Last week we wrote (emphasis added):
“The near-term risk to the short-term up turn is the oil and gas sector.
In June, there were 20 very large crude carriers (VLCCs) in queue at the Qingdoa port in China. This has forced VLCCs arriving at the port to wait for up to three weeks before being able to discharge their cargoes. If these queues lead to a shortage in availability of tankers, oil producers will have little choice but to dump production on to the spot market, which would cause another sharp drop in the price of crude.
As long as OPEC and Russia continue to adhere to production quotas agreed with President Trump, we do not expect this risk to materialise.”
From the Financial Times (emphasis added):
“Opec and Russia are primed to start unwinding the record oil supply cuts agreed earlier this year, as they aim to raise production without undermining a recovery in crude prices.
The oil cartel and its allies are set to scale back the cuts of 9.7m barrels a day that took effect in May to 7.7m b/d from August, Opec delegates said on Wednesday.
It would be the first test of their ability to start returning to the market the equivalent of almost 10 per cent of global crude output, which was removed this spring after Covid-19 lockdowns and travel bans crushed oil demand.
[…]
But adding back production is a delicate act, at a time when new coronavirus cases in the US and elsewhere are soaring.”
Identifying risks is just one aspect of understanding the macro environment, correctly estimating the probabilities of said risks being realised is the other and arguably the more important aspect.
We certainly underestimated the oil cartel’s desire to dial back production cuts.
That being said, given the increasing probability of another wave of rising infection rates, particularly in the US, we fully expect oil exporters to take a cautious approach towards bringing supply back. We do, however, expect volatility in the energy market to increase given the unwind cat is out of the bag. In turn, we expect this to translate into higher realised volatility in other markets as well, particularly equity markets.
In all likelihood, we have entered the most precarious phase of the bull market where both bulls and bears are likely to suffer occasional losses as volatile markets whipsaw traders in and out of their positions.
On to the update, we look at something a little different this week — something closer to home.
Complexity: Singapore’s Struggle Against Dengue
The Aedes species of mosquitoes is a carrier of the dengue virus — a common viral infection active in more than 100 countries, representing roughly 40 percent of the global population. In many of the 100+ countries, dengue is often the leading cause of illness. The more severe forms of dengue can be fatal if not treated.
Incidents of dengue have increased 30-fold in the past five decades, according to the World Health Organization. It has expanded from causing severe epidemics in just nine countries before 1970 to the more than 100 countries today, most of them in Asia and Latin America.
Singapore is a place with a warm and tropical climate — ideal for mosquitoes. The local population generally remains at risk of contracting dengue fever.
In late 2017, senior government officials in Singapore released 3,000 mosquitoes into the open air. These mosquitoes were special — they had been altered in the lab, supposedly rendering them harmless or infertile with Wolbachia, irradiation, or genetic modification. The released mosquitoes were all male. The officials involved in the exercises were making an attempt at suppressing the population of mosquitoes across the island — males infected with Wolbachia are unable to fertilise the eggs of non-infected females. As an added benefit, male mosquitoes do not bite.
Following Singapore, lab studies or field trials involving Wolbachia-infected mosquitoes were undertaken in a dozen more countries.
Fast forward two-years, a new mosquito breeding production facility was unveiled in Singapore in December 2019. The facility aims to breed approximately five million Wolbachia-carrying Aedes species of mosquitoes per week.
A further six-months on, the city-state is on track to face its worst-ever outbreak of dengue. More than 17,000 dengue cases have been reported since the start of the year, according to the National Environment Agency (NEA). The number of cases in 2020 has already surpassed the total number of cases for all of 2019 and number for the whole year is likely to be well in excess of the 22,170 cases reported in 2013 — the largest dengue outbreak in Singapore’s history, according to the NEA. Sixteen people have already died of dengue in the city-state this year — twice the death toll of 2013.
The outbreak in Singapore has been complicated by a less common dengue virus serotype 3 (DENV-3) being more prevalent this year unlike in prior years. The protective immune response against one form of dengue serotype, according to medical researchers, may not be effective in protecting against another form of dengue serotype, potentially leading to a more severe dengue disease.
If that was not enough of a challenge, the DENV-3 serotype was last dominant in Singapore around three decades ago, which means there is now low immunity in the population.
The Fitness Landscape
From Surfing the Edge of Chaos: The Laws of Nature and the New Laws of Business by Richard T. Pascale, Mark Millemann and Linda Gioja:
“Biologists describe a species’ or population’s struggle to secure a niche as a long climb uphill, where “uphill” means better adaptation. When a species reaches a subsidiary peak (called a local optimum) on the fitness landscape, it may choose to remain there. Biologists call this perch on the fitness landscape a basin of attraction—a rest stop during the eternal competitive journey in which equilibrium is only temporarily restored.
Species become stranded on intermediate peaks or basins of attraction. Because there are not suspension bridges to get to the higher peaks of the horizon, the organism must “go down to go up.” (This image is useful because most organisms don’t do this voluntarily.) To do so, there must be sufficient internal unrest and instability; otherwise, an organism would not opt to leave its intermediate peak and suffer the indignities of the valley—low margins, undifferentiated products, customer defections, loss of competitive advantage—on the gamble of reaching a higher perch on the fitness landscape.”
How the mosquitoes in Singapore came back stronger and wiser (carriers of a more viral serotype) is a by-product of adversity. In response to the efforts made by the authorities in Singapore to eradicate dengue, heightened selection pressures within the mosquito population and placed a premium on mosquito reproductivity. Surviving mosquitos had to “go down” to become carriers of a near redundant serotype to maintain reproductivity and in turn were able to “go up” by increasing the population of DEV-3 serotype carriers.
Directing a Complex Adaptive System
Singapore’s struggles with dengue is a reminder that efforts to direct a living system beyond very general goals are counterproductive.
One of the core principles of complexity is that a complex adaptive system cannot be directed (along a predetermined path). It can only be ushered forward with some expectation of progress — living systems do tend to self-organise in an effort to find order and avoid randomness; the path to order, however, is never straight and rarely conforming.
Market Perspective
More from Surfing the Edge of Chaos: The Laws of Nature and the New Laws of Business:
“In fitness landscape terms, it is impossible to get to a distant and higher fitness peak (discover radical breakthroughs) by climbing still higher on the peak one is already on (optimizing). Rather, one needs to descend to the unknown, disregard the proven cause-and-effect formulas, and defy the odds. One embarks on a journey of sequential disturbances and adjustments, not a lock-step path along a predetermined path. We may only be able to see as far as our headlights, but proceeding in this fashion can still bring us to our journey’s destination.”
If you have made it this far, you are probably wondering why all this discussion about dengue and complexity. What does it have to do with markets?
All of the above was a long-winded way to get to the following takeaways:
1. Value and valuations of liquid securities markets are without context counterproductive to investment decision making and downright harmful when used as a justification, positive or negative, during the wrong market regime.
Value-investing is an optimisation algorithm for a regime defined by scarcity of capital and abundance of opportunities to put capital to work. The current US capital markets (and possibly other developed market such as Europe and Japan), however, are operating in a regime defined by an abundance of capital and a shortage of assets — for example, the number of listed stocks in the US is around 50 per cent lower than at its peak in 1996.
Valuations generally speaking are not a determinant of security markets characterised by a shortage of assets and an abundance of capital. When it starts to appear that capital will stop being abundant, we can discuss value and valuations.
2. For equity markets to continue making new highs, there need to be disturbances that lead to pull backs but are not debilitating, healthy markets keep needing to climb the proverbial wall of worry.
A lack of disturbances, on the other hand, should be a cause for concern that would lead to extreme levels of optimisation last seen at the tail end of the tech bubble — if have cash then buy technology stocks.
If the market makes moves 10-20 per cent higher without a pause, then rallies should be sold. If on the other hand there are pull backs of around 3 to 5 per cent at regular intervals, then dips should be bought.
The recent winners — think Tesla, Zoom, etc. — should be managed closely and rallies should be sold irrespective of expectations or ‘the story’.
3. The market is a living organism. The Fed can usher it but cannot direct it along a predetermined path. Do not optimise your portfolio for Fed policy and do not blame the Fed — it is pointless.
4. Do not optimise for momentum. The next ten years will not be like the last ten years.
5. Do not optimise your hedges for the tech bubble, the Great Depression or the Global Financial Crisis. The next crisis is unlikely to be the last crisis. If it happens to be like a prior crisis, then the policymakers already have a play book and it does not make sense to hedge for it.
Thank you for reading!
This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.
