Inflation, Earnings Yields, Stock Prices and Gold
We examine the relationships between inflation, stock prices, valuation multiples, real yields and gold. 15 Nov 2019.
China’s Priorities | Industrial Strength $XLI
Signs of Rotation: Geography, Sector and Style
Eight US Stocks We Are Tracking
Tribalism and Consistency in a Volatile Market
A somewhat lengthy piece discussing some of the psychological hindrances all of us face from time-to-time in investing and trading pursuits.
We share one chart right at the end of the piece with little comment, which is the basis of our expectation that the US equity market is to see new highs still.
The Science of Tribalism
“Everybody wants to protect their own tribe, whether they are right or wrong.” ― Charles Barkley
While watching television, have you ever looked away or squealed in response to a gruesome scene, the kind that became a regular occurrence on HBO’s Game of Thrones? Turns out, this is because the imagery activates our brain’s empathy network, which then stimulates brain areas involved in the sensation of our own pain.
Neuroimaging studies have revealed that watching another person in pain triggers brain areas that are active when we feel pain. The neural response to seeing others in pain, however, is not constant; rather it is modulated by context and by allegiances.
Neuroscientist David Eagleman used functional magnetic resonance imaging (fMRI) to measure the response in the brain’s empathy network. He examined the brains of people watching videos of other people’s hand getting pricked by a needle or touched by a Q-tip. When the hand being pricked by the needle was labelled with the participant’s own religion, the participant’s empathy network showed a larger spike of activity than when the hand was labelled with a different religion.
More surprisingly, when participants were assigned to an arbitrary group immediately before the subject entered the MRI machine, and the hand being pricked was labelled as belonging to the same arbitrary group as the participant, the participant’s brain still showed a larger spike ― even though the grouping did not exist just moments earlier!
Participants also exhibited a diminished response in their empathy networks if they believed the pain-recipient has acted unfairly in a simple economic exchange or were told that the victim is receiving a large monetary compensation for undergoing the pain.
Commitment and Consistency
“Consistency is the hallmark of the unimaginative.” ― Oscar Wilde
Last week we were forwarded a quarterly commentary and portfolio review for a fund managed by a self-proclaimed “old-school value investor”. The commentary was standard fare really, espousing the well-known values of Graham and Dodd and Buffet and Munger schools of investing as would be expected from a value-oriented manager. The fund manager was particularly insistent that they only buy “companies at a big discount to the present value of their future cash flows”.
As we turned to the section listing the fund’s top holdings, that too read like a standard portfolio that we had seen from countless other value managers. There was a lot of Google in the portfolio, a little Apple, a few big-name financial stocks and a not-so-insignificant allocation to General Motors. Except there was one holding which we did not expect, Netflix. And seeing it in the list of holdings, one of top-five in terms of allocation, irked us. Reading the commentary already felt like it was not the best use of our time but after seeing Netflix in the portfolio, the feeling changed to that of being cheated somehow.
Feeling cheated after reading the commentary and seeing the holdings for a fund we are not invested in, strange right?
The following passage is excerpted from Influence: The Psychology of Persuasion by Robert B. Caldini (emphasis added):
Psychologists have long understood the power of the consistency principle to direct human action. Prominent early theorists such as Leon Festinger (1957), Fritz Heider (1946), and Theodore Newcomb (1953) viewed the desire for consistency as a central motivator of behavior. Is this tendency to be consistent really strong enough to compel us to do what we ordinarily would not want to do? There is no question about it. The drive to be (and look) consistent constitutes a highly potent weapon of social influence, often causing us to act in ways that are clearly contrary to our own best interest.
Consider what happened when researchers staged thefts on a New York City beach to see if onlookers would risk personal harm to halt the crime. In the study, an accomplice of the researchers would put a beach blanket down five feet from the blanket of a randomly chosen individual—the experimental subject. After several minutes of relaxing on the blanket and listening to music from a portable radio, the accomplice would stand up and leave the blanket to stroll down the beach. Soon thereafter, a researcher, pretending to be a thief, would approach, grab the radio, and try to hurry away with it. As you might guess, under normal conditions, subjects were very reluctant to put themselves in harm’s way by challenging the thief—only four people did so in the 20 times that the theft was staged. But when the same procedure was tried another 20 times with a slight twist, the results were drastically different. In these incidents, before leaving the blanket, the accomplice would simply ask the subject to please “watch my things,” something everyone agreed to do. Now, propelled by the rule for consistency, 19 of the 20 subjects became virtual vigilantes, running after and stopping the thief, demanding an explanation, often restraining the thief physically or snatching the radio away (Moriarty, 1975).
To understand why consistency is so powerful a motive, we should recognize that, in most circumstances, consistency is valued and adaptive. Inconsistency is commonly thought to be an undesirable personality trait (Allgeier, Byrne, Brooks, & Revnes, 1979; Asch, 1946). The person whose beliefs, words, and deeds don’t match is seen as confused, two-faced, even mentally ill. On the other side, a high degree of consistency is normally associated with personal and intellectual strength. It is the heart of logic, rationality, stability, and honesty.
The fund manager was inconsistent. He championed investing in “companies at a big discount to the present value of their future cash flows” and then went ahead and owned Netflix. The gall of it!
The Incompatibility of Tribalism and Consistency in a Volatile Market
Our vocation is such that we are often engaged in debate. On the merits of buying one security over another. On the signals from one asset class for the prospects of another asset class. On the reaction function of the Federal Reserve to the latest release of economic data. And on many other topics much like these.
Over the last eighteen or so months, markets have been extraordinarily challenging.
US stocks have rallied, sold off, rallied sharply, sold off sharply, rallied sharply and now started to chop. G-7 governments have sold-off with the US ten-year reaching yields of 3 per cent and then rallied to record low yields. The trade-dispute between the US and China has escalated, de-escalated and escalated again on more occasions than we care to recall. Bitcoin lost more than two-thirds of its value, then tripled and then halved. Repo rates spiked for reasons no-one can fully comprehend. Oil witnessed the re-emergence of a geopolitical premium only for it to subside almost instantly.
In our discussions and debates, we have found that a fair share of traders, active managers and asset allocators are, more than ever, struggling to keep up, let alone outperform, broader market indices. Markets are never easy, in these challenging climes even less so. Nonetheless, two of the recurring hindrances to better performance we have increasingly noticed are tribalism and consistency.
Tribalism in Social Media and Investment Decision Making
Tribalism can be easy to spot. Just go on to Twitter and you will find bond bulls re-tweeting bond bulls, goldbugs sharing articles of Paul Tudor Jones stating that gold is his best idea for the next two years, equity market bears praising the analysis of other bearish analysts, Tesla bulls and bears slinging mud at each other, the examples are countless. Worse still, try debating with someone you do not know but disagree with and present factual data that invalidates their view and you are likely to be blocked more often than you would expect.
Tribalism in a social media context leads to filter bubbles and to the consumption of news, views and research that confirms that which we already know or believe. The utility of a social media platform, such as Twitter, to a user is significantly reduced by tribal behaviour. It has never been easier, faster and cheaper to seek out and obtain a variant perception. Investment professionals and traders would be better served and probably see improving performance if they used social media platforms more to seek out non-conforming views rather than searching for the false sense of security that belonging to arbitrary Twitter tribe would bring.
In professional settings tribalism is less of a problem but at the same time harder to spot. At investment firms, it usually manifests in team members with non-consensus views or opinions being cast aside in the investment decision making process.
Tribalism can lead to poor investment decision making when good ideas are rejected because they are put forth by those long belonging to the ‘other tribe’ and bad ideas presented by those belong to ‘our tribe’ are accepted.
Worse still, is the case of tribal behaviour on social media that creeps into professional settings. If you are wondering if it really happens, we recently attended a meeting with a prospective client where one of the analysts quoted recent tweets by three, to remain unnamed, permabears to make a case against an allocation to US equities.
Consistency is the Real Enemy
“Laziness isn’t merely a physical phenomenon,about being a couch potato,stuffing your face with fries and watching cricket all day. It’s a mental thing, too, and that’s the part I have never aspired for.” ― Shah Rukh Khan, Indian actor, film producer, and television personality
While tribalism can be toxic, it is consistency that can be the real enemy in the investment decision making process.
Since a “high degree of consistency is normally associated with personal and intellectual strength” it usually serves one’s interests to remain consistent. The downside, however, is that this fosters almost blind consistency which is detrimental, and at times outright disastrous, in the process of investment decision making.
Blind consistency, outside of investment decision making, has its attractions. For starters, it frees up our mental resources by giving us a relatively effortless means for dealing with the complexities of daily life that make severe demands on our mental energies and capacities. Having made up our mind about an issue, blind consistency allows us to stop thinking about the issue and when confronted with the issue we only react in a manner consistent with our earlier decision.
Another attraction of mechanically reacting to an issue is that it protects us from the uncomfortable truth that we may be wrong. If we never expend the energy to understand the counter-argument, and reject it off the bat, we never have to confront the possibility that we may wrong.
Consider the following (real life) examples and if any resonate with you.
Bond bulls who will exit their bonds positions to lock in profits but will never go long stocks because a recession is always just around the corner.
– Gold bears that short at the lows because it’s a ‘barbarous relic’ and fail to cover or go long even as real rates are collapsing.
– Federal Reserve critics that see every market jitter as further confirmation of central banker incompetence but have not taken the time to understand the intricacies of the financial system.
– US dollar bulls that never go long another currency against the greenback even as it becomes painfully obvious that a rally has become over stretched.
– Permabears that told you that Apple was done after the ‘failed’ iPhone 5 and now poo-poo over the company’s services narrative.
– The bearish fund manager that identifies the flaw in his framework that led them to catastrophically underperform over the last decade somehow finds that the updated framework indicates that is time to short US stocks.
– The technical analyst that shows you analogs of today’s US market performance versus sometime leading up to the crash in 1929, 1987, 2008 or any other market crash that can be found or compressed to fit the narrative but never one that shows the market going higher.
All of the above examples are of blindly consistent people. In any other context you would respect them. In an investment context, they would have at times cost you money, a lot of it. In many instances it is acceptable to underperform. It is, however, unacceptable to underperform because you were unwilling to do the work or to appear inconsistent.
Improving Liquidity Indicators Suggest New Highs Still to Come
Combine the below with the three charts we shared last week and the prospect of the S&P 500 reaching levels 10 to 15 per cent higher from here is not altogether unreasonable.
Thanks for reading and please share!
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
Three Macro Charts
“We can chart our future clearly and wisely only when we know the path which has led to the present.” ― Adlai Stevenson I, 23rd Vice President of the United States of America
A short piece with three macro charts and limited commentary.
1. Global Risk
Data validating recessionary fears have been the flavour du jour recently. The below is a chart of the MSCI All Cap World Index and the twelve-month moving average of the Citi Macro Risk Index, which suggests that a cyclical upturn in global equities is probable.
It is not the magnitude rather the direction of the risk index that acts as a cyclical indicator.
A similar sell-off to that witnessed in the fourth quarter of 2018 is not inevitable in the fourth quarter of 2019.
2. Cyclical USD
A custom leading index of global financial conditions suggests the cyclical trend for the USD is lower, even as the secular trend of the greenback remains intact.
3. Secular Trend in Real Yields
Quoting the National Bureau of Economic Research:
“The large and growing US current account deficits resulted from the large volume of foreign savings pushing in, as indicated by the declining US real interest rates, and not from US ‘profligacy’.”
The below chart is of the sum of foreign reserves held by China and Japan (inverted) and the real US 10 year treasury yield, for the period starting right after the Asian Financial Crisis.
The Asian Financial Crisis set in motion the trend of rising current account surpluses in Asia that were funneled back into the US. One major leg that furthered the trend, Chinese savings being recycled into US assets, has been broken by the protectionist policies of the US and economic challenges China is facing up to domestically.
The recycling of Asian current account surpluses into US assets is coming to end at the same time the US is entering a demographic driven inflationary phase, as argued by the Bank for International Settlements.
The secular tailwinds that drove down real yields in developed economies are weakening.
Thanks for reading and please share!
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.
Nothing Unusual | MMT
Clustered Volatility and the “Momentum Massacre”
“But, as with markets, in the ocean the interesting things happen not at the equilibrium sea level which is seldom realized, they happen on the surface where ever-present disturbances cause further disturbances. That, after all, is where the boats are.” ― W. Brian Arthur
Financial markets exhibit a temporal phenomenon known as clustered volatility. That is, the existence of periods of low volatility followed by periods of high volatility. Low volatility reigns supreme when the the outcome of the cumulative actions of market participants mutually benefits the majority. And, by extension, reaffirms the confidence the majority of market participants have in their forecast, “investment process”, algorithm or “analytical framework” ― or, more crudely, heuristics that they use in making their trading or investment decisions. The majority continue to follow their “process” and among the minority that did not benefit in the run up all but the most stubborn gradually adapt their processes to implicitly or explicitly chase momentum. Low volatility begets low volatility.
High volatility often occurs when an external agent, such as President Trump tweeting about tariffs or the People’s Bank of China excessively tightening or loosening financial conditions, disrupts the seeming equilibrium in the market. All else being equal, which it never is, the impact of external agents on market volatility, however, tends to be fleeting. For example, the declining half-life of President Trump’s trade war related tweets impact on the US equity market.
A structural change in volatility generally occurs when some participants or a group of market participants alter their algorithm ― such as shifting from selling at the money puts to deep out of the money puts ― or investment process or by the entry of entirely new participants with a novel agenda ― like the Bank of Japan buying up ETFs as part of its QE programme ― to the market.
The changing of algorithms or processes may, of course, be in response to the actions of external agents or the impact said actions had on the market. Regardless, this “updating” allows the first movers to front-run or anticipate the behaviour of the majority, which in turn causes other investors to re-adapt. This adaptive behavior, if it successfully percolates and propagates, moves the market away from its seeming equilibrium and into a state of ‘chaos’. It is this process of re-adapting that tends to precipitate longer lasting bouts of higher volatility.
Robert F. Engle, the winner of the Nobel Prize in Economics in 2003, formally defined this process of random periods of low volatility alternating with high volatility in financial markets as the the generalised autoregressive conditional heteroskedasticity (GARCH) process. (Heteroskedasticity is where observations do not conform to a linear pattern. Instead, they tend to cluster.)
Momentum Massacre
From the Financial Times on 12 September 2019 (emphasis added):
“The stock market may appear tranquil again after a rollercoaster summer, but many analysts and investors are unnerved by violent moves beneath the surface, reviving memories of the 2007 “quant quake” that shook the computer-driven investment industry.
The FTSE All-World equity index has rallied almost 3 per cent already this month, clawing back some of August’s losses. However, many highly popular stocks suffered a sudden and brutal sell-off this week, a reversal that analysts have already dubbed the “momentum crash”.
The blow was particularly strong in the US, where strong-momentum stocks — those with the best recent record — tumbled 4 per cent on Monday, in the worst one-day performance since 2009, according to Wolfe Research. Only once before, in 1999, has such a rout afflicted momentum-fuelled smaller company stocks, according to investment bank JPMorgan.”
This is massive,” said Yin Luo, head of quantitative strategy at Wolfe Research. “This is something that we haven’t seen for a long time. The question is why it’s happening, and what it means.”
The flipside has been a dramatic renaissance for so-called “value” stocks — out-of-favour, often unglamorous companies in more economically sensitive industries. The S&P value index has climbed about 4 per cent this week and, compared with momentum stocks, enjoyed one of its biggest daily gains in a decade on Monday.
The chart below is the ratio of the S&P Growth index to the S&P Value index. We are struggling to find the “dramatic renaissance”.
Of course we are being more than a bit flippant. Nonetheless, we do not think it is time to completely drop momentum or growth stocks and load up on value stocks. Rather we think the market is in a transient phase where participants are updating their algorithms and processes to go beyond momentum.
Our prescription from June remains valid:
We are increasingly convinced that a barbell strategy should be applied today in managing equity exposures. With tech and other growth names on one side and value names and precious metals on the other. And if tech and growth continue to rally, investors should re-balance regularly to avoid any lopsidedness in their portfolios.
The above has worked well in the recent “momentum massacre” and can continue to work well as long as uncertainty remains high and sentiment viciously waxes and wanes between optimism and pessimism. A slight adjustment to the above, however, is warranted as follows:
A barbell strategy should be applied today in managing equity exposures. With tech and other growth names on one side and value names and precious metals energy plays on the other.
Do Not Drop Momentum ― Not Completely Anyway
Dropping momentum or growth completely would be akin to calling the end of the transition away from actively managed portfolios to passively managed allocations that has accelerated since the Global Financial Crisis. Passive allocations are implicitly momentum seeking strategies. A strong secular trend is not upended by a 4 per cent move, it will take a crisis or a severe re-think of strategic asset allocation by the managers of the largest pools of capital to bring about an end to the trend.
The rise of passive investing, along with systematic volatility selling strategies, has contributed to the dampening of volatility since the Global Financial Crisis. A growing share of passive allocations, however, is somewhat like increasing leverage. As passive flows now make up the lion’s share of capital market flows, the actions of active investors are spread over a smaller segment of the investment universe. As the size of the active universe shrinks, in terms of what could be described as, in the case of stocks, free float market capitalisation minus passive allocations, the actions of active investors begin to have an exaggerated impact and give rise to higher volatility.
Simply put, the passive flows versus volatility curve is convex. Initially, increasing passive flows dampen volatility but beyond some hitherto unknown level increasing passive flows lead to higher volatility.
Why Energy Over Precious Metals?
Without delving into the geopolitics of it, the attacks on the Saudi Arabian oilfield should remind major oil consumers ― airlines, refiners, transportation companies and emerging economies such as India and China ― to review their energy security and hedging strategies. To balance future energy needs and to not become hostage to a rising geopolitical risk premium in the price of oil. This should lead to a rise in demand for oil at the margin; commodity prices are, of course, set at the margin.
The other angle is that if anything is going to take down the almighty bond bull market its going to be either: (1) fiscal spending by the G-7 governments of the like that we have never seen; or (2) a sharp and sustained increase in oil prices.
Lastly on energy, if Iran is, rightly or wrongly, shown to be the perpetrator of the attacks, China may have to reconsider it decision to purchase Iranian oil.
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.