Portfolio Update: Everything is awesome (for now)…Part I

To supplement the recent portfolio updates on some key positions, OM wanted to talk about his ‘market view’.  He’d normally spare y’all from this but it seems appropriate since the portfolio is the ‘riskiest’ it has ever been.  While OM’s broker’s limited metrics don’t show it, OM thinks of the positions in Brazil, Argentina, Greece and Uranium as being rather correlated and thus the portfolio is riskier.  In addition to the prevalent Emerging Markets risk, all are situations where the broad theme is similar; an element of stress/distress but a combination of fundamental valuation support and catalysts to change investor psychology offer opportunity.  Given the size of these positions, and the risk, Our Man is going to touch on the macro outlook, and then on valuation and psychology to hopefully explain why he’s so comfortable (at the moment).

Macro Outlook

Let’s not bury the lede, as we enter 2018 everything is awesome…

Our Man is a firm believer that recessions and crises don’t come from nowhere, and that there are warning signs for those who are willing to look.  This does not mean that recognizing the warning signs will be easy, and there will be mistakes along the way, but it behooves us to try.  With regards to the US, current data is uniformly rock solid; OM has posted the GDP graph below, but you could look at jobless claims, average hourly earnings, unemployment, inflation, etc. and the story would be the same.  Yes, most of these are lagging/coincident data (i.e. tells us how the economy was/is doing, not how it will do) but there’s no hint of a breakdown.

In terms of forward looking macro data, OM has historically found the Chicago Fed’s National Activity Index to be helpful and timely; it shows no sign of decline.  This is supported by other leading indicators out there such as the St. Louis FED's Leading Index for the US, the Conference Board’s Leading Economic Index and the Philadelphia FED’s state leading indexes.

The best market-based measure for recessions has been the inversion of the yield curve - when long-term Treasury yields are lower than the short-term ones - as it has been an accurate historical forecaster of past recessions.  The US yield curve has been flattening for the last couple of years and it is now at a level last seen before the Great Financial Crisis, which some see as an early warning sign.  However, as the graph below shows, the yield curve has historically inverted well before (i.e. 1-year+) any recession.  Thus, with the yield curve flattening but yet to invert, OM thinks there is more than enough time to enjoy the sunshine.

To summarize, the US continues to enjoy a prolonged spell of economic growth and is enjoying a “beautiful normalization” following the crisis.  What changed in 2017, was that this became a global occurrence; 2017 was the first year since the crisis that the global economy was operating at full potential.  This trend was visible across all regions and different economies, with World GDP growth at 3.0% comfortably outpacing the World Bank’s June expectations (by 0.3%).  Special shout-outs to Japan, which has had its longest growth boom since 1994, and Europe, which has rebounded strongly and where PMI’s suggest continuation in the near-term.

There are legitimate concerns for investors, but for now the economy is not one of them.  EVERYTHING IS AWESOME!!!

[OM will be back with Part II on Valuation and Investor Psychology tomorrow]

BREXIT and Power to the People

As noted, Our Man wasn’t particularly shocked by the Brexit result and given there have been numerous post-mortems, Our Man’s going to limit his thoughts. 

It seems pretty clear that “Leave” ran a much better campaign than “Remain”, starting off with just having a better and more productive name.  Strategically Leave had three prongs, (i) Sovereignty, (ii) Immigration, and (iii) Anti-status quo (and with the major parties both on the Remain side, status-quo has a wider scope than normal, i.e. politics/politicians/bureaucrats/etc); while immigration got all the attention (especially from the press and Remain campaign), sovereignty was much more important.  On the other hand, the Remain campaign’s strategy was primarily driven by the economic cost of leaving the EU (with a nod to apparent strategic benefits of being a member, which were never fully articulated).  The largest flaw in this being that using economic fear (even if justified) has a diminished impact, when the same population (if not electorate) have been exposed to it as the primary weapon in votes in 2014 (in the Scottish referendum) and 2015 (in the General Election).  People don’t have to be economic experts to figure out either (i) the world can only end so many times, or (ii) if the economy is so fragile that Scotland leaving/Labour getting into power/Brexit can each individually crash it, then there will be something else soon enough is Brexit is avoided.  Finally, on a tactical basis “Leave” had better leadership (say what you want about Boris/Gove and their behavior, but everyone knew who to listen to as opposed to Cameron/Osbourne’s the world is ending again, and Corbyn’s errr…errr…exactly) and a simple effective slogan (“Take Back Control”) that meant different things to different people (like Obama’s “Yes, We Can”, and Trump’s “Make America Great Again” – it’s hard to take the opposite side of a good slogan!).

While the campaign matters, the structural setting for a Leave vote was in place; it is readily apparent (to OM, at least) that there is the widespread popular discontent (be it in Greece, Spain, France, the UK and US) with the range of political choice offered and their policy prescriptions.  The widespread nature of this discontent is I think better understood by the population than by the political (and elite) class, and the attempts to ascribe it solely to immigration (more of a symptom) is reflective of this.   The lack of willingness to investigate and understand this discontent has helped create the opportunity for the populist characters on the left and right like Jeremy Corbyn, Nigel Farage, Bernie Saunders and Donald Trump.  Furthermore, the complacency shown by the major parties as these characters rose (due to their low quality and general incoherence), and still being shown towards Mr. Trump, reflects how badly the political class are underestimating the underlying message.  Finally, the distorting impact of QE on inequality and corporate incentives, has only added fuel to the fire of that dissatisfaction. 

That this manifested itself in a vote for Brexit, seemingly aided by stalwart Labour areas in England, should not come as a surprise.  For the last generation, as globalization and with it free trade and free movement of capital (with its negative impact on tax bases) have swept across the globe, the policy prescription has been to increase welfare to deal with the uneven impact.  Now however, the costs of welfare are becoming prohibitive both financially (on government budgets) and in terms of lost productivity.  While welfare is necessary, and one can easily understand how data and economic models suggest it is the best approach, Our Man suspects that likely reveals more about the models, and their over-valuation of the short-term than anything.  The extremes of the welfare state help foster a culture of dependency and while transfer payments help people live their lives, it constrains them to ones that are harder to develop meaning and self-respect.  Furthermore, on an economy-wide basis, it helps undermine productivity through the lost skills (and lack of development of new ones) limiting the economy’s potential.  In the fullness of time and with the repeated prescriptions of the same solution, these micro and macro factors swamp the easy fix of a cash transfer.

Finally, it is said that history rhymes, rather than repeats, and to that end Our Man has been surprised at the lack of mention of Britain’s exit from the gold standard in 1931.  After all, following 6yrs of austerity back then, Britain was the first country to come off the gold standard and its departure came after a naval mutiny (Invergordon revolt), which caused market panic and the Pound fell 25% in the aftermath!   Inevitably, it was deemed at the time to be sacrilege to leave the Gold standard, a tragic mistake from which the country would never recover and one that would doom London's financial centre.  Of course, it proved not to be in part due to the huge stimulus from that devaluation and within 2 years (1933) most other countries had followed Britain’s lead and left the Gold standard.

Now of course, we’ve just had 6yrs of austerity (Chancellor Osborne's first austerity budget was July 2010), and Britain voted to become the first country to leave the EU delivered by a different mutiny (the 2.8mn non-voters who delivered Brexit).  It too has caused market panic (albeit briefly), and (so far) the Pound has fallen 15% in the aftermath!   It’s also being called a tragic mistake, against the perceived wisdom of the day and London's financial centre is doomed.  Time will tell how different ending the UK will have this time…

Our Man, will return shortly, with some things he thinks in the aftermath of Brexit…

(Well) After Half-Term Ponderings

Our Man hasn’t written much in detail for a while, in part because real-life has interrupted and in-part because he doesn’t have much new to say.  However, now seems like a decent time to discuss the portfolio and the risks that Our Man is choosing to take.

The largest position in the portfolio, by some distance is the L USD exposure which (adjusting for leverage) represents almost 50% NAV, versus the Euro (mainly) and also the Australian Dollar.  The high-level premise is fairly simple; the long supercycle bear market in the US dollar, that began at the peak back in late-84/early-85 has come to its end.  The below chart (with OEW technical notation), from the excellent Tony Caldaro’s blog, gives some sense of this.

Post-2008, the US was the first country to undertake Quantitative Easing in substantial scale, and both of the most recent rallies (08/09 and 09/10) in the US Dollar ended just before the beginnings of QE1  and QE 2.  While the US was the first in, now numerous countries have copied this playbook and enacted their own versions of QE (e.g. Draghi’s actions since taking over the ECB) and other market interventions (e.g. Brazil introduced capital controls to stop the realstrengthening, only to ditch them just over a year later as the Real started to tumble).  Furthermore, this comes at a time when the Fed is discussing when to start reducing their ongoing QE, not whether to do more…or, in other words, being the first-out of the QE/manipulation game.  Ironically, after all the claims of emerging market’s superiority to the Developed world in a post-08 world, and their protests when the Fed started QE, it is of course the emerging economies that are seen as vulnerable to QE, something that’s already been seen in the spectacular currency moves in both India and Brazil over the last few months.  A second argument for US Dollar strength is the energy boom that’s beginning to occur in the US.  Oil imports represent 40% of the US’ trade deficit and a reduction in this need to import oil will help reduce the trade deficit, resulting in fewer dollars head overseas (i.e. reduced supply of dollars) to help fund reserves and meet any US$-based obligations.  Thus, unless there’s a sharp change in the demand for US-dollars, then it would suggest that the reduced supply would lead to an increase in the dollar.

So why the Euro and the Australian Dollar?  Our Man thinks they represent interesting opportunities, for different reasons.  The Australian dollar has been a big beneficiary of the China-driven commodity boom, with Australia’s exports to China going up almost 8-fold in the decade 2001-2011 driven by commodities (e.g. Iron ore & concentrates exports increased from A$1.4bn to A$44bn over the same time period).  Given Our Man’s bearish view on China, and by extension commodities, it’s easy to see why being long the USD versus the Australian dollar is a large part of the China thesis book.  To help offset the risk that Our Man is wrong, and that China could fund another stimulus (like 2009) which will once more boost their domestic demand and need for commodities, Our Man has a small long position in Chinese A-Shares as with the crackdown on various banking products, the domestic equity market could also benefit from such a stimulus (like the US equity market has since QE started). 

With Europe’s economy still fragile, especially in the periphery, the probability is that monetary policy will remain accommodative there even after the Fed has started to taper.  However, the size of the long USD vs. Euro position, in the Currencies book, overstates the portfolio’s exposure to this position as the European equity exposure partially counteracts this (i.e. those ETFs are long Euro, short USD).  This European periphery exposure (in the Other Equities book) represents the second largest exposure within the portfolio.  It is also the riskiest, given the magnitude of potential losses in the instruments held.  While Our Man expects the economic and political newsflow from Europe to continue to be somewhere between mediocre and bad, it’s both unlikely to be disastrous and also largely priced in.  As befits positions that are likely to be held for the long-term (read: multi-year), little has changed since Our Man entered the positions at the beginning of the year; peripheral Europe is somewhere between very cheap (Spain and Italy) and extremely cheap (Greece) on long-term measures of value.  While these are positions that are going to be held for a multi-year period, they are also particularly volatile and so the position sizes will be changed more regularly (i.e. a couple/few times a year, so don’t expect much ‘trading’).  With Greece & Spain both seeming to have put in long-term bottoms (in mid-late 2012) and having a favourable technical picture, they’re sized noticeably larger than Italy.  It should be noted that, as the ever astute Josh Brown observes, this positive view on Europe that has steadily started to become more prevalent, during 2013.

Elsewhere, the risks in the portfolio are relatively limited.  The Absolute Return Funds book represents a decent amount of capital, but its risk is much smaller – something that can be seen by its limited negative contribution despite the large recent run-up in bond yields.  The Value Equities book, probably carries more risk in its 2 positions with both THRX (further drug approvals) and DRWI (orders for build-out of 4G) having important events occurring over the next 6-12mos.  Finally, the total exposure in the Alternative Energy, Puts/Hedges and NCAV books is minimal at this point.

After Half-Term Ponderings

After a flat first half, there’s not a vast amount to analyze with regards to the portfolio’s performance.  As such, this year’s half-term ponderings will focus on some (half-formed?) thoughts that have been germinating in my mind. 

- More QE – everywhere?

While the summer has largely been very quiet, the one thing that stands out is the increased likelihood of more quantitative easing or stimulus across the globe.  We’ve had the continual hints of QE3 from various Fed doves, and the market remembers Bernanke’s 2010 words at Jackson Hole that signaled QE2 while it waits for him to speak at the same venue on Friday (my guess is he’ll talk the market up, but we won’t see QE3 enacted till December’s Fed meeting).  More surprising was ECB President Mario Draghi’s July promise to “do whatever it takes” and claims that this action “will be enough”.  This being Europe, it goes without saying that “whatever it takes” depends on what country you’re from and the political dance matters as much as the promises; we wait to see what the reality of Draghi’s promise is and whether it’s enough.  Finally, there’s China where the data continues to come in weak, which has led to hopes of another 2009-style round of investment spending and stimulus.

Frankly, the fact we’re now discussing yet another round of QE should be sign to the Fed that they’re pushing on a string and that the previous rounds have failed at stimulating any sustainable growth.  However, I’m sure they feel the need to do something and the world of the counter-factual (“imagine how much worse it would be without QE1/2/Operation Twist/etc”) that they inhabit no doubt provides reason enough to try more unorthodox policy in the hope something works.   It’s no surprise that I’m skeptical about there being any medium-term benefits (despite the long-term costs).  However, with global QE/stimulus seemingly coming and the portfolio not particularly well positioned for it, Our Man’s added a little Gold as a 6-12month ‘trade’. 

- Has the Fed succeeded, at least on one psychological level, by turning everything into a yield asset?

While there’s much debate over the whether QE1/2/Lite, Operation Twist, et al have succeeded in generating any sustainable economic growth, they have succeeded in getting investors to focus on yields.  This is evident across markets, from the obvious places such performance of Investment Grade bonds (LQD: +9% YTD) and High Yield (JNK: +7.5%) to the keen focus on dividend yield stocks and on potential rental yields in the housing market.  By persuading investors to reach for yield, and kindling their animal spirits the Fed’s moves can be seen, so far, as a success by helping to drive a range of asset prices higher and endowing people with the wealth effect.

The problem, of course, is that by encouraging investors to “reach for yield” the Fed is also trying to persuade them to focus on return on capital rather than return of capital, and thus take more risk.  What do I mean by this?  Let’s take the simple examples: much has been written about how “cheap” stocks are, either due to their earnings yield (inverse of P/E) or their dividend yield.  As these yields compare very favourably to the low yield on a 10-year Treasury, the argument goes that one should own stocks.  After all, a 10-year Treasury yields a mere 1.6%, why wouldn’t you want to own the S&P 500, which has a 2.1% Dividend Yield, instead.  The answer of course lies in the risk you’re taking to earn those yields, or more simply – bond math matters.  In bond-world, a major risk metric is duration which simply tells you the weighted average of the time that the cash-flows from an asset are received.  For a 10-year Treasury bond this figure is between 7-8years, for the S&P based on the dividend yield it is 30-40years, hence in the world of bond-math you’re taking 4-5x the risk to own the S&P.  Suddenly, that extra 50bps/year of extra yield doesn’t quite look as attractive… 

- Earnings: But what about the margins?

Our Man has long been surprised at the resilience of corporate profit margins, which have hovered around historic highs for the l2mos and whose strong bounce-back from 2008/9 has driven Earnings-growth and been an important contributor to the rally in stocks.  Interestingly, we’re now starting to see Earnings-growth falter for the first time post-2008, with YOY Earnings growth turning negative in Q2-2012. 

This fall has also started to impact analyst projections for the upcoming quarters, which have steadily fallen throughout the year. 

Given the falling Earnings, and with margins at historic highs, it means that the market is relying on either multiple expansion or the quick reversion of this trend to help it go higher.  That should sound a note of caution to investors.

- Ideas: what’s Our Man looking at?

As is traditional a little note/insight, albeit brief this time, into some of the new things that Our Man is pondering and spending his free time looking at.

a). Europe:  There are signs, like this Global Shiller/CAPE analysis by Mebane Faber, that Europe is approaching the boundary being potentially very cheap.  While a number of European countries certainly look cheap comparative to other OECD nations, Our Man is keen on looking at them versus their own history before declaring them absolutely cheap and looking to invest.  Given Our Man is limited to US-listed positions, any future positions will largely be ETFs or potentially some ADRs.

b). Possible Puts/Shorts:  Generally, Our Man can only short using puts and predominantly has to use ETFs to get his exposure.  That said, I’m looking at few things that might be interesting.  The fall into two main buckets; (i) Stocks which have benefited as investors chased yield and may offer opportunity if the dividend isn’t as secure as it seems on the surface (areas of interest include REITs and some Consumer Staples/Telecoms), (ii) stocks where the drivers of growth are misunderstood or where the forward-looking expectations are particularly unrealistic (the two names, in particular, that have drawn Our Man’s interest are Lulu Lemon and Tesla, although Apple is, or rather one-day could be, potentially particularly fascinating)

It's Okay to Not Know...

“[T]here are known knowns; there are things we know that we know.

There are known unknowns; that is to say there are things that, we now know we don't know.

But there are also unknown unknowns – there are things we do not know, we don't know. ”

— US Secretary of Defense, Donald Rumsfeld

While I was never much of a fan of Secretary Rumsfeld, it always struck me as peculiar the people took such issue with this statement as it seems a fairly logical distillation of a rather complex thing.  Given that a number of Our Man's friends, acquaintances and contacts are in the financial world, it's even stranger that folks criticized the statement as it would seem to me that unknown unknowns could just as easily be called Black Swans.  Though, I suppose it was made in a pre-2008 world when black swans weren't as popular a topic.

So, why bring up Secretary Rumsfeld’s quote now?  Well, despite what you might hear if you have the misfortune to tune into CNBC, it’s okay to not know or have any conviction in a particular outcome.  It is however, important that you realize that you have limited conviction and behave accordingly.  We’re taught that if we do the “work” – if we research, think about and analyze a problem – we’ll find the answer (i.e. reach a conclusion in which we have conviction).  It’s those known unknowns and the pesky Black Swans (unknown unknowns) that mean this isn’t the case in reality.

I bring this up because Our Man’s portfolio continues to run relatively low exposure and the performance is where it has been all year, roughly flat.  The low exposure is a reflection of my lack of conviction; that I don’t know.  On the Equity-side, this is easy to explain – while the current positions have sufficient assets or earnings to make them ‘cheap’, most of the driver of future returns is based upon some form of change or future growth.  While I believe that you’re paying little to nothing for this growth and/or I’m more positive on the probability of its occurrence, potential size, and proximity, it’s also very likely given their uncertain nature that these factors will be influenced by the macro environment.  Thus, the positions are undersized to reflect my well-known macro skepticism.  What will cause the equity book to grow?  Well, a change in the macro conditions, a change in the risk/reward in existing names, or adding new names or a theme to the book; expect to hear more on these topics soon.

So, if I’m bearish, why are the Puts/Hedges and China thesis portfolios so small?  Well, for the following reasons: we’re not there yet and the Fed (and other Central Banks).  While my bearishness is unchanged and the economy remains relatively weak (and I think noticeably weaker than people realize) it isn’t yet absolutely weak.  As discussed before, my two favourite indicators for getting a sense of where the economy stands today are the Philly Fed’s Aruoba-Diebold-Scotti Business Conditions Index and the Chicago Fed National Activity Index. 

The second reason is the Fed who have shown a belief that throwing liquidity at problems will solve them, despite the lack of evidence that it does any more than provide a temporary sugar high while potentially creating greater distortions in the markets.  However, their willingness to do so seemingly every year (surely a sign of its outstanding success) means that there is a higher bar required (i.e. the economy must be weaker than historically) or signs of greater exogenous weakness (China and Europe) before I’m willing to increase the size.  

In short, my current level of conviction is relatively low ("I don't know") and thus the portfolio's level of exposure is low. So I'm spending my time doing two things (i) waiting for the data to change and help me build some short-medium term conviction in the existing theses, and (ii) looking into, researching, thinking about and analyzing some new ones.  When I've either built greater conviction in the existing theses or am close to putting new ones into the book, then this blog will become more lively and the portfolio's exposure and risk will start to increase.

After Half-Term Ponderings: Where Our Man stands

Our Man has raised a lot of cash in the portfolio over the last couple of months, largely as a result of the exiting most of his Treasury Bond positions as yields fell sharply (and prices rose).  This, of course, leads to the question…what’s he going to do with it?   To get to the bottom of this, it would help to know what Our Man’s baseline macro views and expectations are as well as where and when he’s looking to take some risk.

While there has been positive news in recent weeks, it has done little to diminish Our Man’s bearish mindset.  Unfortunately, despite the talk and the plans, Our Man believes we’ve reached the point where the size of the problems we face is beyond the scope of the politicians and central bankers to solve.  As regular readers will know, Our Man believes we’re in a balance sheet recession; there are no simple and easy solutions to a debt-driven crisis.  Thus while the talk is about just how massive and impressive the latest European bailout plan is, to Our Man it is merely reminiscent of Paulson’s bazooka talk in the Summer of 2008.  The mere idea of leveraging Germany, France et al’s commitments to the bailout fund fails to acknowledge the simple premise that this is not a liquidity issue but a solvency one, and that the problem of excess debt cannot be solved by the issuance of (and increase in) more debt.  So, while more banks will be bailed out (without debt holders being haircut) and there’s the possibility of QE3 from the FED or some minor stimulus program in the US, once more the moves will only solve an imaginary counter-factual (if we’d not done this, then things would be worse) without encroaching on the real world issues. 

For equity investors, the long-term impact of the steady increase in leverage (especially since the 1980’s at the household level) has helped smooth economic cycles and led to numerous distortions in the market.  Furthermore, whenever the economy slows down, politicians & central bankers have become accustomed to using measures that foster an increase in debt (think lowering interest rates so you can refinance your home, or take out a loan, more easily) as their policy of choice.  The problem now is that despite record low interest rates and ample liquidity (thanks to the Fed’s rate cuts, Quantitative Easing, Operation Twist, etc) loan growth continues to be stagnant; there is no demand!  This lack of demand and the deleveraging, through both default and increased saving (i.e. reduced consumption), is something that equity investors should pay attention to. 

In the longer-term, as Our Man has mentioned before, with interest rates losing their potency (now we’re stuck at 0% rates) and demand stagnant, it becomes less likely that policy makers will be able to smooth the economic cycle.  As such, we should expect the choppier growth of recent years rather than the consistent economic cycles we’ve become accustomed to.  Furthermore, the disinflationary tendencies of a balance sheet recession mean that pricing power is likely to be more curtailed (no demand means it’s harder to push price increases through).  Combining these factors, means that over time Our Man is expecting stocks to exhibit greater cyclicality (as the magnitude of the cycles becomes more pronounced) and also to exhibit greater volatility (as the cycles become less smooth and more choppy).  These are, of course, the enemies of the buy-and-hold and value-driven investor.  The volatility affects the investor’s ability to hold his position from point A to point B, and means that the flight-path becomes as important as the destination.  The increased cyclicality will lead to a derating of equities as a greater risk premium should be introduced by investors to account for the more cyclical nature of equities but also due to investors’ long-term expectations proving overly ambitious (due to the deflationary/disinflationary environment limiting pricing power).

In the short-run, none of this would matter if stocks were at low valuations and margins were at or near cyclical lows.  Sadly, as the recent Chartology posts showed, neither is the case.  Now, certainly the use CAPE (or Shiller P/E’s) isn’t flawless, but like other long-term measures of valuation (e.g. Tobin’s Q), it does have a strong historical track record of long-term success.  So why does Our Man use the CAPE?  Well, it’s cyclically-adjusted…the Earnings part of the equation has been smoothed for a cycle, meaning the margins are those that reflect a full cycle (not a point in time) and that the figure takes into account the write-offs that inevitably come from the irrational exuberance of the peak.  Bear these factors in mind, when you next hear a Wall Street talking head say the market is cheap based on forward earnings (or even more egregiously forward operating earnings, which pretend we live in a fairytale world and ignore all the write-offs/etc).  Not only is the analyst assuming that the margins (currently at a record high) will persist at their current level infinitely, they’re not even using the actual earnings but their projections of the future which they then compare to a historical norm (i.e. the market’s average Price-to-(trailing) Earnings, or PE, is 15)!

So, in short; the underlying major issues are not being tackled by the politicians/central bankers, equities are going to be more cyclical & volatile (and thus de-rated, or trade at lower multiples) in the future, and they’re also currently trading at high valuations at a time when they have close to record high margins.  I think it is clear that Our Man’s bearishness remains undimmed.  However, with the increased cash and limited exposure in the portfolio, this bearish is not currently being expressed in any major way.  When will that change?  How will he express it?  Those, my friends, are questions for the next post.