Observations by David Robertson, 4/5/24

Some weeks markets are placid and some weeks the charts looks like EKGs. This was week was the latter. Let’s take a look.

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

Market observations

It was a tough start to the week for stocks but they rallied later in the week, even despite higher long-term yields. Then they nosedived on Thursday afternoon without any clear reason. It’s looking like a race between momentum continuing to push stocks up and long-term rates threatening to crash the party at some point.

In the midst of so much discussion of bubbles and tech stocks, Diogenes points out on X that the exuberance is not limited to the Mag 7. For example, the unexceptional industrial company, Eaton, is also posting eye-watering multiples. Oh, and by the way, it’s revenue growth the last ten years is 5.2% - TOTAL. That averages to 0.5% per year.

While people focus on AI, the Mag 7, etc., I think they might be missing the absolute insane valuations that many no or low-growth industrials are now sporting. Eaton, as basic an industrial conglomerate there is, now trades at almost 30x LTM EBITDA and 6x revenue.

While there is an argument to be made for rotating to more cyclical companies, unfortunately those ranks have also been thinned by runaway valuation multiples.

Economy

Brad Setser recently mentioned a report in the FT on the pharmaceutical industry. As he put it, the article:

Highlights how pharma is really two very different sectors: a patent protected, high margin sector that plays tax games, and a low margin generics sector that has real supply chain vulnerabilities

As such, he is also highlighting another important reality: How the pharma sector is really a system of intense political lobbying and regulatory arbitrage designed to extract financial benefits at the expense of society.

Alas, if pharma were the only such industry. The same could be said of banking, Big Tech, airlines, Boeing, and so many others. The point is that a lot of businesses, which started off as useful economic entities, have evolved into organizations that are far more self-serving and harmful to others. That wastes resources in so many ways.

Until there is more forceful political pushback and greater competition is enforced, things are unlikely to change very much. Unfortunately, until that time, economic growth is also likely to be held back relative to its potential.

The good news is the US economy is strong enough to withstand a lot of imperfections. The even better news is it could be so much better with better governance.

Politics

Trump’s curious effect on trust in science ($)

https://www.ft.com/content/865db3f2-6ac4-49a1-93b3-eaecbe86e6fe

The research, published recently in the journal Science and Public Policy, suggests that scientific misinformation and disinformation does indeed move the dial: not by turning everyone into disbelievers but by jolting them out of a zone of indifference and seemingly turning them into either uber-sceptics or superfans. 

That whittling away of the centre ground, Miller thinks, also results from a decentralised information landscape, as people look beyond established news media to seek knowledge and opinions from a wider range of people and places.

During Donald Trump’s term as President, many assaults were made on science. Partly, science was just another target of widespread alienation and anger that got amplified and propagated by social media. Partly, however, the attacks were fair pushback on a scientific community that in too many instances had become arrogant, sloppy, and insensitive to large parts of society.

Regardless, the degree to which claims against science took off were often breathtaking to those of us who appreciate and respect the scientific process, even if not all the individuals who claim to practice it. Fortunately, the research presented by the FT’s science commentator, Anjana Ahuja, eases our concerns to a large extent: We don’t have to worry too much about masses of society being influenced by misinformation and reverting to the Dark Ages.

The reason is that sentiments expressed against science often don’t have much to do with ardent disbelief. They are probably more accurately characterized as general discontent. It’s easy to trash talk when nothing important is on the line.

When it comes to something genuinely important, however, for example one’s health or that of a loved one, people on the middle ground are much more likely to become superfans that uber-skeptics. When the matter at hand is important, people go to greater effort to figure out what’s going on. As a result, people express a lot of opinions about things that don’t matter very much, but shift into a different gear and often change opinions when things do matter.

Insofar as this is a pretty good representation it suggests political polling is inherently unreliable. Without any qualification as to whether polled questions are truly meaningful to the respondent, the response has very little information content.

The good news is that people are probably less gullible than might be assumed by their proffered opinions. The bad news is the only way to find out where people really stand on things may be for them to experience real adversity. I fear this will be the case in regards to important public policy tradeoffs like the level of deficit spending versus inflation. People will need to suffer higher inflation for long enough to be really painful. Only then will pushback against deficit spending be great enough to effect any change.

Investment landscape

Prayers for IPOs ($)

Grant’s Interest Rate Observer, March 29, 2024

“Capital wealth,” pronounced the celebrated author of Theory of Interest, Irving Fisher, “is merely the means to the end called income”—and don’t cash-hungry private equity investors know it. Last year brought the smallest cash returns to p.e. limited partners in 15 years.

Last year, distributions as a percentage of net asset value in private equity dropped to 11.2%, according to Raymond James Financial, Inc., just 230 basis points above the 2009 low. It could have been worse; 2023 distributions as a percentage of NAV in venture-capital plumbed an all-time low of 4.9%, according to PitchBook.

It’s often useful to evaluate a situation from different perspectives. In the investment world that often involves comparing different asset classes.

Since October last year, stocks have been on a tear. Many reasons have been attributed including the loosening of monetary policy, the boom in artificial intelligence, strong economic growth and rising earnings.

The case for rising earnings, in particular, is subject to a less sanguine interpretation. For one, earnings growth outside the Magnificent 7 stocks has been unexceptional. For another, cash returns to private equity last year were the smallest in 15 years. Not just down, but the lowest in 15 years.

For sure private equity companies are not directly comparable to public companies. They tend to be smaller and more vulnerable to rising interest rates. That said, as a group they tend to be higher than average quality companies with better growth opportunities.

One point then is the cash returns to private equity tell a different story than the earnings growth the market is pricing in for public stocks. That should cause some concern about the likelihood of strong earnings growth for public stocks.

Another point is that income is ultimately what matters for investors. In a landscape of strong price momentum, it’s good to remember market prices themselves do not provide much utility. Total market cap on a monthly statement doesn’t pay bills. Dividends derived from income earned do. If the decline in private equity earnings are indicative of what is coming to public companies, investors may want to recalibrate their public company holdings.

Investment strategy

The Three-Body Problem ($)

https://www.epsilontheory.com/three-body-problem/

Basis uncertainty is the core problem facing every investor today.

It’s not just that we endure large basis risks here in the Hollow Market, unmanageable for many. It’s not just that all of our old signposts and moorings for navigating markets aren’t working very well. It’s not just difficult to identify predictive/derivative patterns in today’s markets. There is a non-trivial chance that structural changes in our social worlds of politics and markets have made it impossible to identify predictive/derivative patterns. THIS is basis uncertainty, and it’s as problematic for humans facing markets that don’t make sense as it is for bees facing weather patterns that don’t make sense.

What is the “[three body] problem”? Imagine three massive objects in space ... stars, planets, something like that. They’re in the same system, meaning that they can’t entirely escape each other’s gravitational pull. You know the position, mass, speed, and direction of travel for each of the objects. You know how gravity works, so you know precisely how each object is acting on the other two objects. Now predict for me, using a formula, where the objects will be at some point in the future.

Answer: you can’t. In 1887, Henri Poincaré proved that the motion of the three objects, with the exception of a few special starting cases, is non-repeating. This is a chaotic system, meaning that the historical pattern of object positions has ZERO predictive power in figuring out where these objects will be in the future.

The recent Netflix series, The Three Body Problem, has given me reason to go back and review this note written by Ben Hunt seven years ago. One big point that comes out that is incredibly relevant to investing is the emergence of massive interventions by central banks since the GFC has radically changed how the investment universe works:

What we have to accept is that there is an Object 3 that has moved into a position such that its gravity absolutely swamps the impact of Objects 1 and 2. This Object 3, of course, is extraordinary monetary policy, specifically the purchase of $20 TRILLION worth of financial assets by the Big 4 central banks — the Fed, the ECB, the BOJ, and the PBOC.

What this means most immediately is that strategies like quality and value that used to work consistently well are now being “absolutely swamped” by the impact of monetary policy. While they may work again at some time, it’s impossible to tell when that may be. This is why a lot of good investors and hedge fund managers have either closed down or converted to family offices over the last fifteen years.

On my part, while I have been right about emphasizing the increasing importance of policy in framing the investment landscape, I have also underestimated its overall impact. With the introduction of the third body of monetary policy, investment outcomes go from being somewhat predictable to being a chaotic system that is entirely unpredictable. In other words, the system changes fundamentally.

This fundamental change obviously has important implications for investing. One is that there are no guarantees we are going back to the system we had with the relationships we understood. Aspects of that system may emerge for periods of time, but only unreliably so. Waiting for a “return to normal” is not a good strategy.

Monetary policy

Fed governors have been out making the rounds giving speeches and commenting on monetary policy. Unfortunately, all that “communication” doesn’t seem to be clarifying anything. The question is, “Why not?”

It’s possible it’s just taking a little longer than expected for the rate increases to take effect and the Fed is trying to convey that its intention to cut hasn’t changed, even if the timing has changed a bit. In the same vein, the Fed may anticipate some deflationary impulses coming down the pike but doesn’t want to front run them.

A less generous interpretation is the Fed doesn’t know what’s going on either. Even though it created the three body problem with massive Treasury and MBS (mortgage-backed security) purchases, it does not understand how those actions fundamentally changed the monetary system.

Consider the Fed’s primary policy tool, the short-term interest rate, has failed to constrain economic activity as expected. Also consider the Fed’s assessment of financial conditions is significantly tighter than that of the market. It’s not hard to see that just like historical relationships for investors have been distorted, historical relationships have also been distorted for the Fed. It’s models are outdated and it’s got the wrong navigational system for the new monetary landscape.

As I wrote in the January Outlook piece, I think of 2024 as “The year of consequences”. It’s looking more and more like one of those consequences will be an enfeebled central bank.

Gold

Gold has stolen the show. After having traded within a fairly tight range of $2,000 for most of the last year, it has bolted up to $2,300 in the last five weeks. As usual, miners have moved even more. This is so typical of gold: When it moves it moves and it’s hard to catch up.

What is interesting about this move is both the underlying fundamentals and the trading patterns. Fundamentally, gold has been in great demand in the East, namely China and India. This is identified most directly through the premia consumers have been paying over market price in places like China. It can also be identified by the movement of physical gold to the East from the West.

This ongoing migration seems to have interrupted some of the hijinks that normally occur in gold trading. Kuppy shared thoughts on the matter and Alasdair Macleod posted an interesting theory (below):

With London closed for Easter Monday, we would expect the bullion banks to smash the gold price after such strong rises to take out the hedge fund stops. But it is just not happening. Also, last week the price rose strongly on declining Open Interest on Comex.

This tells us that there is a strong bear squeeze on the Establishment. The fact that rises in price last week were at the time of London's morning fix tells us that Asian demand is cleaning out London of physical liquidity, and that the bullion banks cannot find adequate hedges, other than by reducing their Comex exposure.

The trading patterns are interesting because it suggests the regular practice of suppressing the gold price may be reaching its natural limit. If that’s the case, the price of gold will be much more determined by the supply and demand of physical gold than the supply and demand of gold derivative financial contracts.

This move in gold could also be indicative of US policy goals. Despite running persistently high fiscal deficits, the US dollar has not only remained strong, but has actually gotten stronger. It is not in the interest of the US for the dollar to be too strong, however. Perhaps, gold is being used as a pressure release valve on the dollar to prevent it from getting too strong? Regardless, it’s looking like gold is getting its turn to really shine as an asset class again.

Implications

As Hunt writes in his note, The Three Body Problem, “It’s not just that all of our old signposts and moorings for navigating markets aren’t working very well”. Yeah. Valuation hasn’t worked. Quality hasn’t worked. Momentum and YOLO have worked ridiculously well. What does an investor do with this upheaval of so many investment signposts and moorings?

One thought that has occurred to me is that the challenge is not quite so bad as it may seem. While extraordinary monetary intervention is new to most of us, it is not new to human history. Russell Napier, for example, stands out in my mind as one of the very few people who are well versed in this particular three body problem - across the globe and through history.

While this doesn’t change the fact that many of our processes are no longer effective, it is not hopeless either. There are identifiable signposts and moorings to navigate environments of extraordinary monetary policy, they are just different ones.

A good starting point is to reassess an assumption like “free” markets. A reevaluation of the role of monetary policy and public policy in general is also due. Further, while old investment tools may still work from time to time, their usefulness will be less predictable. As a result, it will be important to be less dogmatic with historical practices.

Perhaps the worst response will be to refuse to acknowledge the environment has changed and with it, the approaches required to invest successfully.

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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