Holding-your-nose, or bidding-your-time. Pick your poison.

How long can this last...  After all, valuations are hugely stretched by any measure you can think of; there’s no disputing that. Not even the most steadfast bull could make a case that today’s market is cheap in some way. But does that matter? …

And that’s the thing; fundamentally, I think our market is absurdly priced. There are bubbles everywhere, … (but) extreme valuations can persist for a long time before something finally spooks investors into heading for the exits. And I’m not disputing that this is likely to happen at some point but I am saying that shorting the market or sitting in cash for years to wait for it is imprudent. …
 

Indeed, at this point, I’m not entirely sure what would actually bring about a sell-off and that is why, despite my bearishness on the fundamentals, I’m still in the hold-your-nose-and-buy camp.

Josh Arnold. Seeking Alpha (Emphasis mine)

 

“I’m having a hard time with this market because I can see what a powerfully stable social equilibrium is being established around this transformation of capital markets into a political utility. I’m having a hard time with it because, like any powerfully stable social equilibrium, to be truly successful in that world you must give yourself over to that world. You must embrace that world in your heart of hearts. …

I can’t do it. I can’t embrace the machines and the vol selling and the ETF parade and the central bankers’ “communication policy”. So I’m NOT happy. I’m 20+ pounds overweight. I don’t sleep well. I DON’T trust the Fed, much less love them, and I never will. …

So here’s my question. How do you survive, both physically and metaphysically, in a market you don’t trust but where you must act as if you do? How do you pass? How do you reconcile the actions and beliefs necessary to be successful in this market with the experiences and training of a lifetime that tell you NOT to act this way and believe in all this?

Accommodation to the Hollow Market is a miserable experience for discretionary stock pickers (and the same is true for any security selectors, whether it’s bonds or commodities or currencies or whatever), and the higher your fee structure the more miserable it is, which is why hedge funds have been particularly hard hit. Why is accommodation so difficult? Because the point of discretionary stock picking is taking independent, idiosyncratic risk. …

For the past eight years, whenever you’ve stuck your neck out with idiosyncratic risk sufficient to differentiate yourself and move the needle, more often than not you’ve been slapped around brutally for your trouble. So you stop doing that. … you effectively lock in your underperformance and pray for the Old Gods to return and unleash their mighty wrath on global equity markets. Of course, you’ll be down 50% of the market in The Storm, just like you were in 2008, but hey … at least that would give you a reason to come into the office. Anything but this. …

Ben Hunt. Epsilon Theory (Emphasis mine)

Don’t we all (particularly us males) love to think we are smarter than the rest of the pack? We elaborate sophisticated reasonings for the most pressing issues at hand. And we do well at that. If we had to judge market players’ expertise according to their capacity to construct and replace narratives as needed, then the EMH would be indeed viable. Sadly though, players’ capacity for narrative cannot be inferred and transferred to data or conceptual analysis’ efficacy.

We need more profound and unbiased analysis, less narrative, and an effort to keep things simple. Sometimes they are. Like today. Three decades of easy credit, easy money, and permanent ultra low to hard negative real interest rates have generated something really ugly. Now dubbed the “everything bubble”, it is also known as the mother of all bubbles (Saddam-speak), the big fat ugly bubble (The Donald), a permanently high plateau for stock prices (I. Fischer), or … you name it. The result is, in plain wording, a scary, extremely dangerous price environment for investable assets.

And we asset managers have to live with that. Unfortunately for us, this extreme environment begs some very tough heads-or-tails decisions of the kind I really hate. In such a bubbly environment, only four relevant asset allocation decisions matter. That is of course if he/she can afford to decide because passive managers cannot. And most active managers can’t either because of that frequently forgotten concept called career risk.

But if you can decide, you have to take a stance on these four issues. Very much like Josh Arnold and Ben Hunt, all of us active independent asset managers have to pick our poison. The good, safe options dissipated in a central bank deceptive nebulous long ago (not to be confused by the technological cloud where things are supposed to be safely kept).

  • First of all, we need to answer a primary question. Will we be able to reflate ourselves out of debt (explicit debt and off the books entitlement contingencies), without a bust?
  • Second: if the previous answer is a positive one, we must take a warm attitude towards risk. But, if it is negative, should we stand-aside-and-wait (with a more or less active bearish stance), or should we “hold-our-nose” and “buy-and-hold” for as long as we dare?
  • Third: if we think the credit bubble will not burst, or if we decide to hold our nose and go long equities anyway, should we opt for active or passive management?
  • Fourth: In order to obtain some additional return on top of the negligible level of risk-free rates, is it best to overweight bonds (currency, credit or duration risk), or stocks (beta, alpha, or both)?

I have already answered the first question many times over. Sorry for tooting my own horn, but I’ve been proved right up to now. Nobody knows what the future will bring, but I am confident that GDP growth will not bail us out.

My only doubt is if it is possible that, faced with a round of global debt defaults, CBs will manage to activate goods and services inflation, as opposed to asset inflation (see Goldman Sachs chart underneath) -and dilute our debt. I think it is unlikely that they would manage to induce a controlled amount of inflation and sustain it long enough. The odds are stacked against such accuracy, and some episodes of hyperinflation would be unavoidable. But there would be no bust and rare defaults. Inflation and debtors are BFF.

High inflation with bouts of hyperinflation, if achieved, would be no final solution to our woes, but … who cares! Nobody seems to care about long term fundamentals anymore. We are all buying time. In fact, life is all about that. Maybe we should use this mantra and apply it to economics and investments. It would be very Keynesian: the long term doesn’t matter because we are all dead.

Investors are still die hard Keynesians -or maybe they have just switched over to a new discipline: surf-investing. Only today counts. If they can buy USD denominated, one hundred year maturity, unsecured Argentinian bonds, then we are not looking for final solutions -but rather trying to kick the can down the road as far as it will go.

Yes, the Argentinian bond issue went three times oversubscribed, and I doubt anybody thinks that it will be honored at face value in 2117. Investors pick up the yield and feel comforted by the fact that recovering the principal will be somebody else’s problem. It sure will. When you see things like that, there’s that gut feeling that the end has to be near!

The second question is a difficult one to answer. I can’t share his reasoning, but maybe Josh Arnold’s decision to hold his nose and buy (top quote), is appropriate, to use Janet Yellen’s preferred vocabulary. She always finds her opinions appropriate. I find them dumb even though you have to credit her with a lot less hubris than her predecessor. As for me, I just hate to hold my nose … because I can’t hum. Humming and whistling along is essential to my happiness.

Seriously now. I just can’t sleep properly holding Amazon at 150 times earnings or Tesla at infinite times earnings. Hey, I have nothing against infinite -when in it is not referred to an investment valuation ratio. Infinite wisdom or infinite happiness would be great! But I digress, don’t get me wrong about those companies: both are truly exceptional even if I doubt the survival of the latter. Nonetheless, there is a reasonable, sustainable valuation for everything even if it doesn’t show in the market. We should always remember that price is what you pay but “value” is all you get. Momentum is only transient value: timing is everything. You have to remember that if you hold Tesla. At least Amazon has a sound business model with decent entry barriers (to put it mildly). Tesla will have to compete with the large automakers!

This issue is a tough call. I got it wrong until now. For nearly ten years I could have profited from the most obscene bubble in the history of humanity and I did not. Thankfully I made money elsewhere (bonds and currencies). Nevertheless, you have to update your stance every now and then. I do it constantly, but my stand today continues to be “no”. No way I am going to hold my nose and hold equities at these valuation levels and current debt reset risks. Yes, I am aware that there is a residual risk that CBs might get themselves out of trouble reducing the debt pile with no disruption. I will undertake that tail risk.

Why do I think we will not dilute debt with growth or inflation? Well, I explained that in my last post. My reasoning could be flawed, but I am confident that I got this one right. It is another issue altogether if this can be prolonged for another decade. I would have said no to that one a mere five years ago. Facts have made me change my mind, or at least doubt my timing.

Not that I can see this going on for long, but I also lack an immediate catalyst for an abrupt end to this fantasy. It follows that I have to be cautious because I got hit this year by the joint effect of the Chinese 2016 credit boom and the ECB-BOJ massive monetization. The lesson? You never know how much more printing and “crediting” we can take on board before we go under. Sometimes you have to be a coward and preserve some firepower. This might still go on for some time, but I doubt it. My female side tells me the end is not far off.

The third question is an easy answer. In this context, if I wanted to hold equities significantly I would go for passive management. Sorry colleagues! With stratospheric valuations, I do not think stock picking adds a lot of value. I love stock picking myself, even if I am now focused on macro and global strategy. My background is not quant oriented but that of a discretionary trader and investor. And I think stock selection it is the way to go in normal market conditions. But these are not standard fare markets. I even doubt they can be labeled as markets to a full extent anymore.

I would not go passive in my bond selection, but holding equities is a different matter. With equities, your beta is going to be 80% of your performance, and the universe of stocks to invest keeps falling as the “winner takes all” economic model takes its toll on most sectors. If I want to hold US banks, I would go for a sector ETF and remain as liquid as possible in this highly unstable global environment. The same strategy is valid for utilities or consumer staples to name another two sectors. Unless you are a picker in very specific sectors like Biotech or start-ups, stratospheric valuations make active returns at best indistinguishable from passive returns.

What about beta neutral and alpha only (balanced long-short or long alpha index hedged)?Current markets do not offer a pricing efficiency that can generate reliable alpha. And any alpha to be found is infinitesimal compared to the beta risk of your portfolio. Tinkering with your alpha while hedging your beta is not attractive because there is not a lot of upside and hedges would not be all that reliable in a global reset. And long-short strategies have been crucified by position crowding and CB induced stop busting.

I hope all of that changes soon, but for the time being it is all about knowing the exposure you are willing to underwrite in the everything bubble. Forget the subtleties and get the big picture right, or else you will not survive the implosion of the era of the central banker -when it comes if it ever comes (my faith in a return to sanity in global markets wanes and ebbs away daily).

Lastly a few thought on bonds? Sticking to the US (European sovereign spreads are not market spreads at all thanks to the ECB), fifty percent of the market says pricing is bubbly, and another fifty strongly suggest that the lows in ten-year yields are yet to come. The market was ultra short ten and thirty-year Treasuries in January and then flipped to the other side in May. Lots of money was lost in slippage and stops. All that money is in broker or ETF’s pockets now. We, active managers, are close to extinction. I can’t take comfort in the fact that my grandchildren will see a wax prototype of myself and colleagues in a museum, a couple of decades from now. I hate wax figures!

In the short run, I still take sides with the Ice Age hypothesis, but not without some caveats. A substantial part of our unemployed has become unemployable. Our low-skilled segment of the global workforce (a growing segment) is rapidly becoming obsolete. How do you introduce this concept into the NAIRU calculation? Not that I ever thought that you could nail NAIRU with a reasonable degree of accuracy. I think the Fed is getting one thing right: they have to tighten and reduce their balance sheet. Better late than never.

  • Employable worker slack is very tight, and the real cost of living, if you use reasonable weightings for shelter, healthcare or education, is soaring. No wage inflation to be seen just yet (I confess to being surprised) but …
  • And financial instability is atrocious despite, or maybe because of, ultra-low VIX readings and low spreads. They have to tighten financial conditions asap.

In the long run, it all depends on the attitude of CBs when they have to pick their poison. At some point, they will have to print to death, regardless of hyperinflation or whatever, or sit back and accept the global debt reset. Minskian Ponzi debt levels are a larger portion of global debt with every day that passes. In a global default wave, you get rid of all Ponzi debt and then some. I am not sure that CBs would accept that without going Bolivarian. I would only hold very long durations in futures, and then, with conveniently placed stops. Cash markets could become very illiquid if the market smells something remotely Bolivarian.

I said I would not accept passive investment in bonds because credit risk is the one I would like to monitor very closely. I could accept the risk embedded in the run of the mill duration of bond ETFs, and even their currency denomination risk. But credit risk is something to remain particularly active about. Some sovereigns are highly unlikely to survive.

All in all, this is getting more and more difficult. In two weeks time, I will comment on the USD, the yuan, and some trades. Something more specific. For today, the same as in my last post, I had to stress the big picture options. You just have to get them right. And I have to keep this post short. I am leaving tomorrow for an important Mediterranean regatta. I plan to enjoy myself: life is oh so wonderful that you can never get enough of it!