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.
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.
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.