Two things have become clear, thanks to the slightly spicy English of Mario Draghi. To set the stage, it’s October 26th, 2017, and we wait for the latest announcement from the ECB. US 10s are near recent high yields, breaching the tough resistance of 2.40%. The Euro has come off the boil, and stocks everywhere are near the highs. Out comes the text, and Mario does not disappoint, hitting all his lines right on cue. Rates will remain low; however, the ECB will slow down asset purchases, in a measured way, starting next year. Then comes the press conference, and he confidently walks it back. Yes, the economy is doing well, but if we don’t see some inflation, we are fully prepared to hit the gas again. Boom. Bonds and Bunds rally, rates fall, Euro gets creamed, stocks take off. And the two things are….
Two years ago, Dudley was spooked by tightening financial conditions. Now, they can’t figure out why they are so loose.
I think there is a simple explanation. Two years ago rates were so low that credit could not go any lower, as they would go below the default rate. So it looked like financial conditions tightened. Now, as the fed raises rates, credit has stayed at the same price, so it looks like financial conditions are getting looser. Here is a chart of auto loans. Rate has not changed. Unless the central banks buys credit (as they have done in Europe, forcing HY below UST), the nominal rate cannot go any lower, but won’t go up right away either. If you are at the default bond in credit, do measures of financial conditions fail to make sense?
In the great series of historical novels about the British Navy in the Napoleonic era by Patrick O’Brian, and the associated movie Master and Commander, there is a poignant scene where the ship is stuck in the Pacific doldrums, sails limp at the mast for days. The crew looks for a scapegoat, a Jonas, to blame for their misery, and they find one in a hapless midshipman. For the good of the ship he grabs a cannonball and jumps over the side. A prayer is said, the wind returns, and off they go. Complacency is the buzzword of the day, but the winds will return as they always do, and the catalyst will be as much a surprise to the market as to the midshipman who found himself carrying a cannonball.
I am habitually early for meetings. The other day I had some time to sit outside the offices of a major investment bank at the start of the business day. It’s an evergreen notion for me … a scene repeated at all the banks and funds all around the world, hundreds of well educated, motivated, energetic young people all chasing the same pool of alpha. And I wonder, is there enough to feed all these hungry strivers? Risk premium is durable, varied and growing, alpha is zero sum and rare. At Mount Lucas, our approach is to own that risk premium in many flavors through our quantitative trading. Just this month we added a new flavor, a momentum based multi asset credit basket. It fits nicely with the other risks in our capital markets allocation. We continue to search for alpha in the realm of long term behavioral biases. I have to admit it’s tough going, particularly in the doldrums, but the opportunities are there, and we await a stiff breeze to see them realized.
“Mount Lucas employs a number of different strategies each with their own investment objectives and risk profiles. Any reference to a strategy or strategies mentioned above may or may not be indicative of all of Mount Lucas’ products.”
There is a saying in our business,”the trend is your friend.” Given the recent downturn in trend following returns, I am reminded of another saying, “with friends like these, who needs enemies.” I was in a meeting recently with a consultant who asked a question we have heard many times over the years. How do you keep clients invested in managed futures in times like these? We know the history, the diversification benefits, the crisis protection, the long volatility profile…but, each time there is an extended period of challenging performance clients look to throw in the towel – because their equity investments are ripping up and managed futures is down. A good question, and the answer, I think, lies in the statement – it is a matter of faith.
Investors in the equity market have faith. They trust, and have been conditioned, that the market goes up over time, corrections are temporary. Participating in the capital formation of companies provides a risk premium to the investor and is an investment in the economic growth of a country.
Managed futures on the other hand is viewed as a trading strategy, it goes long and short, it is typically quantitative based. The perception is…I can’t have faith in a model, it can break. But this perception is misplaced, trend following measures a real economic risk premium in the market, just like equities (see older posts diving deeper on this topic, Portfolio Symmetry, Commodities are not Stocks, Benchmarking Alternative Beta). Investors in this market are rewarded by taking the price risk companies seek to shed. Faith should be in the durability of this premium, just like there is in the equity risk premium. Faith is gained by understanding this risk premium, when it works (periods of volatility and instability), and when it doesn’t (periods of low volatility and stability). Similar to equities, faith should be garnered from the underlying economics of the markets.
Value investing can be counter-intuitive at times. Acting against our own intuitions is not an easy thing to do; it’s uncomfortable. We form our thoughts and reasons based on what we see and experience in the present, and extrapolating our present situation into what the future holds is something we all do. Predicting the trajectory of long-term trends that have already begun is not rocket science, but investing requires you to be right about the trend, as well as the timing of that trend.
Bill Gates wrote the following a while ago
‘we always overestimate the change that will occur in the next two years and underestimate the change that will occur in the next ten. Don’t let yourself be lulled into inaction.’
It comes to mind as I think about some of the stocks we hold, some of the stocks that are doing really well and the difference between a great company and a great investment. There is a lesson in the drivers of value investing and how it interacts with momentum, and more broadly on real visceral fears that are out there, manifesting themselves in the politics of both the left and the right. One way to think of value vs growth investing is as extrapolations of the current set of worries out to the future. Everyone remembers the Blockbuster video example, killed off by Netflix, and see that story writ large across big chunks of the rest of the economy and stock market. Disrupted businesses are everywhere – just this week Hertz announced a bad set of numbers, sequential declines in revenues and a bigger than expected loss. The stock got hit hard. On the other side? The new ride sharing services, Uber and Lyft, raising money at high valuations as people extrapolate to a future of self-driving on demand cars, and no place for old school Hertz. Amazon making it tough for big box retail is another example. Tech, robots and AI are coming for jobs and business as we know it.
Many instances of these seem perfectly valid, and it’s easy to paint the picture. The likes of Amazon, Netflix and Tesla are amazing businesses that have changed the world and achieved incredible things. The issue we have is that they seem priced for ever greater levels of growth into perpetuity, and don’t seem to take into account what we think is one of the key reasons value investing works – the people running the businesses are scared as well, and where they can, they fight back. Some will be unable to. But not all. Take General Motors and Tesla. General Motors trades around a 5 PE and pays a dividend north of 4%, and the last couple of years has about $9bn in income. The numbers are a bit different for Ford, but the picture about the same. That income is an enormous amount of firepower. The people running these businesses are not stupid, and I’ll bet are more worried about electric vehicles and driverless cars than you or I. The market focuses on Tesla and the incredible way it’s broken into the car market, its Gigafactory, and its solar roof product. They are extrapolating a future whereby Tesla hits the big time with its $35k Model 3 and kills off Ford and GM – at these prices that’s what is implied. Relating it to option buying, by buying Tesla investors are effectively buying calls on this amazing future – things need to get to this new world quicker, and it needs to be more amazing than it seems now. They may be right, but boy are those calls expensive here. With GM and Ford, we see value investing as akin to buying puts on the speed and scale of this societal change, and think that the extrapolation has gone too far – and doesn’t take into account the firepower of the businesses. If the transformation doesn’t happen, takes longer, or investors decide to pull financing from the Tesla project (and they sure will need a lot of funding to build out the scale the stock price is banking on) maybe things looks different and old Detroit transforms itself. That $9bn pays for a huge amount of R&D to fight back – indeed when you look at it, the first few firms to get an electric vehicle to market at a mass market price point have already done so. They Chevy Volt, the electric Ford Focus, the Nissan Leaf. GM is hiring 1000 engineers in Silicon Valley to expand Cruise Automation, the self-driving car unit it spent some $600m on last year. Ford is doing similar, investing $1bn in a self-driving car firm in Pittsburgh. GM is into the battery game as well, opening battery factory in Shanghai. One can make the same case with Walmart and Amazon – Walmart has some $20bn in operating income, and an e-commerce business growing at 30% a year. At its root, Walmart isn’t too far from being an Amazon warehouse with a door and a checkout – it has a brand name, incredible logistics and supply chains – and won’t go down without a fight.
All of this isn’t to say that Tesla and Amazon aren’t incredible companies pushing the world forward – they certainly are. What they also do though, is to bring others up with them, galvanizing competitors into action. Capitalism in all its glory. We think the markets are extrapolating the future too far in both directions – the new kings Tesla and Amazon and their ilk to the high side and older world names to the low side. Back to the Bill Gates quote, investors are focused on the first part, over estimating the next two years at the expense of how things will look in ten years. The people in Detroit and Bentonville are focused on the second part, and not being lulled into inaction. Buying old Detroit at valuations like this is hard, it goes against the story of change. What you are doing by buying is really selling a put on the speed and scale of the change. We’ve seen a movie like this before at the turn of the century. New world growth expectations were out of hand and the growth premium over that five year period was enormous. The following five years were reversed, as value investing outperformed strongly. The chart below has some details on it. That’s how value investing works, in cycles, and it works because it’s uncomfortable.
This FT piece by Gavyn Davies is getting some attention. He makes the case that the upturn in growth we are currently seeing is likely not a secular shift from possible stagnation, but a (welcome) cyclical burst. He references San Francisco Fed President Williams recent paper concluding that the equilibrium real interest rate (r*) is likely to remain much lower than in the past. Briefly, r* is derived by reflecting on an ex post realized output gap relative to the Feds policy stance. If the Fed sets policy rates at what they think ex ante are very accommodative real interest rates relative to the estimate of neutral rates at that time, and yet over the forecast horizon growth doesn’t respond, they conclude that they haven’t been as easy as they thought. They then mark down what the neutral rate must have been, and then judge their current policy stance in relation to the new neutral rate. The effect of this is that in the Feds mind, policy rates at 0.5% could go from being thought of as very easy, to not that easy, if growth didn’t respond. Even though the principal author of secular stagnation Larry Summers is clear that it is a hypothesis, this is lost on the commentariat who treat it as a gospel fact that we are doomed to live out as Japan for the medium to long term.
But is It true? Is it relevant for the future? How much weight should one put on the whole premise? To our eye it’s an exercise in false precision. These are the issues as we see them.
Roger Alcaly wrote the following review of The Man Who Knew: The Life and Times of Alan Greenspan for the February 23, 2017 issue of The New York Review of Books.
Alan Greenspan served as chairman of the Board of Governors of the Federal Reserve System, the most powerful financial position in the world, for eighteen and a half years, from early August 1987 through the end of January 2006. The second longest-serving Fed chairman, his tenure largely coincided with a period sometimes called the “great moderation,” when economic growth was relatively steady, inflation low, recessions short and mild, and serious crises defused without debilitating downturns.
Under Greenspan’s leadership the Fed had an important and well-publicized part in containing threats to the financial system and economy such as the stock market crash of 1987, the junk bond collapse a few years later, the Asian crisis of 1997 with the deep fall in the value of Asian currencies, Russia’s default in 1998, and the bursting of the tech stock bubble at the beginning of the new millennium. Although it may have received more credit than it was due, the Fed’s successes earned Greenspan widespread adulation, including the Financial Times anointing him “guardian angel of the financial markets” and Time saying he was chairman of “the Committee to Save the World.”
But despite—or because of—his achievements, Greenspan and the economy were eventually brought down by his continued failure to contain financial bubbles, sharp rises in market prices that were not reflected in underlying values. That a sustained period of stability and success in imiting potential dangers would engender complacency and hubris among both policymakers and investors is hardly surprising. Even so, Greenspan’s overconfidence is deeply troubling, for he, like the economist Hyman Minsky, was well aware of the dangers posed by financial bubbles that develop during periods of great stability. Sebastian Mallaby’s new biography, The Man Who Knew, ultimately aims to assess how seriously this one great failure undermines Greenspan’s legacy. Continue reading
A while back I read a piece about political stability not being all it seems. It made the case that looks can be deceiving, and illustrated it something like this. Since 1945 Italy has had some 40 changes of prime minister. Saudi Arabia has had 6 rulers in the same period. North Korea has had 3. By that metric, Italy appears pretty unstable, while the other two look like oases of calm. But which keeps you up at night? For all the Machiavellian twists and turns in Italian politics, the political process has a way to reset the compression of the spring, to take out some of the tension every few years to stop it from popping, as the Italians turf out the incumbent and vote for a change. North Korea and Saudi Arabia on the other hand don’t have the mechanism, and need more and more pressure to keep it in place. The force underneath keeps on building though, the eventual reaction getting bigger. But that’s statistics for you – measured that way you get an answer on stability, but it’s probably the wrong one.
Everyone knows that bonds are rich. Right thinking people and smart beta types have looked for ways to get fixed income type results without buying bonds. At this point, it feels like bond markets are driving asset prices the world over. Negative interest rates have perversely led to bonds being used for capital gains while equity markets are being used for income. I’m pretty sure that wasn’t in the textbooks. Versions of these flows can be seen everywhere. Where bonds go, utility stocks, consumer staples, quality factors follow. Financials are the opposite of this flow, driven by net interest margins and return on equity. As bonds fall these stocks rally.
Here is a little thought experiment. Let’s compare the results of buying a basket of momentum stocks (single factor concentrated basket, price momentum) with the results of a basket tempered by volatility (2 factors, momentum (high is good), and volatility (low is good)). The difference between the two models shown below in blue, compared with the 10yr yield in red.
Hmmmmm… people love low volatility momentum stocks because they look like bonds. But as Minsky made clear, over time the things people buy for stability can become a source of instability. The seeds of the demise are being sown, the price moves have brought forward a lot of future income.
2nd quarter PCE is going to be 4.5% annual rate. Things are looking up. What if rates do go up. The exit door will not be wide enough.
Whatever your politics, one can’t help but be fascinated by the Trump phenomenon. One interesting aspect is how pollsters got Trump wrong. We can get insight into that mistake from Nate Silver at fivethirtyeight. To his immense credit, Silver admits he got Trump all wrong, and went back to have a look at the why and the how…. it boils down to a case of algorithmic aversion (see here and here).
Silver’s approach to forecasting, which has been extremely successful across a wide range of subjects, is based on aggregating data from multiple polls to build as big a sample as possible. It is a mechanical, quantitative, model based, statistical method. The model spits out an answer, and that is forecast. But in the Trump case, he over-rode the model. He had a bias, and in this instance he applied it to his forecast, and voila, a bad outcome. Even Silver, a devoted algorithmist if there ever was one, fell into the trap. He did not trust the model, even though it had been right so many times before.