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Arete’s Observations 5/29/2020

By David Robertson | May 29, 2020

David Robertson, CFA serves as the CEO and lead Portfolio Manager for Arete Asset Management, LLC. Dave has analyzed stocks for thirty years across a wide variety of sizes and styles. Early in his career, he worked intimately with a sophisticated discounted cash flow valuation model which shaped his skill set and investment philosophy. He has worked at Allied Investment Advisers and Blackrock among other money management firms. He majored in math with extensive studies in economics and philosophy at Grinnell. At Kellogg, Dave majored in finance, marketing, and international business while completing the CFA program concurrently.

Market observations

The market got off to a strong start this week and again with little incremental news or information to provide a clear rationale. Nice weather (in the northeast) over the holiday weekend probably helped as did reopenings in many locations.

In addition, there is certainly a widespread belief that the additional liquidity major central banks have provided in the last couple of months is bound to support stock prices. Technical indicators may also be playing a part as major indicators are approaching important thresholds. I also wouldn’t neglect any of the reasons I have suggested in prior notes either.

All of that said, there is yet another factor that strikes me as especially interesting. For the past sixteen days (by this chart) the S&P 500 is virtually unchanged during the day session; all the action has happened overnight.

Major Market Buy Sell Review, Arete’s Observations 5/29/2020

As it turns out, this pattern goes back a long time. It is easy to hypothesize that some actors are buying futures in low volume at night and selling them when new flows come in the next day.  

The more important takeaway, however, is this activity does not represent how most investors visualize the market nor is it an indicator of overwhelming market health. Sure, prices move, but not in a way that reflects ongoing processing of economic and business information.

Economy

Bankruptcy Tsunami Begins: Thousands Of Default Notices Are “Flying Out The Door

“’The default letters from landlords are flying out the door,’ said Andy Graiser, co-president of commercial real estate company, A&G Real Estate Partners. ‘It’s creating a real fear in the marketplace’.”

I have highlighted this before and I am highlighting it again because I think the issue of impending bankruptcies is not getting enough attention. One reason is that as the quote highlights, tensions flare and behaviors change long before a bankruptcy ever happens. Another is that even when bankruptcy does occur, it is a process that takes time. Fortunately, that process is reasonably efficient in the US, but it certainly doesn’t happen overnight.

Finally, and importantly, when a company goes bankrupt, it’s capital gets restructured which typically means the equity is destroyed and debt is written down to a sustainable level. In that process, money gets destroyed. This is key. While the Fed has provided a great deal of liquidity thus far, that will be offset by liquidity that evaporates through the process of bankruptcies. In one door, out the other.

Major Market Buy Sell Review, Arete’s Observations 5/29/2020

Another factor to keep in mind is that the efficiency of that bankruptcy process will depend on having adequate capacity. Gillian Tett reports in the Financial Times how strains are already appearing.

Swamped bankruptcy courts threaten US recovery

“What is even more alarming is that America’s legal and financial infrastructure seems ill-prepared.” 

“The fifth — and biggest — problem is a shortage of judges.”

“The alternative is a plague of zombies, sitting in legal limbo, that saps economic growth, erodes enterprise values and creates more investor uncertainty.”

Housing

Ivy Zelman and Barry Habib presented at the Mauldin Strategic Investment conference and provided some interesting insights into the US housing market. By way of background, Zelman is one of the pre-eminent analysts on housing and homebuilders and Habib has done excellent work exposing the intricacies of the mortgage market.

Both were more optimistic about the housing market than I would have guessed. An important reason is demographics. The prime age to buy a house is 33 years old and that segment of the population will be growing for the next several years. So, the demand side looks solid.

Another reason is the way homebuilders have adapted since the last crisis. During the last housing boom, buyers wanted bigger and bigger houses and builders competed to acquire property in attractive areas with good schools.

Now, builders are focusing much more on entry level homes where the incremental demand is. Accordingly, “now 70% of new builds are FHA approved”. Indeed, Zelman pointed out that for most markets, excluding the coasts, owning is cheaper than renting.

It will be interesting to see how this affects demand for housing in cities outside of the top tier. While some first-time home buyers are clearly looking to get out of the city altogether, I suspect quite a few will still be attracted to what cities have to offer. It will be interesting to see if cities that are less dense and more affordable than New York City gain some population.

Tidbits

$650 Billion Facebook To Cut Pay Of Remote Workers Moving To Lower Cost-Of-Living Areas

“The company could be cutting pay – or ‘adjusting compensations’ as CNBC so lovingly put it – based on the cost of living of where people will be working from.” 

“We’ll adjust salary to your location at that point. There’ll be severe ramifications for people who are not honest about this”

Facebook was a good early indicator of the work from home trend when it implemented the policy early in March. We’ll see if it will also be a good leading indicator for compensation adjustments. Regardless, this will be an interesting additional element for workers to incorporate into calculations about moving out of major cities. If it becomes more widespread, it could also have very interesting effects on inflation.

Canada

Almost Daily Grants email, 5/20/20   “The Canada Mortgage and Housing Corp. (a government sponsored mortgage insurer similar to Fannie Mae in the U.S.) sounded the alarm yesterday evening, as CEO Evan Siddall testified to the House of Commons that pandemic-related problems in the housing market are ‘cause for concern for Canada’s long-term financial stability’.”

“Signs of housing-related distress have appeared in greater frequency on the northern side of the border.  Canadian mortgage payment deferments account for roughly 12% of all mortgages according to the CMHC, up from 0.3% at year-end (by comparison, 8.2% of U.S. mortgages are in forbearance as of May 10).”

Canada never suffered a housing crisis the way the US did in the mid – late 2000s and as a result, never experienced a recalibration. That appears to be happening now. As house prices continued to climb, so did household/GDP. By a recent survey, Toronto and Vancouver rank as two of the very least affordable housing markets in the world.

This would be problem enough as is, but the Canadian economy is also heavily dependent on natural resources. As a leading exporter of oil and natural gas, the price declines of those commodities this year will severely affect the economy through lower income and lost jobs. This isn’t going to be fun.

China

“Points of return” email from John Authers, 5/26/20

It is probably fair to say that one of the more important flashpoints across the globe right now is Hong Kong. Belligerent rhetoric between the US and China has been escalating, most recently in the form of a clampdown on Hong Kong security by China.

There is a key point worth keeping in mind here. Hong Kong is a critical entrée to doing business in China because it represents the best of both worlds: stable rule of law on one side and access to China on the other. That appears to be changing. The implication is that there will be a different way of doing business with China for many companies going forward.

Credit

Almost Daily Grants, 5/22/20

“Marty Fridson, chief investment officer of Lehmann Livian Fridson Advisors, LLC, noted that between January 20 and May 15, option-adjusted spreads across the bond market widened in relative lockstep, with triple-As jumping to 107 basis points from 54bps (or 1.98 times wider) and single-Bs to 805bps from 335bps, a 2.4 times ratio.  The one outlier was from the double-B contingent, which more than tripled to 560bps from 186bps. Fridson concludes: ‘Imperfect absorption of newly created fallen angels is a bona fide effect’.” 

Fridson is one of the foremost experts when it comes to high yield and the point he makes here is absolutely worth watching. With the investment grade (IG) bond market much larger than that of high yield, and with a huge portion of IG bonds rated right at the threshold of high yield, there is all kinds of potential for indigestion when IG bonds get downgraded. Fridson’s data show this is already happening.

Topics – inflation vs deflation

“Tree rings” letter by Luke Gromen from 5/22/20.

Gromen raised an interesting point that I have heard few others talking about. In no time flat, The Treasury General Account (TGA) has exploded from about $400B to over $1T. And this happened after several years when it never breached $200B.

Major Market Buy Sell Review, Arete’s Observations 5/29/2020

According to Investopedia, the TGA is the Treasury’s “general checking account” and “The U.S. government makes all official payments from this account”. All of this begs the question, “what are the monster bills that are coming due?”

“… if the US government begins to spend the record $1.1 trillion it currently has sitting in the Treasury General Account (TGA) into the economy over the next 4-5 months in an attempt to juice the economy (and markets) ahead of the election.”

Gromen’s hypothesis is that this a war chest for the upcoming election. While this theory certainly has some conspiratorial notes to it, they happen to also be corroborated by Janan Ganesh, who has done an excellent job covering US politics for the FT

Donald Trump has a way to win the US presidency again: spend massively

“As his standing deteriorates, then, Mr Trump has one hope. He must ‘own’ the fiscal effort to save the economy. This means demanding another bill to that end — Congress passed the first in April — and skewing it to households over business. It means rivalling Joe Biden’s Democrats for federal largesse and not fretting about moral hazard. The president must spend his way to re-election.”

Who knows, maybe we’ll see some significant increases in inflation at the end of the summer in important swing states?

Implications for investment strategy

The Three Sides of Risk

Risk and risk management are subjects that typically cause eyes to glaze over so its unusual to find a discussion of the subject as captivating as Morgan Housel’s. In a beautifully written piece, Housel highlights one of the most important lessons investors could ever learn:

“In investing, the average consequences of risk make up most of the daily news headlines. But the tail-end consequences of risk – like pandemics, and depressions – are what make the pages of history books. They’re all that matter. They’re all you should focus on.”

What does this mean for investors? For one, it means that the vast majority of daily news and research will not have any material effect on long-term outcomes like retirement. As a result, they are not things investors should focus on. This is a point I made in a recent blog: https://www.areteam.com/blog/investing-for-the-end-game.

What types of things should be focused on? For one, valuations are excellent indicators of future returns over long periods of time. If you buy at excessive valuations, like they are right now, the chances of realizing attractive future returns is exceptionally low.

Another issue to focus on is investment strategy. Over the last 35 years or so, both stocks and bonds have performed remarkably well. That means the mix hasn’t really mattered much, so long as you didn’t have too much cash.

The record of financial assets over the last 35 years stands out as an anomaly across a broader history and broader geographic scope, however. In other words, one of the most damaging things that can happen to many investors is that neither bonds nor stocks perform very well through one’s investment horizon. If both perform poorly, with insufficient cash reserves, retirement income could be substantially impaired.

Yet another tail-end consequence is inflation – which is why I have been doing so much research on the subject. I don’t think inflation is an imminent threat, in fact, I believe deflation is the more imminent prospect. However, I also believe that the landscape is setting up such that the emergence of inflation is a distinct possibility well within the investment horizons for a lot of people. If it does emerge, it will wreak havoc with a lot of investment portfolios.

At this point, I would like to add a few comments about value and valuation. The reason why the value investment style has worked over time is because it based on a discipline of not overpaying for securities. The key is to buy something cheap enough so as to ensure a margin of safety in the investment.

Unfortunately, this approach has performed dismally for over ten years now:

Major Market Buy Sell Review, Arete’s Observations 5/29/2020

Major Market Buy Sell Review, Arete’s Observations 5/29/2020

Source: John Authers “Points of Return” email, 5/28/20

This raises an extremely important conundrum for investors: Why has value underperformed so substantially and when can it be expected to regain its longer-term advantage?

There are two parts to the answer and they are related. One is that economic growth has just not been especially strong and corporate debt has continued to rise. As a result, stocks that are cyclical or confronted by idiosyncratic challenges do not have the tailwinds to help them through to the other side like they have had in the past.

Another part is that monetary policy exacerbates these conditions. Low rates encourage higher debt levels which in turn constrains economic growth. Also, measures to “ensure liquidity” are also measures that prevent or abbreviate significant selloffs. As a result, the opportunities for value investors to buy cheap are significantly limited.

The result is captured perfectly by Demonetized in a post at https://www.epsilontheory.com/the-end-of-the-beginning/: “Economic policy will hamper mean reversion.” In other words, monetary policy has substantially undermined the mechanisms which tend to generate excess returns for the value approach.

Unfortunately, these policies put investors in a terrible position. You can invest in value stocks even though policies continue to constrain their performance. Not fun and not profitable, at least for the time being. Or, you can chase growth stocks regardless of valuation which almost ensures terrible returns over the long-term. Fun for a while, but ultimately not profitable.

At some point these things will change and we can pick up where we left off. For now, however, it is incredibly important to be paying attention to “the tail-end consequences of risk”.

Feedback

This publication is an experiment intended to share some of the ideas I come across regularly that I think might be useful. As a result, I would really appreciate any comments about what works for you, what doesn’t work, and what you might like to see in the future. Please email comments to me at drobertson@areteam.com. Thanks!        – Dave

Re-imagining Investment Services

While I have always believed that the investment management industry is well placed to provide helpful services for investors, I also believe that the industry has not stood out as an exemplar of aggressively improving outcomes for investors. My white paper, “Re-imagining Investment Services”, lays out how the investment landscape has changed and suggests some ways in which service providers might adapt to meet new challenges and opportunities.

If you would like to get a copy of the white paper please email me at drobertson@areteam.com.

Principles for Areté’s Observations

  1. All of the research I reference is curated in the sense that it comes from what I consider to be reliable sources and to provide meaningful contributions to understanding what is going on. The goal here is to figure things out, not to advocate.
  2. One objective is to simply share some of the interesting tidbits of information that I come across every day from reading and doing research. Many of these do not make big headlines individually, but often shed light on something important.
  3. One of the big problems with investing is that most investment theses are one-sided. This creates a number of problems for investors trying to make good decisions. Whenever there are multiple sides to an issue, I try to present each side with its pros and cons.
  4. Because most investment theses tend to be one-sided, it can be very difficult to determine which is the better argument. Each may be plausible, and even entirely correct, but still have a fatal flaw or miss a higher point. For important debates that have more than one side, Areté’s Takes are designed to show both sides of an argument and to express my opinion as to which side has the stronger case, and why.
  5. With the high volume of investment-related information available, the bigger issue today is not acquiring information, but being able to make sense of all of it and keep it in perspective. As a result, I describe news stories in the context of bodies of financial knowledge, my studies of financial history, and over thirty years of investment experience.

Note on references

The links provided above refer to several sources that are free but also refer to sources that are behind paywalls. All of these are designed to help you corroborate and investigate on your own. For the paywall sites, it is fair to assume that I subscribe because I derive a great deal of value from the subscription.

Disclosures

This commentary is designed to provide information which may be useful to investors in general and should not be taken as investment advice. It has been prepared without regard to any individual’s or organization’s particular financial circumstances. As a result, any action you may take as a result of information contained on this commentary is ultimately your own responsibility. Areté will not accept liability for any loss or damage, including without limitation to any loss of profit, which may arise directly or indirectly from use of or reliance on such information. 

Some statements may be forward-looking. Forward-looking statements and other views expressed herein are as of the date such information was originally posted. Actual future results or occurrences may differ significantly from those anticipated in any forward-looking statements, and there is no guarantee that any predictions will come to pass. The views expressed herein are subject to change at any time, due to numerous market and other factors. Areté disclaims any obligation to update publicly or revise any forward-looking statements or views expressed herein.

This information is neither an offer to sell nor a solicitation of any offer to buy any securities. Past performance is not a guarantee of future results. Areté is not responsible for any third-party content that may be accessed through this commentary.

This material may not be reproduced in whole or in part without the express written permission of Areté Asset Management.


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David Robertson CFA is the CEO of Areté Asset Management and founded Areté with the mission of helping people to get the most out of their investing activities. Most of his career has focused on researching stocks and markets, valuing securities, and managing portfolios for mutual funds, institutional accounts, and individuals. He has a BA in math from Grinnell College and a Masters of Management from the Kellogg School of Management at Northwestern University. Follow Dave on LinkedIn and Twitter.

2020/05/29
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