Arete's Observations 12/11/20

Market observations

Ignore the Noise. This Is a Classic Cyclical Recovery

“the story the markets tell about the last few weeks is quite clear. We are in the presence of a classic cyclical recovery.”

“But it seems from latest data that it has taken barely six months to recover from the COVID Crisis!”

John Authers provides a good depiction of the dominant market narrative: The economy has recovered, and the next move will be inflationary growth. As he rightly points out, many of the telltale pieces are there. Rising industrial commodities, transportation stocks, and bond yields create a compelling mosaic.

I am skeptical. For one, much of this is happening in the context of an equally compelling mosaic of market euphoria. Rising retail participation, call option volume, and insider sales all provide more information content about individual investors desperate to get in on the action than about economic fundamentals. That does not feel like a recovery to me; it feels like a bunch of investors jumping on the next narrative. Oh, and by the way, the stocks that are really rocking don’t make any money.

For another, I don’t think it is fair to describe a recovery as “classic cyclical” when it is paid for entirely by fiscal and monetary stimulus. Cyclical means the economy goes down, and then it comes back up again. It does not mean the economy goes down and the government and Fed throw a bunch of money at it to keep it from looking so bad.

This raises another issue I have with the current reflation narrative. The description of a cyclical recovery is too narrow in the sense that it is only looking at the “income statement”. A true recovery would also involve improvement in the “balance sheet”. In this case, however, the balance sheet is still weakening. Not only will further stimulus (and borrowing) be needed, but a whole slew of bankruptcies and bad debts will need to be absorbed as well.

The capacity to embrace the cyclical recovery narrative in light of so much disconfirming evidence certainly owes to the preponderance of liquidity available. It also owes to the phenomenon of passive investing. Mike Green of Logica Funds notes in the latest Grant’s Interest Rate Observer, “Any time I spend on fundamentals loses me money … You have to know the game you are playing. The game we are playing is dominated by players who couldn’t care less about fundamentals.

As such, it makes me think of a fresh take on James Carville’s old quote: “When I die, I want to be reincarnated as equity flows because then I can intimidate everyone.


Middle market loan volume is a good indicator for economic prospects for small and mid-sized businesses. As the chart (from @Soberlook) shows, loan volume has fallen to lows not seen since the financial crisis in 2009. Although the second and third quarters may have been impacted by availability of PPP loans, clearly the first quarter volumes were also noticeably lower. This is one more indicator among many that argues against the narrative of cyclical recovery.


Jobs report shows "creative destruction" has begun

“There were 10 million fewer people employed in November than there were in February and at November's pace of jobs growth it will take three years to return to February's employment level.”

"If you want to watch only one indicator  to get a sense of what long-term damage the COVID crisis is likely to do to the economy, this is the indicator to watch," AllianceBernstein senior economist Eric Winograd said of labor force participation.

"The more people who permanently leave the labor force, the bigger the headwind to longer-term growth, and those who are currently out of work increasingly report that their layoffs are permanent rather than temporary."

The dynamics of the labor force are always important to the economy but are probably even more so in trying to disentangle the economy’s trajectory after Covid. Winograd makes a good point: It is right to focus on long-term effects on the economy and labor force participation really highlights this.

One point to observe is that several million people have left the labor force since the pandemic started. It is hard to imagine any kind of sustainable recovery with a step function lower level of employed people. In order to do that, one must assume that those lost employees contributed virtually nothing before and will somehow be self-sustaining without work or will very quickly rejoin the workforce and contribute at the same level.

It is fair to assume that some people will return to the labor force once schools reopen widely and childcare is less of a concern. It is also fair to assume many people will return to different jobs. However, it also seems likely the total labor force will not return to pre-pandemic levels for some time to come. As a result, a gradual and incomplete return to labor force participation will create a drag on demand.


Milton Friedman was wrong on the corporation

“What should be the goal of the business corporation? For a long time, the prevailing view in English-speaking countries and, increasingly, elsewhere was that advanced by the economist Milton Friedman in a New York Times article, ‘The Social Responsibility of Business is to Increase Its Profits’, published in September 1970. I used to believe this, too. I was wrong.”

“the Stigler Center at its (University of Chicago) Booth School of Business has just published an ebook, Milton Friedman 50 Years Later, containing diverse views. In an excellent concluding article, Luigi Zingales, who promoted the debate, tries to give a balanced assessment. Yet, in my view, his analysis is devastating. He asks a simple question: ‘Under what conditions is it socially efficient for managers to focus only on maximising shareholder value’?”

There are many arguments to be had over how corporations should change. But the biggest issue by far is how to create good rules of the game on competition, labour, the environment, taxation and so forth.

For all of the noise about ESG and commentary about how to improve capitalism, this analysis gets it exactly right. The idea that profit should be the only motive of business is based, as are many economic theories, on assumptions that simply do not hold in the real world. Things like perfect competition, no externalities, and complete contracts do not exist in the world in which businesses actually operate.

I agree that an overarching priority ought to be creating good rules of the game. I would also add that effective enforcement ought to be added as a complementary priority. Without those two conditions, doing business too often devolves to sidestepping rules if not outright violation. It doesn’t have to be this way.


A. Gary Shilling’s INSIGHT, December 2020

“The only major economy forecast to grow this year is China with a 1.9% predicted expansion, slower than her 6.1% growth in 2019. In contrast, the IMF expects the U.S. economy to shrink 4.3% this year and 8.3% in the eurozone.”

“Another measure of fundamental weakness in China is decelerating prices. Consumer prices ex food and energy fell to 0.5% in October vs. a year earlier for the first time in three years. Producer prices for industrial products and consumer goods actually fell (Chart 25) and overall producer prices dropped 2.1%.”

An important part of the reflation thesis is that China is powering a return to global growth. While China’s growth is relatively stronger than other countries this year, the fact that 1.9% is down from 6.1% is hardly anything to get excited about. Further, the data on prices suggest a state of deflation, not inflation. With consumer prices hovering near zero and producer prices falling, these are not the markers of strong growth.

That said, an important part of the reflation thesis is predicated on the relatively rapid growth of credit in China. The thesis is also predicated on the assumption that credit growth will continue and generate outsized growth for some period of time. In essence, this would be a replay of the experience in the GFC.

Another explanation, however, is far less optimistic. The alternative theory suggests financial leverage in China is bumping up against its upper limits. As a result, although credit is being used to restart economic growth, this time it needs to be meted out with substantially greater constraint. Either way, the future direction of credit growth in China is likely to reverberate across markets globally.

China’s Financial Markets Start to Price In Deleveraging

“Policy makers are allowing for tighter liquidity in the financial system, a signal that Beijing wants to stabilize the level of debt in the economy.”

In the coming six months, the market will see large volatility with interest rates going even higher and liquidity becoming even tighter,” said Larry Hu, head of China economics at Macquarie Group Ltd. “Investors will be more nervous and worried. Stabilizing macro leverage is a policy priority, and that direction is not going to change.”

Ant, Cold War 2, and You

Capital Dialectics, November 17, 2020

“It is not hard to see, therefore, how from the perspective of a foreign policy practitioner, investors giving dollars to the Chinese govern­ment, by purchasing RMB denominated financial assets, are frustrat­ing US policy goals.”

“The bottom line for investors is that their China exposure looks as if it increasingly seen to be obstructing US foreign policy goals on the one hand, while, at the same time, the more innovative companies are being seen as a threat to the CPC. ‘Don’t fight the Fed is perhaps being replaced by don’t fight the state department.’ What is equal­ly true, as it is always has been, is do not invest in China against the interests of the CPC.”

The higher point being made in this piece is one that deserves a lot more attention: In the increasingly desperate hunt for short-term gains, investors can act in ways that are counterproductive in a broader sense. If hot Chinese stocks can provide a needed boost to a portfolio, why should anyone care if buying those stocks also provides China with needed US dollars and frustrates US policy goals?


1 big thing: Tech research becomes hazardous ground, Axios Login newsletter,

Tech giants have brought on teams of ethicists and diversity advocates to counter criticism of their products' impact on society — but they're not always happy with their experts' findings.”

“Gebru, a leader in the field of AI ethics, wrote Google management with concerns after the company insisted its name be taken off a paper she and others submitted for an industry conference. The paper explores problems with mining vast reams of text to train AI — a practice key to Google's business.”

While there seems to be an element of “he said, she said” to this account, the bigger issues are fairly clear. The result was Gebru was fired and now many of her advocates at Google are up in arms about the dismissal.

One point is that self-policing rarely works, at least in my opinion. At the end of the day, the conflicts of interest are too great for people who are truly conscientious. That leaves people who are less than completely conscientious.

The second point ties in to the first. Big tech companies have a number of significant risks that they have managed to sidestep for a long time. The threat from dissention (from irreconcilable internal conflicts) is serious and can now be added to the threats from competition with other Big tech companies and regulatory backlash.

Artificial intelligence

DeepMind claims major breakthrough in understanding proteins

“DeepMind, the UK-based artificial intelligence company owned by Alphabet, has said it can predict the structure of proteins, a breakthrough that could dramatically speed up the discovery of new drugs.”

“’This advance is our first major breakthrough in a longstanding grand challenge in science, said Demis Hassabis, founder and chief executive of DeepMind …”

As much a fan of technology as I am, I have also been very critical of a great deal of technology that is either applied in ways that do not make things better or that mainly amounts to a cool trick. For all the potential power of artificial intelligence, this area of technology especially has suffered from a dearth of useful applications (at least relative to the potential), an issue I highlighted in a 2019 blog post.

In contrast, the fact that DeepMind’s breakthrough appears to be incredibly useful is refreshing. Apparently, DeepMind has been able to apply artificial intelligence to the gnarly scientific problem of describing how proteins fold. This truly is the kind of advance that radically change the trajectory of biological innovation. Venki Ramakrishnan, a Nobel laureate and president of the Royal Society, called the breakthrough a “stunning advance”.

Implications for investment strategy

Hypervaluation and the Option Value of Cash

“Given the low expected return on the passive investment, coupled with a reasonable level of volatility, it turns out that holding cash has an “option value.” You might miss out on the upmove, but you also gain the potential to invest at a lower price than is currently available. In this example, holding cash for a year, even at zero interest, actually raises your expected wealth …

“Stated another way, given the choice of investing in a risky security, or holding cash in the hope of better opportunities, the “option value of cash” is greatest when a) the expected return of the security is low, and b) the potential volatility of the security is high.”

The role of cash is an oft-disputed issue in contemplating various approaches to asset allocation. On one hand, since it doesn’t yield anything, it can be argued cash should be minimized in investment portfolios. Indeed, cash is minimized in most passive funds. On the other hand, if one accepts that asset prices can fluctuate over time, then cash has option value in the sense of allowing for the opportunity to buy assets at some future time at a cheaper price (and higher expected return).

John Hussman takes the argument one valuable step further by providing quantitative examples to demonstrate exactly how cash can provide option value. Given his expected return on the S&P 500 is -3.5% per year (over a 12-year horizon), this is a perfect time to seriously consider the role of cash in one’s portfolio.

Finally, one of the recurring themes in this note and many others of late is the contrast of short-term versus long-term investment opportunities. One of the points I have made repeatedly is with valuations so high and underlying economic growth so weak, the long-term opportunities in stocks are currently very poor. That said, with so much liquidity available, it does also make an exciting environment for people to speculate.

This raises a fairly serious issue about the purpose of investing though. Theoretically, in a capitalistic, free market economy, active investment is a useful activity because it helps ensure capital gets allocated to the most productive uses. In a market “dominated by players who couldn’t care less about fundamentals”, with the highest returns accruing to companies that don’t earn a profit, and with popular investment trends frustrating US policy goals, it is hard to argue that market participation serves any useful purpose whatsoever.

That begs a question. Sure, we are all trying to earn returns with our investments, but at what cost? Are we willing to accept increasing inequality? Are we willing to undermine long-term economic growth? Are we willing to crash the financial system? Of course, none of us created these conditions, but that doesn’t mean we have to propagate them by mindlessly participating either.

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, I try to represent 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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