Arete's Observations 10/23/20

Market observations

While stocks haven’t done much of anything for a month and a half now, optimism still remains. In particular, the performance of recent IPOs has been phenomenal. A lot of this has been driven by an explosion in special purpose acquisition companies (SPACs).

SPACs are also known as “black check” companies because they don’t have any operating business when they list. Investing in a SPAC is like giving a blank check to someone and hoping you get some money back. That said, SPACs can provide a viable alternative to an IPO for some companies, but almost anyway you look at it, they are speculative ventures.


The End Game Ep. 9 - Felix Zulauf

If fiscal stimulus is provided as needed to generate growth, “government debt explodes, to even higher levels and not only government debt explodes but also the government share of our economies. In the second quarter for the US economy, government share of GDP, nominal GDP, jumped form the mid 20s of what it was to the upper 40 percent.”

“We are moving into a planning economy. It’s government led, it’s government manipulated, it’s government intervened. The free market is pushed out and the planning guys are running the show.”

This is an extremely revealing perspective from one of the great macro investors, Felix Zulauf. For one, while the debt funded fiscal relief may have seemed necessary to ensure economic continuity, it came with a price. That price is an economy dominated by government spending.

For those worried that Democratic victories in the election may lead to socialism, it’s a bit late for that; it’s already happened. Along with the greater spending conferred to the government comes greater power to allocate resources according to political interests. And when that happens, the way the economy works begins to change too. Zulauf is preparing for this, as should we all.

Quarterly earnings

WD-40 Company Reports Fourth Quarter and Fiscal Year 2020 Financial Results

"An unexpected developing trend we experienced in the fourth quarter was an increase in demand for products linked to renovation trends associated with the COVID-19 pandemic.  It seems that the more time people spend isolated in their homes, the more time and money they spend making home improvements.  We are calling this trend, 'isolation renovation' and in nearly all our direct markets we saw double-digit sales growth of WD-40 MultiUse Product due to this phenomenon."  

Perhaps not too surprising, but interesting nonetheless. I know as I spend more time at home I keep noticing things that need to be fixed or improved. It sounds like the same thing is happening to other people as well.


KNX 3Q20 Earnings Presentation

“Inventory restocking and strong demand will support a favorable environment into 2021”

Container Slots Sell Out, Risking Holiday "Shipageddon"

"’The ships are 100% full. The containers are 100% full. Youcan’t get a container built. You can’t pick up a ship from the spot market. The whole container-shipping cycle is at absolutely full pulse,’ exclaimed Jeremy Nixon, CEO of Ocean Network Express (ONE), the world’s sixth-largest container line.”

There seems to be a similar phenomenon going on in both the trucking and shipping industries: Replenishment of depleted inventories is putting pressure on demand while capacity is constrained on the supply side. The big question is, how long will this last? Is the problem transient or structural?

I suspect it is a bit of both. Insofar as that is true, we can infer a couple of things. One is that overall consumer demand will depend greatly on government spending which will be largely unpredictable as to beneficiaries, magnitude, and timing. As such, it will be extremely difficult to manage supply in asset heavy businesses such as trucking and shipping. As a result, it is also fair to expect a lot of inefficiencies and volatile swings as well.


“War and Peace”

“Does it matter if Donald Trump may be a proto-fascist or Joe Biden turns out to be an AOC-type socialist ? [sic] Just as an iceberg is 90% underwater, so too is it likely the core driver of our anxiety is not our bloviating leaders, but rather the grinding transition of power from the Baby Boomers to the Millennials.”

“What is unique about IRAs is that by Federal law they are subject to a Required Minimum Distribution (RMD) once one reaches the age of 70½ to 72. I will save you the math and offer that at least $75bn of these IRA assets must be sold this year, rising to about $250bn in 2030.”

Harley Bassman is one of the most knowledgeable people in the investment business and is also generous enough to share many of his insights on his website. He also has a deep appreciation for history that makes his perspective all the more valuable.

The overarching theme of his latest note is that demographics is the driving force behind much of what we are experiencing. I completely agree with this. I also agree with his perspective that the details of the election this year matter less than the “grinding transition” of power from one generation to another. Many of the challenges we are facing, and many of the differences in opinion about how to resolve them, are ultimately a function of this transition.

One of the many potential challenges is that of mandatory IRA distributions. Those are projected to increase significantly and will create an ongoing liquidation of stocks. If fresh demand for those stocks fails to keep up, prices will be set by discretionary buyers who will only be incentivized to bid at prices that ensure attractive returns. In other words, stocks could go down a lot. For people looking for the cause of the next big downturn, it may be as innocuous, yet intractable, as demographics.


The Projection Racket, Pt. 2

With so much attention being placed on single issues and partisan preferences, one really important issue is often overlooked: our political representation increasingly does not accurately reflect the will of the people. In this respect, our form of democracy is not working well. This is way beyond Democratic or Republican influence. These are structural problems in our political system.

The guys at Epsilon Theory do as good a job as I have seen in articulating the problems and recommending possible fixes. I don’t agree with everything, but I believe the ideas are extremely thoughtful. If you do get a chance to read through the full text, I’d love to hear your thoughts.

Public policy

Caught in a Debt Trap

“I have read that much of the US loses as much as 20% of the water our water systems produce due to leaky pipes. To rebuild the national water system would take hundreds of billions if not over $1 trillion. Congress can easily allow the formation of a public-private partnership and guarantee the bonds so the Federal Reserve could buy them. Cities could access those bonds and raise the cost of water by 1% or so to pay for the bonds. Consumer water bills should still drop since we would be saving 20% of the lost water.”

“Everyone knows this. Congress does nothing. The same could be done with electric power. A smart grid could pay for itself even with debt costs. And consumer power prices would likely go down. I could go on and on.”

John Mauldin makes a good point here. The lockdowns imposed in March reduced or eliminated a lot of incomes which was one problem that needed to be addressed. As a result, it is understandable that a good portion of the funds were aimed at relieving those conditions.

What is less understandable is why there is not greater scrutiny placed on fiscal spending that requires the issuance of debt, especially now. After all, unproductive debt creates a long-term drag on the economy and therefore should only be employed as an emergency measure.

Further, there are plenty of projects that could be funded by debt that could still help the economy long-term. Mauldin provides a couple of examples and I have some of my own. I would put investment in human capital at the top of the list. This would involve making education more accessible, expanding technical and vocational education, and making broadband more accessible. Unfortunately, debt funded handouts will come with a price later on.

Raghuram Rajan: ‘Society has to find a new equilibrium’

“The history of the 20th century, regardless of the system you look at, is the growth of both markets and the state together. And to some extent, the superstate, because we’re beyond national capitals determining everything. But when the power is taken out of the nation-state, the problem is this leaves the person at the bottom without much power.”

“But I think the breaking of family ties by the creation of market mechanisms, or government mechanisms, is an inexorable process, and has benefits, but we also need to find ways to preserve the spirit of the community.”

Preferences for public policy measures have always been shaped by political beliefs. Rajan’s analysis reveals that the predilections of both major parties miss important points. Namely, in the battle for prominence between markets and the state, the important role of the community has often been overlooked.

It is important to appreciate this has not happened as a result of any evil plan. There are clear benefits from free markets just as there are clear benefits from effective government. In fact, the dominance of these ideologies is largely a function of their success.

That said, all is not well. Inequality is high and rising and the prospects for younger generations are just not as good as they were for their parents and grandparents. Perhaps the revitalization of our communities can help repair some of these problems. Rajan thinks so and I think he makes a great point.


A New Bretton Woods Moment

“Today we face a new Bretton Woods ‘moment.’ A pandemic that has already cost more than a million lives. An economic calamity that will make the world economy 4.4 % smaller this year and strip an estimated $11 trillion of output by next year.And untold human desperation in the face of huge disruption and rising poverty for the first time in decades.”

“Once again, we face two massive tasks: to fight the crisis today— andbuild a better tomorrow.”

These comments were made recently by Kristalina Georgieva, Managing Director of the IMF. As a reminder, Bretton Woods was the agreement made in 1944 that laid out the post war currency and financial system. In other words, it was a major, formative event that has shaped the world ever since.

As a result, it is fair to assume that the reference to a “Bretton Woods moment” was used either to gain attention, which is distinctly possible, or it was used to plant the seeds for a formal restructuring of the global currency and financial system, which is also possible.

In this case, I suspect it was more of the former than the latter. If it were intended to anchor a debate about fundamental change it would have been more substantive.

That said, one of the biggest structural problems in the global economy is the dominance of the US dollar as a reserve currency. This exacerbates the tendency for capital to flow to the US and constrains the ability of currencies to adjust. In other words, there is a structural imbalance in the global economy which will persist until the currency system is changed. Such a change would be a big deal and is definitely worth keeping an eye on.


The graph below from The Daily Shot is just one of many that shows rising expectations for longer-term inflation. I have written before that I do believe inflation will rise longer-term but not before we experience some disinflation first as a result of weak economic growth induced by the pandemic.

While it is possible to interpret these results as a belief in the return to healthier growth, I believe another interpretation is even likelier: In order to keep the economy moving, enormous amounts of debt will be issued and eventually this will lead to debasement of the currency. Regardless, this is something to watch. When longer-term rates start rising definitively, it will shake the world of risk assets.

Asset allocation

GMO 7-Year Asset Class Forecasts: 3Q 2020

GMO is well-known as a value shop, long-term investor, and contrarian. It is also well-known for its asset class forecast which is shown above.

One key point is that expected returns vary over time based upon economic and financial conditions as well as valuations. As obvious as this sounds, there are a lot of investors and advisors that plug in a single number like 6.5% for real returns for US equity regardless of the conditions.

So, one point is that using static, backward looking expected return estimates can produce extremely misleading results. Relatedly, using an expected return of 6.5% or thereabouts will currently produce an extremely optimistic result.

In fact, a simple 60-40 mix of large US stocks and US bonds is expected to provide an annual loss of 4.9% or a total loss of about 30% over seven years. Of course, there are ways to minimize this risk, but first one must be aware of them.

Risk management

The Financial Analysts Journal and Investment Management

“A search of books published over the period 1980-2012 on the term "portfolio Insurance" (using the Google N-gram viewer) showed a peak in 1990 and a decline to near zero by 2012, which is consistent with a half-life of interest in extreme risk mitigation of about 10 years.”

So, the last extreme risk event was 2020 – 2008 = 12 years ago. Wait, that’s more than ten years …

Implications for investment strategy

As we countdown towards the election I am finding all kinds of articles that map out scenarios of various election results and the subsequent effect on markets. I’m sure you are too. I don’t think it does anything meaningful to improve investment results. A higher capital gains tax here for a while or a lower corporate tax rate there for a while don’t fundamentally alter how the economy or the markets work.

What does matter are the ultimate causes of our big challenges, not the proximate ones. The really big problems facing the economy, and ultimately the markets, are founded in unfavorable demographics, excessive debt, and the role of the US dollar as the world’s reserve currency. The consequences of these challenges are manifold.

One big consequence is that it becomes all too easy to focus on undesirable symptoms and then politicize them. This has the effect of misdiagnosing problems and misdirecting resources. It also has the effect of distracting attention away from the real issues.

While there is a lengthy discussion that could ensure from this line of thinking, the thread that is relevant for investment strategy is systemic failure to address and correct structural flaws does not bode well for the long-term health of the economy or markets. This is a major reason why I have recommended defensive positioning. There will be a reckoning, but its timing and duration are unknowable.

What is more knowable is the likelihood of central banks continuing to flood the landscape with money. As a result, protecting against the potential for inflation to wreak havoc on financial assets ought to be a primary consideration. There are different ways to go about this, of course, but the biggest issue will be realizing just how fundamentally different the playbook will be.

Principles for Areté’s Observations

  1. All the research I reference is curated in the sense that it comes from what I consider to be reliable sources and to provide meaningful contributions to understanding what is going on. The goal here is to figure things out, not to advocate.

  2. One objective is to simply share some of the interesting tidbits of information that I come across every day from reading and doing research. Many of these do not make big headlines individually, but often shed light on something important.

  3. One of the big problems with investing is that most investment theses are one-sided. This creates a number of problems for investors trying to make good decisions. Whenever there are multiple sides to an issue, I try to present each side with its pros and cons.

  4. Because most investment theses tend to be one-sided, it can be very difficult to determine which is the better argument. Each may be plausible, and even entirely correct, but still have a fatal flaw or miss a higher point. For important debates that have more than one side, Areté’s Takes are designed to show both sides of an argument and to express my opinion as to which side has the stronger case, and why.

  5. With the high volume of investment-related information available, the bigger issue today is not acquiring information, but being able to make sense of all of it and keep it in perspective. As a result, I describe news stories in the context of bodies of financial knowledge, my studies of financial history, and over thirty years of investment experience.

Note on references

The links provided above refer to several sources that are free but also refer to sources that are behind paywalls. All of these are designed to help you corroborate and investigate on your own. For the paywall sites, it is fair to assume that I subscribe because I derive a great deal of value from the subscription.


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