Portfolio Update - (Early) October 2017

Portfolio Update 
- Thematic - Vietnam:  OM took advantage of the recent sharp market moves to add to the position in Vietnam, bringing it from a small/starter position (2-4%) to a more medium-sized one (~6-8%) within the thematic book.  While there has been much talk about a slow down in global growth and concerns over the future of global trade, it’s important to recognize that countries start from different places.   For the long-term, it’s likely much better for Vietnam to have a trade agreement with the EU (such as the one signed this week) even if there’s uncertainty regarding global trade, than it was not having one over the last few years (when global trade saw fewer issues).  Ceteris paribus, Vietnam is likely to continue to increase in size within the portfolio over the coming year. 

- Technical Book: Unsurprisingly, after decorating the field with yellow flags in the second half of September, OM’s technical model flashed a second sell signal.  OM used the bounce earlier this week to exit the technical book’s positions.  Initial analysis suggests the probable scenario is more like the pull backs in 1984 and 2015/2016 - ~6months of 15-20% - rather than some of the grander falls.  However, the mantra of the mentor within OM’s technical group is worth stating – “Project, Monitor and Adjust”.  These initial scenarios are just that…probabilistic projections, to be monitored and adjusted to the reality that prices are showing us. 

- Dislocations - Brazil:  OM used the market strength to exit ~2/3 of the Brazilian position, reducing it to a 6-8% position.  Brazilian stocks rallied strongly into the first round of the election (Oct 7^th), and have continued rallying in the week or so since on the back of Jair Bolsonaro’s exceptionally strong performance.  Bolsonaro is view as the most ‘market friendly’ candidate and is now the clear favorite in late October’s two-person second round. 
Why exit now?  Well, risk and uncertainty.  For all the various global politicians described as “the Trump of XYZ”, Bolsonaro is the best fit; while the market may like his Finance Minister and approach, there are other significant questions and risks surrounding a Bolsonaro Presidency.  With the ETF at $38-40 today compared to the $30-32 of a month ago, more of this risk is embedded in the trade today.  Add in the uncertainty of the market environment (see Technical Book above), especially in Emerging Market countries (see Argentina’s issues over the last 6mos) and Brazil fails to justify being an outsized positions. 

- Idiosyncratic – TPL: OM further reduced to the TPL position, selling another ~30% of the original holding for the same reasons as discussed in the last quarterly update, which leaves a 2-4% position.

Portfolio Thoughts 
Some brief thoughts on the portfolio:
- The below notwithstanding, the portfolio changes mean that OM has likely locked in this year’s performance as a negative number (and most likely -5% to -15%).  That’s a strange feeling!  
- If OM’s current expectations are correct, it’s going to be vital to take advantage of having a lot of cash to buy at attractive prices and earn out-sized returns.  That will be a harder decision that the ones over the last few weeks.   If OM is wrong, and the market rallies away to much higher highs…the performance is going to really really suck both absolutely and relatively!!  I’ll say it now, OM is comfortable with that…he’d regret it MUCH more if he ignored the signs he’s seeing, did nothing and the market pulled back.
- Though the portfolio is only ~56% invested, it is heavily biased towards Emerging Markets.  As a result, OM expects the portfolio will have a higher beta and potentially a negative skew in the coming few weeks.  The higher beta means that the portfolio will behave like it’s more heavily invested (e.g. 66-75%), while the negative skew means it will likely capture a little more of the downs than it will of the ups.
- The negative skew is potentially the most concerning, if it reaches an extreme (e.g. capturing 50-60% of the market’s upside but suffering 90-100% of the downside).  This extreme is most likely to occur due to a rally in the dollar; a US-listed ETF (holding foreign country stocks) would suffer both from the fall of those stocks and also the dollar movement.  Suffice to note, this is a risk OM is monitoring and currently comfortable with.
- OM has a LOT of ideas so expect some half-baked ideas posts in the coming weeks, including a Short/Hedge and a Dislocation.
- OM will be ☹ if Greece isn’t a large/outsized position & huge contributor next year. 


Portfolio (as at 10/17/18 - all delta and leverage adjusted, as appropriate) 
Dislocations: 20.8% 
9.6% - Uranium (URA, and NXE)
6.8% - Brazil (EWZ, and EWZS)
4.5% - Greece (GREK, and ALBKY)

Thematic: 20.8% 
6.9% - Argentina (PAM, DESP, and AGRO)
6.1% - Vietnam (VNM)
5.5% - Tech: 4^th Industrial Revolution (JD, VIPS and IBB)
2.3% - India (IFN)

Idiosyncratic: 14.8% 
11.5% - Funds (CWS, GVAL, and CAPE)
3.3% - Equities (TPL and FNMA)

Shorts/Hedges: 0.0%

Technical: 0.0%

Cash: 43.6% 

Disclaimer:  Nothing above represents a recommendation in any way, shape or form so please don’t even think of trying to take the above that way.  For added clarity, while Our Man is invested in all of the securities mentioned that’s a terrible reason for anyone else to do so.  Our Man also holds some cash and a few other securities (of negligible value).  You should not buy any of these securities because Our Man has mentioned them, but should do your own work and decide what’s best for you given your own circumstances/risk tolerance/etc. 

Portfolio Update: Everything is Awesome (for now) - Valuation & Psychology Edition...

(Apologies to all who are getting this for a second time, there was a small issue with the blog which corrupted the original post).

As regular readers know, the market-wide valuation measure that OM pays the most attention to is Professor Shiller’s Cyclically Adjusted Price to Earnings (“CAPE”) ratio.  Like all measures of valuation it unquestionably has flaws – as some kind folks point out here, here and here – so bear that in mind as you read on! 

Source: multpl.com

First off, the headline CAPE numbers are pretty scary; valuations were only higher during the 1999/2000 Technology bubble, eek!  Wait, but OM’s just spent some blog posts telling you he owns a bunch of risky distressed and/or emerging markets stuff like Brazil, Argentina, Uranium and Greece, and that everything’s awesome – this makes no sense!  Worry not kind reader, OM has not taken (complete) leave of his senses; yes, this chart does look horrific.  But…it is a data point, not a fait accompli, and like many good data points the value is in the context and nuance.

OM is a fan of CAPE, but he accepts it for what it is; a fine measure of long-term value that’s a good guide to long-term (10-year) returns.  Crazy, I know, that a measure that uses 10-years of adjusted data is best used at predicting things over a similar long-term span.  What CAPE is not, and the same holds true for every other valuation measure, is a good indicator if markets are about to crash (or rally).   So the next time you read an article saying “CAPE = X therefore Markets = Y”, or your favorite pundit is filling his 60 second slot on TV with “CAPE didn’t predict (or peaked after) X or Y, and is thus flawed” then for your own sake ignore them.  Sadly, we’re in age where common sense requires data to be believed so OM won’t just ask you to trust him on this.  Fortunately, we’re also in an age where the answers are available if you’re willing to look.  In this case, Vanguard comes to OM’s data-rescue with this most helpful chart from 2012 that shows CAPE is a pretty good guide on long-term returns and everything sucks at predicting next year's.

Source: Vanguard

So, onto the nuance.  It’s January 2018, so (the most updated) CAPE calculations are based upon data from Q4-2007 through Q3-2017.  As Q4-2017 earnings are announced in the coming weeks, they will replace the inflation-adjusted Q4-2007 numbers and as 2018 progresses the 2008 numbers will drop out of the 10-year look back.  Well, pre-crisis earnings peaked in Q2-2007 and during the Great Financial Crisis they fell 90% to trough in Q1-2009.  As the data from the Financial Crisis drops out and is replaced by today’s earnings, the Earnings part of the CAPE is going to look a whole lot stronger.  Folks have tried to model/show the specifics but what matters is that CAPE is going to fall over 2018 (and into 2019) unless either (i) the stock market is up a lot (the P in CAPE), or (ii) something happens to decimate Earnings immediately (i.e. think more nuclear attack, rather an economic recession which needs time to impact things). 

What intrigues OM is the potential change in sentiment (dare he say narrative) from a “CAPE is crazy high” to a “CAPE is high but falling” world.  While fundamentals (and value) provide underpinnings for great returns, it is sentiment and especially sharp changes in sentiment that create the necessary conditions for those returns.  Distressed situations – including Brazil, Argentina Greece, and Uranium – are plays on people’s fear, and it is the depressed valuations coupled with the shift from “this is abysmal” to “there’s challenges, but this is not too bad” that creates the returns.  Today, for the broader markets that are fairly (to expensively valued) it’s the move from “things are pretty good” to “everything’s awesome” as investors’ greed sees them extrapolate out all the trends and find ‘good’ reasons to ignore the warning signs.  While we are still some way from speculative excess, OM thinks he has started to see increasing signs of people wanting and starting to believe…Here are some signs that have piqued OM’s interest.

• Global Economic Growth:  As the first post noted, it’s the first time in a LONG time that everything’s looking pretty rosy globally.  Don’t underestimate what not hearing about economic strife does to people’s risk appetites.  The longer it continues, the more likely people are to extrapolate and expect the good times to roll.
• Length of the recovery:  This has been a long recovery, and a key argument against it has been that it has been very uneven with metropolitan areas doing well, while the rest of the country failing to keep up.  The sheer length of the economic rebound coupled with the demographic trends (people leaving the NE/Midwest for the South and West) means this will naturally change.  Conor Sen wrote a timely piece on this, and it plays neatly into the next point.
• President Trump: Whatever one’s opinion of the President, I think we can all agree that (i) he likes to be flattered, and (ii) that he enjoys taking credit for anything that goes well.  Hence, good economic facts and rises in the stock market are worth Twitter victory laps.  Under President Trump, EVERYTHING IS AWESOME and if it’s not its (pick a group)’s fault and only he can fix it.  It doesn’t matter whether it’s true, if the data keeps rolling in then he will keep saying it.  If you say it long enough, then people might even start to believe it – the signs are that they already do!
• 2008 (and especially 2000) fades from memory:  The further we get from 2000/2008, the easier is to forget the lessons and attribute the events to foolish other people or our naive younger selves.  There’s a reason why there’s a popular misquote about history rhyming.
• Corporate Margins & Tax Cuts:  Corporate margins are near all-time highs, and Congress has just passed a healthy tax cut designed to benefit corporations yet more.  This will be good for corporate earnings, and Our Man suspects that (in the short-term at least) a little of it might even find its way into wages.  Not too much, of course – since wage rises are regarded as bad for corporations and by the Federal Reserve – but enough to make the wage earners feel a little happier and more optimistic.
• Deals: We’ve started to see mega-mergers and IPOs reappearing, the bigger and more publicized these get the nearer we’ll be to the end of the road.
• Big Tech:  In Things From My Newsreader, Our Man mentioned the pushback that bit tech was starting to get.  These firms continue to receive every increasing amounts of media coverage (both positive and negative), and while the companies are starting to get some pushback, the stocks (and those of international peers, e.g. Tencent) continue to rise inexorably.  If Our Man is right, these trends will continue so expect to hear a lot more about Amazon, Apple, Google, Facebook, Netflix, Tesla, etc and how they’re going to change the world, how they’re ruining the world, and how much their stocks keep rising.
• Cryptocurrencies:  Our Man suspects that we’ll look back at cryptocurrencies as the tinder that helped fully unleash the animal spirits.  The blockchain is a great concept but early in its lifecycle (like the Internet in the late 90s) and much is still to be proven and determined.  Thus at this stage it’s a better narrative than product/tool and like all good ideas, it’s ripe to be extrapolated to beyond its current limits.  While the claims of grandeur may come true, it’s already at the stage where it has true believers insisting that it will change the world (Everything will be AWESOME!).  The world we inhabit means their $ profits validate these opinions, and just in the last couple of months we’ve seen a broadening out as people’s greed and FOMO see them join the party.  After all, Coinbase now has more accounts that Charles Schwab.

Final Thoughts

So in summation, get ready!!   OM’s working theory* is that if 2017 was the slow and steady chug to top of the rollercoaster, 2018 (into perhaps 2019) is going to be the insane part, with much more volatility and the possibility of much much higher prices.  It goes without saying, that Sod’s Law dictated that while OM put-off completing this piece over the holidays, someone far smarter and more productive came out with a better (and more aggressive) version of it.   Read value investor and bubble historian Jeremy Grantham’s piece – it’s great and OM hopes he’s right.

* As a ‘sensei’ of OM would say; have a working theory you believe in and then project, monitor and adjust.  In that vein, expect a future post with a list of things that OM is going to be keeping his eye on to help him work out if he’s wrong.

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]