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.