Areté's Observations 5/14/21

Areté (pronounced ar-uh-tay): 1. Goodness or excellence of any kind. Fulfillment of purpose or function, the act of living up to one’s potential. 2. Effectiveness, knowledge.

Market observations

Two of the more prominent themes in markets this year have been the increasing participation of retail traders and the rising presence of cryptocurrencies. What better way to capture the pulse of the market, then, than to illustrate the trading volumes of cryptocurrencies?

While there are valid reasons to be enthusiastic about crypto, too often the optimism is unchecked by critical analysis. As a result, to my eyes, crypto has been a risk-on trade much more than a vote for constructive change. We will have to wait to see which perspective is more accurate, but for now increasing trading volumes suggest speculative sentiment is still high.


John Mauldin’s Strategic Investment Conference (SIC) ($)

A “Who’s Who” itinerary of economists and investment gurus have presented through the first four days of the conference and while there were a number of idiosyncratic views, two themes seemed to dominate.

The first was the debate between inflation and deflation. For what it is worth, most of the inflationists seemed to rely on a slew of anecdotes to make their case. While there is plenty of anecdotal evidence of prices increasing, that is not a sufficient rationale in itself for inflation.

On the other hand, most of the deflationists seemed to rely on economic theory to make their case. While declining money velocity does offset the growing money supply, these are purely economic considerations. Inflation also has a psychological component and is very much a political decision, especially so now in the context of so much debt and so little organic growth. In both cases it would have been interesting (and useful) to hear how the proposed arguments might be wrong.

The other theme I really noticed was generational for lack of a better word. A number of the presentations and panels featured guests who started their careers in the 1970s. Some of the common themes are that stocks always return 7-8% over a period of time, there will always be inflation so you really should invest in stocks as a hedge, and as Ron Baron said regarding the US, “the country just keeps chugging along”.

While many of the comments and insights were very interesting, some presentations felt like investment time machines. The belief that the “country is going to just keep chugging along” with the exploding amount of debt we have is completely unbelievable to most Millennials or Gen Zers, and many Gen Xers as well. The idea that stocks are beyond reproach as investment vehicles also seems to be more of an historical anomaly than an undisputed fact. In short, while many of these people are incredibly talented, their foundational beliefs and assumptions are strikingly different from those of younger generations.

Management and leadership

Jeff Immelt, Mauldin SIC Conference, May 7, 2021

I have not been a huge fan of Jeff Immelt, but I must say I was impressed with his comments and insights from the conference. One that especially stood out for me was his remark that he would have been a better CEO if he had taken a break for a couple of years and done some venture capital work. Interestingly, he felt breaking the company up into one hundred different P&Ls would have been a better way to develop leaders and identify growth prospects.

The comments came in the context of GE being very good at being a big company. But this is exactly what handicaps many large firms: They become so beholden to processes and regularly generating cash flow that they forget how to take risks or are simply too comfortable to do so. It is a classic business conundrum. It is not easy to solve through partnerships or acquisitions either because the cultures and philosophies are often so different.

From a high level, economy-wide perspective, the tension between exploitation and exploration often plays out through the process of creative destruction. When new ideas come along, new firms rise to the top to exploit them. As the business landscape has become increasingly concentrated, however, it will become increasingly important for companies to figure out how to manage the tension internally.


Dr. Mike Roizen, Cleveland Clinic, SIC Conference 5/5/21

With so much attention focused on day to day matters the last year, it is easy to lose perspective on some of the ground-breaking medical advances that are being made. Roizen very matter-of-factly stated there would be an exponential increase in life expectancy between 2020 and 2030. He said there would be developments that could actually reverse some aging mechanisms and as a result people are likely to experience an additional three decades of life on average.

Holy cow! Personally, I can’t even get my mind wrapped around such a possibility. If, instead of living to about 80, we will start living to 110, obviously some things will change. We sure won’t be able to retire in our late 50s or early 60s. It may not matter so much, however, if we are still very lucid and mobile much later in life. While I am reserving some skepticism, it also makes sense to seriously consider the prospect of living much longer than our forebears.


Socially Responsible Hackers ($)

“The hacking group that shut down the Colonial Pipeline has promised to exercise more discretion in choosing targets in the future. They say that the pipeline itself wasn't their target, just the corporate records of its owner. This actually makes sense: the pipeline was shut down as a precaution, not as a direct consequence of the hack. In a way, the good news that hackers aren't directly trying to shut down crucial infrastructure illustrates the bad news that they can. They already operate in a strange gray area where they a) break the law, but b) follow certain rules, like ‘don't go after targets in Russia.’ By building the capability to go after more crucial targets, but choosing not to, their behavior is the cybersecurity equivalent of a nuclear weapons test: a way to demonstrate offensive capabilities before it's time to use them.”

This reminds me of one of my favorite lines from the HBO Series the Wire: “A man’s got to have a code”. So, the good news is these particular hackers may be criminals, but they really didn’t mean to create any chaos. The bad news is they just publicized proof of concept of how to create massive chaos to anyone else with comparable skills.


With 8 mln Americans out of work, why are more companies not filling jobs?

“What gives? It's a long list, but here are some of the highlights:

  • Parents - particularly mothers - cannot work because closures or shortened hours at schools and daycare keep them home to watch their kids.

  • Would-be workers remain concerned about health risks amid a pandemic still claiming about 700 American lives daily.

  • Stock market gains have given some older workers the cushion to retire.

  • Some younger workers are finding jobs in new fields, shrinking the labor pool for the industries they left behind.

  • Many employers need to fill jobs requiring skills that sidelined workers may not have.

  • Employers complain that enhanced unemployment benefits and other government aid are keeping workers on the sidelines.”

This is a pretty comprehensive list of reasons why job openings are not getting filled as fast as they could be. While the diversity of reasons gives plenty of fodder for a wide variety of political narratives, it also indicates this is not a simple problem that can be solved with a “silver bullet”. Rather, the continued array of obstacles preventing people from returning to work highlights the need for policies that reducethe many and varied frictions to employment.

Certainly, some of these obstacles will go away as restrictions are lifted, more normal activity resumes, and pandemic-related policies expire - and that could happen very quickly. Nonetheless, it is likely a large number of job openings will remain unfilled. Will wages increase to lure in workers? Will training become more accessible to filled skilled positions? Will businesses close for lack of workers at economic rates? It will be interesting to watch how the problem gets solved.


Liz Cheney's game plan

“Cheney will take her case to the public with speeches and other appearances. Cheney and her team have been intentional about painting the stakes as higher than a squabble about a leadership job, but instead about truth and the future of the Republican Party.”

The Defenestration of Liz Cheney ($)

“But the idea that this [the vote to oust Cheney] was just a tempest inside the beltway tea pot strikes me as profoundly wrong. History is a bit like one of those choose-your-own-adventure books. Small decisions that seem trivial move events, people, and institutions along paths that lead to more choices while simultaneously foreclosing other choices. If you’ve ever read a book about the lead up to World War I, you know this.” 

With Cheney being voted out of Republican leadership on Wednesday it is clear the party has a preference for loyalty to Trump and the many fictions he perpetuates over conservative ideology. With about a third of voters declaring themselves independent and with the 2020 presidential election largely a referendum on civility, it will be interesting to see if Republicans can maintain the same force in nationwide elections as they do in local ones. Either way, it looks like volume of political acrimony is about to get dialed up again.


The broader lesson from booming copper prices ($)

“The market for copper and other commodities, including oil, is currently in ‘backwardation’, a state in which futures prices are below cash prices (see chart). In theory stock levels should respond to the spread between cash and future prices. In a backwardated market, the marginal benefit of adding to copper stocks is low. So backwardation is a prompt for stocks to be run down to meet immediate demand. It is a telltale sign of physical shortages.”

Two points are made in this commodities primer piece from the Economist. One is the relationship of spot prices to futures contains important information content. When spot prices are higher than futures prices, that signals a short-term supply problem, not a systemic one. The fact that copper prices are backwardated suggests more of a short-term issue, at least for the time being.

Relatedly, producers and consumers of many commodities must make plans based on long time horizons. It takes several years, for example, to open a new mine. Industrial consumers such as electric utilities also need to have reliability of supply. The result is the structural balance between supply and demand is more clearly indicated in future prices than spot prices. In short, while booming spot prices tell a story, it is far from the only story.


An important part of the inflation phenomenon right now is about base effects: Inflation in the early days of the pandemic lockdowns was negative. As those periods roll off, the trailing twelve-month number increases automatically as more normal CPI reports replace them. This point was depicted beautifully by Barry Habib with a slide used in a presentation on housing (below) at the Mauldin SIC Conference.

He assumed incremental CPI of 0.2% per month which would generate Core CPI (for trailing twelve months) of 2.5% in both the June and July reports for the prior month. In other words, it is going to look like core inflation is increasing when all that is happening is some negative numbers from last year are rolling off. With April’s actual core CPI coming in at 0.9%, far above expectations, the year-over-year increase is especially eye-catching.

Base effects are likely to artificially inflate the CPI numbers for the next couple of months and then roll off quickly. At that time either ongoing inflation will also abate and the annual CPI will drop considerably or it will continue leaving annual CPI at an inflated level. The bottom line is there will be lots of noise in the numbers which introduces the potential for lots of volatility.

Capital markets

Reflation Panic Sparks Global Stock Rout

“’The underlying driver is that there is still a rotation out of duration (higher interest rate) sensitive parts of the market and this is why tech stocks are coming under pressure now,’ said Mizuho’s Head of multi-asset strategy Peter Chatwell.”

The evidence is clear that growth stocks and indexes have had a tougher time as inflation concerns have heated up. In financial terms this makes perfect sense. These stocks performed especially well with rates hovering close to zero because their expected payoffs, which occur far into the future, have been discounted at very low rates. In other words, they have high duration. As such, they also suffer disproportionately when rates go up.

On one hand this is just par for the course rotation stuff. However, after such a long period of declining rates, growth (i.e., high duration) stocks have come to dominate major indexes in terms of market cap. As a result, if and when these stocks get hit, it will be very hard for smaller stocks to make up the difference and prevent major losses in the indexes.

This also highlights a major problem for the Fed. The more the Fed acts as if inflation is not a concern, the more growth stocks are likely to get hammered and the lower stocks will go. This reduces asset values which reduces collateral which reduces liquidity and so on. However, if the Fed starts talking up the prospects of tightening, the markets could easily buck at the suggestion and go through another tantrum. This means the Fed is really cornered; the market will suffer if it acts and if it doesn’t act.


Central banks get serious on digital currencies ($)

“As Mervyn King said as Bank of England governor in 2010, ‘of all the many ways of organising banking, the worst is the one we have today’.”

This article is mainly about central bank digital currencies (CBDCs) but is really more far-reaching than that. For all the talk about inflation and deflation and monetary policy, much of it ultimately leads to a bigger problem: The entire global financial system, build around banks and fiat currencies, is not very fit for purpose.

The author, Nicholas Gruen, appropriately asks: “So far, we’ve had the depression and the pandemic. How many more crises might it take to face our demons? How many might we avert by facing them now?” In other words, at some point it is less costly to figuratively hit the “reset” button and introduce a new and better system than to keep fiddling with the inherently faulty one we have. That time is coming.

Implications for investment strategy

With a remarkable rebound in stocks over the last year and a couple of months, now is a good time to reflect on what comes next. While the rule of thumb has been to buy the dip and ride the wave, the list of things that could go wrong is also becoming quite impressive and deserves serious consideration.

Record high valuations and record low credit spreads still remain in place. At the same time, however, the threat of taxes increasing is quite high, inflation prospects are increasing, and easy year-over-year comparisons are ending and about to be replaced by much more difficult ones. The fact that all of this is accompanied by record high leverage indicates a great deal of fragility if anything does go wrong.

At the same time, the broader political environment is also becoming less market friendly. With Republicans ousting Liz Cheney from leadership, the party is likely to be even less amenable to working with Democrats and less cohesive in terms of strategy. In addition, most indications are the regulatory environment, especially enforcement, is going to get more difficult. On the geopolitical front there are many issues but elevated tensions with China are plenty enough to darken market prospects.

Finally, it seems much of the fervor of the last several months has been a function of increasing participation by retail investors. The tweet below by Eric Balchunas highlights the pros and cons of this activity. Money is drawn in when performance is good and disproportionate amounts of money comes in at peaks. For all of the money that has come into hot funds like ARKK, cryptocurrencies, and a slew of story stocks, it will be worth watching how long it stays there after returns become negative.

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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