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Arete’s Observations 7/10/2020

By David Robertson | July 10, 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.

Areté’s Observations 7/10/20

Market observations

While the main story of the quarter was the dramatic rebound for stocks from a terrible first quarter, there were several interesting stories playing out under the surface.

First, the rebound in April was substantial but slowed down considerably in May and again in June. For example, the returns of the Russell 1000 index for the three months were 13.21%, 5.28%, and 2.21%, respectively.

, Arete’s Observations 7/10/2020

Another interesting story was that growth comfortably outperformed value for each month. In fact, the Russell 1000 Value index actually declined in June.

Although returns for major indexes moderated through the quarter, one would hardly know it by just looking at the big tech stocks. Apple rose 44% in the second quarter and Tesla rose over 100%. The huge moves in big tech stocks tended to overshadow some other important happenings.

One of those happenings is simply a math problem. The Russell 1000 was down 20.22% in the first quarter but up 21.82% in the second quarter. That leaves the index down 2.81% for the first half. The key point is that losses are not symmetrical to gains in performance calculations. The key lesson is that it is extremely important to avoid big losses.

Another interesting tidbit is that banks have not joined the recovery. A quick look at the financial sector ETF, XLF, shows a bounce from the lows of late March but pretty much a holding pattern since early April. This is useful because banks tend to be good indicators for the overall health of the economy.

Finally, Lansdowne Partners and John Paulson recently announced important closures. This continues a long string of shutdowns by prominent hedge fund managers and provides a good indication of how hostile markets have become to active management.


Companies will start reporting second quarter results soon and hopefully we will start getting some better insight into how much economic harm was caused by the lockdowns and how business looks going into the rest of the year. Until then, a couple of interesting nuggets …

US retail rebound falters as virus infections surge

“After an initial jump in footfall as lockdowns were lifted, the latest figures show that more shoppers are shying away from reopened malls, especially in states such as Texas that had helped drive the initial recovery.”

“Fears about contracting the virus were preventing prospective shoppers from visiting bricks and mortar stores in hard-hit states, said Janine Stichter, retail analyst at Jefferies.”

Early evidence is confirming exactly what I expected: Official policies matter a lot less than whether consumers feel safe or not. If they don’t, they won’t go out and spend.

Huge Political Disconnect Over The State Of The Economy

, Arete’s Observations 7/10/2020

This graph provides a vivid illustration that economic beauty is in the eyes of the beholder. While it is well known that beliefs and biases taint our perceptions, this relationship may be even more important to perceptions of economic health. This also highlights how crucial it is to remain as objective as possible in order to make the best possible investment decisions.


In the midst of dealing with the coronavirus and trying to reopen the economy, there has not been much discussion of the election coming up in November. A deeper look into the possibilities for the election reveals this to be an important oversight.

Could this election capsize America?

“A number of academics have been warning of the similarities between today and the

eve of the American civil war. Stress indicators include mutual contempt between a

factionalised elite, the inability of America’s system to address a mounting backlog of

deep-seated problems, and a popular tendency to view the other side as the enemy.

Such conditions make the ordinary compromise of politics almost impossible.”

“Slightly likelier is that Biden either wins narrowly in November, or takes the popular vote but

loses the electoral college. Each case is a recipe for US civil breakdown.”

Ed Luce participated in a “war gaming” exercise for the presidential election and described the scenarios as both “credible and disturbingly plausible”. For instance, “Several states, including Michigan and Wisconsin, sent competing electoral college returns to the US Congress (the Democratic governor one result, the Republican legislature another).”

Most importantly, across various starting points and scenarios, “America was plunged into a constitutional crisis.” In other words, this is not some far out possibility like an asteroid striking the earth. There is a good chance something like this could happen and we ought to prepare for it.

A nation stuck in the worst of all worlds

“The tighter the inspection [of the US], the more numerous the revealed flaws, and the more compromised is America’s ability to command global deference.”

“The world is moving on from American hegemony. It is not moving on from the American spectacle.”

This piece captures two quick points that I think are important to keep in mind. While much of the world is still captivated by what happens in this country, the soft power of the US is diminished in important respects. This will be a limitation to what the country can achieve on a geopolitical platform.

Commercial real estate

Is investors’ love affair with commercial property ending?

One part of the economy that is most vulnerable to adaptations made for Covid-19 is that of commercial real estate. While these companies mostly escaped the severe liquidity problems that emerged in March, it will be important to monitor future developments because the industry is big and because relatively small changes in rents could devastate valuations.

“The global stock of investible commercial property—hotels, shops, offices and warehouses—has quadrupled since 2000, to $32trn.”

“If the net effect [of the pandemic] were a reduction in rented space, it could cause havoc. Victor Calanog of Moody’s, a rating agency, calculates that if tenants in New York gave up even 10% of their space over the next five years, it could result in a halving of rents sought on vacant properties.”

The slowest asset

Grant’s Interest Rate Observer, April 24, 1992

Leave it to Grant’s to reference an article from almost 30 years ago that discusses events from the Great Depression that are relevant today. In recounting the story of the Equitable Building in New York City, Grant’s reveals a key lesson of commercial real estate: “a decline and fall takes time.”

“For those who like to use the stock market as a leading indicator of business activity, the failure occurred some nine years after the Dow Jones Industrial Average made its all-time low.”

“In a deflation, even quality projects will become unprofitable. It’s inevitable.”

To be clear, I am not featuring this story as a means of “forecasting” a big deflationary episode, but nor am I refuting the possibility. The main point is to acclimate investors to the slow-motion nature of decline in commercial real estate. It unfolds over many, many years. As a result, you don’t have one good quarter and then rest assured that you are out of the woods.


What Aircraft Crews Know About Managing High-Pressure Situations

There are several reasons why I find management insights especially interesting. One is because I can apply them to my own life to improve relationships with other people and to make better decisions. Another is that they can be extremely useful as an analyst in evaluating company management teams. Different people and different teams have different ways of working and that has implications for other parts of a company analysis.

Some of my favorite lessons come from situations that regularly involve extreme conditions. This is because such situations, which often involve life and death consequences, are studied and rehearsed so as to minimize negative consequences. Although most of us do not have to confront such extreme situations very often, we do often have to operate under stressful conditions. There are great lessons to be learned. Some managers get this – and some do not.

“The captain’s style of communication had a major impact on crew performance in two ways. First, crews performed consistently better under intense time pressure when the copilot was included in the decision-making process than when the captain analyzed the problem alone and simply gave orders. Second, captains who asked open-ended questions—’How do you assess the situation?’; ‘What options do you see?’; ‘What do you suggest?’— came up with better solutions than captains who asked simple yes-or-no questions.”


We are all taught that riskier capital costs more than less risky capital. As a result, equity costs more than debt, and lower-rated debt costs more than higher-rated debt. If a business gets dicey, it may have to pay up for additional capital and if it gets too dicey, it may not be able to afford to do so. Capital allocation is commensurate with business quality.

When policymakers intervene in the allocation process, availability can become a greater consideration than cost. This has extremely important implications for businesses and investors. For one, capital decisions go from being linear to non-linear. For another, those decisions go from being market-driven and predictable to politically motivated and unpredictable. This affects both ends of the credit spectrum.

At the top of the spectrum, things couldn’t be better. Just in case there was any doubt about the ability of Apple to support its bonds with its $94 billion in cash $1.6 trillion market cap, the Fed came in to provide assurances by buying its bonds. In addition, Amazon, one of the highly touted success stories from the Covid-19 lockdowns, set a record with the lowest corporate borrowing costs ever with an offering in early June.

Other borrowers are not so lucky. Joe Rennison reported in the FT that weaker credits are struggling to raise money at all.

Riskiest US companies are left behind in rush to buy debt

“The lowest-rated companies in the US are struggling to raise much-needed cash despite a resurgent market for selling bonds, signalling that investors are staying away from borrowers that went into the Covid-19 crisis with the sickliest balance sheets.”

However, if you are just the right kind of lowest-rated company, you might get a break anyway …

US Treasury takes stake in trucking company with $700m bailout

“The US Treasury department has reached a deal to bail out YRC, a struggling US trucking company, with a $700m loan using funds from the $2.2tn stimulus legislation passed in March.”

And, if you are an individual trying to borrow, it is an entirely different game altogether. Good luck trying to get a jumbo mortgage regardless of your credit …

One Weird Sign Of Trouble In The Banking Sector

“Literally every single bank told us, ‘Yeah, we’re just not doing jumbo loans…’”

Topics – inflation

In the 5/15/20 edition of Observations I wrote about Lacy Hunt and his excellent exposition on monetary policy and inflation. One of the key variables in that discussion is the velocity of money. It is also a notoriously enigmatic variable because it is at least partly a function of consumer psychology. As such, the velocity of money often does not get the consideration it deserves.

Investors should prepare for a welcome return of inflation

“In recent years, the capacity of money supply to lift inflation, sometimes called the velocity of money, has been very low. But velocity will need to fall even more sharply to offset today’s growth in money supply. Higher inflation appears more likely.”

While there are some fair points in this FT opinion piece, I also find some glaring problems. Foremost, the author assumes that just because money supply has increased so much, it is unlikely that velocity can fall enough to offset it. Not only is there is no necessary reason for velocity to not fall further, but it’s just not that hard to conceive of plausible causes with just a little bit of reflection.

First, it is important to recognize that when the Fed creates money, it does so by way of banks. The money does not (at least not yet) go directly to consumers. As a result, increased money supply is only inflationary to the extent that opportunities exist for productive investment. If debt is raised purely for consumption and not for productive investment, velocity decreases.

The mechanics of creating inflationary pressure by rapidly increasing money supply are also obstructed by the Fed’s policy of paying interest on excess reserves (IOER). As the July 10, 2020 edition of Grant’s reports, “IOER renders obsolete the formerly simple connection between the Fed’s open-market deeds and inflationary results.” In short, “the dollars it creates lie fallow”.

In addition to these mechanical causes of velocity deterioration, there can by psychological causes as well. Economic hardships caused by the lockdowns, for example, are prompting people to re-evaluate their financial plans. I reported in the 6/26/20 Observations that Covid was crushing personal finances and many people were living on a “knife edge”.

In addition, John Mauldin reports that he is seeing “extraordinarily high savings rates and less spending from those who are uncertain about the economy”. He also makes it clear that this includes a lot of people who are reasonably wealthy. These observations are corroborated by another report …

Americans’ Biggest Financial Regret Is Not Saving Enough Before The Coronavirus Hit

, Arete’s Observations 7/10/2020

“Among the survey’s key takeaways was the notion that Americans’ biggest financial regret – along every income group, including the wealthy – was not setting aside enough emergency savings, with 23% citing this reason as the biggest source of current anxieties.”

The key points are: Velocity is an important variable in the inflation equation that bears watching, there are indications that the economic shock from Covid-19 is fundamentally changing consumption patterns, and one should never assume something will happen just because it might be hard to imagine.


China’s support for US dollar can no longer be relied upon

“But markets follow money. The coming flood of ECB liquidity and eurozone safe assets, alongside the pressing need for China to diversify, could cause a radical change in capital flows.”

When I discussed Michael Howell’s new book, Capital Wars, in the Observations letter from 6/5/20, I highlighted the phenomenon of liquidity and its impact on capital markets. As Howell points out in this update from the FT, the prospect of increased liquidity from the ECB has the potential to not only affect asset prices, but the balance of geopolitical power as well. This is definitely worth watching.

Investment advisory

Here Are The Thousands Of Investment Advisors And Portfolio Managers Who Received Government Bailouts

“And yet, a casual search through the list of PPP recipients reveals that no less than 1,436 Investment Advisors applied for, and received PPP assistance, in many cases for well over $1 million.”

As data on the Paycheck Protection Program is becoming available, it is clear that at best, it did not work as advertised, and at worst it was a massive transfer of taxpayer money to companies that didn’t need it.

While there is plenty to take issue with if one is so inclined, the single thing that stands out most for me as a wrong is the massive uptake of PPP money by investment advisers. While I have not evaluated each advisor individually and therefore cannot make judgments on any individual case, I can say that in general, there is no good reason why an advisor should participate in this program.

First of all, the program was created with the intent to smooth over business disruptions caused by the lockdowns. There were no significant disruptions to investment advisors. The markets remained open and clients could be contacted in any number of ways. Secondly, advisory businesses are especially amenable to working from home – I have done it for over twelve years.

Finally, and importantly, advisors are supposed to be fiduciaries – people who act in the best interest of their clients. If their inclinations are to chase down government money regardless of how inappropriate that may be in a broader social context, what does that say about their desire to do what is right for you?

Implications for investment strategy

Talking Your Book About Value, Part 3, by Mike Green at Logica Funds

“As we have repeatedly discussed, the widespread transition to index products (both futures and passive mutual funds/ETFs) has changed the behavior of markets. Transactions focused on buying or selling all stocks and profitability derived from index arbitrage (again, both futures and the creation/redemption process of ETFs) rather than security selection have irrevocably changed the incentive structure on Wall Street.”

“We have reached the inevitable conclusion that no one is standing in the way of insanity. We are seeing this in our social lives where Cancel Culture has raised the stakes for anyone willing to stand in the way of the shaming mob, and we are seeing it in our public (and private) markets where any attempt to express rationality is met with underperformance and redemptions.”

Mike Green is one of the smartest and most independent thinkers in the investment world today. The case he makes in his latest research both explains much of what we are observing in terms of market action and guides us to constructive investment approaches.

One of the most difficult things to manage in a market like this – in which stocks keep going up – is to wonder what you are missing. Green makes it clear we aren’t missing anything. Rather, he explains how the incentive structure on Wall Street has changed away from security selection and that there is no longer anyone who is “standing in the way of insanity.”

And insanity it is. Valuations are rising from high to absurd levels even though we know there is going to be a big hit to earnings in the second quarter. At the same time, coronavirus infections are rising again which threatens more lockdowns. The geopolitical skirmish between the US and China is heating up. And oh, the presidential election in November could radically change the business environment.

So why would anyone maintain or increase exposure to risk assets under such conditions? Because “any attempt to express rationality is met with underperformance and redemptions.” This is an important clue. People who manage money for others, i.e., mutual funds managers, pension managers, hedge fund managers, etc. are all subject to redemptions; if they don’t keep up they lose money and maybe even their jobs.

So, it is fair to infer that there are many participants who are very involved in markets because they are compelled to be, not because they want to be. When a disruption comes, and it will, many of these investors will be scrambling to unload as fast as possible.

Fortunately, this is not a game that individual investors and advisors with strong client relationships and fiduciary duty need to participate in. These investors can wait patiently for opportunities that are “sane” and by doing so, substantially increase their chances of hitting their long-term investment goals.


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 Thanks!        – Dave

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.


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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