(3D/L) July was relatively restful. The S&P gained 2.38%, bringing it to up 17.99% for the year. Volumes were down. Corporate reporting season was generally positive, although expectations were not meaningfully exceeded. Only the most curmudgeonly voiced dismay at the third consecutive high inflation report. The MSCI World Index rose 1.82% in dollar terms.
It would be tempting fate to call these the quiet summer doldrums, but it certainly feels that way. August, in our experience, is generally a half-speed period of vacations, except for the years in which it is a month of crisis and volatility. For the 2021 edition, we are hoping for calm in the markets and good beach weather.
We sometimes describe our investment philosophy as long term confident but short term anxious. The equity markets have been a great source of wealth accumulation over time, and we believe in our hearts that they will continue to be for generations to come. But we also believe that they are a dangerous and fickle place. Bad months can turn into bad years and sometimes bad decades. It may be unfair and even a bit illogical, but the path to the prosperity that many of us believe in is neither straight nor well paved.
Regular readers of this letter know that our recurring theme is expressions of anxiety over bad things we fear may happen soon. That they often fail to materialize, or turn out to be less upsetting than we imagined, is not a failing. The stock market is as much about probabilities and possibilities as it is about cold facts.
In general, we write about anxieties inspired by recent events, worries more or less widely held. But this is limiting. This month, taking advantage of what may turn out to be a short-lived period of calm, let us visit with a worry not currently widespread: student loans.
The first thing to know about student loans is the almost implausible rate at which the total amount outstanding has been growing. The chart below, data from the St. Louis Fed, shows the total amount of Federal loans, from 1994 to the present, a period in which it grew by an average of 22.5% a year.
This chart does not include private loans, which were the bulk of student loans before 2009. All loans outstanding totaled $1.7 Trillion at the end of last year. That number is undoubtedly higher now.
Google the phrase “student loan crisis” and you will get a raft of articles telling you that there are millions of people who are having trouble paying off loans they took out when they were optimistic teenagers. (At least until recently. There is currently a pandemic-related zero-interest moratorium on paying back federal loans. It expires at the end of September.)
The subtext of much of the crisis talk is lobbying for a blanket student loan forgiveness. Candidate Biden actually promised to wipe out $10,000 of debt per borrower during the 2020 campaign. President Biden has not made it a priority.
Loathe as we are to make political predictions, large scale loan forgiveness does not seem to be likely in the near future. The problem is not that it would only benefit about 15% of voters, but that those 15% are not seen as especially sympathetic by the other 85%. Many Americans did not have the opportunity to go to college. Others did and have already paid for it. A recent poll by Grinnell College found that only 27% of Americans were in favor of forgiving loans for all with student debt. (39% said they would support forgiving it for those “in need.”)
If this reminds you of the mortgage debt crisis that overtook the world in 2007, there is good news and bad news. On the good side, as large as student loans have become, they are still much smaller than home mortgages, which account for about ten times as much debt. And unlike mortgages, the bulk of student loans are held directly by the federal government, rather than being securitized in bonds, meaning there is less direct risk of a capital market panic.
On the other hand, mortgages are secured by a house. Student loans are unsecured. Borrowers generally have no assets, income, or credit history, and only a broad expectation of future earning potential.
Perhaps unsurprisingly, student loan default statistics sound like the worst of the sub-prime mortgage stories from 2008. According to educationdata.org, within one year of graduation, 40.9% of borrowers had at least one delinquency. 10.8% manage to default inside the first year, which is particularly impressive if you understand that the definition of default for student loans is nine months of delinquency. 25% default in the first five years. Between 10% and 20% of all student loans are currently in default.
What happens now? In the short term, we are guessing nothing, although the expiration of the student loan repayment vacation in a few weeks could raise the profile of the problem. More likely, student loan debt will continue its epic growth, borrowers will have increasing trouble keeping up, and the politicians in Washington will do nothing until the pot fully boils over. What happens then is anybody’s guess, although it is safe to say it will not be entirely pleasant. In the meantime, enjoy August.
The Market Sentiment Framework
We use our Market Sentiment Framework to adapt the mechanics and weightings of our full quantitative models to changing market conditions.
The Sentiment Framework gauges the current state of market psychology on two dimensions. Efficiency measures the crowdedness of the market, the volume of participants seeking investment opportunities. Lower levels of efficiency imply more market mispricing. Optimism measures the willingness of investors to take on risk in exchange for distant and uncertain rewards. Higher levels of optimism imply a better outlook for risky asset classes.
July saw both the Optimism and Efficiency levels decrease modestly.
Optimism began the month at 0.51 and ended the month at 0.32, essentially reversing its movement from June. Although still relatively low in absolute terms, Optimism is above its pre-COVID level and not far from its post-COVID high of 0.70 seen in mid-April of this year.
Efficiency fell, starting the month at 0.32 and ending at nearly zero. Efficiency continues to be comparatively low as compared to historical averages, which suggests a market that is still under stress, and indeed increasingly so.
Both measures are higher than where they were in early 2020. The current positioning of the Sentiment Framework implies a market that is functioning less than ideally, with marginally optimistic but fearful investors. This would imply a positive but challenged outlook for the market as a whole, but possibly an opening for value strategies to find opportunities.
Disclaimer:
PAST PERFORMANCE IS NO GUARANTEE OF FUTURE RESULTS OR PROFITABILITY.
The above is the opinion of the author and should not be relied upon as investment advice or a forecast of the future. It is not a recommendation, offer or solicitation to buy or sell any securities or implement any investment strategy. It is for informational purposes only. The above statistics, data, anecdotes, and opinions of others are assumed to be true and accurate however 3D/L Capital Management does not warrant the accuracy of any of these. There is also no assurance that any of the above are all-inclusive or complete.
