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Arete’s Observations 7/31/2020

By David Robertson | July 31, 2020

Market observations

Goldman Spots A Historic Inversion In The Market

“The average daily value of options traded has exceeded shares for the first time, with July single stock options volumes currently tracking 114% of shares volumes.”

Three things strike me from this report. One is when activity in a derivative surpasses activity in the underlying asset, it is often a sign of excess. When the number of mutual funds overwhelmed the number of stocks, mutual funds endured a long period underperformance. Same with hedge funds.

Another thing is that since options represent leveraged positions in underlying stock, the increased activity represents increased speculation.

The third thing is this phenomenon demonstrates why the policy of lowering volatility is ultimately counterproductive. There will always be people who want to do better. Indeed, the active money management industry is predicated on it. Plus, some people are just inclined to speculate. Regardless, any efforts to reduce short-term or idiosyncratic risk only do so at the expense of increasing longer-term systemic risk. It looks like we just got another indicator systemic risk is increasing.

Jim Chanos: ‘We are in the golden age of fraud’

“Chanos describes the current environment as ‘a really fertile field for people to play

fast and loose with the truth, and for corporate wrongdoers to get away with it for a

long time’.”

“This market is setting up to be one of the great short opportunities of all time … Trouble’s coming, I don’t know when, but it’s coming.”

Jim Chanos pockets $100m from Wirecard short

“’If you’re a fundamental short seller, the Wirecard story was a classic,’ Mr Chanos said in a Lunch with the FT interview. ‘The buzzwords, the numbers that didn’t make sense, the business model that seemingly didn’t make sense’.”

“When people ask us, who were the auditors, I always say ‘Who cares?’ … Almost every fraud has been audited by a major accounting firm.” 

The first point to make is that from everything I have observed over the years, Jim Chanos is a class act and someone worth listening to. He is an elite analyst and benefits from doing hard analytical work rather than from spreading sensational stories. I heard him present at a CFA conference and his lessons are those of forensic accounting combined with practical experience.

So, when Chanos describes the current environment as “a really fertile field for people to play fast and loose with the truth”, this is something to pay attention to. I have been observing the same behaviors myself in going through financial statements and valuing companies and reported what I saw most recently in a blog post entitled, “The bursting bubble of BS”. What I can say is that it is hard to capture in words how flimsy the financial foundations of many public companies are.

Major Market Buy Sell Review, Arete’s Observations 7/31/2020

Earnings adjustments, non-gaap earnings, aggressive reporting assumptions and other deceptive practices have always been part of the investment landscape; it happens. What seems different this time is that is has been going on for so long that many deceptive practices have essentially become institutionalized. This creates a feedback loop: Deceptive reporting practices become commonplace, investors habituate to the reality, aggressive managers and fraudsters learn that there is room to push things even further.

An interesting observation on this phenomenon came out of a podcast with Marc Cohodes hosted by Grant Williams and Bill Fleckenstein. Cohodes and Fleckenstein, both accomplished short sellers, agreed that “shorting frauds is almost impossible any more – there is almost no enforcement”. In other words, you can be absolutely right on the facts and still face an uphill battle because there is so little effort to prosecute the case or to defend you from retaliation. Who needs it?

Another consequence is that an environment with weak enforcement creates challenges for people and businesses just trying to do their thing. For example, as a major producer of N95 masks, 3M was in a position to benefit from the pandemic response. Indeed, according to its second quarter earnings release, the company was able to produce “nearly 800 million respirators in the first half of 2020”.

Along with those benefits, however, also came important challenges. In its efforts to “fight fraud and price gouging”, the company also reported that it “Secured removal of more than 7,000 counterfeit websites and more than 10,000 false or deceptive social media posts to date”. Of course, this takes time and money and effort to accomplish. 3M was able to do it; many smaller companies are not and succumb to such nefarious behavior.

I strongly suspect Chanos is right in his assessment that “trouble is coming”.

Economy

The second quarter GDP number came out on Thursday and at -32.9% it revealed a truly massive decline. Also on Thursday, new jobless claims came out and affirmed a troubling pattern of reversed progress. The graph at the right seems to capture the trajectory fairly well.

Major Market Buy Sell Review, Arete’s Observations 7/31/2020

While we have clearly rebounded off the lows from late March and early April, the recovery has clearly flattened out – and at levels much lower than they were before the Covid shutdowns. Needless to say, it is essential to get activity levels back on the rise to return to any semblance of normalcy.

In order to get some sense of where the economy is headed, I will be watching the trajectory of infections across different states and the country as a whole as a primary indicator. I will also be watching to see how the expirations of various policies (such as moratoria on evictions of renters) filter through into real economic impact. That said, I also expect new relief policies to be implemented that will partly replace expired ones and further obscure the true underlying strength of the economy.

Emerging markets

I have mentioned Turkey a few times and most recently two weeks ago discussing how “little snippets” can make their way through the news without ever hitting the radar of “importance”. Nonetheless, such snippets can also quietly reveal how more important happenings unfold.

In the last few days we have seen news of an escalating conflict between Turkey and Greece and of further depreciation of the Turkish lira. Unimportant coincidence? Yeah, I don’t think so either.

Commercial real estate

Although a portfolio of five office buildings is hardly a representative sample of New York City, the fact that these buildings in aggregate have only 3% occupancy in the most densely populated city in the country truly is “staggering”.

Major Market Buy Sell Review, Arete’s Observations 7/31/2020

One takeaway is what is happening in NYC is, as Grant’s Interest Rate Observer puts it, on more of a “depression” scale than a “recession” one.

Another takeaway is that this magnitude of downturn may be fairly unique to NYC. Most other areas seem to be doing better.

Also on the commercial real estate front, a brief evaluation of the market from Annaly Capital Management in its second quarter earnings presentation captures the environment well: “Commercial property investment remains muted as sellers and buyers differ on price expectations given the change in economic environment.”

This is code for, “the two sides are so far apart on price that no deals are getting done”. This means there are virtually no clearing prices from which to establish values. We will have no idea how bad things are until deals start getting done. This is a latent deflationary force.

Public policy

As debate is heating up regarding a follow up pandemic relief program, Republicans want credit supports for their cronies and Democrats want to funnel money to unemployment benefits and to states and municipalities. In other words, arguments are going in their typical partisan directions. Neither party, however, seems particularly concerned about spending a lot of money.

Forget the Income Cliff for a Moment. The U.S. Is About to Go Over a Child-Care Cliff.

Major Market Buy Sell Review, Arete’s Observations 7/31/2020

“The current fiscal debate is off-key, says Betsey Stevenson, professor of public policy and economics at the University of Michigan. A lack of child care, she says, is a much bigger disincentive than the extra $600 when it comes to decisions not to work.”

Two things strike me about the debate. One is despite obvious differences between Republicans and Democrats in terms of where additional money should go, both seem to believe that more money is the solution to the problem.

The second is that Stevenson is on to something when she calls the debate “off-key”. What is missing is consideration of all the other elements that are important for a family’s livelihood. Sure, money matters, but so does child care and education and safety and some degree of stability. Failure on many of these fronts is crippling the ability of parents to take care of their families AND return to work in the same capacity.

Shadow banking

I’ve written several times over the years about shadow banking because I think it is both important and under-appreciated. Based upon much of the commentary I come across regarding monetary policy and assessments of it, it is clear much of the commentary comes from outdated mental models of the financial system. This piece from the Economist serves as a useful primer …

Banks lose out to capital markets when it comes to credit provision

Major Market Buy Sell Review, Arete’s Observations 7/31/2020

“But capital markets have played a mighty role [in economic development], too. Today that is truer than ever, which in turn helps explain the stunning scope of the Federal Reserve’s response to the latest economic crisis.”

“Worldwide the exercise [to identify firms most susceptible to liquidity or solvency panics] identified $51trn (or 59% of gdp) in ‘narrow’ shadow investments, almost three-quarters of which are held in instruments ‘with features that make them susceptible to runs’. This slice has grown rapidly, from $28trn in 2010 (or 42% of gdp).”

This background helps evaluate and interpret central bank actions. For one, central banks are designed to oversee banks, not capital markets. As a result, “policymakers have once again found their customary tools do not work as well as they might like.”

For another, the panoply of initiatives the Fed has announced since March make a lot more sense in the context of the rising role of credit markets. As the Economist summarized, “Rather than acting as a lender of last resort to the banking system, therefore, the Fed has been forced to act as a marketmaker of last resort.” In other words, the Fed has had to redirect attention to the shadow banking system because that is where the greater liquidity and solvency risks reside.

US dollar/gold/inflation

One of the biggest stories over the last few weeks has been the incredible runup in gold. A related story that has also gotten a lot of attention is the weakening of the US dollar since the end of May.

A simple and common argument is with the Fed printing so much money, it will ignite inflation and significantly devalue the dollar. The trend in gold reinforces this belief. This has also come at a time when there has been some excitement about the euro after the EU agreed on a pandemic relief program.

Major Market Buy Sell Review, Arete’s Observations 7/31/2020

There is truth to the argument, but as with many narratives, it oversimplifies things in a way that can be really confusing and counterproductive for long-term investors. In the short-term, the selloff in the dollar is probably overdone as is the runup in gold.

That said, it is important to understand the longer-term forces. For the dollar, clearly its status as the world’s reserve currency is an essential consideration. This means there is always demand for US dollars. People who are concerned about fiscal profligacy in the US (and I am one of them) need to weigh those concerns relative to fiscal conditions in other countries (which are as bad or worse).

What? Default? Where? Dollar?

“But the US has borrowed so much money!, you say. Yes, but so have Europe, and Japan, and China, everyone has who could.”

“I don’t see anything there that would make me think the dollar is collapsing, no more than the euro is. What I see is gold and silver rising.”

So, the dollar is unlikely to collapse against other fiat currencies but it is fair to be concerned about the loss of value in the dollar relative to gold over the longer-term. That said, if the dollar is oversold here, which I believe it is, then a rebound in the dollar will cause a decrease in the price of gold in dollar terms. This could create a nice opportunity for investors seeking to increase their exposure to gold.

Implications for investment strategy

I came across Russell Napier during the GFC when I read his book, Anatomy of the Bear, which is a deep study of the four major bear markets of the last 100 years. Napier is an independent thinker and is one of the few analysts with a deep appreciation of history as evidenced by his founding and directing The Practical History of Financial Markets course.

Napier has been right about persistent deflationary forces, but now he sees something that is changing his mind …   

https://www.ft.com/content/a7663749-179f-4194-ab89-0f8d7f0158ed

“During the Covid-19 crisis, control of the supply of money has quietly passed from central banks to governments. As a result, investors need to prepare for a new era of inflation.”

“Savers, through government-mandated bond holdings, will have to bear the burden of capped yields and will watch a portion of their savings eaten away through inflation.”

Inflation expectations are always a complex and dynamic mix of monetary policy, fiscal policy, and level of public acceptance. The key change Napier identifies is government guaranteed loans. These have all the makings of evolving into what he calls the “magic money tree”. I agree with Napier that these arrangements undermine any kind of accountability for growth in money supply, but am more uncertain as to the timing.

The second point is an important one for investors to fully embrace. Here’s the deal: the government is not there to allow you to comfortably earn returns to fund your retirement. No. You are a source of wealth that can be exploited to help the government manage its debt. Through the tool of inflation, your wealth will be gradually, but persistently, taxed and transferred. So, this will be a real challenge.

Napier’s final point is also an important one. In the context of strong tailwinds for stocks and bonds over the better part of forty years, the big investment call hasn’t been whether to be 40% or 50% invested in bonds but simply to be exposed to stocks and bonds. Conversely, in an inflationary environment, the key is to preserve purchasing power. Government debt will undermine that objective; gold will help:

“In this new age of repression, the secret to preserving the purchasing power of savings lies not in the mix of assets that are held but in the quantities they are held. Investors should hold as much gold, and as little government debt, as they feel comfortable with.”

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.

2020/07/31
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