Observations by David Robertson, 12/2/22
Observations by David Robertson, 12/2/22
We are coming into the home stretch for 2022. It’s been a wild and crazy year for investing and by all appearances will be another one in 2023. If you ever want to follow up on anything just let me know at drobertson@areteam.com.
Market observations
Stocks got clobbered on Monday with the S&P 500 down 1.5% and with the relatively rare instance of market leader AAPL falling quite a bit more. Stocks then bounced around until Jerome Powell’s speech on Wednesday afternoon during which they popped about 2% during the one-hour presentation and were up 3% by the close. Obviously, stocks are still following the lead of the Fed.
graph of three returns ytd
Stepping back and looking at year-to-date performance of the three main large cap indexes reveals widely disparate performance. It’s been an awful year for tech-heavy Nasdaq while Dow Jones stocks have only sustained a minor dip. Even the S&P 500, which is the most representative index, has recovered enough to turn around what looked like a disaster into just an off year.
Finally, any analysis of the last few weeks of market activity would be incomplete without consideration of the US dollar. After running higher all year due largely to the Fed’s much tougher monetary stance, the dollar has fallen considerably in the fourth quarter. Regardless of whether the decline is justified or not, it has provided support for asset prices across the spectrum including stocks, oil, and gold.
Economy
On one hand, we are meandering into one of the most expected recessions ever. With persistent yield curve inversions and anecdotal signs of credit weakening and consumer stress, continued monetary tightening by the Fed appears to be having the intended effect of slowing down demand - and economic growth with it.
On the other hand, however, a wide range of indicators point to a fairly strong economy. As Ethan Wu writes for the FT’s Unhedged ($) newsletter, “this quarter has brought a smattering of surprisingly punchy data in areas like new home sales and durable goods orders.” Further, consumer spending continues to hold up well:
One takeaway is the picture of economic growth is not likely to suddenly become very clear any time soon. Not only are multiple cross currents pushing and pulling the economy in different directions, so too is public policy. What the Fed takes away through tight monetary policy, fiscal spending and other public policy measures often give right back. It’s hard enough to tell what the net effect currently is, let alone what it will be in a year’s time.
Another takeaway is that underlying economic health is going to become an increasingly important indicator for capital markets. Through the times of artificially suppressed interest rates, the key driver was liquidity. Low rates and easy money meant more financial activity - which did boost economic growth of sorts. Going forward, more economic growth with less credit growth will be key.
Finally, in the context of a great deal of uncertainty, it is fair to expect a wider range of possible outcomes. As such, it makes sense to hold opinions of specific possible outcomes lightly and to incorporate a lot of different possibilities into the planning process.
Technology
Great point by @AitkenAdvisors that often gets overlooked. Sure, the value of tech firms can go parabolic when the value of their network increases exponentially with the number of users. This is what makes the successful creation of platforms so wildly attractive.
The phenomenon also works in reverse, however. When growth reverses and the number of users starts falling, so too does the value of the network fall exponentially. Combine this with the fact that falling values also massively undermine stock option values that often comprise a large share of employee compensation (and motivation) and it is easy to see why many tech shares tend to be very cyclical.
Real estate
With rates being high enough for long enough now to start affecting real estate values, a number of forecasts predicting a real estate armageddon are coming out. An excellent point is made here that US Treasury rates are now providing returns that are competitive with assets like real estate but without the risk. As such, it is reasonable to assume money will flow out of one and into the other. This process is starting but has a long way to go.
As @EpsilonTheory rightly points out though, the correction in real estate values can happen in two ways - by values dropping but also by rents increasing. Don’t be surprised if real estate weakness does not translate into broadly cheaper rents.
China
Covid cases have picked up in China again which isn’t too surprising. What is at least somewhat surprising is the increasingly vocal pushback from Chinese citizens. With the ghosts of Tiananmen Square in 1989 etched indelibly in Chinese history, it is all-too-easy to envision an authoritarian crackdown on protesters.
@biancoresearch is spot on regarding two points. First, there is great concern that “human rights abuses are coming”. Second, “What happens next will impact the entire global economy”. It’s hard, for example, to not draw a line between the potential for a significant slowdown in China and weak oil prices.
Oil
This graph from https://themarketear.com/premium ($) captures one of the big quandaries of the past year. You think oil is going to go up because of supply issues - persistent under-spending on capital and Russia’s invasion of Ukraine. But then the Biden administration eases supply issues by draining the Strategic Petroleum Reserve and the Fed tries to quash demand by tightening monetary policy. Pfft.
At the same time, while oil itself has trended down since shortly after Russia’s invasion, oil stocks (represented by XLE) have trended up. What should be made of this paradox?
One take is XLE has gotten way ahead of itself. Retail punters prefer stocks as the vehicle by which to express a bullish view on oil and stocks are where the money has gone. The only question is timing: Will oil catch up fast enough to justify the bet, or will some traders get shaken out of their positions if oil fails to trade high enough soon enough?
Another take is the stubborn resistance of oil to trade higher is actually reflective of fundamentals that XLE traders have underestimated. Since the price of oil tends to be one of the least tainted global economic signals, this take is plausible. Certainly, global demand is a major question mark with recession concerns in the US and Covid lockdowns in China.
Either way, the differential between oil and XLE is becoming extreme - which means it is increasingly likely to get resolved one way or another.
Investment landscape
Collateralised fund obligations: how private equity securitised itself ($)
https://www.ft.com/content/e4c4fd61-341e-4f5b-9a46-796fc3bdcb03
The product is known as a “collateralised fund obligation” and its aim is to diversify risk by parceling up the companies providing returns. CFOs are, in some ways, a private equity variant of “collateralised debt obligations”, the bundles of mortgage-backed securities that only reached the public consciousness when they wreaked havoc during the 2008 financial crisis.
Combine the concepts of securitization, leverage, illiquidity, and lack of transparency and you have the new and improved(?) version of collateralized debt obligations that blew up in the GFC. These have been flying under the radar, but I suspect 2023 will be their big coming out in terms of media attention. Also, FWIW, this is one of the first big stories I’ve seen in a long time that was scooped by MSM rather than social media.
Excessively low rates and loose monetary policy caused a lot of shenanigans with meme stocks and SPACs and you name it. Now, CFOs are also in the competition for top honors. @PauloMacro characterizes this trend as, “BEYOND STUPID”! Sounds about right.
Public policy
One of the more important but less discussed trends of the last two to three decades has been the increasing influence of public policy in economics and finance. When resources are abundant and economic growth is good the best thing to do is to stay out of the way. When growth slows and the minions start to grumble, however, something needs to be done.
Going back to the GFC in 2008, it was pretty clear something needed to be done and that something was to confer great authority to the Federal Reserve to guide the economy through monetary policy. The result has been a massively bloated Fed balance sheet which severely constrains what the Fed can accomplish with monetary policy going forward.
During the Covid pandemic, fiscal spending really took over as stimulus checks were distributed and loans were backstopped by the government in order to keep the economy chugging along. Now, with a split Congress, the bar for additional large spending bills making it through to realization is much higher.
Since these important channels of public policy have largely been closed down, other channels are picking up the slack. Namely, things like regulatory changes, executive orders, and other administration decisions are serving to provide the boosts and nudges to keep things moving along. For example, releasing oil from the Strategic Petroleum Reserve increased oil supply, decreased oil prices, decreased gasoline prices, and in doing so, freed up money consumers could (and did) spend elsewhere. The extension of student loan forbearance would accomplish the same thing.
One important consequence of this trend is that economic and financial data is becoming less and less reliable. The market price for bonds (and therefore yields) are less indicative when the Fed is the dominant buyer. Similarly, economic statistics are less indicative when the economy is periodically juiced by capricious public policy measures.
These kinds of distortions and uncertainties are commonplace in emerging markets (EMs) - and that is a big part of what makes them EMs. As @PauloMacro rightly points out, these kinds of distortions and uncertainties are becoming increasingly rife in developed markets (DMs) too:
Insofar as policy is capricious and data is unreliable, forecasts should be treated with a great deal of skepticism. It’s hard enough to establish a decent assessment of where things are currently; it is almost folly to project very far into the future. Forecast are subject not only to unrepresentative starting points, but also to an enormous array of possible interventions between now and then. To an important extent, intermediate growth is just as much a function of what the powers that be want it to be as it is what economic trends would suggest.
Monetary policy
Federal Reserve Chair Jerome Powell: The economic outlook, inflation, and the labor market
Traders and other market participants anxiously awaited Jerome Powell’s speech on Wednesday to provide guidance through the end of the year and into the (presumably) final stages of this rate hiking cycle. The speech consisted mainly of cut and pasted remarks from the last few FOMC press conferences and as such revealed virtually nothing new. Nothing new is exactly what markets wanted to hear though as stocks took off on the remarks.
One interpretation is that we are now on the downhill side of Fed tightening and on the way to better times. I am still extremely skeptical things are that easy. I am still working from the hypothesis that rates are mainly a side show and liquidity is the key driver. To that point, liquidity is set to tighten in December with QT accounting for its regular drawdown while the Treasury’s TGA account will also have to pull nearly $200B of liquidity this month to meet it $700B target.
So, who will win out? To some extent the aggressive trading on essentially no news reflects an effort to make the best of what has been a terrible year for many. The longer-term issue, however, it that it is going to get increasingly difficult for the Fed to micromanage its message. The markets have a way of pushing central banks to the limit, essentially daring them to take uncomfortable positions.
This is the dynamic that causes mistakes to be made and causes volatility to rise. It is also the dynamic on the menu for next year.
Cryptocurrencies
In the context of all kinds of chatter about crypto and FTX and Sam Bankman-Fried and all kinds of other supporting characters, I will keep my comments brief and hopefully additive. First, by far the best and most informative commentary has been outside of mainstream media (MSM). If ever there was a disuse case for MSM, this is it. There are a lot of subjects for which you need to look elsewhere to stay informed.
Conversely, probably the best analysis and overviews I have seen come from Ben Hunt at Epsilon Theory. His piece, “The MacGuffin, Part 2: The Story Arc of SBF and FTX”, is the clearest and most comprehensive analysis of the situation I have seen. Check it out if you want to learn more about crypto, about frauds in general, about the rot in the legal and regulatory system, or just have a curiosity about how criminal minds work. Books and movies will be written about this.
Secondly, the silence of regulators and law enforcement has been absolutely deafening. As discouraging as that is, a very few individuals including Ben Hunt (@EpsilonTheory) and Marc Cohodes (@AlderLaneEggs) are putting enormous personal efforts into exposing the wrongdoing and holding the wrongdoers to account. Thank you gentlemen!
Implications for investment strategy
Every once in a while I like to take a step back from day-to-day market activity in order to gain perspective on the things that are most important. As a result of that exercise, a couple of phenomena strike me as being extremely important for long-term investors to consider right now.
One of those continues to be the weaknesses of a traditional 60/40 portfolio in this environment. The 60/40 portfolio is a lot less a cleverly engineered portfolio design than a product of recency bias. In the aftermath of exceptionally high inflation and interest rates in the early 1980s, the path of least resistance was for rates to go down and stocks to go up. And that’s what they did.
Today, with the emergence of inflation, geopolitical conflict, and threats to globalization, virtually all of the forces that powered the 60/40 portfolio are thrust into reverse. While there are lots of ways to screw up an investment portfolio, failing to react to changing conditions currently ranks at the top of the list.
While inflation is a far bigger threat today than it has been in a long time, that isn’t to say it is the only possibility. Excessive debt could cause periods of deflation in parts of the world as well. Further, lower organic economic growth and high valuations undermine the case for stocks. In short, the variability in possible outcomes over a relatively long investment horizon has increased substantially while the attractiveness of many popular assets has decreased. Things are getting a lot harder.
None of this is reason to despair and give up hope. It does mean care and action will be required to avoid major drawdowns and care and action will also be required to select investments that can be additive in the new environment. All of this will take time and effort, but as prices go down, so too will opportunities and future return potential go up.
Note
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