Arete's Observations 2/12/21

Market observations

The VIX is known as the “fear” gauge and with a near record drop the prior week, it wasn’t exactly a coincidence that market has been on a tear since.

Fear is only part of the story though. Because VIX is a volatility indicator, it is widely used to calibrate risk in leveraged portfolios. Lower volatility equals lower risk equals more capacity for leverage and bigger long positions. Of course, risk is a two-way street so when VIX shoots up, it also forces leveraged portfolios to sell down long exposure.

Source: The Market Ear


Pop quiz: Given an economy that suffers the largest decline in GDP in a hundred years due to a pandemic, what do you think happens to bankruptcies? Bzzz – wrong! They decline to the lowest level in twenty years.

This factoid provides an important window into what is happening with the economy. Policy makers are intentionally tipping the scales such that good things are allowed to play out, but bad things are put on hold. While moratoriums, forbearance programs and other measures can provide some immediate relief to people in need, such measures can also forestall the inevitable reckoning.

Source: Axios

US Courts 'Clogged Up' With Eviction Cases As Activist Groups Fight Back

“More than 40 million people owe $57 billion in back rent, a staggering number that continues to increase as the economy stumbles.”

One of the problems with extending forbearance for too long is it hides failure. Aid that may have been originally intended as a tide-me-over quietly becomes life support for a business that is not going to make it. As such, extended forbearance forestalls economic adjustments that need to be made.  

Extended forbearance also creates an impression of false prosperity. Avoiding the recognition of problems makes it a lot harder to harness resources and channel them where they are needed.

Finally, if forbearance and bad debts are put off long enough, confidence in the entire economic and financial system can erode. It becomes very difficult to know if counterparties are solvent or not. If such conditions persist long enough the loss of confidence can morph into a deflationary mindset. We aren’t at that point now, but we could get there.


Not a whole lot to say here other than to confirm what has been fairly clear through other data: Lower and middle wage workers are getting pounded while higher wage workers are relatively unaffected. This is both hugely unfortunate and largely avoidable.

Number Of Americans On Jobless Benefits Surges Back Above 20 Million

“And while it is well below its peak levels in June, last week saw the total number of Americans of some form of jobless benefit surge back above 20 million...”

A couple of important points here are easy to let slide by. The first is there is still an extremely high number of people still out of work. As I have noted many times before, the longer joblessness persists, the more likely many of these people will become permanently unemployed.  

In addition, the number of people receiving jobless benefits ticked up again. This is very disappointing, especially in light of improved results on the coronavirus front. This is only one data point and therefore should not be taken too seriously, but it is worrisome.


The Morning Dispatch: Democrats Make Their Case ($)

“The trial this week will set not only the direction of the Republican Party for the foreseeable future, but also a precedent about whether what happened January 6—and in the weeks leading up to that day—is acceptable.”

The impeachment trial is underway, but the immediate outcome is probably a foregone conclusion. That isn’t what the trial is really about, though. The trial is really about the future shape of the Republican party. The Dems are doing everything they can to force Reps into a tough spot. Reps will need to decide if it will be easier to get re-elected by maintaining the support of Trump loyalists but looking like accomplices to domestic terrorism or by forsaking the support of a meaningful constituency for a higher ideal. Tough call.

There will be at least some entertainment value because the tension is already making politicians squirm. More seriously, though, there will be a precedent set that will have significant implications for government and politics in the future.  

Public policy

Missed school will cost U.S. trillions

“The U.S. economy could take a $14 trillion to $28 trillion blow in the long run due to coronavirus-induced learning loss, according to economists' projections. And the longer the pandemic keeps kids out of classrooms, the higher that number will climb.”

"Nobody’s paying attention to this absolutely stunningly large economic cost that just keeps piling up," says Eric Hanushek, a Stanford economist and an architect of an OECD analysis of the economic impact of COVID learning loss.

Ok, I’m not a person to take multi-year many trillion dollar estimates too seriously; there are too many sources for error. However, if the estimates above are anywhere in the ballpark, the loss would be similar to shutting the entire economy down completely for a year.

Whether the estimates are reasonable or not is immaterial to the fact that the risk was never discussed and not even hinted at when the pandemic really started biting last year. It seems to me if there was any potential for a $21 trillion hit (midpoint) it should have warranted substantial debate. The fact that there was none is just one more indication of how dramatically public policy, especially in regard to the pandemic, has failed miserably.


EU ready to follow Australia’s lead on making Big Tech pay for news ($)

“EU lawmakers overseeing new digital regulation in Europe want to force Big Tech companies to pay for news, echoing a similar move in Australia and strengthening the hand of publishers against Google and Facebook.”

The regulatory powers that be are homing in on Big Tech. One of the issues in the limelight right now is the demand for tech platforms to pay fair value for the news content they use. Previously, the head of Google’s business in Australia claimed Google would have to quit the country if forced to pay for news it used.

Those comments were disingenuous but revealing. If Google can only make money in Australia by stealing news content, it is not much of a business anyway. Clearly, the strategy was to force the country to make a tough political decision. Playing hardball like that, however, is not a good look for Google, it’s bad PR, and it is a long way from the credo of, “don’t be evil”.

Thus far, the Big Tech companies have been able to keep the big regulators at bay but now, even the states are joining in the fracas …

States leapfrog federal government in restraining tech

“Maryland's House of Delegates is expected Thursday to override Gov. Larry Hogan's veto of a tax of up to 10% on digital advertising. The state Senate is expected to do the same Friday.”

“It's likely, for instance, that we'll see more proposals out of red states aimed at punishing tech for perceived censorship of conservatives, while blue states may follow Maryland's lead on digital taxes, among other tech priorities.”

Now, Big Tech is fighting a regulatory war on multiple fronts with multiple ideologies and different priorities. And the EU and US regulators are still in the fight and continuing to press too. It feels like the environment has changed for tech and that is not being discounted by investors yet.


Breakeven inflation near post-crisis highs, real rates near lows, The Market Ear, Feb 08 2021 ($)

“Breakeven inflation near post-crisis highs, real rates near lows. Can both be right? The rise in interest rates has been driven by an increase in 10-year breakeven inflation. Breakeven inflation has risen from 1.65% on November 6 to 2.17% today, the highest level since October 2018. Higher breakeven inflation in part reflects improving investor growth expectations, which drives the ERP lower. In contrast, real rates have actually continued to decline to -1.02%, close to the lowest level post-2003.”

Inflation is necessarily a multifaceted affair and several items this week contribute insight to the overall outlook. The commentary above by The Market Ear raises an excellent point. For all the noise around rising breakevens, if inflation growth expectations really were rising, we would expect a positive real interest rate, not one that is negative and declining. Very mixed signals. My bet is the real interest rate is the better signal.

Another one of the signals being used to justify reflationary expectations is the rise of cyclical companies and commodities producers. As the graph shows, the stock price movements of these companies have been negative on earnings day. Since the data set is not extremely robust there shouldn’t be too much weight placed on it, but it does look like the economic reality of earnings reports may have checked expectations that had gotten too high. 

Finally, the graph below shows the fairly dramatic decline in credit card balances over the last year but also captures a distinct slowdown that began around 2017. This sends many signals, none of which are positive for growth.

One is credit cards are only used for spending so declining balances means declining spending. Another is this probably represents consumers who are most likely to spend but are paying down debt instead. Declining balances means there is less borrowed money which means money is actually being destroyed. This counteracts growth in other types of money supply. 

The big question is, does this represent a short-term reaction to pandemic conditions, or does it represent a longer-term behavioral change? The more it is the latter, the worse off for growth prospects.

Zerohedge reveals that even as people paid down their credit card balances, however, “they went to town” on student loans and car loans. In both cases, there are reasons to believe the loan may not need to be paid back in full. On student loans, the Biden administration seems predisposed to discharge a certain amount of student loan debt. For car loans, existing terms allow for a loan maturity greater than the expected life of the car. In other words, it may be that the decline in credit card debt primarily reflects an arbitrage in favor of borrowing least likely to require full repayment.

The graph above highlight the wide disparity between commodities inflation and services inflation over the last year. Much has been made of booming commodities as “proof” of reflation, but services is a huge part of the US economy.

Further, it is very hard for me to conceive of demand that is “pent up” for most services. Not only that, but in my opinion, many services revolve around helping people maintain hyperactive schedules. Take away some of the hyperactivity and combine it with a more manageable schedule that involves a certain amount of working from home, and new habits are formed.

As a result, the demand for many services goes down – permanently. If this is anywhere close to correct, not only will services CPI go lower, it will remain low for some time as the supply of services contracts to the new lower level of demand.

Capital markets

The Rise of Carry, by Tim Lee, Jamie Lee, and Kevin Coldiron

“The arguments of those who called the stock market right in the wake of QE3 were uniformly [of the opinion] that the stock market would inevitably rise because the Fed would be pumping money into the financial system—on a large scale—some of which must be bound to flow into equities.”

“The true reason that the US stock market rose is that the S&P 500 has become a carry trade and the Fed’s QE policy represented a massive selling of volatility. The Fed became possibly the biggest carry trader of all: its balance sheet is a huge carry trade with large holdings of yielding securities, such as Treasury securities and mortgage-backed securities, financed by very low-cost liabilities including zero-interest cost cash currency in circulation. The Fed’s increasing carry trade will eventually depress the returns to be earned from carry as a whole.”

This book was recommended by Russell Napier in his “Solid Ground” research piece. Now that I am over halfway through it, I highly recommend it as well. Framing a great deal of market activity as carry trades goes a long way in being able to better understand market action and risk.

As a point of reference, a traditional carry trade involves being long a currency with high interest rates and short a currency with low interest rates. This position nets a low-risk profit. There are two important caveats, however. One is the risk is contingent upon the tendency of central banks to intervene in a way that allows rate differentials to persist longer than they otherwise would. Another is leverage is required to generate meaningful returns from the trade.

One important takeaway is the sawtooth return pattern of carry trades has become a signature characteristic of markets. Returns edge up incrementally over time and then eventually crash down. It is all a structural element of the leveraged nature of carry trades.

Another takeaway is the alternative explanation for rising markets. By one account, increases in bank reserves are bound to eventually find their way into equities. However, the authors provide an alternative explanation. By their account, the Fed’s QE policy has represented a “massive selling of volatility”. The different interpretations lead to very different consequences.

For example, one of the unusual events that occurred last year was a massive increase in the Treasury General Account (TGA). As a result of that increase, it will be forced to run down this year – and that will flow into bank reserves.

Believers in the “reserve theory” use this dynamic as rationale for why stocks are quite likely to continue rising. After all, something in the range of $1 trillion will need to flow to bank reserves in the next several months.

Believers in the “carry theory”, however, describe a dynamic that is dangerously close to its logical limit. As the Fed becomes an increasingly dominant carry trader, returns will decline for everyone. That means leverage will keep increasing as returns keep decreasing. Any little blip in volatility will cause the house of cards to fall.

While I do believe the “reserve theory” has some explanatory power, the “carry theory” seems better at describing market action in recent years and in capturing embedded risk.

Implications for investment strategy

One of the recurring themes I have highlighted in this section is the idea that flows have taken on a primary importance in determining market movements. More specifically, it is a lot more important to stock prices that money regularly flows into target date funds than it is that the underlying companies perform well in an economic sense.

I don’t believe this will always be the case, I don’t believe it can always be the case, but it does appear as if it will for the foreseeable future. As a result, strategies and approaches that depend on research, analytics, and valuation work are likely to underperform because in this market environment, those pursuits are distractions.

So, given an environment in which research and analysis do not help performance, and in which carry trades provide a strong and consistent bid for most risk assets, it is easy to understand the desire by many investors to just get involved. All you really need to do is hoist your sail to reap big rewards. Easy-peasey. So far, so good.

There is truth to this, but there are some significant caveats too. First, the return pattern of a carry trade is like a sawtooth; a long, gradual rise punctuated by an abrupt substantial decline. As a result, it is exceptionally difficult to both identify the end of the trade AND to liquidate before everyone else. An elite macro investor like Stan Druckenmiller might be able to do it, but your average investor? Forget it.

Another aspect of carry trades is they tend to get bigger over time. After Lehman Brothers almost tore down the global financial system in 2008, and the Fed threw in the kitchen sink to prevent the US Treasury market from imploding last year, the next carry crash is setting up to be a real humdinger. As a result, jumping in to markets now is likely a “Hotel California” trade – one you can never leave.

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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