Excerpted from Achaea Capital‘s Latter to Investors,
Blind faith in policymakers remains a bad trade that’s still widely held. Pressure builds everywhere we look. Not as a consequence of the Fed’s ineptitude (which is a constant in the equation, not a variable), but through the blind faith markets continuing to place bets on the very low probability outcome – that everything will turn out well this time around. And so the pressure keeps rising. Managers are under pressure to perform and missing more targets, levering up on hope. As we wrote last year, bad companies were allowed to push their debt up in order to pay generous shareholder dividends and director packages that are now (in an uninspiring turn of events) higher than their free cash flow. Buybacks are “all-in” at cycle-highs, funded with shareholder money while insiders continue to cash out their own. Individual investors pressured to pick up yield became their debt or equity holders – lured by higher returns, easy-to-use ETFs, and asking no questions. And so, just as Moody’s suggested a year ago would happen (and we presented in last year’s report), high yield spreads have widened all year – in stark contrast to the gains in stocks and one of the most supportive government Bond rallies in history. The default cycle doesn’t appear to be that far off anymore, and not just in U.S. markets. Credit markets have embarked on a new fundamental narrative – bills still need to be paid, and not everyone deserves to sell new paper at the same price. Markets are illiquid, fractured, and in many cases unable to sustain any real test of selling. Meanwhile it’s business as usual at the Fed, where credibility remains intact and market participants blindly expect another magic trick for Equities in the coming year.
We think 2015 could mark a turning point in the narrative – and for the first time in eight years we’ve begun deploying capital, albeit still conservatively, in areas with the largest potential for significant dislocations—without risking much if we are wrong.
Without further delay we present our slightly unconventional annual list. Instead of the usual what you should do, we prefer the more helpful (for us at least) what we probably wouldn’t do. Five fresh new contenders for what could become some very bad trades in the coming year. As usual this is not intended as an exhaustive list. In fact we had to leave out some rather compelling candidates on this go-around. To further complicate things, some bad trades from last year happen to be sneakily carrying over as we mentioned before. We’ll discuss these and others in the next section.
Five Bad Trades To Avoid Next Year – 2015 Edition
BAD TRADE #1 For 2015: “Leaked” Research.
In March of this year one of the biggest Emerging Markets-focused macro funds in the world leaked a 100+ page slideshow for why EM, and specifically Brazil and China, were going to implode (and bring down the world with them). Around the same time the head of macro research for a major fund published an article in a top newspaper warning of an imminent systemic calamity in Emerging Markets, and specifically China. We spoke with some managers at the time and they said: “Our team went to [insert country name here] with a bearish view, and came back even more bearish”. This statement probably deserves a whole section/discussion for itself. What followed is now history.
Long ago, there was a time when professional money managers on average possessed an informational advantage over the average market participant – as well as the ability to translate this advantage into superior performance. Some may attribute that edge to a combination of better data, research departments, experience, portfolio construction, and risk control. We don’t necessarily disagree. But a sixth factor may have been the most important of all – patience to let high-conviction, asymmetric bets pay off. Whatever the weights one assigns to each factor or edge, most have been in irreversible decline for over a decade. Data is free. Research departments are increasingly rigid. Average experience keeps falling as the industry contracts. Six years and a rising market have forced portfolios to ignore probabilistic outcomes and focus only on the past trend. Risk control is modeled so it doesn’t have to be understood. Patience has been cut to zero.
The result of this – October 2014 a prime example, is that major developed equity markets can now easily decline nearly 10% in a period of only 3-4 days, without any new or significant information released from news or government sources at the margin. And some individual stocks (which appeared liquid not even a day before) can now effectively stop trading as if the market were closed.
Valuable and timely research doesn’t come in a polished easy-to-flip format. It is planted and cultivated over time and with great care. It doesn’t copy-and-paste what is happening, but drives an ever-changing discussion of what may happen in the future. It is exchanged with clients as part of a broad conversation on future investments, goals, and strategy. Sometimes it may not even aim to recommend a specific course of action. It may simply conclude that different information is needed, and outline the paths to get there. Good research should include alternate scenarios. It should guide towards the most likely outcomes, not shut the door on everything else. Keeping an eye on the vault labeled “won’t open” can sometimes be much more rewarding. Next year should be no different.
BAD TRADE #2 For 2015: It’s A Bull Market, If Markets Rise Then Volatility Will Fall.
We’ll save the bit about “It’s A Bull Market” for Bad Trade #3. In this section we’ll discuss “Volatility Will Fall”.
Volatility used to be regarded as a highly-specialized tool for risk management. Hedgers used it to hedge, and every few years or so a levered speculator (read: seller) blew up. Today, six years of rising markets have turned every yield-starved investor and performance-chasing fund manager into a volatility seller.
Selling volatility has become a casino floor bleeping with offerings of ETFs, leveraged structures, swaps and futures. Every table offers its own brand of excitement and adventure. Yet unlike a real casino where some patrons know they’ll lose money – and consciously play small to enjoy a free drink on a getaway with friends – no one selling volatility today thinks they can lose at this game.
Let’s step back for a moment. The biggest monetary experiment in history has just (possibly) ended. From 2008 to 2014, the Fed was the largest synthetic seller of volatility in financial history. Following smartly along, countless asset managers and even the world’s largest Bond fund came out as proponents of selling volatility. That is, until the founder of said fund left to manage a smaller fund he could actually trade without the whole market knowing about it. Two weeks after his departure, the market collapsed and volatility briefly doubled. So the two biggest volatility sellers in history have just left the casino floor and are sitting down to eat at the complimentary buffet, while everyone else is doubling down on a new deck.
But let’s ignore all of that. It’s a bull market, you know, Mr. Partridge. So stocks will rise and volatility will fall. Well it turns out… not really. Six years into this bull market, calling this environment Mid Cycle would be very, very generous. More likely, we just ended the first year of a two-year Late Cycle phase.
Take a look at the picture below. In over a century, U.S. Equities on a year-on-year basis have made gains with falling volatility about one-third of the time, and made gains with rising volatility about a quarter of the time. In total, U.S. Equities have made gains roughly 60% (one third plus one quarter) of the time on a year-on-year basis.
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As it turns out, the long-term averages are trumped by the specifics of the stage in the cycle. Very strong trending returns with rising volatility, both of which are firmly observed today, are the hallmark of late cycle bull markets with very few exceptions. In late stage bulls, the market and volatility rise together well over double the long-term average. Not very good odds. This is one of those cases where one doesn’t have to be right about the underlying trend in stocks to make a thoughtful, truly hedged bet. We wish the brave few hedgers luck.
BAD TRADE #3 For 2015: It Didn’t Work The First Two Times, So Let’s Go All-In On The Third.
We could spend all day on the previous comment – “It’s A Bull Market”. But the fundamental truth, at least for us, is that it doesn’t really matter what animal this is. Market participants devote too much time to this discussion and usually with little benefit other than satisfying their need for confirmation bias. We believe in watching risk instead – and letting the returns take care of themselves.
One way we define risk is price acceleration in any direction. Two of the ways we estimate this are by monitoring market conditions and assessing the equity cycle. What has become increasingly clear is that more parts of the market now behave as if we are in Late Cycle, while others have transitioned to a new Bear Market. These conditions have been developing all year.
To our surprise this late cycle pricing (and risk) had not yet started to show up in our Core Risk guidelines. So in our view, throughout most of the year we were dealing with a normal extension of prior conditions, with brief periods of elevated risk.
Then over the last 2 weeks something truly remarkable happened.
We track a number of late cycle fundamental data series that we call our Core Risk framework. Our primary concern in running these long-term price series is risk-management. The bigger the dislocation in our long-term data, the larger the risk. Further, in our experience risk is also non-linear. Historically, above certain levels of risk the probability and magnitude of severe drawdowns follow patterns similar to a power law.
The chart below offers an example. In almost thirty years, the highest value (risk) ever achieved in our Late Cycle Equity Pricing Model was during May 2008. It also led to the largest drawdown. The occasional failure such as 2005 produced a flat market, but in the process gave us valuable information that High Risk dynamics were not yet in play. Even then, caution and patience were highly rewarded.
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As can be seen above, the last few weeks have finally produced what we call an “All-In” Late Cycle risk dynamic. Historically this has transitioned to very high volatility and very large drawdowns for U.S. equity markets. We can’t control how the market will respond to this. All we can do is recognize the problem and manage the risk accordingly.
Also “Going All-In”, another one of our Core Risk monitors:
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We hope this drives the point that debating a Bull or Bear case is particularly irrelevant here. Yes, it could be either one. But the risk of one’s bias being wrong has almost never been higher. And going “All In” this third time around doesn’t look right either.
BAD TRADE #4 For 2015: I’ll Worry About It Tomorrow.
We live in a world where long-term thinking has been thrown out the window. Stock traders have decried this on a daily basis for over a century and yet it still rings true. Nowhere is this clearer than in the below chart. It starts at the inception of the SPY ETF in January 1993. We break out the market’s cumulative price return into overnight (which we’ll call “investors”) and cash-session (which we’ll label “day traders”) components.
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During its first few years of existence, the Cumulative Return of holding the SPY overnight vs. the cash session was roughly equal. The market advance was being driven by both. Then in 1997 something changed. Day trader returns peaked and became a headwind. Overnight returns started to accelerate and overtook the Market return. Even more fascinating, this outperformance was maintained with lower volatility and lower drawdowns. None of this factors in transaction costs or taxes. Regardless, it’s an extremely powerful visualization of what we think is a key structural change in stock investing.
Recent years have been even more fascinating. Zooming in since 2009, the SPY has gained +195%, with the investor component gaining +60% and day traders gaining +84%. The chart below shows their normalized returns anchored at the March 2009 bottom:
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While it may seem like day traders have collectively beaten the pants out of investors, individually today each group has only been able to reach where the broad market was roughly in 2010. As was the case since 1997 a great deal of money has been left on the table by those unwilling to hold positions past the close – which in this day and age is an ever-growing chunk of market participants. In this bull market (like the ones before it) a significant and steadily reliable component of returns came from thinking more like an investor.
As with every year before it, 2014 produced several periods of worrisome economic and geopolitical news. Sooner or later one of these hit close enough to a portfolio manager’s “sell button”, and panic ensued. In a market increasingly dominated by automated HFT day trading, speed-based market-making strategies, and generally ultrashort-term thinking, those who preferred to “Worry About It Tomorrow” instead of accepting overnight risk were accordingly giving up risk premium.
Worse, over the past year short-term thinkers have given up even more of this risk premium. And along with it, much of their performance lead. The next chart illustrates this interesting trend. Since the 2009 advance started, the Ratio of Cash to Overnight Cumulative Returns has been broadly stable between 1.10 and 1.20. This meant the cash session was maintaining a 10-20% lead. Since May 2013 however, day traders started to underperform overnight returns – giving up nearly half their previous lead. At one point in October they nearly gave it all back:
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This unfolding weakness is quite significant. The S&P gained 25% since May of 2013. The overnight return was 15.3% and the cash session return was only 8.7%. Heading into next year, there is little reason to expect this gap to shift back in favor of short-term thinking. In fact, it peaked in late 2009. And then failed again in 2011. If history is our guide and late cycle dynamics become even more entrenched, investors seem more likely to outperform – and intraday returns to drift relatively lower. For those taking this to mean a strong market environment ahead, we look back to 2002-2007 when the Cash/Overnight Ratio finally fell below 1.10 for good, after a 2+ year drift lower in nearly identical fashion to what we observe today:
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BAD TRADE #5 For 2015: It’s the only game in town.
Much of this section has been covered in the other four trades. Nevertheless we think a separate mention is important. Increasingly, investors are riding trends without understanding their fundamentals. We see this philosophy particularly prevalent in volatility, inflation expectations, and the Dollar. We see it mentioned alongside the Fed, with QE frequently hailed as “the only game in town”. Its siblings Abenomics and Draghinomics now compete for the same label. It’s become a well-worn phrase. We heard it in 2011 when some described the Gold market, in mid-2012 on Bonds, in mid-2013 on Japan, to name a few. Meanwhile pressure continues to build as market prices dislocate further from underlying driving forces.
This year almost no market has been spared the deadly phrase. Leaders became losers and vice-versa, in a particularly nasty game of musical chairs. Mean-reversion doing its dirty work. At one point this year European Equities were the only game in town. So were high-flying U.S. momentum stocks. Then Japan again. Then Emerging Markets. Then China. Then the Dollar, followed by U.S. Equities. These last two, along with a few others, still stand unchallenged.
We worry about the velocity of price adjustment required to close the wide gap between momentum investors extrapolating trends and what fundamentals can truly support. The consensus reasoning is that price adjustment won’t happen because markets are permanently supported by central bankers. Unfortunately in every year since 2009, despite massive coordinated central bank intervention, price adjustment did happen in virtually every major market and often with very painful knock-on effects. So when something is hailed the only game in town we’ve decided to quietly agree, pack our bags, and move to a different town.
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