More volatility. Less predictability

S&P 500 stock market values are experiencing the same volatility as the first half of 2020, the start of the Covid-19 pandemic (based on the 50 largest value movements as a percentage of the index’s total market value).

Heightened volatility has grown more common across the stock market even as major indexes are approaching record highs. The volatility is not limited to specific circumstances of craziness, such as GameStop (rising more than 2,000% and then cratering), or Viacom (losing more than half its value as Achegos imploded). Apple gained $265 billion in market value during only five trading sessions in January – more than the total worth of Coca-Cola. In March, NVIDIA and PayPal each lost over $50 billion in market value in just a couple of days.

These dramatic movements show that market volatility leads to big price movements in stocks, both up and down. There are a couple of factors combining to enhance this turbulence:

The popularity of the momentum trade (buying stocks that are rising quickly and dump the relative losers quickly).
Decreasing liquidity (fewer buyers and sellers for the other side of trades).

Both factors magnify the market’s moves in either direction.

Lessons from a Financial Blowup

The Archegos implosion teaches the same lessons that apparently need to be taught over and over again. High leverage eventually brings margin calls. Margin calls equal disaster. Margin calls come when too much leverage is attached to securities linked to market volatility. All securities are linked to market volatility. There is no such thing as uncorrelated assets anymore. Investment strategies founded on the belief that the securities held are somehow immune from previously “uncorrelated” volatility are anachronistic. Combine these investments with substantial leverage intended to enhance returns, and this strategy ends in disaster. If it’s zero eventually, great quarterly performance is meaningless. It’s risk-adjusted return, idiot. Diligence matters. Questioning assumptions and decisions constantly are the table stakes for any investor. The too clever, overleveraged, overconfident manager believes work is done before an investment decision. That’s the beginning, not the end, and a failure to be diligent in a market with many more influences, uncertainties, and factors impacting a portfolio ends, well, the way Archegos ended. Watching carefully and acting quickly, getting out of suddenly unattractive positions, and revising thinking is almost as good as a good investment choice in the first place. Building a portfolio the way Archegos did is not investing. It’s gambling. The most important lesson is to know the difference.

Things Have Changed – Sort of

The last few weeks highlighted the need to bring a new understanding of, and strategy for, investment risk. Volatility is increasing and occurring over a significantly compressed timeframe – for individual stocks and the overall market. Recent trading activity in GameStop, AMC, and a few other stocks demand an investment strategy focusing on Risk Adjusted Return.

The new power of retail investors is here to stay, and that will shake up traditional portfolio managers because they are increasingly losing control of the trading process.

A Trading Floor in My Pocket.

Trading apps on platforms like Robinhood and social media chat rooms found on Reddit are game changers, fueling an unprecedented level of interest and activity (social media information is easily accessible and trading activity has very little friction – few, if any fees, and immediate). These two factors are irreversibly changing the market.

In the past year, U.S. brokers added at least 10 million new retail trading accounts, and a shift to zero trading commissions late in 2019 unlocked a wave of activity that dwarfed even the wild days of the dot-com bubble. Beginning in early 2020, and coinciding with coronavirus lockdowns, trading activity started to surge and has not subsided, even as the economy has gradually reopened. Average daily trading at the biggest retail brokers hit a record of 6.6 million a day in December 2020. In January 2021, it reached 8.1 million. On January 27, 2021, equity volume was triple the average day in 2019.

Retail investing has been a small fish trading in the large hedge fund and institutional pond. But that’s changing. Before the pandemic, retail trading made up about 15% of equity volume; now, it’s consistently making up more than 20%. The game changer is when that activity is concentrated on just a few stocks, a much more likely event among retail investors (driven by social media platforms), and it makes a substantial difference. In the case of GameStop and several other highly shorted stocks, it can cause startling price movements in a very short time.

A New Industrial Revolution

A New Industrial Revolution

Businesses that combine closed-loop, arms dealer and monopoly characteristics represent something fundamental that is shifting in the global economy. They represent automation that is pervasive, smart, and is a layer that sits across the entire economy. Data processing and prediction build these business models. They permeate all services, including supply chains, logistics, mobility, and consumer offerings. Pervasive and innovative, they represent opportunities for increasing investment returns. Incumbents enhance their position, generate increasing value, create challenging barriers, enable more innovation to solidify their position and will sustain their value because of this new competitive dynamic. Innovation is always a threat, and value can be created from a new entrant, but the bar is increasingly higher for both the level of disruption and quality of innovation to an existing or even new market.

To be sure, new opportunities will be created as new technology develops. An example is the wireless data and smart phone market. Essentially, 4G mobile technology enabled the substantial value creation at Facebook, Netflix, Uber and AirBnB. These companies could build their services on top of this technological platform and create not only a new competitive business, but a new market where they could be the dominant player. As 5G develops and we see unimagined high-speed for data, entertainment, communication, and other services, we will have new businesses and opportunities created on this platform – only so much can be imagined today, others which are yet to come. But there will be real-time connection with customers enabling new and innovative products and services, artificial intelligence permeating software and communication enhancing quality and innovation further, enhanced gaming (perhaps even to a professional level), and virtual reality and augmented reality perhaps finally becoming the market opportunity that has been imagined for many years. This list is far from exhaustive, and without doubt, there will be valuable companies created whose business models we can’t quite imagine today.

Markets and Valuations

The current low interest rate environment increases the discounted present value of future cash flows and reduces the return demanded for every investment. In other words, when the Fed funds rate is zero, 6% bonds become disproportionately attractive. Buyers have now bid bond prices up until yields are now significantly less. What does it mean if the prices of stocks and listed credit instruments are at levels not driven primarily by fundamentals reasons (i.e. current earnings and the outlook for future growth), but in large part because of the Fed’s buying, it’s injection of liquidity, and the resultant low cost of capital and the market’s lower demanded returns on financial instruments? My conclusions are limited by inadequate foresight and influenced by my optimistic and pessimistic biases. Experience teaches it is hard to get the answer right. Or, as Charlie Munger has said, “it’s not supposed to be easy. Anyone who finds it easy is stupid.” At the risk of being stupid, equity investments in companies, including the five largest, with the unique competitive positions and “closed-loop” business models will remain excellent investments. In addition, certain fixed income securities paying high yields with attractive long-term risk-adjusted safety are extremely attractive and are being ignored in this unique interest-rate environment. This combination will create substantial value. Unique macro forces created by the central banks, unprecedented and sustainably low interest rates combined with pandemic-tested sustainable business models have created truly unique opportunities.

Currency Values in a Zero Interest Rate World

We are rapidly approaching a zero-interest rate world. Interest rates are being driven to zero (or below zero in many cases) as a first-line tool for central banks to generate economic activity in the face of the dramatic negative impact of the pandemic, as well as existing and lingering economic fallout. This toolbox will be empty soon, and the only remaining weapon will be fiscal policy. Among other things, fiscal policy and domestic financial markets will have an overwhelming influence on global currencies. Capital flows will dramatically impact currency volatility as capital moves to more attractive countries with more liquid and robust asset markets.

Portfolio Strategy

The government is providing a backstop for all government-backed securities. The Fed is also going to be extremely active in the markets, buying not only fixed-income securities but also stock index funds. They are working very hard to keep the market aloft and preventing it from cratering (they still may not be successful). This is an election year and this administration will do everything it can to make sure things look as good as possible through November.
I understand there is riskiness, but I expect economic activity and fed support to continue to increase. Even if we have an increase in coronavirus cases, people will remain optimistic – justifiably or not.
There will be extreme volatility. Economic activity will waiver, increase suddenly, pull back, and the pattern will continue for some time to come.
Market volatility is our friend because we have a stable source of cash flow that protects our capital base. On top of that, the speculative strategy will profit from volatility while the equity investment strategy will play for the long term – it is a multi-year long-term perspective.

Although there are a handful of investments where confidence in the five-year curve is justified, and now is a great time to make these long-term investments, it is still very unpredictable.
The short- and long-term state of the economy, how this massive amount of debt gets repaid, how we reopen businesses, etc. is unknown, volatile, and any attempt to predict seems fruitless. But, understanding how to adjust for risk, accept, and ultimately take advantage of volatility, will be powerful. Along with a long-term perspective, this will be the most effective investment strategy. The Fed is printing more money. We’re going to see a lot of capital injected into the global economy. But the presence of money is not the important factor. It’s the velocity of money – how people are spending it and is that money chasing after other goods. That will drive inflation. We didn’t see it in the past even though we had a massive capital injection. Deflation and recession are much bigger concerns. Inflation is not on the horizon. The Fed’s enhanced bond-buying, which includes high-yield bonds and other fixed-income securities is unprecedented and has boosted the value of debt portfolios. However, these portfolios (mostly just above or just below investment grade) still yield attractive disproportionate risk-adjusted returns.

Does the Music Stop in China?

Does the Music Stop in China?

Chinese economic policies and motivations since 2008 not only emphasize growth and sustainability of state-owned enterprises but, a critical but much less well-appreciated dimension is the Chinese government’s emphasis on stability. No economic policy in China will ignore this, and the high value placed on stability pervades all the current trade talks with the United States.

The Overvaluation Engine

The Overvaluation Engine

High growth companies competing for large total addressable markets may not be creating long-term value. Cheap capital has created a vicious circle of unproductive investment. Markets will correct this overvaluation and misappropriation with a rather unpleasant bang.

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