Observations by David Robertson, 4/12/24

Drama continued this week with the inflation report and Treasury yields. Let’s dig in.

As always, if you want to follow up on anything in more detail, just let me know at drobertson@areteam.com.

Market observations

Momentum has been a driving factor for stocks which have had a huge run since last October. Two important items stand out from the chart. One is that momentum has been especially strong relative to the broad S&P 500 index since the beginning of the year. Another is that momentum has leveled off and may be starting to turn down. If that turns into a more pronounced decline, stocks could suffer.

With earnings season upon us, it makes sense to consider what surprises might be in store. Almost Daily Grant’s (Monday, April 8, 2024) reports, “Seventy-nine S&P 500 members have issued negative guidance as of Friday by FactSet’s count, a tally topped only once since 2006 and well above the 5- and 10-year quarterly averages of 58 and 62, respectively.” Maybe, just maybe, stocks are ready to take a breather for a while.

In other news, President Biden predicted that a rate cut would still be coming before the end of the year after the inflation report came in hotter than expected on Wednesday. While he is certainly entitled to his opinion, venturing such a guess about the policy of an ostensibly independent agency like the Fed, in a very public forum, comes very close to coercion. Regardless, it sheds some light on the environment in which the Fed operates and may provide some insight into its sudden dovish pivot late last year.

Inflation

The CPI (consumer price index) report on Wednesday was widely expected to come in at 0.3% month over month, but came in a tick higher at 0.4%. S&P 500 futures immediately dropped about 1.5% and yields on the 10-year Treasury shop up over 13 bps.

After the dust settled on CPI, the 10-year yield continued to rise another 5 bps into what turned out to be an ugly auction at 1:00. At the same time, the US dollar, as measured by DXY, rose almost 1% on the day.

One takeaway from the clearly negative reaction is the degree to which markets had hitched their hopes on a smooth ride down to the 2% inflation target. Part of that was the assumption of imminent rate cuts by the Fed. Today’s report put all those silly dreams to rest.

Another takeaway is the relatively relaxed reaction by the S&P 500. Although it was down on the day, it is still up 9% year-to-date - even as the 10-year yield is also up 60 bps in that same span. It’s beginning to look like the S&P is fairly immune to rate increases under a certain threshold. Of course what that means is the market will almost certainly push until that threshold is reached. I’m guessing we’re pretty darn close to it at 4.5%.

Gold

With gold continuing to run up, it makes sense to step back and get some perspective. For starters, the basic case for a role in an investment portfolio is still valid. As I mentioned in this year’s Outlook piece (and the one before)

Gold has proven to be an excellent diversifier over time, often serving to limit drawdowns in times just like this when stocks and bonds do not look attractive. Further, gold plays an important role in wealth retention in times of turmoil.

At the time, I also described:

As the prospect of financial repression becomes increasingly imminent, so too does the prospect of fiat currencies losing their value. This is exactly when gold provides a valuable hedge. This is a bigger concern for China than the US right now, but it’s just a matter of time. It looks to me like gold is right on the doorstep of a long bull market.

In an important sense then, what we are now seeing with gold is simply the actual manifestation of conditions that were fairly evident at the beginning of the year. While inflation and currency debasement are key themes, the main driver right now is China, not the US.

This can be seen to some extent in a nice chart posted by TF Metals Report on X. As described, “Shanghai buys physical. Comex sells paper [i.e., shorts futures contracts].” This is a good illustration of “some of the hijinks that normally occur in gold trading” that I mentioned last week.

The same phenomenon (Chinese demand for gold) can also be in China’s ETF market. Eric Balchunas reports, “More wild stuff in China as local investors pile into a gold stock ETF pushing its premium to 30% and forcing it to halt trading. Investors there are so desperate to buy things that are not linked to their own economy/stock mkt …” Diogenes reminds us, “ETF’s and closed-end funds trading at big premiums to easily-purchased underlying NAV’s have always been a reliable sign of speculation.”

What’s driving Chinese investors so crazy for gold? Partly it is the lack of speculative appeal of either real estate or Chinese stocks which have been the main beneficiaries in the past. Probably even more important now though is the potential for devaluation of the Chinese yuan. As public policy options to revive China’s economy become increasingly limited, the chances of devaluation increase. That means there is a race to preserve wealth any way possible - and gold is arguably the best option on the list.

China is the most glaring example right now of investors desperately trying to preserve wealth, but there are others, and there will be plenty more. The point is the time has finally come when people realize the fiat currency “emperor” has no clothes. This is likely to be a long process.

Investment landscape I

Macro/USD/Oil - The Battle of the BADS ($)

https://www.urbankaoboy.com/p/re-macrousdoil-the-battle-of-the

Given China’s divergent policies (both short-term and long-term), it’s no wonder that China is the only major country in the world contending with DEFLATION now, and a CNY Devaluation would be an equilibrating mechanism to EXPORT  China’s Deflation to RoW and IMPORT Commodity Inflation into China, given its status as a large Commodity Net Importer.

There are several things in this Substack from Michael Kao that provide useful perspective on the macro investment landscape. First, for many large economic actors, like the Bank of Japan (BOJ), the People’s Bank of China (PBOC), or the European Central Bank (ECB), policymakers are increasingly “forced to choose between TWO BAD OUTCOMES”. There just aren’t easy decisions to make any more, the problems are too big and the constraints are too great. As a result, any decision these organizations make will come with negative consequences.

Another interesting aspect of Kao’s analysis is how global it is. Sure, he talks about the Fed and the US dollar, but he investigates how US policy affects other global entities and their decision making - and how that might blow back on the US. Commentary that focuses only on economic growth and inflationary pressures in the US misses important influences in other parts of the world.

China is a prime example of this point. The country is currently dealing with outright deflation and that could get much worse if the yuan gets devalued - which is a real possibility. In that case, China’s export goods would become even cheaper to other countries which would lower inflationary pressures in those places. Further, the challenges would not stop there as one devaluation would likely lead to competitive devaluations.

This sets up an interesting conundrum. Just as investors are gauging the economic strength and inflationary pressures in the US, the real potential for deflationary pressures being exported into the US is increasing. This also means the gap in economic performance, inflationary pressure, and monetary policy between the US and much of the rest of the world is increasing. As a result, the net effect on the global economy and globally priced assets like commodities is especially uncertain.

Investment landscape II

Buying Back the Farm ($)

https://www.yesigiveafig.com/p/buying-back-the-farm

The nature of the shareholder base and the company's dividend policy significantly affect the market impact of buybacks, and inelastic markets are key to shaping stock prices and market movements. Dividends and buybacks are not equivalent in their effect on markets, challenging prevailing financial theories and practices.

The introduction of DRiP programs made dividend payments quite powerful in the 1980s. The move away from single-stock to indices changed the game and made it far more important for companies to buy back shares than pay dividends.

And all of this is before we consider the possibility that executives are focused on self-enrichment.

This is a wonkish piece by Mike Green that would serve well as a discussion piece for students of corporate finance, but it also has important messages for investors. One point is the change in the investment landscape from ownership of single stocks to ownership of passive indexes changed the financial tradeoff between share buybacks and dividends, making buybacks more beneficial. It essentially created a cheat code for improved stock performance.

This is true based solely on financial and market considerations. There are also other considerations like the self-interest of corporate executives. At the same time as share buybacks were becoming more beneficial than dividends, corporate executives were also receiving larger proportions of their compensation in company stock. As a result, those executives benefited directly from the decision to increase buybacks.

The insight into buyback effects is all well and good for finance junkies, but it also has implications for investors. Number one, buybacks have exacerbated the degree of momentum in markets, along with the effects of the proliferation of passive investing and loose monetary policy, by causing self-reinforcing feedback loops.

Number two, this can create the appearance to a casual observer of a market that is far stronger than it actually is. Such appearances can also facilitate excessive exposure to stocks. It is helpful to note that buybacks are not wealth creation dynamos. Buybacks will decline when cash flows decline, when regulation constrains them, or both.

Investment advisory landscape

Fidelity clawback of ‘free’ trading costs to hit investors ($)

https://www.ft.com/content/86ec1ce5-68d2-4ef1-bd71-aded75606acc

Fidelity plans to start charging investors $100 per trade to buy exchange traded funds if sponsors do not agree to make “support payments”, pushing back against retail brokers’ long-standing policy to offer customers low-cost trading.

The proposed higher charges for buying ETFs come after more than a decade in which brokers have squeezed fees on trading to attract customers.

“We’re just getting hammered, and this is just another hammering,” said David Young, founder and chief executive at southern California-based Regents Park Funds, which is one of the nine ETF firms Fidelity has put on notice. “The next ETF we come out with, we’re going to go to the market with the maximum fee we can justify.”

While this story appears as a minor scrape between a large financial powerhouse and some smaller inconsequential funds, it illustrates one of the biggest problems in the investment industry. Wes Gray spells it out beautifully in a blog post: “Today’s railroad monopoly is the banking system. Leveraging their distribution networks to sell proprietary financial services, banks reap tremendous profits, usually at the expense of their clients.”

Things are certainly better today than they used to be, but noncompetitive behavior is still deeply ingrained. Banks and other large financial services firms “continue to push high-fee, tax-inefficient, opaque, non-client-friendly products into the financial services marketplace.” The result is hidden fees, fewer choices, and worse outcomes for investors.

The good news is that almost all of these issues are avoidable; the only caveat is investors need to do some work on their own. Whether it is proactively tracking down investment funds or strategies that suit their needs or doing some research and asking good questions of providers, investors are not fated to “high-fee, tax-inefficient, opaque, non-client-friendly products”. A great place to start is to force any financial service provider “to detail how–and why–they get paid”. Good advice.

Implications I

One of the age old arguments against gold is that it’s a “barbarous relic” that doesn’t generate any cash flows (like a stock does). That is true, but also misses two key points. First, the value of those cash flows, in real economic terms, is a function of the value of the currency they are denominated in. A decent stock in a rapidly depreciating currency is worth a lot less than one in a solid currency, all else equal. Sometimes, wealth preservation is a more important goal than wealth accumulation.

Second, the attractiveness of stocks, which represent a stream of cash flows, is heavily dependent on the price paid for them. As John Hussman points out, stocks are only useful inflation hedges, and therefore effective wealth preservers, to the extent their initial valuations are attractive. And the valuations typically become attractive only after “inflation crushes valuations”.

Stocks generally earn their reputation as "inflation hedges" only after inflation first crushes valuations, or turns lower. We'd need the CPI to roughly triple in order for the benefit on nominal earnings to overcome the headwind of extreme valuations.

At very least, this argues for a meaningful holding of gold to serve as an inflation hedge. In addition, it suggests re-evaluating the use of stocks as an inflation hedge until either valuations get “crushed” or inflation falls sustainably to its target level.

Implications II

Last week I discussed implications for investors who had faced an upheaval of “so many investment signposts and moorings” such as investors favoring “value” and “quality” strategies. There are also implications for investors whose practices have worked brilliantly - by just adding risk and following momentum.

Russell Napier hints at the issue in his latest Solid Ground ($) newsletter dated April 8, 2024:

I remain baffled as to why most economists, investors and strategists are focused on the near-term gyrations in inflation and interest rates while the world is going through a profound structural change in geopolitics and in how the international monetary system works.

In other words, there are two very different “games” going on here. One is a “profound structural change in geopolitics and in how the international monetary system works” of which Napier speaks. Another is a disproportionate focus on “near-term gyrations in inflation and interest rates” that most investors and strategists seem to be focused on.

The paradox is while the near-term focus on gyrations has worked remarkably well since last October, and pretty darn well since way back to the GFC, it’s time is running out. The system on which it is based is changing in a structural, fundamental sense.

This means the chaotic Three Body system that has flummoxed value and quality investors for fifteen years, is about to exert its force on momentum investors. While it is easy to see this will negatively affect a lot of aggressive, short-term investors, it is also going to affect a lot of investors who have inadvertently become hugely exposed to the momentum factor.

Namely, I’m talking about investors in passive indexes which comprise a huge part of the universe of retirement investments. Simply by virtue of their design, passive indexes exacerbate price momentum. Simply by virtue of selecting these common retirement options, many investors are significantly exposed to them.

What this has meant over the past several years is investors have been able to ride the wave without very few adverse effects. The benign environment allowed them the luxury of “focusing on near-term gyrations” if they wanted to, but also afforded them the luxury of ignoring market information altogether if they preferred. Ignorance was bliss.

As the world progresses “through a profound structural change in geopolitics and in how the international monetary system works”, however, these investors are likely to confront two major challenges. One will be the loss of momentum providing a nice, persistent tailwind. Another will be a host of challenges virtually incomprehensible from the perspective of short-term gyrations. Investors who don’t start figuring out the new context will have a very difficult time catching up and adjusting.

Note

Sources marked with ($) are restricted by a paywall or in some other way. Sources not marked are not restricted and therefore widely accessible.

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