As We See It: Value

Here’s a fun chart one of our colleagues spotted. On August 30, 2020, Salesforce replaced Exxon in the Dow. The following chart shows the total return of each since the change:

Source: Bloomberg

We realize the keepers of the Dow want to stay up with the times, but it’s not like Exxon was going out of business.

We can find no better argument for an allocation to value stocks. Valuation is often driven by fashion. I seem to recall that, at the height of the pandemic, Zoom had the same market cap as Exxon. Fashion. Style. The key thing to remember about stocks is that no one needs to own them, demand is completely elastic. Unlike, say, commodities, the price of a stock is not part of any practical business decision beyond capitalization. In simple terms, that means they can trade anywhere and anytime. It also means that value managers must buy things that are often wildly out of fashion, not our natural human tendency.

So, break out the leisure suits, the big lapels, and the super wide ties, and buy some value.

As We See It: Yen Intervention

The big story in the past week was the massive currency intervention by the Bank of Japan (BOJ). Hard to know exactly how much went through, but reports were in the range of $70bn on Friday alone. FX interventions by major central banks are less frequent than they were years ago. This was the first BOJ buy side intervention since 1998. There is a pretty simple reason we don’t see intervention much anymore – it does not work. Let’s have a quick look at what’s going on.

Against the trend of most other central banks, BOJ policy has been to maintain low interest rates and keep long term yields under 25bps (a policy called yield curve control, YCC), despite rising inflation and a global backdrop of major economy yields rising substantially. They have been the principal buyer of Japanese Bonds, leading to a crash in liquidity. In recent weeks we have seen multi day streaks when the benchmark ten-year bond (the JGB as it’s known) has not traded. Forcing long-term interest rates to below market levels (the 10y swap market has rates around 70bps) has created massive pressure on the currency, and the BOJ has tried to stem the tide.

Intervention is like trying to hold 100 ping pong balls underwater at the same time – sooner or later one will pop up. As long as the BOJ keeps interest rates artificially low and continues yield curve control, the currency will eventually, intervention or not, get blasted. When the Fed is guiding market yields close to 5% and even the Europeans are raising 75bps a meeting, the policy gaps are untenable. Something has to give. As we write this, the BOJ is intervening again – they moved the currency about 1 percent, and then it immediately sold off again.

So why is the BOJ doing this. Japan is by far the most indebted major economy. That was fine as long as rates were low. What changes that calculus is – you guessed it – inflation. Unwinding these policies is like landing a jumbo jet on a football field. As the now ex UK PM Truss found out, the room to maneuver can shrink pretty quick.

Source: Bloomberg

As We See It: Small Markets

Right to the Source ….

The current trend in the managed futures world is … expand the portfolio, trade every little market in every suspect exchange around the world to get the maximum diversification. That’s fine I guess if your goal is to create a standalone investment with the best possible Sharpe ratio. But if your goal is to diversify a broader portfolio, adding many second-tier markets may be counter-productive. Let me explain.

Right now, moves in the stock market are being determined by moves in the 10yr Sterling bond, the gilt, and as the LDI debacle unfolds and spreads into other markets. Gilts down, stocks down. All concentrated managed futures portfolios would trade the gilt, and would be short. However, if your fixed income portfolio trades a zillion different bond and interest rate contracts, the impact of that gilt short, and its diversifying character, would be diminished. It’s highly unlikely that something that happens in Sweden or Thailand would have the same impact as something that happens in the UK, a major money center. It’s the major things that cause major problems in equity and credit markets. A more concentrated managed futures portfolio is likely to have more exposure to those major drivers.

This problem gets compounded by the desire of quants to “risk adjust”. In the current environment, risk adjust means cut the gilt short because volatility has gone up. That may risk adjust for the manager, but not the holder of the broader portfolio. He now has less participation on the source of market volatility. We’ve written more about how that looks in a portfolio here and here.

Remember, what’s good for the manager’s Sharpe ratio may not be good for your portfolio Sharpe ratio.

Managed Futures In The Portfolio – Update

2022 has been an awful year for most all assets. Through the end of the 3rd quarter, the S&P 500 is down 23.9%, High Yield bonds down 14.4% and Investment Grade bonds down more at 21.2% (worse than HY due to the longer duration in IG). Over the past few decades, investors have been somewhat accustomed to seeing US Treasuries do well in tough times for equity and credit markets, this year though, 7-10 year US Treasuries are down 15.7%. It’s an ugly scene…not a lot of places to hide.

Source: Bloomberg, Mount Lucas

One bright spot – Managed Futures strategies. We wrote about these earlier in the year here. Our long-held view is that Managed Futures are fantastic portfolio elements. We like them more than most – and execute them in a purer form than most as well – but recognize them for what they are. A Portfolio Element. Most investors, us included, hold portfolios of stocks and credits. To our eye these are also Portfolio Elements. Stocks tend to do well in times of economic stability, growing earnings and rising multiples. Managed Futures tend to do well in periods of macro-economic uncertainty and instability. Combining these two elements makes a lot of sense to us.

As with all portfolio construction, the only thing more important than having a plan is following a plan. Rebalancing is plan-following in action. In the years prior to the pandemic, it had been a fairly fallow period for trend following strategies. Continuing to hold exposure to portfolio elements that are out of favor for a period is not easy to do. A lot of investors start with a great portfolio of undiversified elements, then at the end of every year take a look down the list of line items and chop the bottom few. If you do this a few times in a prolonged cycle, you end up with quite a correlated book – whether you notice it or not. This happened pre 2008 when both energy stocks, emerging markets, commodities and carry strategies were all doing well. If you aren’t careful and you chop the other pieces as they underperformed and didn’t rebalance the winners, you end up with a chunky overweight in those things. As that cycle continued it became fairly clear the drivers were narrowing. Commodities were going up, which helped energy stocks. It also helped emerging markets, which at the time were more heavily raw materials based economies. Hot money flows into the markets amplified the FX component of the returns too, and in currency carry the commodity currencies were outperforming and had higher rates. They all unwound together.

Fast forward to the past couple of years. Tech has been doing incredibly well – fabulous business performance, network effects, buybacks and multiple expansion. Venture capital had been doing well. The broader stock indices became more concentrated along the way, and low rates seem to boost steady subscription type businesses and REITs. We have a common factor forming. The cycle extends and credit spreads tighten, borrowers extend and refinance into new bonds at lower coupons, increasing duration and reducing risk premium. Government bond yields got lower and lower, as they were the perfect component – uncorrelated to negatively correlated positive carry hedge. Managed Futures allocations…some folks maintain in dollar terms, others reduce or cut it, or don’t rebalance into it, letting the weight drop.

This year so far, when everything else has been getting hit as the common Achilles heel – inflation – rears its ugly head at a time when with hindsight, stocks and bonds were priced for perfection. An ugly war in Europe didn’t help either. The definition of macro-economic uncertainty into markets that were priced for stability. Record high SPX at a 23PE, a US30 year yield under 2% and high yield spreads at just 3% – less than most estimates of full cycle default rates. A rare bright spot in a sea of tough market returns? Managed Futures.

Source: Bloomberg, Mount Lucas

Interestingly, at least to us, is the reason why. Managed Futures tend to have commodity exposures, fixed income exposures and currency exposures. Some do stock as well. All instruments that tend to shift with the macroeconomic uncertainty. They don’t tend to do individual stock or credit picking, these are large global macro markets. Inflation impacts all of these. Commodity prices up in the first part of the year helped a lot – oil markets and grains. Short positions in fixed income as bond yields rose across the globe. Currencies are maybe the most direct expression of macro and were large contributors. The Euro fell hard driven by relative interest rates and growth trajectory impact due to proximity to the geopolitical situation. The Bank of Japan continues to maintain ultra loose monetary policy settings through a 25bp 10-year yield curve control policy at a time when the US is raising the front end by 75bps every meeting. The Japanese Yen moves abruptly lower. We show a few of these market moves in the postscript below. Managed Futures has exposure to each of these moves. The uncertainty hurts equity markets, Managed Futures diversifies uncertainty.

So where do we stand now. Well one reason you do different things in a portfolio is that when one set of things is struggling and another is doing well, you can rebalance along the way. Use the gains in Managed Futures to buy stocks and credits when they are more reasonably valued. 2008 was a great example – stocks fell 37%, CTAs had great years. The years after were reversed, with stocks making 26% in 2009. Rebalancing the CTA gains meant one could use the gains to buy equity at lower levels. One has to decide the timing – truth be told it doesn’t matter too much, as long as you do it. Annual maybe a little too infrequent, quarterly or monthly seems about right to us. And if they haven’t moved a lot relative to each other, maybe it’s not worth it and a rebalance threshold approach is more reasonable. That’s fine too. Examples of what this would look like are below – monthly schedule when they have moved a chunk. Rebalancing the CTA as it goes up, and buying equity like clockwork. No fuss, no panic.

Source: Bloomberg, Mount Lucas

If you don’t have exposure to Managed Futures in a portfolio, maybe consider if it makes sense as a way to get exposure to a different return stream that often benefits from uncertainty, in a way that fits your goals. If you already do have exposure and it has performed well while other things haven’t, and the allocation has naturally grown through those performance differences, consider rebalancing. Now timing this is next to impossible. But picking a time, rebalancing mechanically like clockwork is important. If you have a good portfolio plan, follow it.

Postscript:

Below are examples of moves that have worked in Japanese Yen, Crude Oil and US 10YR Notes, respectively.

Source: Bloomberg, Mount Lucas
Source: Bloomberg, Mount Lucas
Source: Bloomberg, Mount Lucas

As We See It: Quadrants

The idea of investing quadrants has been around a long time. Divide the potential environment into 2 planes, basically growth and inflation. Determine the current intersecting box, invest in the things that have done well historically in that box. It’s a great shorthand method of putting order to chaos, most of the time. Thought experiment … Is the economy growing? Real GDP is negative, so no, nominal GDP is on fire, so yes. Weekly unemployment claims are low, so yes, but job openings are falling, so no. You get the point – picking the box is tough. We are in a really inflationary time, so buy gold, right? Wrong, regardless of what the cable ads say.

Check out this chart:

Earnings expectations have fallen, particularly ex-energy, as the market factors in a recession. Strange recession where energy companies are the leader.

We prefer to let price be the guide. It’s no surprise that when researchers looked at a vast array of possible variables that drive AI investment decisions, momentum clearly dominated all other choices (OP-REVF200009 (chicagobooth.edu)). Our preferred method is trend-following. If you boil it down, trend-following is simply a robust method of identifying an unobservable state variable (fancy, huh). Am I in a bull world or a bear world, across a wide range of markets. It’s not locked into a pre-defined set of relationships. An overused quip is of use here – history doesn’t repeat, but it rhymes. Use trend to get the beat.

As We See It: The UK Bond Debacle

Same tune, different words. Every. Single. Time.

Some big pool of money (BPM) would like something for nothing. Large financial institutions (LFI) are happy to help. Heck, they even compete to help the most. As long as X never happens – and of course it never does – we can give you exactly what you want. In the 1980s, pension funds wanted to be long stocks but not the downside tail. Buying puts was too expensive. No problem says LFI! We will give you something called portfolio insurance. Instead of paying implied volatility, you can own an option-like structure at realized volatility. As long as the market does not gap down a lot – which of course it never does – there is plenty of liquidity to execute the hedge. October 1987 put an end to that little fantasy. Then there were those good old sub-prime loans. Some BPM would like some higher yielding debt. No problem says LFI! Each mortgage may be risky, but they are much better behaved when we look at a big basket of them and we’ll spread them out all over the country. As long as house prices never go down, which of course they don’t, and certainly not all over the country, these bonds are golden. We’ve even paid someone to give them a AAA rating! That ended…not well.

The current situation. UK pension funds (BPM in this case) have a problem. On paper, falling interest rates lower the discount rate on the future liabilities of the fund. Makes the fund look bad. Can’t have that, say LFI. We will buy a leveraged position of long duration bonds. As rates fall, the increase in liabilities will be offset by gains in the long bond portfolio. If rates begin the rise, the losses on bonds will be offset by paper gains in the reduced liabilities. Sounds good, or as Dire Straits crooned…Money for Nothin. This will work fine, as long as we don’t get a real fast inflationary spike in rates, which of course we won’t because we know inflation is dead. Whoops…

Source: Bloomberg

Rates spike, liabilities do fall on paper, but the margin call on the bond long requires real money…right now. A classic liquidity mismatch. All of a sudden, pension funds have a margin call. On this latest yield spike, the central bank has to intervene in the name of financial stability. Liquidations spread to other markets as the funds scramble for cash. Normally history doesn’t repeat exactly, but rhymes. In this instance though, it’s closer to a straight rerun. This happened in Orange County, CA in 1994 when rates rose, and it’s literally used as a finance case study on risk management and what not to do. And yet here we are, just far enough along for a new generation to make the same mistake.

Rule 1 in finance…keep it simple.

Postscript – October 11, 2022

The FT has published a fabulous piece on the episode at this link (paywall). It fills in the BPM and LFI cast of characters and has some great quotes – turns out our read was pretty accurate all told…

As they made their pitch to overhaul the pension scheme of one of Britain’s biggest retailers, Next chief executive Lord Simon Wolfson remembers the consultants were “very sure of themselves”.

“Liability-driven investing”, the consultants promised, was a stress-free way to protect the fund from swings in interest rates by using derivatives.

There is one particular phrase that still sticks in Wolfson’s mind from the 2017 meeting: “You put it in a drawer, lock the drawer and forget about it.”

“The speed and the scale of the move in the gilts market was unprecedented,”

“The crunch event was not in anyone’s models,”

But even he acknowledges that its complexity is an issue, with tricky collateral management and an orchestra of instruments from gilt total return swaps to gilt repo and inflation swaps. “Undoubtedly the problem is that people don’t really understand it,” he said. “It’s like trying to explain some aspects of quantum physics to people who aren’t really physicists.”

…pension schemes in aggregate will have to come up with as much as £280bn to fully recapitalise their interest rate and inflation hedges with new lower levels of leverage. This is in addition to the £200bn that schemes have already had to deliver to meet LDI collateral calls…