At times like these, it’s essential to understand that risks don’t come from what you see and understand, but rather from what you are unable to see or understand. This pattern has repeated itself every time a crisis has hit the markets: you never see it coming.
The Direction of Markets
Earlier today I published a rather long post on Linkedin in which I basically argue that, on close inspection, most investment portfolios are poorly constructed because they are overly reliant on getting the direction of markets right. Also and related to this, most traditional portfolios are not properly risk-diversified or hedged. (This is not just my opinion: It is consistent with quite a lot of academic research and as important, the insights and core principles espoused by the most successful of market veterans.) Just as worrying, the advisors that manage these portfolios are so wired to think about price directionality that they can be easily spooked in a crisis.
I worry that too many feel they have seen this before. Too many have been successful in buying prior dips and have become conditioned to think they do know what will happen: The fed will come in, asset prices will stabilize and run up again. Again, they disrespect the very nature of reality -that the future is always uncertain- especially at critical junctures. They speculate assured they will be right. They might. But they also might not. My point is that risking such binary outcomes with other people’s money is outright irresponsible.
We do not need to be certain about the future to manage an investment process and make decisions. All we need to realize is that there are many ways the future can turn out, think very carefully about the different scenarios, cognizant of the hypothesis and assumptions that drive our approximations and biases. Then follow your discipline calmly, diversify risks-types, size your positions and trades appropriately, and hedge.
In my text this morning I also layout many of my concerns about the current situation: Both the global economy and the financial system (the structure of the system) have been growing very fragile. The “only game in town” as Mohamed El Erian, William White and many many others have been arguing for several years have been Central banks. If this basic market belief is tested and proven illusory, this can get very VERY complicated.
As I write this note (Sunday, March 15th in the evening), the FED announced it is marking down rates basically to zero, announced a massive $700 billion QE, and showed coordination with global central banks regarding support for global dollar liquidity. Yet, US Markets are again trading “limit down.”
Please tread carefully everyone. We might be entering unknown territory.
Best of luck,
Founder and Chief Strategist
Harbor Ithaka Investment Management
Making sense out of no sense
Investing is about having a proper strategy. Most investors don’t know how to tell the difference, so they end up overly exposed to the wild gyrations of markets.
Risk Markets in Stress Mode.
Treasury bonds hit their lowest yields ever. US stocks broke down, hitting daily numbers that are surprising to many. Stock volatility has broken through 2011 to hit the highest levels since the Lehman Brother’s bankruptcy in 2008. Corporate bond spreads have burst higher; and not just high yield, but spreads throughout the investment-grade space have cracked down, while a number of other signals suggest that credit market liquidity has begun shutting down. Emerging Markets buckled. FOREX markets have hit the skids.
The Fed lowered rates in an emergency meeting. February US unemployment figures were apparently stellar, but risk markets kept dropping. The Fed intervened aggressively again, this time in the overnight funding markets, and reacting to treasury markets showing severe signs of stress, followed up with a commitment to buy over $1,5 trillion in treasury bills. Sometimes, it seems good news is suddenly no longer good enough. Then the sharp snapbacks. Are these dead-bouncing cats or reinvigorated bulls?
Where do we go from here?
No one knows. No one can know. These serious events could trigger a series of cascading second and third-round effects that could degenerate into something much worse and hard to bounce back from in anything shorter than several years.
The double driven COVID-19 / Oil Price-War market crash happens to hit the world at a particularly delicate time: characterized by high valuations across risk assets and unbelievable levels of crowding and leverage among market participants as well as the accumulation of secular fragilities, including never before seen levels of global debt, a very recently traversed 18-month steep growth slowdown (from Q3 2018 to about Q3 2019) which was ostensibly only averted -let’s not forget- by very aggressive FED actions all throughout 2019.
Think of the never before seen levels of US corporate leverage, or of the amount of global debt in general: There are trillions of dollars that need to be refinanced in the next 12 to 18 months. Or the impact of the aging of baby-boomers, both in the US and the rest of the developed world, who as a generation, both through their investment accounts as well as beneficiaries of juicy, yet largely underfunded pensions schemes, are becoming natural marginal sellers of risk assets. Throw into this mix, uncertainties related to the growing number of industries facing technological disruption -business moats that might not be so protective-, and social-political as well as geopolitical shifts which are of uncertain impact.
Then consider the important yet barely understood changes in the underlying market structure of the public markets: The regulations, market piping and overall incentives guiding new types of market participants, corporate stock buybacks, ETF and algorithmic trading, the belittled role of active managers, and the questionable robustness of levered institutional strategies; All these pose another set of worries, this time not about the direction of the game, but about the instability of the game itself.
And to top it all off: As the marginal utility of debt in real economies throughout the world has been seriously weakening, there has been an intensifying questioning regarding the efficacies of monetary policies deployed since the global financial crisis. Academics, market pundits, even Central bankers have been warning their tools cannot be counted upon to avert another recession. Shared discourse matters as it drives market participant confidence; or so argues Professor Shiller.
Clearly sudden economic stops and the severe loss of revenue threaten highly levered business plans, not to mention leveraged investment strategies. Lowered revenues hit profit margins reduce dividends and buy-backs and very probably triggers credit rating downgrades. Higher costs of refinancing and falling equity prices heighten corporate stress. Then, those who need to sell in stressed markets, sell what can be sold, typically the best stuff, not exactly what they would like to sell so that the falling prices of tenuous assets end up pulling down the prices of the healthier ones. Fund redemptions can be more aggressive than managers of supposedly liquid vehicles ever plan for. Again, one fall drags the other. In a levered system, these cascades feed upon themselves: Note that every highly-priced asset sits as collateral on someone else’s balance sheet.
“Priced to perfection” implies nothing can go wrong. That is equivalent to no plan at all.
Or… Perhaps, political authorities might finally get their acts together and with monetary authorities coordinate the equivalent of trillions upon trillions worth of “helicopter money” and keep the system greased up enough to avert disaster one time more and convince investors to spike things back to nosebleed levels. Germany (among countries!), seems to be doing just that; Perhaps it is widely copied.
So… Buy? Sell? Head-in-the-sand and wait it out?
(You should have started with a good investment strategy. But most do not know what that looks like.)
Have you ever understood the point that asking the wrong questions begets the wrong answers?
Every couple of years, investors face the poignant and inescapable reality that the direction of markets, of the global economy in general, is entirely uncertain. (I challenge you to find one economist, central banker, investment manager, even among the very top, who has a consistent record.) Facing it, investors get nervous, many panic, change strategies, fund managers, advisors and banks all the while missing the key point that the deep-seated problem festering within their portfolios, as in most portfolios and the investments strategies that make them up, is that they are over-reliant on getting the direction of the various asset markets -the future- right.
Note that this is how most private bankers or investment conferences start: “Our outlook is X and Y, and therefore, and because it is sensible -and sounds eloquent- we think we should position your portfolio this way.” (Worse: This is what the buyers of investment advice buy: When it comes to money -hard-earned dough- the brain demands nothing less than certainty.)
Well wake up, sip the coffee: There is no such certainty to be had. The precise point of proper portfolio construction and risk management, especially when it refers to private wealth, must be to manage uncertainty and this is very different than guessing market directions.
Time ends up exposing the deficiencies of most traditional portfolios. Some seemingly sensibly “diversified” portfolios work poorly, with too many of the losers trumping the effect of the winners, and neither the diversification nor the “rebalancing” really helping because what is being attempted time after time is to improve at the guessing about what will go up the most the next time around (and perhaps, some attempt to guess what will not correlate with which other assets). Other portfolios -full of risk- simply rush up in one direction (although typically less than what the risk taken should have generated) only to then crash and burn.
Inexorably, most assets tend to move in the same direction especially when things get really, really bad: It’s an airbag that works only if you crash at under 30-mph. The only plan left then is to hope everything bounces back.
It may be that a 50-year bull market in all types of financial assets, from US Treasuries to stocks, from credit to private equity has made this guessing-the direction-formula seem benign: “Buy the dips.” “Hold, because in the long run…” economic growth, with little help from the FED -or a heck of a lot-, will always be there to induce the market rallies and bail investors out.
Look closer at the historical evidence: It does not always corroborate such heuristics. Especially when prices are way out of whack with fundamentals. Or when, like now, there is an exogenous shock. Or when an important macro-shift that has been building up suddenly starts becoming apparent. Go check the historical record for periods when equities wobbled around taking six, nine or even 14 years to recover their real value. (After over two and a half decades, the Japanese stock market is still trying to get back. OH, Right: that cannot happen here. Worse Still: My bank, advisor or consultant will know when to get us out. Still thinking some do know).
So, what if more debt finally does not help; if monetary authorities are really losing control. (That the repo and Treasury markets have been coughing up ever more greenish-yellowish stuff is no joke).
Again, it is difficult to say. But it is a risk. And your portfolio has got to be able to withstand such a crisis. (Can it?)
Sometimes paying 18 to 20 times forward earnings for stocks following strategies such as “buy the dip” and cheap fallbacks such as “stocks, in the long run…” should not be so reassuring then. That the market can be more irrational than investors can be solvent applies as much to the shorting bear in the bull run, as it does to the hoping bull in the bear trap. As Keynes would have us remember: “In the long run we are all dead,” which is pertinent, because most money needs to be spent before that and if the assets in which money was supposedly kept to grow in is severely devalued, then spending needs to be adjusted.
Unnecessary Nonsense. (Let’s recall some basics.)
The point is that the well-constructed portfolio should not have to rely so much on the directionality. And that it must survive even the worst of shocks; Best if it could coast through and even thrive because of the shocks. Should not a portfolio strategy assume and be prepared for crises and unprecedented shocks? That hard-earned money should be that important. Or does the excuse “we really did not see that one coming” resolve the practical mess that is left.
So instead of looking for better guessers – better salesmen and women of confidence- investors might do better seeking those who know they cannot know. Read through the biographies of any of the great masters of the investment world and you’ll see this theme repeated: They are humble, confess the limits of their knowledge and invest accordingly. They embrace uncertainty. All of them will assure you that this is key to their having learned to thrive.
Investing is -has always been- about identifying intrinsic value and discounting cash flows. All that needs to be understood –relearned– is that market prices are not the same as intrinsic value. Market prices are only reflective of what the last marginal buyer just paid for the asset:
They are not reflective of the reasonable buyer, not even the average one! If monetary flows push money in if desperate Japanese pension funds think that US equities are the least worst thing, and 10-dozen algorithms feel that directional buying and simultaneously front-run-it via ETF futures while other algorithms step out their way (evaporating the sellers), well neither the price action or the level, have anything to do with intrinsic value. Has it not seemed curious to you how often uncle Buffet says “I really do not care much about market prices.”
Nor do prices reflect what perfectly rational and omniscient information processing people could agree upon as many textbooks still suggest. That is fine in the classroom, not reality. The market is not efficient. Not all of the time. And when it’s not, which -ex-ante- will always remain a mystery, it tends to run over many investors. History shows that much. With frequent periodicity.
A Smarter Strategy.
While most risk assets and long-focused managers only offer traditional exposures to market betas, there are more efficient ways to improve portfolio construction. This is not nearly enough.
A key part of the investment discipline at Harbor Ithaka is looking for intrinsic value; Investing is about discounting cash streams; an important part of risk management is about properly gauging the visibility of those future cash streams. We seek asset classes in which the disturbing volatility of the spread between prices and intrinsic value is more subdued than that which has characterized the public financial markets during the last 25 years. Then we work hard at harvesting return and controlling risks.
Another key is diversifying properly. This means diversifying risk-types, not just asset classes.
Take liquidity, which most everyone assumes is a good thing. If everyone piles into liquid vehicles that hold assets that are less liquid than the instant liquidity they promise; If important groups of the buyers of these liquid vehicles are trend loving computers and investors who in their reaching for yield are entering new markets the risks of which they do not really comprehend; If regulators have taken out the market makers, and there are less active investors who actually work to estimate intrinsic value and will step in to buy when they see prices that are justified; If the markets in which the instruments these funds invest in, have been for years evidencing volatile levels of liquidity, then there is a problem and certain types of “liquidity” are not so favorable. Such is the case with corporate bond and high yield ETF’s and UCITS that regulators and investors so love.
Investors need to dig deeper. Risk is not just backward-looking volatility. There is a myriad of risk types and most of these are not constants to any asset class. And they need to be properly managed and diversified.
The 2020 crisis and Harbor Ithaka’s strategies.
We, our funds and managed account clients are doing well. But it is not because we are smarter at timing or have a better macro framework. It is mainly due to the two factors enumerated above (and rigorous discipline): We search for and invest in asset classes and sub-segments that offer better access to intrinsic value and good visibility of both the cash flows and the different risks to those cash flows. Then design investment strategies that seek to keep the different risk types that are assumed, well-diversified. We simply opt-out from playing the guessing games, the short term rushing and, yield-reaching. And still, we remain prudently opportunistic and hedged for crises at all times. All along, the focus is on the risk that we are willing to take to collect on the returns streams available in those sub-asset classes. Risk discipline requires that we not overpay; And have a bit of patience as well.
We believe that investing is a long game in which patience and consistency are rewarded with the effects of positive compounding (something really only possible if the drawdowns along the way are very shallow). And although investment strategies should both display patience and be prudently tactical when prices align with value, investment portfolios cannot be short-term minded. Investors should learn to know the difference.
At the end of the day, our concern is making sure that the wealth (and well-being) of the end beneficiaries that are invested in our strategies and portfolios is improved. Why else exist if we cannot offer a real contribution to our community. We would be nothing more than another set of yapping ties.
Founder & Chief Investment Strategist
Harbor Ithaka Investment Management