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.
The market continued its impressive rebound despite incremental economic reports further exposing the terrible economic impact of shutdowns. John Authers captured the sentiment in his “Points of return” email from 6/2/20. I wouldn’t have used the word “special”, but the point is the same:
“Still, a disconnect this extreme between nightmarish scenes on the streets of the U.S. and a global pandemic, on the one hand, and a continuing rally in the stock market, is something truly special.”
I have mentioned potential reasons for the disconnect in prior letters and can add yet another one to the list. CrossBorder Capital compiles proprietary global liquidity indicators and reports that “liquidity conditions are clearly improving”.
While liquidity may very well be driving the rally, companies themselves are not buying into the idea of sustainable improvement. After repurchasing shares in record volumes the last several years, companies have made a dramatic U-turn and have begun issuing shares in huge volumes into the recent rally.
“U.S. public companies sold more than $60 billion in shares in May, the biggest monthly haul ever, as they capitalized on a stock market rally …”
While there are a lot of different reasons management teams may want to purchase shares, the reasons for issuing shares are much more limited. The primary reason is that management thinks shares are overvalued and therefore provide cheap capital at the existing price. If they did not believe this, most other forms of capital would be cheaper. Fortunately for these companies, there are plenty of willing investors to take the other side of the trade right now.
One of the things I have been focused on is the effects of the lockdowns on economic activity. The early effects are mostly lost wages, the intermediate effects will involve bankruptcies and credit tightening, and the longer-term effects will involve labor force reduction through the permanent exit of some people from the labor force. As a result, it is also distinctly possible that these forces will highlight the poor risk/reward tradeoffs for small businesses and therefore also further reduce entrepreneurial dynamism.
Now that we are getting information on wages the news is grim. Early reports show that wages fell more than they did in the financial crisis in 2008-9 (top graph).
This clear negative, however, has thus far been masked by the overwhelming extension of unemployment benefits, stimulus checks and other payments (shown in the graph of transfer receipts). These payments exploded in March and April and served to significantly offset the decline in wages.
As I have reported before, and the Zerohedge article clearly points out, spending has also declined significantly. This goes to show that the regular income from a job is an extremely important foundation for spending. As such, existing transfer payments, and any potential future payments, are only makeshift solutions. They are wholly inadequate substitutes for jobs. The key to watch for is the number of people who either get back to work in their old jobs or find new ones.
“The consistent pattern is that the most common [reproduction] number is zero,” professor Jamie Lloyd-Smith, from the University of California, Los Angeles, told the journal Science. “Most people do not transmit.”
“Clusters, the Hong Kong academics found, were more common in social venues, such as bars and music clubs, than at home or work. Large outbreaks have also struck worker dormitories, hospitals, care homes, churches, ships, meatpacking plants and schools.”
As many areas are reopening and many others planning on doing so soon, the question of how to do so safely is a timely one. I found this article by Anjana Ahuja to be both useful and oddly uplifting. Add to this the evidence that transmission is far less likely outside and we effectively have a map of risk vectors to plan around.
Most interesting to me is the finding that most Covid-19 cases are caused by a relatively few “superspreaders”. Conversely, most people who get infected do not transmit the disease to anyone else. This implies that people who are especially gregarious and not especially careful around others present the greatest risk of being superspreaders. It also implies that most other people probably present a low risk of spreading the virus to you.
While the finding about clusters is not surprising, it too provides a silver lining. The clusters provide a fairly clear definition of the types of situations that are higher risk. They require greater care to operate safely and should be avoided, if possible, by people who may be more vulnerable. In both cases, the new data allows us to manage risk better.
I don’t want to say too much about the protests because I’m sure everyone has already seen and heard more than they want to already. What I will say is that despite fairly widespread vandalism and bits of violence, these recent episodes have not featured the same kind of palpable anger and racial tension as the Freddy Gray riots in Baltimore did a few years ago (in my opinion). This violence seems to have a different character to it.
I will also say that I am mostly encouraged by the peaceful protests. There are plenty of things in this country that can be done better and it is refreshing to finally see people standing up for that. It doesn’t happen on its own.
This raises a point made by the historian and author, Jared Diamond. In his book, Collapse, Diamond identifies the key reasons why societies can eventually collapse. One of those reasons, and the only one completely under a society’s control, is “the society’s responses to its environmental problems”. He takes this notion of agency even a step further in his more recent work …
“In my recent book Upheaval, I established a dozen outcome predictors that have made it more or less likely that a nation would respond successfully to a national crisis: among them were acknowledgment rather than denial of a crisis’s reality; acceptance of responsibility to take action; and honest self-appraisal.”
At any rate, let’s hope that these protests are signs of honest self-appraisal, acknowledgement of serious problems and acceptance of responsibility to take action.
Advisor Perspectives, The Most Read Articles from May
This item is a bit of a non sequitur but addresses something I see and struggle with almost every day. The bottom line is that it is very hard for investors to tell what different advisors actually do and what their level of expertise is. The reality is that in many cases they are essentially glorified sales people.
So, Advisor Perspectives (AP) is a platform that aggregates content from a variety of sources and distributes it to advisors, brokers, wealth managers and others in the investment business. Content is provided for free for the sake of increasing awareness for its contributors and is consumed by advisors for the sake of gaining free access to potentially useful investment insights. I send my quarterly reviews to AP and generally receive positive indications as to the quality of the content.
A recent email from AP provided a list of the most read articles in May. As I scanned down the list it occurred to me that a number of the articles referenced presentations from John Mauldin’s Strategic Investment Conference (which I also listened to). When I glanced through a couple of the articles, it was obvious that these were just notes taken from the presentations with no additional color or interpretation. In essence, six of the top ranked stories in May were cliff notes from Mauldin’s conference.
This highlights a point that I think a lot of investors don’t fully appreciate. A substantial portion of investment advisors do very little in terms of research in order to stay apprised of markets. As a result, they feed on what they can get externally and this is often nothing more than investors can acquire on their own.
I do believe that most advisors are good people and truly want to do right by their clients. However, and I think this will increasingly be an issue, good intent is not enough to produce good outcomes, especially in times of significant change. That requires work and expertise and the reality is that the business model for many advisors does not incorporate substantial research efforts. It will be interesting to see if investors start demanding more.
Capital Wars: The Rise of Global Liquidity, by Michael J. Howell
I first came across Michael Howell a couple of years ago on Realvision in my quest to better get my arms around the subject of liquidity. Specifically, I have been trying to better understand the degree to which liquidity drives market movements and the mechanisms by which it works. I have written about it several times here, here, and here.
Howell’s comments struck me as thoughtful, global, and different from virtually all the other research I was reading on the subject. I bought his book shortly after it came out earlier this year and found it to be extremely insightful and well-written.
Liquidity is a worthwhile topic because, as Howell puts it, “measures of global liquidity are one of the best performing leading indicators of asset price booms and busts”. Importantly, as changes have occurred in banking and globalization over the years, so has the nature of liquidity.
To this point, Howell offers an updated and expanded view of liquidity. While M2, a measure of money supply, has been the standard metric for liquidity, Howell substantially expands the definition. Accordingly, global liquidity is:
“A source of funding that measures the gross flows of credit and international capital feeding through the world’s banking systems and collateral-based wholesale money markets. It is determined by the balance sheet capacity of all credit providers and represents the private sector’s ability to access cash through savings and credit.”
This absolutely makes sense to me because in a credit-based economy, you don’t need to have cash in order to buy things; having credit will suffice. As Howell puts it: “The spending is not limited by the amount of money in existence, but it is related to the amount of money people think they can get hold of whether by disposal of capital assets or by borrowing”. As such, this expanded view of liquidity also represents a “growing disconnect between economic textbooks and the practical operation of the economy”.
Howell breaks liquidity down into three primary components: “(1) Central Bank provision; (2) private sector supply and (3) cross-border inflows.” Further, since “institutional repos now surpass household bank savings accounts as the most popular financial instruments”, private sector supply has taken on the pre-eminent role in liquidity provision.
Some extremely important implications arise from these simple premises. One is that the balance sheet of the Federal Reserve is no longer a good indication of overall liquidity conditions because it doesn’t speak to the private sector supply component. Another is that a collateral-based credit system is subject to market pricing, and therefore potentially volatile.
This may reveal a great deal about the market’s resilience the last several years in general, and since the selloff in March in particular. What the Fed says is that it needs to maintain market liquidity. What the Fed means is that it needs to keep stock and bond (i.e., collateral) prices up so as to keep private sector liquidity flowing.
Implications for investment strategy
By Howell’s liquidity framework, the Fed’s expanded measures in March and April bode well for stocks by virtue of improving both central bank provision of liquidity as well as conditions for private sector supply. So, that can at least partly explain why markets have been so strong even with rapidly deteriorating fundamentals. We had strongly suspected the “what”; now we know more about the “why” and the “how”.
But how long can the liquidity game go on? Can liquidity keep pushing financial assets onward and upward or is there an end game? Surely, the process of markets going down, Fed increasing liquidity, markets going back up, cannot be repeated ad infinitum?
Both evidence and common sense suggest there are limitations. An important one that is not getting much attention is that there are legal limits; the Fed is not authorized to do whatever it wants. In particular, John Hussman describes how the “Secondary Market Corporate Credit Facility” (SMCCF) “is already illegal”. Although there has been shockingly little pushback thus far, the fact that the Fed was compelled to cross the threshold of legality strongly suggests it is approaching the limits of its policy reach.
Another limitation is one of effectiveness. Specifically, the Fed cannot resolve solvency issues, as I outlined in my Q120 Market review. It may well be that the Fed attempts to keep the prices of as many public securities artificially afloat as possible. Regardless, it has no power to prevent insolvency and it has very little power to affect credit conditions for small companies. As a result, any bankruptcies that do occur will serve to offset liquidity that has already been provided.
Yet another limitation to what liquidity improvements can accomplish is that monetary policy loses its effectiveness and beyond a certain threshold actually becomes counterproductive.
“As low growth & inflation make low-risk-asset income scarce (e.g. from government bonds), households are forced to reduce consumption and increase savings in order to meet retirement goals.”
“Forced saving further depresses demand in a vicious cycle.”
In other words, “monetary easing is deflationary”. The harder the Fed tries to help out by increasing inflationary pressures, the worse it makes things. I seriously doubt the Fed is going suddenly wake up to the errors of its ways and repent, but that is not what matters. What does matter is that the path is not sustainable from an economic or a political perspective.
To be sure, there are no easy answers for investors in this environment. I certainly understand the temptation follow the liquidity signal and chase stocks, but such a pursuit would require a belief that economic fundamentals will be almost instantaneously restored to pre-Covid-19 levels (which I don’t) or a belief that stocks can remain magically suspended right up to the point you want to sell them (whenever that may be). I can’t in good conscience do that with other people’s money and I sure don’t want to do it with my own.
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 email@example.com. Thanks! – Dave
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 firstname.lastname@example.org.
Principles for Areté’s Observations
- 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.
- 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.
- 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.
- 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.
- 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.
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.
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.