Arete's Observations 1/22/21

Market observations

Why everyone is now an options trader ($)

“The bucket shops on the other side of the wagers loved it, too, because hour-to-hour fluctations [sic] in the price meant punters often got wiped out. No stock certificates ever changed hands. This was betting, pure and simple.”

“Much of the surge in demand for options comes from small investors seeking long-odds bets on single stocks. The bucket-shop punter is back.”

“This kind of call option—deeply out-of-the-money and close to expiry—is favoured by the new cohort of retail investors that has rapidly emerged in America and elsewhere … It has the features of a long-odds sports bet.”

OK, this may sound like just a grumble from an old curmudgeon. While the “old” and the “curmudgeon” part may be right, the “just” part is not. The fact is observed behavior by individual investors and the specific types of options instruments they use are effectively long odds bets. Of course, it will end badly and of course a lot of people will lose a lot of money. But at least we can see it for what it is.


Quarterly earnings are starting to come out but the most important economic news for the next several weeks (at least) is going to be the trajectory of coronavirus infections. On the negative front, Scott Gottlieb is highlighting the potential for new strains to “change the game” (an issue I also mentioned last week). On the positive front, the Biden administration seems fully prepared to take on the coronavirus challenge. Nonetheless, it will be a race against time and the outcome will be a key determinant of economic performance.

Source: Twitter


The minimum wage alone can’t save the US working class ($)

“The first lesson is reassuring. Minimum wages set at up to 60 per cent of median pay don’t seem to affect employment levels very much.”

“The second lesson from the international evidence is more cautionary. Some benefits of a higher minimum wage can leech away in an under-regulated labour market.”

With the new administration comes very different public policy priorities. One of those is minimum wage which is interesting because it illustrates the differing political ideologies fairly clearly.

The conservative argument overplays the cost of raising minimum wages by claiming any increase in costs will reduce revenue and choice. Most products and services are not that elastic, however. Further, most people have some sense that the prices of goods and services should include the cost of fair wages to produce them.

The progressive argument overplays minimum wage as a panacea that solves the plight of low-wage workers in one fell swoop. While fair pay for work is an important element of well-being, “fair” depends on a lot of things and security also an incredibly important dimension as well. When workers cannot count on the number or timing of the hours they receive, it is difficult and costly to schedule around other demands, not least of which are family obligations.

The good news is technology and relatively modest oversight could, hypothetically, vastly improve the condition of minimum wage workers. It will be interesting to see how this debate unfolds and whether improvements can be made.

Social trends

The raging trust crisis and its consequences

“Americans are losing trust in leaders across every area of their lives — and the information coming from every source of their news, according to the 21st annual Edelman Trust Barometer, out Wednesday, which measures trust in institutions globally.”

“A majority of people around the world believe that journalists, government leaders and business leaders are all purposely trying to mislead people by spreading misinformation.”

Without trust it is incredibly difficult to coordinate human activities. This is a shame because much of the success of human beings as a species owes to their ability to coordinate with one another. It is also a shame because as trust continues to decline, so too do the opportunities for development and implementation of constructive solutions.

The effort to combat coronavirus with vaccines provides a case and point. Back in the 7/24/20 edition of Observations, I stated:

“I am far less optimistic that vaccines will actually have a huge impact on controlling the coronavirus, however … Having the technology (which I am assuming will be developed) is a necessary, but not sufficient, condition to stanch the pandemic. What is also required is a focused effort to distribute the vaccines and a prevailing desire to receive them. Although I would like to be wrong, I don’t think either is likely to happen.”

My basic argument was one that applies broadly. It is essentially a recognition of the conjunction fallacy in which people tend to overestimate the probability of outcomes that are subject to multiple specific criteria. Sure, technology is great and is capable of doing great things. But fully realizing that potential requires a lot of different interactions among people and that requires trust. The breakdown of trust acts like friction: it slows things down and makes them harder.

As a result, the low level of trust in society implies the distribution of vaccines will be slower and less comprehensive than we would like. It also means the great potential from many technologies will not be fully realized. And it means expectations of economic growth should be moderated in relation to growth in times when higher levels of trust prevailed.


Almost Daily Grant’s, Tuesday, January 12, 2021

“On Jan. 1, China officially rolled out its “three red lines” policy governing the nation’s property sector. The new rules, designed to limit systemic risk resulting from leveraged capital structures, compel developers to cap liabilities at 70% of total assets and net debt at 100% of equity, while short term borrowings must not exceed cash reserves. Those that fail to meet these metrics will be barred from growing liabilities for one year.”

“The powers that be are making sure the message is received loud and clear. Bloomberg reported yesterday that Beijing is set to expand its watchlist of property developers within the three red lines program, with an additional eight concerns set to join the original list of 12 companies who must comply before they are permitted to issue additional debt.” 

Realvision interview: Bass and Pettis - Dueling Perspectives on China’s Economic Reality ($)

“this idea that China is naturally tending towards a zero current account surplus, or even a current account deficit is based on an assumption that China is not trying to get control of its debt and it is. It's failed to do so, and it is trying to do so.”

“The savings rate is very high not because the Chinese love to save, and all that Confucian culture nonsense. The savings rate is very high because who saves and who consumes? Ordinary people consume, everybody else saves. The rich save, businesses save and government save.”

As with all things China, good information is hard to come by and appearances can be deceiving. This makes the interview of emerging market expert and China-whisperer, Michael Pettis, by one of the best minds in the investment business, Kyle Bass, a real treat.

Two of the points that come out are ones that I believe are often misinterpreted by investors. One is there are severe constraints on China’s debt level and therefore its ability to grow significantly. It has reached the end of its regime of debt-fueled growth and the evidence points to lower growth ahead.

The second point is that China’s ability to significantly expand its money supply is often overstated. For one, that ability is significantly curtailed by China’s desire to control its currency. As a result, money supply cannot be expanded unless dollars are coming into the country. The result is many investors significantly overstate China’s growth potential and liquidity environment.


Where Does the South End and Christianity Begin?

“But I also have come to believe there’s a danger in American Evangelicalism becoming too southern.”

“Instead, I’m going to talk about something that’s crucial to understanding race in the South but also transcends race. That ‘something’ is southern shame/honor culture. And I submit that what we’re watching right now in much of our nation’s Christian politics is an explosion not of godly Christian passion, but rather of ancient southern shame/honor rage.”

“People are extremely anxious that their group might be condemned or denigrated. They demand instant respect and recognition for their group. They feel some moral wrong has been perpetrated when their group has been disrespected, and react with the most violent intensity.”

I found this piece by David French to be fascinating because he explains a lot of unusual political phenomena and from an angle I almost certainly would not have conceived of on my own. As he states: “And what does it have to do with Christianity? Because when we talk about American Evangelicalism in a secularizing world, we’re increasingly talking about southern Evangelicalism.”

In other words, the traditional southern cultural values of shame and honor are often expressed in a religious context. Further, since American Evangelicalism is also an important faction of Republican politics, we find it there as well. The net effect is instances of perceived disrespect have a very direct pathway to outrage and violent pushback in politics. The situation highlights both the challenges and opportunities for political reconciliation.

Public policy

Hoisington Quarterly Review and Outlook, Fourth Quarter 2020

“the macroeconomic impact of the expenditure shock depends on four key country characteristics. First, industrial countries respond with a positive multiplier. Second, economies operating under flexible exchange rates have a negative multiplier. Third, countries that are open to trade have a negative multiplier. Fourth, the government spending multiplier is sharply negative in highly indebted countries.”

Considering the above criteria as it applies to the U.S., it is our conclusion that U.S. fiscal multipliers are in fact negative for non-investment type of spending.

As ever, Lacy Hunt and Van Hoisington bring deep research and lucid thinking to economic analysis and public policy implications. Based on prevailing conditions in the US, they conclude non-investment fiscal spending (i.e., handouts) don’t help the economy.

This is important for a couple of reasons. One, with incoming Treasury Secretary Janet Yellen imploring legislators to “act big” in regard to pandemic relief, the emphasis is more on quantity of spending than the nature of the spending. This creates vast opportunities to spend money that has little or no chance to improve underlying conditions. In other words, Yellen’s statement enables wastefulness. It would be far more constructive to emphasize the investment qualities of spending rather than the amount of spending.

The details of pandemic relief are also important because if another pandemic package is agreed upon it will be the third. This brings to mind the old adage, “there is nothing so permanent as a temporary government program”. While each has been billed as an “emergency” measure, there is a troubling pattern beginning to form. Whatever gets done may be the baseline for a long time to come.

Cryptocurrencies and gold

Rosenberg: Why Comparisons Between Bitcoin & Gold Are Absurd

“No one ever talks about the risk that gold could go to zero because it simply can’t — there is a floor in its price, because it has physical properties that make it useful even outside of its primary function as a safe-haven asset. But bitcoin, which has marginal intrinsic value, relies on the faith of its holders that it is worth more than nothing and that the technology is sound.”

Ep. #11: Mike Green – The Money MBA Podcast

Mike Green says he is “trying to explain to people that what they have fallen prey to [the argument for bitcoin and cryptocurrencies] is swinging too far in the opposite direction in a manner that will actually have incredibly catastrophic outcomes for society …”

It’s about time. Finally, some adults in the room have stood up to describe what bitcoin (and cryptocurrencies in general) are and what they are not. No less than the respected and authoritative figures of David Rosenberg and Mike Green have made clear, in no uncertain terms, that bitcoin is not going to save the world’s monetary system. Notably, Gary Shilling also contributed to the discussion in his January Insight letter.

It is interesting it has taken this long. Many investment luminaries have been cautious about voicing strong opinions in order to avoid harsh rebuke by the often-fanatical bitcoin tribe.

In their efforts, Rosenberg highlights the inherent valuelessness of bitcoin and Green highlights its inelasticity. As Green sees it, much of the bitcoin phenomenon is predicated on blowback from the obvious abuses of fiat currencies. However, that blowback swings too far in the opposite direction. Having no elasticity of supply would be even more of a constraint on the economy than a gold standard.

There are a few important implications for investors. One is bitcoin is a speculative asset; invest at your risk. Another is the appetite for bitcoin despite the obviously flawed investment thesis is indicative of the high level of speculative fervor and low level of intellectual rigor. In addition, it is true that fiat currencies have been abused, but the need is for a currency that can fluctuate with economic growth and yet not be easily manipulated. That is the challenge.

Finally, all of the speculative interest in cryptocurrencies has deflected a lot of attention away from gold. As a result, this presents an excellent opportunity to consider gold purchases.

Capital markets

Direct indexing allows investors to pick and mix ($)

“The key thing, though, is customisation. If, for example, that retail investor wanted to have S&P 500 exposure but not hold gun stocks, they could exclude them. Or, if an investor already held a large position in a single company, perhaps because of stock-based pay, they could reduce exposure to its shares in the direct indexing product.”

Although customization can provide some real value for managing risk it looks like the main application will be for deriving bespoke portfolio exposures. This is interesting because it highlights how stocks increasingly are being selected based on narratives.

Themes such as technology and innovation and ESG principles have been around for a long time. More recently, the MAGA and DEMZ ETFs allow investors to flaunt their political preferences. Hypothetically, any frivolous factor, such as stocks that begin with a certain letter, could be used to create new funds. The main point is this is a marketing phenomenon and simply highlights the degree to which stocks have become more fashion statements than investment vehicles.

Implications for investment strategy

Last week I highlighted two general scenarios for risk assets. One is basically a major selloff. The other involves the market becoming essentially a government utility with prices maintained at inflated levels for an extended period of time. The first one is easy to deal with; just be patient and wait with cash to deploy once the bulk of selling is complete.

The second is harder because it creates a real challenge for anyone with a reasonably long investment horizon. How long can artificially high prices last? Will I be able to cash out in time? To the extent there is uncertainty about the answers, investors will also need to consider investment alternatives other than financial assets like stocks and bonds.

This presents both an opportunity and a challenge. It is a challenge because stocks and bonds have been rewarding investments that are fairly easy to deal with. It is also a challenge because most investment advisors and planners place a huge emphasis on financial assets.

The opportunity is to do things most other people are not focused on. Part of that is to consider bigger allocations to both cash and inflation hedges. Such moves may feel uncomfortable but are actually extremely important elements in a long-term investment plan.

Another opportunity is to consider investments that are not purely of a financial nature. Education, training, and skills development, for example, are all investments in future income potential. At a time when the expected returns of financial assets are unattractive, the relative returns to education are higher.

Another “alternative” investment opportunity is to expand a hobby. There are all kinds of platforms to market and sell products and services that people create primarily for the fun of it. Finally, although the pandemic has been especially hard on small businesses, that also means there will be a lot of economic “holes” to fill once a more normal economic trajectory is realized. Further, there are also certain to be lasting effects of the pandemic that will create entirely new business opportunities.

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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