Friday, February 26, 2016



  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


   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 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.  


Monday, March 23, 2015

Structural Dislocations in the Volatility and Sovereign Debt Markets

   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.

  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.


Thursday, January 22, 2015

The Crude Collapse


   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.


Friday, May 30, 2014

Profiting from Depreciation

   The global supply of base money is growing at a ferocious pace.  The US is tapering (still expanding the money supply, but at a slowing pace), and the velocity of money is likely to pick up causing broad money measures to continue expanding.   More dramatically, the rest of the world has joined in our money printing efforts, with the central banks of UK, ECB, Japan, and Switzerland aggressively increasing the size of their balance sheets.  Productivity is growing far slower than the money creation, so we're seeing currency depreciation that is likely to accelerate.  If all the major currencies depreciate simultaneously, exchange rates won't necessarily move.  Rather the prices of real assets (like commodities and real estate) generally increase. Slack in the labor market is shrinking, so the price increases in real assets may spread more generally and produce moderate inflation. 
    The big challenge is that the money printing has already pushed up the price of assets that provide yield to very "optimistic" levels.  The cap rates on real estate (basically a measure of yield) are low, reflecting both the low interest rate environment and the minimal risk premium.  The pricing for companies that provide commodities is similar.  This makes it difficult to get excited about buying a lot of the traditional depreciation/inflation hedges.  Investing is 1/3 about making the right prediction, but 2/3 buying at the right price. 
   My best guess is that moderate inflation is about 18 months away, but the market will begin positioning for it sooner.  I suggest purchasing a basket of assets that do well under stagflation regimes (low growth, moderate inflation), as well as under pure currency depreciation scenarios.  This includes a focus on precious metals, with smaller allocations to REITs with pricing power (like hotels), the equity of companies that benefit directly from rising commodity prices (miners, farmers, drillers, wildcatters, energy servicing companies etc), pure commodities, and maybe a little Bitcoin.  Insofar as you hold equities, it's smart to focus on emerging market economies; EM equities are trading much cheaper than the US and those countries will likely benefit disproportionately from continued money printing.  Probably the clearest advice is what not to own.  Fixed income of all types will do poorly.  

The Growing Money Supply:
The central banks of the world are in full out money printing mode.  The US led the way beginning in 2008 and ultimately produced a staggering 5x increase in the base money supply, but Europe and Japan have been ramping up their own efforts.  While the US federal reserve is "tapering", this simply means they're printing money at a slower rate than before, but they're still printing, and as I'll discuss shortly, the US money supply is likely to continue growing quickly.  Central banks are printing money faster than productivity is growing, which means the value of currencies will depreciate in real terms.  We usually think of the value of a currency as an exchange rate, but what if all currencies are depreciating together?  You get price increases in real assets.  Whether that turns into general inflation depends on whether labor can demand wage increases, and that depends on the amount of slack in the labor market.  Economists are debating that last point at length, but the debate centers around a pretty narrow range.  Is "hidden" unemployment an extra 1% or 3%?  The slack in question is really minimal compared to the upward pressure on demand from the flood of cash, and global GDP growth will continue eroding whatever slack remains in the coming year.  
   Distinguishing between inflation and global currency depreciation is tricky.  The former is a self-sustaining cycle that must eventually include wage increases and rising consumer demand.  If there's enough slack in the labor market, it's possible to get global currency depreciation without inflation.  In an inflationary scenario, "useful" assets like housing and crude oil are more likely outperform.  In the depreciation without inflation scenario, currency alternatives like gold will likely outperform.  Whether depreciation will turn into inflation requires a complicated and contentious discussion of the amount of slack in the global economy. 

Monetary Basics:
Back in 2008, market watchers noted that the Fed Balance sheet had ballooned from $800 billion to $2,200 billion dollars, and it has continued rising to over $4,000 billion.  Economics 101 tells us that Price x Quantity = Money Supply x Velocity of Money.  The equation tells us that if the money supply increases and neither velocity nor productivity changes, then prices must rise.  In even simpler terms, if there's more money chasing the same goods, prices will rise.  
  So why didn't prices increase threefold in 2008?  The velocity of money collapsed.  People hoarded their cash and used earnings to pay down debt instead of invest or consume.  Similarly, banks hoarded their capital instead of making loans.  None of this was surprising in 2008, or 2009, or even 2010.  But now in 2014 with the economy humming along with moderate growth, it's surprising that the velocity of money remains at recession levels.  There's a lot of debate on exactly why this is, mostly centered around a reduction in the size of the "shadow banking" system.  The bigger question is when will velocity normalize and what "normal" means.  I don't have good answers for you here, except that the rise in asset prices, expected low real yields, decreasing labor slack, and increasing money printing out of the weaker parts of the global financial system (ECB and Japan), will likely push up the money multipliers sooner rather than later.  

Bonds Moving With Stocks:
People often think of bonds and stocks as moving in opposite directions, but this has only been true for about 1/3 of the time over the last 50 years.  When we're in a deflationary environment (or a high real growth environment), the correlation is negative, as it has been for the last 12 years.  But when inflation is the focus, the correlation is positive, as it was from 1970 to 2000.  The last 5 years have had the most negative bond/stock correlations of all time, and I think that will soon reverse.  Here is a chart of the stock/bond correlation using 5-year rolling returns.  Being short bonds is currently a crowded trade, but the fundamentals are correct.  Interest rates are near all time lows and at the end of a generational cycle.  

What To Buy
  I've written in the past that gold is a mediocre inflation hedge.  The best predictor of gold returns is not inflation, but real returns.  When other assets offer opportunity, investors prefer them.  When other assets look ugly, investors are content keep their wealth in gold.  Quantitative easing has pushed every asset class to at least fair value if not far above fair, and with interest rates suppressed globally, real returns are likely to be very low over the next decade.  This makes gold an attractive inflation hedge in the current economic regime. I haven't kept a close eye on the commodity markets over the past year, so I'm wary of offering specific recommendations.  Personally I've bought a basket with an emphasis on natural gas, for similar reasons to what I wrote two years ago.  For investments of longer than a year, I generally prefer investing in companies that profit from commodities rather than in commodities themselves.  Equity investment provides a "tailwind"; even if commodities remain at current prices, the companies can earn a reasonable return and their equity may still appreciate at 5%+ a year.  Second, while you can buy physical gold and store it, it's not feasible to do this for things like crude oil or corn.  Owning commodity futures for more than a year incurs roll costs and unfavorable tax treatment, and ETFs are forced to roll their holdings and get taken advantage of by traders.  With all that said, I think that US equity markets are generally overpriced, so I'm also including some pure commodities in my basket.  
   A speculative candidate for addition to your portfolio is bitcoin.  Bitcoin is a cryptographic method of transferring value.  There's debate as to whether it's best thought of as a currency, commodity, or simply a method of transaction like Visa.  Regardless, it supports a fascinating variety of new technologies that may become integrated into the real economy in all sorts of interesting ways.  The biggest names in Venture Capital like Andreessen Horowitz as well as major players like Richard Branson and Li-Kashing are pouring money into bitcoin related start-ups.  It's inherently deflationary by nature as well, so investors may like allocating some portion of their wealth to it as a hedge against currency depreciation and inflation.  To be clear, bitcoin is not an investment, it's speculation.  It could easily collapse to worthlessness in the near future.  But...I think it's a smart addition as a small part of your portfolio, and I think it has the potential to achieve 5x returns in the near future.

Your Thoughts?
  I generally lack the time these days to delve into specific assets in great detail.  Do you like a particular commodity, company, or equity index as a depreciation/inflation hedge?  I'd love to hear from you.

  The trade I've recommended most strongly in the last 3 years was shorting the Yen, and that's worked out very nicely.  The easiest money is already captured so I've cut my position to 25% of the original size.  The long-term fundamentals continue to support shorting the Yen and I expect to leave on the remaining position for another 5 years or so.  The basic reasoning that I put forward back in January of 2012 remains sound.


Tuesday, January 21, 2014

The view from 10,000 ft.


   While short-term forecasts are near impossible, and medium-term is hard and requires a lot of luck, long-term forecasting is easier because market values generally head towards "fair" and mean reversion operates at a lot of levels.  The best long-term forecaster that I'm aware of is Jeremy Grantham, partner at GMO.  Grantham produces 7 and 10-year forecasts based on fundamental relationships and the assumption that over a long time frame, asset classes will revert to intrinsic value.  His current forecast suggests that US equity real returns over the next 7-years will be negative; he thinks US equities are currently 75% overvalued.
   He updates the forecasts quarterly to account for changes in things like GDP and investment levels, but most importantly, to account for changes in asset prices.  In 1999 he predicted that equity returns over the next 10 years would be zero, a staggering contrarian prediction at the time.  After the tech bubble burst, he became moderately bullish in 2002 before again predicting negative long-term equity returns in 2007.  He was then bullish again in 2009 before becoming bearish in 2012.  He also correctly forecast the outperformance of commodities and emerging market equity in the 2000s.  This is not to suggest that his timing is perfect; he became skeptical of equities in 1997, 3 years too early.  He seems to have little skill in picking the turning point, but is excellent in identifying when we're far above or below the "trend line" to which we will eventually revert.  
   The bulk of his work is to simply ignore the narratives of the pundits, and focus on some very basic metrics that ultimately drive returns.  For equities, long-term returns come down to revenue and profit margins (which determine net profits), leverage (which converts profits to return to equity), and the earnings multiple (which converts earnings per share to a stock price.)  Revenue generally trends upwards with the economy, and the rest is strongly mean reverting.  While we can't know what the mean reverting level is exactly, we can be sure that, for example, profit margins won't climb and climb until breaking 100%, and the P/E ratio must ultimately relate to real interest rates.  
   This simple analysis is just the starting point however, because things do fundamentally change over time.  For example, the top quartile of venture capital funds earned annualized returns of over 40% from 1990 to 2000.  That's likely a decade that will never be repeated for venture capital, because it was a new, underpopulated asset class investing in a new, underinvested industry.  Today venture capital is crowded with ten times the capital chasing a similar number of opportunities. 
  Long-term secular environments are also critical.  We're now 5 years into a period of financial repression with artificially low real interest rates.  The further the government pushes real interest rates below equilibrium, the higher asset prices may get above fair value.  
   Grantham thinks the biggest cause of excess market volatility and mispricing is faulty extrapolation.  Investors assume that trends will continue indefinitely, instead of identifying short-term aberrations for what they are.  For example, investors consistently overprice "growth" stocks, despite research showing that future earnings of growth and value stocks are actually the same; in other words, the prior revenue growth rate has no predictive value for future revenue growth rates.  This is why mindlessly buying stocks with low price to earnings ratios has outperformed most professional investors over the last 90 years.  Right now, the biggest false extrapolation is profit margins.  It depends on the measure you use, but profit margins are about 35% too high.  This means that if absolutely nothing else changes with the economy or corporate fundamentals and valuations, we should expect net profits to fall 35% and stock prices to fall 35%.  Of course the adjustment is unlikely to happen instantly, so the market may adjust to lower profit margins over time while other inputs into stock valuation provide support (e.g. stocks may lose 35% from lower margins but gain an offsetting 35% from revenue growth over the next 4 years).  
    Here is a link to an article about GMO's methodology (which they recently updated), and Grantham's latest quarterly letter:  You have to register to read it, but it's a quick and painless process and well worth it.  I've attached their latest 7-year forecast.
   It's worth noting that the forecasts are in real (aka inflation adjusted) terms.  So, if we expect inflation to average 3% over the next decade, this forecast then predicts small positive nominal returns for US equities.  As you can see, none of the asset classes look attractive.  Even top performing timber is projected to return a modest 6%.  This is a result of "financial repression" and the major run-up in all asset prices over the last 4 years.

   So where should we have our money?  Grantham's forecast suggests that neither emerging market equities nor commodities are undervalued, but both areas look far more attractive than US equities.  I've been tip-toing in to emerging market equity, particularly China.  I've also been continuing to scale into commodity-linked equities.  I was a little early getting long natural gas related equities in 2012, but those are now paying off nicely, and I think the sector has a long way to run.  I'd also suggest looking at the mining and agriculture sectors.  My concern is that the credit situation in China leads to a mini-panic and sell-off in both emerging market equity and commodities across the board.  If that happens, I think both asset classes will represent a phenomenal buying opportunity.  


Sunday, November 17, 2013

Economic Commentary: Healthcare

  I attended a healthcare conference on Friday and learned a few things, but I'll start with a personal anecdote. I recently had my annual physical and received the itemized bill. The standard battery of blood tests cost $1300 as part of the Northwestern university medical system. My physician asked me to retake two of the tests because of lab errors. I'm on a high deductible plan and so I was curious if I could get the same tests done less expensively elsewhere. The exact same tests were offered at numerous labs around Chicago for $130. Why would any individual or any insurance company agree to pay 10x more than necessary for routine blood tests? How can such an enormous pricing disparity persist?

The Current State
   US healthcare spending is about double that of comparable countries with similar outcomes. A little bit of this difference comes from superfluous procedures and tests, higher medical liability insurance premiums, and hospital emergency room procedures. But the vast bulk of the disparity comes from higher prices on the same medications and procedures.

  The trillion dollar question is why do the same procedures and medication cost 2x-5x as much in the US as in other developed countries? 

Prices are higher here primarily for two reasons:
   1. Prices are not transparent.  This is, I believe, by far the biggest issue. A hospital in the US often charges literally 30 different prices for the same procedure to different constituents, and these prices are not public. Every insurance company receives a separate price, as do medicaid and medicare patients and the uninsured. This lack of transparency means there's no price competition. Consumers usually have no idea in advance what they will be charged for a procedure and so they can't comparison shop. This means that not only is there no competition between providers on price, but there isn't even any substitution. With price transparency, consumers would go to hospital A for the services it provides most efficiently and hospital B for the services in which it specializes, which would yield a lower effective cost of service, even if the prices themselves didn't change at all. In most comparable countries, there's some government entity that can see all prices and is able to purchase the healthcare from the most efficient providers in each category. This is also true with pharmaceutical drugs. In the US, two pharmacies within a 10 mile radius will offer the same drug at a 400% price disparity. The disparity persists because consumers don't know, and don't care. Which brings us to #2.

 2. No one pays directly. No one is simultaneously both incentivized and capable of being an intelligent purchaser of healthcare in the US. Consumers are mostly on low deductible plans or medicaid and medicare, and so most don't care about the prices they're being charged. Insurance companies are somewhat incentivized to negotiate for lower prices, but in many cases they can pass their costs on to consumers, and they're stymied in their ability to negotiate by consumers' preference for broad coverage networks. Insurance companies can't limit their coverage to just the most efficient providers, because consumers will buy other insurance plans that give them access to a broader network.

The Future
   The key trend in healthcare is towards choice. It's not clear if and when pricing information will become more transparent, but many other aspects of healthcare are becoming shoppable. There are now both public and private systems for rating doctors and hospitals and much more performance data is being collected by the government. This has created opportunity for startups that help hospitals improve their performance figures (like a company that is installing RFID sensors into soap dispensers to insure that all physicians wash their hands), as well as by 3rd party medical providers that now have the data to convince consumers they're better. The CEO of One Medical Group spoke at the conference; their tag line is, "The doctor's office reinvented." They provide more convenient care (e.g. offering consultations by skype to patients that would rather not trek into the office) that also provide cost savings (e.g. by encouraging earlier patient-physician contact, they catch problems earlier when they're cheaper to fix.) The battery of new data allows One Medical Group to provide a strong pitch to patients that the quality of care they provide is better than that of traditional, much larger institutions.

 The presenters at the conference all believed that sudden, radical change was unlikely. Rather they expected increasingly large cracks in the traditional healthcare model, cracks that will be filled by startups that treat healthcare like consumer electronics.


Tuesday, June 11, 2013

The Tepper Rally and the End of the 30 year Bond Bull Market

   From November of last year through May 22nd, equities crawled higher, slowly but consistently for a whopping 26% rally.  The last few days of the move were nicknamed the "Tepper" rally, because hedge fund titan David Tepper went on CNBC to explain why he was bullish.  The doubters were concerned that as the Fed tapers quantitative easing over the next year, the reduction in easy money may prove fatal to equities and possibly most other assets.  The Fed is currently buying $85 billion a month in treasury and mortgage securities and investors wonder how much of the equity rally was because of this buying and if it ends, will the equity rally reverse?
   Tepper explained that while the Fed will be reducing its stimulus, the size of the fiscal deficit is shrinking even faster.  The fiscal deficit has fallen from about a peak of $1.4 trillion in 2009 to $1 trillion in 2012.  Next year was previously projected to fall slightly to $850 billion but the latest estimates put it at closer to $600 billion.  This $400 billion reduction in the deficit from 2012 to 2013 comes primarily from an increase in taxes from higher personal income and corporate profitability.  
   From a basic value investing perspective, the market appears roughly fairly valued.  I think the greatest risk to equity performance is currently Japan.  Japan is the world's third largest economy and if it faces a crisis, the contagion effect will be drastic.  
   Bill Gross is the founder of PIMCO, the word's largest bond fund with $2 trillion in assets under management.  Gross recently said that he thinks the 30 year treasury bull market finally ended this April.  Over the last month we've seen a sharp increase in treasury shields, but they're still quite low in any sort of historical context.  Over the last 50 years, 10-year yields have averaged about 6.6% and they're currently 2.2%.  That 6.6% number is probably a bad anchor since it included the severe inflation of the late 70s and represents the period with the highest consistent GDP growth that humanity has ever seen.  Still, 2.2% 10-year yields are unsustainably low in any sort of growth environment.  
 Gross predicts that while the Bull market ended this April, the Bear market won't start for another 3 to 4 years.  He suggests a generally range bound market in treasuries in the mean time, albeit with higher volatility.  I think Gross is likely right.