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.
Areté’s Observations 6/19/20
After the market hit an air pocket at the end of last week and futures were down going into Monday morning, it looked like this might be a week of digestion or even reckoning.
As soon as the market opened, however, stocks started moving up and continued to do so steadily through the day. One reason may have been that discussions of a large infrastructure spending plan came up again. Another reason was that the Fed made a surprise announcement that it was expanding its corporate bond buying program.
This happened as the volatility index (VIX) remained elevated from the week before which may have provided some motivation. However, the Fed move also nudged the bond fund LQD up to hit its all-time high. The paradox leaves the Fed’s rationale as an open question, but market participants wasted no time interpreting the move as open season for stocks.
On Tuesday, a strong retail sales report kept the positive sentiment going. Wednesday was quiet and on Thursday, greater than expected new unemployment claims sent prices down again. Friday is a big options expiration day and started on an up note.
Last week I discussed the surprisingly good May jobs report and the qualifications that should accompany those numbers. This week proves the point. New data from the Monthly Treasury Statement shows “federal withheld income tax receipts falling a record 33% from the comparable period one year ago”. In addition, “The scale of the decline in tax receipts is nearly three times the decline in reported household and payroll employment.”
This discrepancy raises a couple of points. One is that you can increase your conviction about something when you have more data and more confirming data. A single data point can be subject to a lot of error.
Another point is that hard data is better than modeled data and tax receipts are hard data. As a result, the tax receipts are more likely to provide an accurate picture of the situation than the May jobs report.
Yet another economic report – the May retail sales report – came out on Tuesday and this time the news was good and fairly uncontroversial. Although a rebound was expected, the reported numbers were better than expected with headline sales up 17.7% sequentially. That said, the year over year change was still down 6.1%. Dig into the sales categories a bit and you can see why it is important to maintain perspective. Clothing sales, for example, were up 188% in May, but are still down 63.4% from where they were a year ago.
This tweet by @TaviCosta also reveals something potentially interesting about spending trends. While OpenTable reservations have trended up, as would be expected, recently they have ticked down again. Why?
There is always a possibility of a data glitch, but that doesn’t seem very likely in this case. I’ll offer another hypothesis – which is also partly a projection of my own experiences: After being cooped up for three months, people are champing at the bit to return to normal ways and experiences.
Once people actually get out to realize those experiences, however, they discover in many cases that the experiences are not as good as they remembered or hoped for. As a result, some enthusiasm for repeating the experience is lost. This isn’t anyone’s fault; it is just a function of the world adapting and trying to keep people safe.
The important question this raises is, how robust will the recovery be? While there are good reasons to be encouraged that some sense of normalcy is returning, this is also happening with the helpful (and temporary) cushions of extended unemployment benefits, rent and mortgage moratoria, and small business loans. When such assistance runs out, there is a good chance that several businesses will not be able to continue.
Nowhere is such caution more appropriate than with the restaurant industry. Many restaurants are independently owned, run on thin margins, and are dependent on relatively dense seating arrangements in order to be economically viable.
“As many as 85% of independent restaurants may permanently close because of the pandemic by the end of 2020, according to a report commissioned by the Independent Restaurant Coalition.”
This is an issue that I continue to think is hugely underappreciated. The fact is that Millennials have faced more difficult economic conditions than any other generation in a few hundred years. I’m pretty sure most other generations do not appreciate the degree to which this is the case.
Although part of the problem is demographics, and therefore not controllable, part of the problem is excessive debt, which is controllable. Persistent overspending, excessive aversion to paying for it, and an unwieldy backlog of entitlement promises have been dealt with by issuing increasing quantities of debt.
Since the vast majority of the incremental debt is paying for consumption (as opposed to investments), it is simply pulling forward demand at the expense of future growth.
I don’t have kids but I still cannot understand why a society would choose to systematically deprive its kids of a fair chance to be economically productive. Things like Medicare, Social Security, and extended unemployment benefits are not bad things, but they are not free either. The graph at the right is an excellent illustration of the cost of such programs.
Fiscal and monetary policy
Given the scale and prominence of policy initiatives (both fiscal and monetary) since the market’s selloff in March, it is fair reflect on what has been done and how effective it has been. As Nomi Prins tweeted, it appears the Fed’s recent efforts to expand purchases of corporate bonds was wholly unnecessary.
This begs the question of why the Fed felt compelled to act? Was it spooked by the rise in the volatility index the week before? Maybe. Nonetheless, the moves are extremely difficult to justify given the record low yields on corporate bonds.
Is it possible that the Fed has finally capitulated and accepted that this is it’s “do whatever it takes” moment? Possibly, and scary if true. There certainly seems to be some degree of acceptance that this might be the case.
My favorite contender as an explanation is similar but more specific: the Fed can see all-too-clearly how weak the underlying economy is and knows that it needs to do whatever it can to keep things afloat.
John Hussman mentioned a Wapo article that highlights the lack of transparency in regard to the PPP loans. As an analyst, I have found that when companies or people do something well, they have every incentive in the world to publicize that performance. I have also found that there is pretty much only one reason why people fail to disclose information and that is to hide something. Regardless, the recalcitrance of the administration to disclose information regarding the disbursement of public funds not only raises warning flags about potential impropriety, it also raises the hurdles for securing additional funding to support the economy. What Senator or Representative wants to be accused of approving public funds for dubious purposes?
Finally, this note by Brad Huston helps put things in perspective. We all have our own views as to how effective or ineffective policy has been in dealing with the coronavirus. How does that perceived benefit match up with $10,393 for every single person in the US? My vote is less.
One of the flagship monetary policies the Fed has relied on dating way back to the financial crisis in 2008 is quantitative easing (QE). As Michael Lebowitz describes in a recent post, QE was useful in “forcing investors into riskier assets” by reducing the supply of “safe” Treasuries.
In anticipation of even greater issuance of Treasury debt and the distinct possibility that there will be a dearth of investors willing to buy it at acceptably low yields, the Fed is planning its next moves. Near the top of the agenda is what is referred to as yield curve control (YCC).
As Lebowitz also describes, “Embedded in YCC is the specific goal of targeting particular interest rates across the entire yield curve.” In other words, the Fed buys or sells Treasuries in order to achieve the prescribed interest rate for each tenor.
The only problem is, should the Fed buy Treasuries to achieve the desired rates – or sell them?
“I argue that LSAP [large scale asset purchases such as QE] ultimately result in higher (not lower) Treasury term premia, steeper (not flatter) yield curves and higher (not lower) long-term yields.”
“LSAP are multi-faceted: the signalling and liquidity impacts of LSAP on the demand for government bonds outweigh any scarcity and duration effects.”
Research by Michael Howell not only provides valuable insight into the dynamics of asset purchases, but also raises serious questions about how to conduct monetary policy.
A key assumption behind YCC is that the price (and therefore yield) of Treasuries responds directly to supply and demand. If the Fed steps in to buy existing Treasuries, demand goes up, price goes up, yields go down. Simply dial purchases up or down until you get to the desired yield.
Howell indicates that things are not nearly so straightforward. Although purchases of Treasuries have an incremental effect on demand, those purchases have an even greater (and opposite) effect by signaling an improved environment for risk-taking. Recent experience with Treasury purchases through QE has also shown that those purchases cause prices to go down and yields to go up instead of the other way around.
This puts the Fed in quite a quandary and one that I have not yet heard discussed. If the Fed implemented YCC, it could purchase Treasuries with the intent of lowering yields, but inadvertently send yields higher. Alternatively, it could sell Treasuries, and inadvertently send the wrong signal. My conclusion is that there is a significant chance of some severe interest rate volatility in the foreseeable future.
“It’s established now that anything can be an offense, from a UCLA professor placed under investigation for reading Martin Luther King’s “Letter from a Birmingham Jail” out loud to a data scientist fired* from a research firm for — get this — retweeting an academic study suggesting nonviolent protests may be more politically effective than violent ones!”
“All these episodes sent a signal to everyone in a business already shedding jobs at an extraordinary rate that failure to toe certain editorial lines can and will result in the loss of your job.”
While Matt Taibbi is sure to provoke some disfavor by writing, “the American left has lost its mind,” he goes on to address an important issue for all of us who rely on news and information. Increasingly, reporters and editors are being penalized for doing what they are supposed to do: report the news.
Of course there are reporters who misrepresent situations and those who act unethically. But there are also journalists who investigate wrongdoing, who speak truth to power, and who provide a platform for discussing serious issues. None of the examples Taibbi highlights were people with an intent to cause harm. Quite the opposite. They were people with the courage to address important issues. It’s not that hard to tell the difference.
I’m not sure what motivates people to try to shut down constructive conversation and I am still struggling to understand why so many people passively allow it to happen. Regardless, the effect is to significantly constrain society in its effort to work through difficult challenges. It also dilutes the quality of information we receive and therefore makes it even harder to make good decisions on things that require good information (like investing).
Implications for investment strategy
So, we have an environment in which GDP is going to be terrible for the second quarter but we are clearly recovering. The big outstanding question is, recovering to what?
At the same time, fiscal policy is filling in for lost income in a number of places but in doing so, is also masking some of the permanent damage underneath. Monetary policy has been even more aggressive seemingly jumping into action at any little flinch in the markets. How should investors balance these tradeoffs?
An easy answer is to simply capitulate and concede that the Fed is “all-in” when it comes to keeping markets afloat and there is no use fighting it. There is at least some truth to this although it is more of a pragmatic decision than an investment decision.
One thing that has been abundantly clear is that the Fed is determined to push investors further and further out on the risk curve (I addressed this subject earlier in the year in a blog post). Evidence of this can be seen in growth stocks that discount absurdly high growth rates, pension funds further increasing exposure to higher returning assets such as private equity, and unusually large equity exposures for retirees.
How far is too far? We may be getting close. Advisors who manage money for other people must do so in a way that is responsible and prudent if they want to be registered advisors. If valuations get stretched, implied growth numbers get too high, or exposure to risky assets creeps up, there is usually enough wiggle room to explain discrepancies away.
However, there are things that cannot be explained away. For example, last week I mentioned that some of the best performing stocks were from companies that were either severely distressed or actually bankrupt. Hertz (HTZ) was a prime example.
Since then, HTZ decided to exploit this good fortune by petitioning the bankruptcy court to do a secondary offering of up to $500 million. In the registration statement the company states as a risk:
“Consequently, there is a significant risk that the holders of our common stock, including purchasers in this offering, will receive no recovery under the Chapter 11 Cases and that our common stock will be worthless.”
Indeed, with stock valued at approximately negative $2 billion, the offering of $500 million would most likely end up being a direct transfer of value from equity holders to debt holders. As such, it is hard to imagine a situation in which a registered advisor could argue that such an investment is prudent. If this is an indication of how far the Fed is willing to push investors out on the risk curve, they are going to push registered advisors right out of the business.
Interestingly, on Wednesday, the SEC (which is broadly tasked with protecting investors) intervened and HTZ withdrew the offering. So, on one hand a government agency is incentivizing investors to take on more and more risk, and on the other hand a different government agency is stepping in to protect investors from the recklessness that ensues from those actions.
The HTZ example, although extreme, does provide a useful benchmark for investors. If the value proposition of an investment is so poor that an investment professional would risk breaching their fiduciary duty by recommending it, it probably is not suited to your long-term investment needs. Trade, speculate, gamble with money you can afford to lose, sure. But remember that’s all it is.
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
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.
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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.