I'm Not a Market Timer or a Forecaster

I observe.  What I've observed in the past can be seen in my posts which date back to July 2013. Two years later, it's been interesting and informative watching how things have progressed and unfolded.

The causes of the declines in almost all asset classes have ALL been forecasted perfectly in hindsight: the narratives constructed are both tight and logical, very appealing to our need for pattern recognition and desire for plot.

Without predicting causes or direction, but by simply observing initial conditions and comparing them to history could have provided a reliable sextant or compass to navigate the unpredictable and uncertain seascape or landscape.

Have a time horizon, know your tolerance for loss and recognize that capital, like it's counterpart debt, is not an infinite quantity.  Debt (carry trades) is particularly insidious.  Closing a carry trade takes borrowed money out of assets (selling the asset) BUT does not create "money on the sidelines" that can be redeployed... it reduces debt but it is not free capital.

Risk is about paying irrational prices for assets, and future returns are dependent on the price you pay and the sustainability and quality of the future cash flows of the underlying asset. You can't always sell your asset to the greater fool, but you can abstain from being the fool who is driven by emotion and the need to be part of the herd.

The dynamics and the behavior that drive markets apply to markets that rise and markets that fall.  Mental flexibility and mental agility will be important to be able to continue to recognize were we are and how we got here; the famous initial conditions that determine (not predict, the outcomes are multiple) the "behavior" of  non linear, complex systems.

No Predictions, Just Observations

• Lots of debt, public and private, has been created and "must be" repaid or refinanced (or not).
• When you "invest" in bonds you're lending money.
• Leveraged share repurchases have substituted productive investment (capex).
• Risk premiums (term, credit, inflation, liquidity) are thin or non existent: we're not being compensated adequately for the risks we're assuming, there's no real margin of safety.
• Today's US equity valuations are extreme and unsustainable unless one believes that the conditions "created" in the last 5 years will be continued indefinitely.
• Today's valuations ALWAYS have an impact on tomorrow's returns.
• There IS a difference between value and price.
• Momentum can be negative too...things that can't continue indefinitely eventually end.
• Complacency and overconfidence are the fruits of incomplete analysis and lack of critical thinking.
• Greece has been a problem for 4 or 5 years.
• Initial conditions matter more than predicting the future.
• Herding behavior exists...crowded trades sew the seeds of there own destruction.
• Liquidity and volume are not the same.
• Liquidability matters.
• There may be a buyer for every seller but perhaps not at every price point or risk level.
• Cash seems like a bargain with respect to the value (and opportunity cost) of other risk free and risky assets.
• Things, as always, are unpredictable and complicated.

Echos and Rhymes

While it's true that a bell doesn't ring at market tops (or bottoms) it is also true that valuation and psychology matter when determining prospective returns and risks in markets.  Complacency implies more (not less) uncertainty about future outcomes as some probabilities are excluded a priori. Stretched valuations in asset markets imply lower (not higher) expected returns in the medium term.  At high levels of valuations and high levels of complacency I have low conviction that the near term returns will be sustainable; the current speculative returns on capital will risk becoming negative returns of capital in the median term.

China is unraveling, one tenuous, credit woven thread at a time. Seemingly insignificant corporate / trust defaults, a weakening currency (piloted or not) and the devaluation of debt collateral (see copper and iron ore futures).  Problems aggravated by rampant rehypothecation.

The Shiller CAPE is at 25, a level associated with mediocre (0% to 2%) stock market returns in the subsequent 5 to 7 years. Margin debt is unsustainably high as is bullish sentiment (85% bulls).

Credit markets are very active. Corporate IG grade issuance to finance stock buy backs is exploding at spreads that leave little room for protection when the credit cycle turns. New High Yield bond issues have increasingly fewer protective covenants, at low absolute yields and insufficient spreads.

Risky assets in general are not inexpensive, risk is the crowded trade. We're closer to the end than the beginning of a large cyclical bull move in stocks (S&P 500 666 in 2009).  I'm not calling a top, I simply believe that the easy money has been made and at these valuation levels there are insufficient prospective returns for the risks assumed.  Markets may continue to levitate but the speculative returns in this phase will probably prove temporary and I think it's better to have less capital at risk until valuations and psychology become more favorable to investing.

January Avalanches

In my post on July 28, 2013 "Early and Wrong?" I wrote :

When central bankers and central planners meddle in financial markets and market economies (or quasi market economies) they pervert the price discovery mechanism and distort the risk and liquidity premiums that are fundamental to the efficient allocation of capital and resources. In the near term interventionist policies can alleviate some pain or create apparently favorable market conditions (QE induced rallies) but in the longer term these policies create complacency at the cost of superficial and incomplete analysis of underlying micro and macroeconomic activity and risks.

I'll speculate that fundamentals eventually will matter again and when they do it will be imperative to have estimated how much systemic risk, because of the mispricing of risk, has been created by manipulative policy.  Start your (independent) analysis early.  Where are we? How did we get here? Under which conditions are the current  risk premiums and valuations sustainable? And most importantly how much can I lose if I'm late to the party and wrong?

Forget about looking for a catalyst to explain what we saw in world financial markets in the month of January, it's really not that important. Unstable and unsustainable conditions create corrections and dislocations in financial markets, much like avalanches are inevitably created not by the the skier but by the amount of snow on the slope and the climatic conditions preceding the event. 

Don't look for the next skier. Have conditions changed enough to alleviate the disequilibrium / distortions  in valuations and risk premiums, the excess leverage and the overconfidence in markets?  I'm preserving capital and thinking about the reversal of the flows of the past five years that brought us to these conditions. Is it possible that what was erected in five years (malinvestments) can be demolished in five weeks? Perhaps, but I can't know that and I'm not betting on it.

Change and positioning

Change happens at the margin (periphery)…ice doesn't melt from the inside.  In the developed world we often don't consider that the margin of an interconnected system is part of the system and that changes at the margin can provoke changes throughout, including the core.  And then there are the initial conditions of the complex system which influence the possible paths and outcomes as the system evolves. (future returns)

Consider : valuations, multiple data points, sentiment AND contextualize these initial conditions.
Add apparently insignificant / unconnected change at the margin : Argentina, Turkey, Venezuela, Ukraine, shadow banking in China (trust and wealth management products).
Then think. What possible outcomes could there be? How is our portfolio positioned, does it take into account our ignorance about the future or does reflect overconfidence in our ability to predict uncertain outcomes?

More things can happen then will happen but we can't know a priori, with certainty, what will happen and we shouldn't pretend that we can. What is certain is that we'll create a narrative ex-post that will have explained with precision exactly what has happened.

Bulls and Bears and tops and bottoms.

For every seller there's a buyer, but at what price??

Early and Wrong??

In my post of Sunday, January 29, 2012 Is Anyone Thinking About Japan I wrote, "Let's keep our eyes on the East, Japan and China in particular, for clues to the next phase of the financial crisis." Eighteen months have passed since that observation and nothing too dramatic has happened yet in Japan or China that would, in isolation, constitute a threat to the global unrecovery.

The highly interdependent second and third largest economies of the world are going in opposite directions in order avoid or to postpone the inevitable economic pain that is inherent in cyclical and secular adjustments. The actions of both countries have contributed to increased volatility in their respective financial markets and economies, which of course are connected to other financial markets and more importantly, to other economies. 

Japan is attempting to stimulate and inflate to devalue and to reduce, in real terms, its unsustainable debt load. The BOJ is engaged in one of the greatest monetary policy experiments ever seen of which the medium and long term outcomes and consequences are anything but certain. 

The PBOC is allowing, if not causing, tight monetary conditions in order reign in runaway credit creation by non bank entities which threaten the health, stability and sustainability of centrally planned economic growth.  The chinese "economic miracle" has resulted in badly misallocated capital and the authorities are trying to address this problem though moral suasion and limits to short term funding for non banks.  China would like to rebalance its economy with a growing emphasis on domestic consumption over exports and capital formation. Here, like in Japan, the outcome and consequences of these policies is highly uncertain.

When central bankers and central planners meddle in financial markets and market economies (or quasi market economies) they pervert the price discovery mechanism and distort the risk and liquidity premiums that are fundamental to the efficient allocation of capital and resources. In the near term interventionist policies can alleviate some pain or create apparently favorable market conditions (QE induced rallies) but in the longer term these policies create complacency at the cost of superficial and incomplete analysis of underlying micro and macroeconomic activity and risks.

I'll speculate that fundamentals eventually will matter again and when they do it will be imperative to have estimated how much systemic risk, because of the mispricing of risk, has been created by manipulative policy.  Start your (independent) analysis early.  Where are we? How did we get here? Under which conditions are the current  risk premiums and valuations sustainable? And most importantly how much can I lose if I'm late to the party and wrong?

Pay Attention to the Data

Moments ago Ben Bernanke indicated under which conditions the FED would begin tapering and the time frame for completing the "normalization" of the abnormal FED Policy: it will depend on the incoming economic data. More precisely, the FED will taper and will finish tapering (Q2/Q3 2014) IF the economic data confirm the FED's forecasts for an improving economy. (Unemployment trending to 6,75% and inflation approaching 1,8/2,0%. )

The FED basically said that fundamentals will count (remember what those are?). We should pay more attention to what the FED in monitoring and less to what they're doing, that is continued QE. What happens IF the FED forecasts prove to be too optimistic or even wrong?  Sure the markets are already discounting that the FED will be right, but the FED has continually over estimated economic growth and its sustanability during this recavery.  Do your own analysis and pay attention to the data, finally we have an indication from the FED that economic data are important once again.

Equilibrium and Transition

Economics suffers from physics envy and often attempts to model the world with the precision of classical physics, which of course cannot be done.  What one can do, however, is to look for analogies between complex evolving systems, human behavior and the economic ecosystem. Predicting economic and financial market outcomes is very uncertain (think about meteorology) and we must recognize the importance of the initial conditions of a system while attempting to forecast and to understand outcomes in both natural phenomena and economic phenomena.  In short, recognizing a chaotic path dependence anchored to the initial state and the attractor (think of a single factor that influences the entire system) of a complex system.

Presently, in the major developed economies the initial state (expectations) are for low growth, artificially low interest rates, thanks to global quantitative easing, and continued disinflation, if not outright deflation. Investors and economic agents have their behaviors, and their asset allocations decisions anchored to these initial conditions. Right or wrong, this is our "equilibrium condition" which until recently has been unquestioned for the last few years.

In last few months a butterfly has been flapping its wings in Japan and has agitated financial market conditions throughout the globe.  In fact, the objective of the current policy of the Bank of  Japan is to move the deflationary expectations away from the actual "equilibrium" state to a new state of inflation. Change in a system or a condition is not usually instantaneous, heat must be applied to ice in order to transition to water in the liquid state : the water molecules must become "volatile". The financial markets were crystallized in a low volatility environment in which the status quo was the discounted future outcome and now have begun to transition to a new and yet uncertain equilibrium state.

In the month of May the bond markets around the world had their worst monthly performance in four years as investors began to rethink how a different future (one not previously considered imminently possible) might effect portfolio returns.  The BOJ has ignited a flame on bond market volatility and the FED,  which has raised doubts in the mind of market participants about the flow and sustainability of quantitative easing, has turned up the flame, accelerating the transition to a new initial state with new expectations.

The markets were in a state of low or negative real yields, very low absolute yields, compressed credit spreads and low liquidity premiums.  In short, all the sources of risk premiums were reduced or non existent.  Passing from this condition to one in which the markets will require compensation for risk has been facilitated by selling in all segments and geographic regions of the bond market and in all currencies, especially those for which no expectations for depreciation were incorporated.

The future paths for this chaotic, deterministic system are uncertain but we can arrive at possible scenarios if we keep in mind from which initial conditions we are transitioning. In evaluating possible outcomes, and positioning a portfolio,  it is more important to understand what expectations are discounted in present valuations (initial conditions) than forecasting the timing and the precise levels of yields, prices or indexes.

Trust

If you look up the word trust in a dictionary you'll come to realize that it is a ephemeral condition in our post post modern world. When you consider the synonyms for trust such as faith, reliance, confidence and dependence, you're confronted with an uncomfortable truth : we can have no assurance (a related concept to trust) that trust should even exist or should be deserved by our leaders and institutions, by the media or, sadly, by one another.

Trust is dangerous.  In a society which has been intellectually anesthetized and is incapable of critical thinking, it can be betrayed and used as an instrument of control.  Critical thinking isn't easy and is sometimes uncomfortably painful. It requires sceptisism and doubt which are the antethisis of trust.  It's easier and more pleasant to be disracted and escape through entertainment, drugs and reality shows.
We should challenge ourselves and question everything, ask why.

Trust requires engagement and interaction with others. It demands that we immerse ourselves in another person's struggle and that we honestly try to understand what they are experiencing. Unalloyed empathy is challenging and strangely unnatural, but it is crucial to understanding ourselves and our world, and to discovering where trust is merited.

Through our own intellectual self reliance we can begin to rediscover the humanity in man and put man at the center of civil society, at the center of existence.