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.”
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.
St Louis Fed President James Bullard has released a paper detailing a revised approach to economic forecasting. It’s a very smart way of looking at the world – read it here. Briefly, he is saying that the current way of viewing the world as converging to a single state is no longer useful and instead should be thought of as a set of possible regimes the economy could visit, with the regimes being generally persistent, requiring different monetary policy responses, and switches between regimes as not being forecastable. In his submission to the FOMCs quarterly economic projections, he declines to provide a forecast for the ‘Long Run’, as it is outside his model projection range. His low projection of the Fed Funds rate over the coming years reflects his view that the present regime has a low neutral real interest rate, a switch to a higher regime is unforecastable. If it were to happen, it would cause a change to many variables – policy would not reflect a gradual shift to a single state, but would have switched regimes.
This approach to forecasting was pioneered by James Hamilton. The math is pretty complex (lots of markov processes, etc.), but here is a simple way to look at it. Suppose we have two possible states in the world, the bull state and the bear state. The variable that determines the state is unobservable, and since you can’t see it, you can’t forecast it. Suppose in the bear state that the daily returns to an asset, like the stock market, are selected from a normal return distribution with a negative mean. Conversely, in the bull state, the mean is positive. If the state variable is pointing at bear, the trend will be down, if bull, the trend will be up. The trendiness of a market is determined by how likely we are to remain in the current state. For example, if the probability of jumping from one state to another is 5%, trends are more likely to persist than if the probability were 20%. What causes the state variable to jump is unknown, as Bullard describes.
Macro trades come in two flavors, modern and classic. Modern trades are short term, liquidity driven, mean reverting market dislocations. You stare at the screen, pounce, make or lose your money, and exit. Symmetric risk, big premium for risk management and timing. Classic trades are long term, cyclical shifts in the investment landscape. Classic trades take advantage of the myopic nature markets – extrapolating the present. Classic trades have the potential to make big money, because the risks are asymmetric and the herd is against you.
We think we see a macro classic – inflation. Take a look at this study from the St. Louis Fed… https://www.stlouisfed.org/on-the-economy/2016/february/future-oil-price-consistent-inflation-expectations. Current inflation expectations imply a future crude oil price of $0 under a semi-reasonable set of assumptions. Quibble with the model if you like, but you cannot escape the fact that current market pricing anticipate little future inflation. Am I able to predict what will drive future inflation….No. Like the card counter in blackjack, however, the deck sure looks rich.
Certain funds that Mount Lucas manages may or may not, from time to time, have positions which seek to realize an exposure to future inflation. There is no guarantee that such positions, if established, will be established timely and exited profitably.
Is the Fed the world’s central bank or a domestic institution? As we see it, this is the key question for the Fed at its next meeting. The economic data since the last meeting, looked at in isolation, should lead them to continue hiking the Fed Funds rate – simply put, the unemployment rate now stands at 4.9%, and inflation has made further progress back to the target with core CPI at 2.2%. The charts below show the progress toward the dual mandate. On the employment side we look at the unemployment rate against the NAIRU measure. On the inflation side we use the sticky and flexible price series.
The BLS Quarterly Census of Employment and Wages, collected from unemployment claims data, provides the Labor Department with a comprehensive view of the jobs and earnings market for the U.S. economy. The first quarter 2015 survey covered over 9 million establishments employing a total of over 135 million employees—around 98% of the total population of individuals on company payrolls. In contrast the non-farm payroll series surveys a small sample, 143,000, of the population of 9 million establishments.
When I started at Commodities Corporation in 1979, we managed $100MM dollars. We had computers that sat on raised floors in climate controlled rooms. We were state of the art….and we still had 100 employees. Alas, fees were higher, but my point is that advancing data availability and data processing has been a boon to the investment industry.
But there has been an unmistakable downside to all this power and information, what my partner Roger has christened “false precision”. Everyone has lots of data and the power to manipulate it with ease. All questions can be answered with “hard numbers”. Risks can be fully calibrated (see previous post, A Note on Risk). Nowhere has this thinking reached more heroic levels of absurdity than at your Federal Reserve. From a Chairman Yellen speech, circa 2012:
Although simple rules provide a useful starting point in determining appropriate policy, they by no means deserve the “last word”–especially in current circumstances. An alternative approach, also illustrated in figure 10, is to compute an “optimal control” path for the federal funds rate using an economic model–FRB/US, in this case. Such a path is chosen to minimize the value of a specific “loss function” conditional on a baseline forecast of economic conditions. The loss function attempts to quantify the social costs resulting from deviations of inflation from the Committee’s longer-run goal and from deviations of unemployment from its longer-run normal rate. The solid green line with dots in figure 10 shows the “optimal control” path for the federal funds rate, again conditioned on the illustrative baseline outlook. This policy involves keeping the federal funds rate close to zero until late 2015, four quarters longer than the balanced-approach rule prescription and several years longer than the Taylor rule. Importantly, optimal control calls for a later lift-off date even though this benchmark–unlike the simple policy rules–implicitly takes full account of the additional stimulus to real activity and inflation being provided over time by the Federal Reserve’s other policy tool, the past and projected changes to the size and maturity of its securities holdings.
Lord have mercy! Can she really think this can work? Is there any Fed model that caught 2008, 1998, 1987, or any other market moving event? This is the event horizon of the false precision black hole. But don’t worry, just throw a bunch of junk mortgages in a bucket, stir, and voila – AAA. It’s all right here in this spreadsheet.