Observations by David Robertson, 7/12/24
For as quiet as the markets have been for most of the last two weeks, there have been a lot of things going on. 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
By just about any measure, it’s been hard to explain recent market behavior. The S&P 500 keeps going up, the Nasdaq keeps going up, and a whole bunch of smaller stocks keep going down. It doesn’t really matter what is happening with fundamentals or macro developments.
While there are plenty of narratives going around (e.g., AI), this post by Dr_Gingerballs gets to the heart of the matter:
Everyone who looks at price to explain the last year will be confused. What you are witnessing play out is volatility and dispersion trading taken to new extremes. Short index vol, long stock vol. $SPX pinned, half stocks shoot straight up half straight down.
In other words, this is yet another case of the tail wagging the dog. The unusual market action is a result of the huge popularity of short index volatility strategies and has nothing to do with fundamentals. These types of strategies usually work for periods of time and then usually fail spectacularly - and quickly. Thursday’s price action may or may not be the start of a big unwinding, but either way, it gives a taste of what that unwinding looks like.
In other news, the consumer price index came out on Thursday and as many expected, came in on the light end. The headline number even showed a decline, though the trailing twelve month number is still above target at 3%. Per the report, “the gasoline index decreased 3.8 percent in June” and “The electricity index decreased 0.7 percent over the month”.
While these declines provide welcome relief for the moment, it is extremely unlikely they will provide sustainable relief from inflationary pressures. Indeed, the most notable move after the report was a drop in the US dollar (DXY) of 80 cents. Apparently, the market is viewing the CPI report more as substantiation of an imminent Fed rate cut than as an indication of enduring disinflationary conditions.
On a related note, given the prospect for a rate cut and a weaker US dollar, one would expect bitcoin to rally along with other non-fiat alternatives. Not so. While bitcoin did go up on the CPI news, it’s looking more like it is losing steam than gaining it.
Economy
One of the more confounding paradoxes of late has been the continued strength of nominal GDP growth despite no growth in money supply and very weak credit growth. Helpfully, Bob Elliott makes sense of the conundrum: Economic growth has been driven by rising velocity.
More specifically, velocity has been rising because wages are rising. As a result, as long as wage growth remains in the mid-single digit area, it’s fair to expect GDP growth to stay in that range as well. This explains the unusual persistence of growth despite a lack of movement in historical drivers like money supply and credit. As Elliott explains, this is new ground for a lot of people:
Basically no economist or anyone one trading markets today has ever been through a truly income-driven expansion where the velocity of money is "financing" the expansion. We've seen credit booms. We've seen money booms. We've never seen an income-driven velocity rise.
In terms of monitoring progress on this front, employment is obviously getting a lot of attention. Within a business cycle it is fair to expect rising unemployment to manifest in lower wage increases. As I’ve mentioned several times before, however, I strongly suspect a longer-term political cycle is also in play. After several decades of labor losing out to capital, labor is finally regaining some lost ground. That suggests wage gains, and the rising velocity and economic growth that goes along with them, are likely to persist.
Law
At the end of the second quarter, the Supreme Court made news with several controversial rulings. One that looks likely to have wide-ranging implications is the Loper-Bright decision. It addresses what has been referred to as the “Chevron deference”.
Justin Slaughter does a very nice job of providing background for the case in a thread on X. Essentially, the issue is the status and power of the administrative state. As Slaughter concludes:
There are no cheat codes in politics. And the last few years have seen Dems & GOPers try clever tricks when they can’t win a majority at the ballot box. The idea that you can dodge the need for a new law with clever legal analysis was one, and now this Court is closing that road.
Unsurprisingly, there has been an outpouring of reactions, mainly along ideological lines. That said, I see an even greater philosophical divide being represented. That is, if you believe the current state of affairs (in this case, the administrative state) is so flawed that it must be changed, how do you go about doing so? Do you try to change it incrementally, recognizing inertia will make it hard to achieve much real change? Or do you effective hit the “reset” button and start all over from scratch? The Supreme Court has decided on the latter.
Personally, I have sympathies for both viewpoints so I am not thinking the ruling is going to be universally good or universally bad. I do believe the administrative state has too much power and many of its decisions should be made by elected officials instead. However, I also believe that in most instances, the administrative state basically works and completely ripping it out will not only induce a great deal of uncertainty, but will quite likely lead to a host of unintended consequences.
It bears mentioning here that a big reason the administrative state grew as it did was because over time, Congress has systematically failed to assert its authority when it could have. Matt Stoller posts:
The Supreme Court's rulings are quite bad, but most of the badness is dependent upon Congress refusing to act. So any agenda to address the court has to be about winning Congress and enacting legislation.
While I am not counting on it, who knows, maybe the decision will force Congress to finally start doing its job.
China
The fact that China has had overvalued real estate has been an open secret for years now. As a result, the fact that a lot of banks are suffering from nonperforming loans shouldn’t come as a surprise. A new wrinkle to the landscape as the Economist ($) reports, however, is that there is no formal process to manage failing banks: “Regulators are doubling down on consolidation because they lack mechanisms to allow banks to fail and leave the market.”
By contrast, in the S&L crisis in the US, legislators established a process to wind down crippled banks and thereby to “resolve the crisis in an orderly manner”. As the Economist notes, “China has fumbled such a law for years” and highlights, “Such ineptitude is now common in Chinese policymaking.”
In yet another arena, the problems are clear, the policy precedents exist, and yet China has not yet been able to formulate an effective policy response. I stand by the assessment that growth in China is likely to disappoint for years.
Politics
As everyone has heard many times over by now, President Biden had, let’s say, a subpar performance in the first presidential debate. While it is tempting for Democratic partisans to explain away the performance as a “bad night”, as Ben Hunt explains, that’s not how it works:
Because that’s the thing about private information, no matter how widespread. Even if everyone in the world believes a certain piece of private information, no one will alter their behavior. Behavior changes ONLY when we believe that everyone else believes the information. THAT’S what changes behavior.
Nope. The notion that Biden would not be fit to serve a second term had been private information - believed by many people, but only privately. When Biden stumbled repeatedly in the debate, that private information became public. Everybody then knew that everybody knew that Biden was not fit.
This isn’t to pick on Biden, or to endorse Trump in any way. It is simply to recognize the importance of common knowledge games. In regard to the election, Biden is out of the race for all intents and purposes. He may continue running, but the damage caused from the new common knowledge is irreversible. It’s best to accept this reality and move on.
Another takeaway from this vivid example is that private knowledge can become public knowledge almost instantly. When the issue relates to behavior, like market behavior, it’s not a matter of linear analysis. Nope: “Behavior changes ONLY when we believe that everyone else believes the information. THAT’S what changes behavior.”
So, don’t be surprised when beliefs about the economic impact of artificial intelligence, or the investment merits of mega cap tech companies, or any market narrative, change, and change suddenly.
Knowledge management
Numbers have always been a part of baseball, but it wasn’t until Bill James established the practice of sabermetrics (the statistical analysis of baseball numbers) that those numbers took on a new life. Michael Lewis captured the development in the book (and later movie), Moneyball. Not only did James’ approach revolutionize baseball, the insights and methods also leaked into other industries - like investing. The bottom line was that carefully analyzing the numbers could lead to insights that are often counterintuitive and run against conventional wisdom.
This background makes it all the more interesting that James is now lamenting the current state of sabermetrics. He posts:
My goal in starting sabermetrics was to use measurement and logic to address basic, large-scale issues about baseball and sports. Why do teams win? What are the characteristics of a winning team? How are runs created? What elements of an offense are most important?
We studied those with some success for a period of time, and then the field was hijacked by the computer guys. The vast proliferation of (and fascination with) small measurements (exit velocity, pitch counts, pitch movement, launch angle, etc.) represents not the success of sabermetrics, but its failure. We have fallen back into details.
The fact is that the development of real understanding about the essential questions that form the game--all games--has essentially stopped. No one really works on them or writes about them. At some point, our field must find the courage to set the decimal points aside, and return to the study of basic, large-scale questions about which we know no more now than we did in 1970.
In short, James thinks the baseball industry has lost the plot line by focusing too much on details and not enough on critical thinking about “the essential questions that form the game”. The “fall back into details” has left the game with no more knowledge about the “large-scale questions” than was available in 1970. I agree wholeheartedly.
One point is that having lots of numbers and lots of computing power does not contribute to growth in knowledge in the absence of a purpose. What all those data points do accomplish, however, is to inject a great deal of noise into the equation and to provide a vastly larger universe of items to gamble on.
Another point is that James’ critique of sabermetrics is also applicable to economics and finance, among others. These are also fields in which numbers have proliferated without careful thought as to what important questions need to be answered. Artificial intelligence is a prominent example of a technological “answer” in search of an important business “question”.
Interestingly, for all the talk about human workers being increasingly replaceable by machines, James makes the case that what is really lacking are the types of humans who can ask really good questions.
Gold
Fred Hickey posts some useful comments about gold that serve as a good update:
For the second consecutive month, the People's Bank of China (PBOC) said they did not add to their gold reserves last month. Could herald an extended period of such claims. Those past periods (when they were still buying but not acknowledging it) lasted for several years. Following the PBOC's announcement a month ago, gold took a sharp one-day dive with computer algos leading the selling. However, last month's price drop was exacerbated by a strong jobs report released the same day. That's not the case now. Would expect another decline tonight/tomorrow, which will make for a good test of the recent rally. Will the decline be quickly bought by dip buyers eager to get in? For long-term holders, it doesn't matter. Gold is in a secular bull market.
Investment landscape I
Quite arguably, the most important price in the world is the yield on the 10-year US Treasury bond. This is so because virtually all financial assets are priced on it in one way or another.
This reality makes its recent behavior all the more interesting. While it hasn’t quite been bouncing around like a penny stock, it sure has been bouncing around a lot.
Andy Constan recently posted some of his top explanations for bond weakness. They include: “1. Why had they rallied to begin with”, “2. Debate”, “3. China/japan”, “4. Duration extension was less than estimated”, “5. Vol targeting was more than expected”, and “6. Economic data on Thursday and Friday and Monday wasn't as weak as some expected”. His conclusion is, “it's all of the above and mostly term premiums suck and supply is spiking”.
These issues become increasingly important with the passage of time. While bond bulls are champing at the bit for the Fed to cut rates and launch another glorious run for bonds, others like Constan see miserable term premiums and increasing supply as factors more likely to cause bond yields to rise than to fall.
While none of that resolves the debate, supply issues are likely to become more prominent in July and August. Greater issuance is expected in these months and will not be moderated by tax payments as was the case in June.
In addition, a new Quarterly Refunding Announcement will come out at the end of July. It will either indicate an increase in the issuance of bonds, which would pressure yields, or an increase in the issuance of bills, which will inflame concerns about the inflationary impact of deficit spending. Either way, long-term rates are likely to be in the news again.
Investment landscape II
The FT’s Unhedged ($) newsletter recently reported that star strategist, Marko Kolanovic, had left JP Morgan. In his last report, he provided a laundry list of reasons the market environment is unstable:
Momentum trades are massively crowded
Most of the returns are concentrated in a few megacap stocks
To keep the momentum going, the mega-caps will have to keep beating consensus estimates
Those estimates encode expectations of double-digit growth for the foreseeable future
Year-over-year earnings comparisons will get harder in the second half
Investors are already aggressively positioned in equities, and sentiment is bullish
The business cycle is moving sideways at best, with the low end consumer under stress
Rapid rate cuts are unlikely, and even if they occur, the long end of the curve — which is the discount rate for risk assets — could stay high
The impact of buybacks is fading
Money supply growth is weak
Interest expenses are rising
Valuations are at cycle highs
The equity risk premium is very low
Volatility is unsustainably low
As it happens, every single point he makes is valid; his rationale is sound. All evidence indicates that stocks are extremely stretched. As such, long-term investors should be using the opportunity to make sure they have risk exposures they can handle through a selloff.
Another point is that good, objective analysis like this is not what works on Wall Street. Nope. Anything more than a periodic spat of bearishness is viewed as revenue-inhibiting, regardless of its analytical value. This is a poignant example of career risk and a good reason why a lot of smart people don’t tell the whole truth about what they see in the market.
The final point is that Wall Street strategists come and go, but when a very good one goes because of a bearish call on the market, the market is probably a lot closer to a top than a bottom.
Implications
The current market dynamic whereby stocks inch up, and up, and up, regardless of fundamentals, creates challenges for long-term investors. The payoff diagram shows persistent upward advances, ultimately followed by a steep decline. Since we haven’t experienced the steep decline yet, it’s easy to fret that either a big decline isn’t coming or that it won’t be that big.
As with many things in life, the main problem is with the point of focus - the comparison group. At this moment, there is nothing that can beat Nvidia as a stock and nothing that can beat US stocks (S&P 500, Nasdaq) as a stock market. Any alternative is sure to underperform until whatever event happens that causes stocks to fall.
For investors who enjoy risk and won’t be materially worse off if/when stocks suffer a material selloff, it makes perfect sense to stay in stocks despite the extremes being breached. The problem is, a lot of people, especially those with significant assets at risk, would be materially worse off in a significant drawdown.
For such investors, Nvidia/US stocks is not the best comparison group. Rather, a more diversified group of financial assets is a better comparison. With cash still yielding over five percent, commodities still fairly cheap, and lots of US small cap and non-US assets trading at much lower multiples, there are plenty of very good investments that also offer greater protection against the permanent loss of capital. After all, that’s what you are really trying to accomplish with long-term investing.
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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