.

As for the gravest sin of the QE era, in the fiscal year 2015, the U.S. government paid 1.8 percent on public debt. One would be hard pressed to identify any other debtor whose borrowing costs decrease despite its trebling in debt outstanding. Actually, that’s a privilege we need to protect. As for indemnifying the nation’s balance sheet, that opportunity has been squandered by spineless politicians who would rather maintain the veneer of scant deficits rather than extend the maturity of the nation’s debts. Our wise neighbors to the south recently issued a 100-year bond. Where, one must ask, is our leaders’ wisdom when we need it most?

Could it be that hiding behind the Fed’s largesse is the path of least resistance? It would certainly appear to be the case. All the while, the excesses in the financial markets continue to build unchecked. The time has long come and gone to abandon the model-driven decision framework that pushes the Fed into an ever-shrinking corner. It is high time central bankers acknowledge their complicity in enabling Congress to fiddle while the country burns. As was the case with the revelation that the Great Moderation was but a myth, it is crucial that our leaders retake the country’s reins thus also bringing to an end the deeply damaging era of The Great Abdication.

Up next:  Some ideas on next steps for the country.

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