September 2017

The Dilemma of the Grey Rhinos

A "gray rhino" is a highly probable, high impact yet neglected threat: kin to both the elephant in the room and the
improbable and unforeseeable black swan. Gray rhinos are not random surprises, but occur after a series of warnings
and visible evidence. In Michele Wucker’s book “The Grey Rhino: How to Recognize and Act on the Obvious
Dangers We Ignore” she explores why leaders and decision makers keep failing to address obvious dangers before
they spiral out of control. As we look across the investment, economic, and geopolitical landscape we are wondering
the same thing. Do we ignore the Grey Rhinos? Do we participate with the crowd in a narrow market ignoring
valuation? Given that it is our goal to protect as well as to grow, we continue to err on the side of caution and
monitor our portfolios for the ever changing balance of risk/reward among the investments that we own.

The US economy continues to move along at a 2.5% GDP growth level with corporate
What is the Dilemma and earnings moving higher and job growth at a historically good pace. The worldwide
What are some Grey economy is also showing synchronized global growth and strong international earnings,
which in turn has sent many overseas stock markets to new highs. Yet, many investors
Rhinos?
feel at least complacent if not uncomfortable. Is it the dilemma of buying the leading
sectors like technology and the FAANG (Facebook, Amazon, Apple, Netflix, and
Google) stocks as they move to historically high valuations? Is it the narrowness of the
returns? Or is it the Grey Rhinos which represents the big obvious problem(s) that are
right there in front of us but which we refuse to acknowledge? It’s hard to put your
finger on it. After all, the market is up almost 15% in the US, with other markets
around the world up even more. But something seems amiss in all this, and we
remember that over time, things revert to the mean.

One of the greyest rhinos that we see is the reduction of central bank liquidity that is
Grey Rhino #1: The end
starting in the US and is likely to spread to the rest of the world over the upcoming
of easy money year or so.

   
 

With global economies stronger, central banks across the world are signaling that the
past decade of monetary easing is over. The ballooning of worldwide government
balance sheets is about to be reeled in. Liquidity, as we have known it, is about to end.
And yet, markets continue to move up unfazed.

One argument is that central banks around the world are getting better and better at
signaling their intentions. Therefore, these movements get ‘built into’ expectations
and thus are not worrisome to market participants. While we agree in part, we also
think that the pain points have not yet arrived. For example, while US central bank
balance sheets are going to begin to shrink very soon, expansion is happening elsewhere,
and thus GLOBAL liquidity is increasing. Once global balance sheets begin to shrink
that is likely to be a bigger concern. We are not sure when this will happen, but Krishna
Guha of Evercore ISI believes that this could happen as early as Q3 2018.

Another argument is that 10-year yields are only coming back to ‘normal’ and still
don’t have power to weaken growth. What is the tipping point? Jeff DeGraaf of
Renmac thinks that the crossover point to consider is a 10-year yield of approximately
3.6%, almost 100 bps higher than today. When you consider that several Fed
participants expect 100 bps of tightening between now and the end of 2018, and that
the 10-year today is about 2.5%, 3.6% is not really that far away.

Table 1
At 3.6% 10-Year Yields Could Begin to Negatively Affect the Stock Market

Table 1: “How do we get here?

This predicts the probability that
the correlation between yields and
the market will be negative over the
next 65 days. That probability is
50/50 at 3.61% which implies
stocks react negatively above that
level. We trust math, but are aware
of the dangers of precision when
applied to markets.” -Renmac

Source: Renmac
 

We believe that geopolitical instability is another Grey Rhino. Political upsets now
Grey Rhino #2: appear to be the norm – with Brexit in the UK and an unexpected Republican Sweep
in the US last year. The worldwide populist movements are disrupting governments
Geopolitical Uncertainty
everywhere as countries move away from decades of globalization and freedom of
immigration. In addition, issues surrounding North Korea, Iran, and Russia continue
to escalate. The rules of the sandbox are changing and thus outcomes more uncertain.

Domestic stock market valuation is our third Grey Rhino. The majority of market
research we see today references high valuation and either sees it as a source of worry
Grey Rhino #3: or something to be explained away due to the “current environment”. Average price-
Valuations to-earnings ratios for the S&P 500 have averaged 16.5x for the past 60 years, and just
under 19x for the past 20 years. Today we are close to 22x. While the current level of
multiples is high relative to history, the reality is that it can stay this way for an extended
time until a catalyst happens. While we can’t predict the catalyst, we have always
believed in reversion to the mean.

Table 2
Valuations Are Currently Above Average
Price-to-Earnings Ratios 1955-2017

Source: Bloomberg
 

Adding to the uncomfortable nature of high valuations is the fact that the market is
incredibly narrow. This means that the market is going higher because a relatively few
number of stocks, such as the FAANGs (Facebook, Apple, Amazon, Netflix, and
Google). We believe this adds yet another level of risk.

Our dilemma becomes, what to do when faced with these Grey Rhinos? According to
Dilemma: Should we Michele Wucker, the worst thing to do is nothing. “I think that’s a big reason why
gray rhinos don’t get dealt with. People are afraid they’re going to make a wrong
ignore the Grey Rhinos? decision about how to fix something, or they’re going to get blamed for doing the
wrong thing, instead of at least trying to do something. In many cases, you may make
the wrong decision about what to do. But that may actually change the playing field.
It can shake things up so that you’re more likely to get to a better place.”

We do our best to acknowledge and take action in the face of Grey Rhinos. We never
stop asking questions. We realize that we don’t have all the right answers. We try to
We Err on the Side of
learn from our mistakes and never get too complacent with our wins. Sometimes we
Caution get it right, sometimes not. But we completely agree with Ms. Wucker, that the worst
thing to do when faced with a Grey Rhino is nothing.

We have been cautious since the end of the first quarter. Our concern has grown as
Congress and the new administration have made no progress on their plans. We have
actively taken profit in areas that we think have reached our targets. Year-to-date from
a broad perspective we have used the rallies in the stock market to sell into strength,
keeping our cash balances higher than normal, and we parked the money in Treasury
Bills for a bit of extra return until we found opportunities. You should expect this plan
of action to continue.

Bonds remain in the crosshairs of all three Grey Rhinos. Over the past few years we
have been approached by several clients frustrated by low yields and asking our
We Continue to Favor opinions on investing in middle market bank loans where the aim is to return 5%
Investment Grade annually. With credit spreads at all-time lows (i.e. not being ‘paid’ for risk) and the
illiquid structure, we remind clients that these instruments are more expensive then
Laddered Bond Portfolios
they initially look. We continue to recommend a short-term ladder of investment
for the Risk/Reward grade bonds as the best balance of risk/reward. In fact, with recent increase in short-
term rates, we are finding highly liquid 3 year bonds at 2.5-3.0% yields. If one utilizes
bonds as part of an overall asset allocation strategy to reduce risk in one’s portfolio,
then the higher yields that come with higher interest rates are welcome.
 

As always, we welcome the opportunity to discuss your portfolio and our current
thinking with you at any time. While we have only spoken generically about asset
allocation in this letter, we believe that it is a very individual decision. We do our best
work for you when we are up-to-date on changes that may be occurring in your lives.
We enjoy speaking with you and sharing ideas on a consistent basis, and if your
situation changes at any time between our regular discussions, please reach out to us
and let us know.

We look forward to speaking with you soon and thank you for entrusting us with the
management of your money.

Bourgeon Capital Management Sincerely,

777 Post Road
Darien, CT 06820

203.280.1170 | 203.662.1100
[email protected] John A. Zaro III, CFA, CIC Laura K. Drynan, CFA, CFP®, CIC
Managing Partner Partner
[email protected]
This letter should not be relied upon as investment advice. Any mention of particular stocks or companies does not constitute
and should not be considered an investment recommendation by Bourgeon Capital Management, LLC. Any forward-looking
statement is inherently uncertain. Due to changing market conditions and other factors, the content in this letter may no
longer reflect our current opinions. Different types of investments involve varying degrees of risk, and there can be no assurance
that the future performance of any specific investment, investment strategy, or product made reference to directly or indirectly
in this letter will be profitable or suitable for your individual portfolio. In addition, past performance is no indication of
future results.

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