Areté's Observations 6/25/21

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.

Welcome back to Observations!

If my anecdotal observations are any indication, people are jumping in their cars in droves and heading out on vacation. If you are going to be doing the same any time soon, I hope you have a great trip and stay safe!

If you have any comments or questions please reach me at drobertson@areteam.com.

Market observations

News flow is picking up again as a number of developments have attracted attention. The Russell indexes will be rebalanced this week for one. For another, cryptocurrencies had a dramatic up and down week. Similarly, stocks took a dive after the Fed meeting last week and then quickly recovered. John Authers of Bloomberg captured the activity as well as anyone: “But still, five days of such excitement and speculation and all it got us was a 0.00% return on the S&P with 0.00% momentum? It’s hard not to laugh.”

One thing that is doing better than coming out even is household equity as a percent of total financial assets. Now at an all time high, investors are taking on as much risk as ever.

This record exposure to risk is actually understated given the high level of debt taken out to support it. As the graph below illustrates, a significant majority of Millennials and Gen Zers have taken out debt in order to invest. While such activity is usually imprudent on an individual level, when done more broadly it creates the conditions for forced selling that can roil markets.

Finally, as if to punctuate the set of market observations, here are Jeremy Grantham’s comments from a recent interview with John Authers: “’Meme’ investing -- the idea that something is worth investing in, or rather gambling on, simply because it is funny -- has become commonplace. It’s a totally nihilistic parody of actual investing. This is it guys, the biggest U.S. fantasy trip of all time.”

Credit

Historically low yield levels are indicative of the degree to which yield chasing has become something of a national sport. This is an excellent indicator of how stretched risk appetite is currently and will also be an excellent indicator when that appetite begins to wane. No signs of that yet.

Regulation

Joe Biden appoints Lina Khan to head the Federal Trade Commission ($)

https://www.economist.com/united-states/2021/06/19/joe-biden-appoints-lina-khan-to-head-the-federal-trade-commission

“Yet many of Ms Khan’s views are also popular with conservatives, who bash big tech firms for their size and stifling of free speech. ‘She’s a controversial figure within antitrust circles, but a very popular one in political circles,’ says Blair Levin of New Street Research, an analysis firm.”

“According to Mr Levin, the agenda to combat the tech giants’ power will have four fronts. Ms Khan will work with Congress on bills (which have a degree of bipartisan support) to constrain the power of big tech firms by, for example, banning them from favouring their own services. Second, Ms Khan will collaborate with European regulators, who have led the charge against the tech behemoths. Third, she will launch investigations. And fourth, she will litigate cases against businesses.”

The potential for greater regulatory pushback against tech firms has been visible for a while but failed to gain much traction. With the appointment of Lina Khan to the FTC and her selection as chairperson, this threat just became much more tangible. Not only is Khan an intellectual force who can bridge regulatory philosophy with the internet age, but she also has significant bipartisan support from which to accomplish that politically.

As a result, this development poses a serious threat to business as usual for Big Tech. While these companies have been able to dodge any serious impositions to their business models thus far, the odds are getting longer they can maintain that record. Big Tech stocks have not reflected the threat yet but that is unlikely to persist.

Public policy

Half of the pandemic's unemployment money may have been stolen

https://www.axios.com/pandemic-unemployment-fraud-benefits-stolen-a937ad9d-0973-4aad-814f-4ca47b72f67f.html

“Unemployment fraud during the pandemic could easily reach $400 billion, according to some estimates, and the bulk of the money likely ended in the hands of foreign crime syndicates — making this not just theft, but a matter of national security.”

“Unemployment fraud is now offered on the dark web on a software-as-a-service basis, much like ransomware. States without fraud-detection services are naturally targeted the most.”

I almost didn’t include this item because it is so depressing and at least partly tinged with partisanship, but it also speaks to bigger issues which are very relevant. For one, too often only the benefits of public policy programs are measured, not the costs. This is unfortunate especially when the costs are extremely high as appears to be the case with pandemic unemployment funds.

Perhaps even worse, the undesirable outcome was not some wildly unforeseen black swan event. At the time I wrote in a blog post from May 2020: “Of course, there is truth to this right-sounding mandate [that time is of the essence]. From another perspective, however, it simply enables the all-too-human tendency to overlook long-term consequences.”

I also noted the military special forces approach of “slow is smooth, smooth is fast” implies “it is not just speed that is crucial, but also correct action. It also implies that speed without smoothness is often counterproductive. It is important to be deliberate. Get it right the first time, and you won’t have to waste time or miss an opportunity.”

One takeaway is in a world of immediate gratification, efforts to plan ahead are unlikely to receive sufficient political support. The natural consequence is public policy measures will largely be enacted only in response to emergencies. Since emergency responses are far more likely to be impulsive, they are also less likely to be effective. Plan accordingly.

Infrastructure

Time-saving tech is coming to two new U.S. border crossings

https://www.axios.com/time-saving-tech-us-canada-mexico-border-4bca2e84-2ff0-4c52-bc6c-de12c938e3d2.html

“The new international border crossings, both funded by public-private partnerships, are designed to bolster trade with Mexico and Canada while reducing wait times and improving local air quality.”

“Also set to open in 2024, its flexible lanes and variable pricing scheme are designed to provide a data-driven release valve for backups elsewhere along the California-Mexico border that can last up to five or six hours.”

This is an interesting little tidbit that came across this week. It is timely given the talks in Washington regarding infrastructure spending and it is interesting because it demonstrates how technology can make things better. By collecting and sharing data about conditions at the borders, “Cars and trucks equipped with transponders will know how traffic is moving miles ahead so drivers can plan the fastest route across the border.”

I am inherently skeptical of infrastructure projects because so many turn out to be boondoggles that don’t provide adequate returns – either economically or socially. That said, the EZ Pass express lanes have saved me and a lot of other drivers countless hours in the car so it doesn’t make sense to be overly pessimistic either.

Gold

In Gold We Trust report, May 27, 2021

https://www.incrementum.li/en/ingoldwetrust-report/

“That gold is no longer considered money by governments today is in gold’s thousand-year history the biggest difference from earlier times. All the historical episodes of gold confiscation have occurred when governments desperately wanted to raise money and thus confiscated gold as a means to that end. Today governments and central banks do not have a strong incentive to confiscate gold, because it is not considered money or part of the fiat monetary system.”

“Gold is no longer the primary target of theft by kings, emperors and politicians, because it is no longer the largest store of wealth. Today the bond market is the primary store of wealth, and that is where confiscation of wealth is most likely to occur.”

One of the things that can strike fear into the heart of an investor in stocks and bonds is the prospect of inflation. One of the things that can strike fear into the heart of a gold investor is the prospect it can get confiscated (as it has been in the past). Although desperate governments will take what they can, the easier (and much bigger) target for now is bonds, not gold.

Another risk is that taxation of gold holdings may increase. While this is certainly true, it is also true taxation of stocks and bonds may increase. Given a trial balloon has already been floated for a retroactive increase in capital gains taxes, it appears as if stocks and bonds are much more on the taxation radar than gold.

Cryptocurrencies

Why we shouldn’t listen to crypto ‘experts’ ($)

https://www.ft.com/content/26283f09-c3df-4c7e-814c-65083b063d8a

“But recently I’ve been struck by one increasingly common jibe, because it inadvertently undermines the supposedly altruistic aims of the bitcoin brigade: ‘Have Fun Staying Poor’.”

“What the bitcoiners never explain — and some don’t seem to quite understand — is that this is a zero-sum game: we can’t all get rich from it. But if you listen to ‘expert commentary’, there is no acknowledgment of this, nor of the way the system is skewed to enrich those at the top of the pile.”

In an eventful week for crypto I thought it made sense to post a couple of updates. The first is Jemima Kelly speaking truth to power, or at least to the power of narrative. Many thoughtful analysts have refrained from uttering words critical of cryptocurrencies for fear of retribution from its core base of zealots. This is unfortunate because it inhibits a broader and more objective discussion of the pros and cons of both cryptocurrencies and the fiat money system currently in place.

All of that said, Kelly’s points are good ones. Much of the fervor and sentiment behind cryptocurrencies belies altruistic stated goals. In short, there seems to be significant lack of coherence between the broader goal of creating a better money regime and the individual incentive to get rich. Regardless, the narrative tide does seem to be turning against cryptos and now central banks are also jumping on the bandwagon …   

Central banks step up fight against cryptocurrencies ($)

https://www.ft.com/content/b6a3bf06-ad6b-4ab4-9ae3-15aca453f50d

“In a report published on Wednesday, the Bank for International Settlements, the global body for central banks, also dismissed stablecoins — a link between crypto and conventional assets — as an ‘appendage’ to traditional money. The strongly worded report was the clearest signal yet from central banks that they are ready to fight any effort to undermine their key role in the global financial system.”

“It is clear that cryptocurrencies are speculative assets rather than money, and in many cases are used to facilitate money laundering, ransomware attacks and other financial crimes,” the BIS said. “Bitcoin in particular has few redeeming public interest attributes when also considering its wasteful energy footprint.”

One observation is in the context of normally sedate and conditional central bank communications, these are “fightin’ words”. Another observation is none of this should be a surprise. Back in November last year I wrote: “Control over money is power and there is no way governments will cede that power to entities they do not control.” The only difference between then and now is now the reality has been expressed explicitly.

Market landscape

Following the Money Suggests Stocks Have a Problem

https://www.bloomberg.com/opinion/articles/2021-06-22/stocks-are-at-risk-of-decline-as-money-supply-growth-dries-up

“U.S. monetary base growth has plummeted to 7%: it peaked at 78% only 10 weeks ago. It is driving the downturn in policy liquidity expansion.”

Both the quote above and the graph below come from Crossborder Capital by way of John Authers’ note in Bloomberg. The key feature is liquidity, which had been a primary driver of markets since the pandemic hit, is now rapidly decelerating. If there is one measure to watch for guidance, liquidity is it.  

The chart below shows cumulative flows into equity by regions. For most of the last five years, flows into European and emerging market stocks have been steady while funds have flowed out of US stocks. The trend in US stock flows reversed sharply late last year and has continued sharply positive ever since. While those flows help explain the recent resilience of US stocks and the ongoing downward pressure on volatility, it is also hard to believe the same trajectory can be maintained.

Source: themarketear.com

Implications for investment strategy

“Lurking at the Scene” by Harley Bassman

https://www.convexitymaven.com/wp-content/uploads/2021/03/Convexity_Maven_-_Lurking_at_the_Scene.pdf

“Convexity is the measure of unbalanced risk so, almost by definition, a negatively convex portfolio will be unstable. Markets become disturbed when the instability of negative Convexity becomes greater than the market’s liquidity.”

“FED policy is encouraging Moral Hazard as desperate investors reach for yield by selling Convexity in various forms; I am happy to buy those options.”

One of the more technical but more important aspects of investing is the concept of convexity and Harley Bassman is one of the best teachers of the subject. Simply put, convexity is the phenomenon of asymmetric or disproportionate returns. Positive convexity is the potential for huge upside with relatively little downside risk and negative convexity is the opposite – modest upside potential with huge downside risk.

With those characteristics one might guess investors would be clamoring for products with positive convexity. Alas, that has not been the case. In fact, quite the opposite is happening. Negative convexity (convexity selling) has had two big things working in its favor. One is convexity sellers are paid up front and therefore realize immediate gratification. Another is the Fed has come to the rescue at each major selloff and therefore effectively eliminated the downside risk, at least to date.

The key factor is the Fed cannot continue to refresh speculative fervor forever. The Fed can, and has, managed to push out the time frame of the selloff, but it cannot change the math of asymmetric returns and it cannot destroy risk. To this point, Bassman explains, “Not to cast aspersions on some investors, but often their greed outweighed their fear; which makes me think they do not fully appreciate the mechanics of negative Convexity.”

This has created a frustrating dynamic for many long-term investors. In more normal market environments greed and excess create opportunities for more disciplined investors. This environment, however, has penalized discipline and rewarded greed. There is reason for hope, though, on two counts. One is volatile and uncertain inflation is rapidly undermining the Fed’s ability to keep markets calm – which would be good for the restoration of free market forces. Another is new and better ways to access positive convexity are becoming available …

Head, Shoulders, Knees, and…Tails? How Passive Investing is Changing the Structure of Markets

https://www.simplify.us/case-study/head-shoulders-knees-andtails-how-passive-investing-changing-structure-markets

“The growth of passive investing is systematically modifying equity return distributions. By introducing convex strategies into portfolio construction, we can improve equity outcomes by exploiting fatter left tails, thinner right tails, and rising volatilities. Ultimately, the mispricing of options against this changing market structure can become a source of excess return.”

While I am extremely hesitant to endorse investment products, I am much more willing to provide support for individuals who I believe are both competent and well-intended. On that front, the relatively recent addition of both Harley Bassman and Mike Green (whom I have mentioned many times on these pages) to Simplify Asset Management speaks volumes about what that organization wants to accomplish. In short, it is solving some of the historic challenges surrounding positive convexity for investors and advisors.

For example, one of the bigger challenges of investing in the current carry regime is having to decide between exposure to an extremely overvalued market (but one that keeps going up) and cash. Staying in cash for too long seems like missed opportunity but exposure to overvaluation suggests significant eventual losses. Simplify is expanding the opportunity set so investors have better options. While a great many new investment vehicles are designed primarily to harvest fees in new ways, new offerings from Simplify come as very welcome answers to challenging problems.

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.

Comments

One goal of this letter is to provide fairly dense information content – so you don’t waste your time filtering through a lot of fluffy verbiage. A consequence of that decision, however, is sometimes things may not be as understandable as they could be.

If you have a general question that may also be useful for others to know the answer to, please make a comment in the newsletter and I will do my best to answer the question or make a clarification. If you have a more specific question, please send it to drobertson@areteam.com.

Disclosures

This commentary is designed to provide information which may be useful to investors in general and should not be taken as investment advice. It has been prepared without regard to any individual’s or organization's particular financial circumstances. As a result, any action you may take as a result of information contained on this commentary is ultimately your own responsibility. Areté will not accept liability for any loss or damage, including without limitation to any loss of profit, which may arise directly or indirectly from use of or reliance on such information. 

Some statements may be forward-looking. Forward-looking statements and other views expressed herein are as of the date such information was originally posted. Actual future results or occurrences may differ significantly from those anticipated in any forward-looking statements, and there is no guarantee that any predictions will come to pass. The views expressed herein are subject to change at any time, due to numerous market and other factors. Areté disclaims any obligation to update publicly or revise any forward-looking statements or views expressed herein.

This information is neither an offer to sell nor a solicitation of any offer to buy any securities. Past performance is not a guarantee of future results. Areté is not responsible for any third-party content that may be accessed through this commentary.

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