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Having Your Cake & Eating It Too

Written by David Robertson | Sep 6, 2019

One of the more interesting aspects of our social and investment landscape is how little appetite many people have for bad news. Problems can be so messy and hard after all; who wants to deal with them? Boris Johnson catered to this reality in the UK when he said his policy on cake is “Pro having it, and pro eating it.” Why make difficult choices when they can be obviated with a rhetorical flourish?

Not only do people not want to hear bad news, though, but often they work actively to ignore or reframe it. This makes a difficult investment environment even more so by inviting opportunists to exploit such tendencies by misrepresenting things. While following proclamations that are too good to be true will inevitably produce pain for many investors, it will also create opportunities for others.

One thing that can be objectively said about the investment landscape is that interest rates are low on an absolute and historical basis. As a result, it is fair to say that “easy” investment options like buying Treasury bonds that yield well more than the inflation rate are just not available to today’s investors. If you want anything like the returns of past years, you are going to have to take on more risk.

This is the mild account of the investment landscape. The harsher version was provided by a “luminary of one of America’s largest family offices” in the Financial Times:

It is the hardest investing climate I have ever seen in my career in public markets now.

There simply are not abundant opportunities in publicly traded financial assets like stocks and bonds. As a result, the vast majority of investors are “exposed to the vagaries of low interest rates.”

Low rates force ordinary investors into a difficult trade-off: They must either accept the vagaries of low interest rates or forego the potentially higher returns of risky assets altogether. Temptation often tips the scales. As the FT describes, “eagerness to outperform benchmarks is likely to push investors into the riskiest and least liquid areas.” 

It is easy to get a sense of deja vu.

It was just over ten years ago when low rates were driving persistent demand for yield which compelled efforts to manufacture yield and disguise risk. As Zwirn, Kyung-Soo Liew, and Ahmad explain in their paper, “This Time is Different but it will End the Same Way“, the same basic risks exist today. The only difference is that some of the specifics are different:             

  1. “Lack of market-making and other regulatory changes that will impede price discovery in the next downturn
  2. Masking of the deterioration of underlying collateral and ‘rearview mirror’ analysis
  3. New versions of the old games played by the rating agencies
  4. Explosion in Asset-Liability mismatched structures
  5. Regulatory changes in compliance of financial institutions.”

The outcome, however, is unlikely to be very different:

“Wrapping fixed-income securities into ETFs does not solve the problem of the lack of exchange-traded markets for fixed-income securities. It only hides the lack of liquidity of the underlying constituents.”

John Dizard addressed the issue in the FT

“Because we no longer have the banks doing market-making, we have created the conditions for liquidity mismatching. We need to do better analysis of both sides of the balance sheet and not confuse listed assets with liquid assets, since in a crisis, liquidity and even pricing is uncertain.” 

Stephanie Pomboy of MacroMavens summarized the situation as well as anyone:

In 2007, the lie was that you could take a cornucopia of crap, package it together, and somehow make it AAA. This time the lie is that you can take a bunch of bonds that trade by appointment, lump them together in an ETF, and magically make them liquid.

In important respects, it is odd that after investors got beaten down so badly in the GFC that they would expose themselves to the same kind of beating again. Why are they behaving so foolishly?

Why are they repeating the same mistakes?

Rana Foroohar throws out one idea in the FT:

“My answer to the question of why we haven’t yet seen a deeper and more lasting correction is that, until last week, the market had been willfully blind …”

According to Foroohar, investors have been blind to “the fact that there will be no trade deal between the US and China” and blind to the reality “the Fed’s decade-long Plan A — blanket the economy with money, and hope for normalisation — has failed.”

Ben Hunt and Rusty Guinn from Epsilon Theory have also picked up on this oddity in investor behavior. They believe that many important issues don’t garner more attention because they never hit the radar of mainstream media. In Does it make a sound“, Rusty Guinn describes serious topics like the Jeffrey Epstein case and the protests in Hong Kong are unlikely to fade “because they don’t exist.”  He explains,

“There is no narrative, no common knowledge in the US about these [Hong Kong] protests. American media have largely stopped covering them.”

Mainstream media does not consider them newsworthy – so they don’t cover them – so they don’t exist in any meaningful sense for most people.

For curious people and concerned investors, the pervasiveness of willful blindness is as cringe-worthy as it is astonishing. Why don’t people push back? Why don’t people demand better coverage, better information? Guinn has a hypothesis for that too. In “The Country HOA and Other Control Stories“, Guinn describes: 

Even when we know something is a story written for us, that we are being told how to think or feel about something to serve someone else’s purposes, there is a visceral, emotional part of us that wants to believe it. Needs to believe it. We yearn to see it as an echo of some truth rather than a construction, and when some paltry data emerges to confirm it, it becomes almost irresistible.

Indeed, it is nice to believe stories. The Fed has our back. The economy just needs some time to get back to normal. High debt levels don’t have serious long-term consequences. Modern companies have such abundant growth prospects that they don’t need to focus on profitability. 

However, these are all just stories. As Mohamed El-Erian recently warned in the FT, the believability of some stories is now being seriously tested: “Long spoiled by the comforting support of central banks, investors are getting a feel for what it would be like when economic concerns rather than central bank monetary policies take a bigger role in determining asset prices.”

More specifically, El-Erian highlights two different narratives that deserve fresh consideration:

“With recent developments, however, investors need to seriously reconsider two other widely held hypotheses: that trade tension is temporary and reversible; and that a more indebted global economy would navigate them without serious setbacks.”

Additionally, cracks are now beginning to appear to the narrative that “Everything is OK” in ways that echo the problems with Bear Stearns hedge funds in early 2008. John Mauldin describes one such early warning indicator:

“Some bond issues have been bought in their entirety by a small handful of high-yield bond funds. The problem is that the company that issued these bonds has defaulted on them. Not just missed a payment or two, but full default. Their true value, if the funds tried to sell them, might be 25–30% of face if they actually traded, according to the people who told me this. But the funds still value them at the purchase price of $0.95 on the dollar.”

This can happen because the funds have not tried to sell the bonds and therefore there is no “mark-to-market” price. The important lesson for investors is that the loss has already been incurred; it just hasn’t been recognized yet. This creates what will be very disappointing news for unwary investors. Their returns are already down; they just don’t know it yet. 

Higher yielding sovereign bonds are also suffering severe losses. Argentina’s markets got hammered on a single day in August on the basis of a single primary election. As the FT reported, “the biggest loser was the $11.3 billion Templeton Emerging Markets Bond Fund, which fell by 3.5%, a drop that has continued on Tuesday as the selling was nowhere near done. That was its largest daily drop since the October 2008 global financial crisis.” 

Nor was this a one-off blip that could easily be recovered. In the last month conditions in Argentina eroded to the point where it defaulted on a number of short-term bonds and implemented capital controls to buy time to restructure. In short, a lot of pain will be felt by investors.

Other cracks are appearing as well. Asset managers such as Woodford Investment Management and H2O Asset Management have had difficulty meeting surging redemption requests due to a proliferation of illiquid investments in their funds. This highlights another interesting nuance of the current environment. During the GFC, banks suffered the greatest liquidity crises; this time it may be money managers that have the biggest liquidity problems.

Regardless, the overarching point for investors to understand is that you don’t get to have your cake and eat it to. John Mauldin describes the investment consequences of those who try:

“More money is going to be lost by more people reaching for yield in this next high-yield debacle than all the theft and fraud combined in the last 50 years.”

Unfortunately, investors are unlikely to get much help from mainstream commentators and advisers. For example, Schwab sent out a note trying to calm investors after a big down day in early August by encouraging them to “Maintain a long-term view on investing”. The note advised:

“It’s important to remember that timing the market is virtually impossible and that it’s generally better to maintain a long-term perspective on investing. Market fluctuations, such as those we’re experiencing, should not alter your overall investment strategy, unless your financial plan has changed.”

The problem is, there is a lot of truth to the statement, so it sounds plausible enough to not be challenged very seriously. What the statement does not do, however, is consider the possibility that recent volatility might be providing useful new information. Nor does it acknowledge the inherently flawed financial system that undermines what constitutes long-term financial planning. The ultimate message is that most investors don’t want to hear those things, so you won’t hear them from major channels.

Despite such obstacles, it is still distinctly possible to navigate the investment landscape successfully. In doing so, it is useful to keep in mind that we’ve seen this movie before. There is no need to overthink things; it will end the same way. A day will come when liquidity freezes and prices start dropping in chunks rather than small increments. Many investors will be shocked, and many will be in denial. 

In such an event, however, there will also be opportunity. Mauldin describes: 

My own goal is to be a buyer, not a seller, whenever it [a liquidity crisis] occurs. For now, that means holding cash and exercising a lot of patience. If I’m right, the payoff will be a once-in-a-generation chance to buy quality assets at pennies or dimes or quarters on the dollar. I think the next selloff in high-yield bonds is going to offer one of the great opportunities of my lifetime. In a distressed debt market, when the tide is going out, everything goes down. Some very creditworthy bonds will sell at a fraction of the eventual return.”

This highlights an underappreciated aspect of investing: One person’s gain is another’s loss. On one hand, it is hard to tolerate low returns and harder yet to do so when commentators and advisers encourage complacency. As a result, it is easy to fall prey to lies and misrepresentations – like being able to get decent yields with the same amount of risk. Most people want to have their cake and eat it too, but that is usually a formula for losing money.

On the other hand, because it is so hard to resist such temptations, few succeed. As a result, enormous opportunities get created for the few who are diligent and disciplined enough to do so. They only come along a few times in your life, though, so you need to be prepared. That preparation involves incorporating the deep structural flaws of the financial system as a risk factor, actively seeking out information outside the channels of mainstream media, and holding cash and exercising a lot of patience”.

 


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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.

2019/09/06
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