Observations by David Robertson, 12/3/21
Stocks started a roller coaster ride last Friday that continued through this week. There are a lot of interesting things going on so let’s dig in.
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In the holiday-shortened session last Friday, markets sold off in a broad-based “risk-off” wave that we haven’t seen for quite a while. While the immediate impetus was the emergence of the omicron variant, some oddities in market behavior suggest other factors are also in play.
On Friday, oil closed down 15% and commodities in general were down big. The DJP ETF was down about 4.5% at noon. The 10-year Treasury yield also dropped 9% during the day. Gold was up modestly which supported its case as being a good hedge. Conversely, bitcoin was down 7.5% which massively undermined its case as a good hedge. Interestingly, the US dollar (DXY index), which is normally a safe haven during turmoil, was also down considerably.
On Monday, investors took the opportunity to buy the dip and the S&P 500 gained over half of what it had lost on Friday. Interestingly, however, the Russell smallcap index barely budged on Monday and oil continued falling. On Tuesday, S&P futures were up overnight but then stocks sold off during the day and finished down. On Wednesday, futures were up again overnight, continued gaining through midday and then sold off sharply to finish down 1.3%.
The graph above from Yahoo finance shows the roller coaster action over the last week with a clear downward trend. Each time investors came in to buy the dip, they were overwhelmed with selling – an incredibly unusual phenomenon in post-financial crisis markets. There are several possible reasons why things may have changed, not least of which the Fed is intentionally trying to tamp down speculative fervor in order to preserve space for raising rates without destabilizing the market.
Another possible reason for weakness is increased concern about global growth. Oil has been one of the few reasonably accurate indicators, having sold off well before Covid led to the initial lockdowns early in 2020 and started selling off after Thanksgiving. Similarly, small caps are also indicative of growth expectations and have also noticeably sold off.
Bond stress at March 2020 levels, Nov 27 2021 at 14:48 ($)
“MOVE index continues moving sharply higher and is now at March 2020 levels. VIX is trying to ‘catch up’, but the gap remains rather wide. Last time MOVE was here, VIX traded at 55. That is obviously not an ‘accurate’ comparison, but gives you a "feeling" of just how stressed bonds remain, despite equities fear stealing the show on Friday.”
Two important points here: One is that bond volatility has been rising for a year and a half. The conditions for turmoil have been present for quite some time. Another point is that stocks are just now getting the same message. It looks a lot like the voracious appetite retail investors have had for stocks has also masked eroding underlying conditions. If that is the case, there will be a lot more beat-downs to come.
The Pentagon needs a new AI strategy to catch up with China ($)
“The solutions to this threat are clear. The Pentagon must embrace agility and understand that innovation involves failure. It should set up a joint IT office, centralising all functions such as IT procurement, cloud services, data warehousing, AI, cyber security and training into a dedicated Technology and Information Merged Enterprise, which reports directly to the Department of Defense’s deputy secretary.”
“However, as I have observed, defence leaders often fail to understand the technology itself, and refuse to empower those who do. If you are a leader and you don’t know the subject matter, then educate yourself and be prepared to take advice, or step out of the way.”
“We must also create respected career paths for software, cyber security, data science, AI and machine learning, with progression of pay and titles so they are not seen as dead ends.”
The commentary here provided by the former chief software officer at the US Air Force and Space Force is a grumble about the many ways in which the Pentagon fundamentally mishandles technology, but it serves just as well as a warning for corporate leaders.
One big problem is that too many leaders in both the public and private sectors do not understand technology and do not work actively to mitigate that weakness. Another problem is that too often, tech is relegated to the backwaters of the organizational hierarchy and therefore is vastly impaired in terms of its capacity to be deployed effectively.
Both problems, and a host of others, are founded in the antiquated mental models of organizational leaders. Unless and until those mental models change, through some combination of learning, delegation, and replacement, organizations will be crippled in their ability to fully realize the benefits of technology. That creates an opportunity, but also a huge risk.
The metaverse is just the latest incarnation of Las Vegas ($)
“In the long run, if there is any moral to the Las Vegas story it’s that if you want to bootstrap a fantasy realm for the purpose of enriching a small elite at the expense of users, it helps to have a repressed, desperate and captured demographic within your proximity. With the metaverse it’s unlikely to be any different. You’re still going to be the product. You may be more accepting of it, but only because base reality is getting more and more like historic Boulder City by the day.”
It's very telling that Izabella Kaminska uses the analogy of Las Vegas (aka, “Sin City”) to illustrate the proposition of the metaverse that Mark Zuckerberg has been promulgating. In one sense, both are artificial constructs designed to distract. In another sense, both use technology to exploit human frailties rather than to improve their lives.
These points raise a third, more philosophical point. If people willingly gravitate to “worlds” in which they are systematically exploited, and they prefer that to the real world, that is quite a dystopian commentary on living conditions for a lot of people.
Private equity’s biggest Ponzi scheme
“Simon Clark is frustrated. The Wall Street Journal reporter is five months removed from the publication of his well-received book on Abraaj Group, a private equity pioneer turned Ponzi scheme, but tells me the industry has turned a blind eye to the cautionary tale he co-authored with Will Louch.”
“A lot of LPs [limited partners] fell down on the job. If Farnum found the fraud, others could have too. It's a big reminder of how so much of private equity is based on trust, despite the billions of dollars at risk. The lack of other large-scale frauds may be more by luck than by design.”
“Naqvi's key insight was that many investors are uncomfortable with the amoral nature of textbook capitalism. He promised that Abraaj would make money while doing good, a combo so intoxicating that red flags were ignored.”
Several interesting points come out of this piece about a private equity scandal. First, sometimes people are so careless with their money that they are almost begging fraudsters to exploit them. Without some modicum of skepticism and diligence, it is all too easy to tell an interesting story to a willing participant. That raises another issue: The enormous demand for ESG friendly investments creates a target rich audience for fraud.
Finally, a more general point is that booming markets create fertile ground for fraud. Rising asset prices cover up problems, distract attention, and can provide fresh capital if holes need to be filled in. This was the pattern of Bernie Madoff in the financial crisis, and it was the pattern of many internet and tech firms in the tech bust of 2000-2001. The problem is that a lot of investors won’t know how bad the problems are until it’s too late.
China Lockdown & Herd Behavior
“Meanwhile, in the world of crypto, the herd mentality seen throughout the global financial markets is in full force and then some. If you think it is dangerous to express divergent opinions on dealing with COVID inside Xi Jinping’s nation prison, then consider the situation in crypto land.”
Brent Donnelly of Spectra Markets writes: “The BTC and crypto hype machine is 10X more powerful than the 1999/2000 internet hype machine. Nobody is ever going to tell you when to sell. It is borderline verboten for anyone in crypto to even utter a bearish word. Keep that in the back of your mind. Every story you ever hear is going to be bullish.”
The problem with bull markets is that after a while, a lot of the narratives become BS. Traders need to recognize when conditions change, and Brent Donnelly is calling it: “the favorable conditions for such speculations [in crypto and equities] are now reversing.” The ability to re-evaluate, turn on a dime, and completely reshape a portfolio is what makes great traders great. It is exceptionally hard to do. I suspect we’ll be hearing a lot of sob stories from wannabe traders who could not adapt.
American inflation: global phenomenon or homegrown headache? ($)
“President Joe Biden, for his part, has adjusted his tone on inflation. As recently as July he described the jump in prices as temporary, a by-product of the pandemic. In recent weeks he has instead been forthright in saying how much inflation hurts Americans and declaring that ‘reversing this trend is a top priority’.”
Fed signals it could yank economic support quicker as inflation sticks around
“The Federal Reserve will consider pulling back economic support sooner ‘as the threat of persistently high inflation has grown,’ chair Jerome Powell said during a congressional hearing on Tuesday.”
Astute observers might recognize the possibility of a cause-and-effect relationship: The President starts worrying more about inflation and the Fed responds by jawboning about addressing inflation by accelerating the taper – and therefore pulling forward the potential for rate increases.
One observation is the Fed under Powell is likely to be a quiescent servant to the White House. Let’s dispense with the silly notion of “independence”. This isn’t new but is useful corroborating evidence. Another observation is this is still just jawboning on both sides. Of course, the President wants to sound sensitive to inflation and of course the Fed wants to sound like it is on top of things. Talk is cheap; the bigger test will come when a difficult choice must be made between stronger growth but higher inflation or more moderate inflation but weaker growth.
What Jerome Powell must do next as Fed chairman ($)
“Yet it would take courage for Mr Powell to do this [accelerate the taper]. ‘If suddenly you have a new taper schedule and, critically, it has clear implications for rates, you are rolling the dice as to the market reaction,’ says Krishna Guha of Evercore isi, an advisory firm. But sticking to gradual tightening as inflation gallops higher is just as big a gamble.”
As the difficult tradeoff between growth and inflation becomes pressing, things will start to get very interesting. As Krishna Guha rightly points out, favoring either side of the equation is a “big gamble”.
There is no easy escape from the global debt trap ($)
“One of the big mysteries in the global economy is why, though inflation is making a strong comeback, long-term interest rates have barely budged in recent months.”
“Yet the yield on 10-year government bonds is now well below the rate of inflation in every developed country. The market is likely intuiting that, no matter what happens in the near term to inflation and growth, in the long term interest rates can’t move higher because the world is far too indebted.”
I have addressed the conundrum of low long-term interest rates in light of elevated inflation a few times and this article by Ruchir Sharma is a good complement. It also provides a good interpretation of market expectations: Because debt is so high, long-term rates cannot be allowed to rise.
This is an important assumption being made by many market participants. It is also a tenuous one. Just because long-term rate increases would be painful doesn’t mean they won’t happen. The alternative could be even worse. One point is that major central banks are down to only really terrible policy choices. Another point is when push comes to shove, central banks will prioritize covering their butts, not saving yours.
Is Omicron different for markets? ($)
“The monetary and fiscal policy contexts have changed. US policy rates were pinned to zero when Delta hit and are in the same place today. But the tapering of QE is afoot now and policy rate increases are on the horizon, even if Omicron (in the view of the market) could delay or temper both processes somewhat. The crucial difference is inflation, which the Fed and central banks globally will have to watch closely, however the medical situation evolves. They will not want the current ‘growthflationary’ environment turn into a stagflationary one.”
Much of the commentary over the last week has been comparing omicron to other coronavirus variants in an effort to gauge its impact. This overlooks the far more important factor that the context of monetary policy has changed considerably. From the beginning of Covid lockdowns in March 2020, the Fed has papered over adverse market impact by buying several trillion dollars of securities.
Now the conditions are different, as the Fed continues to pare back on purchases of Treasuries and mortgage-backed securities (MBS), the incremental effect is less liquidity. Not only has a hugely important buyer backed off, but in doing so, it (the Fed) is sending a powerful signal that it can no longer pledge fealty to stock appreciation since it must make some effort to control inflation.
In other words, the ultimate cause of recent market weakness is falling liquidity due to the Fed’s tapering program. While the omicron variant seems to be serving as a proximate cause of the weakness, if it weren’t for omicron, it would be something else. As a result, it is important for investors to stay focused on what matters most – and that is the reaction function of the Fed to balancing the risks of inflation and market/economic growth.
Trading conditions reveal more fragility than investors think ($)
“An imbalance has developed between the supply of and demand for liquidity and, as a result, we’ve seen a significant increase in the potential for the public equity market to jump from a state of calm to one of chaos …”
“Bowler points out that, if inflation continues to run hot, it may tie the hands of central banks in future market nosedives, short-circuiting the ‘buy-the-dip’ mentality that has dominated the past decade.”
I have talked several times over the past several years about the notion of market fragility and it is especially relevant now. One of the most important ways in which markets have changed is the organic depth and resilience of buyers and sellers has worsened. As a result, “the potential for the public equity market to jump from a state of calm to one of chaos” has increased substantially. This condition is worsened by the new constraints inflation places on the Fed. As such, this presents a very different landscape than investors have operated in over most of the last twelve years.
Implications for investment strategy
One thing the selloff last Friday seemed to do was to highlight the presence of a new volatility regime. When prices bounce around a lot it creates a lot of obstacles for investors. For one, it is easier to get head faked and lose a lot of money on trades. There is also less momentum so simply staying invested, or buying the dips, doesn’t work consistently either. Those who use options must pay more for them, due to higher implied volatility, and face a greater risk of losing the premium when the market moves against them. In short, it is a lot easier to lose money in a volatile market and as traders realize losses, they need to lower their risk by lowering their exposure.
While one week of volatile trading should not be overstated, nor should the clear upward trend in bond market volatility since the third quarter of 2020 (see “Market observations”) be understated. Change is afoot and requires a very different approach to risk.
At one level, it will be fair to expect ebbs and flows in volatility for some time. This will be painful for aggressive investors and buy-the-dippers. If volatility continues to trend higher, then serious concern must be given to the potential end of the current carry regime.
The Rise of Carry, by Tim Lee, Jamie Lee, and Kevin Coldiron
“an important sign that the carry regime is ending would be the emergence of inflation itself, or it might be measures taken by the authorities that are so extreme that very high inflation becomes an inevitability.”
“the absolute end of the carry regime is likely to be marked by either systemic collapse that ends the dominant role of central banks or galloping inflation — or both”
First, the Rise of Carry is one of those few books that seem to magically pull together so many of the seeming inconsistencies and conundrums of the market over the last couple of decades. I highly recommend it and Jeremy Grantham call it, “An important and unusual book. Critical not just for investors but for all of society.”
Second, the authors’ descriptions of the end of the carry regime are beginning to look very real. “The emergence of inflation”? Check. “Measures taken by the authorities that are so extreme that very high inflation becomes an inevitability”? Half check. The main point is the ingredients to end carry are present and that signals a shift to a very different investment regime.
Cash is a low-yielding asset but has other virtues ($)
“The true appeal of cash as a portfolio asset lies somewhere else. More and more capital is tied up in investments where much of the payoff lies in the distant future. You see this in the huge market capitalisations of a handful of tech companies in America and in the money flooding into private-equity and venture-capital funds. Investors have to wait ever longer to get their money back. In the meantime their portfolios are vulnerable to a sharp rise in interest rates. A simple way to mitigate this risk is to hold more cash.”
An excellent point here about how to manage one of the biggest risks in portfolios today: duration. As interest rates have plumbed all-time lows, long duration assets have performed the best. As a result, these investments have come to dominate passive portfolios exposing those portfolios to record high amounts of interest rate risk.
For investors chasing returns, clearly cash is a difficult asset to like much of the time. However, for investors who want to protect their wealth and prudently insure their portfolio against interest rate risk, cash is a very convenient way to do it. Oh, and by the way, cash is extremely nice to have on hand to buy assets when they get cheap.
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