This week we visit perhaps one of the more contentious topics within the context of modern day investing. That is the role of price discovery and fundamentals in today's investing world. Talking to both existing and potential clients on a daily basis, I constantly hear people coming up with doomsday scenarios and/or rules of thumb that don’t seem to work. It is rather frustrating.
How is it that valuations continue to go up, the NASDAQ and the S&P keep hitting all time highs while, at the same time, we are seeing the highest unemployment levels in modern history, earnings uncertainty continues to paralyze many investment managers and previously inconceivable levels of fiscal stimulus are dished out on a seemingly daily basis?
Bear with me and take my comments with a grain of salt since I do have an incentive to make the case for being invested. Not only that, I am also firmly in the camp that markets can stay irrational for far longer than people can stay solvent (not that I necessarily think that the current environment is all that irrational). In making this argument I shall also borrow heavily from a man I personally admire, and one you might very well be familiar with through the 2015 Oscar-winning film 'The Big Short' (or Michael Lewis’ 2010 book), Michael Burry.
At TAMIM, one of our more consistent beliefs (and we do have lively discussions - some would say arguments - around these) is that investors must always challenge their paradigm. I won’t get too deep into it but for those of you who are unaware of Thomas Kuhn and his ‘The Structure of Scientific Revolutions’, it’s at least worth a Google. Speaking more toward science, he highlights the concept of a paradigm shift, a fundamental change in the basic concepts and experimental practices of a discipline. Very simply put (or as simple as we can make a complex philosophical theory), he posits that research and practices are conceived of and undertaken to fill out (and fit within) the current dominant paradigm, i.e. people operate within the set of rules and principles that they know and accept. But our paradigms are not perfect, they will have intractable problems that result in anomalies. Eventually these anomalies will trigger a shift in the dominant paradigm. If you want an economic example, think the Keynesian Revolution following the publication of 'General Theory' in 1936. Keynes' view that demand, not supply, is the driving factor determining levels of employment replaced the neoclassical understanding of employment and has been informing economic policy for almost a century. Kuhn's point, relating to science, is that following a paradigm shift there is a flurry of scientific advancement as we can now operate within the new and improved perspective or set of 'rules', so to speak. So, to bring it back to investing, the economist in me insists that current market conditions are unusual (an anomaly?) and cannot be sustained but the real world market participant in me has been observing and insists otherwise. So, is the paradigm shifting? Keep this question in the back of your mind.
In trying to grapple with it all, including how my all-time favourite investor, the grand old Mr. Buffett, can underperform to this level. I look elsewhere, to a thesis put forth by Michael Burry.
Mr. Burry, for all his fame, takes a rather low-key approach to his self-promotion in a world where many of his compatriots try (with differing levels of success) to create a larger than life persona. He has put forth the idea that the biggest risk, and the reason for the continuous upward trend in valuations, is not irrationality but rather the modern innovations of index funds. For him the flood into index funds and liquidity has created a scenario where very little price-discovery is actually done. Bassell III, which was supposedly meant to increase the stability of the financial system, has done very little. Especially with the combination of recent monetary policy mechanisms, such as putting credit risk on the balance sheet.
Ask yourself this question: if the discount rate you use (typically the rate of return on sovereign debt or treasuries) is suppressed to zero, what would an ideal valuation be? And if negative (as our European counterparts decided)? We certainly don’t know. If this is the case and the cost of future capital is nothing (or negative), valuations on companies are, in theory, infinity… That is to say, if one decides that the cost of capital (indexed to the cash rate) goes or stays zero bound, how would an actual company go bankrupt? Are we actually taking equities risk for equities return? This might seem farcical and sound like a bizarre question but think through that process. And if companies are not incentivised to maintain capital discipline and no one actually asks those questions, is there a place in this brave new world for fundamental analysis?
So where do index funds come into this equation?
Let us begin by explaining one thing about how index funds work. Forgive us if this is a tad basic for the veterans amongst you but it is surprising how many people don’t understand this. There are three components making up the investment universe of index funds: the investors, the market makers and the actual underlying assets. An ETF or passive index fund could theoretically be created for anything from bullion to more vanilla equities. But here’s the thing (whether open-ended, closed-ended or ETF), what happens when there is a discrepancy between the distribution of daily dollar value traded amongst the securities they supposedly mimic and their own?
Michael Burry uses the example of the Russell 2000 Index, which is composed of lower volume, lower value-traded stocks which often trade at a tiny proportion of the hundreds of billions that are linked to the stocks themselves. This is usually not a problem because market makers (the other component of the overall market), typically in the form of institutional investors, use this as an arbitrage opportunity. For example, if there is discrepancy behind the price of underlying securities held by the ETF and the investments themselves, then they use this as an opportunity to buy securities on either side of the trade to eat away the differential. They don’t, in fact, act as a price discovery function but liquidity makers. So, in a self-fulfilling prophecy of sorts, if an underlying asset has momentum behind it then the market weighting changes in proportion. But if liquidity does dry up, and market-makers decide not to take that sort of risk on the balance sheet because the momentum is in the opposite direction? What happens? The liquidity ends up hurting both the investors and the overall functioning of the market.
Could this be the reason why, in the US, the Fed decided to take the help of a gentleman named Larry Fink? Fink leads one of the largest passive index funds in the world, a little shop called BlackRock. Call me a conspiracy theorist but the question is no longer about credit risk or market efficiency, but purely about liquidity and liquidity on a grand scale. As one professor at the Chicago-Kent School of Law stated, "it is now impossible to think of BlackRock without thinking of them as a fourth branch of government”.
Moral of the Story
If you’re asking yourself the question, what is the point this guy is trying to make? Then let me make it rather simple, you would be correct in assuming that current markets are not driven by fundamentals. The only thing driving them is liquidity. It is bubble-like but not in the traditional sense of the word.
In this market, it is momentum at all costs and just don’t be left with the hot potato at the end when the sell-off inevitably comes. This seems to be the very definition of a bubble but the reason why it isn’t traditional is that the sell-off is not what you might be thinking of. Unlike the tulip-mania that gets wheeled out every time someone discusses a bubble. A bubble that resulted in the underlying assets never again reaching their nominal value. They are shorter in time frame and much more bloody, as is the recovery afterwards. Think of the collapse of the VIX complex, the sell-off of Q4 2018 or the February and March sell-off. The following recovery is just as quick. If we take out the fundamentals then the only thing that matters again is liquidity. Central bank policy effectively puts a floor on the price action and passive money helps keep the relentless pressure trending upwards. This is one giant short vol and long momentum trade. This, by the way, is probably one reason that the most famous March-money-maker to make headlines, decided to use CDS (Credit Default Swaps) as opposed to shorting the market directly. Here I refer to Bill Ackmann.
If this current cycle were to end, in a worst case scenario, markets in this environment track side-ways for an extended period of time. For those of you who have a bit more time on your hands, have a look at how this story has played out in Japan since 1989. Fortunately (or unfortunately?) a lot of liquidity, including pension liabilities, insurance companies, have now been forced into risk-assets (or whatever you want to call them). They have nominal targets to hit and they will be allowed to do so at any cost. The likely policy outcome is to inevitably make those assets, at least nominally, less risky as opposed to allowing them to take their due course.
This also helps make sense of why the top end of the market, like the tech giants on the NASDAQ, benefit disproportionately since it's not cash flow that matters anymore but liquidity and cost of capital. The top end of the market's cost of capital is disproportionately benefited since not only do their valuations allow them to access capital at a cheaper rate but you would’ve effectively taken out their competition at the other end of town whose lives have gotten a whole lot more miserable no matter how disciplined their balance sheet is. Trust me, we know; we write loans at nominal rates of 7-10% for senior secured debt. Consider what Uber pays or, in Australia’s context, the likes of the Australian banks, who pay 3.36% above the cash rate on their hybrids (which effectively gives them equities like risk).
Unlike mainstreet and the rest of the economy, the only voice that matters for investors is the voice of Powell and, at home, Lowe. US elections in November might impact what happens on the fiscal side of the equation and mainstreet, but as far as Wall Street (in Australia’s case Macquarie Street) is concerned, the only game in town are the minutes of central bank policy meetings. For any government expenditure will ultimately be financed in those meetings. The trillions issued in deficit spending around the world aren’t going to be financed by the taxpayer (of course they will eventually, likely through inflation) but by simple numbers on the balance sheets of the central banks. Thank whatever god you choose for fiat currency. The asset of market participants (as long as you don’t hold it too long) and the liability of the state.
Don’t believe me? The very analysts who are now concerned about a possible Trump loss in November are precisely those that were concerned about his win in 2016 and markets not reacting negatively. Yes, they might be right in the short-run. But, as industry participants, we must insist that we remain masters of the universe.
So, are the people who insist that the markets are irrational (at the moment) correct?
Probably. But we will make the call that this environment creates immense opportunities for the discerning investor. Invest in passives, but understand that the liquidity is a mirage. So if you were going to invest, understand what the underlying assets are and what price discovery mechanisms are actually in play. Having the ability to actively think through the factors, taking momentum into consideration when it helps but also looking to make actual price discovery, especially in the often under researched small cap space or the deep value in emerging markets, can stand an investor in good stead.
At the very least, as long as inflation doesn’t come back into the equation, we can continue to have this party going since monetary policy will effectively act as downside protection. If inflation does come back into the equation, changing the factors to be looked at by going towards hard-assets or infrastructure is a much better option than sitting in cash and waiting for the ‘dead-cat bounce to be over’. In the approximate words of our global equities portfolio manager Robert Swift, how has this particular dead-cat managed to bounce higher dead than when it was alive?
Just don't forget to ask yourself the question, has our paradigm shifted? Is it shifting?
Food for thought!
Afterthought - I subscribe to the Jim Bianco school of thought that this situation creates massive distortions and impacts the long-term sustainability of our markets. Having market corrections, price discovery etc is fundamental. Public risk and private profits might not necessarily lead to market corrections but have broader ramifications in the political and real economy.
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