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Arete’s Observations 7/17/2020

By David Robertson | July 17, 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

One of the reasons why I have included observations on the market is because I have often found that unusual or peculiar market behavior can be indicative of something more important happening under the surface. In this way, strange occurrences can help inform a productive course of inquiry.

However, recent work by Mike Green at Logica Funds (which I mention in the Implications for investment strategy section below and in my Market review for the second quarter) has caused me to adjust my views on this. In short, when a market is dominated by passive investors, as this one is, it is important to keep in mind that stock prices do not have much information content. As a result, most price action is more akin to gossip than it is to informed conversation.

As such, it doesn’t make sense to pay as much attention to it. I am not going to completely stop watching what happens with prices, but I will be more discriminating.

On that note, the big tech stocks bolted up first thing on Monday and then took a nosedive from which they have not recovered. NFLX reported on Thur and guidance disappointed. Ben Hunt (who does some fascinating work with natural language processing) says the tech narrative has broken. This is worth watching.

Major Market Buy Sell Review, Arete’s Observations 7/17/2020

Economy

Earnings season has started and it promises to be interesting a couple of respects. One is that although many companies did not have much to report last quarter because lockdowns had just started, this quarter we should have some real data to work with to gauge the impact of the lockdowns.

That leads to a second reason. Much of the economic data through the second quarter have been of questionable quality. Many gathering techniques were disrupted by the rapidity and magnitude of decline in activity. Various public policy measures obscured underlying trends. Even company reports in the first quarter studiously avoided saying anything very meaningful about expectations for the second quarter.

One of the sources of information that is starting to come in, and that probably has fairly high information content, are the early reports from the major banks. Because their loan books reach far and wide into the real economy, they have as good of information as anyone as to what is really going on. According to the early reports, the news isn’t good …

Banks Brace For A Historic Crash With Record Loss Provisions

“Here are the facts: JPMorgan, Citigroup and Wells Fargo (BofA, and a bunch of other banks are set to report on Thursday) set aside almost $28 billion for bad loans in Q2, up almost $10 billion from last quarter, rising to a level just barely surpassed only once before, during the depths of the financial crisis in Q4 2008.”

One of the stories from the first quarter was that the big banks took excessive loan loss reserves in an abundance of caution and in light of the uncertainty surrounding the economic impact of the lockdowns. Now, with a lot more information available, it turns out those reserve builds were not excessive at all.

“This is not a normal recession. The recessionary part of this you’re going to see down the road,” Jamie Dimon said Tuesday. “You will see the effect of this recession. You’re just not going to see it right away because of all the stimulus.”

Major Market Buy Sell Review, Arete’s Observations 7/17/2020

From early on in the crisis, I have highlighted the importance of high unemployment, bankruptcy risk, and high levels of uncertainty and so have others. While public policy measures did blunt some of the force of the shutdowns, it also obscured the economic path we are on. Now that path is becoming clearer and it sounds like Jamie Dimon is coming around to the same view. But over in Europe …

Banks need to prepare now for Covid-19 losses later

“Absent the sharpest of V-shaped recoveries, Europe’s banks will at some point need to recognise the new economic reality and raise their provisions for loan losses dramatically. The forthcoming results season may provide just such an opportunity.”

Europe’s banks did not get off to the same start on loan loss reserves that US banks did and as a result, will need to do some catching up. The risk is that just like in the GFC, Europe’s slow and indecisive responses will diminish credibility.

Investors must prepare portfolios for Covid-19 debt crunch

“The financial stress caused by Covid-19 is far from over. Investors should brace for non-payments to spread far beyond the most vulnerable corporate and sovereign borrowers, in a reckoning that threatens to drag prices lower.”

“There is still time to get ahead of this trend. Rather than buying assets at valuations stunningly decoupled from underlying corporate and economic fundamentals, investors should think a lot more about the recovery value of their assets and adjust their portfolios accordingly.”

Major Market Buy Sell Review, Arete’s Observations 7/17/2020

For a person prone to diplomatic messaging and balanced assessments, words like “stunningly decoupled” and “investors should think a lot more about the recovery value of their assets” come across as doomsday prepping. I actually think he is correct in turning up the volume though. Once the darker economic reality becomes more widely realized, it will become a lot harder to protect one’s investments.

Politics

America’s eerie lack of debate about China

“Ferocious partisanship has its uses. If nothing else, a divided nation can console itself that no government idea goes unexamined and unopposed. Scrutiny can be all the more exacting for being born of tribal malice rather than Socratic truth-seeking. The US is riven — it has managed to politicise the workaday face-mask — but it avoids the equal and opposite danger of unreflective consensus.”

“The absence of such voices now is disconcerting. For it means that policy is not being refined and stress-tested through argument.”

I found this article interesting because it captures so much of what I observe happening in many spheres of life. There seems to be a tendency to doggedly focus, but on the wrong things. People can get entirely bent out of shape over a tweet, and yet avoid any meaningful dialogue about what public policy measures could sustainably improve unemployment, which is a monstrous economic problem right now.

I am increasingly finding others picking up on this subject as well …

“In 2020, I’ve Seen Enough” – Liberty Blitzkrieg’s Mike Krieger Says “Farewell For Now”

“After watching the first half of 2020 play out, I’ve finally seen enough. I’ve concluded and admitted to myself that the general public is simply unwilling or unable to put aside petty differences to unite and effectively challenge the ruling class on the really big issues of the day.”

I deeply empathize with Krieger’s views as they mirror my own in many respects. The issue he raises, which I think is a fair one, is that much of the problem resides with the general public – with us. I do absolutely believe that politicians and business leaders have exacerbated problems, but we, the general public, have enabled them by almost completely failing to push back when they go too far.

As it turns out, quirky paradoxes have been a deep part of the American character for a long time …

Americans want to be free to be stupid

“His [Frederick Jackson Turner’s] landmark 1893 essay The Significance of the Frontier in American History has long been criticised for promoting a self-aggrandising view of US exceptionalism. But critics miss the fact that Turner believed Americans could be exceptionally stupid.”

“This attitude has a long history. ‘Scorn of older society, impatience of its restraints and ideas, and indifference to its lessons’ characterised the frontier mentality, Turner wrote.”

One lesson I take from this is that the American character has great capacity for both achievement and stupidity. A lot of what happens depends on the environment. We should always keep in mind that either or both of these tendencies can be expressed.

Another lesson is that these opposing tendencies can wreak havoc on governance. I have always been extremely optimistic about what human beings are capable of accomplishing. I am also optimistic about the potential for collaboration and the ever-improving tools available to us. However, if we cannot find ways to have constructive conversations, it undermines all of those positives.

Public health announcement

Major Market Buy Sell Review, Arete’s Observations 7/17/2020

Source: @ianbremmer on Twitter

Inequality

Trade Wars Are Class Wars: How Rising Inequality Distorts the Global Economy and Threatens International Peace, by Matthew Klein and Michael Pettis

I’m sure I will have more to say about this book in the future, but for now I will stick with a couple of key points. One is this is my kind of book. While the norm is to identify a hot button topic, overly simplify it, and then politicize it, this book does almost the exact opposite. Rather, it takes a hot topic, deeply analyzes it, calls it by its right name, and then explains the case in clear, readable language.

The other key point is that the right name for what most people refer to as “trade wars” is actually “inequality”. The lesson is that “countries with large trade surpluses have them only because they cannot consume all they produce”. They cannot consume all they produce because income is transferred to the rich and “away from people who would spend more on goods and services, such as workers and pensioners”.

Viewed from this angle, it is easy to see that trade surpluses are not mainly a function of productivity but of unequal distribution of income and wealth. While there are certainly elements of moral content to this perspective, it is fundamentally one of sound economics. It was Mariner Eccles himself who believed the root problem of economic fragility in the 1920s was “the shift in the U.S. distribution of income from the masses to the elites”.

Emerging markets

Almost Daily Grant’s, Tuesday, July 14, 2020

“Turkey’s Capital Markets Board announced today it will fine seven brokerages and 18 individual investors a total of TRY 16.7 million ($2.4 million) for violating short-selling bans instituted on Feb. 25.”

                “Good luck with convincing the world capital controls are off the table now,”

This is how big things can happen. There is all kinds of noise being made – the stock market this, the Fed that, gold keeps going up, should you wear a mask or not? And then these little snippets come across and often don’t even hit the radar.

While Turkey’s moves may seem innocuous enough, they provide important signals. By way of background, Turkey has a lot of US dollar denominated debt and is struggling to prevent capital from leaving the country. Having few options left to defend its currency, which it needs to do to repay the debt, it is resorting to whatever tactical measures it can contrive.

If this were only an issue for Turkey, it probably wouldn’t be very important for global markets. However, a lot of emerging market countries have similar problems. They have too much debt, too much of it is denominated in a foreign currency, and their economies are stricken by the pandemic. As a result, whatever happens with Turkey can quickly carry over into other emerging markets.

The nail in the coffin would be capital controls. If there is a serious threat of those being implemented, then any remaining capital would flee elsewhere. So, it looks like the race is on.

Implications for investment strategy

The End Game Ep. 3 – Mike Green

I talked about Mike Green’s work at Logica Funds last week and I’m going to do so again this week because there is so much content that is relevant for investors.

One of the ideas Green introduced that really affected my thinking was the notion that the marginal investor in stocks is the owner of a passive target date fund. I have absolutely been following the increasing penetration of passive funds and have absolutely been aware of the potential for systemic risk. I even highlighted the connection myself in a blog post from 2014. When I did so, however, I considered the marginal investor to be someone who invested in an S&P 500 ETF.

The important difference is that the S&P 500 ETF investor directly experiences the shock of stocks dropping, like they did at the end of the first quarter. The target date fund investor, on the other hand, is largely insulated from such volatility. Given that passive flows never went negative during the first quarter selloff, it seems as if Green’s assessment better captures reality.

Finally, one of the key points that Green makes is that the passive dominated market structure is not likely to break until 10-year bond yields hit zero or go negative. While I think this position deserves a healthy amount of respect, I also do not believe this is the only scenario in which well insulated target date investors might be compelled to sell.

For example, bankruptcies have been rising and most evidence points to the continuation of that trend. The higher provisions for loan losses that we have seen from some of the larger banks already this quarter points to a lot more pain to come. As economic hardship becomes more visible – in the form of bankruptcies and further job losses – I strongly suspect that many people will be less willing and less able to keep putting money into stocks at the same rate.

Talking Your Book About Value (Part 2)

Another fascinating finding features the source of excess returns from the value style. According to Green, one of the primary sources is the migration of stocks out of the value category. Although this does not happen frequently, when it does the effects are huge.

This helps explain why value tends to do well in environments of declining volatility – because it is easier for these companies to break out. It also helps explains why value has still not performed well recently as volatility has remained elevated. I would encourage anyone interested in value investing to take a close look at this paper.

Gold

I would be remiss if I didn’t reiterate my interest in gold at this point. With most stocks richly valued, bond yields flirting with zero and an economy that looks like a slow-motion train wreck, it is hard to get excited about risk assets. Of course, there are exceptions and I always try to find them, but in my mind the greater focus in this environment should be on preserving wealth rather than squeezing the last bit of returns out of the stock rally.

That being the case, one could hardly find a better vehicle for doing just that than gold. Gold retains its value whether in an environment of deflation or inflation, and this is especially useful now given that both extremes are distinctly possible.

One of the major lessons of history is that there can be extended periods of poor returns for both stocks and bonds. The vast majority of investors today have not actually experienced this and so are inclined to discount the possibility. Another major lesson of history is that every once in a while, there are major redistributions of wealth across society. They don’t happen often, but when they do, the consequences run deep and wide. The key during these times is to preserve the wealth one already has.

I see a lot of signs suggesting that we may be entering one of these momentous turning points in history. That does not mean that it must happen, but it does mean we should be prepared. If there was one thing to be learned from the GFC, it is that low probability/high impact events should not be ignored. With that, stay safe and stay smart!

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

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.

2020/07/17
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