Tag Archives: bull

Seth Levine: COVID-19 Is Not The Last War

These are truly remarkable times in the investment markets. The speed, intensity, and ubiquity of this selloff brings just one word to mind: violence. It would be remarkable if it wasn’t so destructive. Sadly, the reactions from our politicians and the public were predictable. The Federal Reserve (Fed) faithfully and forcefully responded. Despite its unprecedented actions, it seems like they’re “fighting the last war.”

Caveat Emptor

My intention here is to discuss some observations from the course of my career as an investor and try to relate them to the current market. I won’t provide charts or data; I’m just spit-balling here. My goal is twofold: 1) to better organize my own thoughts, and; 2) foster constructive discussions as we all try to navigate these turbulent markets. I realize that this approach puts this article squarely into the dime-a-dozen opinion piece category—so be it.

Please note that what you read is only as of the date published. I will be updating my views as the data warrants. Strong views, held loosely.

The Whole Kit and Caboodle

Investment markets are in freefall. U.S stock market declines tripped circuit breakers on multiple days. U.S. Treasuries are gyrating. Credit markets fell sharply. Equity volatility (characterized by the VIX) exploded. The dollar (i.e. the DXY index) is rocketing. We are in full-out crisis mode. No charts required here

With the Great Financial Crisis of 2008 (GFC) still fresh in the minds of many, the calls for a swift Fed action came loud and fast. Boy, the Fed listen. Obediently, it unleashed its full toolkit, dropping the Fed Funds rate to 0% (technically a 0.00% to 0.25% range), reducing interest on excess reserves, lowering pricing on U.S. dollar liquidity swaps arrangements, and kick-starting a $700 billion QE (Quantitative Easing) program. The initiatives are coming so fast and so furious that it’s hard to keep up! The Fed is even extending credit to primary dealers collateralized by “a broad range of investment grade debt securities, including commercial paper and municipal bonds, and a broad range of equity securities.” Really?!

Reflexively, the central bank threw the whole kit and caboodle at markets in hopes of arresting their declines. It’s providing dollar liquidity in every way it can imagine that’s within its power. However, I have an eerie sense that the Fed is (hopelessly) fighting the last war.

The Last War

There are countless explanations for the GFC. The way I see it is that 2008 was quite literally a financial crisis. The financial system (or plumbing) was Ground Zero. A dizzying array of housing-related structured securities (mortgage backed securities, collateralized debt obligations, asset-backed commercial paper, etc.) served as the foundation for the interconnected, global banking system, upon which massive amounts of leverage were employed.

As delinquencies rose, rating agencies downgraded these structured securities. This evaporated the stock of foundational housing collateral. Financial intuitions suddenly found themselves short on liquidity and facing insolvency. It was like playing a giant game of musical chairs whereby a third of the chairs were suddenly removed, unbeknownst to the participants. At once, a mad scramble for liquidity ensued. However, there simply was not enough collateral left to go around. Panic erupted. Institutions failed. The financial system literally collapsed.

This War

In my view, today’s landscape is quite different. The coronavirus’s (COVID-19) impact is a “real economy” issue. People are stuck at home; lots are not working. Economic activity has ground to a halt. It’s a demand shock to nearly every business model and individual’s finances. Few ever planned for such a draconian scenario.

Source: Variant Perception

Thus, this is not a game of musical chairs in the financial system. Rather, businesses will be forced to hold their breaths until life returns to normal. Cash will burn and balance sheets will stretch. The commercial environment is now one of survival, plain and simple (to say nothing of those individuals infected). Businesses of all sizes will be tested, and in particular small and mid-sized ones that lack access to liquidity lines. Not all will make it. To be sure, the financial system will suffer; however, as an effect, not a primary cause. This war is not the GFC.

Decentralized Solutions Needed

Given this dynamic, I’m skeptical that flooding the financial system with liquidity necessarily helps. In the GFC, a relatively small handful of banks (and finance companies) sat at the epicenter. Remember, finance is a levered industry characterized by timing mismatches of cash flows; it borrows “long” and earns “short.” This intermediation is its value proposition. Thus, extending liquidity can help bridge timing gaps to get them through short-term issues, thereby forestalling their deleveraging.

Today, however, the financial system is not the cause of the crisis. True, liquidity shortfalls are the source of stress. However, they are not limited to any one industry or a handful of identifiable actors. Rather, nearly every business may find itself short on cash. Availing currency to banks does not pay your favorite restaurant’s rent or cover its payroll. Quite frankly, I’m skeptical that any mandated measure can. A centralized solution simply cannot solve a decentralized problem.

Fishing With Dynamite

The speed and intensity at which investment markets are reacting is truly dizzying. In many ways they exceed those in the GFC. To be sure, a response to rapidly eroding fundamentals is appropriate. However, this one seems structural.

In my opinion, the wide-scale and indiscriminate carnage is the calling card of one thing: leverage unwinding. It wouldn’t surprise me to learn of a Long Term Capital Management type of event occurring, whereby some large(?), obscure(?), new (?), leveraged investment fund(s) is (are) being forced to liquidate lots of illiquid positions into thinly traded markets. This is purely a guess. Only time will tell.

Daniel Want, the Chief Investment Officer of Prerequisite Capital Management and one of my favorite investment market thinkers, put it best:

“Something is blowing up in the world, we just don’t quite know what. It’s like if you were to go fishing with dynamite. The explosion happens under the water, but it takes a little while for the fish to rise to the surface.”

Daniel Want, 2020 03 14 Prerequisite Update pt 4

What To Do

This logically raises the question of: What to do? From a policy perspective, I have little to offer as I am simply not an expert in the field (ask me in the comment section if you’re interested in my views). That said, the Fed’s response seems silly. Despite the severe investment market stresses, I don’t believe that we’re reliving the GFC. There’s no nail that requires a central banker’s hammer (as if there ever is one). If a financial crisis develops secondarily, then we should seriously question the value that such a fragile system offers.

Markets anticipate developments. I can envision a number of scenarios in which prices reverse course swiftly (such as a decline in the infection rate, a medical breakthrough, etc.). I can see others leading to a protracted economic contraction, as suggested by the intense market moves. Are serious underlying issues at play, even if secondarily? Or are fragile and idiosyncratic market structures to blame? These are the questions I’m trying to grapple with, weighing the unknowns, and allocating capital accordingly.

As an investor, seeing the field more clearly can be an advantage. Remember, it’s never different this time. Nor, however, is it ever the same. This makes for a difficult paradox to navigate. It’s in chaotic times when an investment framework is most valuable. Reflexively fighting the last war seems silly. Rather, let’s assess the current one as it rapidly develops and try to stay one step ahead of the herd.

Good luck out there and stay safe. Strong views, held loosely.

Robertson: When “Stuff” Gets Real

We all can be tempted to follow the path of least resistance and in a competitive world there are always incentives to get the most bang for the buck. Often this means taking shortcuts to gain some advantage. In a forgiving world, the penalties for such transgressions tend to be small but the rewards can be significant. When conditions are extremely forgiving, shortcuts can become so pervasive that failing to take them can be a competitive disadvantage.

In a less forgiving world, however, the deal gets completely flipped around and penalties can be significant for those who take shortcuts. This will be important for investors to keep in mind as rapidly weakening economic fundamentals and increasing stress in financial markets make for far less forgiving conditions. When things get real, competence and merit matter again – and this is a crucial lesson for investors.

Leaders of companies and organizations normally receive a lot of attention and rightly so; their decisions and behaviors affect a lot people. In the best of situations, leaders can distinguish themselves by creatively finding a “third” way to resolve difficult challenges. In other situations, however, leaders can reveal all-too-human weakness by taking shortcuts, cheating, and acting excessively in their own self-interest.

One of the situations in which these weaknesses can be spotted is in whistleblower incidents. For example, the Financial Times reported on the illuminating experiences of one HR director who in successive jobs was requested to break rules by a boss:

“Told by a senior manager at a FTSE 100 business to rig a pay review to favour his allies, she refused. ‘After that, he did everything to make my life absolute hell,’ she says. Then, at the first opportunity, he fired her, claiming that she was underperforming. Warned that the company would use its resources to fight her all the way if she took legal action, she accepted a pay-off and left’.” 

“Her next employer asked her to manipulate the numbers for a statutory reporting requirement to make its performance look better. She refused, signed another non-disclosure agreement and resigned.”

As unfortunate as these experiences were, they were not isolated events. The HR director described such incidents as happening “left, right and centre”. The fact that such cases are extremely hard to prosecute in any meaningful way helps explain why they are so pervasive. Columbia law professor John Coffee describes: “It’s extremely difficult to make a case against the senior executives because they don’t get Involved in operational issues. But they can put extreme pressure on the lower echelons to cut costs or hit targets.”

Company employees aren’t the only ones who risk facing hostility for standing for what they believe is right. Anjana Ahuja reports in the FT that scientists can fall victim to the same abuses. As she points out, “Some are targeted by industry or fringe groups; others, as the Scholars at Risk network points out, by their own governments. The academic freedom to tell inconvenient truths is being eroded even in supposed strong holds of democracy.”

Ahuja noted that the Canadian pharmacist and blogger, Olivier Bernard, was chastised for “interrogating the claim that vitamin C injections can treat cancer.”  As a consequence of his efforts, “He endured death threats” and “opponents demanded his sacking.”

In yet another example, Greece’s former chief statistician Andreas Georgiou “has been repeatedly convicted, and acquitted on appeal, of manipulating data.” The rationale for such a harsh response has nothing to do with merit: “statisticians worldwide insist that Mr Georgiou has been victimised for refusing to massage fiscal numbers.” It is simply a higher profile case of refusing to be complicit in wrongdoing.

The lessons from these anecdotes also play out across the broader population. The FT reports:

“According to the [CIPD human resources survey], 28 per cent of HR personnel perceive a conflict between their professional judgment and what their organisation expects of them; the same proportion feel ‘it’s often necessary to compromise ethical values to succeed in their organisation’.”

Employees are all-too familiar with the reality that such compromises may be required simply to survive in an organization and to continue getting health insurance: “Most HR directors know colleagues who have been fired for standing their ground.”

Yet another arena in which expertise and values get compromised is politics. While political rhetoric nearly always involves exaggerations and simplifications, the cost of such manipulations becomes apparent when important issues of public policy are at stake. Bill Blain highlighted this point on Zerohedge:

“It’s as clear as a bell that Trump had no plan to address the Coronavirus before he was finally forced to say something Monday [March 9, 2020]. Until then it was a ‘fake-news’ distraction. He made a political gamble: that the virus would recede before it became a crisis, making him look smart and a market genius for calling it.”

Blain’s assessment illustrates a point that is common to all these examples: Each involves a calculation as to whether it is worth it or not to do the right thing based on merit or to take a shortcut. Each involves an intentional effort to reject/deny/attack positions that are real and valid. Evidence, expertise and professional judgment are foresworn and replaced by narrative, heuristics, and misinformation. While such tactics undermine the long-term success of organizations and societies, they can yield tremendous personal advantages. The good of the whole is sacrificed for the good of the few.

Another point is that these efforts are absolutely pervasive. They can be found across companies, academia, politics, and beyond. They can also be found in countries all across the world. In an important sense, we have been living in an environment of pervasive tolerance of such decisions.

A third point, and the most important one, is that now it is starting to matter. It appears that the real human impact of the coronavirus has shaken many people out of complacency. The types of narratives and misinformation regarding the market that had been accepted suddenly seem woefully out of place when dealing with a real threat to public health. As Janan Ganesh reports in the FT, “This year provides a far less hospitable atmosphere for such hokum than 2016”. He concludes, “Overnight, competence matters.”

True enough, but Ganesh could have gone further. Suddenly, additional traits such as courage, good judgment, and ethical behavior also matter. Overnight, carelessness and complacency have become much more costly.

All these things will become extremely important for investors as well. For example, information sources are crucial for early identification of potential problems and for proper diagnosis. Most mainstream news outlets were slow to report on the threat of the coronavirus even though it was clearly a problem in China in January. By far the best sources on this issue have been a handful of independent researchers and bloggers who have shared their insights publicly.

One form of news that will be interesting to monitor is upcoming earnings reports and conference calls. These events can provide an opportunity to learn about companies as well as to learn about management’s philosophy and decision-making.

Which companies are busily responding to the crisis by scrutinizing their supply chains and developing HR policies to ensure the safety of their employees? Which companies already had these measures in place and are simply executing on them now? Which companies are withdrawing guidance while they frantically try to figure out what’s going on? These responses will reveal a great deal about management teams and business models.

In addition, a much higher premium on merit will also place much higher premia on security analysis, valuation, and risk management. Alluring stories about stocks and narratives about the market can be fun to follow and even compelling. At the end of the day, however, what really matters is streams of cash flows.

Finally, a higher premium on merit is likely to significantly re-order the ranks of advisors and money managers. Those ridiculed as “overly cautious” and “perma bears” will emerge as valuable protectors of capital. Conversely, those arguing that there is no alternative (TINA) to equities will be spending a lot of time trying to pacify (and retain) angry clients who suffer big losses. Further, things like education, training, and experience will re-emerge as necessary credentials for investment professionals.

As the coronavirus continues to spread across the US, things are starting to get real for many investors. Suddenly, the world is appearing less forgiving as it is becoming clear that economic growth will slow substantially for some period of time. This especially exposes the many companies who have binged on debt while rates have been so low. Further, it is becoming increasingly obvious that there is very little the Fed can do with monetary policy to stimulate demand.

While the coronavirus will eventually dissipate, the increasing premium on merit is likely to hang around. The bad news is that in many cases it will be too late to avoid the harm caused by leaders and managers and advisors who exploited favorable conditions for personal advantage. The good news is that there are very competent people out there to make the best of things going forward.

Technically Speaking: Risk Limits Hit, When Too Little Is Too Much

For the last several months, we have been issuing repeated warnings about the market. While such comments are often mistaken for “being bearish,” we have often stated it is our process of managing “risk” which is most important.

Beginning in mid-January, we began taking profits out of our portfolios and reducing risk. To wit:

“On Friday, we began the orderly process of reducing exposure in our portfolios to take in profits, reduce portfolio risk, and raise cash levels.”

Importantly, we did not “sell everything” and go to cash.

Since then, we took profits and rebalanced risk again in late January and early February as well.

Our clients, their families, their financial and emotional “well being,” rest in our hands. We take that responsibility very seriously, and work closely with our clients to ensure that not only are they financially successful, but they are emotionally stable in the process.

This is, and has been, our biggest argument against “buy and hold,” and “passive investing.” While there are plenty of case studies showing why individuals will eventually get back to even, the vast majority of individuals have a “pain point,” where they will sell.

So, we approach portfolio management from a perspective of “risk management,” but not just in terms of “portfolio risk,” but “emotional risk” as well. By reducing our holdings to raise cash to protect capital, we can reduce the risk of our clients hitting that “threashold” where they potentially make very poor decisions.

In investing, the worst decisions are always made at the moment of the most pain. Either at the bottom of the market or near the peaks. 

Investing is not always easy. Our portfolios are designed to have longer-term holding periods, but we also understand that things do not always go as planned.

This is why we have limits, and when things go wrong, we sell.

So, why do I tell you this?

On Friday/Monday, our “limits” were breached, which required us to sell more.

Two Things

Two things have now happened, which signaled us to reduce risk further in portfolios.

On Sunday, the Federal Reserve dropped a monetary “nuclear bomb,” on the markets. My colleague Caroline Baum noted the details:

“After an emergency 50-basis-point rate cut on March 3, the Federal Reserve doubled down Sunday evening, lowering its benchmark rate by an additional 100 basis points to a range of 0%-0.25% following another emergency meeting.

After ramping up its $60 billion of monthly Treasury bill purchases to include Treasuries of all maturities and offering $1.5 trillion of liquidity to the market via repurchase agreements on March 3, the Fed doubled down Sunday evening with announced purchases of at least $500 billion of Treasuries and at least $200 billion of agency mortgage-backed securities.

In addition, the Fed reduced reserve requirements to zero, encouraged banks to borrow from its discount window at a rate of 0.25%, and, in coordination with five other central banks, lowered the price of U.S. dollar swap arrangements to facilitate dollar liquidity abroad”

We had been anticipating the Federal Reserve to try and rescue the markets, which is why we didn’t sell even more aggressively previously. The lesson investors have been taught repeatedly over the last decade was “Don’t Fight The Fed.”

One of the reasons we reduced our exposure in the prior days was out of concern the Fed’s actions wouldn’t be successful. 

On Monday, we found out the answer. The Fed may be fighting a battle it can’t win as markets not only failed to respond to the Fed’s monetary interventions but also broke the “bullish trend line” from the 2009 lows.  (While the markets are oversold short-term, the long-term “sell signals” in the bottom panels are just being triggered from fairly high levels. This suggests more difficulty near-term for stocks. 

This was the “Red Line” we laid out in our Special Report for our RIAPro Subscribers (Risk-Free 30-Day Trial) last week:

“As you can see in the chart below, this is a massive surge of liquidity, hitting the market at a time the market is testing important long-term trend support.”

It is now, or never, for the markets.

With our portfolios already at very reduced equity levels, the break of this trendline will take our portfolios to our lowest levels of exposure.

What happened today was an event we have been worried about, but didn’t expect to see until after a break of the trendline – “margin calls.” This is why we saw outsized selling in “safe assets” such as REITs, utilities, bonds, and gold.

Cash was the only safe place to hide.

We aren’t anxious to “fight the Fed,” but the markets may have a different view this time.

Use rallies to raise cash, and rebalance portfolio risk accordingly.

We are looking to be heavy buyers of equities when the market forms a bottom, we just aren’t there as of yet.”

On Monday morning, with that important trendline broken, we took some action.

  • Did we sell everything? No. We still own 10% equity, bonds, and a short S&P 500 hedge. 
  • Did we sell the bottom? Maybe.

We will only know in hindsight for certain, and we are not willing to risk more of our client’s capital currently. 

There are too many non-quantifiable risks with a global recession looming, as noted by David Rosenberg:

“The pandemic is a clear ‘black swan’ event. There will be a whole range of knock-on effects. Fully 40 million American workers, or one-third of the private-sector labor force, are directly affected ─ retail, entertainment, events, sports, theme parks, conferences, travel, tourism, restaurants and, of course, energy.

This doesn’t include all the multiplier effects on other industries. It would not surprise me at all if real GDP in Q2 contracts at something close to an 8% annual rate (matching what happened in the fourth quarter of 2008, which was a financial event alone).

The hit to GDP can be expected to be anywhere from $400 billion to $600 billion for the year. But the market was in trouble even before COVID-19 began to spread, with valuations and complacency at cycle highs and equity portfolio managers sitting with record-low cash buffers. Hence the forced selling in other asset classes.

If you haven’t made recession a base-case scenario, you probably should. All four pandemics of the past century coincided with recession. This won’t be any different. It’s tough to generate growth when we’re busy “social distancing.” I am amazed that the latest WSJ poll of economists conducted between March 6-10th showed only 49% seeing a recession coming”.

The importance of his commentary is that from an “investment standpoint,” we can not quantify whether this “economic shock” has been priced into equities as of yet. However, we can do some math based on currently available data:

The chart below is the annual change in nominal GDP, and S&P 500 GAAP earnings.

I am sure you will not be shocked to learn that during “recessions,” corporate “earnings’ tend to fall. Historically, the average drawdown of earnings is about 20%; however, since the 1990’s, those drawdowns have risen to about 30%.

As of March 13th, Standard & Poors has earnings estimates for the first quarter of 2020 at $139.20 / share. This is down just $0.20 from the fourth quarter of 2019 estimates of $139.53.

In other words, Wall Street estimates are still in “fantasy land.” 

If our, and Mr. Rosenberg’s, estimates are correct of a 5-8% recessionary drag in the second quarter of 2020, then an average reduction in earnings of 30% is most likely overly optimistic. 

However, here is the math:

  • Current Earnings = 132.90
  • 30% Reduction = $100 (rounding down for easier math)

At various P/E multiples, we can predict where “fair value” for the market is based on historical assumptions:

  • 20x earnings:  Historically high but markets have traded at high valuations for the last decade. 
  • 18x earnings: Still historically high.
  • 15x earnings: Long-Term Average
  • 13x earnings: Undervalued 
  • 10x earnings: Extremely undervalued but aligned with secular bear market bottoms.

You can pick your own level where you think P/E’s will account for the global recession but the chart below prices it into the market.

With the S&P 500 closing yesterday at 2386, this equates to downside risk of:

  • 20x Earnings = -16% (Total decline from peak = – 40%)
  • 18x Earnings = 24.5% (Total decline from peak = – 46%)
  • 15x Earnings = -37.1% (Total decline from peak = – 55%)
  • 13x Earnings = 45.5% (Total decline from peak = – 61%)
  • 10x Earnings = 58.0% (Total decline from peak = – 70%)

NOTE: I am not suggesting the market is about to decline 60-70% from the recent peak. I am simply laying out various multiples based on assumed risk to earnings. However, 15-18x earnings is extremely reasonable and possible. 

When Too Little Is Too Much

With our risk limits hit, and in order to protect our clients from both financial and emotional duress, we made the decision that even the reduced risk we were carrying was still too much.

One concern, which weighed heavily into our decision process, was the rising talk of the “closing the markets” entirely for a week or two to allow the panic to pass. We have clients that depend on liquidity from their accounts to sustain their retirement lifestyle. In our view, a closure of the markets would lead to two outcomes which pose a real risk to our clients:

  1. They need access to liquidity, and with markets closed are unable to “sell” and raise cash; and,
  2. When you trap investors in markets, when they do open again, there is a potential “rush” of sellers to get of the market to protect themselves. 

That risk, combined with the issue that major moves in markets are happening outside of transaction hours, are outside of our ability to hedge, or control.

This is what we consider to be an unacceptable risk for the time being.

We will likely miss the ultimate “bottom” of the market.


But that’s okay, we have done our job of protecting our client’s second most precious asset behind their family, the capital they have to support them.

The good news is that a great “buying” opportunity is coming. Just don’t be in a “rush” to try and buy the bottom.

I can assure you, when we see ultimately see a clear “risk/reward” set up to start taking on equity risk again, we will do so “with both hands.” 

And we are sitting on a lot of cash just for that reason.Save

RIA PRO: Risk Limits Hit

For the last several months we have been issuing repeated warnings about the market. While such comments are often mistaken for “being bearish,” we have often stated it is our process of managing “risk” which is most important.

Beginning in mid-January, we began taking profits out of our portfolios and reducing risk. To wit:

“On Friday, we began the orderly process of reducing exposure in our portfolios to take in profits, reduce portfolio risk, and raise cash levels.”

Since then, as you know, we have taken profits, and rebalanced risk several times within the portfolios.

Importantly, we approach portfolio management from a perspective of “risk management,” but not just in terms of “portfolio risk,” but “emotional risk” as well. By reducing our holdings to raise cash to protect capital, we can reduce the risk of our clients hitting that “threshold” where they potentially make very poor decisions.

In investing, the worst decisions are always made at the moment of the most pain. Either at the bottom of the market or near the peaks. 

Investing is not always easy. Our portfolios are designed to have longer-term holding periods, but we also understand that things do not always go as planned.

This is why we have limits, and when things go wrong, we sell.

So, why do I tell you this?

On Friday/Monday, our “limits” were breached, which required us to sell more.

Two Things

Two things have now happened which signaled us to reduce risk further in portfolios.

On Sunday, the Federal Reserve dropped a monetary “nuclear bomb,” on the markets. My colleague Caroline Baum noted the details:

“After an emergency 50-basis-point rate cut on March 3, the Federal Reserve doubled down Sunday evening, lowering its benchmark rate by an additional 100 basis points to a range of 0%-0.25% following another emergency meeting.

After ramping up its $60 billion of monthly Treasury bill purchases to include Treasuries of all maturities and offering $1.5 trillion of liquidity to the market via repurchase agreements on March 3, the Fed doubled down Sunday evening with announced purchases of at least $500 billion of Treasuries and at least $200 billion of agency mortgage-backed securities.

In addition, the Fed reduced reserve requirements to zero, encouraged banks to borrow from its discount window at a rate of 0.25%, and, in coordination with five other central banks, lowered the price of U.S. dollar swap arrangements to facilitate dollar liquidity abroad”

We had been anticipating the Federal Reserve to try and rescue the markets, which is why we didn’t sell even more aggressively previously. The lesson investors have been taught repeatedly over the last decade was “Don’t Fight The Fed.”

One of the reasons we reduced our exposure in the prior days was out of concern we didn’t know if the Fed’s actions would be successful. 

On Monday, we found out the answer. The Fed may be fighting a battle it can’t win as markets not only failed to respond to the Fed’s monetary interventions, but also broke the “bullish trend line” from the 2009 lows.  (While the markets are oversold short-term, the long-term “sell signals” in the bottom panels are just being triggered from fairly high levels. This suggests more difficulty near-term for stocks. 

This was the “Red Line” we laid out in our last week, in the Special Report Red Line In The Sand:

“As you can see in the chart below, this is a massive surge of liquidity hitting the market at a time the market is hitting important long-term trend support.”

It is now, or never, for the markets.

With our portfolios already at very reduced equity levels, the break of this trendline will take our portfolios to our lowest levels of exposure. However, given the extreme oversold condition, noted above, it is likely we are going to see a bounce, which we will use to reduce risk into.

What happened today was an event we have been worried about, but didn’t expect to see until after a break of the trendline – “margin calls.”

This is why we saw outsized selling in “safe assets” such as REITs, utilities, bonds, and gold.

Cash was the only safe place to hide.

This also explains why the market “failed to rally” when the Fed announced $500 billion today. There is another $500 billion coming tomorrow. We will see what happens.

We aren’t anxious to “fight the Fed,” but the markets may have a different view this time.

Use rallies to raise cash, and rebalance portfolio risk accordingly.

We are looking to be heavy buyers of equities when the market forms a bottom, we just aren’t there as of yet.”

On Monday morning, we took some action.

  • Did we sell everything? No. We still own 10% equity, bonds, and a short S&P 500 hedge. 
  • Did we sell the bottom? Maybe.

We will only know in hindsight for certain, and we are not willing to risk more of our client’s capital currently. 

There are too many non-quantifiable risks with a global recession looming, as noted by David Rosenberg:

“The pandemic is a clear ‘black swan’ event. There will be a whole range of knock-on effects. Fully 40 million American workers, or one-third of the private sector labor force, are directly affected ─ retail, entertainment, events, sports, theme parks, conferences, travel, tourism, restaurants and, of course, energy.

This doesn’t include all the multiplier effects on other industries. It would not surprise me at all if real GDP in Q2 contracts at something close to an 8% annual rate (matching what happened in the fourth quarter of 2008 which was a financial event alone).

The hit to GDP can be expected to be anywhere from $400 billion to $600 billion for the year. But the market was in trouble even before COVID-19 began to spread, with valuations and complacency at cycle highs and equity portfolio managers sitting with record-low cash buffers. Hence the forced selling in other asset classes.

If you haven’t made recession a base-case scenario, you probably should. All four pandemics of the past century coincided with recession. This won’t be any different. It’s tough to generate growth when we’re busy “social distancing.” I am amazed that the latest WSJ poll of economists conducted between March 6-10th showed only 49% seeing a recession coming”.

The importance of his commentary is that from an “investment standpoint,” we can not quantify whether this “economic shock” has been priced into equities as of yet. However, we can do some math based on currently available data:

The chart below is annual nominal GDP, and S&P 500 GAAP earnings.

I am sure you will not be shocked to learn that during “recessions,” corporate “earnings’ tend to fall. Historically, the average drawdown of earnings is about 20%, however, since the 1990’s, those drawdowns have risen to about 30%.

As of March 13th, Standard & Poors has earnings estimates for the first quarter of 2020 at $139.20/share. This is down just $0.20 from the fourth quarter of 2019 estimates of $139.53.

If our, and Mr. Rosenberg’s, estimates are correct of a 5-8% recessionary drag in the second quarter of 2020, then an average reduction in earnings of 30% is most likely overly optimistic. 

However, here is the math:

  • Current Earnings = 132.90
  • 30% Reduction = $100 (rounding down for easier math)

At various P/E multiples we can predict where “fair value” for the market is based on historical assumptions:

  • 20x earnings:  Historically high but markets have traded at high valuations for the last decade. 
  • 18x earnings: Still historically high.
  • 15x earnings: Long-Term Average
  • 13x earnings: Undervalued 
  • 10x earnings: Extremely undervalued but aligned with secular bear market bottoms.

You can pick your own level where you think P/E’s will account for the global recession but the chart below prices it into the market.

With the S&P 500 closing yesterday at 2386, this equates to downside risk of:

  • 20x Earnings = -16% (Total decline from peak = – 40%)
  • 18x Earnings = 24.5% (Total decline from peak = – 46%)
  • 15x Earnings = -37.1% (Total decline from peak = – 55%)
  • 13x Earnings = 45.5% (Total decline from peak = – 61%)
  • 10x Earnings = 58.0% (Total decline from peak = – 70%)

NOTE: I am not suggesting the market is about to decline 60-70% from the recent peak. I am simply laying out various multiples based on assumed risk to earnings. However, 15-18x earnings is extremely reasonable and possible. 

When Too Little Is Too Much

With our risk limits hit, and in order to protect our clients from both financial and emotional duress, we made the decision that even the reduced risk we were carrying was still too much.

One concern, which weighed heavily into our decision process, was the rising talk of the “closing the markets” entirely for a week or two to allow the panic to pass. We have clients that depend on liquidity from their accounts to sustain their retirement lifestyle. In our view, a closure of the markets would lead to two outcomes which pose a real risk to our clients:

  1. They need access to liquidity, and with markets closed are unable to “sell” and raise cash; and,
  2. When you trap investors in markets, when they do open again there is a potential “rush” of sellers to get of the market to protect themselves. 

That risk, combined with the issue that major moves in markets are happening outside of transaction hours, are outside of our ability to hedge, or control.

This is what we consider to be unacceptable risk for the time being.

We will likely miss the ultimate “bottom” of the market?


But that’s okay, we have done our job of protecting our client’s second most precious asset behind their family, the capital they have to support them.

The good news is that a great “buying” opportunity is coming. Just don’t be in a “rush” to try and buy the bottom.

I can assure you that when we see ultimately see a clear “risk/reward” set up to start taking on equity risk again, we will do so “with both hands.” 

And we are sitting on a lot of cash just for that reason.Save

Technically Speaking: On The Cusp Of A Bear Market

“Tops are a process, and bottoms are an event”

Over the last couple of years, we have discussed the ongoing litany of issues that plagued the underbelly of the financial markets.

  1. The “corporate credit” markets are at risk of a wave of defaults.
  2. Earnings estimates for 2019 fell sharply, and 2020 estimates are now on the decline.
  3. Stock market targets for 2020 are still too high, along with 2021.
  4. Rising geopolitical tensions between Russia, Saudi Arabia, China, Iran, etc. 
  5. The effect of the tax cut legislation has disappeared as year-over-year comparisons are reverting back to normalized growth rates.
  6. Economic growth is slowing.
  7. Chinese economic data has weakened further.
  8. The impact of the “coronavirus,” and the shutdown of the global supply chain, will impact exports (which make up 40-50% of corporate profits) and economic growth.
  9. The collapse in oil prices is deflationary and can spark a wave of credit defaults in the energy complex.
  10. European growth, already weak, continues to weaken, and most of the EU will likely be in recession in the next 2-quarters.
  11. Valuations remain at expensive levels.
  12. Long-term technical signals have become negative. 
  13. The collapse in equity prices, and coronavirus fears, will weigh on consumer confidence.
  14. Rising loan delinquency rates.
  15. Auto sales are signaling economic stress.
  16. The yield curve is sending a clear message that something is wrong with the economy.
  17. Rising stress on the consumption side of the equation from retail sales and personal consumption.

I could go on, but you get the idea.

In that time, these issues have gone unaddressed, and worse dismissed, because of the ongoing interventions of Central Banks.

However, as we have stated many times in the past, there would eventually be an unexpected, exogenous event, or rather a “Black Swan,” which would “light the fuse” of a bear market reversion.

Over the last few weeks, the market was hit with not one, but two, “black swans” as the “coronavirus” shutdown the global supply chain, and Saudi Arabia pulled the plug on oil price support. Amazingly, we went from “no recession in sight”, to full-blown “recession fears,” in less than month.

“Given that U.S. exporters have already been under pressure from the impact of the “trade war,” the current outbreak could lead to further deterioration of exports to and from China, South Korea, and Japan. This is not inconsequential as exports make up about 40% of corporate profits in the U.S. With economic growth already struggling to maintain 2% growth currently, the virus could shave between 1-1.5% off that number. 

With our Economic Output Composite Indicator (EOCI) already at levels which has previously denoted recessions, the “timing” of the virus could have more serious consequences than currently expected by overzealous market investors.”

On The Cusp Of A Bear Market

Let me start by making a point.

“Bull and bear markets are NOT defined by a 20% move. They are defined by a change of direction in the trend of prices.” 

There was a point in history where a 20% move was significant enough to achieve that change in overall price trends. However, today that is no longer the case.

Bull and bear markets today are better defined as:

“During a bull market, prices trade above the long-term moving average. However, when the trend changes to a bear market prices trade below that moving average.”

This is shown in the chart below, which compares the market to the 75-week moving average. During “bullish trends,” the market tends to trade above the long-term moving average and below it during “bearish trends.”

In the last decade, there have been three previous occasions where the long-term moving average was violated but did not lead to a longer-term change in the trend.

  • The first was in 2011, as the U.S. was dealing with a potential debt-ceiling and threat of a downgrade of the U.S. debt rating. Then Fed Chairman Ben Bernanke came to the rescue with the second round of quantitative easing (QE), which flooded the financial markets with liquidity.
  • The second came in late-2015 and early-2016 as the market dealt with a Federal Reserve, which had started lifting interest rates combined with the threat of the economic fallout from Britain leaving the European Union (Brexit). Given the U.S. Federal Reserve had already committed to hiking interest rates, and a process to begin unwinding their $4-Trillion balance sheet, the ECB stepped in with their own version of QE to pick up the slack.
  • The latest event was in December 2018 as the markets fell due to the Fed’s hiking of interest rates and reduction of their balance sheet. Of course, the decline was cut short by the Fed reversal of policy and subsequently, a reduction in interest rates and a re-expansion of their balance sheet.

Had it not been for these artificial influences, it is highly likely the markets would have experienced deeper corrections than what occurred.

On Monday, we have once again violated that long-term moving average. However, Central Banks globally have been mostly quiet. Yes, there have been promises of support, but as of yet, there have not been any substantive actions.

However, the good news is that the bullish trend support of the 3-Year moving average (orange line) remains intact for now. That line is the “last line of defense” of the bull market. The only two periods where that moving average was breached was during the “Dot.com Crash” and the “Financial Crisis.”

(One important note is that the “monthly sell trigger,” (lower panel) was initiated at the end of February which suggested there was more downside risk at the time.)

None of this should have been surprising, as I have written previously, prices can only move so far in one direction before the laws of physics take over. To wit”

Like a rubber band that has been stretched too far – it must be relaxed before it can be stretched again. This is exactly the same for stock prices that are anchored to their moving averages. Trends that get overextended in one direction, or another, always return to their long-term average. Even during a strong uptrend or strong downtrend, prices often move back (revert) to a long-term moving average.”

With the markets previously more than 20% of their long-term mean, the correction was inevitable, it just lacked the right catalyst.

The difference between a “bull market” and a “bear market” is when the deviations begin to occur BELOW the long-term moving average on a consistent basis. With the market already trading below the 75-week moving average, a failure to recover in a fairly short period, will most likely facilitate a break below the 3-year average.

If that occurs, the “bear market” will be official and will require substantially lower levels of equity risk exposure in portfolios until a reversal occurs.

Currently, it is still too early to know for sure whether this is just a “correction” or a “change in the trend” of the market. As I noted previously, there are substantial differences, which suggest a more cautious outlook. To wit:

  • Downside Risk Dwarfs Upside Reward. 
  • Global Growth Is Less Synchronized
  • Market Structure Is One-Sided and Worrisome. 
  • COVID-19 Impacts To The Global Supply Chain Are Intensifying
  • Any Semblance of Fiscal Responsibility Has Been Thrown Out the Window
  • Peak Buybacks
  • China, Europe, and the Emerging Market Economic Data All Signal a Slowdown
  • The Democrats Control The House Which Effectively Nullifies Fiscal Policy Agenda.
  • The Leadership Of The Market (FAANG) Has Faltered.

Most importantly, the collapse in interest rates, as well as the annual rate of change in rates, is screaming that something “has broken,” economically speaking.

Here is the important point.

Understanding that a change is occurring, and reacting to it, is what is important. The reason so many investors “get trapped” in bear markets is that by the time they realize what is happening, it has been far too late to do anything about it.

Let me leave you with some important points from the legendary Marty Zweig: (h/t Doug Kass.)

  • Patience is one of the most valuable attributes in investing.
  • Big money is made in the stock market by being on the right side of the major moves. The idea is to get in harmony with the market. It’s suicidal to fight trends. They have a higher probability of continuing than not.
  • Success means making profits and avoiding losses.
  • Monetary conditions exert an enormous influence on stock prices. Indeed, the monetary climate – primarily the trend in interest rates and Federal Reserve policy – is the dominant factor in determining the stock market’s major decision.
  • The trend is your friend.
  • The problem with most people who play the market is that they are not flexible.
  • Near the top of the market, investors are extraordinarily optimistic because they’ve seen mostly higher prices for a year or two. The sell-offs witnessed during that span were usually brief. Even when they were severe, the market bounced back quickly and always rose to loftier levels. At the top, optimism is king; speculation is running wild, stocks carry high price/earnings ratios, and liquidity has evaporated. 
  • I measure what’s going on, and I adapt to it. I try to get my ego out of the way. The market is smarter than I am, so I bend.
  • To me, the “tape” is the final arbiter of any investment decision. I have a cardinal rule: Never fight the tape!
  • The idea is to buy when the probability is greatest that the market is going to advance.

Most importantly, and something that is most applicable to the current market:

“It’s okay to be wrong; it’s just unforgivable to stay wrong.” – Marty Zweig

There action this year is very reminiscent of previous market topping processes. Tops are hard to identify during the process as “change happens slowly.” The mainstream media, economists, and Wall Street will dismiss pickup in volatility as simply a corrective process. But when the topping process completes, it will seem as if the change occurred “all at once.”

The same media which told you “not to worry,” will now tell you, “no one could have seen it coming.”

The market may be telling you something important, if you will only listen.


Technically Speaking: Sellable Rally, Or The Return Of The Bull?

Normally, “Technically Speaking,” is analysis based on Monday’s market action. However, this week, we are UPDATING the analysis posted in this past weekend’s newsletter, “Market Crash & Navigating What Happens Next.”

Specifically, we broke down the market into three specific time frames looking at the short, intermediate, and long-term technical backdrop of the markets. In that analysis, we laid out the premise for a “reflexive bounce” in the markets, and what to do during the process of that move. To wit:

“On a daily basis, the market is back to a level of oversold (top panel) rarely seen from a historical perspective. Furthermore, the rapid decline this week took the markets 5-standard deviations below the 50-dma.”

Chart updated through Monday

“To put this into some perspective, prices tend to exist within a 2-standard deviation range above and below the 50-dma. The top or bottom of that range constitutes 95.45% of ALL POSSIBLE price movements within a given period.

A 5-standard deviation event equates to 99.9999% of all potential price movement in a given direction. 

This is the equivalent of taking a rubber band and stretching it to its absolute maximum.”

Importantly, like a rubber band, this suggests the market “snap back” could be fairly substantial, and should be used to reduce equity risk, raise cash, and add hedges.”

Importantly, read that last sentence again.

The current belief is that the “virus” is limited in scope and once the spread is contained, the markets will immediately bounce back in a “V-shaped” recovery.  Much of this analysis is based on assumptions that “COVID-19” is like “SARS” in 2003 which had a very limited impact on the markets.

However, this is likely a mistake as there is one very important difference between COVID-19 and SARS, as I noted previously:

“Currently, the more prominent comparison is how the market performed following the ‘SARS’ outbreak in 2003, as it also was a member of the ‘corona virus’ family. Clearly, if you just remained invested, there was a quick recovery from the market impact, and the bull market resumed. At least it seems that way.”

“While the chart is not intentionally deceiving, it hides a very important fact about the market decline and the potential impact of the SARS virus. Let’s expand the time frame of the chart to get a better understanding.”

“Following a nearly 50% decline in asset prices, a mean-reversion in valuations, and an economic recession ending, the impact of the SARS virus was negligible given the bulk of the ‘risk’ was already removed from asset prices and economic growth. Today’s economic environment could not be more opposed.”

This was also a point noted by the WSJ on Monday:

Unlike today, the S&P 500 ETF (SPY) spent about a year below its 200-day moving average (dot-com crash) prior to the SARS 2003 outbreak. Price action is much different now. SPY was well above its 200-day moving average before the coronavirus outbreak, leaving plenty of room for profit-taking.”

Importantly, the concern we have in the intermediate-term is not “people getting sick.” We currently have the “flu” in the U.S. which, according to the CDC, has affected 32-45 MILLION people which has already resulted in 18-46,000 deaths.

Clearly, the “flu” is a much bigger problem than COVID-19 in terms of the number of people getting sick. The difference, however, is that during “flu season,” we don’t shut down airports, shipping, manufacturing, schools, etc. The negative impact to exports and imports, business investment, and potentially consumer spending, which are all direct inputs into the GDP calculation, is going to be reflected in corporate earnings and profits. 

The recent slide, not withstanding the “reflexive bounce” on Monday, was beginning the process of pricing in negative earnings growth through the end of 2020.

More importantly, the earnings estimates have not be ratcheted down yet to account for the impact of the “shutdown” to the global supply chain. Once we adjust (dotted blue line) for the a negative earnings environment in 2020, with a recovery in 2021, you can see just how far estimates will slide over the coming months. This will put downward pressure on stocks over the course of this year.

Given this backdrop of weaker earnings, which will be derived from weaker economic growth, in the months to come is why we suspect we could well see this year play out much like 2015-2016. In 2015, the Fed was beginning to discuss tapering their balance sheet which initially led to a decline. Given there was still plenty of liquidity, the market rallied back before “Brexit” risk entered the picture. The market plunged on expectations for a negative economic impact, but sprung back after Janet Yellen coordinated with the BOE, and ECB, to launch QE in the Eurozone.

Using that model for a reflexive rally, we will likely see a failed rally, and a retest of last weeks lows, or potentially even set new lows, as economic and earnings risks are factored in. 

Rally To Sell

As expected, the market rallied hard on Monday on hopes the Federal Reserve, and Central Banks globally, will intervene with a “shot of liquidity” to cure the market’s “COVID-19” infection.

The good news is the rally yesterday did clear initial resistance at the 200-dma which keeps that important break of support from being confirmed. This clears the way for the market to rally back into the initial “sell zone” we laid out this past weekend.

Importantly, while the volume of the rally on Monday was not as large as Friday’s sell-off, it was a very strong day nonetheless and confirmed the conviction of buyers. With the markets clearing the 200-dma, and still oversold on multiple levels, there is a high probability the market will rally into our “sell zone” before failing.

For now look for rallies to be “sold.”

The End Of The Bull

I want to reprint the last part of this weekend’s newsletter as the any rally that occurs over the next couple of weeks will NOT reverse the current market dynamics.

“The most important WARNING is the negative divergence in relative strength (top panel).  This negative divergence was seen at every important market correction event over the last 25-years.”

“As shown in the bottom two panels, both of the monthly ‘buy’ signals are very close to reversing. It will take a breakout to ‘all-time highs’ at this point to keep those signals from triggering.

For longer-term investors, people close to, or in, retirement, or for individuals who don’t pay close attention to the markets or their investments, this is NOT a buying opportunity.

Let me be clear.

There is currently EVERY indication given the speed and magnitude of the decline, that any short-term reflexive bounce will likely fail. Such a failure will lead to a retest of the recent lows, or worse, the beginning of a bear market brought on by a recession.

Please read that last sentence again. 

Bulls Still In Charge

The purpose of the analysis above is to provide you with the information to make educated guesses about the “probabilities” versus the “possibilities” of what could occur in the markets over the weeks, and months, ahead.

It is absolutely “possible” the markets could find a reason to rally back to all-time highs and continue the bullish trend. (For us, such would be the easiest and best outcome.) Currently, the good news for the bulls, is the bullish trend line from the 2015 lows held. However, weekly “sell signals” are close to triggering, which does increase short-term risks.

With the seasonally strong period of the market coming to its inevitable conclusion, economic and earnings data under pressure, and the virus yet to be contained, it is likely a good idea to use the current rally to rebalance portfolio risk and adjust allocations accordingly.

As I stated in mid-January, and again in early February, we reduced exposure in portfolios by raising cash and rebalancing portfolios back to target weightings. We had also added interest rate sensitive hedges to portfolios, and removed all of our international and emerging market exposures.

We will be using this rally to remove basic materials and industrials, which are susceptible to supply shocks, and financials which will be impacted by an economic slowdown/recession which will likely trigger rising defaults in the credit market.

Here are the guidelines we recommend for adjusting your portfolio risk:

Step 1) Clean Up Your Portfolio

  1. Tighten up stop-loss levels to current support levels for each position.
  2. Take profits in positions that have been big winners
  3. Sell laggards and losers
  4. Raise cash and rebalance portfolios to target weightings.

Step 2) Compare Your Portfolio Allocation To Your Model Allocation.

  1. Determine areas requiring new or increased exposure.
  2. Determine how many shares need to be purchased to fill allocation requirements.
  3. Determine cash requirements to make purchases.
  4. Re-examine portfolio to rebalance and raise sufficient cash for requirements.
  5. Determine entry price levels for each new position.
  6. Determine “stop loss” levels for each position.
  7. Determine “sell/profit taking” levels for each position.

(Note: the primary rule of investing that should NEVER be broken is: “Never invest money without knowing where you are going to sell if you are wrong, and if you are right.”)

Step 3) Have positions ready to execute accordingly given the proper market set up. In this case, we are adjusting exposure to areas we like now, and using the rally to reduce/remove the sectors we do not want exposure too.

Stay alert, things are finally getting interesting.


Robertson: One Is The Loneliest Number

With passive funds continuing to grow share at the expense of actively managed funds and markets on a roll since late 2018, analyzing individual stocks can seem like a quaint if not downright outdated exercise. Indeed, many investors and advisors have become so deeply habituated to passive investing that they don’t even consider other alternatives. As a result, the exercise of analyzing individual stocks has become a fairly lonely pursuit.

This reality, however, also spells opportunity. While the rising tide of easy monetary policy lifted most equity boats for many years, the beneficial effects now are being shared by a decreasing number of the largest stocks. In addition, as the share of active management declines, so too do analytical efforts that keep market inefficiencies in check. A key consequence is that some much more interesting stock ideas are beginning to emerge for investors who are willing and able to rummage around in less visible parts of the market.

In a sense, it shouldn’t be surprising that individual stock opportunities are creeping up. After all, there are only a relatively few stocks with the size and liquidity requisite to be constituents in a broad array of passive funds. Pretty much by definition then, most stocks do not benefit so disproportionately from large flows of funds from price-insensitive investors. It also follows that without such support, most individual stocks are still vulnerable to eroding fundamentals to a greater or lesser extent.

And eroding fundamentals there are. Weak economic growth across the globe and repeated flirtations with yield curve inversion provide plenty of fodder to beat up on stocks with economic exposure. Companies across the energy sector have been hit, but so have those in transportation, shipping, retail, and plenty of other industries.

While poor economic news (and plenty of other uncertainty) is negative for stock prospects, it does come with a bit of a silver lining. Such clear detrimental forces induce investors to react, and in doing so, they often overreact. These types of situations are the bread and butter of valuation-based stock picking.

This also relates to another point that seems nearly forgotten. It wasn’t all that long ago that investment research was dominated by company-specific work. Before the financial crisis in 2008, Wall Street research emphasized company analyses. Investment platforms such as Motley Fool and Seeking Alpha (among others) emerged to address the widespread appetite for company-specific insights. Even casual conversations often revolved around stock tips.

While much of that activity was overdone and not especially useful, the key tenets of equity analysis remain as valid as ever. With the opportunity set beginning to open up again, now is a good time to either refresh those skills or develop them anew. More specifically, the thrust of such efforts is to identify the degree to which situational factors affect a company’s cash flow stream and then to determine if the market’s reaction is excessive.

As an example, one of the stocks I have found interesting is a small-mid cap supplier to the food and beverage industry. It has been around for a long time and sells all over the world; less than half of its revenues are in the US. Because it sells to the food and beverage industry, its revenues are fairly stable. While they don’t go up a whole lot, they don’t go down a whole lot either.

This particular company is also a leader in its industry. It dominates market share and as such, it provides significant logistical and reliability advantages to its customers. On top of all this, it is also a technology leader and finds various ways to monetize its position.

The company does have debt, but the debt level is manageable given the stability of the business and its prodigious generation of cash flow.

Based upon this description of fundamentals, how would you expect the stock to have performed? By way of comparison, the S&P 500 produced a total return of 31.5% in 2019 and finished with a trailing price/earnings multiple of 21.75. Would it be up by half as much as the S&P500? Flat? Maybe down a bit?

The reality was far harsher. Not only did the stock fail to keep up with the S&P 500 last year, it crashed on the order of 50% after a negative earnings surprise. This was interesting for two reasons. First, it was left with a price/earnings multiple in the mid-single digit range which is nearly unheard of in such overvalued markets. Second, the stock fell to a level below its lows during the Great Financial Crisis over ten years ago, despite being in a far more benign economic environment. To value buyers, this starts to sound interesting.

Obviously, not all cheap stocks will outperform and there are plenty of other factors that can come into play. Further, if economic conditions continue to erode, a number of companies will be negatively affected and could run into serious trouble. This is certainly happening in the energy industry right now.

But that’s not the point. The main point here is to recognize the world of individual stocks is becoming increasingly bifurcated. On one side is the glossy veneer of index averages regularly pushing higher. These are driven be a relatively few mega cap tech names that seem to be nearly impervious to negative news.

On the other side is a growing group of stocks that are not only vulnerable but seem to be hypersensitive to such factors. This is a different environment than a few years ago when it was extremely difficult to find any stock that was cheap. Something has changed.

This opens up new challenges and opportunities for investors. A big challenge is that the mega cap tech leaders today are unlikely to remain impervious to bad news forever. One of the great lessons of the internet boom in the late 1990s is that tech companies are not immune from economic pressures.

Many will be surprised to find out this is still true. Whether it comes in the form of reduced capital spending by companies, lower discretionary spending by consumers, or lower advertising spend as corporate budgets get squeezed, technology businesses are still very much affected by economic conditions. As it turns out, these conditions affect all their customers.

Another big challenge is that with major indexes near all-time highs and with little earnings growth to support those prices, common passive strategies are set up to deliver exceptionally poor returns over the next several years. As a result, the returns from passive investing may very well be insufficient for many investors to reach their goals. The ride over the last ten years has been terrific, but the next ten will likely be very different.

There is also opportunity, however. The best chance investors will get to realize the kinds of returns that can really help them is to return to the hard work of uncovering undervalued companies. Such an endeavor is the bread and butter of active investors and focuses on identifying cash flows and determining how sustainable they might be. Competitive advantages are important and often come in the form of less tangible attributes such as an organization’s capacity to learn and adapt. It takes a lot of work, but the opportunities exist.

While the work of toiling on individual company analyses can be a lonely endeavor, especially while passive strategies remain in the spotlight, it is also a valid way to extract decent returns from an otherwise overvalued universe of options. Indeed, such efforts may be the last best hope to realize attractive returns for some time to come.

Seth Levine: Commoditizing My Framework For A New Paradigm

When it comes to investing it’s never different this time; nor, however, is it ever the same. This difficult-to-navigate paradox creates a scarcity of longevity. Today’s persistently low yield environment has upped the ante and put many marquis names out of business. To be fair, alpha’s been elusive of late. It’s not that anyone suddenly became dumb. Rather, traditional methodologies are less robust today. Perhaps adopting a commodity framework can help generate returns in these investment conditions.

Let’s face it, investment yields are scarce. Those on sovereign bonds evaporated. Corporate credit interest rates are numbingly low. Earnings yields on stocks are paltry (i.e. multiples are high). Real estate cap rates are tumbling. No matter what the cause—central banks, safe asset shortages, the proliferation of passive investing, a lack of growth, whatever—cash flows derived from invested principals are small. Unfortunately, this is the current state of the investment markets. It’s our job to play the hand.

Money Now for Money Later

Valuation lies at the heart of my investment framework … at least it did, historically. As Warren Buffett famously said, “Price is what you pay. Value is what you get.” This resonates with me; however, I’m currently rethinking my position. Price is easy to determine, just look at it. What about value?

Before answering this seemingly simple question, it’s helpful to clarify just what investing is all about. Making money, right? Well, one can make money in lots of ways. I can perform a service for my employer in exchange for a paycheck; I can bake some cookies and sell them on my corner; I can also buy a bond and earn its yield. In all cases I make money, yet in different ways. (Note, that’ll use money interchangeably with currency, despite a pet peeve).

In the first case (the job), I trade my time and labor for money. In the second (the baker), I also buy raw materials in order to produce higher value goods. In the investment case, however, I purchase an (assumed) income stream using money that I currently have in order to earn even more over the course of time; it’s money now for (more) money later. Thus, investing is the act of making money from money.

With a clear definition of investing in hand, we can get back to our question of valuation. Valuation is a way to assess the attractiveness of an investment. In other words, it’s a way to frame how much money we expect to make (or lose) in the future in return for our money today. More later for less now is the objective—risk aside.

Today, however, cash flow yields are low when compared to history. Thus, investing appears less attractive under a traditional valuation framework. Yet, the “show must go on”, especially for us professionals. We must find a way to grow our capital in spite of these challenges.

Herein lays the dilemma: What to do when one’s approach no longer applies? Abandoning discipline is simply not a satisfactory solution for serious investors. We all need investing principals to guide our actions. Luckily, my friend Daniel Want, the Chief Investment Officer of Prerequisite Capital Management and one of my favorite investment market thinkers, offers some helpful advice.

Everything’s Commodity-like

In a recent client letter, Want notes that:

“When ‘everything’ is commodity-like… when bonds, fixed income securities and even most equities have minimal to no yield … , then it’s not a ‘valuation’ paradigm you need, but rather you need more of a merchant-type trading philosophy to guide your portfolio operations – you need to focus more on capital/money flows and positioning in order to harvest the natural swings in market prices driven by the underlying behaviours of participants …”

Prerequisite Capital Management’s January 10th, 2020 Quarterly Client BRIEFING

According to Want, traditional valuation-based frameworks are less efficacious in low yield environments. Rather, the supply and demand dynamics of capital flows matter most. I’m certainly sympathetic to that! However, I think this view can be harmonized with a valuation approach without overhauling one’s entire investment philosophy.

When everything is “commodity-like”, the final price dominates its return profile. Remember, the purpose of investing is to earn money, not to hold the underlying assets. Thus, as yields converge to zero (and below, absurd as it may be), positive returns increasingly require the selling at a higher price; or as Want puts it, to “harvest the natural swings in market prices.” In essence, all assets become “trading sardines.”

“There is the old story about the market craze in sardine trading when the sardines disappeared from their traditional waters in Monterey, California. The commodity traders bid them up and the price of a can of sardines soared. One day a buyer decided to treat himself to an expensive meal and actually opened a can and started eating. He immediately became ill and told the seller the sardines were no good. The seller said, ‘You don’t understand. These are not eating sardines, they are trading sardines.’”

Seth Klarman, Margin of Safety via ValueWalk

Thus, as yields dissipate, all investment decisions converge to price speculation … even for bonds that can only return par. (Please see the Appendix at the end of the article for some illustrations.) However, valuation need not be cast aside whole cloth. Rather, it must be reframed to acknowledge that all the “value” lies in the asset’s terminal value, when it’s finally exchanged for cash—be that at maturity or an intermediate sales date.

I find Want’s framework of recasting financial assets as commodities to be clarifying. It helped me override my previously held notions of valuation and provided me with a more powerful framework with which to understand the current investment landscape.

The Commodity-like World

What might this commodity-like world look like? Well, perhaps more commoditized (pun intended). Want continues:

“… Such swings won’t always make sense to a traditional analysis paradigm, it’s likely going to be best to dispassionately view each ‘asset class’ category as simply ‘categories of inventories’ that you may or may not wish to hold at different times depending upon how capital is behaving, where the money is flowing (& why), and how participants are positioned. A more detached and objective approach to markets will be even more valuable than usual.”

Prerequisite Capital Management’s January 10th, 2020 Quarterly Client BRIEFING

In other words, as differentiations of cash flows diminish, investment decisions increasingly shift from allocation within asset classes to allocation among asset classes. Thus, the importance of (tactical) asset allocation increases in Want’s framework.

I can see other investment implications of a more commodity-like world. Perhaps:

  • Speculation in bonds increases and investment horizons shorten as investors take a more total rate of return approach in light of falling yields; volatilities could rise
  • Equity investment time horizons extend, as higher multiples force investors to look further into the future for required growth to materialize; volatilities could fall
  • Commodities appear more attractive as storage costs become less of a relative disadvantage in a world where bonds don negative yields
  • Correlations converge as interest rate sensitivities increase
  • Security selection’s role in portfolio construction shifts to risk management as the risk of loss dominates return profiles
  • Or, I’m wrong about all of the above!

Unfortunately, we’re short on historical precedents for the current paradigm. Hence, we can only guess what impacts might materialize. However, I suspect that focusing on capital flows as Want suggests is a useful framework.

Reframing for the New Paradigm

It’s an understatement to call these challenging times for active management. Many traditional investment frameworks simply don’t work as well. Is it truly different this time?

Rather than abandon valuation in my framework, I’m reframing my decisions. Commoditizing my investment approach has brought some clarity to these confounding times.

Rather than abandon valuation in my framework, I’m reframing it. Conceptualizing “’everything’ [as] commodity-like” helps. We must speculate on all assets, plain and simple, looking to terminal values for returns. While my acceptance has been slow, commoditizing my investment framework has brought some clarity to these confounding times.

Appendix: Speculation Rises as Yields Fall

In this section I show what happens to hypothetical bond returns (using IRR) when coupons fall, maturities shorten, and when a sale occurs at a higher price prior to maturity. Note that in all cases the value shifts more towards the final payment. Thus, the incentive for speculation rises as yields fall. Assume all values are in U.S. dollars and undiscounted for simplicity. This exercise is for illustration purposes only.

Example: Initial Bond

Below is the payment stream for a hypothetical bond that matures at par in 5 years with a 10% coupon.

Note that the holder receives $150 in total payments. The final payment ($110) accounts for 73% of all value received.

Example: Falling Coupon

Here, I illustrate the payments for the same hypothetical bond but with a lower coupon of 5%.

Note that only $125 is received—due to the lower interest rate—and that the final payment ($105) accounts for a greater percentage (84%) of the total value.

Example: Shortened Maturity

Next, I show the payments for our 5% hypothetical bond but with a 3 year maturity instead of 5.

Here, only $115 is received due to 2 fewer years of coupon payments, though the IRR remains constant. As a result, the final payment occurs in year 3. It also accounts for 91% of the of the total value received.

Example: Pre-maturity Sale

In this last example, I illustrate what happens to the 5% hypothetical bond with a 5 year maturity when sold at a higher price ($105) prior to maturity (shown year 3).

There are a couple of interesting points to note. Since it was sold for $5 more than the maturity value (par), our total payments amount to $120. While this is $5 less than had it been held to maturity, the IRR increases to 7% (from 5%). The final payment now accounts for 92% of the total value received—the highest percentage of all our examples.


Note that the pre-maturity sale example had the highest return for the hypothetical, 5%-coupon bond. The sale price also dominated the return profile, illustrating how the bond became a more effective total rate of return instrument, ripe for speculation.

It’s Not 2000, But The Market Is Mighty Narrow Again

For those of us who were around in 1999-2000 looking at charts and perhaps writing about them, there is an eerie familiarity with the market of today. Back then, when indices and the Nasdaq in particular, were rallying harder each day than the last, market breadth was looking fairly weak. In other words, the big the names were soaring, forcing indexers and ETFs to buy them just to keep their weightings, and the positive feedback cycle roiled on.

I remember, looking at this stuff for BridgeNews and having to forecast where resistance levels might be based on Fibo projections or the top of some trading band. Walking by my desk, it was not unusual for me to exclaim, “This is nuts!” By that way, a much funnier TV show than “This is us”.

Now, I am in no way comparing 2000 and 2020 in any way but they did have one thing in common. Big cap, and mostly big cap tech, was powering ahead while mid-cap and especially small-cap lagged far behind.

No, that does not show up in the advance-decline line, which just managed to set a new high after its late January swoon. A colleague had a good explanation for this, saying that plenty of stocks can be rising but by smaller amounts and far below previous highs. That would certainly explain why the a/d line is rising and up/down volume is mediocre, at best.

Have you looked at a small-cap advance-decline? Not pretty.

Check out these charts:

(Click on image to enlarge)

This is the regular, cap-weighted S&P 500 vs. the equal-weighted version. The trend has been accelerating higher for months. While it is not anything near what it looked like in 1999-2000, it is still quite significant.

(Click on image to enlarge)

Here is the Nasdaq-100 ETF vs. the equal-weighted Nasdaq-100 ETF. To the moon, Alice.

(Click on image to enlarge)

And then let’s look at a mega-cap stock. This is Microsoft MSFT and it looks just as nuts. Don’t forget this is a $1.4 TRILLION stock so every gain packs on huge amounts of market cap.

What happens when this stock finally decides to pull back? It scored an as yet unconfirmed bearish reversal this week on huge volume. And look how far above it is now from its 200-day averages. Nuts!

Considering that it is a member of the Dow, the Nasdaq-100, the S&P 500 and XLK tech ETF, what do you think will happen when this huge member (keep it clean, pervs) corrects? And there is a lot of correcting room before even thinking about a change in a major trend.

There you have it. A narrow market at all-time highs, ignoring news and having utilities among the leading groups.

But don’t worry, the Fed has already committed to more quantitative easing. Whoopee! Kick that can, Jerry.

Robertson: Only Time Will Tell

A great way to learn more about any phenomenon is to gain perspective by examining it from different angles. While it is certainly true that a great deal is known about stock returns, it is also true that a broader understanding of the subject has been hampered by overly simplified narratives and recency bias.

What is needed is a fresh perspective and a fairly recent (2018) study provides just that. The study helps to better understand the proposition of investing in stocks and in doing so, provides valuable insights for long-term investors.

The study in question was conducted by Hendrik Bessembinder from the W.P. Carey School of Business at Arizona State University (h/t Steve Bregman from Horizon Kinetics by way of his interview with Real Vision). A key difference in Bessembinder’s approach is that rather than looking at returns from broadly diversified stock portfolios, he focuses his attention on “returns to individual common stocks.”

More specifically, he looks at the excess market value created from holding a stock over the value of simply holding a one-month Treasury bill. Drawing on data from the Center for Research in Securities Prices (CRSP) database, he analyzes the series of one month returns of each stock relative to a T-bill from 1926 to 2016. His finding is somewhat surprising at first look:

“More than half of CRSP common stocks deliver negative lifetime returns. The single most frequent outcome (when returns are rounded to the nearest 5%) observed for individual common stocks over their full lifetimes is a loss of 100%.”

He goes on to explain how this happens: “These results highlight the important role of positive skewness in the distribution of individual stock returns.” In other words, stocks have very asymmetric returns. Most stocks don’t create value relative to Treasuries (over their lifetimes), but a small subset of stocks create vast amounts of value. Bessembinder’s work highlights just how lopsided the contributions are:

“When stated in terms of lifetime dollar wealth creation, the best-performing 4% of listed companies explain the net gain for the entire US stock market since 1926, as other stocks collectively matched Treasury bills.”

Importantly, the poor performance record for most individual stocks casts a very different light on both active and passive management and therefore has important implications for investors.

For active investors, it highlights both a challenge and an opportunity. Since only a relatively few stocks drive all of the wealth creation, failure to have adequate exposure to those few will severely impair portfolio performance. This can be seen quite clearly in the comparison of median and mean buy-and-hold returns for the universe:

“The mean annual buy-and-hold return is 14.74%, while the median is 5.23%. The divergence is more notable for the decade horizon, where the mean buy-and-hold return is 106.8%, compared to a median of 16.1%.”

The key challenge of active management, then, is to establish sufficient exposure to the relatively few disproportionate value creating stocks. If a manager has no special capability to single out these types of stocks, active returns are more likely to be close to the median than the mean.

This reality also creates opportunities, however. Insofar as a manager does have research and analytical processes that create an edge in identifying value creating stocks, the chances of outperforming a passive index are pretty decent. Bessembinder notes, “Investors with long investment horizons who particularly value positive return skewness” can significantly increase their chances of outperforming. The reason is that such an effort can focus on the types of stocks that create disproportionate wealth and concentrate them in a portfolio.

Active management also creates other opportunities. Bessembinder’s study focuses on buy-and-hold returns which excludes the universe of stocks that create value for some period of time before losing that capacity. Active management allows managers to reap the benefits of value creation for part of a company’s life cycle and then to eliminate exposure if evidence of erosion arises. Further, when active managers focus on value creating stocks, there is far less need to offset the performance drag caused by the majority of stocks in the universe.

Of course, the implications for passive investing are just opposite side of the same coin. While passive funds are often lauded for their low costs, little attention is paid to their investment merits. Bessembinder reveals the investment proposition of broad index funds fairly clearly – and the main advantage is diversity. More specifically, owning a piece of everything ensures that you get exposure to the relatively few stocks that create excess wealth.

Along with that benefit, however, comes the baggage of exposure to a lot of stocks that do not create any value. Further, such funds also necessarily include exposure to stocks that are visibly overvalued with no inherent mechanism to hedge that exposure. Stocks that create value for some period of time but then lose out to competition and fade away are included on the way up – and on the way down.

This highlights another point, “Individual common stocks tend to have rather short lives” with a median of seven-and-a-half years. This means that long-term investors in broad market passive funds will churn through several generations of failed companies through the course of their investment horizons.

Based on these insights, we can characterize passive investing more by what it is NOT, than what it is. A broad market passive fund is NOT a collection of mostly value creating securities (over their lifetimes) nor is it an efficient way to gain exposure to businesses that do create long-term value.

Yet another useful lesson from Bessembinder’s study is that it lends historical perspective to individual stock returns by illustrating some important changes over time. For instance, “the percentage of stocks that generate lifetime returns less than those on Treasury bills is larger for stocks that entered the CRSP database in recent decades.” So, as skewed as the returns have been, they have become even more so over time. This progression is evidenced by the fact that “the median lifetime return is negative for stocks entering the database in every decade since 1977.”

Not surprisingly, the worsening trend in performance also coincides with “a sharp decline in survival rates for newly listed firms after 1980.” While a number of potential causes are at play,  prominent ones feature the increased prevalence of stocks “with high asset growth but low profitability”. History suggests this combination leads to lower survival rates.

This history is especially interesting because it contrasts so sharply with today’s market ethos. For example, many of the current market darlings such as Netflix and Tesla not only exhibit high growth and low profitability, but also embrace and promote those attributes. History suggests such companies are overfit for very specific business conditions that are unlikely to persist and therefore are unlikely to survive more challenging conditions.

The issue of resilience is one that Nassim Taleb captured well in his book, Antifragile. For example, he described how he only drinks wine, water, and coffee based on the logic that liquids that are at least a thousand years old have been adequately tested for fitness. While Taleb’s standards of fitness for beverages may be extreme, the point is still a valid one: With such a long history, these beverages have proven themselves safe over a wide variety of conditions.

The concept of resilience is also critical for long-term investors. Part of the reason is that companies that regularly operate at (or beyond) the thresholds of prudence are completely beholden to the graces of a favorable environment. Just as soon as things become even modestly more difficult for whatever reason, they do not have the wherewithal to survive.

This matters because for firms to be able to create a great deal of wealth, they must be able to generate excess returns, and also to do so repeatedly so returns can compound. That means survivability is also a precondition for significant wealth creation.

It really helps for long-term investors to keep this in mind. When stocks keep running up and the news is positive, it is easy to get caught up and lose perspective. Bessembinder’s study provides a striking reminder that the vast majority of these price moves do not reflect lasting value creation. In order to track lasting value creation, it takes company and industry research along with detailed analysis of economic returns and sustainable growth rates.

Finally, one of the great benefits of studying history is that it expands understanding well beyond our own personal experiences. Bessembinder’s study provides useful historical context but also much more. By uncovering the net returns of individual stocks over Treasuries, he also creates a much richer understanding from which to evaluate active and passive approaches to investing. Time will tell which approach is more useful for investors with long time horizons.

Seth Levine: The Unsurprising Repo Surprise

Have you heard? There’s trouble in the repo markets. Even casual investment market participants probably know that something’s amiss. While only a handful of investors participate in repo, this obscure corner of the investment markets rests at the epicenter of the financial system—hence all the attention. The turmoil caught many by surprise, prompting the Federal Reserve (Fed) into emergency action. However, the real surprise is, in my opinion, why this took any of us by surprise to begin with?

What is Repo

Repo is financial jargon for a repurchase agreement. While it sounds complex, repo is simply a form of short-term, secured lending. The borrower sells collateral (typically a high quality bond) to a lender. At the same time, it agrees to repurchase the same collateral back at a later date for a predetermined and higher price; hence the moniker repurchase agreement. The borrower receives the use of currency for this short period. The lender receives interest in the form of the price difference.

If this sounds overly complicated, it’s because it is. The details, however, are unimportant for our discussion. One need only grasp that repo sits at the bottom of the financial system pyramid. It’s a primary funding source for many large institutions that comprise the plumbing of financial markets. Due to leverage, small disturbances in the repo (and other money) markets can ripple through the entire system. This is what some fear.

What Went Wrong

Repo rates dramatically spiked on September 17, 2019, more than doubling the previous day’s (using SOFR as a proxy). This is highly unusual for the most illiquid of all markets, let alone one of the most trafficked. Arbitrage should render this behavior anomalous as the rise in repo rates represented a highly profitable opportunity. Why weren’t the big banks picking up all this free money? With the Great Financial Crisis (GFC) still fresh in the minds of many, the rumor mill kicked into overdrive surmising why.

Repo rates (estimated with SOFR) unexpectedly spiked on September 17, 2019.

The cause of this unexpected rate spike is still a matter of speculation. The financial system is highly complex with innumerable inputs and outputs making it difficult to establish direct, behavioral links. However, it’s likely that routine balance sheet mismanagement by the Fed was the culprit (as discussed by George Selgin here and Zoltan Pozar of Credit Suisse here).

The Fed’s responsibilities expanded as a result of the GFC. These, and other regulatory changes, might have created some idiosyncrasies that underpinned the unexpected rise in repo rates. One is that the Fed now banks the U.S. Treasury. The Treasury used to have bank accounts with private institutions. It now keeps its money at the Fed in an account called the Treasury General Account (TGA). Another important development is the increased size of the foreign repo pool. The Fed avails its balance sheet to “about 250 central banks, governments and international official institutions.” While not new, the aptly named foreign repo pool usage is up nearly 3-fold since 2014.

The significant growth in the TGA (blue) and foreign repo pool (red) after the GFC creates new balance sheet volatility for the Fed to manage.

The chart above illustrates that both the TGA and foreign repo pool are large and volatile. They are also relatively new in their importance to the Fed from an operational perspective. Let’s not forget that while the Fed is a central bank, it’s nonetheless just a bank. Unpredictable and violent swings in account balances are difficult to manage—community, commercial, and central bank alike. Too be sure, we may later discover different reasons for the repo rate spike … but not until later.

Centralization Breeds Instability

It’s easy to get bogged down in the details when analyzing the financial system. After all, it may be the most complex one we’ve built. Thus, applying some more macroscopic principles can help in understanding the system as a whole.

Generally speaking, decentralized systems are more stable than centralized ones. We intuitively get this and can witness its widespread application throughout the man-made and natural worlds. We diversify our investment portfolios, manufacturers source from multiple suppliers, organisms spawn many offspring, and successful animals eat varied diets. Decentralization is a primary thesis for Bitcoin, breeds a fear of monopolies, and is why I find capitalism so attractive (among other reasons).

Imagine if you kept your entire net worth in a single account at a single bank and it failed (ignoring FDIC insurance, which protect against just this). Your wealth would disappear overnight. What if your investment portfolio comprised of a single stock and it went bankrupt? Such reckless behaviors are rightfully condemned. Yet, we expect differently from our financial system; why?

For some reason we believe that centralizing our monetary system reduces volatility and increases stability. Thus, the financial system is either a complete outlier or the premise is false. Modern day economies are built on the belief of the former, yet the evidence is underwhelming.

Merely a Matter of Time

I find no reason to believe that centralizing our financial system holds unique benefits. It’s just another type system. From a stability perspective, all benefit from decentralization. It follows that our financial one should too. Thus, I believe it was (is) only a matter of time until the monetary system broke (breaks) again. It happened in 2008—which I see as a run on banking collateral rather than a housing market collapse (ask me to explain in the comment section if you’re interested in my view)—and it will inevitably happen again. It has to because the future is unknowable and risks are concentrated.

It’s not that decentralization breed omniscience. No, omniscience doesn’t exist. Rather, it allows for discovery. Decentralized systems have more actors striving towards the same goals. However, all will not proceed in the same way. Inevitably, some will fail and some will succeed and to varying degrees. Diversity ensures that the failures are inconsequential to the system as a whole. Yet, we all benefit from the knowledge that those who succeed discover. Hence, human prosperity advances.

Following the GFC we changed a bunch of rules and allegedly strengthened regulations. Despite the best of intentions, these actions further homogenized behavior ensuring that the system breaks again! Remember, centralized systems are most fragile. Further centralization—which is what laws and regulations actually do—limits diversity by raising the barriers to entry (compliance costs money) and conforms incentive schemes (to comply with regulatory demands). Thus, we got fewer actors behaving in more similar fashions. The financial system became more fragile as a result, not stronger. Here we are, a decade later, and low and behold trouble’s a brewin’ in financial markets again, and in new and unforeseen ways.

Principles Bring Clarity

In the end, the presence of a central bank and the myriad of rules and regulations are counterproductive. They work to limit competition, stymie diversity, and ultimately increase frailty. Progress requires failure and centralized systems are not flexible enough to allow for this. If a centralized actor goes down, so goes the whole. “Too big to fail” is only a feature of centralized systems.

While unexpected, the breakdown of repo markets should come as no surprise. Further centralization of the financial system increased its fragility qua system. Of course, predicting how and when it might fail ex ante is nearly impossible. If the current problems were obvious they wouldn’t have escalated to this point.

That said, the inevitability of a system failure doesn’t make it an investible theme, especially for casual observers. In fact, waiting for a repeat of the GFC may be expensive in opportunity cost terms and cause one to miss out on other profitable investments. Rather, I plan to simply keep this analysis in the back of my mind. If financial markets seize up (again), I know what to look for: decentralizing, market fixes.

Following causal chains of events is one of the many challenges of macro investing. While the spike in repo rates is perplexing, proper first principles can bring some clarity. Faulty ones, however, breed only surprises.

Robertson: The Fed’s Monetary Magic

Given the strong performance of stocks over the past year and the past decade, investors might be forgiven for enjoying a sense of calm. Regardless of what one might believe about underlying fundamentals and valuation, it is hard to dispute that whenever markets have run into trouble, central banks have provided ample liquidity to get them back on track. Although maintaining exposure to risk assets in such an environment can hardly be called investing in any conventional sense, it has been profitable to do so.

The main problem with such a benign outlook is that it rests on the assumption that central bankers will be both willing and able to protect markets by way of monetary policy. The bad news is that when all the ongoing challenges are considered together, it becomes clear just how complicated and difficult the task will be to keep markets afloat with monetary magic. The good news is that it is easy to identify those challenges by just reflecting on the last year and a half or so.

One big challenge that shows up on the radar is China. In September 2018 I wrote that Chinese residential real estate is “The most important asset class in the world.” Much like in the US in the mid-2000s, a housing boom in China has been fueled by cheap and easily available credit. The only major difference is that the excesses in China’s real estate market have not yet been resolved.

While the pattern of resolution is likely to be different in China for a variety of reasons, the implications are very similar. The main one is that the process is deflationary. The reason is that the resolution of bad debts both reduces money supply and tends to put downward pressure on prices until excess supply gets worked off.

Importantly, these deflationary pressures are unlikely to be neatly contained within China’s borders. Given China’s disproportionate influence on incremental global economic growth, any declines will be felt broadly. The persistent weakness in copper prices is one important indicator.

Another big challenge will be contending with the structurally lower demand for Treasuries outside of the US. I highlighted Russell Napier’s thesis in “Dollars and nonsense, Part 2” which explains that the halcyon days of persistently rising foreign exchange reserves, forced buying of US Treasuries from abroad, and artificially subdued interest rates are over.

Going forward, US savers will bear a much greater burden to buy Treasuries, and that burden will be made even greater yet by fiscal policy that allows massive deficits. The result is that US savers will need to either sell other assets or save more in order to fund growing government debts. This in turn will impede economic growth and significantly complicate monetary policy.

Yet another factor that threatens to complicate monetary policy is the Eurodollar system. I noted in “Dollars and nonsense, Part 1” that shadow banking in general, and the Eurodollar system in particular, create all kinds of headaches for policy makers. In this system, money supply is a function of capital markets and falls outside the regulatory purview of central banks. In addition, money created through the Eurodollar system is largely a function of global trade and therefore vulnerable to geopolitical risk. As a result, the Fed has virtually no control over this money and only vague ideas as to its quantity. 

In addition, a factor that can present serious challenges is the potential for severe capital controls to be implemented in a major emerging market. Although such measures are typically reserved for only the most extreme monetary challenges, they are always a policy option. Such controls can create immediate liquidity challenges which can spread quickly and widely.

The set of unhelpful consequences of monetary policy itself is yet another complicating factor. While policy prescriptions like low rates and asset purchases may provide some short-term benefits, they also come with longer-term costs. After ten years, the costs are accumulating, and the clock is ticking. Low and negative rates in Europe and Japan have destroyed the profitability of banks and eroded their ability to build strong capital bases. This can’t go on forever.

In addition, low rates induce companies (and consumers) to take on more debt. Increased burdens substantially reduce the margin of error by which companies operate. Any modest decrease in revenue, increase in interest costs, or increase in other costs (e.g. labor) can erode operating profits. With such fragile conditions for success, corporate financial health can decline quickly.

Indeed, such pressures are already being felt in a number of industries. For example, bankruptcies have been rising in the energy sector through 2019 and new capital is all but unavailable to these companies. Transportation companies are also feeling the pinch. Thus far financial stress has remained fairly localized, but the pressures are mounting.

With all these factors fresh in mind, it is easier to see just how complicated the task will be for central bankers. Because many of the issues are global in scope, the Fed will need to coordinate successfully with other major central banks, even as their objectives and priorities increasingly come into conflict.

At the same time, central bankers will need to maintain a balancing act between providing just enough stimulus to keep markets afloat but not so much as to further increase the risks of financial instability. Low rates undermine bank profitability and encourage over-consumption of debt. Excess liquidity encourages risk-taking. All these measures have costs and those costs are coming due.

If these aren’t problems enough, the ability of monetary policy to keep markets afloat is largely dependent on investors’ perceptions. In this symbiotic relationship, the ability of monetary policy to calm markets is at least partly determined by the belief of investors that it will work. In other words, maintaining this belief system takes on even more importance than fixing problems.

Unfixed problems can only persist for so long, however, before people start to notice and protect their wealth accordingly. When this happens, the power of central banks can unravel quickly. Importantly, a number of these unfixed problems are already revealing themselves in the forms of increasing bankruptcies, greater deflationary pressures in China, and the risk of a big bank in Europe or Japan failing.

Finally, the belief that stocks will keep going up because central banks will keep supporting them is based largely on the simple belief that since it has worked for ten years, it will continue to work. This, of course, is a fallacy and a misread of statistical probabilities. Such harmful, but common, tendencies are why the investment warning that “past performance is no guarantee of future results” has become so familiar.

Will the monetary magic wear out this year? It is impossible to say with certainty, but we do know a few things. One is that central banks cannot continue to implement policies with short-term benefits and long-term costs forever. Another is that the balancing act is getting increasingly difficult. Yet another is that we are closer to the end of the road this year than last year. So, if investors want to join (or remain in) the stock rally, they should do so with the full knowledge that they are playing with fire.

The Real Investment Guide For The Next Decade

Written by Lance Roberts, Michael Lebowitz, CFA and John Coumarianos, M.S. of Real Investment Advice

As we head into the next decade, this complete set of articles delves into the fallacies of always owning stocks for the long run (aka “buy and hold” and passive strategies). Given that market’s cycle over time, it is important to understand how markets, and investing actually work, the impact on your wealth, and what you can do about it.

This series of articles will cover the following key points:

  • “Buy and Hold,” and other passive strategies are fine, just not all of the time
  • Markets go through long periods where investors are losing money or simply getting back to even
  • The sequence of returns is far more important than the average of returns
  • “Time horizons” are vastly under-appreciated.
  • Portfolio duration, investor duration, and risk tolerance should be aligned.
  • The “value of compounding” only works when large losses are not incurred.
  • There are periods when risk-free Treasury bonds offer expected returns on par, or better than equities with significantly less risk.
  • Investor psychology plays an enormous role in investors’ returns
  • Solving the puzzle: Solutions to achieving long-term returns and the achievement of financial goals.
  • Spot what’s missing: A compendium of investing wisdom from the world’s greatest investors.

Robertson: Ain’t Nobody Home

One of the great challenges of financial markets is that certain important events only happen infrequently – which makes it all the easier to overlook them during intervening periods. One of those important situations is when it becomes extremely difficult, if not impossible, to sell an investment because too few people are both willing and able to buy it.

Through the course of a cycle the phenomenon of illiquidity occurs periodically but is normally contained to very specific situations and does not affect broader markets. Increasingly, however, there are signs that liquidity could be a problem in the foreseeable future, so it is a good time to review the risks.

To start with, there is nothing inherently wrong with illiquid investments. In fact, illiquid investments can produce higher returns for investors who don’t need immediate liquidity. As a result, they can make great sense for long term investors like pension funds and endowments. Indeed, David Swensen has made famously good use of this characteristic with the endowment at Yale.

Of course, many other investors who might need the liquidity are also attracted to those incremental returns, and especially so in an environment of exceptionally low yields. As a result, many investors have succumbed to the temptation by plowing into private equity, venture capital, real estate, structured credit, fixed income ETFs and all kinds of other investments for which liquidity can be a problem.

As investors pursue this course of action, however, a couple of things happen along the way. One is that the prices of illiquid investments get bid up and therefore the prospective returns come down. Another is that as progressively more money flows into investment vehicles that can be difficult to exit, systemic risk increases. I described these phenomena in “A formula for losing money“.

As the risk of systemic illiquidity increases it can challenge, and overtake, the risk of slowing economic growth as a key risk factor. This change manifests itself in a subtle way. Unlike in 2017 when markets rose in a climate remarkably devoid of volatility, this year there are a number of rumblings underneath the calm veneer of market index performance. The Financial Times reports:

“Yet, through all of this, the sanctity around the market price has remained. Most don’t question whether basic formation of market prices is faulty. What if market gyrations are less to do with shifts in expectations on the economy or company performance, and more to do with participants coming to terms with a less well-functioning market?”

It is now time to add another worry to the list: the unravelling of the market liquidity illusion.

The “unraveling of the market liquidity illusion” is both a worthy consideration, and increasingly, a timely one. Further, there is a growing body of evidence to support the hypothesis. As the FT spells out, increasing bond market volatility is a signal:

“’It’s impossible to know the catalyst, and this market is good at shrugging off bad news. [But] bond market volatility is a good sign of the fragility,’ Mr Croce said. ‘We’ve seen steadily rising bond volatility this autumn, and that will eventually have an impact on asset prices’.

Auctions in fixed income markets have also been highlighted by Zerohedge:

“The number of high yield credits trading at spreads over a thousand basis points over treasuries has been rising all year long. Also, you’re seeing a lot more volatility in the leveraged lending space. Credit Investors increasingly are firing first, and ask questions later.”

Russell Clarke provided similar foreshadowing in a Realvision interview dated September 18, 2019:

“Like I said, the weird classic macro indicators are diverging radically from what equities are doing. That does happen sometimes. Usually, the macro indicators are right.” 

In addition, another signal can come from broader market factors. Since the relationship of supply to demand for securities is relative, whenever sellers overwhelm prospective buyers, deficiencies in liquidity can arise. This phenomenon often occurs when investors chase a common theme, as the FT describes:

But Marko Kolanovic, head of quantitative strategy at JPMorgan, says there is still ‘extreme crowding’ in the more defensive, bond-like parts of the stock market, as well as in stocks enjoying positive momentum. He said this was evidence of the ‘prevalence of groupthink … across investment strategies’.”

With several signs all pointing in the same direction, the chances of some kind of liquidity event appear to be increasing. Importantly, many of the warning signs are virtually invisible to investors and advisors who rely primarily on market indexes for information content.

Lest investors forget what happens when liquidity dries up, Russell Clarke provides a useful refresher:

Speaking of the Lehman bankruptcy in 2008, Clarke described: “Then suddenly, and it was very weird, didn’t make a lot of sense. Then suddenly, it broke in way. That’s typically how markets work. They force everyone into an asset at exactly the wrong time and then liquidity just disappears, and you are stuck in it.

The notion of suddenly being “stuck in it” was also crystallized by the FT in a recent report. The UK Mexican restaurant chain Chilango issued mini-bonds and intentionally lured investors with an attractive yield: “Free food for four years! Plus 8 per cent APR!”

The only problem was, just months after its last mini-bond offering, the company’s solvency came into question and it was forced to hire restructuring advisers. While Chilango is reminiscent of WeWork’s bond offering to sophisticated investors, there was one major difference:

“While red-faced hedge fund managers can sell their WeWork bonds at a loss and move on, Chilango’s bonds are explicitly non-transferable. The doors are locked.”

Unfortunately, retail investors are learning another lesson from institutional debt markets the hard way: liquidity matters.

In simple terms, there is no way for investors to get their money out of Chilango’s mini-bonds. They are stuck. This is exactly what can happen when liquidity vanishes for whatever reason. Although there may be some recovery down the road, there will be no access to those funds for the indefinite future.

This leads to a few important lessons regarding liquidity risk. One is that it is an insidious risk. It gathers gradually, over time, without revealing at what point it might strike. Indeed, markets can be most alluring at the most dangerous times. As Clarke notes, “They [markets] force everyone into an asset at exactly the wrong time.”

Liquidity is also nonlinear – and this is very hard for many investors to fully appreciate. It is easily available for long periods of time and then suddenly vanishes. When investors start running for the proverbial exits, many end up getting trapped inside. While it is true that this happens only infrequently, it is also true that there are no do-overs – the damage can be permanent.

Finally, when liquidity shuts down, it can be contagious. When it becomes impossible to exit illiquid investments, investors have only one choice if they need cash – and that is to sell what they can – and that is usually more liquid assets. As a result, problems in a relatively small niche of illiquid investments can easily infect a much broader realm of assets. This was an important dynamic in the financial crisis of 2008 when problems with subprime mortgages started surfacing. It is a lesson that still applies today.

An important takeaway is that investors should not be unduly focused on a market crash as the worst possible outcome. Crashes happen but can be recovered from. However, if investors urgently need liquidity and cannot access it, they can suffer permanent harm. Indeed, insufficient access to cash, not a market crash itself, many be the greater risk for many investors.

The risk of losing liquidity is a real one for investors, but it is often underappreciated. B.B. King illustrates the same basic point in his classic song, “Ain’t nobody home”, in a way that is both personal and memorable.

He describes how he once fawned over a girl and followed her “wherever you’d [she’d] lead me” and in the process, endured some “pain and misery”. After he finally decides he’s had enough, she begs him to come back. By then, he is no longer in a forgiving mood and lets her know, “Ain’t nobody home.”

In a similar way, liquidity can seem so ample and forthcoming at times that it is easy to take for granted. When the tables turn, however, investors had better beware. Just when they need it most, there might not be anyone home.

Seth Levine: Why Are We So Scared

I always find this time of year to be self-reflective. Year-end provides a natural point for critiquing past performance and fitting it into a broader investing context. These holidays in particular have a way of foisting this perspective upon me, and with deep meaning. As a parent of two young kids, my holidays now kick off with Halloween. Perhaps stuck in this spirit, I find myself wondering: Why are we so scared?

I can’t seem to shake this sense that we live in a culture that’s scared. I see a number of signs across the economic, political, and investment landscapes that seem support this observation. To be sure, this is not universally true on an individual level. However, as a culture we seem to have lost our mojo, our swagger, and the confidence that fuels significant economic advancements.

Why Scared

Scared is psychological state. It connotes being afraid or frightened. Scared feelings typically arise when one feels helpless in a situation or believes he/she is unable to improve it via action. Thus, it’s closely associated with victimhood. Scared is not a feeling that accompanies independence, confidence, and capability.

By all accounts this is the best time in human history to be alive. It’s never been easier to access information, collaborators, and different perspectives, nor in such abundance. These conditions should enable self-reliance and wealth creation. They are a perfect crucible for unbounded development and prosperity.

Yet, economic independence doesn’t seem as valued today as it once was. The cultural impetus shies away from proximal challenges and looks to others for solutions—and in particular, for political solutions. This doesn’t square with the times.

In my view, this shift is a matter of confidence and self-esteem. It’s not the shirking of responsibility that’s telling; it’s the unwillingness to engage with the issues. Confident individuals face challenges head-on. Scared ones look to others. Problem solving often requires creativity, not reverting to staid and ineffective ideas. The former is a strength of the market; the latter is a politician’s. To be sure, there’s a time and place for politicians and bureaucrats to assist. However, economics is not the place and these are not the times. The obsession with finding political fixes for economic underperformance suggests to me that we lack the self-confidence to tackle it ourselves. We seem scared.

Central Bank Dependence

The clearest example of this in the investment markets is the neurotic obsession with central banks. I commonly hear people critique their ignorance and ineffectiveness only to follow with—the same people, mind you—what central bankers ought to do next. I thought central bankers were ineffective?

It’s time we stop looking to central banks for solutions. They don’t have them. In fact, I see no need for them at all. In theory, central banks were created to oversee the money supply. Dual mandates were afterthoughts. Since the money supply merely reflects economic activity, this should be a fairly mundane task and one that decentralized private banking centers performed quite well (despite the popular narrative).

Today, however, our opinions of central bankers are quite different. They are viewed as omniscient, economic alchemists. We look to central bankers to manipulate business cycles, control inflation, and prescribe prosperous economic conditions. Where did this come from and when did it become so prevalent? Central banks can’t create money let alone produce these other conditions. They fall under the purview of the productive economy and thus are products of our actions alone. The perception of central bank dependence is false and marginalizes our own economic efficacies.

Political Dependence

The central bank obsession is, in my view, part of the more general, cultural shift towards increased political dependence. This can be observed by the rise of populism writ large. From Trump’s presidency in the U.S., to Brexit, to the Five Star Party in Italy, to the yellow-vest movement in France, there’s a clamor for retrenchment within national borders. The U.S.-China trade war is just another iteration of this, justified rationalized or not.


To me, there’s a common theme to these movements. They are indicative of a reversion to tribalism, the cutting of global ties that underpin modern day prosperity, and represent a fear of “the other” mentality common in all primitive and destructive cultures.

Why is it important where the human who produced your steel resides? Seriously, why does it matter to you? If that person’s so evil the solution is simple: deal with someone else. I promise you there is no greater commercial influence than that. Just put yourself in the shoes of a business owner to see (go ahead, close your eyes and imagine).

Why are we suddenly seeking politicians to protect us from the ever-changing world? Economic issues are those of voluntary exchange and they are dynamic. Very few problems require political fixes. Seeking them indicates that one is too scared to trust his/her actions. It’s a skepticism over the power one commands in the marketplace. It’s cowardly.

The Monetary Policy—Fiscal Policy False Dichotomy

It’s often helpful to compare and contrast ideas against extreme conditions. Doing so can surface the essential issues for easier analysis. This is especially true for complex concepts such as those found in economics. Oftentimes, impacts are not obvious and secondary and tertiary effects must be considered.

In the investment markets we often hear about fiscal or monetary policy initiatives. Whenever the economy needs a boost, commentators opine that more accommodative monetary policy might be needed (such as lower interest rates). Or perhaps this particular instance requires a fiscal policy response (like lower taxes and/or greater government spending). Whatever the case may be, prescriptions are framed as being a matter of monetary policy or fiscal policy initiatives.

Nothing, in my view, illustrates cultural fear more than this false dichotomy of monetary policy—fiscal policy. They are conceptually similar and not appropriate book-ends of a conceptual dichotomy. Rather, monetary and fiscal policies are different flavors of central planning. Both seek government intervention in the economy, differing only by their preferred branch. Monetary policy utilizes central bank action while fiscal policy seeks legislative cures. They are not opposites.

The true opposite to central planning is economic liberty. Thus, the proper spectrum, in my view, has economic freedom on one side (deregulation and less controls) and central planning—i.e. fiscal and monetary policy, which are greater controls—on the other. One side reflects independence and confidence while the other forceful paternal shelter. Considering monetary or fiscal policy actions only rejects self-reliance as an option altogether. It’s a scared perspective.

Pacifying Investment Decisions

I also see the shift to passive investment strategies to fit into the fear of independence theme. To be sure, there are virtues of passive investing. Track records and fees relative to active management are compelling enough. But are these the sole motives?

Source: Morningstar

What if a fear of underperforming popular indices or standing out plays a part? Speculating on the future often yields wrong outcomes; it’s part and parcel with investing. As a colleague of mine is fond of saying, “we’re not bootstrapping treasuries.” By this he means that earning returns requires taking risks. Sometimes things don’t pan out as planned and losses occur. The trick, of course, is to minimize the losses; not neurotically seek to avoid them.

Are allocators more concerned with finding the comfort of consultants’ consensus rather than investing according to their own observations? Could career risk play a part in this trend? Are we too scared of being wrong to invest in themes that might play out over longer time horizons?

Share Buybacks Are Safest

What about share buybacks? Much has been made about the magnitude at which corporations have repurchased their shares. Why is this happening at such an unusually high level?

Source: 13D Research

To be sure, I take no issue with share repurchases and see them as a legitimate use of capital. However, even accretive buy-backs have short-lived impacts. They last only a year when year-over-year comparisons are made. Why aren’t businesses investing in projects that could yield multi-year benefits? Are executives simply playing it safe, too scared to commit capital to projects that might fail? Are the majority of shareholders really so shortsighted?

Scared As An Investment Theme

It’s easy to roll your eyes at this article and dismiss it as another meme. However, my intention is neither to seek scapegoats nor to emotionally vent. Rather, I’m interested in exploring whether this behavior is part of a larger cultural phenomenon of fear. If so, the next downturn could push us further from economic liberty and more towards political controls. This would surely have investment implications.

Of course, there is no such thing as “we.” We is just an aggregation of “I’s.” Thus the real question is: Why am I so scared? While an uncomfortable, if not antagonistic question to ask, it’s critical to understanding this emergent theme.

The world is in constant flux. No one should appreciate this more than investors. Change is the essence of our jobs—to profit from the movements in asset prices. Prices don’t move in stagnant conditions.

Yet, as a culture we seem terrified by change. I find this puzzling since we’ve never been better equipped to adapt and capitalize from it. Those investors who embrace change will survive and thrive. Those who don’t could perish from this business. What could be scarier than that?

David Robertson: “Best Used By”

Most people have had an experience or two with something that is out of date. Whether gulping down some spoiled milk, biting into some moldy bread, or sipping a glass of wine that has turned to vinegar, the experience tends to be shocking, unpleasant, and memorable, all at the same time. The lesson quickly learned is that you need to pay attention to how “fresh” certain things are to avoid an unpleasant experience.

The same thing happens with social norms, albeit with a longer time frame. Historical practices that were once met with widespread acceptance are today considered unreasonable and uncivil. The main point is that times change; some can adapt, but others either cannot or do not. Since business success depends on resonating with customers, employees and investors, it matters when belief systems get stale.

For better and worse, the financial news has been rife with examples of rich and powerful people being discredited by their statements and/or behaviors. This has happened to such a degree that it looks like a pattern. The cases are too numerous to dismiss as anomalous.

One of the more recent incidents involved Ken Fisher, who runs a firm with over $100 billion and is worth $3.6 billion himself. At a financial conference, zerohedge reported, he “shocked attendees when he compared gaining a client’s trust to ‘trying to get into a girl’s pants’.”

Those comments alone might have been easy to pass over. Offensive, sure. But they could have been dramatized, or taken out of context, or just not that important. Fisher, however, decided to eliminate any possible doubt that he really meant what he said when he added:

I have given a lot of talks, a lot of times, in a lot of places and said stuff like this and never gotten that type of response.

As such, the comments were revealing in a couple of ways. First, the absence of any real contrition indicated he stood behind what he said. He did, however, seem disappointed that he had lost the respect of a lot of people.

Most importantly, he seemed genuinely surprised that anyone might take issue with his comments. That surprise was most likely caused by having fallen dangerously out of date with social norms, and that says something about Fisher.

In a very different example, Jorge Paolo Lemann, head of the private equity firm 3G Capital made comments at a conference last year that also demonstrated a disconnect with the real world, albeit in a very different way. The Financial Times reported Lemann’s comments at the time:

I’ve been living in this cosy world of old brands, big volumes, nothing changing very much,” he said. “You can just focus on being efficient and you’ll do OK. And, all of a sudden, we’re being disrupted in all ways.

The idea that food and beverage products are “not changing very much” seems almost laughably out of touch. Anyone who ever eats out, goes to restaurants or bars, goes to the grocery store, watches tv, follows social media, or interacts with other people is overwhelmed by the amount of change in the food and beverage industry. It is no secret that younger customers want different things.

It is also no secret that these changes have been developing for many years, as has disruption in the food and beverage industry. As a result, Lemann’s perception that disruption happened “all of a sudden” says more about him than about the market. Specifically, his beliefs about the “cosy world of old brands” had become seriously outdated.

To Lemann’s credit, he admitted that he felt like “a dinosaur”, so at least he eventually came around to realizing this. It did not come easily, however. It took a shocking rejection of his underlying assumptions about the market, in the form of poor financial results, for him to eventually change his views. Rather than observing gradual change over time, it was more like getting hit with a 2×4 upside the head.

Yet another example is that of Christine Lagarde, the new head of the European Central Bank. Shortly before her term began, the FT reported on comments made primarily to a European audience. In particular, she declared:

We should be happier to have a job than to have our savings protected.

In one sense, it is understandable that Lagarde might want to establish continuity with ECB policy, even if it is problematic in many respects. In proclaiming what people should prefer, rather than listening to what people actually do prefer, however, she also revealed a degree of arrogance and condescension that come across as passé in today’s more egalitarian ethos.

It may be tempting to write off these examples as just some innocuous bits of disappointing behavior. It’s not like it is illegal to have outdated beliefs, and there are certainly plenty of scandals involving illegal activities among the wealthy and powerful class to grab our attention. Further, outdated beliefs can even be a bit humorous when revealed unintentionally.

It would be a mistake to dismiss such incidents, however. For one, these are not isolated incidents but rather are emblematic of widespread behaviors and belief systems. The incidents reported are indicative of similar instances that happen every day. The FT describes the landscape:

In decades prior, Mr Fisher’s remarks may have elicited a warm hum of laughter from the usual greying, male crowd. He may even have impressed some would-be allocator in charge of a family office or endowment with his maverick touch. Not so today. Instead, this has ended up being a costly mistake.

Another problem is that many leaders seem unaware of how completely their personal belief systems fail to comport with those of society as a whole. To be fair, the belief systems of a society are moving targets; they change over time.

The Economist explains,

Over time, public opinion has grown more liberal. But this is mostly the result of generational replacement, not of changes of heart.” A key factor is that the composition of society changes due to demographics. The Economist explains, “many socially conservative old people have died, and their places in the polling samples have been taken by liberal millennials.” 

While there have always been generational differences, part of what makes today’s differences so interesting is the magnitude and breadth of those differences. The generation of Millennials is much more diverse than the Baby Boom or Silent generations. Millennials, as a group, are also far better educated. It’s no wonder that significant political differences exist.

As a result, some social beliefs are changing quickly. The Economist illustrates with the example of gay marriage:

“As recently as the late 1980s, most Americans thought gay sex was not only immoral but also something that ought to be illegal. Yet by 2015, when the Supreme Court legalised same-sex marriage, there were only faint murmurs of protest. Today two-thirds of Americans support it, and even those who frown on it make no serious effort to criminalise it.”

One important consequence is that this rapid change in social beliefs is exposing a number of leaders and managers as being distinctly out of touch. Whether it be Fisher making vulgar comments to a group of financial professionals, Lemann professing how stable big food brands are, or Lagarde telling people they should prefer jobs over savings, each of these figures revealed that they have completely missed important changes happening across society.

In a sense, it is a bit sad when leaders reveal such striking shortcomings. They can seem like beached whales; potentially majestic but so desperately out of their element. One day they were swimming in a set of beliefs that they fully understood and the next, they were stranded and helpless.

This phenomenon is not harmless, however, and can affect investors in a myriad of different ways. One important way is through the boardroom. Board members are normally chosen for their business acumen, contacts, and decision-making ability, among other things. Because these qualities often tend to improve with age, most board members are more experienced.

While all those qualities are valuable, all of that experience can also engender certain belief systems that are not helpful at all. Indeed, “experience” can also engender a great number of lessons learned in past environments that are unlikely to recur in future ones. 

This can create a real problem. Whether intentionally or not, the behaviors and beliefs of board members get propagated through the entire company. This point was made clear by the Economist in summarizing Ben Horowitz’ new book: “Leaders set the tone. If they lie, shout or swear, then others will do the same.” Likewise, if they make lewd comments, ignore rapidly changing consumer preferences, or treat people as “subjects”, others will also do the same. It usually doesn’t take long for such behavior to thoroughly permeate an organization.

An excellent example of this was Uber. Back in the summer of 2017, when Uber’s board was trying to deal with the unseemly behavior of Travis Kalanick, board member David Bonderman made things worse. As the FT reported, “it took less than seven minutes before Mr Bonderman … interrupted fellow board member Arianna Huffington. As Ms Huffington was telling staff that research showed boards with one female director were more likely to appoint a second, Mr Bonderman interjected: ‘Actually what it shows is that it’s much more likely to be more talking’.” Is it any wonder that Uber had a “corporate culture known for being aggressive and sexist”?

Although many forego the opportunity, there are things investors can do to reduce such risks. Proxy statements reveal a number of “tells” that indicate which boards and which companies may be especially prone to outdated belief systems, most of which revolve around an element of insularity. For example, low board turnover, concentrated power among a few long-serving members, and boards that are “captive” to a powerful CEO/chairman are all indications of potential problems.

Another investment consequence of outdated belief systems involves the competition for talent. Perhaps no business is more affected by the clash of conflicting belief systems than that of business schools themselves.

Nitin Nohria of Harvard Business School notes in the Economist that “younger alumni and incoming classes want ‘the place of work to reflect purpose and values’.” Jonathan Levin of Stanford’s Graduate School of Business (gsb) highlights the responsibility of business schools “to recognise the societal consequences of corporate actions.” Simply put, a lot of tomorrow’s managers and leaders don’t want to work within the belief systems of some of today’s managers and leaders.

Of course, stale belief systems are not solely the purview of leaders and managers. Since belief systems tend not to change much at the individual level, once they become stale, they tend to remain stale. As the Economist notes. “It is hard to beat bias out of individuals …”

When this happens on a large scale, it can create systemic risk. For example, a lot of people have experienced enormous appreciation in financial assets over their careers. Given this powerful experience, it is easy for one to believe that it always makes sense to invest in financial assets.

This creates consequences for all investors. Price discovery becomes much more a reflection of an entrenched belief system and much less an ongoing analytical exercise. Prices become disconnected from fundamental reality.

What can cause things to change? Certainly, beliefs can change. It is possible that investors stop believing that central banks can, and will, continue to support financial asset prices. It is also possible that investors start getting more squeamish about valuations.

Sooner or later, however, the thing that will definitely cause change is demographic replacement. Older generations that have fared extremely well by owning financial assets are gradually being replaced by younger generations that have had far less positive experiences. When a tipping point is reached, attitudes towards stocks are likely to change just as quickly, and permanently, as they did with gay marriage.

In sum, outdated belief systems are a fact of life and are often harmless. The main lesson though, is that there are absolutely situations in which stale beliefs can cause extremely unpleasant experiences. Fortunately, there are ways for investors to identify the risk and manage it before it becomes a problem.

Offense/Defense Index Looking Better

But technical analysts like ratios, too, and one of them is telling us that this bull market is not over yet.

Many years ago, a technical analyst named Boris Simonder, with whom I’ve lost touch, showed me his offense/defense index, which he created from a proprietary classification of stocks deemed part of the “offense,” such as technology, and stocks deemed part of the “defense,” such as consumer staples. I adapted it to use standard SPDR ETFs and have been following it ever since.

Here’s the formula:

( XLK * XLY ) / (XLP * XLV)

or, if you prefer:


That’s tech and consumer discretionary in the numerator and consumer staples and health care in the denominator.  And you may have noticed that it is an expansion on simpler XLY / XLP ratio many analysts now use.

We can argue on the specifics and you may think you want to substitute utilities for health care or some other tweak. Go ahead and float that boat but for this missive, I’ll stick with what’s been doing OK for me.

Anyway, take a look at this chart:

That’s a nice coiling pattern for my version of the offense/defense index. And you might think that we’re in a small decline within that pattern right now. I agree. But stochastics applied to the ratio shows a higher low on the last price swing lower. For regular stocks and indices, that suggests a bit of internal strength and there is no reason why it should not apply here.

Of course, we have to wait for the actual breakout to declare the bulls to be in charge but this is certainly a better picture than that of the traditional discretionary / staples ratio:

This also looks like resistance is at hand and it shows no encouragement in stochastics. Perhaps the lack of lower low in Sep/Oct is bullish but I’d like to see the index hold near the trendline and then make the breakout attempt.

Consider this one more, albeit small, bit of evidence that this bull market is not over yet.

The Bursting Bubble Of “B.S.”

On the surface, middle of the road performance for stocks in the quarter indicated relative calm. Especially coming off strong performance in the first half of the year, there was little cause for concern.

Performance was choppy in the quarter, however, as steady, modest gains were repeatedly undermined by significant losses. In addition, a quant quake came out of nowhere and led to massive outperformance of value over growth for a short period of time. Also, out of nowhere overnight repo rates spiked higher until the Fed intervened. Gold prices rose steadily. Under the surface, something seems to be amiss. What is that something and what does it mean for investors?

For a growing number of investors, the answer is a short one: Stocks have overshot their fundamentals and a market crash is imminent. Such concerns are serious partly because they come from some highly respected players and partly because if true, there would be serious consequences for investors. However, stocks have been highly valued for a long time and for the past ten years bumps in the road have always been smoothed over by central banks. Is anything different this time?

It helps to establish some perspective. One of the more prominent themes over the last ten years has been the outperformance of growth stocks relative to value stocks. Rick Friedman of GMO points out that “Over the past 12 years … value stocks have underperformed”. 

John Pease, Friedman’s colleague at GMO adds, “All in all, it has been a harrowing decade for those who have sought cheap stocks.”

This recent underperformance of value provides a notable break from its historical pattern. Friedman continues:

“Historically, buying companies with low price multiples has delivered substantially better returns than the overall market, with the added benefit of lower absolute volatility. From the inception of the Russell 3000 Value index through 2006, value stocks outperformed the broad market in the U.S. by 1.1% per year starting in 1978.”

Dan Rasmussen, founder and portfolio manager of Verdad Capital Management, described just how unusual this performance has been in the September 20, 2019 edition of Grant’s Interest Rate Observer:

“What has been abnormal … is the remarkable performance of growth stocks. That has really been driven by the very largecap tech companies, which have had this amazing combination of high growth, high profitability, high and sustained growth, high and sustained profitability (and starting to actually dividend out money). That historically is very, very anomalous. You don’t typically see the largest stocks grow the fastest.”

Indeed, Friedman explains that the reason value stocks tend to outperform is because they offer an attractive tradeoff:

“While value companies did in fact under-grow the market, their cheaper valuations, higher yields, and a number of other factors more than made up for their weaker fundamentals.”

The “engine of returns behind value portfolios is ‘the replacement process, whereby a formerly disappointing company sees its fortunes change and its prices respond (à la General Electric in the 80s).’

Investors systematically underestimate the ability of weaker and distressed companies to mean revert to profitability and reasonable growth levels. Instead, they overpay for growth by extrapolating relatively strong growth too far into the future.” notes Friedman.

Pease notes, “In the last 13 years,” however, “rebalancing has disappointed somewhat,” and with it, the primary mechanism by which value tends to outperform. Friedman adds that factors that typically inhibit the most outlandish expectations for growth have been unusually weak:

Of late, expensive stocks have remained expensive for longer than usual. Typically, high growth companies are unable to sustain excessive growth rates for long periods. In the last decade, however, the growth universe has been more retentive than in the past.

So, one thing that is amiss is exaggerated expectations for growth. One exercise I regularly perform is to identify market-implied growth rates by matching discounted cash flows with current market prices. A couple of patterns are clear. One is that the prices of a lot of companies assume growth rates that are much higher than those that can be sustained by internally generated cash flows. In other words, the company’s growth is entirely dependent on access to outside capital.

Another pattern that is evident is that many implied growth rates are so high as to defy all practical constraints on growth. Historical experience, competitive response, industry size, economic growth, regulatory response, input costs, input availability, discretionary income, changing tastes and preferences, and real cash flows (as opposed to non-gaap earnings) all provide practical limits on growth for various businesses. It usually doesn’t take a ton of math to identify a ballpark range of growth estimates that is reasonable for a company.

As it turns out, the top-down evidence of unrealistic growth expectations corroborates the bottom-up observations. Rasmussen notes:

“You’re at this point … where the spread between the valuations of growth stocks and the valuations of value stocks is near all-time highs. The two times it has been this high in the past 50 years are 2000—the height of the tech bubble—and 1973—the height of the Nifty Fifty boom.”

One implication for investors, then, is the risk of exposure to exaggerated growth expectations is high right now. That risk may well be greatest in the IPO arena. Grant’s surveys the “abnormal” IPO landscape by way of statistics from Jay R. Ritter, chaired professor at the Warrington College of Business at the University of Florida:

81% of firms that went public in 2018 showed GAAP losses. To date in 2019, 74% of companies debuting in the public-equity market have been similarly loss-making. Each figure is substantially higher than the 39% average of profitless new public companies that IPO-ed between 1980 and 2018.”  

While these numbers portray an exceptional level of enthusiasm for IPOs, cracks have been emerging. The high-profile offerings of Uber and Lyft have both performed poorly and more recently, Peloton fell immediately from its offering price and has remained weak. Obviously, something has changed. Richard Waters from the Financial Times ascribes such weakness to a diminishing desire to believe “airy promises”. In other words, the market finally seems to be pushing back on exaggerated claims for growth.

“Airy promises” are not the only thing amiss in the IPO market, however. As Waters also notes, the easy cash available for many IPOs “has bred bad habits.”

The poster child for bad habits is WeWork. When WeWork started the IPO process, its valuation was targeted at $47 billion. After a great deal of pushback ahead of the roadshow and several price cuts, the IPO was finally pulled.

Not only is the company not going public, however, now it is in serious risk of going bankrupt. The FT reports, “Last week rating agency Fitch downgraded WeWork’s credit rating to CCC+, a level at which ‘default is a real possibility’. It said ‘the risk that the company is unable to restructure itself successfully has increased materially’.” How in the world can a company go from hot IPO prospect to bankruptcy candidate in a couple of months?

While WeWork provides plenty of entertaining drama, it also provides instructive lessons for the broader market. Importantly, all the information necessary to assess WeWork as a fragile financial proposition and a low-grade credit was available for all to see prior to its aborted IPO. There were no surprising revelations at the company. The only thing that changed was how people chose to evaluate the same body of information.

An important part of that body of information, as is the case with many younger companies, is the founder, Adam Neumann. Well known for his quirkiness, outlandish proclamations, and use of recreational drugs, Neumann also successfully crafted himself as a visionary. The balance between visionary and crackpot, however,  is often a very tenuous one as Scott Galloway describes:

“Since people want abnormal results, they try to find abnormal thinkers. But no one should be shocked when people who think about the world in unique ways you like also think about the world in unique ways you don’t like. If you want the party, you also get the hangover. Big, bold, visions are important and should be celebrated. But they have to be matched with stable, reality-based operators who have equal power if those visions are to have a fighting chance at surviving outside incubation.”

He elaborated on this tenuous balance in a separate interview in which he was blunter in his assessment:

The lines between vision, bullsh*t, and fraud are pretty narrow.

Galloway’s evaluation is not just that of some aggrieved tech investor who lost money either. He was actually a CEO during the internet boom of the 1990s and saw all-too-well what can happen when self-indulgence and fantasy are not only not constrained, but actively encouraged. As he puts it,

“If you tell a 30-year-old male he’s Jesus Christ, he’s inclined to believe you.”

Ostensibly, the task of constraining leaders who are naturally inclined to push limits is at least partly that of the board. Among the reasons to have a board is to ensure good decision making and to maintain corporate decorum. That didn’t happen with WeWork. According to Galloway:

“It’s safe to assume that board members already knew all of the details about Neumann’s antics … his hard partying and yoga babble were seen as features, not bugs, until the market threw up on it. Now, all of a sudden, the board is acting shocked. The board didn’t fire this guy; the board enabled him … Basically, as long as people were willing to buy into this charade, they [the board members] kept it going as long as the music kept playing.” 

Two other elements come into play in facilitating such excesses. One is the cyclical view towards charismatic leaders. There are times when dynamic founders are replaced by more experienced managers to run a business as it matures. Recently, however, founders have been allowed more latitude to stay in power longer.

The excesses are also partly a function of the marketplace as Galloway explains:

It’s frothy, and there’s more capital than operators. Any operator who has a vision and can promise the potential and convince people they can be the next Google or Facebook can attract billions of dollars right now. The reality is there’s more money out there.”

All of this provides useful context from which to evaluate market conditions. First, there are clear analogies with the subprime crisis. As long as things are working, the vast majority of actors are making money. As long as people are making money, there is little incentive to change things. Positive feedback loops ensure the good times run longer than they should.

This creates an interesting possibility. What if the thing that is amiss is simply an increasingly sober evaluation of existing conditions? What if investors have become less willing to dismiss math as some kind of weird science and more inclined to seriously apply it to growth expectations? What if, in the context of weakening growth, investors are less willing to believe in “vision” and “airy promises” and more inclined to manage downside risk?

What if a bubble is bursting, but it is not one of stocks per se, but one of bullsh*t?

This would have major implications for investors. First and foremost, any exposure to bold visions, airy promises, and barely credible growth expectations would need to be re-evaluated and re-calibrated. How many of those growth estimates are realistic? How many are off by a long shot? How many are not even possible? How many are only possible if funded indefinitely with free capital? Such scrutiny is even more likely to increase as earnings growth declines, global growth slows, geopolitical tensions rise, and as the credibility of central bankers fades. The result is likely to be a major rotation from growth into value.

Such a rotation would affect more than just growth investors; it would also have a disproportionate impact on broad index investors. Since capitalization weighted indexes overweight stocks that are overpriced and underweight stocks that are underpriced, broad indexes have become increasingly comprised of inflated growth stocks. That exposure becomes especially painful when the process reverses.

To the extent the primacy of bullsh*t diminishes or even vanishes as a determinant of stock prices, it will also have a significant impact on strategies for investors and advisers. When BS is ascendant, investors need only follow the same trends that everyone else does; it is no more complicated than that. Valuation, however, is a fundamentally different exercise. Determination of reasonable growth estimates is subject to all kinds of research, analysis, and judgment. This will create new opportunities for stock selection, but in doing so, will also leave a lot of people bereft of necessary analytical and investment tools.

Finally, the bursting bubble of BS also has implications for risk management. When the inflated expectations facilitated by BS are the norm, there is little reason to worry about how inflated the expectations are. Rather, the main concern is regarding the catalyst that could change things. The current environment provides many good examples including trade wars, election outcomes and the potential for a recession.

Focusing on a catalyst is a poor way to manage risk for a number of reasons, however. It is very hard to imagine all possible catalysts. Often, catalysts have a different effect than supposed. Thing can happen randomly. Further, the world is a complex place; oftentimes there is no particular, recognizable catalyst at all.

The thing that can usually be judged with far greater confidence than a catalyst is downside risk. You usually have a pretty good idea of what you can lose if things go bad. With that in mind, imagine playing a game of Russian roulette with your investment portfolio. You have one chamber of a gun loaded that you know can destroy your savings. Why would you focus on what might cause the barrel to stop spinning at the filled chamber rather than avoiding the inherent risk of the situation altogether? In other words, if stocks are significantly overvalued, why accept so much risk?

In sum, it is fair to say that something is amiss in the investment landscape. If that something is a bubble in BS rather than a bubble in stocks, the fallout will likely be different. Rather than one big, sudden crash, it will be more like a process of individual balloons popping over time as particular manifestations of BS get called out and re-calibrated.

As this happens, it will create a great deal of pain for sure, but there will be opportunities. The best vantage point will be that from security-specific analysis.

ESG Investing & The Quest For Sustainability

Almost anywhere you look there is commentary on sustainability. What used to be known fairly narrowly as “socially responsible investing” has now grown into a broad effort captured by the acronym “ESG” (environmental, social, governance). These issues range from climate change to sustainable food production to better versions of capitalism.

It is easy to infer from all this coverage that sustainability is something we should be talking about. It is far less clear, however, what we should actually be doing about it. The bad news is that some sustainable efforts are ineffective and even harmful. The good news is that the dialogue on sustainability is maturing in meaningful ways.

In August the Business Roundtable made waves when it released a statement indicating that the purpose of a corporation is to benefit all stakeholders, including customers, employees, suppliers, communities and shareholders. Signed by 181 CEOs, this statement marked a break from the past and made a lot of headlines.

Interestingly, several other organizations have also recently upped the ante on highlighting various sustainability issues. The Economist recently published its “Climate” issue under the pretense that “Climate change touches everything this newspaper reports on.” The Financial Times recently heralded a “New Agenda” which explicitly responds to the fact that the “liberal capitalist model” has “come under strain.” Advisor Perspectives recently sent out its “most read commentaries on ESG, SRI and impact investing.”

As if there weren’t already enough dots to connect, Ben Hunt and Rusty Guinn from Epsilon Theory recently identified the top six articles from the past 24 hours [as of September 23, 2019] that were the “most on-narrative (i.e. interconnected and central) stories in financial media. Those articles were: 

  • “Danish pensions to put $50 billion into green investments” [Reuters] 
  • “Gender diversity pays off: A new Stanford study finds equitable hiring boosts companies’ stock prices” [Business Insider] 
  • “Aluminium industry must commit to carbon reductions” [Business Insider] 
  • “Daughter of Ebony founder resigns from spot on magazine’s board” [Chicago Tribune] 
  • “At Amazon, workers push climate policy; Bezos sets net-zero carbon emission goals, but employees want more urgent action.” [Vox]
  • “General Motors Shares Extend Declines As Nationwide UAW Strike Hits Day Five” [The Street]

The narrative is clear: Sustainability issues are front-and-center. Guinn offers a couple of hypotheses as to why this is happening now: 

“We have commented before that ESG specifically tends to follow the fortunes of the market. It usually becomes a cohesive, high attention narrative when times are good and investors feel confident. When markets decline and perceived risk rises, ESG issues tend to fade from investors’ attention.

Independent of ESG investing as a topic in itself, however, the politics of climate, inequality and identity that we have shown to be dominant in electoral coverage are becoming similarly prominent in financial markets coverage.”

Another hypothesis seems to suggest, shall we say, a more sustainable explanation. An FT report on “The limits of the pursuit of profit” notes:

“Prof Ioannou’s latest research, with George Serafeim of Harvard Business School, shows the adoption of common sustainability practices is increasingly a survival issue. ‘The ones that fall behind in adopting best practices are the ones whose performance gets hit in the long run,’ he says.” The article continues, “Chief executives face the threat that if they fail — or if they only apply a veneer of stakeholder concern — they will be accused of ‘purpose-washing’, leading to further cynicism about their motives.”

While this research is encouraging, the reality on the ground is often less straightforward. The very same FT article, which highlighted Danone as a positive example of sustainable approaches, admitted,

It is shareholders, not other stakeholders, who are most in need of convincing with regard to Danone’s good intentions.

The FT also noted the challenge of “persuading asset owners to approach investment differently” when it reported, What is blindingly obvious is that it is very hard for company bosses to take such steps if investors are pulling very strongly in the opposite direction.

What is also blindingly obvious is that many efforts to address sustainability simply do not work. The FT identified Vanguard funds that were designed to “invest in companies with strong environmental, social and governance records” but which also happened to own “A private prison operator, a gun manufacturer and Rupert Murdoch’s media groups.” Vanguard claimed, “the companies were included ‘erroneously’ in an ESG index designed by FTSE Russell”, but regardless of the cause, the funds failed to do the one thing they were designed to do.

Nor have quantitative efforts produced much headway. The FT reports on efforts to “find a so-called ESG ‘factor’ — a systematic, repeatable way of identifying such stocks which rivals would find hard to copy.” Despite the potential that “The rewards for the fund managers could be huge”, the truth is that “It’s extremely hard to find that factor”.

The silver lining in such failures is that they are leading to more robust and constructive discussions around the relevant issues. “The limits of the pursuit of profit” story in the FT, for example, highlights the fundamental definitional issues of sustainable investing. While a wealthy individual may care relatively more about the “impact” of an investment than the ultimate financial returns, a pension fund has an obligation to produce adequate returns for their beneficiaries. Paul Singer, founder of activist hedge fund Elliott Management, said that earning a rate of return for pension funds and charities “is itself a social good — a very high one”. He’s right.

Not only can the “investment” aspect be understated in ESG efforts, but the “sustainable” element can be overstated. The story also reveals the potentially negative consequences of simple ESG ratings which can be “based on incomplete information, public shaming and shunning wrapped in moral rhetoric preached with cold-hearted, self-righteous oblivion”. The worst part is that the consequences of such misguided efforts “ultimately fall on real people”.

Bill Gates also recently chimed in on the debate by challenging a common practice among sustainability practitioners. He criticized efforts at divestment saying they “won’t change anything“. Gates explained, “Divestment, to date, probably has reduced about zero tonnes of emissions. It’s not like you’ve capital-starved [the] people making steel and gasoline.” As a result, Gates concluded, “Climate activists are wasting their time lobbying investors to ditch fossil fuel stocks.”

Helpfully, he offers an alternative approach that he thinks has greater potential to make a difference:

“Those who want to change the world would do better to put their money and energy behind the disruptive technologies that slow carbon emissions and help people adapt to a warming world”.

Indeed, Gates is among a cadre of wealthy businesspeople who are thoughtfully considering what types of actions can really promote sustainability and really make money. The Economist’s “Climate” issue describes them as people who are “putting serious money into climate-friendly investments – and expect serious returns”. According to the piece, “All want to do good by the planet. Most expect to do well for themselves.”

In addition, Sarah Kaplan of Toronto’s Rotman School of Management describes a model by which business leaders can succeed with sustainable investment.

“One way to survive,” she says, “is for companies that have already pursued the business case for responsible action, to ‘innovate around trade-offs’.”

“One example is how Nike, attacked over its suppliers’ working conditions in the 1990s, not only improved standards but developed an entirely new manufacturing process to take pressure off the old supply chain. The US sportswear company’s Flyknit ‘woven’ shoe was one result.”

This course is a noticeable break from the modus operandi of many global companies. When confronted with such challenges it is frequently the case that the problem is solved by some combination of moving to a jurisdiction with less scrutiny, leveraging the company’s power and authority, and simply paying penalties if they are not excessive. In other words, a lot of people get paid good money to dodge the spirit, if not the letter, of the law.

Looking across the realm of sustainable investing today reveals some striking features. One is that a lot of shortcomings regarding sustainability are related to deficiencies in enforcement. Why would a company spend a lot of money upfront to avoid penalties if the penalties are so small as to be trivial and the chances of being penalized are slim? It is a real business tradeoff.

Further, it is often the case that rules don’t even need to be broken if regulations can be cleverly arbitraged. Too often, regulators and enforcement authorities are no match for their corporate counterparts. Sustainability could be greatly improved simply by leveling this playing field. Penalties and enforcement reflect society’s values. If they are substantive enough, they will incentivize compliance.

Another striking aspect of the sustainability movement is just how noncommittal many consumers are. Many people express opinions, and many people take some action, but actual consumer behavior is not matching the sustainability preferences being expressed.

A recent article in The Economist provides a possible explanation, “Many consumers neither read nor understand the contracts they sign”, even when it is clearly in their interest to do so. While the research was conducted primarily in regard to the “terms and conditions” of apps and online services, the behavioral phenomenon is broadly applicable. Many consumers simply don’t want to exert the effort to ensure better outcomes.

Researchers “concluded that savers doubted the benefits of shopping around and were put off by the perceived inconvenience.” The Economist suggested, “‘Caveat emptor’, it seems, may apply in principle but not in practice.”

This results in any number of interesting paradoxes. For example, if a big beverage company packages soda in a can with a liner containing BPA, that company is often targeted for its unfriendly business practices. If, however, a local craft brewer packages its products in the same can, is lauded for its “sustainable” practices and the BPA is conveniently overlooked. Nobody even asks the question even though it is exactly the same practice.

In addition to paradoxes, the incomplete engagement by consumers creates a real hurdle for well-intentioned sustainability efforts to overcome. You may have great ideas and you may be right it the long run, but if consumers don’t vote for you by way of their purchase decisions, none of it really matters. 

This is a shame because the threats of unsustainable practices are becoming very real. Gillian Tett reports in the FT that an information asymmetry regarding climate change appears to be widening. 

Jupiter, a climate advisory group that provides modelling for banks and insurance companies, “forecasts a tripling of losses from flood damage in the next couple of decades.” The company arrives at its conclusion by evaluating the type of residential mortgage exposure of a real bank. This is consistent with work done by McKinsey:

“Coastal regions such as Florida … could deliver asset price shocks for lenders, insurers and homeowners. So, too, in places such as Spain, southern France, Greece and Italy which are projected to see eye-popping increases in drought.”

Further, when the information asymmetry narrows, it could be punishing for many homeowners: “while American households typically use 30-year mortgages to buy properties, the price of insurance is reset annually.”

The same information asymmetries exist in the markets for financial assets as well. According to the entity Principles for Responsible Investment (which is supported by the UN), “financial markets today have not adequately priced-in the likely near-term policy response to climate change”. Tett voices her concern about the likely consequences:

“History shows that extreme information asymmetries produce market shocks. That’s what happened in the subprime mortgage saga. It is hard to believe it will be any different with climate change.”

Given such risks, what can investors, leaders, and consumers do to overcome inertia and narrow the information asymmetries? Dave Stangis, ESG expert and former CSO of Campbell Soup, provides a useful perspective:

“I always sense the macro challenge is trying to find the right language to describe what so many people are talking/writing about.  I do believe the expectations of good business have shifted and we see many examples of business done right (not just activities or initiatives) can deliver measurable benefit to shareowners, execs, other employees and customers/consumers.  The debate seems centered around what is that called when it works and how do we describe when it misses the mark – or when it is something else (negative screening).”

In other words, don’t get hung up on the language and miss the forest for the trees. Sure, there are frivolous and virtue signaling sustainability efforts, and sure, there are business practices that extract disproportionate benefits from society. But those can all be identified as such and avoided.

On the other hand, there are real efforts to innovate around tradeoffs. Properly considered, these can be characterized as something like continuous improvement in capitalism. It takes ongoing effort, thought, and research to differentiate between “business done right” and business “missing the mark”, but expectations are shifting and the benefits can be substantial. Conversely, the costs of failing to do so are rising every day.

A Somewhat Bullish Market Commentary

Let’s just put the lead where it should be. Stocks are resilient and short-term dip notwithstanding; they are likely to be higher before the end of the year.

Here’s the evidence in bullet form.

  • The NYSE advance/decline is hovering at all-time highs.
  • Three-month bill yields are dropping hard. The Fed will cut rates one more time this year.
  • Financials are holding tight near resistance thanks to the “uninverting” of the yield curve. You can argue with me on that point later.
  • Trade deals are getting done (Japan) so China will feel the heat. I do not buy the argument that the Chinese are waiting out the current administration (i.e. impeachment or failed reelection). They know better than that.
  • Sector rotation is a healthy sign. Chart below of value and growth.
  • Retail is not dead. Chart below.

Of course, it’s not all great. I’d like to see more stocks hitting new highs and small caps, which started to perk up nicely, have eased back.

Now let’s talk about those headlines.

  • Impeachment inquiry. This may or may not hurt the orange fella but it is likely to seal the deal for Elizabeth Warren on the blue side. Wall Street has already vocalized that it will crumble for President Warren.
  • Softening economic numbers. Nothing stays that good forever. The U.S. is still the best game in town. Why else is the U.S. dollar at a 2 ½ -year high? Yeah, we’ve got positive bond yields but we’ve also got a growing economy. By the way, the UUP bullish dollar ETF is at an 11-year high.
  • What the heck happened to gold? After a major, long-term upside breakout in June and a nice rally to resistance in August, it is now overstaying its welcome as a correcting market. That pesky dollar, right? Well, gold priced in euros has been flat for more than a month, too.
  • And while I’m using such foul language, what the heck happened to bitcoin? It was supposed to get a boost from all this economic turmoil. And when I say foul language, I mean bitcoin.

So, unless something big and bad happens, I’m still a stock market fan.

In the spirit of Warner Wolf, CMT, let’s go to the charts.

(Click on image to enlarge)

Important support for big cap indices.

(Click on image to enlarge)

Important support for the Transports (yes, this is a chart of DJTA, not what eSignal labeled it).

(Click on image to enlarge)

Rotation value from growth.

(Click on image to enlarge)

Retail ice age seems to be enjoying a little market climate change.

(Click on image to enlarge)

There you go. A new low.

Your move Chairman Powell.

Negative Rates Are Destructive But Profitable

“Remember that Time is Money.”

Benjamin Franklin, Advice to a Young Tradesman

It’s unfortunate that such genius identifications as the above have long been forgotten by the economic community. First penned in 1748, Benjamin Franklin makes the connection between human effort—or rather the application of human effort towards productive work—and the effect/product, i.e. wealth. We measure this increase in prosperity, of course, in terms of money. Thus, “Time is Money” (or rather, time is potential money). They are one in the same since time is the one truly scarce resource with which all living creatures have to work.

However, you’d never know this by a look at today’s markets. Negative interest rates are now common place and widely accepted as a policy tool. In fact, a tradition of thought is being established as a means of “normalizing” them. Pushing deeper into negative territory seems all but a foregone conclusion. No longer is the absurdity and devastation of such policies discussed. No longer discussed is that negative interest rates negative human life.

Negative Interest Rates Negate Human Life

“Negative interest rates negative human life” is a bold statement, I know, but I stand by it. I suspect “Big Ben” would too. We both understand what economics is all about. It has nothing to do with fine tuning commercial activities for some nebulous greater good. Rather, economics is about individual, human happiness. It’s about making the most of our time on this planet; to use our time, effort, and brainpower to maximize the human experience while it lasts. The better use of time we make—via productivity—the more wealth can be created, the more comfortable and fulfilling our lives, and the better the existence we can enjoy. Hence, time is money in a pure, genuine, and profound way.

This is why negative interest rate policies (NIRP) are so pernicious and beyond absurd, irrespective of whether or not they saved the collapsing financial system in 2008. NIRP implies contractions on such fundamental scales that they cannot be beneficial. Specifically, that either: 1) your time and efforts are valueless (or worse, destructive), or; 2) your currency is valueless. In other words, action is detrimental to survival; time is not money, and; one’s currency choice is not important. None could be more obviously false.

Time and Effort Are Valuable

Your time and effort are valuable. Fundamentally, these are your survival tools. If time and effort were not valuable then there would be no need to ever take any action of any sort. You’d be better served to lay curled up in the fetal position than to attempt to work. This is clearly false. Human survival (and thriving beyond this basic need) requires one to produce and trade for values. This requires action; hence time and effort are valuable.

Time is Money

If time were not money then no one would work, full stop. Why toil if the fruits of one’s labor did not exceed the effort and time spent while working? Humans work for the purpose of survival; however we’re lucky that civilization has sufficiently advanced such that immediate survival is no longer of primary concern for much of the developed world.

Instead of concerning ourselves with food and shelter, human effort can be diverted towards life enhancements. Today, engineers make software, artists make films, ride-sharing drivers transport us, and financiers fund dreams. Without people working on such projects there would be none of the results. There’d be no Ubers and iPhones and movies and biotechnology and office buildings without men and women applying their time towards these endeavors.

If time were not money why on earth would anyone work? Surely there would be better ways to spend one’s only truly scare resource of time. Simply doing nothing and conserving energy would be an evolutionary advantage. Why work if there are no values to gain?

Working to lose would favor not working or acting at all. This is the absurdity of negative interest rates. To apply capital only to lose it—i.e. NIRP—would favor not applying capital in the first place. Thus, NIRP’s existence implies a contrived construct to exist, not one grounded in natural law.

Sound Money Is Universally Desired

Another possibility of NIRP is that it says something negative about the currency and not necessarily output. The currency is depreciating over time. But this too is nonsensical. Why would anyone use a depreciating currency given the choice? In fact, no one ever chooses such inferior currency, looking at history. These circumstances typically arise with a healthy dose of force. Poor currencies are typically foisted upon an unwilling population and they typically don’t last; no one wants to lose value in a transaction. If a currency cannot serve as a reliable unit of account, the populace will eventually find something that can—officially or unofficially sanctioned.

Thus, people will flock to the best currency option available so long as they are not forced to choose otherwise by regulation and statute. This in part explains the U.S. Dollar’s dominance in international financial transactions. True it’s the “reserve currency” but it’s the reserve currency for a reason and the dominance of the U.S. Navy is not one. Rather, the respect for the rule of law, deep capital pools, and established and incentivized institutions are what likely preserves the U.S. Dollar’s reserve status. Don’t kid yourself; an IMF mandate for settling trade in renminbi would yield no (material) results. Economic actors will act according to their best interests, factoring in the price of non-compliance. Thus, the “bag-holders” are always those compelled to hold depreciating currency.

Sweet Siren’s Song

The challenge with negative and low rates is just how profitable they can be to trade. Hence, they should not be ignored, in my view. I introduced the chart below nearly a year ago. It illustrates how much return potential is embedded in the 10 year U.S. Treasury bond (USTs) expressed as a function of its current yield (see here for a more detailed description). As yields have fallen, the appreciation/depreciation potential has dramatically increased. No longer are USTs boring, yield providing investment vehicles. In the environments of NIRP and ZIRP (zero interest rate policy) they are now total-rate-of-return vehicles ripe for speculation and outperformance.

Today’s Bizarre State of the World

These dynamics gave us the current state of the world. Investors cheer the stupidity of NIRP because they yield profits. The more ZIRP, NIRP, and QE (quantitative easing) the more capital gains can be reaped despite no detectable economic benefits produced. Hence, investors cheer the nonsensical which policymakers mistake as as endorsements. A self-reflective loop is established.

Many claim that NIRP, ZIRP, and QE saved the failing financial system. This, however, is mere conjecture. We simply don’t know what would have arisen from the ashes, better or worse. Counter-factual claims cannot be empirically debated.

Thus to claim that NIRP is beneficial displays one’s bias and, in my view, is grounds for mistrust on non-objectivity. This is particularly true since we can see how truly absurd the theoretical construct for NIRP is. Time is money and freely exchanging citizens desire sound currency, these we know as fact. Arguing to the contrary in papers or by inciting tradition can’t negate these.

So long as the academic and political will favors the incumbent policies they will likely be entrenched. The IMF recently published their playbook for the next economic slowdown and NIRP plays prominently. Economics (true economics) illustrate why these next rounds will also fail to stoke economic activity.

There’s no breaking the link between time and money and the desirability for sound currency. These are universal truths. That said, bond math illustrates that trading “rates” in such an absurd environment can be lucrative, at least for the time being. Thus, I find it useful to know both: the absurd and the trading potential. Profitably trading won’t negate the deleterious effects of NIRP, but it can help preserve one’s capital for better, more intellectually sound times.

The Lunacy Of The Dow

I’ve been on Twitter (TWTR) quite a few times railing against the Dow Jones Industrial Average and its price-weighted calculation. And, of course, I am not alone. This index presents a distorted view of any given day’s events although most of the time its foibles are hidden in the performance of the rest of the market.

Let’s look at today, September 11, 2019. I am writing at about 2:30 in the afternoon and the Dow itself is up roughly 137 points on the day. All of that gain, and I mean all of it (within my writer’s margin of error) is attributable to three stocks and number three in that group is good for only 10 points.

That means for all practical purposes, only two stocks are responsible for the Dow’s gain. All the others more or less cancel each other out.

Right now, Boeing (BA) is up 3.4%. That’s a pretty substantial gain but since the stock carries such a high dollar price (381), that percentage yields a 12 point (rounded) gain. And that 12 points translate, through the magic of the Dow’s divisor, into 83 points for the DJIA, itself.

Boeing alone is responsible for the 83 of the Dow’s 127-point gain at this hour.

Apple (AAPL), fresh on the heels of its big tech reveal (no thanks, I do not need a phone with three camera lenses) is up 2.5% or 6 points. That’s 38 Dow points.

And for those of you keeping score, the third stock was Caterpillar (CAT), up 1.2% for 10 Dow points.

Why is this? Because the Dow is calculated by adding up all the changes on the day for the 30 stocks within and then dividing by some engineered number that is less than one. That means a one-point move in any stock, regardless of the stock’s actual price, results in a greater than one point move in the Dow itself.

Now, on days when the high-priced stocks such as Boeing, Apple, and Caterpillar have very small changes, the Dow Industrials will be in step with the other major market indices. But there are times, lots of times when the Dow will be higher on the day and every other major is lower.

Of course, the media will report that the market was up because they focus on the Dow. It does not matter (most of the time) that everything else was lower. Sure, you might hear a more advanced talking head say the market was mixed but that is an easy cop-out.

Here’s a recent tweet of mine – $BA responsible for 102 of the Dow’s 98-point gain.

Why? Because most everything else was lower or flat.


A one-point change in UnitedHealth (UNH) is treated the same as a one-point move in Pfizer (PFE). At a price of 233, United’s one-point is good for 0.4%.  That’s just noise. Meanwhile, a one-point move in Pfizer at 37 is 2.7%.

Which stock had a more important day?

You know.

Fun with Fractions

And then comes the real fun. Every time they change the Dow, they have to change the divisor to keep the continuity of the historical price record. And every time a Dow stock splits, they have to do it again.

With each change, the divisor seems to get smaller and smaller and anyone who knows math just a little knows that the smaller the divisor (the bottom of the fraction) gets, the larger the value of the result gets.

By all means, track the Dow. It’s not always misleading and I personally more quickly absorb the level of the overall market and change on the day when I look at it, warts and all. However, if you want to really know what happened in the market, you need to look at a bunch of diverse indices, such as the Nasdaq, Russell and S&P 500. Toss in a few sector indices or ETFs, too.

The cheese may stand alone* but the Dow really cannot.

* Hi-ho, the derry-o, the cheese stands alone.

Having Your Cake & Eating It Too

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”.


Inverted Yield Curve Is Actually Bullish

My favorite meme following last week’s yield curve inversion was captioned, “I survived the yield curve inversion.”

My favorite tweet (from @jfahmy) was, “The next Jobs Report should be very strong with the 50,000 “Yield Curve Experts” that were added this week.”

Last Wednesday, the day the Dow dropped 800 points, the yield curve inverted for a few hours. There is a lot to unpack in that sentence, so let’s get to it.

First, I have to briefly define what the heck a yield curve is so if you already know, skip the next three paragraphs.

The Explanation

The curve is a representation, or plot, of the yield on bonds from the same issuer across all maturities for which it is issued. Typically, we talk only about the yield curve of U.S. Treasuries, although they do exist for many sovereign debt markets. Analysts looking at the U.S. version have the luxury of a robust curve with maturities running from three and six months, to one, two, five, seven, 10, 20 and 30 years.

The normal yield curve is upward-sloping, meaning that yields on shorter maturities are lower than yields on longer maturities. Investors are paid more to take the risk of loaning their money for longer periods of time.

When the curve is flat or downward-sloping, that’s when we think the economy is running into trouble. The downward-sloping curve is called the inverted curve. This frequently appears a year or longer before recession begins, but as they say, the inverted yield curve has predicted 15 of the last 10 recessions. In other words, it does not always work.

Inversion Therapy

OK, now that our more sophisticated readers are back with us, the curve got somewhat funky in April when the five-year yield dipped below the 3-month yield. Then in May, the three-month yield was above the seven year and then above the 10-year.

Some pundits called the three-month to 10-year condition the inverted yield curve. My opinion is that was questionable, at best. Why? See next paragraph.

For most of June, only the three-month was out of whack, which we can partially blame on the Federal Reserve’s rate policy. Everything else looked to be a regular, upward-sloping yield curve.

Then one grey day it happened (Jackie Paper came no more.) On August 14, the two-year ticked above the 10-year to create the dreaded inversion. The financial media went nuts. Recession is coming! Recession is coming!

However, within hours, the curve un-inverted. Was recession averted? Did that temporary inversion mean anything at all? And the real question, does a positive 10 basis point spread (0.10 percentage points) mean something all that different from a negative 10 basis-point spread? And if the economy is going to go into the pooper, shouldn’t the inversion last for weeks and months, not just hours?

How it Got There Matters

Just like knowing how a stock got to its current price, we should know how the yield curve got to its inverted state, albeit a temporary one.

I’m not a bond maven but I did notice that the 10-year yield dropped like a stone recently and that is what seemed to have driven the inversion. We’ll get to the why that happened later.

After posing the question to a group of pros, I got the answer from a real bond maven, Michael Krauss, the former Managing Director and Head of Global Fixed Income Technical Analysis and U.S. Equity Technical Analysis at JP Morgan Securities.

It turns out that my observation was right (blind squirrel, I know). It does matter how the yield curve got flat or inverted. What Krauss said was that the steep drop in the 10-year yield and a slower drop in the two-year yield was called a “bull flattener.”

When they talk about an inverted yield curve, most people think of the “bear flattener” variety, where short rates rise quickly and long rates do not. This is where the Fed sees something overheating in the economy or the ugly head of inflation rearing so it clamps down on easy money. This tends to lead to a slowing of the economy and weakness in the stock market.

However, the bull flattener means something entirely more positive. It could mean sentiment for a stronger economy is strong. Or that investors are piling into longer-term bonds. The latter seems to be the case as money from around the world is pouring into U.S. bonds.

Why? Because trillions of dollars’ worth of global government bonds have negative yields. Negative!

Of course, money will flow to the best return and that is in good ol’ America. We also can see that in the strong U.S. dollar, which everyone needs to buy U.S. bonds.

Don’t believe me. Former Fed Chief said the same thing.

Mutual funds specializing in bonds are also seeing record inflows of money.

Superforecasting A Bear Market

There’s an ongoing debate about whether or not the U.S. is approaching a recession. As an investor, this question is of utmost importance. It is precisely at these times when fortunes can be made and lost. There’s no shortage of pundits with strong opinions in both the affirmative and negative camps armed with plausible narratives and supporting data sets. How to decide which side to take? Applying some proven forecasting methods to historical data can help bring clarity to this question.

Forecasting is tricky business. It’s really hard to do well consistently, especially in investing.

Fortunately for us, Philip Tetlock has made a study of forecasting. In the book Superforecasting: The Art and Science of Prediction (aka Superforecasting) he and coauthor Dan Gardner share their findings of a multi-year study aimed to discover the best forecasters, uncover their methods, and to determine if forecasting skills could improve. There are many great lessons conveyed in the book. We can thus apply them to our problem at hand: the question of whether or not the U.S. will enter a recession.

The Lessons

By running a series of geopolitical forecasting tournaments, Tetlock and Gardner discovered a group of elite forecasters and uncovered their best practices. Ironically, specialized knowledge played little role in their success. Rather, it was their approach.

Superforecasting had a profound impact on me. I took away a more concretized framework for dealing with predictions. Rather than feeling my way through a situation, Superforecasting gave me a method I could apply. Well-devised forecasts share four characteristics:

  1. They’re probabilistic
  2. They start with a base rate formed by an “outside view”
  3. They’re adjusted using the specifics of the “inside view”
  4. They’re updated as frequently as required by incoming facts, no matter how small the increments

Think Probabilistically

The best forecasters (aka Superforecasters) made predictions in a probabilistic manner. In other words, outcomes weren’t binary—i.e. something would or would not occur. Rather, the Superforecasters ascribed a probability to a forecast. For example, they would assign a 30% chance to the U.S. entering a recession rather than saying it was unlikely. This precision is important.

Establish a Base Rate Formed by an “Outside View”

Before making a prediction, the Superforecasters first established a base rate informed by an “outside view.” A base rate is merely a starting probability. It will later be adjusted. An outside view, as introduced in his book Thinking, Fast and Slow by Daniel Kahneman, is a perspective that looks for historically analogous situations for guidance.

To establish a base rate using an outside view, we should first look at previous recessions and periods where economic conditions were similar. How often did conditions deteriorate into recessions? What events tended to precede them? This should give us starting point.

Adjust Using the “Inside View”

After establishing a base rate using an outside view, the Superforecasters adjusted it by taking an inside view—another Kahneman concept. An inside view is a perspective that only considers the situation at hand. It ignores historical precedents and seeks to induce an outcome using only the current facts. In a sense, every situation is treated as unique.

Thus, the Superforecasters considered both the historical context and idiosyncratic characteristics to inform their predictions. In a lot of ways this resembles using deductive and inductive reasoning in concert with each other; a practice I condone. To follow with our example, a Superforecaster would adjust their 30% recession base rate up or down based on current economic and market conditions. It might be increased due to the prospect of a trade war; it might be reduced based on strong jobs data.

Frequently Updated

Lastly, the Superforecasters frequently adjusted their forecasts. They constantly updated their probabilities, even in increments that seemed insignificant if warranted by new information. While this might sound trite, Tetlock and Gardner found it to be a key component of accuracy. Thus, forecasts might be changed with each presidential tweet in our ongoing example.

Establishing a Recession Base Case

Armed with an improved forecasting method, I applied it to the recession question. I ditched my bullish or bearish perspective and established an outside view base rate. Here, I illustrate my process using two of the most hotly debated metrics: the Institute for Supply Management’s Purchasing Manager’s Index (PMI) and the U.S. Treasury yield curve (YC), defined by the 10 year U.S. Treasury bond minus the Federal Funds Rate.

I compiled monthly data through July 2019. I then looked at the frequency of negative monthly returns for the S&P 500 index (SPX) after a specific threshold was breached. For the PMI I used its latest reading of 51.2. For the YC I looked at periods of inversion (i.e. when the spread was zero and below). Once these months were identified, I calculated the SPX’s return over the following 1 month, 3 months, 6 months, 12 months, and 24 months.

Note that I analyzed SPX returns and not whether or not a recession occurred. As an investor, my only concern is if asset prices will rise or fall, not recessions as such. It just so happens that recessions and falling stock prices coincide; but it’s the values that we ultimately care about, not recessions.

Findings From PMI Data

Below is my analysis of SPX returns for when the PMI historically reached these levels (51.2). Note that my data covered 858 months for my 1 month sample period and 835 months when looking at 24 month returns (i.e. 23 less data points). The PMI was 51.2 or below in 322 of those months, or ~38% of the time across sample periods. During these instances, successive SPX returns were negative for 14% of the months using a 24-month time horizon and 35% of the months using a 1-month one. Thus, 29% is a reasonable base rate for taking a bearish stance on the SPX over a 6 month time horizon using an outside view of PMI data.

Also, note that the longer the negative return environment persisted the larger the average losses.

Here is a similar table examining YC inversions. Both the instances and magnitudes of negative SPX returns appear to be higher for this data set. A base rate of 52% seems reasonable for taking a bearish stance on the SPX over a 6 month time horizon for this data set.

Findings From Combined PMI & YC Data

It’s an even rarer occurrence for the YC to invert when the PMI is 51.2 or below. This happened in just 65 months out of the past 780, or 8% of the time. SPX returns were negative 28% to 55% of the time depending on one’s timeframe, with 3 month displaying the highest frequency. We could use a 46% base rate for a 6 month time horizon. While losses were less frequent using this dual-signal than the YC alone, they were also more severe. Average drawdowns ranged from 4.3% to 31.4%.

Calibrating Your Grizzly

This analysis affords us two advantages. First, it removes the binary guesswork in trying to predict a recession. We no longer need to make a definite call on whether returns are likely to be higher or lower under the current conditions; we can take a more nuanced, probabilistic approach. Secondly, we can establish a starting base rate that is grounded in historical data.

According to the best practices discussed in Superforecasting this is just the first two steps in creating a robust forecast. The base rate requires adjusting by considering an inside view of today’s economic and market landscapes. It must also be updated as new information materializes.

The conditions examined (a PMI lower or equal to 51.2 and an inverted YC) were recently triggered. History suggests that we’re in a serious position. In the past, SPX returns were negative nearly half the time over the succeeding 3 to 12 months. To be sure, using just two signals is not an exhaustive process. However, it was a good first step in helping me calibrate my bearish instincts.

I’ll leave it to you, the reader, to apply your own inside view of the markets to this base rate. Ultimately, we must determine the extent to which “it’s different this time.” While forecasting is guesswork by definition, Superforecasting provided me with a useful framework to apply to all investing situations. Hopefully I’ll do so profitably.

Unmasking The Voodoo Yield Curve

To normal people, the typical response might be, “What in the name of the almighty are you talking about?

To market geeks likes us, it means the yield curve is as flat as its been since just before the financial crisis and recession.

Still not getting it? Not to worry, you are still normal. The panic in pundit hearts is that a flat yield curve suggests a recession is near. No, not tomorrow, but sometime in the next year or so.

Lazy are we are, we use the spread between the 10-year U.S. Treasury note and the 2-year note as the proxy for the whole curve. The whole curve is actually all the key Treasury rates from three and six months all the way out to 30-years.

Basic Curvology

Normally, these VooDoo articles are mostly time agnostic. However, the current state of the yield curve allows us to cover all sorts of things so I am going to go with it. It will keep, however, once the curve gets more benign again.

Here’s a picture of what everyone calls a normal yield curve (source: StockCharts.com). It is upward sloping as we go from short-term rates to long-term rates. The idea is that investors get paid more to take more risk. And since these are supposedly default-risk free U.S. Treasuries, that risk is interest rate risk. Having your money exposed, i.e. locked up, in longer maturities puts you at risk for rates going higher and your principle going lower.

You know, bond prices and yields move inversely to one another. If you want more, you’ll have to use the google because that will take me too far off track here.

Anyway, that’s the way the world works when things are, ahem, normal. But since the financial crisis and the artificial lowering of short-term rates by they who shall remain nameless (the Fed), this is what the yield curve looked like for the past few years.

Note it still has that nice upward slope. The difference is that the left side (the short end of the curve) starts near zero.  Don’t forget, this was smack in the middle of a rip-roaring bull market is stocks so the economy was humming along, albeit at rather low growth.

Next, look at it today.