Arete's Observations 4/2/21
Is the proper mark 27% down?, Mar 27 2021 at 06:24 ($)
“Both [Viacom]CBS ($30bn market cap) and Discovery ($20bn market cap) were down a neat 27% Friday, on what appears to be (allegedly) forced selling from Tiger Cub Archegos Capital. If this is the truth and there is nothing else going on here - this is a horrendous data-point on the true liquidity in the markets. The rumored ‘block offerings’ from MS and GS were not multiple days of average volume. These are not some Mickey Mouse companies with shaky fundamentals.”
The selloffs in CBS and Discovery provide an instructive look into some of the market risks at this juncture. One risk is the “true liquidity in the markets” is a lot less than advertised. Another is forced selling can still disrupt supply and demand balances for stocks even as passive funds continue to take in new money. In addition, as John Authers highlights, the recent losses beg the question of whether leveraged buying was the main reason for the big gains in the first place.
Markets will soon pivot to focus on sustainability of recovery ($)
“The only way to ensure sustainable growth, public debt and market stability is to secure an economic recovery long beyond the short and sharp sugar-rush effects of the end of lockdowns.”
“This is more than the work of a one-off rescue package. It requires multiyear structural government commitments to repair productive private sector capital and labour market scarring, supporting the vast intersections of society that will feel the economic pain long after pandemic curves have peaked.”
While there certainly are bright spots on the economic front, this article reminds us it is far too soon to declare victory on economic growth. Relying on the end of lockdowns and a significant burst in fiscal spending is like trying to solve the problem of food insecurity by sponsoring a hot dog eating contest. What is really needed is an ongoing effort to address systemic problems such as weak labor participation and lack of necessary skills. Multiyear and structural are the key words here.
The US needs to rediscover the meaning of investment ($)
“American capitalism has undergone a transformation into a system that might more properly be called ‘uncapitalism’. The real economy now serves the financial sector, instead of vice versa.”
“Sustainers and growers have been overtaken by a third category of ‘eroders’. The eroder has sufficient profit to both replenish the assets it consumes and return cash to shareholders. But it chooses to do only the latter, handing back profits at the expense of its capital base. From 1971 to 1985, eroders accounted for 6 per cent of market capitalisation. By 2017, that had risen to 49 per cent. The sustainer share had fallen to 40 per cent and the grower share to 3 per cent.”
As people are getting vaccinated, activity levels are picking up, and fiscal spending is kicking into gear through the American Recovery Plan, there is some space now to consider bigger picture issues. One of those is a cold, hard look at how our economy actually operates.
The answer is not all that pretty. In fact, the economy has gradually shifted from one constantly refreshing and growing its capital base to one that persistently erodes its capital base. Notably, strong market performance has disguised this underlying erosion. As the author notes, “But no innovation is spurred nor groundwork laid for prosperity.”
The situation is akin to waiting for a great harvest and then realizing the seeds were never planted. Clearly, this bodes poorly for future growth prospects. In addition, it also suggests initial returns on investment could be disappointing insofar as those investments simply replace capital that has already been depleted rather than adding to it.
LACY HUNT: BONDS, GROWTH, AND JOBS IN A “DISINFLATIONARY STEW” ($)
“What the Fed is basically doing [with quantitative easing and other interventions] is they are signaling to the corporate managers that financial assets, the price is protected and the liquidity is protected. And so this causes the corporate managers to put more and more of their resources in financial investment and less investment in the real. But now financial investment is good for those assets but to get economic growth you need real investments. And so the net result is that the Federal Reserve in its desire to support the financial markets, they're actually causing increasingly inferior results.”
Leave it to Lacy Hunt to tell it like it is with no sugarcoating! Bottom line: In the Fed’s efforts to support financial markets, it is impeding growth in the real economy. There could hardly be a harsher, or more succinct criticism of the Fed.
Ireland unveils remote working plan to redress urban-rural divide ($)
“Ireland is seizing the ‘unparalleled opportunity’ offered by changing pandemic-era work habits to shift people from major cities to the rest of the country, envisaging a network of remote working hubs and rejuvenated town centres in an effort to redress the country’s longstanding rural-urban divide.”
As many companies are developing policies for returning to work, Ireland stands out as one of the few nations (thus far) discussing the subject as a matter of public policy. Measures such as accelerated broadband rollout and financial incentives for people to live in rural areas are being discussed as ways to encourage a more even distribution of its population. While I am a big fan of cities for a lot of reasons, there are also a lot of good reasons for increasing opportunities elsewhere.
The delusions of techno-futurists who ask: crisis, what crisis? ($)
“There are three main criticisms of Altman’s equation of AI + UBI = utopia. The first is that he wildly overestimates the short-term impact of AI. The second is that he wildly underestimates the difficulties of policy change. The third is that by focusing on the fascinatingly improbable, we will crowd out more useful discussion about the worryingly probable.”
“Their efforts would be better spent figuring out how best to use AI to enhance human creativity and innovation in small, discrete and meaningful ways, rather than render it redundant.”
This article captures almost all of my major criticisms of the technology ethos. For example, from the perspective of techies, tech is the hammer for every nail (problem). What advocates deem as visionary is often little more than narcissistic fantasy. When it comes to public policy, the attitude is often one of extreme condescension.
John Thornhill hits on all the right points and it is time to have a serious discussion about them. The best technology solutions are ones that enhance the human experience, not ones that replace it. As Scott Hartley put it …
The Fuzzy and the Techie: Why the Liberal Arts Will Rule the Digital World, by Scott Hartley
“The point of emphasizing the role of fuzzies is not to say they have an exclusive on the opportunities opening up; it is to say that the fuzzy combined with the techie is the formula for the most transformative, and most successful, innovations—the ones that will most effectively solve the many vexing problems to be tackled and will most humanely enhance our lives.”
Stripe’s $95bn price tag heralds internet shift from ads to commerce ($)
“It’s kind of funny, or tragic, that so many decades into the web’s history, and given the central importance of being able to generate that sort of sustaining income from the internet, that it has gone so undone and under-built,” noted entrepreneur Patrick Collison at a Wired event a few years ago.
“But the pull towards payments and commerce is simple: it is a far, far bigger market than advertising.”
In hindsight, much of the promise and hype of the internet from its commercial inception in the late 1990s has come to fruition. Interestingly, the thing that did not evolve with its rollout was a viable business model. Although advertising has brought in bucks, it is not an especially large market and kind of came in as an afterthought in regard to monetizing web businesses.
This background makes the emergence of Stripe a very interesting case study. If the company can continue to prove out the business case for the far larger market of payments, there would be far-reaching implications for several industries.
A green solution to sovereign debt restructuring ($)
“For some emerging market countries, public debt has reached an unsustainable level. The IMF and World Bank reckon that more than 36 (out of 70) low-income developing countries are either in debt distress or ‘at high risk’ of being so.”
“There may be alternatives to seeking outright principal haircuts in post-Covid sovereign debt workouts. One might involve giving the debtor country the option to discharge a portion of its restructured external liabilities by paying the equivalent amount in local currency to fund environmental and conservation projects within its own territory.”
When it comes to sovereign debt restructuring, Lee Buchheit is THE go-to guy. In this piece he wrote for the FT, he highlights a couple of important issues.
One of those issues is the increasing severity of the crisis in public debt for emerging market countries. This has not gotten a lot of headlines but has been percolating in the background and will boil over at some point. Rising US interest rates and the US dollar threaten to make the eruption sooner rather than later.
Another issue is how these unsustainable debts ultimately get resolved. Buchheit describes how some portions of the debt could be exchanged for environmental projects funded in local currency. This creative idea takes a bad situation and gives both parties something to walk away with. While this is partly a sales pitch, given the credibility of the source, there is an extremely good chance we will see quite a bit of this type of restructuring activity in the future.
The filibuster is an oddity that harms American democracy ($)
“This has turned the Senate into the only legislative body in the world which requires a supermajority for ordinary business.”
America’s legislative system is often lauded as having sufficient checks and balances to prevent indiscriminate and abusive law making. In a sense, this is akin to a “prevent” defense in sports in which the aim is to prevent the offense from scoring, or at least from doing so quickly. It is designed to make time the enemy of the offense.
What is discussed far less often is the cost of such a setup. When the offense is in a hole and needs to score in a hurry, prevention is a bug, not a feature, of the system. Increasingly, this is the case in the US, which is burdened by excessive debt, slow underlying economic growth, poor infrastructure, and a labor force scarred by the pandemic. The longer it takes to address these systemic issues, the worse things will be.
The main point, then, is in this constrained environment, the filibuster serves more as an obstacle than a protection. While I am not a particular fan of Biden’s infrastructure plan, the constraints the filibuster imposes highlight the need for greater flexibility in the process of ordinary governance.
A couple of useful insights come out of this graph in regard to inflation. First, the price of copper is staying elevated which continues to send an inflationary signal. However, an important part of that price rise has coincided with higher speculative positioning. As the speculative positioning rolls over, we will be able to get a better sense for the underlying strength in commodities like copper.
Bill Blain: Brace, Brace, Brace
“This morning it looks like the Suez has been uncorked – the boat has been shifted – but I was asking because I reckon slowing global trade by sending it the long way round Africa isn’t just about miles and time – it’s finding the ships capable and seaworthy for the longer trip, and bunkering them accordingly. It’s not just a matter of a longer voyage. Suddenly everyone wants Air Freighters.”
“The key-thing is what happened on the Suez demonstrates is just how easy it would be to block the bottlenecks of global trade. Everything from consumer tat to chips would be stressed.”
Even with the container ship floated, this incident is going to be a shot across the bow (so to speak) for logistics managers everywhere to re-assess vulnerabilities in their systems. I suspect this is just one more data point on the path to more resilient, but also slower and more expensive, global supply chains.
Shape Up or Ship Out, Almost Daily Grant’s, March 26, 2021
“The imminent reorganization of Japan’s equity market is encouraging some shareholder friendly behavior across the Land of the Rising Sun, Bloomberg reports today. As the Tokyo Stock Exchange prepares to split into three classes (prime, standard and growth), exchange constituents are unwinding minority stakes in other businesses and bolstering corporate governance in a bid to secure a coveted prime designation ahead of a June 30 deadline.”
“We are seeing some companies move to unwind their cross-shareholdings,” analysts at SMBC Nikko Securities recently observed. “Companies that struggle to meet the [prime] criteria may ask some shareholders to divest their positions and are also considering buybacks or equity issuance” to get on the right side of the stock-market fence.
There have been rumblings of improvement in Japan’s notoriously bad environment of corporate governance. The latest development is interesting and may prove to be an experiment worth replicating in other markets as well.
As Japan reorganizes its stock market, only the top (prime) tier will be guaranteed membership in the Topix index. This is no small prize as the Bank of Japan provides a constant source of demand through its ongoing purchase of domestic ETFs. In order to qualify, however, companies need to clean up their convoluted web of cross-holdings.
It is not hard to imagine how central bank interventions could be used to incentivize better governance or other desired behaviors. Imagine, for example, at some point in the future the Fed starts purchasing stocks in order to “ensure the smooth and proper functioning of financial markets”. However, to qualify for Fed purchases, eligible candidates would need to have certain restrictions on share repurchases, or more diverse board representation or certain ESG credentials or whatever. Just a thought.
BlackRock ETF may be forced to sell billions in energy stocks ($)
“Massive investor inflows into two BlackRock exchange traded funds pinned on just 30 clean energy stocks may force the asset manager to sell billions of dollars worth of shares to prevent it building up overly large holdings in the companies.”
“Too much money is chasing too few shares and those shares are too small,” said Sleep. “$11bn is chasing after these tiny stocks and it just drives up prices.
Reports like this are useful for providing landmarks to show just how ridiculous many parts of the market have become. Some of the more niche, themed ETFs have a great deal of demand from investors, but do not yet have a lot of stocks in which to invest. Of those stocks, many are still small and illiquid.
The result is many of these stocks keep going up not because of their financial results but simply because so much money is chasing a hot investment theme. One thing this makes clear is the degree to which most funds are much more marketing machines than investment machines. Relatedly, this game is more about money flows than it is investment analysis.
There are obvious risks to this dynamic. One is some niche ETFs will have a hard time managing inflows without accumulating large positions in illiquid stocks. This causes disproportionate price increases on the way up but can also be catastrophic on the way down. In addition, the excessively strong demand for public companies in popular businesses means in many cases their cost of capital is negative.
Blain: The Market "Has 1929, 1987, 2000 Writ In Bold Blood Letters" All Over It
“The really interesting thing about this Lagoon Park deal is how liquid these bonds are – despite the fact I suspect M&G is the only holder. I am told by an external investor he believes these bonds trade regularly. According to Bloomberg, there are regular prices posted. I wonder.. could it be that brokers supportive of the deal are posting imaginary prices between themselves?”
“It would a crying shame if it turned out that wholly illiquid bonds were being painted as liquid. I mean, what would the regulators think of a fund holding illiquid bonds that were described as liquid so they appear eligible as liquid UCITS eligible investments? A shade of Woodford? Naughty – if it was happening…. Ahem..”
Bill Blain provides another perspective on liquidity with his note. The point is the same: A great deal of liquidity is illusory. As he puts it, “I am absolutely sure all these junk bonds and corporate debt deals held by fund managers will prove illiquid as set concrete if/when the market’s day of reckoning arrives…”
Implications for investment strategy
A Tiger Can’t Change Its Stripes
“In the days and weeks to come, you’ll hear the usual suspects say that swaps and derivatives are the ‘problem’ here. Pfft. The problem is doing business with convicted criminals like Bill Hwang. Want my keenest Wall Street observation? Once a raccoon, always a raccoon.”
“There is a tide that is flowing out today, and it’s revealing Lex Greensill and Bill Hwang in 2021 just as surely as it revealed Jeff Skilling in 2001 and Bernie Madoff in 2008. The big trade around Skilling and Madoff wasn’t directly on their specific scams and frauds, but on what their specific scams and frauds showed us about systemic rot in the financial system. It’s exactly the same with Greensill and Hwang today.”
There has been plenty written on Bill Hwang and Archegos already so I won’t rehash the basic facts. Instead, Ben Hunt does a nice job of highlighting the more relevant implications for investors.
One is there are a lot of people like Bill Hwang in the financial world who make money by cheating. Further, for every convicted criminal like Hwang, there are many, many more who are unconvicted grifters. How can so many shady characters persist and thrive? In a word, greed. The banks know who they are dealing with (i.e., a convicted criminal) and yet make the calculation it is worth having the relationships because it will be obscenely profitable.
This leads to another important implication in the form of what these scams show us “about systemic rot in the financial system.” While Wall Street never gets top marks in ethics in the best of times, when rates are near zero, banks and financial firms need to get more “creative”. I strongly suspect the rot runs pretty deep.
Principles for Areté’s Observations
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.
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.
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.
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.
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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