Monday, December 5, 2016

Economic Commentary: The Melt Up Trade

I've been thinking more about the possible bullish scenario I described in my last commentary on the tails of the Trump and GOP victories.  In addition to the possible bullish effects of corporate tax repatriation, fiscal stimulus, and reduced regulation, there is also a technical element; we're seeing increased retail stock buying, which is pushing price-to-earning ratios above long-term institutional resistance levels.  The combination of higher P/E ratios with higher corporate earnings could bring the S&P 500 50% higher over the next 2 years as under-invested money managers chase the rally attracting ever greater retail flows. 

Such a rally would be a bubble, and an excellent shorting opportunity, but I'm not going to wait to play it from the short side.  Because of the substantially negative call skew in US markets, we can buy out of the money calls on the S&P 500 extremely cheaply (13.5 implied volatility for 20% OTM 2 year options).  I'm taking 5% of the value of my entire portfolio and spending it on December 2018 SPY 260 call option premium (and a some similar calls on other indices).  If SPY ends up anywhere between down 100% and up 18%, I'll lose my 5% premium.  My breakeven point is a roughly 20%* rally from here over 2 years, or 9.5% annualized.  If markets end 30% higher after 2 years I'll make a 5x return on that 5% notional for a 25% total portfolio return.  If they end 40% higher, 10x on the investment and 50% to the portfolio.  With markets 50% higher ,15x and 75% etc.

Most likely these calls will expire worthless, but I think it's an excellent opportunity in terms of expected value, reward per unit of risk, and as a way to keep up with a potential raging bull market with minimal exposure to the downside.  Given the wide range of possible economic outcomes ahead of us, this seems like an exceptional alternative to owning equity directly today.

A related alternative is to buy Eurozone equity calls and currency hedge them with a short EURUSD position; I'm dividing the bet about 2/3 in US equities, 1/3 in currency hedged European equities.

My forecast for a normalization of inflation expectations is well on its way to fruition (although I had no idea Trump's election would be the catalyst), with the 5-year inflation swap rallying up to 2.1%, close to its historical average (from a low of 1.35% 6 months ago).  This trend still has a ways to go; I think it will continue trending upwards and end 2017 above 2.8%.  In the melt-up scenario, we might even see 4%+ in a couple years.  Down the road (3+ years), much higher inflation is a possibility, but I'll start analyzing that in a year or two.  


*The math here ignores the forward discount (a reflection of high dividends and low interest rates), which has minimal effect on the numbers presented.

Wednesday, November 16, 2016

Economic Commentary: Trump

This commentary is a purely economic analysis of the election results. 

This election marks a major secular shift that will replace the long-term trends of 1. increasing global interconnectedness, 2. mild fiscal policies, 3. sluggish domestic growth, disinflation, and falling bond yields, with 1. economic and social isolationism and protectionism, 2. expansive fiscal policies, and 3. faster domestic growth, higher inflation, and rising real yields.

On election night, global markets tanked.  By noon the next morning, US equities had regained all the lost ground and then some (although emerging markets remain depressed).  Why?

The first reaction was a top-down analysis.  Trump has threatened economically devastating protectionist trade wars.  He's threatened to pull out of NAFTA, to impose massive tariffs on China, and much of his economic policy seems vague and poorly thought out.  These factors are all heavily bearish all equity markets.

The market rally was a bottom up analysis focusing more on the GOP control of the legislative branch than of the Trump presidency.  The promise of rescinding Dodd-Frank sent financial stocks higher.  A likely reduction in environmental regulation sent investors scrambling to buy the energy sector.  Less regulation of pharmaceuticals (both in general, and due to the failure of California's proposition #61 to pass), is bullish the biotech sector.  

Additionally, investors found evidence for optimism among Trump's policy goals.  Greater infrastructure spending and repatriation of offshore corporate cash could spur domestic growth.  Lastly, investor Ray Dalio of Bridgewater notes that there was also a sudden shift in market participants - "those who drove the markets after his election were largely those who kept their powder dry until they saw the outcome and chose to process (and bet on) the policies themselves."

Markets are very cautiously reflecting an expectation for higher US GDP growth, moderately higher inflation, and higher real interest rates.  Markets are also implying that Trump will enact at least some of his protectionist policies, which will be very damaging for emerging markets, especially those that are export-focused like Brazil.  It's critical to note that on many of these policies, Trump and the GOP leadership are at odds.

There is a possible Goldilocks scenario in which we get the best of Trump's policies and the best of the GOP's policies: increased infrastructure spending, offshore cash repatriation, lower corporate tax rates, smart reductions in onerous regulations, and minimal reduction in foreign trade.  This scenario is extremely good for the US economy and strongly bullish US markets and moderately bullish global equities.

There's also a nightmare scenario where we get the worst of both worlds: Global trade wars and not only no new infrastructure spending, but fiscal austerity.  That scenario likely produces a global depression in which emerging markets are hit the hardest but no risk asset is unscathed.

Each extreme is very unlikely.  

My own view is a slightly less rosy version of current market expectations.  Now more than ever, I think it's important to think probabilistically.  The range of possible outcomes is very wide.  Trump will be hashing out his policy agenda with GOP leadership over the next few months, and no one (including Trump and the leadership) know the outcome of those negotiations at this point.  I think the most likely endpoint of equities in 5 years is higher today than it would have been under a Clinton presidency, but uncertainty is much greater as well, and the market correctly applies a discount rate to uncertainty.  For me personally, those two factors roughly balance out and I continue to view most equity markets worldwide as unattractive from a risk/reward perspective.  I paired my moderate emerging market exposure by 1/2, but will consider dramatically increasing the size of the position if protectionist policies become less likely, or if the market overreacts and send EM stocks far below their current already very cheap valuations.  Trump's election validates the market's long running favoritism of US equities over emerging market stocks and is likely to cause that outperformance to continue, but the valuation differential is already so large that I'd rather stand on the sidelines of that trade, wait until it reaches a greater extreme, and then bet against it selectively.

In all likely paths forward, the USD will rally versus most other currencies.  I established a substantial short EURUSD and expect to hold it for at least a year.  It is a bet on stronger US GDP growth, rising US interesting rates, but even more a bet against the Eurozone.  Trump's election increases the odds of similar nationalist elections throughout Europe.  Italy has a major nationalist referendum next month, France may elect Le Pen, Austria's far-right continues gaining power, and if Angela Merkel chooses to retire, that will likely be the nail in the Eurozone's coffin.  Short EURUSD is a bit of a crowded trade, so I'm sizing it to be prepared for a major snapback.  If the EUR rallies to 1.17 I will happily triple the bet size.  This is a screamingly good trade and I'd suggest having it on, just size it to allow for substantial volatility.

Gold looks less attractive now as it is usually highly negatively correlated to real interest rates (a far better model than comparing gold returns to inflation), but it potentially benefits from increased uncertainty and may become sought after by global elites in response to Trump protectionism and possible resulting collapses of EM currencies; I think there's a decent chance it falls 25% from current levels and I will view that as a great buying opportunity.  Cryptocurrency (mostly bitcoin) remains a very substantial portion of my portfolio and the asset I'm most excited about.  Stay away from energy commodities because reduced environmental regulation and increased middle-eastern geopolitical uncertainty will likely increase both US and OPEC oil production, but other commodities are likely to benefit from infrastructure spending.

For those of us in "asset owner" roles who were starting to wonder if active management can produce alpha: we're likely entering a golden age for hedge funds of almost all types.  There will be great opportunities for global macro and stock selection alpha generation over the next few years, and I'd wager that unlike over the previous presidential term, hedge funds will outperform passive investment.    

Lastly, I think volatility (and things that are volatility related like credit default swaps) are currently extremely underpriced by the market as a remnant of "financial repression" (i.e. artificially low global interest rates that force investors to find yield by doing things like selling options).  This probably won't last long.  I would much rather own moderately out of the money equity calls than outright equity today.  Emerging market CDS looks very cheap.

For the more active traders out there, we also have opportunities to trade around volatility; we're seeing sharply increased volatility of volatility (reflecting a more uncertain world), but spot vol itself remains depressed due to financial repression.  In the last two weeks, the VIX (a measure of short-term S&P 500 implied volatility) rallied from 14 to 19 fell to 15 rallied to 24 and then fell to 14.  I'll be playing it from the long side whenever it gets below 16.  There are a number of structural costs that make a simple strategy of buying VIX when it's low ineffective - you have to account for the term structure.  When I say that I'll buy "VIX", I'm oversimplifying, it's sometimes more attractive to buy volatility 3 or 6 months forward, or to buy volatility on currencies, bonds, or commodities rather than on equities.  If you're experienced with vol trading there are some great opportunities; if you're moderately knowledgeable but uncertain on execution, I'm happy to chat about it.

*I owe about a quarter of the analysis in this commentary to Ray Dalio of Bridgewater.  

Cheers,
Ari

Thursday, August 4, 2016

Understanding Millennials

Investors, 

  This is going to be a very strange commentary, almost entirely sociological in nature.  I think I've found a useful lens to explain a wide variety of emerging social/political/economic puzzles.
  • Why do 70% of Americans think the country is heading in the wrong direction even as violent crime, deaths from terrorism, and unemployment are near the lows of the last 100 years?
  • Why do so many people from all over the ideological spectrum think the US is in the midst of a crisis (for such wildly different and conflicting reasons)?
  • Why do young progressive liberals seem to be demanding very "illiberal" social justice policies (like racial quotas for professors and campus censorship)?
  • Why is most popular media today so "squeaky clean" (Taylor Swift, Drake, "Modern Family", super hero movies)?
  • Why are technologically "boring" products like Twitter, Game of War, and Pokemon Go so successful, and should we expect that to continue?
  • Why did Bernie Sanders produce such strong youth turnout and earn nearly half of Democratic support in the primary; can we expect high youth turnout going forward?
  • Why are teen suicides rising even as academic performance and optimism among that age group are off the charts, and violence in general is falling?
  • Will the push for radical changes to our economy and political system from both left and right succeed?  What form will the changes take?  


Synopsis:
  The questions above became less puzzling to me after thinking about them within a generational framework that properly identifies the Millennial zeitgeist.  
   Millennials (currently aged 12 to 34) are civic-minded collectivists.  They trust authority and government institutions, but think little of current leadership.  They are optimistic and conformist.  They're outer-directed; instead of self-improvement, they focus on improving the world around them.  They're team players.  
   As consumers they will look for products that let them engage with a community (e.g. Twitter, Pokemon Go), they will continue preferring media that is idealistic and "clean" (e.g. Taylor Swift, "Modern Family", and simple super hero movies.)  As voters they will produce record turnout and throw their support behind politicians who promise ambitious social reforms via a larger federal government (i.e. Bernie Sanders.)  As employees, they will demand meaningful work and a sense of being part of a team.  As citizens, they will be honest collectivists with a strong sense of social responsibility.  They'll ambitiously and optimistically rebuild large institutions around themselves and their vision for the country.  While they tend to be more liberal and atheistic than previous generations, the civic collectivism crosses party and theological lines.  Religious millennials are embracing huge christian rock concerts and public purity ring ceremonies.  Millennials are in many ways traditional, non-rebellious, and conformist; a generation of boy scouts...and occasionally bullies.

 I am of course grossly simplifying when I reduce the extreme diversity of a generation to a set of common traits, but capturing general trends is useful.  This commentary draws very heavily on the work of authors William Strauss and Neil Howe.



​​

Social Justice: Rejecting Baby Boomer Individualism
  There have been major protests on over two hundred college campuses in the last 18 months, with some of the most newsworthy at the University of Missouri, Yale, and Amherst.  The protests have centered primarily around social justice for black Americans, with demands and tactics that are problematic for even most self-described leftist liberals.  For example, students at many schools are demanding quotas for black professors, mandatory "cultural competency training" for all students, censorship of political discourse, and the renaming of buildings named after US presidents like Thomas Jefferson and Woodrow Wilson.  The latest version of the "Movement for Black Lives" platform (which has been endorsed by Black Lives Matter), demands legalized racial discrimination, including free national education exclusively for people with black skin. To many veterans of the civil rights movement, these demands threaten the rights of others, through active censorship and racial discrimination.  
  I previously thought of Millennials as continuing the idealism, materialism, and individualism of the Baby Boomers, and that left me perplexed by the form that some of the recent social justice protests have taken.  The Baby Boomers (born between 1943-1960) were inner-directed idealists.  Some of their most famous and representative members were president Bill Clinton, comedian Steve Martin, and entrepreneur Steve Jobs.  They believed in the individual - individual rights, individual transformation (through drugs and dance as adolescents, and now through diets and exercise schemes and religious revival movements as adults), and individual success (through materialist consumption).  The civil rights movement was focused on the individual and the argument could be summed up simply: people are people, treat them the same.  A black person should be treated equally to a white person, a gay person deserves the same rights as a straight person, immigrants the same rights as native born Americans etc.
   In contrast, Millennials care about injustice, but frame it not as justice for individuals, but as justice for groups.  Previously, assistance to the poor or oppressed was generally framed in terms of providing equal opportunity.  But the rhetoric of Bernie Sanders, the Millennials' candidate, is about outcomes of groups - that income inequality is in itself an obvious problem and inherently wrong.  To put it simply: Civil rights advocates of the baby boom generation were fighting to remove institutional obstacles from individuals.  Social justice minded millennials are fighting to provide equal opportunity for groups, and measure opportunity in terms of outcomes.    
  The inward-focus of Baby Boomers led to the surge in psychedelic drug use, therapy and self-help books, fad diets and gym memberships.  As adolescents they sought inner purity, as adults they chased personal wealth and happiness, and as parents they believed in coaching their children to personal perfection.  In contrast, Millennials are outward-focused; when they talk about "fixing things", they don't mean their waistlines or relationships with their mothers, they mean the environment and the societal institutions around them.


Optimism and Ambition: Rejecting Gen X Cynicism
  Gen X (born 1961 to 1981) was a cynical, pessimistic generation.  Nihilistic, rebellious, and scared, they came of age in an atmosphere of low expectations and neglect.  They caused a spike in crime rates and a drop in academic performance.  Gen X is the generation of punk rock, Marilyn Manson, Dennis Rodman, "South Park", and "heroin chic" fashion.  Gen X views the world as a cold and unforgiving place.  They don't trust authority or each other and subscribe to a mantra that if you don't look out for yourself, no one else will.  To Gen X, success is self-sufficiency, independence, and survival.
  In contrast, Millennials are incredibly optimistic and ambitious.  They reject the cynicism of "Seinfeld" in favor of idealistic "Modern Family" and "Parks and Recreation."  Their favorite musicians are squeaky clean idealists in every subgenre - Drake, Taylor Swift, NSYNC, and Skrillex.  I'm personally a fan of electronic music so I'll use that as an example to dive a little deeper: Gen X listened to electronic music in illegal underground raves in filthy warehouses in groups of a few hundred or a couple thousand adolescents; millennials fill stadiums to hear their favorite DJs and buy their tickets 6 months in advance via Ticketmaster.  

Boy Scouts: Embracing GI Collectivism 
  So if Millennials are are wildly different from Gen Xers and Baby Boomers, who can we compare them to?  The GI generation (currently between 93 and 115).  As youths they were similarly civic-minded team players.  Theirs was the generation that started the Boy Scouts, built the nation's highway system, and put a man on the moon.  They gave us sunny idealists like JFK and Reagan the pols, Artie Shaw and Judy Garland the musicians, and Joe DiMaggio the sportsman.  
  Millennials began developing their worldview with a childhood of "gold stars."  They grew up in a culture that embraced children as the future, with mothers that kept a pile of child-rearing books on the bedside table, and with schools that sought to replace competition with encouragement.  They could do no wrong.  Unlike most previous generations, they were told even as children that their views were important and valuable. Their parents and society as a whole demonstrated they were constantly here to protect and support them.  
   By the time Bill Clinton took office, "kinderpolitics" dominated the political scene - it seemed like every public policy debate was framed in terms of what was best for children.  "Children are our future" became the mantra.  Adults were expected to embrace parenthood as a defining role of their life.  Adults who chose not to have children, or to have children but not make them a central priority of their life, were viewed as selfish.
  As a result, Millennials trust authority and are quick to anger when high expectations aren't met.  Their childhood made them ambitious, confident, demanding, and fragile.  They don't know how to deal with disappointment or failure.  On college campuses, this manifests as a very specific type of protest.  Unlike the civil rights protesters of the 60s, today's students have no desire to "burn it down."  When they encounter something they don't like, like a school newspaper that publishes Op-Eds they view as insensitive, today's protesters don't react by creating an alternative/competing paper - rather they demand that the administration fix or replace the existing newspaper.  Millennials believe in institutions (even if they think those institutions are currently run by corrupt people).
  Millennials' life is always quantified.  They count their Facebook "likes" and Twitter "followers."  They know how many Pokemon are in their Pokedex.  Their popular computer games always include some form of "leveling up."  In public policy, they reject abstract ideals in favor of tangible results on both sides of the political spectrum.  Debates over the role of government or constitutional interpretation, are the domain of ideological Boomers.  For Millennials, these abstract discussions are uninteresting and unimportant.  They're far less interested in thought experiments than concrete results.
     

Sense of Crisis:
   Strauss and Howe's generational model suggests that "hero" generations like the GIs and Millennials always come of age during a time of crisis.  The idea of "crisis" is less about fact than about narrative.
   I look at statistics that define our quality of life - violent crime, deaths from terrorism, hunger, infant mortality, life expectancy, etc, and by almost every measure imaginable, Americans (and people throughout most of the world) have never had it so good.  Yet, 70% of Americans say they believe the country is headed in the wrong direction.  Many black Americans feel like they're in the midst of a crisis after watching youtube videos of police killing unarmed black teens.  The LGBT community feels under assault after the North Carolina Trans Bathroom bill and Orlando terrorist attack.  Middle-America whites feel under assault from a variety of angles - they feel unsafe from foreign risks due to Islamic terrorism, unsafe from domestic threats of racial violence and the recent assassinations of police officers; and they feel like they're losing the "culture wars" and being painted as villains for being christian, straight, and white.  Blue collar workers have a sense of economic hopelessness after a generation of stagnant wages and decreasing job security.  Parents feel helpless in the face of school shootings.  
   Perhaps most nefarious is the perception that our political system is increasingly corrupt.  More people believe that the economy and political system are rigged and controlled by a small number of elites.   People have less faith in police and congress and industry leaders than at any time in the last century.
   This sense of crisis was launched by the 2008 economic collapse.  High school and college age millennials went from a certainty that they would have wonderful job offers showered on them to a reality of moving back in with their parents, scrambling for unpaid internships, and returning to grad school or taking disappointing low-skilled jobs as a fallback.  It seemed like overnight the narrative for a 16 year old went from, "get good grades, go to a good college, and you'll have a wonderful life" to "if you're lucky, you may some day be able to pay off your student debt and afford a mortgage."  The financial sector bailouts made Americans believe the economy was rigged in favor of the already rich and powerful.  Some of the hardest hit in the Great Recession were the black and hispanic poor who experienced a disproportionate increase in unemployment and destroyed the sense of slow progress in those communities.  While the economy has largely recovered since 2008, the sense of disillusionment and lack of opportunity remains.
  For the GI generation, the crisis began with the 1929 stock market crash and culminated in WW2 victory.  So far we seem to be following a similar timing.  If history continues to rhyme, this crisis period might culminate around 2022, possibly against an external threat like Radical Islam, or perhaps as domestic crisis in the form of a massive corruption scandal that shakes our confidence in government (far deeper than even our current distrust.)  
   This sense of crisis spawned both the Trump and Sanders candidacies.  Millennials are still too young to take control of the political sphere, but we can expect to see them playing an increasing role each coming election.

Millennials as Populists: The Dangers of Collectivism
  What's the next step?  This cohort of Millennials isn't going to fade away quietly.  Rather, we'll see a rebirth of civic engagement, rising rates of voter participation, and increasing (often shrill) public discourse over expanding the role of government.  The danger (at least to people with Boomer values) is that the civic minded Millennials will demand too heavy handed intervention from the government.  Their trust in authority and belief in collectivism may slide into fascist tendencies.  Millennials weren't outraged by Edward Snowden's revelations of government spying; they're more outraged by a lack of government action to right historical wrongs, to prevent domestic violence, to censor hate speech, to prevent terrorism, etc.  Traditionally, liberals believe in "big government" on economic issues, and "small government" on social issues, while conservatives believed in the opposite.  But millennial liberals expect increasing involvement from the government on social issues as well to enforce their sense of fairness, shifting liberalism into populism.
  The Millennial belief in collectivism can take the form of bullying.  In the Baby Boomer's adolescence - individualism was hip.  In the Gen X world - rebellion was cool.  In the Millennials world - being a team-player is paramount.   The millennial generation is quick to ostracize, condemn, and bully those who fail to conform.  As a result, we're seeing an increase in teen suicides and an increase in school shootings by self-identified outcasts.

Conclusion
  This whole essay is a great oversimplification of the infinite diversity of humanity...but hopefully a useful one for explanatory and maybe even predictive purposes.  Let me try to reduce all of this to a single takeaway that transcends context and may be useful to you when you think about economic and political issues:
  In every aspect of life, Millennials want to join a team, set a quantifiable goal, and climb a ladder with measurable steps to that goal.  They are collectivists, and institution builders.  

Credit:
This essay is based directly on work by Strauss and Howe, especially "Generations" and "Millennials Rising", (with a few twists by me, for better or worse).  Finally, I owe thanks to my friend Ben Kream for recommending the authors to me.

Monday, June 20, 2016

Depreciation, Fed, and Brexit

Investors,

 The currency depreciation story has been gaining steam, leading to a surge in my favorite investments of gold (+23% YTD) and bitcoin (+77% YTD). Neither has a great correlation to inflation, they're more like psychological bets that investors will try to ditch their government-issued currency. I expect both to continue doing well, and I'm maintaining my large exposure to each. If you don't own any cryptocurrency, I'd still strongly suggest buying some (mostly Bitcoin, a little Ethereum and DASH). You haven't missed the boat. This is just the start of the birth of a new asset class. The crypto world is a complex beast for the uninitiated - I'm happy to chat about it if you'd like more information.

 Last week's Federal Reserve meeting had a few major surprises. While the interest rate was (unsurprisingly) unchanged, the Fed issued very pessimistic forward guidance on the economy, and substantially reduced their expectation of future rate hikes. Additionally, the St. Louis Fed. led by James Bullard, released an entirely new policy framework for how to think about the economy and how the Fed should manage interest rates. To oversimplify - rather than focusing on a single base case economic scenario, Bullard thinks the Fed should focus on a range of possible outcomes and the uncertainty around them. In other words, just because unemployment is very low today, he advocates dovish policy because of things that could go wrong in the future. This shift towards dovish Fed policy will further support the currency depreciation theme.

 While the "inflation hedging" assets have rallied strongly, actual inflation expectations (represented by the inflation swap market) are only up slightly. Unemployment has fallen to 4.7% and money printing continues in most countries, but investors feel that deflationary forces are even stronger. That strong unemployment number hides a falling labor force participation rate. Even China is starting to replace human labor with robots on a massive scale. Long-term we'll continue seeing deflation in commodities and input prices, and inflation in the cost of final goods as a result of currency depreciation. I think that in the next year we'll see a moderate jump in inflation expectations back to more historical norms, although it might be short-lived. Speaking of equities, US stocks are near all-time highs, while European and Emerging equities are still far from it. For technical reasons I think US equities might have a strong 6-12 months ahead, but valuations are terrible. Expected returns for US equities over the next 7 years are barely above zero. I've sold the last of my very small US equity holdings and am currently leaving the proceeds in cash. I still very much like holding emerging market equity, and that makes up about 1/3 of my portfolio.

 The Brexit (Britain's vote to leave the European Union) is on June 23rd. The odds implied by the market are currently about 33% that Britain will leave. If so, the pound will fall and volatility will rise. Beyond that, I can only guess. I think Britain's departure may be the first domino in the dissolution of the EU. The Eurozone never solved their problems from 2008. All of the issues remain - from heavily overlevered banks to labor productivity disparities that cause low-productivity countries like Portugal to constantly accumulate debt to high-productivity countries like Germany. If Britain leaves, the electorates in many other countries will start talking about following.

 Conclusion: I like gold, cryptocurrency, and emerging market equities. US equities are overvalued, but may have a strong 6 months ahead (after which, I would likely put on S&P 500 shorts.)

Friday, February 26, 2016

Correction

Investors,

  World markets are mostly in moderate correction territory, and I think it’s mostly a “correction” in the common usage of the term – we’ve eliminated most of the froth and excessive optimism in valuations in the US and Europe. The sell-off in the US was partially driven by falling earnings forecasts and growth estimates by US companies. I think US equities are now roughly fair (maybe a bit rich still). Looking globally, emerging markets are scared of the Chinese slow down. I think EM equity now represents excellent value generally, although I wouldn’t be surprised if China related panic brings us another 25% sell-off some time this year. In Europe and Japan, investors are concerned that quantitative easing is proving insufficient to create growth. Sweden, Japan, and the ECB have all discussed negative interest rates recently, but rather than having a stimulative effect on equity prices, this discussion has investors focusing on the weakness of central bank attempts to stimulate growth.

  Below is a chart that starts with all indices set to 100 at the start of 2015. The S&P 500 is about 13% off its highs. Developed markets excluding the US are 24% off their highs. Emerging markets are off 35%, and China is almost 50% off its highs. A lot of these losses look less severe in the context of recent gains though. For example, the Chinese market is only 10% below where it started 2015.

  China is facing continued problems. Their banking system remains insolvent – they have tons (possibly $5 trillion) of non-performing loans. Their equity market has continued falling even with huge government intervention. Some smart hedge fund managers like Kyle Bass think China will have to devalue the Yuan by up to 30%. Most financial analysts think 10% is more reasonable. Part of the problem is a fear of capital flight – China is afraid that if they make a small devaluation, that will scare the Chinese into pulling money out of the country (legally and illegally) in fear of further devaluations. No one is clear on how China deals with these problems. I don’t have great insight here, but I think similar to the US in 2009, China has the financial tools and capital to deal with the problems and come out strong. I’m happy to maintain my long-term bet on Chinese equity markets, and on EM more broadly.

  Commodities have recently started recovering, and I think they are good value (both as direct investments and by buying equity in companies that produce them.) I like commodities at these prices for both fundamental reasons (global demand has likely troughed) and also as a currency hedge. As countries continue competing to devalue their currencies, investors and average citizens will be looking to protect their wealth. This makes gold and bitcoin particularly attractive.

  Credit spreads have been steeply increasing and are now above historical averages. I’ve never invested substantially in credit before. Credit is a “hybrid” instrument with lower return and lower risk than equity – I think that it’s almost always better to “barbell” by investing in a mix of equity for the high return and cash or treasuries to dampen risk. Credit tends to be overpriced because lots of investors (like pensions) are legally required to invest in credit instead of equity, and investors like the payoff profile of lots of small wins and only the rare big loss. In financial jargon, investors overvalue the high sharpe ratio of credit, and underweight its negative convexity. But…we may be nearing an exception. If credit spreads continue widening over the next 6 months, I think they we’ll see an attractive opportunity to lock in some very high yields with only moderate risk. The best way to invest will be to buy closed end high yield bond funds. During market declines, these funds often trade at steep discounts to their NAV. So, for example, we can buy a fund that holds bonds yielding 8%, at a 20% discount to the market value of the bonds. This increases our yield from 8% to 10%. We can win by either the discount to NAV narrowing, or we can simply hold the fund and collect the extra yield as dividends. US economic fundamentals are relatively strong, but I’m pessimistic about equity returns – this provides a good environment to lock in a high yield that is safe unless the US falls into a very deep recession.

  My own portfolio is: long emerging market equity, long commodities and commodity producers (overweight gold), long bitcoin, and long cash. I’ll look to invest in high yield US credit via closed end funds trading at a discount to NAV if spreads widen a bit more. If US equities or European equities fell another 15% I’d be interested in buying.

  I’ll be in Florida next week representing the University of Chicago endowment at two conferences. I’ll be presenting on our tail hedging program at the CBOE RMC and on a panel discussing smart beta at the Credit Suisse Global Trading Forum. If either topic peaks your interest, I’d be happy to chat about them. Cheers, Ari

Monday, September 14, 2015

Sell-off, Syrians, and Self-driving cars


Investors,

   I promise to get to the pertinent global equity sell-off, but I'd like to take us through a bit of a detour first, hopefully as fascinating to you as it is to me. 

   Last week I was in Oxford, England for an investing conference.  One moment stood out as surreal and I think a powerful symbol for the decisions facing investors.  Richard Thaler, father of behavioral finance, was a guest speaker.  Thaler is also closely connected to Eugene Fama, one of the father's of the efficient market school.  It was actually Thaler's work in the mid 1980s on stock market inefficiencies that led to Fama's most famous paper on the 3-factor model, which is a bedrock of the current "markets are mostly efficient" camp.
   Thaler and Fama are old, both in years, and in the fact that their work is the foundation of modern finance.  And we're talking about work that is only about 30 years old.  We were listening to Thaler in a hall that was about 400 years old at a university that was over 900 years old.  And further exaggerating the distinction of timeframes was one of the themes of the conference: The deflationary forces of automation.

Automation
   Automation is nothing new, but it's quickly accelerating, and for the first time, starting to destroy more jobs than it creates.  It's hard to overemphasize how automation is going to change the world, and the "smart money" in the financial community is gradually becoming obsessed with the concept.  A few specific examples:  McDonald's is replacing cashiers with automated kiosks and my hotel replaced its check-in desk with automated kiosks as well.  Just as robots have replaced a large percentage of factory labor, the same is now starting to happen throughout the economy.  Self-driving cars (and trucks and trains and airplanes) will put at least 5 million Americans out of work. Automated kiosks and smart troubleshooting algorithms will render a large percentage of customer service jobs obsolete.  While some new jobs are created by new technologies, it will be far fewer than those destroyed.  It's important to note a distinction between this wave of automation and the the previous robotics revolution in factories.  The previous revolution produced a great many engineering and programming jobs.  The next wave will produce far fewer jobs, because even many of the engineering and programming jobs will be done by computers.  For example, software like Mathworks lets me perform fairly complex operations with just a few lines of pseudo-code.  Eventually we'll have software that lets the average person issue simple instructions to the computer, and the computer will write the code.  Some form of the programming profession will always exist, but it will be much smaller and much higher skilled.  Today, most programmers perform repetitive and relatively low-skilled "grunt work"; straightforward coding that's been done many times before.  This will all be abstracted and automated.   And while the new technology creates wealth, it still produces a huge deflationary effect (since goods and services become cheaper).  We're heading into a world where most people are simply obsolete - machines will design themselves, 3D print themselves, program themselves, and perform maintenance on themselves.  The high level designers will be well-rewarded, but there won't be all that many of them.  
    The deflationary force of automation is real. I've emphasized my fear of inflation in this newsletter for the last 2 years, and my view has moderated a bit, but not fundamentally changed.  The old equation Money Supply x Velocity = Price x Transactions still holds true.  The technological improvements mean that productivity will be increasing, which gives central banks room to print some money without causing inflation.  But they're not printing some money, they're printing tons of money, and I don't think that will stop.  They are simply carrying too much debt to stop printing and they're too deep into competitive currency devaluation.  The US might raise interest rates by 25 basis points, but if Europe and China and Japan continue easing, we'll quickly feel huge pressure to do the same as our currency rises and corporate earnings start plummeting as US companies become less competitive.  The battle between technological deflation and money printing may take two decades to play out and probably won't have a one directional outcome.  Currently, the market is pricing in near zero inflation, partly a result of temporary influences like the massive drop in commodity prices and excess capacity in China.  Sooner or later, and I think sooner, the market will take a more balanced view, and so I still expect inflation bets to pay off handsomely.  To be clear, I'm not predicting rampant inflation, just a temporary move away from our current deflationary world that changes the narrative and produces a flight away from fiat currency.    

Global Sell-off
   China has been in the headlines, but it's more of a tangent.  The US stock market has been held up by ultra cheap credit, which creates a bid in equities via stock buybacks (companies issue debt to buy shares) and by the promise of Mergers & Acquisitions activity (financed again by cheap debt).  There's a growing consensus that the credit cycle is at its peak and cheap financing will become scarce.  Without that stock buyback and M&A bid, US equities should probably be at least 10% lower than they are today.  Additionally, investors are thinking about higher real interest rates.  Assets are priced by discounting future cash flows by the real interest rate.  Real interest rates are near zero around the world.  A 1% increase in real interest rates reduces the value of a $20 stock by something like $3.  (there's no consensus answer to just how much, $3 is a very rough estimate).  
   Additionally, the Eurozone has still not found a solution to its existential problems.  It is still likely to dissolve (I think 60% chance in the next 5 years).  The Syrian refugee crisis may be the trigger; it's spurring additional talks of a British exit of the European Union and pushing the national politics of many countries rightward. The Eurozone is a failure, producing growth of zero over the last decade.  Sovereign debt levels remain at all time highs and the banking system remains hugely overlevered.  


My portfolio
  I covered my short S&P 500 futures position at around a 1920 index level; I will probably re-establish if we rally a bit higher. I've doubled my long GXC (Chinese H-shares) position to a moderate size; this is a medium-term bet on China's ability to flood their economy with liquidity and a long-term bet on the ascendancy of China.  I'm holding my positions in gold, silver, and bitcoin, all suffering; I still like them as bet on currency depreciation.  My investments in commodity-related equities was awful, but the market has reduced my small allocation to a tiny one.  And at current prices, I like holding the remainder.  The commodity sell-off is a long-term secular phenomena, but we have to fight to think contrarian and look for value in areas that no one else is interested; I'll be adding selectively and would love to hear ideas for specific commodities or commodity-related equities to buy.  Lastly, being short Eurozone sovereign debt is one of the those rare screamingly obvious and easy trades that don't come along often - fantastic potential reward for minimal risk.  

Tuesday, May 5, 2015

Monetizing Chinese A-Shares

 I wasn't expecting to write another commentary so soon, but my favorite investment has performed so well that it was required.  China is the top performing major stock index of the last year; the Shanghai Composite is up a whopping 120% since last June.  I remain long-term bullish on China but it's no longer an obvious relative value play.  Also, the A-shares of duel-listed Chinese companies are trading 32% over identical shares listed in Hong Kong.  I sold all of my A-shares.   I've re-invested 1/3 of the capital in Chinese H-shares, 1/3 into a diversified emerging market ETF, and the last 1/3 I'm putting into precious metals as I continue to anticipate continued currency depreciation globally.  
 A-shares are Chinese equities that are listed on exchanges in mainland China and denominated in Renminbi.  Many companies also issue H-shares (listed in Hong Kong), and B-shares (a class that was created for foreigners before China allowed foreign investors to purchase A-shares)  Prices between exchanges can diverge greatly because of regulatory challenges to arbitrage and tremendous buying pressure from Chinese locals.  A-shares are predominantly owned by Chinese locals, while B and H-shares are predominantly owned by foreigners.   If you're looking at broad indices of these share types though, there are other differences; many companies only list a single share class, and the A-shares tend to be smaller and less internationally focused companies.  The surge in A-shares relative to H-shares suggests that most of the buying pressure was from Chinese locals; I've seen many other statistics to back this up.  Most of the westerners I talk to have been continuously pessimistic on Chinese equities and remain so.   


 Are Chinese equities overvalued now?  Is it a bubble?  I don't think so.  First, the simple valuation metrics suggest fair value, although it depends heavily on the specific index you're looking at.  Chinese H-shares have a P/E ratio of about 18 (vs 18 for the S&P 500) and a P/B ratio of about 2.2 (vs 2.9 for the S&P 500), while A-shares are trading at about a 35% premium.  The Chinese economy is growing at around 7%, vs the US' anemic 0.2% in the latest report (or closer to 2% if we ignore the last quarter).  Now, no one knows just about how much fraud is in Chinese reported earnings.  Back in 2008 I sold all my Chinese equities when I started delving into their financial statements and spotted massive fraud in minutes in every statement I examined (even with my superficial accounting skills).  One fun example was a Chinese mining company that claimed to be selling raw minerals at 5x the going market rate.  In 2009, the narrative of "you can't trust Chinese accounting" took hold and western investors have eschewed Chinese equities ever since.  While there's still lots of fraud (and I can't even try to quantify how much) the Chinese regulatory infrastructure has improved and standards are higher now.    


 From a psychological perspective, I think things are balanced to bullish.  Local Chinese citizens are speculating on margin in ways that are being compared to daytraders in the US in 1999, but that may be just the start of a trend with a long way to run.  The real estate boom is over, and the rates offered by banks on savings accounts are artificially low, so equities look attractive to the average Chinese person.  China is generating tremendous wealth that has to go somewhere.  Also, western investors missed the boat completely and remain pessimistic.  This means that if sentiment turns, there could be a flood of western money pushing Chinese equities higher.    


 What about the Chinese economy?  China is facing some huge problems but has equally massive tools at their disposal to deal with them.  They have excessive debt at the state level, too much of their financial system is corrupt and un-regulated, capital markets are underdeveloped, and their environmental problems are growing worse.  To even superficially touch on each of these would require a full essay, but I'll point out some of the highlights that explain my optimism.  China has the policy tools to stimulate growth.  While the US was "pushing on a string" and had to invent new monetary tools to encourage lending despite 0% interest rates, China has tremendous room to ease, and they've been using those tools intelligently.  Bank reserve requirement rates in China are at 18.5%, up from 7% in 2005, for example.  Additionally, while state banks are over-levered, small businesses and households are under-levered.  The Chinese government has passed a number of laws recently to encourage the formation of more small banks, bring greater transparency to the shadow banking system, more accountability to state finances, increasing lending to small businesses and decreasing lending to the largest SOEs, and new laws to accelerate the resolution of non-performing loans.  A few specific examples all from the past 18 months:  the Chinese government injected 500 billion RMB into the biggest 5 commercial banks via the Standing Lending Facility, and then another 400 billion via the CDB.  They injected 1 trillion RMB into the China Development Bank.  They cut taxes on utility companies and for manufacturing investments.  The central government passed a series of laws requiring much greater transparency in the budgeting process of local governments and forbidding municipalities from raising debt through off-balance sheet vehicles.  They are gradually opening capital markets via reduced currency controls and a wider RMB trading band; mainland Chinese mutual funds can now invest in H-Shares, and there are reduced restrictions on foreign investment in private companies.  There are a growing number of free-trade zones including Shanghai, Guangdong, Tianjin, and Fujian.  Lastly, the Chinese government is seriously cracking down on corruption - hundreds of thousands of party officials have been investigated with many senior officials arrested, including at least five members of the powerful Central Committee, and 70 executives of State Owned Enterprises.  This is just a small sample of recent reforms initiated by the Chinese government to overcome their obstacles.



Big Picture:Most assets are overvalued.  US equities and real estate are moderately overpriced; venture capital, biotech, and bonds are in or near bubble territory.  European and emerging market equities look roughly fair.  The global money supply continues expanding.  My own portfolio consists of emerging market equity, a small amount of european equity,a little commodity related equity exposure, and a small short S&P 500 position that I just initiated as a partial hedge to my long equity exposure.  I am also long a growing amount of precious metals and bitcoin.  



Cheers,
Ari

Monday, March 23, 2015

Structural Dislocations in the Volatility and Sovereign Debt Markets

Investors,
 
   In this post I'll cover some of the biggest structural distortions visible in the market with a few ideas of how to profit from them, or at least avoid getting run over.  The bulk will be on distortions in the volatility market, which requires some technical jargon.  This post is more geared more towards the professional investor/trader than most of my "Risk over Reward" commentaries.  
 
Equity Index Skew
  Asian stock index volatility looks radically different from the S&P 500 because of structured products in Asia and the behavior of US investors.  There are a variety of structured products throughout Asia that aggressively sell long-term volatility, and particularly downside skew (example: "autocallables" in Japan.  These insurance products pay out less when equity markets are down, and so they result in consumers of insurance basically selling long-dated out-of-the-money puts).  The basic theme is that asian investors enhance the yield of all sorts of investment products by coupling them with a sale of long-dated volatility.  This causes the index vol curve of most Asian markets to be much flatter than the US (probably too flat), and to price in much less downside skew (probably way too little.) 
  In contrast, the US has tons of short-term call overwriting and downside put buying.  The short-term call overwriting is done to generate yield for investors like pension funds desperately trying to earn 6%+ on their portfolios; it results in a steeply upward sloping volatility curve.  Downside puts are being purchased more aggressively than ever before by banks because of new regulations (i.e. Dodd-Frank, Volcker Rule, and CCAR) that require stress testing of portfolios and limited risk taking.  Short-term and deep out-of-the-money puts help banks meet the stress testing requirements.  Insurance companies have also increased their buying of short-term puts because of the death of certain types of variable annuities, which previously required them to buy very long-dated downside protection.  
   The simplest application of this mispricing is in a simple hedging scenario.  If you want to buy protection on your portfolio, you should avoid puts on the S&P 500, because S&P put skew is currently overpriced relative to other sources of downside protection.  Instead, consider replacing some of your equity exposure with an out of the money call.  That way you dodge the overpriced puts and benefit from the cheap call skew.  A picture of the put/call skew ratio is attached.  The high number associated with the S&P 500 reflects the fact that the market is pricing puts with much greater skew than calls, unlike in the Nikkei and Hang Seng where the premium on puts is small to almost non-existent.



Energy
  Options on crude oil are trading with an implied volatility of 45 (taking the average of Brent and WTI 1-year option implied vol).  The market is pricing in a substantial chance that crude oil will soon trade below $30.  I've had some recent discussions with analysts who have convinced me that $30 crude is indeed a possible (albeit unlikely outcome) and that crude could potentially stay there for at least a couple years.  While $30 is well below replacement cost, banks can force the oil companies to keep pumping oil to generate cash to pay off the debt that financed the wells.  In other words, crude oil supply may drop surprisingly slowly in response to low prices.  This isn't a comment on crude's direction, but on its probability distribution.  
  In contrast, the options market is pricing  the volatility of the energy large caps (represented by the ETF XLE) at only 20 vol, and even smaller E&P companies at only 50.  Many of the E&P companies will go bankrupt with oil below $40 and are worth much more than where they're trading if oil rebounds above $70; they're a heavily levered bet on the price of oil, but the options market isn't reflecting that.  The simple trade is to sell volatility on crude oil futures and buy vol on energy companies (both E&P and broader large-cap).  The more sophisticated version is to do the same, but also buy the debt of these companies (especially E&P which are severely discounted) and short the equity as well.  The latter trade looks like owning delta hedged convertible debt against crude vol.  
  
Sovereign Debt
  We all know about how central bank buying has artificially suppressed interest rates, but only recently have investors become totally complacent about the negative nominal interest rates that a good chunk of the developed world is now exhibiting.  The following countries are all being paid by investors to borrow money for 2 years, i.e. they have negative nominal interest rates: Germany, France, Belgium, Austria, Sweden, Czech Republic, Switzerland, Finland, Netherlands, Austria, and Denmark. In many spots, the market is offering staggering reward for relatively low risk to the investor.  For example, shorting Japanese debt (or buying vol on it) may fail as a trade, but you can structure it to offer you 5:1 or better.  Instruments like the LIBOR-OIS spread and equity puts contingent on a currency move offer similar payoffs.  One very specific trade that I like is buying equity puts contingent on higher interest rates. The pricing of this trade depends on the implied correlation between bonds and equity.  The biggest player in this market are pension funds who need to hedge the risk of equity falling while bonds rise (in which scenario the present value of their liabilities increases and they face a funding shortfall), and so these behemoths sell down the implied correlation between equity and bonds to artificially low levels.  By taking the other side of the trade (betting that bonds and equity will move down together), we can buy puts at highly subsidized prices.  Currently, the implied correlation is so low that you can save roughly 70% of the premium on the puts.  
  The pattern of interest rate suppression and volatility selling by investors may continue, but it provides a fantastic opportunity to construct asymmetric trades with great reward for minimal risk. Unfortunately, the best trades require the use of OTC derivatives, so they're out of reach for most of our personal accounts.  

Big Picture
  Most assets are overvalued.  US equities and real estate are moderately overpriced; venture capital, biotech, and bonds are in or near bubble territory.  European and emerging market equity looks roughly fair.  I'll provide a more detailed look at each of these areas in my next letter.

Cheers,
Ari

Thursday, January 22, 2015

The Crude Collapse

Investors,

   The last 6 months have seen a collapse in commodity prices (particularly crude oil), a strengthening dollar (and collapsing Yen), and generally flat equity prices with rising volatility.  In this commentary I'll focus on crude and then discuss the big picture.

Crude Oil   
  Oil's price has been falling primarily because US crude production has been skyrocketing, for fundamental and sustainable reasons.  New technologies developed over the last 15 years have increased US crude oil production from 5 million barrels per day in 2008 to 9 million barrels per day currently, and likely over 10 million per day within a year.  The US is now the world's largest energy producer, and that appears unlikely to change any time soon.  There has been a huge amount of new well drilling in the US over the last few years; while many of these projects will be unprofitable at current low prices, much of the cost is sunk and unrecoverable, so the companies will recover as much cash as they can by drilling.
  But none of that is new, so why did the price crash in the last 5 months?  There were a few timely triggers.  First is the abatement of geopolitical risk.  Turmoil in Iraq and Libya, as well as tensions with Russia and Iran have not substantially affected production.  The market was pricing in a substantial geopolitical risk premium to the price of crude, and much of this has now been removed.
  Second is global recessionary fears.  The global rate of growth has slowed and investors are pessimistic.  Weaker global growth means less demand for crude.
   Third is OPEC.  The market expected OPEC to cut production at their meeting at the end of November, and instead they held steady.  There is speculation that this was due to internal politics - that Saudi Arabia wanted to put pressure on Venezuela and Russia who more desperately need the higher oil revenues that come with higher prices.  Another hypothesis is that Saudi Arabia wanted prices to fall far enough to completely shut down research into alternatives and new exploration.  However, it may be that Saudi Arabia simply felt that cutting production wouldn't raise the price enough to justify the drop in their sales volume.
   Crude prices today are unsustainably low unless the world falls into a global depression.  The marginal cost of developing a barrel of crude at today's production levels is about $70 per barrel.  But...the glut of recently finished and nearly finished wells means that the price could stay depressed for at least a couple years while we work off the excess supply.  I think buying crude oil futures out 3 to 5 years forward is an attractive bet, but it's not a crazy mispricing by the market. 
   The market is still trying to decipher how oil related equities should be affected.  Many oil companies will go out of business, while others are probably trading at excessive discounts.  I don't have a sense if the sector as a whole is cheap or rich, and I lack the expertise in the sector to try to identify the winners and the losers.  Some smart stock pickers will make a lot of money in this sector over the next couple years though.  There are also lots of interesting and hard to calculate second order effects.  For example, the Canadian banking sector will be hit hard by the drop in investment banking activity that was previously supported by tar sands projects.  
   While cheaper energy is unambiguously a major boon to GDP growth, its effect on markets is more subtle.  Energy is over-represented in US equity and debt markets relative to its role in the economy, because the energy sector is mostly composed of large and publicly listed companies.  So while the economy as a whole will benefit from cheaper energy, specific equity and debt markets may not because the companies in that particular index will see their profits fall.  Below is a graph that shows the relative weight of energy in various indexes.  Those indexes with the largest percentage of energy have been hit the hardest by the crude price decline.  
  Thinking globally, countries that are large net importers of oil (like China, Japan, South Korea, and Germany), stand to benefit the most from the price drop.



Big Picture:
 Global interest rates remain near all-time historic lows and artificially suppressed.  Additionally, credit markets are pricing in almost no default risk.  Between these two factors, bonds are very unattractive investments today.  
  US equities are substantially overpriced, to the point that their expected real returns over the next 7 years are near zero.  Global developed market equity (Europe and Japan) are a little overpriced, and emerging market equity is about fair (which is very cheap in relation to the US).   
  The US unemployment rate is now at 5.6%.  While there's no magical number, 5% is often referred to as "full employment."  This suggests there is very little slack left in the labor market.  However, wage growth has been slow and we have not yet seen evidence of inflationary pressure.


Mea Culpa and Positioning: 
  In my last commentary 6 months ago, I suggested positioning for inflation and highlighted the rampant global money printing.  Instead of inflationary pressure, we've seen strong disinflationary or even deflationary pressures globally that may continue for the next 6 to 12 months.  My basic perspective is unchanged - the massive money printing will eventually create inflationary pressure, and we continue to see slack in the labor market shrinking. The market is pricing in very little risk of inflation, and very few people are worried about it.  That doesn't tell us whether it will happen or not, but it does suggest that at the first hint of inflation, we'll see an exaggerated response by the market since many participants will be caught out of position.  I continue to favor gold, silver, bitcoin, emerging market equity, short Yen, and commodity related exposure.  If crude oil falls any further, I will likely buy futures settling in 2020.  
  Wealth inequality is a hot button political topic, but it's also of critical interest to investors today.  One reason the Federal Reserve has been able to quadruple the money supply without triggering rampant inflation is because the newly printed money has ended up in the pockets of the very wealthy.  The very wealthy aren't spending the extra cash, rather they're investing it and bidding up equity, bond, and real estate prices.  If more of the newly minted cash finds its way to lower and middle class households, a much larger percentage will be spent on consummables and services, which will create upward pressure on prices and then wages.

Cheers,
Ari