The Fallout

“It became a domino effect, as infected people took foolish risks, knowing full well they could spread the virus.” — Jason Medina, The Manhattanville Incident: An Undead Novel

“My worlds collide. When one thing happens, it just starts a domino effect – everything else goes on.” — Wanda Sykes

We apologise for not having issued any trade alerts or weekly pieces for some time. It has been a complicated few weeks in Singapore. For monthly subscribers your next payment will be refunded and for annual subscribers a month will be added to your subscription.

The Fallout

Over the past 10 days or so, we have been having discussions with management teams at companies operating in many different sectors in Asia to understand the potential fallout from the 2019-nCoV coronavirus outbreak.

In some instances, we will mention the companies by name, please note this information is for your consumption not for public dissemination.

Before we get to the snippets from our discussions what seemed to be almost a constant across all discussions was the overarching conviction that China is almost certainly under-reporting the number of infected people there are across the Mainland

#1 De-Coupling from China is Not Easy

We recently met with the ASEAN retail sector team at GlaxoSmithKline (GSK), the British multinational pharmaceutical company. As an anecdote they shared that typically they have 90 days of inventory on hand of various versions of one its best-selling products, Panadol (generic: Paracetamol) — a level they recently deemed excessive and were implementing initiatives to bring it down to less than 60 days.

As of last week, in ASEAN their inventory at hand had dropped to less than one week of regular demand. Demand is anything but regular at present. Residents are in hoarding mode, particularly of medical, sanitary and food items.

Our discussion with the team at GSK revealed how difficult it is for multinational and regional companies to (1) re-engineer supply chains away from the Mainland and (2) de-couple from China.

Let us elaborate. Given the shortage in Panadol inventory, GSK reached out to manufacturers in Malaysia and offered a higher price than usual if the Malaysian outfit could do an urgent production run for them. The Malaysian producer rather than witnessing a surge in capacity utilisation found its plant almost idle and did not accept the order from GSK. The producer informed GSK that even if it accepted the order from them, it would not be able to fulfil it as the primary active ingredient used in production is sourced from China.

Chinese manufacturers have been temporarily shuttered by the government and will not re-start operations till at least 25 February. Chances of a further delay are not zero.

The issue has been exacerbated by inventory levels across most consumer facing industries already having been low prior to the outbreak due to production having been halted during the extended Chinese New Year break.

#2 Germany is Not a Viable Alternative

Dependence on Chinese manufacturing afflicts almost all industries with a physical product. So, we asked many of the companies what the alternative was. Most management teams were unable to come with a viable alternative. Others cited Vietnam and Germany as potential alternatives but lamented their relative lack of scale, the limited sophistication of the former and the much higher cost of the latter.

Companies operating in more sophisticated, higher priced categories could turn to Germany as a stop-gap measure and in some specific technology related cases to South Korea. For most industries, however, Germany is simply too expensive — anecdotally, 2 to 4 times the cost of China — and, for Asia-specific demand, too far, as shipments from Germany take 2 to 4 weeks longer to arrive. Worse still, in some cases China still becomes a bottleneck as a key input material or component is sourced from China during the normal course of business.

#3 Plastics and Petrochemical Producers to Feel the Pinch

Commodities are priced at the margin. At the margin, demand for petrochemical products is nil. Polyethylene, polypropylene, benzene and other such commodities have seen near-term demand plummet.

We spoke with the commodities trading team at Unilever (producer of consumer brands such as Dove, Red Bull and Lipton), which handles the commodities purchasing activities for the group from London, England to India to the ASEAN and pretty much anywhere in-between.

Our expectation, prior to the discussion, was that Unilever and its peers would actively be locking in lower prices and securing supply needed 9 to 18 months down the line. Turns out that is not the case. Rather, it has become a bit like a game of chicken.

Unilever worried that prices may drop further and that its key competitors may secure better prices is not buying. Instead, if notional loss limits are hit as set by internal policies, the team may be required to unwind positions and sell at prices they would prefer to buy.

We pressed on the point about competitors securing better prices and why it mattered. The argument goes that if they secure better prices, they would be able to offer higher discounts and gain market share at Unilever’s expense.

So, we turned to a contact at Reckitt Benckiser (producer of Dettol and other leading consumer brands), a direct competitor of Unilever across a number of categories. The argument made by Reckitt Benckiser was almost identical to that made by the team at Unilever.

The natural question then is what is their reaction function if prices start to rise. Turns out, they would probably rush to buy to lock in prices just in case their competitors lock-in lower prices…

That’s probably how V-shaped bottoms are formed in commodities markets.

#4 Interim Disconnect Between Finished Good and Commodity Prices

Unilever and Reckitt Benckiser have received an estimated 1 million units of additional daily demand for their Life Buoy and Dettol branded hand sanitizers since the start of the 2019-nCoV coronavirus outbreak, respectively. Regional production capacities are an estimated 250,000 units per day cumulatively.

GSK has little to no inventory of Panadol and other popular products remaining.

One of the leading ASEAN pharmaceutical chains is all out of thermometers, disinfectant sprays, surgical masks and many other hygiene related products.

Demand for many finished goods is far outstripping supply. Where supplies are available, price gouging is starting to occur, particularly on online market places.

Production has ground to a halt, hurting commodity prices and elevating retail prices. This disconnect could persist unless Chinese production comes online sooner rather than later.

#5 Chinese Aversion but Some Requests are Simply Ridiculous

A number of companies mentioned that Asian consumers are starting to show an aversion toward goods manufactured in China.

In response, one electronics retailer allegedly asked HP if they could provide a letter stating that their laptops, manufactured in Wuhan, would not transmit the virus. HP, obviously, would not expose itself to such a liability. HP laptops were duly removed from the unnamed retailers branch network.

Given all of the above, we think software remains one of the better sectors to be exposed to given the absence of supply chain challenges.

We may issue a follow-up piece to further discuss implications of the outbreak.

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.

Progressives for Progression | A Few Interesting Charts

“It’s easier to hold your principles 100 percent of the time than it is to hold them 98 percent of the time.” — Clayton M. Christensen, How Will You Measure Your Life?

A shorter piece this week, a little heavier on charts than usual though.

#MeToo: Hollywood Goes for the Jugular

What do Amy Schumer, Scarlett Johansson, Ryan Reynolds, Shonda Rhimes — producer of Grey’s Anatomy, former head of DreamWorks Jeffrey Katzenberg, Chrissy Teigen, John Legend, founder of wireless speaker and home sound systems company Sonos John Macfarlane, Chamath Palihapitiya of Social Capital, and Spotify executive Barry McCarthy have in common?

They are all backing Democratic presidential hopeful Elizabeth Warren.

Ricky Gervais may have reminded Hollywood of its hypocrisy at the Golden Globes and put off award winners from using the platform to push their political agenda. But Hollywood, as a collective, is clearly using the silver screen to push an anti-Trump / down with the old, white all boys club agenda.

If you are a movie-buff, as we very much are, think back to the subtle and not subtle ways in which Hollywood has responded to the fallout from the #MeToo movement and a Trump presidency in its movie scripts.

The remake of Aladdin introducing audiences to a stronger Princess Jasmine with a more pivotal role to the story, not defined by her romance with Aladdin. A progressively minded royal longing to steer her country in the right direction and vying to be Agrabah’s first female Sultan, a feat she eventually achieves — not Aladdin. The Avengers needing Captain Marvel, Marvel’s first stand-alone female superhero, to defeat Thanos. Woody, voiced over by Tom Hanks, handing his sheriff badge to Jessie at the end of Toy Story 4 and exiting Pixar’s long-running franchise. The Charlie’s Angel reboot revealing one of the few mainstay male characters of the series, John Bosley, to be a traitor and finally revealing who Charlie is — turns out Charlie is a woman.

This month, however, Hollywood, with the release of Bombshell, has gone for the jugular.

Bombshell, starring Nicole Kidman, Charlize Theron and Margot Robbie, is a fictionalised account of the women who brought down Roger Ailes, the chairman and chief executive of Fox News. We will save you from any spoilers but, as the trailers reveal, President Trump is featured in the movie and sexual predators, Roger Ailes and Bill O’Reilly, are clearly likened, if not linked, to the US President.

Will Hollywood’s overtures work in denying President Trump a second-term? We do not know but expect the upcoming US Presidential Election to be hotly contested.

On to more investment related matters.

A Few Charts

What About Tesla?

Today a dear friend of LXV Research asked us what we think of Tesla, the stock not the car. The short answer is, we do not think of Tesla — the company and the stock have too many emotions associated with it and we prefer our investments served cold and emotionless. Nonetheless, here is a chart comparing the relative performance of Ferrari, since its IPO, to that of Tesla.

RACE TSLA

Not what you expected, we bet. Certainly not what we expected. Ferrari has outperformed Tesla since its IPO, even after Tesla’s mind-boggling rally of late. The question is which one do you think will perform better from here. We know which horse we would back. (Hint: Ferrari’s logo is a horse, not Tesla’s.)

Software Over Semiconductor

Microsoft reported earnings after market hours yesterday, the software giant reported its tenth consecutive quarter of double-digit growth. Impressive.

We reiterate our call from the start of the year of preferring software over semiconductors.

The below is a chart of the software ETF $IGV to the semiconductors ETF $SOXX. Semiconductors have had a great run, the tide, however, appears to be shifting.

IGV SOXX

An idea that can potentially be added for this theme is IT security company Mimecast $MIME. The below is a chart of $MIME relative to $IGV. The stock is strongly outperforming the sector ETF, which in turn has strongly outperformed the S&P 500 Index over the last 4 months.

MIME IGV

Pakistan

Since Pakistan was upgraded and included into MSCI’s Emerging Markets Index, it has, at a country level, been the worst performing constituent of the emerging markets universe.

With the equity market, on trailing- and forward-earnings multiples, appearing cheap, a private sector shorn of debt and the currency no longer overvalued, Pakistan could be one of the more interesting emerging markets, despite its over reliance on oil imports, in 2020.

The below is a chart of the Global X MSCI Pakistan ETF $PAK relative to the emerging markets ETF $EEM. On a relative basis, Pakistan looks to have bottomed.

PAK EEM

Thank you for reading!

Caution Not Courage

“Let yourself be silently drawn by the strange pull of what you really love. It will not lead you astray.” — Rumi

“A group experience takes place on a lower level of consciousness than the experience of an individual. This is due to the fact that, when many people gather together to share one common emotion, the total psyche emerging from the group is below the level of the individual psyche. If it is a very large group, the collective psyche will be more like the psyche of an animal, which is the reason why the ethical attitude of large organizations is always doubtful. The psychology of a large crowd inevitably sinks to the level of mob psychology. If, therefore, I have a so-called collective experience as a member of a group, it takes place on a lower level of consciousness than if I had the experience by myself alone.” — The Archetypes and the Collective Unconscious by C.G. Jung

In “Threshold Models of Collective Behavior”, published in The American Journal of Sociology in 1978, Mark Granovetter outlines a simple model that attempts to shed slight on how seemingly identical crowds can each, collectively, react to events in profoundly different ways.

From the paper:

“Imagine 100 people milling around in a square—a potential riot situation. Suppose their riot thresholds are distributed as follows: there is one individual with threshold 0, one with threshold 1, one with threshold 2, and so on up to the last individual with threshold 99. This is a uniform distribution of thresholds.”

That is, there is one individual amongst the 100 that is willing to riot on his or her own, one individual that will riot if he or she witnesses at least one-person rioting, one who will riot if at least two people are rioting, and so forth.

Continuing from the paper (emphasis added):

“The outcome is clear and could be described as a “bandwagon” or “domino” effect: the person with threshold 0, the “instigator,” engages in riot behavior—breaks a window, say. This activates the person with threshold 1; the activity of these two people then activates the person with threshold 2, and so on, until all 100 people have joined. The equilibrium is 100.

Now perturb this distribution as follows. Remove the individual with threshold 1 and replace him by one with threshold 2. By all of our usual ways of describing groups of people, the two crowds are essentially identical. But the outcome in the second case is quite different—the instigator riots, but there is now no one with threshold 1, and so the riot ends at that point, with one rioter.

Even this simple-minded example makes the main point suggested earlier: it is hazardous to infer individual dispositions from aggregate outcomes.”

While by no means exhaustive, Granovetter’s simple threshold model shows why aggregate outcomes in a socioeconomic context can be so difficult to predict. Moreover, from the simple example provided in the paper, we can see how a very small change in the distribution of preferences can lead to large differences in outcomes.

In today’s hyperconnected world where virality is a daily, if not hourly, phenomenon, Granovetter’s model is highly relevant in coming to terms with the unpredictability of virality. It also helps understand why the giants of the internet-era — Google, Facebook, Amazon, etc. — have, subject to limitations, witnessed an acceleration, not deceleration, in growth as they have become larger.

In an investment context, the model highlights the pitfalls of blindly superimposing the experience of one market on to another or from one time period on to another.

Take for instance the experience of investors that have been betting against the Canadian and Australian housing markets, and by extension their banks, since the Global Financial Crisis. These bets have largely fared poorly and could to some extent be described as ‘widow maker’ trades — the moniker usually reserved for shorting the Japanese bond market. From what we have seen of the cases made against Canadian and Australian markets, most analysts have superimposed economic and demographic metrics witnessed in the US, and the UK in some instances, prior to the sub-prime mortgage crisis.

The trajectory of the Australian and Canadian housing markets over the last decade, however, suggests there are subtle, almost unidentifiable, differences in the thresholds of stakeholders and homeowners in those markets when compared to those either in the US or UK. These subtle differences have resulted in far different outcomes despite the overt similarities across the markets. The housing markets in both commodity exporting economies remaining largely intact, despite years of low commodity prices, seems to confirm as much.

Similarly, we can begin to understand why neither historical nor panel data has served well those calling for a hard landing in China or impending doom for the US equity markets.

Subtle variances can lead to huge differences in outcomes.

For anyone but the most extraordinary, identifying subtle differences is nigh on impossible. That is why, it is generally very difficult to call a market top or bottom. The better strategy, and the one we recommend, is to shoot a trend in the back — i.e. short after a clear break of an uptrend — than to time a market top.

“One of the most helpful things that anybody can learn is to give up trying to catch the last eighth—or the first. These two are the most expensive eighths in the world.” — Reminiscences of a Stock Operator by Edwin Lefèvre

Some Caution is Warranted

With that being said, we will somewhat contradict ourselves by arguing that at this juncture in markets, some caution is warranted. We think now is a good time to build up cash to re-deploy on a pull back.

Market momentum, on a global and cross-asset class basis, is the highest it has been since late 2017 — that is, just before the “volmageddon” of February 2018. Almost two fifths of global markets, irrespective of asset class, are at or have recently recorded 52-week highs. More than two thirds of developed and emerging equity markets have recently recorded 52-week highs.

Cross-asset breadth of 35 per cent or above has generally been associated with subsequent market corrections. That is, a cyclical pullback but not an end of the prevailing uptrend. Moreover, given how defensive investors became in the summer of 2019, the outsized moves in markets in recent months suggest that investors have covered shorts / underweights — making markets more susceptible to short-term pullbacks. Commodity Trading Advisors (CTAs), that is trending following strategies, are now at maximum equity market allocations. Target Risk Funds — asset allocation funds that hold a diversified mix of stocks, bonds and other investments — are also at maximum equity market allocations.

To re-iterate, now is a time for caution not courage.

Cyclical Not Secular

For further clarification, we are, however, not calling for an end to either of the long running equity or bond bull markets.

With the centenary anniversary of the Communist Party of China in 2021 and a US Presidential Election at the end of this year, we suspect policymakers in the world’s two largest economies will be pulling out all the stops to keep the uptrend intact.

Thank you for your support!

Financial Innovation

“During the 10 years I traded for George Soros, I never heard him speak about a winning trade. To hear him talk, you’d think he had nothing but losers. Conversely, listening to the biggest losers, you’d think they had nothing but winners.” ― The Education of a Speculator by Victor Niederhoffer

Starting a new year, more so a new decade, it has become almost customary to look back and reflect on what transpired and what insights can be gleaned to have a better tomorrow. For us, in the context of public market investing, learning that the S&P 500 Index outperformed almost four fifths of all US stocks in 2019 and approximately two-thirds of them over the last three-years was astonishing.

Not active managers, stocks! Simply staggering.

This begs the questions, is the committee that selects stocks for inclusion in the US equity index comprised of geniuses? (Hint: it is not.)

Financial Innovation in the 1920’s

The ‘Roaring Twenties’ was a decade of economic growth and widespread prosperity. A significant, not comprehensive, list of socioeconomic achievements of the US economy in the 1920’s is as follows:

A 20 per cent increase in the national income per capita from 1922 to 1928
A 30 per cent increase in physical production
An almost doubling of profits of the larger corporations
A housing program that expanded faster than population
An increase in average health and longevity
An increase in educational facilities greatly surpassing the growth of population
A per capita increase in savings and insurance
A booming stock market, at least until October 1929
A 5-hour decline the average working week
Slowly rising wages with little to no inflation
Ever increasing productivity per worker

(Source: Prosperity Fact or Myth by Stuart Chase)

A recovery from wartime devastation and deferred spending, a boom in construction, and the rapid growth of consumer goods such as automobiles and electricity are often credited for the economic boom during the decade. A less well-known contributor to the boom and the subsequent bust, however, is the financial innovation that took place.

The twenties were a decade of rapid financial innovation – from the development of the modern investment trust to consumer credit tied to purchases of durable goods like automobiles. And of the democratisation of financial markets – between 1922 and 1929 US national banks and their affiliates operating in securities business increased from 72 to 235, a more than threefold increase.

Credit fuelled a real estate boom in 1925 – real estate bond issuance accounted for nearly a quarter of all corporate debt issued in the US in 1925. Issuance of commercial mortgage-backed securities financed the construction of most of the US skyscrapers in the 1920’s and led to overbuilding and then widespread vacancies. New York and Chicago were the primary focus of the real estate run-up. More office buildings taller than 70 metres were constructed in New York between 1922 and 1931 than in any other ten-year period before or since, according to the National Bureau of Economic Research.

Credit also powered the Wall Street boom of 1928-29 and a consumer-durables spending spree spanning the second half of the decade. That these booms developed under the fixed exchange rates of the gold standard meant that they generated little inflationary pressure in the US, and that their effects were transmitted to the rest of the world. Without inflation, the Federal Reserve had no reason to increase short-term interest rates.

Eventually, however, the Fed and other central banks grew concerned over the speculative excesses in financial markets and started tightening monetary to rein in asset-price inflation. Banks passed higher rates and costs of increased reserve requirements to borrowers and reduced the amount of margin they will offer to stock market speculators. By this time, however, investors, particularly stock market speculators, were highly leveraged. Consequently, borrowers felt the pinch of tighter monetary policy leading them to reduce their spending, and consumption and investment turned down. Ultimately, as we know, the deflationary bust that ensued almost took down the financial system and the economy more generally.

Financial Innovation in the 2000’s

More well-known are the transgressions of Wall Street in the 2000’s that led up to the Global Financial Crisis.

Yield starved institutional investors following the interest rate cuts enacted by Alan Greenspan in response to the bursting of the tech bubble began investing heavily in another Wall Street concoction. Real estate-backed collateralised debt obligations that came with the stamp of approval from the credit rating agencies offering a higher yield than bonds with comparable rating became the flavour du jour in 2000’s.

We all know how that story ended.

Financial Innovation Today

“Stock market bubbles don’t grow out of thin air. They have a solid basis in reality, but reality as distorted by a misconception.” ― George Soros

The S&P 500 is outperforming individual stocks not due to some superior skill in index composition, but because institutional investors are opting to pass over active managers in favour of investing passively in free-float market-capitalisation weighted indices. Compounding the challenge for active managers, the largest institutional investors in the world are actively running systematic volatility selling programs that make the market even harder to beat.

An example of a systematic volatility selling program includes selling a fixed dollar value of S&P 500 Index call options and put options with the same strike price and expiration on daily / weekly / monthly basis. There is no bet on the direction of the stock index; as long as the S&P 500 Index does not go up or down too much, the straddle will be profitable.

Following the short volatility blow up of February 2018 and the sharp market sell-off in the fourth quarter of 2018, Wall Street became even more innovative. For example, Bank of America Merrill Lynch created something a called a VCorrel swap, while we do not know exactly it works, we understand it scales volatility exposures for its clients dynamically over the course of a trading session rather than at market opens and closes. When volatility is expensive e.g. during an intra-day market sell-off, the swap involves selling more volatility and reducing exposure when volatility is cheap. Such dynamic volatility selling programs reduce intra-day volatility much like selling put and call options at market open and close reduced day-to-day volatility.

Lower volatility emboldens speculators to take more risk and increase leverage.

The innovations of the 1920’s led to the construction boom of the likes never witnessed before or since. The innovations of the 2000’s blew the greatest and probably the first truly global real estate bubble. Extending that, we do not think it unreasonable for the current rendition of the bull market, in stocks and bonds collectively, to evolve into a bubble bigger than anyone, ourselves included, expects.

“When I see a bubble forming, I rush in to buy, adding fuel to the fire.” ― George Soros

Thoughts and Investment Ideas for 2020

Thoughts and Investment Ideas for 2020

Ideas

Summary

Energy

The Speculative Phase: Software Over Semiconductors

Playing the Strength in US Housing Demand

Founder Exodus: A Reduction in Existential Flexibility

USD

Thoughts

Summary

Macro Risks

Inflation is the Enemy

Valuations

US Treasury Yield Curve

Modern Monetary Theory

Books

Five We Have Read and Recommend

Five from Our 2020 Reading List

Thoughts and Investment Ideas for 2020

“Can you ask a new question? It’s the new questions that produce huge advances…”

― Why Model? by Joshua M. Epstein

“A reward-sensitive person is highly motivated to seek rewards―from a promotion to a lottery jackpot to an enjoyable evening out with friends. Reward sensitivity motivates us to pursue goals like sex and money, social status and influence. It prompts us to climb ladders and reach for faraway branches in order to gather life’s choicest fruits.

But sometimes we’re too sensitive to rewards. Reward sensitivity on overdrive gets people into all kinds of trouble. We can get so excited by the prospect of juicy prizes, like winning big in the stock market, that we take on outsized risks and ignore obvious warning signals.”

― Quiet: The Power of Introverts in a World That Can’t Stop Talking by Susan Cain

“Stock prices have reached what looks like a permanently high plateau.”

― Irving Fisher (1867 – 1947)

The last twelve months, and pretty much the entirety of the last decade, handsomely remunerated the reward-sensitive ― the risk-takers, the optimists, the dip-buyers, the trend-followers, the bitcoin HODLers ― and punished the sceptics, the value-conscious, the doomers and the gloomers, and the short-sellers, without prejudice.

The sceptics, and others of their ilk, are quick to remind of the cyclicality of markets even as they lick their bull-horned wounds. That, as surely as night follows day, the years of plenty will be followed by years of famine. That valuations matter.

They, the doubters, are, as history shows, not wrong. Markets are indeed cyclical. Valuations do matter, eventually. The record shows, claiming otherwise will surely find you embarrassed, if not immediately, most definitely in due course.

There is, however, a wrinkle in the cyclicality argument.

All finite, deterministic systems are guaranteed to cycle. Capital markets, however, are neither finite nor deterministic.

Finite systems, to paraphrase James P. Carse author of Finite and Infinite Games, are comprised of known participants, fixed rules and agreed upon objectives. Infinite systems or games, on the other hand, are defined by participants both known and unknown, changing rules and an objective to keep the system or game perpetuating.

Markets are an infinite system and market participants ― investors, traders, brokers, market makers, regulators, corporations and whoever else that may choose to participate ― are engaged in an infinite game. To survive in an infinite game, participants must adapt or die. It is this process of adaptation that allows the system to perpetuate but at the same time necessitates that neither the duration nor the form of any given market cycle can be known before the fact. Just because the average bull market may have lasted 7-years or ended within a certain time period following a yield curve inversion does not in any way imply that this or the next market cycle will follow the same pattern.

Market participants should not, nay cannot, simply rely on a passing understanding of market cycles. Rather, we must all continuously strive to better understand how the game and the participants are adapting so that we may have a better shot at positioning for that which lies ahead.

In this piece, we try to ask questions ― with a bit of luck, some different, if not entirely new, ones ― and share our thoughts and ideas that, we hope, will help you, the reader, better play the infinite game over the coming six to twelve months.

Note: Comparable pieces for 2018 and 2019 can be found here and here, respectively.

Ideas

Summary

Energy: Long Chevron $CVX, National Oilwell Varco $NOV and Cactus Inc $WHD and avoid allocations to energy importing emerging markets

Speculative Phase: Prefer software $IGV to semiconductors $SOXX in the US

Founder Exodus: Avoid long positions in companies that have recently seen their founders exit such as Alphabet $GOOG, Under Armour $UAA, Chipotle $CMG and Alibaba $BABA

USD: Below 95 on the US Dollar Index $DXY, short Australian dollar and New Zealand dollar

Energy

“Rise early, work hard, strike oil.” ― John Paul Getty

“Do not waste energy, make it useful.” ― Wilhelm Ostwald (1853 – 1932), winner of the Nobel Prize in Chemistry in 1909

Humans have been burning fossil fuels to generate electricity since 1882. Coincidentally, the first hydroelectric power plant also began operations in 1882. Fissioning uranium isotopes has been a source of electricity since 1956.

The technology to harness fossil fuels as a source of energy at scale has transformed everything from agriculture to industry, transportation to warfare, quality of life to the environment, and everything in-between. Fossil fuels remain the most concentrated and versatile source of energy that can be converted at affordable cost and high rates of efficiency into heat, light and motion.

The quest to harness alternative sources of energy at comparable levels of efficiency, cost and scale as to that of fossil fuels remains just that, a quest. Progress is being made and the political will to turn our collective backs on fossil fuels has never appeared stronger.

The rise of environmental, social and governance (ESG) criteria in investing, the US Democrats’ “Green New Deal” on climate mitigation, and the recent unveiling of the “European Green Deal”, are raising the cost of capital for the global energy sector. All the while, returns on invested capital being generated by the sector remain dismal.

The potential unintended consequence of a seemingly coordinated desire to penalise the global energy complex and starve it of fresh capital is the prospect of a negative energy supply shock becoming increasingly probable.

With the promises of blockbuster shale wells fracking companies made to investors turning out to be a busted flush ― according to The Wall Street Journal wells drilled recently in the four largest US oil regions were on track to produce nearly 10 per cent less oil and gas over their lifetimes than companies forecast ― and the sector facing ever increasing costs of capital, the prospects of a global energy supply shock in the near-to-medium term, we think, are under-priced.

Barring a negative-demand shock, or a breakthrough in technology that enables the harnessing of alternative sources of energy as efficiently and cost effectively as harnessing fossil fuels, we think oil prices can head higher, much higher, in the near- to medium-term.

We often use the 48-month moving average, for commodities and major currency crosses, to guide our trading strategy. For now, WTI crude prices remain above the moving average. As long as prices do not meaningfully breach the 48-month moving average, our bias is to be long in expectation of prices continuing to climb the ‘Wall of Worry’ over the next 6 to 12 months.

Tactical Perspective

President Trump’s decision to order the Iranian Major General Qasem Soleimani’s death via drone attack in Baghdad in the evening on 2 January saw oil prices spike by as much as 4 per cent. Such is the antipathy towards energy stocks that despite a sharply higher oil price, the SPDR Energy Select Sector ETF $XLE closed in the red on 3 January.

With that being said, oil may have to work off overbought conditions if and when the geopolitical risk premium subsides. We would hold off till that point to have a full-sized allocation to energy.

Ideas: Long Chevron Corporation $CVX, Long National Oilwell Varco Inc. $NOV, Long Cactus Inc. $WHD.

Avoid: Energy importing emerging markets.

The Speculative Phase: Software Over Semiconductors

If the US equity market is in the throes of a market melt-up, or an almighty blow-off, the rally should devolve into becoming increasingly speculative.

Last year, software stocks were leading the pack till around mid-year when, as the trade tensions between the US and China thawed, semiconductor stocks started climbing a wall of worry and ended the year at all-time highs. Software stocks were the laggards during the second-half of last year.

We think as the rubber of hope meets the road of financial performance semiconductors are likely to falter. Further, given the sensitivity of semiconductor stocks to the trade deal and with a phase one deal between the US and China more than priced in, it behoves the prudent investor to pare allocations to semiconductor stocks. Rather, as growth becomes precious once again, we think, investors are likely to turn to software afresh. And as software incumbents look for new ideas and business models, more than a few acquisitions are likely to be in the offing.

For now, in US equities, we prefer software to semiconductors.

Ideas: Long Manhattan Associates $MANH, Long Salesforce.com $CRM, Long Avalara $AVLR, Long Slack Technologies $WORK, Long iShares Expanded Tech-Software Sector ETF $IGV

Avoid: iShares PHLX Semiconductor ETF $SOXX

Playing the Strength in US Housing Demand

Falling long-term interest rates equate to more affordable housing and on a relative basis make the economics of owning a home better than of renting one. With US long rates having dropped sharply during the summer, US home purchases have picked up.

On an annual basis, sales in October increased 4.6 per month from the same month the previous year, marking the fourth straight month of year-over-year gains.

With homeowners in the US remaining in their homes thirteen years on average, five years longer than they did in 2010, and housing inventory estimated to be at an 11-year low, the surge in demand for housing is rippling through to increased applications for and issuance of building permits.

The thing about buying a home is that, once you have bought one, it comes a with a long list of mandatory and not-so-mandatory purchases. For this reason, US consumer durable goods spending tends to closely track home sales and housing permit issuance with a lag.

While demand for housing fluctuates with long-term interest rates, once a house has been bought the spending that follows it, will follow irrespective of the fluctuation in interest rates. This makes consumer durable plays, broadly the consumer discretionary sector, a less interest-rate sensitive means of gaining exposure to the robust demand for US housing.

Ideas: Long Floor and Décor $FND and conditional on high-levels of risk appetite small caps such as Bassett Furniture $BSET and Hooker Furniture $HOFT

Founder Exodus: A Reduction in Existential Flexibility

Simon Sinek in a talk about his book The Infinite Game shares an anecdote in which Steve Jobs was almost on a whim willing to pivot Apple Inc., despite the prospect of huge near-term losses, when faced with an existential crisis. He describes this ability to be “existential flexibility”.

Founders, in general, are more likely to have the strength of character and conviction to make the difficult decisions ― that is, existential flexibility ― than do managers. A number of prominent companies ― such as Google, Under Armour, Alibaba and Chipotle Mexican Grill to name a few ― have recently seen their founders step down.

With the business cycle long in the tooth and regulatory risks, particularly for technology companies, rising, we prefer to avoid investing in companies that have transitioned from founder CEOs to manager CEOs.

USD

Analysts, ourselves included, have spent an inordinate amount of time and energy in an attempt to ascertain the direction of an asset that has remained in a mind-numbingly narrow range. Such is the importance of the greenback, implicit or explicit, in any investment framework, however, that we would be remiss to not once again touch upon it.

Yield Differentials

We use Australia and New Zealand, given access to a longer history and better quality of data, and because they serve as good proxies for China and commodity producing emerging markets. The below charts show that on the 10-year government bond yield differential basis there is a strong case to be made for a stronger dollar relative to these currencies. (We also include Indonesia, despite the limited data, as a further example.)

From the Perspective of Select ‘Fragile’ Emerging Markets

The real trade-weighted dollar has posted a smaller advance since mid-2014 than the US Dollar Index $DXY, suggesting that the threat to the world from a stronger US dollar is not as great as is often hyped to be.

Below we share three charts of select emerging markets that suffered severe crises and saw their currencies plummet versus the US dollar in the 1990’s. Most of these countries are better placed to withstand a stronger US dollar than they were prior to the crises in the 1990’s and at the time of the ‘taper tantrum’ in 2013.

Note: Pre-crisis metrics for 1996 for all countries except India, for India we use 1990

While a stronger US dollar would be painful, it would not, we think be apocalyptic barring a a severe spike (10%+ in a matter of months).

Ideas: Using $DXY as the guidepost, long US dollar below 95 versus the Australian dollar and New Zealand dollar, given the low cost of carry.

Thoughts

Summary

Macro Risks: Using rallies to reduce equity exposures tactically and increase bond allocations, take profits in European equities

Inflation is the Enemy: Growth shocks and not inflation shocks are probably the bigger risk to diversified portfolios in the near-term

Valuations: Gold is indicating equity market multiples have peaked

US Yield Curve: Prefer steepeners and then the short-end of the curve

Modern Monetary Theory: Probably not what you expect

Macro Risks

The chart above is of the 52-week moving average of the Citi Macro Risk Index. It is not the magnitude rather the direction of the risk index that acts as a cyclical indicator. (Rising line indicates increasing macro risks.)

With the risks that built up during the sell-off in the last quarter of 2018 and the recession fears that peaked in the summer of last year having been largely unwound, some caution is now warranted. We think equity rallies hereon should be used to gradually reduce allocations to leave powder dry for cyclically more opportune times to go on the offensive.

The chart above is the ratio of gold, in euros, to the Euro Area all shares index versus the differential between 10-year government bond yields of the ‘fragile’ European economies and Germany. (For the latter we use the average of the yields on Spanish, Portuguese and Italian 10-year bonds and subtract from it the yield on 10-year German bonds.)

The two series are a means of measuring sovereign, or break up, risk in Europe. Rising ratios imply rising sovereign risks and a rush towards the safe havens of gold and German debt. Recently, with gold having rallied and some form of Brexit related agreement forming, the two time-series have diverged. The yield differentials indicate a declining risk premium while the gold-to-shares ratio indicates a rising risk premium.

With the hard work to resolve Brexit still pending and the potential for a flare up in a trade spat with President Trump under-priced, we think there is more than a modicum of complacency on investors’ part with respect to risks in Europe. Profits should be taken on European equities.

Avoid: Shorting funding currencies, namely the euro, Swiss franc and Japanese yen, as they can rally sharply during risk-off periods

Inflation is the Enemy

Generally, the main macroeconomic risk factors that drive expected returns in equities and bonds are growth and inflation. With equity returns being most sensitive to growth and bonds to inflation.

Lower expected risk-adjusted returns in equities begin to be priced in when the economy is supply constrained and central banks are tightening monetary policy to lower nominal growth. This also tends to be the more inflationary phase of the business cycle with rising unit labour costs and valuation multiples at or near cycle highs. In contrast, higher expected returns begin to be priced in when the economy is operating below potential and central banks are easing monetary policy to prop-up nominal growth. This generally tends to be a disinflationary phase in the business cycle with unit labour costs falling and valuation multiples at or near cycle lows.

The chart above is of the trailing earnings yield (inverted price-to-earnings ratio) of US stocks and realised inflation rates. Theoretically, since stocks are real assets, changes in the rate of inflation should not have a meaningful impact on stock prices or valuation multiples. In practice, however, the principle does not hold. Historically, US earnings yields have been more closely related to the rate of inflation than to nominal or real bond yields.

A comparable relationship between inflation and earnings yields has also been found to exist in many other markets.

The expected risk-adjusted return in bonds also tends to be counter-cyclical. Specifically, policymakers are more prone to hiking policy rates when there is little to no slack in the economy and inflation pressures begin to emerge.

At a portfolio level, risk-adjusted returns of the portfolio also depend on the correlation of constituent assets over the course of the cycle. Economic theory has it that asset prices reflect the present value of future cash flows. Given that inflation determines the discount rate for both equities and bonds, it also tends to drive both assets in the same direction. At times when inflation shocks dominate, equities and bonds become positively correlated. While, since growth rates affect equities more than they do bonds, growth shocks dominating leads to bonds and equities being negatively correlated.

The chart above is of the US stocks-to-bond correlation and the 6-month rolling average of the annual rate of inflation, as measured by the consumer price index excluding shelter.

During the period from 1965 through to 1997, when inflation expectations experienced large swings, the stock-to-bond correlation was almost consistently positive. That is, changes in inflation expectations drove both stock and bond returns and during periods of equity market weakness bond allocations did not make up the difference. For example, in the sub-period between 1973 and 1981, during which there was a negative supply shock from the OPEC oil export embargo, multiple recessions, high unemployment rates and high inflation, equity market weakness coincided with poor bond market performance.

The time-series demonstrates how the correlation between equities and bonds is not static. The implication being that bond allocations do not always serve as a suitable diversifier for equity allocations. Rather, it is the prevailing market regime, as described above, that determines the efficacy of bond allocations to lower drawdowns and portfolio level volatility during equity market sell-offs.

As the chart shows, the last decade, as all of us already know, was characterised by low-growth, negative growth surprises and low-and-steady inflation. That is, a decade of negative correlation between bonds equities.

Asset Allocation

A strategic asset allocation framework, it then follows, should contain equity and bond exposure levels conditioned on the phases of the business cycle.

Upside inflationary shocks make traditional 60/40 and risk-parity like allocations suffer as bonds and equities sell-off concomitantly. While periods of benign inflation with the occasional growth shock are well-suited to portfolios diversifying equity exposures with heavy bond allocations.

According to our framework, however, the probability of a near-term inflationary shock remains low. Rather, we anticipate the risk of a near-term negative growth shock to be much higher than that of inflation sustainably surprising to the upside.

“The driving force for underlying profits is credit growth, and in the process the most conservative among institutions compromise standards and engage in practices that they would not have dared pursue a decade or two ago. The heroes of credit markets without a guardian are the daring―those who are ready and willing to exploit financial leverage, risk the loss of credit standing, and revel in the present casino-like atmosphere of the markets.”

― Interest Rates, the Markets and the New Financial World (1986) by Henry Kaufman

An example of growth remaining elusive comes from the Federal Reserve’s recent senior loan officer survey, which revealed that banks left commercial and industrial lending standards mostly unchanged amid weakening demand for credit.

Bonds, rather than commodities and other inflation hedges, remain, for the near-term, the most suitable hedge for equity allocations.

Ideas: Long Japanese Government Bonds and allocations overweight bonds relative to equities and commodities (excluding gold / precious metals)

Avoid: Treasury Inflation Protected Securities (TIPS)

Valuations

The chart above is of the S&P 500 Index expressed in terms of gold (in US dollars per Troy Ounce) versus the index’s cyclically adjusted price-to-earnings ratio (as calculated by Professor Robert Shiller).

While we use the CAPE to smooth out the effect of the Global Financial Crisis, using annual price-to-earnings multiples would convey the same message. In simple terms, the price of gold is inversely correlated to the price-to-earnings multiple of the index.

The price of the S&P 500 in terms of gold suggests that valuation multiples have peaked on a cyclical basis.

Ideas: Gold can serve as a hedge for equity market multiple-contraction

US Treasury Yield Curve

“During 1870-1910, the decades of dynamic expansion, German government bond yields were actually declining. German yields did not decline as far as did British, Dutch, and French yields but were low enough to suggest that the savings of the people were keeping up with the financing requirements of a fast-growing economy. Germany was enjoying the benefits of that mighty weapon, a smooth annual accrual of new savings seeking investment in interest bearing securities. In the years before 1914, German bond yields were similar to yields in the United States, another large and fast-growing nation during the period 1870-1914.”

― A History of Interest Rates by Sidney Homer (1864 – 1953) and Richard Sylla

The chart below is of the US yield curve (10 year minus 3 month) versus private saving less private investment. The latter points towards a further steepening of the US yield curve.

The chart below is of the de-trended 3-month Treasury bill rate (inverted) ― de-trended by subtracting the 10-year moving average from the bill rate ― versus the US Treasury 10-year and 3-month yield curve. The chart dates from 1962 till today, suggesting that the de-trended 3-month Treasury bill rate contains information about the direction of the yield curve.

The two-time series have a correlation of -0.75 with an r-squared of 57 per cent.

(The dashed lines on the above chart are the average de-trended bill rate and levels one standard deviation above and below the average.)

This relationship, too, points towards a further steepening of the US yield curve.

Ideas: Long yield curve steepeners or alternatively long the short-end of the yield curve

Modern Monetary Theory

“‘War Board’ Proposed

April 13, 1933

A plan to mobilize private industry under the government for expansion in the production of articles and materials in normal demand, this expansion to be coeval with the administration’s public works activities, is being developed by the President’s closest advisors and they hope to persuade him to attempt it.

Certain types of industry, under the plan, would be assembled and regulated by a government agency reminiscent of the War Industries Board. Competition would be regulated: hours of work and minimum rates of pay would be fixed; and some of the proponents of the idea also would have the government guarantee manufacturers against loss in resuming or increasing the manufacture of prescribed articles and materials.

The thought behind the plan is that a public works program standing by itself, even if the five billions is expended upon it, will not sufficiently reduce unemployment or make use of the new purchasing power. It is contended that private industry must, at the same time, be put in a position to absorb the new purchasing power, composed of the billions which the government will be putting in the hands of citizens all over the United States. To do this, it must resume manufacture, and that will restore many to private employment in the factories themselves and in the retail establishments which will dispose of the products of these factories. This will, in turn, give purchasing power to those privately as well as those governmentally employed. A part of the billions will then flow back to the Treasury in various forms of taxation.

The argument which seems to have been most effective in bringing the administration to support the public works appropriations is that the deflationary policy has cut down the purchasing ability of the country by seven billions. Of this five billions is in closed banks, one billion in the budget savings and another billion in reductions made by the several State governments.

The vast public works program having been definitely agreed upon, with the probability that it may involve an expenditure of as much as five billions, it soon became evident to the architects of administration policy that this plan needed a companion.

It was all very well to balance the budget, and, with government credit thus establish, to borrow billions for roads, buildings, flood control and the like. But this question remained: How could private industry get the full use of those billions for purchase? Without some form of government stimulation and aid, it was felt that manufacturers of ordinary consumers’ commodities would wait to clear their stocks, while retailers were clearing theirs, and when the manufacturers did resume production, they would simply proceed at “depression pace.”

The result of these considerations was the plan to set up a government agency to induce industrial expansion, to quicken and regulate it meanwhile, to protect it against loss and perhaps even to fix the prices of labor’s product as well as the wage of labor itself.”

― In The Nation: 1932-1966, Arthur Krock (1886 – 1974)

Modern Monetary Theory (MMT) advocates fiscal measures and the role of government in the creation of money over monetary policy and as such stands in almost complete contrast to traditional macroeconomic theory. A key to understanding MMT is to appreciate the difference between users of currency, primarily the private sector, and the monopoly issuer of said currency, the government.

Beginning with the economic assumptions of full employment and full capacity utilisation ― that is, a country facing real resource constraints. Under such a scenario, inflationary pressures can become a genuine and immediate danger and monetary policy can, arguably, play a critical role play to dampen excess demand and by extension inflationary pressures. For instance, by raising the level of interest paid on excess reserves, the central bank could increase the opportunity cost of lending activities, encouraging banks to instead place more cash with the central bank or demand a higher rate of return from potential borrowers. Thereby raising the cost of capital.

Proponents of MMT contend that adjustments to the government’s fiscal policy could just as easily be used to achieve the same objective. For example, excess demand could be dampened by raising tax rates, be it income, sales or value-added taxes.

The reality today, however, is that few, if any, economies face resource constraints. Rather, interest rates persist at or near historic lows, inflationary pressures have remained transitory at best and the global commodity complex remains largely mired by excess capacity. Monetary policy has proven impotent in reflating the economy and zero-bound interest rates have neither spurred demand for credit nor compelled banks to lend.

In the current state of the global economy, MMTers argue, is when the prescriptions of the theory are most potent. Tax cuts, for example, can be utilised to immediately increase private sector disposable incomes.

By divvying up the economy across private and public sectors and recognising that the balance sheet constraints across the two sectors are incongruent, MMT perceives fiscal policy as a means to lessen (increase) private sector funding pressures, when the economy is operating below (at or above) capacity.

In a fiat currency system, the government has the flexibility to affect changes in private sector behaviour by fine-tuning its budget deficit. At a time when the private sector is deleveraging, if government fails to offset this by widening its budget deficit, it effectively starves private sector activity. In a fiat currency system, it is government, not the central bank, that creates new liabilities that become the assets of the private sector.

So, at any level of income, if the private sector decides to deleverage, the public sector must by definition, end up saving less by running a larger budget deficit or shrinking a budget surplus. In an ideal world, any shifts in the private sector’s propensity to save would be matched by an immediate change in the tax rate, and the combined income of the public and private sectors would remain stable. A key policy prescription stemming from MMT, then, is to keep monetary policy steady and to manage the economy by adjusting the tax rate.

The Practical Implications

Most discussions on MMT devolve into either how it spells the end of the US dollar, or fiat currencies in general, or how it will spur uncontrollable inflation and therefore one must own gold or bitcoin or both. With time these proclamations may prove correct. The thing about capital markets, however, is that for the most part it is the path not the endgame that matters.

And as far as the path is concerned, it is not unreasonable, in our opinion, that, initially, MMT, or any other form of government led fiscal activism, reinforces deflationary not inflationary forces. That is, by opening up the fiscal spigot policymakers continue to keep cost of capital artificially suppressed thereby further delaying the inevitable impairment of excess capacities, zombie companies and unproductive debts. Ever increasing advantages would then continue to accrue to large companies, with access to low cost capital, at the expense of small and medium enterprises, further compounding the issues of inequality and declining productivity. Such a deflationary death spiral is what, we think, precipitates the endgame, not a sudden burst of inflation.

Books

Five We Have Read and Recommend

Surfing the Edge of Chaos: The Laws of Nature and the New Laws of Business by Richard Pascale, Mark Milleman and Linda Gioja
The Match King: Ivar Kreuger, The Financial Genius Behind a Century of Wall Street Scandals by Frank Partnoy
The Man Who Solved the Market: How Jim Simons Launched the Quant Revolution by Gregory Zuckerman
The Great Rebalancing: Trade, Conflict, and the Perilous Road Ahead for the World Economy by Michael Pettis
How Global Currencies Work: Past, Present, and the Future by Barry Eichengreen, Arnaud Mehl, and Livia Chitu

Five from Our 2020 Reading List

The Education of a Speculator by Victor Niederhoffer
The Model Thinker: What You Need to Know to Make Data Work for You by Scott E. Page
Micromotives and Macrobehavior by Thomas C. Schelling
Clash of Empires: Currencies and Power in a Multipolar World by Charles Gave & Louis-Vincent Gave
Energy and Civilization: A History by Vaclav Smil

Thank you for reading and please share!

This document 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.

The January Effect

“Trying to change before you’re ready isn’t likely to be productive. For example, most New Year’s resolutions don’t last because people spring into action without being prepared for the work it’s going to take. Forcing change based on a date on the calendar, rather than a true readiness to transform, can be a setup for failure.” ― Amy Morin
“Another lesson I learned early is that there is nothing new in Wall Street. There can’t be because speculation is as old as the hills. Whatever happens in the stock market to-day has happened before and will happen again. I’ve never forgotten that. I suppose I really manage to remember when and how it happened. The fact that I remember that way is my way of capitalizing experience.” ― Reminiscences of a Stock Operator, Edwin Lefèvre,

Please note, this will be the last weekly piece for the year. The next piece will be sent out between 6 and 8 January.

The beginning of a New Year seems like a great time to take stock of the last year and set goals for the next one. Unfortunately, by February an estimated four-fifths of people have failed to stick to the goals they have set for the year. Life-changing commitments are just hard to, well, commit to. The corollary of most people being unable to stick to their goals for more than six weeks, is that most of us are almost surely going about the process of setting goals the wrong way.

We do not know, or profess to understand, the reasons that most people fail to stick to their New Year’s resolutions or how to correct the process. It’s probably a combination of factors and life just getting in the way. That does not mean we cannot recognise the repetitive behaviour.

In this week’s piece we discuss the ‘January Effect’, a seemingly repetitive phenomenon occurring in capital markets.

The January Effect

The above is the average price return by month for the S&P 500 Index over a number of different time periods, all ending 30 November 2019. In all of the sample periods, the monthly return for the S&P 500, on average, has been higher in January than the average monthly return over the entirety of the respective period. In the two longest sample periods, January also has the highest average monthly return.

We do not have the same amount of data available for small-cap stocks, but at least for the 10 years, we can see that even in small cap stocks the average monthly return for January was well above the average monthly return for the entire period.

The January Effect is not limited merely to stock market outperformance in January relative to the other months of the year. Rather, it also extends to the type and form of stocks that tend to generate the highest returns during January.

Empirical research published in 2009, Gambling Preference and the New Year Effect of Assets with Lottery Features by Dorian-Jiang-Peterson, found evidence for seasonally high risk appetite at the beginning of the year. The research shows that lottery-type stocks – those with low prices, high volatility and / or high skewness – tend to outperform during January. Moreover, out-of-the-money options tend to be relatively more richly priced than at-the-money options – especially when compared to the relative pricing of the options in other months. The most striking relative outperformance in January was found to be that between high volatility and low volatility stocks.

Notably, the raised gambling appetite at the start of the year is not only an American phenomenon. In China, Chinese lottery-type stocks tend to outperform around the Chinese New Year (rather than in January).

Other empirical research has also identified the following phenomena related to the January Effect:

Small-cap stock risk premia, that is the outperformance of small-cap stocks over large-cap stocks over the long-term, is almost entirely captured during Januaries. January is the time of year to be long small-cap stocks.
High-volatility stocks, on average, only outperform in January and underperform the rest-of-the-year.
Bond term premium – that is, the excess return from being long, longer-dated bonds over shorter-date bonds – is earned almost entirely outside Januaries. January is not the time of year fixed-income investors should be extending duration.
Reversion-to-the-mean strategies tend to, on average, outperform momentum strategies in January. This is probably explained to some extent by tax-loss selling whereby underperforming stocks are sold at the end of the year to reduce tax liabilities and bought back at the start of year.
High-yield debt and the US dollar, on average, tend to fare better in January than during the rest of the year.

Finally, some detailed but somewhat dated studies have found that the bulk of the January effect comes in the first few days of the year – a pattern also found in many other countries, even those where the tax year does not coincide with the calendar year.

Explaining the January Effect

The persistence of the January Effect is somewhat baffling; one would expect it to have been arbitraged away by now. The reasons often cited for its persistence are technical and behavioural such as tax-loss selling and institutional investor window-dressing.

Tax-loss selling puts general pressure on underperforming assets and those exhibiting low-levels of liquidity at year-end. A technical factor leading to the selling at year-end is also likely to contribute to inflated demand for such assets at the start of the year.

Institutional window dressing is the tendency of institutional investors to want to show safe, liquid and outperforming assets on their books when holdings are revealed at the end of the year. Such behaviour tends to drive demand for momentum stocks and government bonds in November and December, which is probably reversed at the start of the following year.

Another plausible behaviour factor is the feeling of starting the year anew and full of optimism. That is optimism is high in January and recedes over the course of the year as reality sets in and risks manifest.

Positioning

“Well, this is a bull market, you know” ― Reminiscences of a Stock Operator by Edwin Lefèvre

The longest bull market on record and probably the most hated is unlikely to go out on a whimper. We expect a few fireworks before its all over and that could make the coming January as exciting as any. For that reason, while we would keep some powder dry (cash on the sides), there is a case to be made to add some volatile names to one’s allocation.

That is why we added Slack Technologies $WORK and Uber Technologies $UBER to our Trade Ideas yesterday.

At the same time, we leave you with one more quote from Reminiscences of a Stock Operator, to remind you to reduce exposure once you are happy with your returns.

“One of the most helpful things that anybody can learn is to give up trying to catch the last eighth—or the first. These two are the most expensive eighths in the world.”

Thank you for your support during 2019!

Loan Growth, US Dollar Liquidity Dynamics and Gold

“A man who is used to acting in one way never changes; he must come to ruin when the times, in changing, no longer are in harmony with his ways.” ― The Prince (1532), Machiavelli Niccolò

A quote-heavy piece to aid us as we start thinking about and preparing for 2020. In this week’s piece we focus on US dollar liquidity and gold.

Before the update, we wanted to comment on many people bemoaning President Trump’s habit of tweeting market moving news, or that purported to be news, in and around market trading hours. Whilst unfortunate, as the following quote from Robert E. Shiller shows, President Trump is not the first and unlikely to the be the last US President trying to nudge the equity market higher:

President Calvin Coolidge was an exceptionally pro‑business president. His most famous quote is “The business of America is business.” He was criticized for not bringing artists and classical musicians to the White House. He just brought businessmen. He liked businessmen. He believed in them. Whenever the stock market had a downturn, he would get on the radio — or Andrew Mellon, his US Treasury secretary would. Coolidge thought that was his job, to reassure the Americans that business is sound and profitable. It led to the biggest stock market boom seen at that point in history. I think it shows that political leaders do have an influence on the markets, so we can learn lessons.

On to the update.

Commercial and Industrial Loans

From Interest Rates, the Markets and the New Financial World (1986) by Henry Kaufman (emphasis added):

With the onslaught of deregulation, financial innovation, and new technology, government officials have urged private market participants to limit their zeal―as one authority recently put it, “to suppress the drive to reach out for that one last deal or that last basis point of profit.” These pleas are laudable but ineffective. Market participants cannot avoid being caught up in debt creation. If they turn their backs on the world of securitized debt, proxy debt instruments, and floating-rate finance, they will lose market share, fail to maximize profits, and be unable to attract and hold talented people.

The driving force for underlying profits is credit growth, and in the process the most conservative among institutions compromise standards and engage in practices that they would not have dared pursue a decade or two ago. The heroes of credit markets without a guardian are the daring―those who are ready and willing to exploit financial leverage, risk the loss of credit standing, and revel in the present casino-like atmosphere of the markets.

From Money creation in the modern economy, issued in the Bank of England’s Quarterly Bulletin 2014 Q1:

Banks making loans and consumers repaying them are the most significant ways in which bank deposits are created and destroyed in the modern economy. But they are far from the only ways. Deposit creation or destruction will also occur anytime the banking sector (including the central bank) buys or sells existing assets from or to consumers, or, more often, from companies or the government.

Banks buying and selling government bonds is one particularly important way in which the purchase or sale of existing assets by banks creates and destroys money. Banks often buy and hold government bonds as part of their portfolio of liquid assets that can be sold on quickly for central bank money if, for example, depositors want to withdraw currency in large amounts.

According to the Federal Reserve’s most recent senior loan officer survey released last month, banks left commercial and industrial lending standards mostly unchanged amid weakening demand in the third quarter of 2019. Weakening demand for credit from the commercial and industrial sectors means that residential mortgage demand is the only engine for credit growth in the US economy at present. That is not a healthy dynamic. If not loan demand, particular from corporations, remains weak this will call into question the continuation of the US’s record long economic expansion.

Liquidity Metrics Do Not Signal A Continuation of the Gold Rally, At Least Not Yet

The below chart is of the price of gold, in US dollars, versus and adjusted metric of US broad money supply, M2.

Gold and M2.png

We have adjusted money supply such that a rising (magenta) line indicates that the creation of dollar liquidity in the monetary systems exceeds the needs of the economy. Excess liquidity creation translates into a debasement of the currency relative to real assets. A declining line is indicative of the monetary system not generating sufficient liquidity as demanded by the economy.

Gold functions both as a safe haven and a real asset. Therefore, its price has three broad drivers: the demand for safety (or high-quality collateral), the amount of excess liquidity being created by the monetary system and the level of real interest rates. Outside of periods of economic uncertainty, the primary determinate of the price of gold is the level of excess liquidity being generated.

As we can see from the above chart, there has been very little excess US dollar liquidity being generated by the economic system. Rather, the level of liquidity has just about been sufficient to support the US economy’s demand for dollars and this does not take into account the demand emanating from other economies. Therefore, the price of gold has been driven by demand for safe haven assets and declining real yields, which to an extent also reflect safe have demand.

With demand for credit in the US remaining tepid, as discussed above, we do not expect excess dollar liquidity manifest. Rather, an accelerant coming from either a further loosening of monetary policy by the Fed, the US Treasury draining its cash reserves or some form of fiscal stimulus are the obvious candidates that can lead to increases in dollar liquidity.

For now, with real yields starting to rise gradually, the only bid in gold, we think, is that of capital in search of high-quality collateral.

The Repo Facility is not Gold Neutral

The repo blow-up earlies this year set markets on edge and prompted the Fed to pump billions of dollars of emergency funding into the financial system. That is not all, the Fed has indicated that it will pump almost half a trillion dollars into the financial system over the end of the year, dramatically increasing intervention in the market in an attempt to avoid a repeat of September’s alarming rise in short-term borrowing costs.

The expansion of the Fed’s balance sheet and the pumping of US dollars into the repo market has been seen by some as bullish for gold. We think that drawing such conclusions is perilous for investors. Adding liquidity to the repo market to increase reserves is not akin to generating excess liquidity because adding liquidity into the financial sector’s “plumbing” does not result in said liquidity making its way into the economy. Rather this liquidity remains in the financial system, allowing it to operate without, hopefully, any further hiccups.

If this is not completely clear, we apologise and request you to please get in touch as we can share articles from those better placed to discuss the intricacies of the repo market and the plumbing that underpins the financial system.

Change is Afoot

“Good governance with good intentions is the hallmark of our government. Implementation with integrity is our core passion.” ― Narendra Modi, current Prime Minister of India

From the Wall Street Journal:

“India, the world’s biggest untapped digital market, has suddenly become a much tougher slog for American and other international players.

Over the past year, Indian policy makers have begun erecting roadblocks through special requirements for how U.S. tech companies structure their operations and handle data collected from Indian customers, according to industry executives and experts following the market.

Seeking to match China’s success at protecting and promoting homegrown tech giants, such as Alibaba Group Holding Ltd., Tencent Holdings Ltd. and TikTok parent Bytedance Inc., India is increasingly trying to shelter domestic companies. In the crosshairs, beyond Walmart, are firms including Amazon.com Inc., Alphabet Inc. ’s Google and Facebook Inc. and its WhatsApp messaging service.

Indian officials say they have an array of aims: protect small bricks-and-mortar businesses, secure user data and allow room for India’s own tech firms to grow. That smacks of protectionism to Western tech executives, who say India’s goals make it difficult to predict business conditions.”

The best laid plans of mice and men often go awry.

Investing in emerging markets is fraught with risk. Moral hazard and fluid regulatory regimes, means unsystematic risk cannot be easily diversified away, especially by foreign investors.

On to the update.

Change is Afoot: Fiscal Stimulus

Last week we commented that for markets to continue marching to higher levels there is a need for another catalyst. This week, we seem to have received the first hint what that may be.

Japan’s Prime minister Shinzo Abe has launched a new fiscal stimulus program with a larger-than-expected yen 13.2 trillion (US dollar 121 billion) package to repair typhoon damage, upgrade infrastructure and invest in new technologies.

According to the Financial Times, “the spending package is one of the largest since the 2008-09 financial crisis, as Japan seeks to fend off weakness in the global economy, drag from a recent rise in consumption tax and the risk of a slowdown after next summer’s Tokyo Olympics.”

Since the Global Financial Crisis, despite loose monetary policy and record low interest rates, corporate spending in most major economies, as a share of GDP, has failed to reach pre-crisis levels. For example, the below is a chart of gross private investment in the US as a percentage of GDP.

Cyclically, US domestic investment peaked at the end of 2014 ― right after oil prices collapsed, sending shale companies into a tailspin and drastically slowing the pace of capital heading for the shale patch. Just as gross private domestic investment started picking up again in response to President Trump’s tax reforms, the Fed started tightening monetary policy by raising interest rates and shrinking its balance sheet. Meaning that the global economy remained deprived of the two engines of increasing capital investment and loose monetary policy in the US firing simultaneously.

The Fed has since famously reversed course by cutting rates and re-starting balance sheet expansion. Corporate spending, however, has not picked up.

Corporations do not like to invest in uncertain times and there has been plenty of uncertainty about. To continue with the US as an example, companies are still coming to terms with the impact of the trade dispute with China and at the same time facing the prospect of an Elizabeth Warren or Bernie Sander presidency ― both candidates running on platforms with socialist leaning policies and neither seeming in the mood to curry favours to big business.

With corporations unwilling to spend, governments need to take the lead. And Prime Minister Shinzo Abe’s announcement this week indicates that the powers that be in developed market economies are getting the message.

Europe, too, seems to be getting its act together. Governments, universities, EU institutions and a number of major corporations have joined forces in a new industrial policy drive that could become a blueprint for many other technologies and sectors. A fear of becoming an economic and industrial backwater in the face of US technological supremacy, growing trade protectionism and Chinese state capitalism, European leaders, despite facing much political criticism, have embraced a reinvigorated industrial policy as a tool to assert the continent’s technological independence and ensure its economic survival.

The next step for Europe is too see a coordinated effort towards a comprehensive fiscal policy and loosening of the purse strings. With discussions over the EU’s euro 1 trillion-plus Multiannual Financial Framework on going, there is still hope for Europe to follow Japan’s footsteps towards a looser fiscal policy.

If the US, Japan and Europe can pick up the slack from corporations and engage in loose fiscal policies in and around the same time, the longest economic expansion on record can get longer and global equity markets can head higher still.

The Importance of Fiscal Stimulus

Why is fiscal stimulus important? To answer that question, we turn to the Kalecki-Levy Profit Equation:

Corporate Profit = Investment + Dividends – Household Saving – Government Saving – ROW Saving

From Profits and the Future of American Society: A Dramatic New Perspective on Capitalism by S Jay Levy and David A. Levy:

“The effect of government saving on the profits of the consumer-goods sector is the same as the effect of household saving. Whether consumers themselves save or government acting as their “purchasing agent” saves, the money will not reach the consumer-goods sector. Thus, a government surplus, like personal saving, would be a negative source of profits.

In 1980, the government had a deficit; its outlays exceeded its receipts. In other words, the government borrowed. Thus, it added to the flow of funds into the consumer-goods sector; it contributed to the sector’s profits. A government deficit is always a positive source of consumer-goods-sector profits.”

Most developed market governments can create money directly. Giving them, at least theoretically, an infinite capacity to borrow and dissave. More importantly, governments do not, or at least should not, operate for their own wealth generation, rather they operate for the benefit of the populace. For this reason, in periods where the desire to save is high, and the desire to invest is low, governments must dissave by running deficits and be the propellant for their stalling economies.

Based on the above formula, we can see that government spending (or dissaving) increases corporate profits. Increasing corporate profits, generally, translate into increased employment, higher wages and increased liquidity. All factors that contribute positively to household wealth and should translate into rising equity prices.

US Housing and Consumer Charts and More

“Housing wealth – the net equity held by households, consisting of the value of their homes minus their mortgage debt – is the most important source of wealth for all but those at the very top.” ― Janet Yellen

“Housing traditionally is not viewed as a great investment. It takes maintenance; it depreciates. It goes out of style. All of those are problems. And there’s technical progress in housing. So, new ones are better. So, why was it considered an investment? That was a fad.” ― Robert Shiller

A short one this week.

A technology focused private equity fund manager is buying a stake in an English football club at a huge mark up over its last valuation. LVMH is acquiring Tiffany’s by paying a premium of 37 per cent over its undisturbed share price and in the process more than doubling its market share in branded jewellery. Saudi Aramco is slated to go public imminently with the largest market capitalisation for any company listed across any market.

These are exactly the kinds of events that would be expected in and around market tops. It is getting precarious and we would not be surprised to see a pull back with bullish sentiment so high and VIX so low. With global central banks in easing mode and given the abundance of liquidity, we still expect markets to push on to higher levels before the party ultimately ends. For markets to continue marching to higher level, however, we think there is a need for another catalyst ― what that may be remains to be seen.

On to the update.

US Housing and Consumer Charts and More

US Housing and Durables Goods Spending

Falling long-term interest rates equate to more affordable housing and on a relative basis make the economics of owning a home better than of renting one. With, US long rates having dropped sharply during the summer, US home purchases have picked up.

On an annual basis, sales in October increased 4.6 per month from the same month the previous year, marking the fourth straight month of year-over-year gains.

The below are charts of the year-over-year change in new houses sold and new residential building permits issued versus the year-over-year growth in consumer spending on consumer durables, respectively.

The following is a chart of the Consumer Discretionary Select Sector SPDR ETF $XLY versus monthly consumer durable expenditures.

If spending on consumer durables picks up as is suggested by the pickup in demand for housing, the consumer discretionary sector is likely to be one of the better performing sectors in the US market in the coming months.

US Real GDP and Real Long-Term Yields

The below is a chart of US real GDP growth versus the yield on 10-year Treasury bonds deflated by CPI. Barring a sharp drop in the GDP print for the second half of the year, long-term bonds still look expensive.

The Search for Anti-Fragility

Nassim Taleb describes antifragility as a property of systems that increase in capability to thrive as a result of stressors, shocks, volatility, noise, mistakes, faults, attacks, or failures.

As markets scale to new heights, it becomes increasingly important to scale into assets that provide some degree of antifragility, that is benefit from rising volatility.

Over the coming weeks and months, we hope to identify as many antifragile assets as we can to provide different options investors can incorporate into their portfolios. One such asset is the Japanese yen.

Since the beginning of 2009, the VIX has increased by 10% or more from one trading day to the next on 225 occasions, on average the Japanese yen, versus the US dollar, has gone up by 30 basis points on those days. The VIX has increased by 20% or more from one trading day to the next on 61 occasions, on average the Japanese yen has gone up by 50 basis points on those days. The VIX has increased by 30% or more from one trading day to the next on 22 occasions, on average the Japanese yen has gone up by 80 basis points on those days. The very definition of antifragile.

A Mix of Macro Charts

“The Federal Reserve has an official commitment to two different policies. One is to prevent inflation from getting too high. The second is to maintain high employment… the European Central Bank has only the first. It has no commitment to keep employment up.” ― Noam Chomsky

“A small group of people, they raise the price of oil and the whole world will suffer from this.” ― Ahmed Zaki Yamani, minister in OPEC for 25 years

A Mix of Macro Charts

In this week’s piece we share three macro charts that we hope will provide readers with an insight on how various risks are priced in markets by a seeming disparate range of instruments and indicators.

Short-Term Rates and the Yield Curve

YC 3m bills

The above chart is of the de-trended 3-month Treasury bill rate (inverted) ― de-trended by subtracting the 10-year moving average from the bill rate ― versus the US Treasury 10-year and 3-month yield curve. The chart dates from 1962 till today, suggesting that the de-trended 3-month Treasury bill rate contains information about the direction of the yield curve.

The two-time series have a correlation of -0.77 with an r-squared of 59 per cent.

(The dashed lines on the above chart are the average de-trended bill rate and levels one standard deviation above and below the average.)

The relation between the de-trended bill rate and the yield curve indicates a strong tendency of interest rates to mean revert. The wider the gap between the current de-trended bill rate and its long-term average, the stronger the markets expectation of mean-reversion. For example, the de-trended bill rate being one standard deviation above (below) its average generally serves as a guide post to position for a yield curve steepening (flattening / inversion). (The time series is inverted, so above the average means visually below on the chart.)

The de-trended bill rate recently reached one standard deviation above its long-term average and has since turned down, suggesting that fixed income investors position for a yield curve steepening, as opposed to a direct long or short position at either end of the curve.

Equity market investors can play a steepening yield curve by being long financials.

The Golden Period of Risk-Parity and 60/40 Allocations

stock bond correl

The above chart is the 6-month rolling US stocks-to-bond correlation and the 6-month rolling average of the annual rate of inflation, as measured by the consumer price index.

The relationship demonstrates (1) how the capital markets price in inflation and (2) the correlation between stocks and bonds is not static. The implication of the latter is that bond allocations do not always serve as a suitable diversifier for equity allocations. Rather, it is the prevailing market regime that determines the efficacy of bond allocations to lower draw downs and portfolio level volatility during equity market sell-offs.

Capital markets price in inflation ― outside financial crises when the safe haven demand for bonds can overwhelm implicit inflation expectations ― through an adjustment of the correlation between stocks and bonds. During the period from 1965 through to 1997, when inflation expectations experienced large swings, the stock-to-bond correlation was almost consistently positive. That is, changes in inflation expectations drove both stock and bond returns and during periods of equity market weakness bond allocations did not make up the difference. For example, in the sub-period between 1973 and 1981, during which there was a negative supply shock from the OPEC oil export embargo, multiple recessions, high unemployment rates and high inflation, equity market weakness coincided with a poor bond market performance.

To re-iterate the point again, it is market regime that determines whether Treasury bonds are a “wonderful hedge” or a “terrible investment”. Moreover, we can from the chart above why the last decade and a half has been a golden period for risky parity strategies and 60/40 allocations ― stock-to-bond correlations have been and remained at or close to 100-year lows.

The question then is, how does one determine market regime?

Market regime is just another way of saying inflation expectations. Rising inflation expectations equate to rising stock-to-bond correlations. Retreating inflation expectations translate to declining stock-to-bond correlations. By extension, something touched upon last week, the combination of stable, that is expectations of more of the same, and low-levels of inflation makes for the optimal investment environment.

Continuing to bet on more of the same when stock-to-bond correlations have been at 100-year lows for a prolonged period is surely asking for trouble. All the more, with political movements the world over nudging the global economy from being driven by negative and positive demands shocks to becoming one that will be driven by positive and negative supply shocks, a market regime change seems inevitable.

Demand shocks, either positive or negative, do not move the Phillips curve; supply shocks, however, shift it in and out. When the Phillips curve shifts in response to a negative supply shock, nominal bonds exacerbate losses suffered in equity markets. For example, an adverse supply shock in the form of the oil embargo by the OPEC in 1973 shifted the Phillips curve by increasing both production and distribution costs of almost all industries and led to losses for both equity and bond market investors.

That is why we think investors need to consider instruments other than bonds to hedge equity allocations. The Japanese yen, precious metals, Treasury Inflation-Protected Securities (TIPS), oil and energy stocks are some of the viable options. It is likely that there are others.

Why do we keep insisting on oil and energy stocks? Well because oil is the most obvious negative supply shock we can conceive of in the event of an Elizabeth Warren or Bernie Sanders presidency. Both Democratic presidential contenders have proposed to ban fracking altogether.

Europe Sovereign Risk Model

euro sov risk.png

The above chart is the ratio of gold, in euros, to the Euro Area all shares index versus the differential between 10-year government bond yields of the ‘fragile’ European economies and Germany. (For the latter we use the average of the yields on Spanish, Portuguese and Italian 10-year bonds and subtract from it the yield on 10-year German bonds.)

The two series are a means of measuring sovereign, or break up, risk in Europe. Rising ratios imply rising sovereign risks and a rush towards the safe havens of gold and German debt. Recently, with gold having rallied and some form of Brexit related agreement forming, the two time series have diverged. The yield differentials indicate a declining risk premium while the gold-to-shares ratio indicates a rising risk premium.

We think the two series should start to converge with European stock markets continuing to head higher.

The Fallout

#MeToo: Hollywood Goes for the Jugular

A Few Charts

What About Tesla?

Software Over Semiconductor

Pakistan

Some Caution is Warranted

Cyclical Not Secular

Financial Innovation in the 1920’s

Financial Innovation in the 2000’s

Financial Innovation Today

Contents

Thoughts and Investment Ideas for 2020

Ideas

Summary

Energy

Tactical Perspective

The Speculative Phase: Software Over Semiconductors

Playing the Strength in US Housing Demand

Founder Exodus: A Reduction in Existential Flexibility

USD

Yield Differentials

From the Perspective of Select ‘Fragile’ Emerging Markets

Thoughts

Summary

Macro Risks

Inflation is the Enemy

Asset Allocation

Valuations

US Treasury Yield Curve

Modern Monetary Theory

The Practical Implications

Books

Five We Have Read and Recommend

Five from Our 2020 Reading List

The January Effect

Explaining the January Effect

Positioning

Commercial and Industrial Loans

Liquidity Metrics Do Not Signal A Continuation of the Gold Rally, At Least Not Yet

The Repo Facility is not Gold Neutral

Change is Afoot: Fiscal Stimulus

The Importance of Fiscal Stimulus

US Housing and Consumer Charts and More

US Housing and Durables Goods Spending

US Real GDP and Real Long-Term Yields

The Search for Anti-Fragility

A Mix of Macro Charts

Short-Term Rates and the Yield Curve

The Golden Period of Risk-Parity and 60/40 Allocations

Europe Sovereign Risk Model