Fault lines and opportunities
(the next +/-50% for the stock market)
Summary: 1) a short update of my (poor) adherence to this year’s plans, 2) the equity bull case (+50%?), 3) the bear case (-50%?)
Featuring: why Goldman Sachs considers a hard landing in China a marginal event
Conclusion: I’m still net short the stock market, but gradually less so, as I keep finding better investment opportunities in unlikely places outside the public space.
Winners decide more often
(losers keep New Year resolutions)
First things first:
I’ve already done some for me unexpected reshuffling of my investment portfolio, despite aiming to trade less in 2017, not more.
For example, I’ve increased my positions in GIG (online casino platforms) and Stockwik (a tiny investment company), sold a little in Peptonic (oxytocin pharmaceuticals research company), and bought a significant amount of GDX (senior gold miners, see next paragraph). I’ve even bought some BrainCool again (cooling technology to reduce infections), not to mention URA, the uranium ETF.
I thought I had outsourced my gold exposure once and for all, but it turns out, “Canada” hasn’t invested my money yet (that’s been a good thing so far, but I’m getting worried a serious gold rally is about to get underway).
All of the above, as well as lending out more money for real estate projects, mean I’ve reduced my OMX short position yet some. I’m actually no less bearish than before (read the rest of this article and you’ll see). It’s just that I think I’ve found better investments, probably due to my investment fatigue receding after a few years off.
To lift or not to lift
In other news, I’m already having second thoughts about my exercise regime for 2017. Instead of going after PB:s in benchpress and deadlift, I’m entertaining thoughts of bodybuilding or even going back to martial arts after a 22-year hiatus.
It’s a principle of mine not to pay much attention to my younger self, no matter how recent his plans are. Winners decide more often.
Reasons to buy this market
Sharmin at Goldman Sachs recently (g.s. podcast) elaborated on her reasons for recommending U.S. stocks in 2017.
The perhaps most retarded argument was that “although stocks have only been this expensive 10% of the time since WWII, selling at the current valuation level would have left a cumulative 200% return on the table over the last 72 years“
In effect she would have recommended buying at the arrows, since there actually was a little upside left before the crashes.
Not only was the risk /reward ratio retarded, but capturing a cumulative return of 200% over 72 years amounts to a measly 1.54%-2.78% per year, depending on the method of compounding. Considering a typical 35-50% downside from peak valuations (top 10%, remember?), the all but negligible upside she’s talking about seems more like a perfect trap than an opportunity.
A hard landing in China would be a “marginal event”
The second most retarded thing was stating that: “We actually see an impact (at all), if there is a hard landing in China, despite the direct U.S. exposure to China being a marginal 0-1% in terms of, e.g., exports and profits”.
Pretending to be overly cautious and responsible, Sharmin said that there are other market-based and sentiment factors and quirks to take into account that could have an impact, even if China’s economy crashing in and of itself would be irrelevant.
Sharmin half empty
Sharmin actually demonstrated a couple of important points on macro analysis in her Exchanges interview, not least the issue of cherry picking, as well as how you can always choose a positive or a negative macro spiral, no matter the starting point. Macro feedback loops, no matter if positive or negative, are typically self-reinforcing, rather than stabilizing and mean reverting.
Macro research can always go any which way you’d like
When discussing macro variables, there’s always a discretionary choice of whether to assume the variable at hand will continue its trend or mean revert, and whether a high level is good, or implies a risk of going lower:
Low unemployment was a good thing in her view, but at the same time she thought a low job participation rate meant there was plenty of room to grow.
You could just have well said that the low UE rate could go higher (bad), or that the low rate in itself could cause inflation (bad).
In a similar fashion, a low participation rate could be interpreted as large cohorts of the population having obsolete skills, and thus being a long term burden on the economy (bad). Even worse, the trend toward lower participation could continue (bad) due to, e.g., an accelerated pace of automation and export of jobs.
Productivity growth is the most important variable for economic growth and rising living standards. The last ten years it has fallen to below 1% per year, from earlier levels of 2-3%. Sharmin predictably assumed it could magically rise again (good), despite all the low hanging fruit (leverage, cheap capital, the IT and internet revolution, globalization etc.), of the last 10-20 years having already been plucked (few easy wins left=bad).
Sharmin pollyannaishly assumed higher productivity, higher gdp growth, higher job participation rate, low inflation, low interest rates (positive returns on bond investments in 2017), and on and on.
Further, although she admitted the upcoming French elections might be a small risk, she thought Brexit was a marginal event since the EU would take a tough stance to prevent more countries from leaving. Pretty naive, in my humble opinion. She may be right of course, but in my view a hard stance against leaving could ignite a non-trivial level of nationalism and voices for leaving the EU and euro.
Summary of the positive view
- Productivity and growth accelerates: they admittedly are at very low levels and could bounce back. The last Philly Fed reading, e.g., was quite positive
- Profit margins remain at record levels, or increase to new highs: they have already climbed this far and stayed higher for longer than expected so why not even higher or longer? Accelerated automation could have that effect
- Interest rates remain low, perhaps fall even lower: again, they fell this low, so why not even lower? Resuming/accelerating QE and even lower policy rates could make bond yields fall back from the recent surge
- Trump optimism prevails throughout the year, making equities the asset of choice, providing support for record high valuation multiples.
- Capital inflows (due to repatriation as well as follow-on capital) boost the economy, stocks and the dollar. Despite low interest rates, the dollar keeps appreciating due to tariffs and repatriation efforts. A strong dollar attracts foreign capital and flows into both the economy and the stock market. The Swedish stock market follows suit as always, not least helped by a strong dollar boosting our export companies, but mostly just mirroring the S&P 500 index as per usual.
Tweaking the above variables for the better, it’s not at all impossible to imagine 50 per cent higher stock prices over the next three years. If the average investor can’t conceive of an alternative to stocks, then there is in fact no alternative. It does take quite a leap of imagination though.
Fault lines – the cautious view
There is a a plethora of things to invest in this year:
- peer to peer lending (Lendify, To Borrow etc. offer ca. 10% annual returns)
- semi-private market places (Pepins offers stocks in a stream of small and promising local private companies)
- crowd funding (Kickstarter, e.g., where you could really channel your inner Peter Lynch and buy whatever product interests you and your friends)
- venture capital (for accredited investors there are endless possibilities)
- record number of IPOs (even the ordinary retail investor has a lot to choose from, albeit often loss-making)
- real-estate projects (Tessin’s cases often offer 10% yields)
- House and apartment prices are soaring (at least in the US and Sweden)
- Gold has corrected downward, and might bounce back up soon (I think so)
- Crashed southern European stock markets (national markets rarely fall more than 90-99% before bouncing hundreds of per cent)
- Stock markets in general are trending higher, rallying to new highs and indicating a strong appetite for risk, despite a slightly less dovish Fed and record high valuation multiples. Why not follow the trend for a while?
What could possibly go wrong?
Well, there are a few danger gauges that used to be useful that are flashing red:
- Flat yield curves point to low growth or recession (however, central bank policy have distorted the yield curve to irrelevancy so it’s hard to tell what the yield curve is saying)
- Market internals are diverging. The bull-market pattern of indiscriminate buying of all things is breaking down. When valuation ratios and price trends for various companies, industries, sectors, asset classes and regions stop moving in concert, it’s typically a harbinger of a trend change from bull to bear. Further emphasizing the divergence, the market advance is narrowing (see advance/decline measures), and investors are rotating more intensely between sectors in search of what few investments and strategies that are still working.
- Interest rates are rising (it could reflect better growth, it could reflect a budding inflation. No matter which it is, together with the other gauges rising rates year-over-year typically signal weaker markets ahead)
- Rate spreads are widening (meaning smart investors, that worry about the return of their capital rather than the yield on paper, are selling or hedging their exposure to riskier debtors)
- Buybacks and insider purchases are at highs (insiders are typically at least as “stupid” as the average investor when it comes to euphoric buying at market peaks)
- NYSE margin debt is at highs (whether measured nominally or as a ratio to market cap. high stock market margin debt signals pak optimism and creates a vulnerability that feeds on itself as a price drop begets forced selling and yet more price falls)
- Government debt and corporate leverage are also at highs, only sustainable as long as interest rates are held at zero. Sure, there is no reason why the current situation where central banks are holding themselves and their countries up by the hair can be prolonged indefinitely. It’s just that it has never worked before.
- In-synch: Individuals, corporations and governments are already stretched in terms of debt burdens, meaning all sectors wold struggle hard in a downturn. In addition, the world has become more synchronized than ever before, and there are no new BRICS countries left to halp pull the global economy out of a tail spin should it commence
- Real market liquidity and trading volumes have dwindled, despite a new generation of happy, carefree newbies that thrive on back slapping internet forums and have never seen a market downturn, let alone a serious correction or crash. 80-90% of the trading volume is mechanical, algorithmic computer trading that could disappear overnight, not to mention start playing the market on the downside.
- The median valuation on the US stock exchanges is the highest it has ever been, despite rapid technological evolution causing a higher churn of companies in the top 500.
- Speculation and malinvestment. Ever more resources have been poured into speculative activities (financials and rate sensitive industries) rather than actually productive endeavors. In parallel, ever more debt has been used to prop up asset prices. Both these trends have acted together to set the stage for much lower economic growth as well as asset valuations going forward.
- Record high profit margins. Sure, profit margins can go even higher – technology, globalization, low interest rates etc. – but over the last century, and basically as long as there has been capitalism and more or less free trade, margins have been reliably and strongly mean reverting (coming back down to average levels), not to mention inverting (periodically undershooting their long term average – which is a mathematical imperative, lest the average permanently shift upward). All this means profit margins (and profits) are due for a significant drop
Other known fault lines include:
- China’s build-up of bad debts in the wake of unprofitable infrastructure products. Whenever a country has increased its debt ratios as quickly as China, some kind of financial crisis has followed
- Brexit paves the way for more exits and a collapse of the EU
- Unusually long time since the last cyclical downturn typically means there are widespread fault lines throughout the economy
- Record high amounts of covenant light loans (i.e., debt with relaxed safety measures and collateral) signals any and every investment gets funding and thus inevitably many unprofitable ones (malinvestment)
- Record high number of IPO’s with loss-making companies typically coincides with market peaks.
- Flash crashes
- Desperate central banks (negative rates and QE, hello!) signal something is afoot
Known unknowns should be discounted at all time
Those were the known knowns, i.e., indisputable facts that are out there for everybody to see.
In addition to those, there are unknowns that manifest from time to time, and thus can be considered known phenomena. It’s just that we don’t know when they’ll strike, or how hard; although we can be fairly sure they will during the typical 25-50 year period duration that equities exhibit (currently closer to 50 years).
This category includes for example the following power-law distributed occurrences:
- war – should we extrapolate the unusually peaceful period, or expect some kind of mean reversion?
- natural disasters: earth quakes, tsunamis, extreme weather, volcanoes
- ponzi schemes
- pollution, spills
- product recalls
- Airborn pandemics
Ideally, all of the above should be discounted in today’s stock prices. We know they will happen every now and then over the coming 25-50 year discounting period, and thus should be taken into account by any serious long-term investor. Surprisingly enough, that’s typically not the case, except for some time right after a catastrophe.
As if the known fingers of instability weren’t enough, despite having sown the seeds of future financial earthquakes and avalanches, there are the unknown unknowns and black swans to take into account as well.
The reason stocks on average are priced at levels promising some 10 per cent returns per year is that known fault lines sometimes trigger negativity and significant downturns, that known unknowns more or less regularly reduce sales and profits or even cause financial crises -and that sometimes, albeit vary rarely, something completely new and terrible strikes.
Every once in a while (e.g., 1929, 1972, 1987, 2000, 2007, 2016?) the investor collective forgets why stocks are “cheap”, when they seem to always promise better returns than other assets. Not long after they are often reminded of why, i.e., that inevitably bad things happen to good stocks and thus should be discounted beforehand. And you, you shouldn’t buy stocks for the long term unless their price reflects that reality. Sometimes that means waiting for several years, or having to look in unfamiliar places.
Again, there is never any reason to hurry when investing in stocks. Every new generation gets its opportunities. The most important thing when investing is the price you pay -not how early you get in. Make sure you pay a price that compensates for future shocks. If you don’t you’re really just picking pennies in front of a steam roller and hoping for the best.
P/S-type multiples are twice what history tells us is reasonable. Once a re-set gets underway, the market often undershoots (it has to, at least sometimes, due to math), but I would nevertheless start buying publicly listed companies in earnest 50% lower than today.
That, however, doesn’t mean I don’t try to find something else to invest in in the meantime.
Summary: Why I’m short (but less short)
Short: Record high valuations and multiple macro fault lines, in combination with risk aversion gauges in the form of increasing divergence between various market variables
Less short: I’ve found other offers that were too good to refuse, not least my investment in a private motorized watersports start-up. Expect to be wowed sometime around this summer.
In addition, my market fatigue since my time as a hedge fund manager is diminishing, which means I have more interest again in managing my money more effectively than just keeping a single large and quite expensive hedge.
Finally, I’ve partially given up, due to the market’s strength prevailing longer than I ever considered likely. I’m actually looking to places like Venezuela for inspiration of what might happen in the west. You wouldn’t have wanted to add insult to injury by being short their stock market the last few years.
Where I see opportunity: southern Europe, private companies, gold (negative real rates, streamlined mines, correction coming to an end), Swedish house construction, true innovation, true growth niches.
I’m not entirely sure about stocks in Japan and parts of SE Asia, or bonds.
That’s it for today.
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