Reflating Expectations

By Dr. Vinay Nair, co-founder/co-chairman at 55 Capital and Max Wolff, market strategist at 55 Capital

From the Federal Reserve Chair down, expectations have been building with equity valuations. Forecasts and kudos have been handed out based on the S&P index run up. We see fresh monies in the hundreds of billions chasing flows into equities.

We believe the reflation trade is conducting this cacophony.

Many have heard what they wanted to hear and declare the noise a symphony. We hear the noise and sense the conviction – beyond that, we see thick haze. There’s been a nearly $1 Trillion decline in fixed income assets, pushing rates higher. Commodities took this trip up and then back down. Despite the lack of surviving commodity price pressure, reflation remains. Equity excitement – U.S. equities particularly – seem everyone’s favorite reflation play. Rising rates on U.S. Treasuries, pushed up as bonds are sold down, is the other side of the same story.

Reallocation to assets positioned for higher growth and higher inflation is the portfolio expression of reflation, unless those assets are oil and other commodities. Selling traditionally less volatile positions and buying traditionally more volatile assets, generally pushes up indexes and sends a reflation signal to those who infer trend from equity markets. As such, reflation becomes a cause and effect of asset appetite.

Sources: 55 Capital and Federal Reserve.

We have seen the market rally since September 2016. Ironically, the pre-election rally was thought to be based on Hillary as the 45th President. Following the Trump surprise, we have seen a 4-plus-month rally boosting the S&P by 9%.

Sources: 55 Capital and S&P.

The rally is based on offers of lower tax rates for individuals and corporations. Reductions of up to 50% in corporate rates, mentions of estate tax repeal, cuts in capital gains, and repeal of AMT float around. Export subsidies, tariff walls, $1 Trillion infrastructure spend are said to be on their way. Reflation confidence is based on extrapolation of campaign promises.

Mounting tensions within the Republican Party and legislative setbacks on immigration and health care have not shaken confidence.

The usual macro suspects, like spiking wages and commodity prices, do not presently explain reflation. We have substantive and rising concern as to the robustness of the reflation trade. Assumptions regarding:

  1. unpassed legislation
  2. phasing of effect from future legislation
  3. net macro impact from legislation passed
  4. effect of higher interest rates
  5. unintended effects that reduce growth and optimism

amount to conjecture heaped upon conjecture. Estimating compound political and economic effects out into the future and then properly discounting them back to the present, is a fool’s errand. We believe there is little reason – aside from optimism – to believe that we will see all that is hoped for and priced in from Trump.

Legislative processes are slow, opaque and subject to swings in opinion. Market price movements are opaque and subject to swings in opinion, but markets move quickly. Single party political rule in the U.S. was alleged to offer clarity on legislation. The recent misadventure in repealing and replacing the Affordable Care Act suggests otherwise.

Expectations remain elevated for policy driven reflation to deliver what markets have spent 4 months pricing. Legislation is more likely to deliver disappointment than expectations and market trends have suggested. We see commodity and U.S. Dollar weakness signaling that expectations are slowing down toward legislative speed and success probability.

Only time will tell if we are in an actual reflation cycle or a reflation expectation cycle. The endings are very different. Expectations are a good bit ahead of legislative progress, despite the recent market pause.

 

Opinions expressed are current opinions as of the date appearing in this material only. While the data contained herein has been prepared from information that 55 Capital believes to be reliable, 55 Capital does not warrant the accuracy or completeness of such information. This communication is for informational purposes only. This is not intended as nor is it an offer, or solicitation of any offer to buy or sell any security, investment or product.

Copyright © 2017, 55 Capital Partners and/or its affiliates. All rights reserved.

Record ETF Inflows in 2017: Active Management Shrinking Fast

Lee Kranefuss is Co-Chairman of 55 Capital.

A front-page article in The Wall Street Journal this week reported that $124 billion has poured into ETFs in fewer than 60 days. These ETF flows are the strongest start to a year ever1. If this rate continues, ETFs will capture about three-quarters of a trillion dollars this year in the U.S.

ETFs keep growing fast because traditional security-selection active management frequently struggles to perform. We all know the story. First, traditional active is expensive. Second, over the long-run, few if any traditional active managers deliver enough performance to offset their cost. Third, the opportunity for success from picking stocks is getting smaller, in part due to the impacts of technology and capital market innovation. Fourth, because active managers tend to hug the index, they seldom get investors out of harm’s way – as people had (wrongly) assumed they tried to do. And fifth, it has long been known that 90% of portfolio return variability depends on where you invest not which securities you select from within exposures2. With a huge array of ETFs investors can get more benefit through holding a diversified global multi-asset portfolio of ETFs. This, coupled with the radical transparency of the Internet, makes traditional active seem doomed.

Many pundits describe this as “the transition from alpha to beta.” But that oversimplifies the trend. It is wrong to assume investors are simply shifting to buy-and-hold strategies that were formerly associated with index funds. We believe the shift away from traditional active is a complex shift to additional asset classes, additional regions, and ideas like smart beta.

Many pundits describe this as “the transition from alpha to beta.” But that oversimplifies the trend.

This tectonic shift toward ETFs raises a number of new challenges. At 55 Capital, we describe this as the “need for active management of passive exposures.” What is needed takes many shapes and forms, and in some cases, raises issues that didn’t appear before.

Here is my list of the major ones:

Who is going to shape the “base” portfolio?

You can agree or disagree with the basic idea of cap-weighting, but it provided a great simplifying guideline for portfolio construction: if large-cap is 70%, mid-cap 20%, and small-cap 10% of the stock market, you have a basic blueprint to work with.

Once you add more asset classes, we believe cap-weighting as a guideline makes little sense. We already know this from bonds, where no one holds them in relative market weight. The balance of stocks and bonds in the market has nothing to do with relative value; it is a creature of the non-market forces of corporate finance, tax policy, and regulation (many institutions like insurers can’t hold equity even if they would like to). The same holds true for foreign markets, where the equity market may be huge, but a small part is publicly listed. Once more, cap weight is of little help. And, with today’s ETFs, you can also get exposure to commodities, currencies, and other alternatives (maybe even BitCoin soon). What is their “right” weight?

Strategies like 60/40 exist because we needed some rule for mixing stocks and bonds. But when you add in foreign exposures, currencies, etc., a new calculus of portfolio weighting is needed.

Who is going to regularly manage risk and market dynamics?

People used to believe traditional active managers not only caught the upside, but also moved to safety at times of risk. But most traditional active managers try to stay fully invested at almost all times because they are judged on relative performance. If their sector goes down, they don’t underperform by going down with it; but if their sector rockets up when they are in cash, they grossly underperform and lose customers and revenues. At a time when investors are fleeing active overall, it is very costly to try to replace ones who have left dissatisfied.

But unless you are just willing to ride the waves as they come, someone somewhere needs to make the frequent decisions about when to dynamically reallocate across positions – and when to move to safety (like cash and gold) when markets are choppy. A deep knowledge of global markets is required to do this right.

The good news is all this can be done with an ETF portfolio. The bad news is that few investors are set up to do this in a systematic, reasoned way across global stock, bond, and alternatives exposures. And, once again, there aren’t widely known rules of thumb we can all use.

Back when ETFs were a small part of many portfolios they often served as a placeholder. What happened if you didn’t have a domestic small-cap active manager you liked? Putting that 5% of the portfolio into a Russell 2000 Value ETF was an easy solution. Ditto for emerging markets, commodities, etc.

When ETFs were a condiment and not the main course this was fine. But no more. ETFs continue to steal the lunch of traditional active managers, which I think is warranted. But this is not a shift to “passive” investing. Rather, it requires a new set of ideas, tools, and approaches to effectively manage these “passive” exposures.

This is what we spend all our time on at 55 Capital. It is crucial work because the answers are still being developed for navigating this ETF-heavy world. And it is no small task: we often liken this to shifting from playing checkers to three-dimensional chess. But in a world where ETFs are growing at a rate of nearly a trillion dollars a year, it is crucial that it gets done and gets done right.

Because the world is not becoming passive: it is becoming active in a new and more useful way.

 

1 Source: The Wall Street Journal, “Small Investors Run to ETFs,” March 4, 2017.

2 Source: CFA Institute, Financial Analysts Journal, “Determinants of Portfolio Performance,” 1986.

 

Are Bonds the Riskiest Asset in the Market?

Lee Kranefuss is Co-Chairman of 55 Capital.

People often buy bonds seeking safety or risk reduction. There is an assumption here that needs exploring – because right now long-term bonds are one of the riskiest assets in the market.

First, a little refresher on long-term bonds (and I will assume we are talking about 30-year bonds since we are talking about bonds, not notes or bills).

If you buy $100,000 of U.S. Treasury bonds today, and if interest rates are 3%, you will get $3,000 per year for 30 years (totaling $90,000 in interest), plus get your $100,000 back in year 30. Put in $100,000 today, and you end up with a total of $190,000 returned at year 30.

If you are an insurance company or government and have some fixed liability of $190,000 that you must pay in 30 years, this works fine: put up $100,000 today and you have immunized your future fixed liability. But few of us have those sorts of long-term, fixed liabilities. Instead, we invest to maximize future wealth without too much risk. We treat bonds as an investment like stocks.

Similar to any investment, problems arise in the future, whether it be unknowable future returns (as with stocks) or unexpected timing needs (as with bonds). To see this, suppose you had put $100,000 into bonds for “safety” at 3% yesterday. Imagine if next year you lose your job and need to move to a pricier city to work. To buy a house that’s more expensive than your current house, you need to come up with $100,000 in cash after selling your current home. If interest rates stay the same, you are in luck – because you have $100,000 in bonds squirreled away for just such a rainy-day scenario.

But what if rates went up in the meantime? What if they went from 3% to 5% along the way?

Go to any reference on bonds and you will learn that a 30-year bond loses about 15% of its value when rates rise 1%. This ratio between rates and price is called duration. Duration is roughly half the life of a bond: a 30-year bond has a duration of about 15, so a 1% increase in rates reduces the bond’s value by roughly 15%. Thus, a 2% rise in rates causes something like a 30% drop. If you try to sell those “safe” bonds to get $100,000 back, you have a surprise: you can’t sell those bonds for much more than $70,000. Whoops. Given the timing, those bonds were a very risky asset.

Bond risk is hard for people to understand because it is backwards from stocks. With stocks, we don’t know the future price or dividends; prices adjust in the future to reflect business results. Bonds are the reverse. With bonds, we know all the future payments, so prices must adjust now to reflect changes in current interest rates.

Everyone has the impression that government bonds are a risk-free asset when it comes to investing. They are not.

Here is another way to see this. Suppose you bought $100,000 of bonds yielding 3% on a Monday and you held them to maturity. After getting the $90,000 in interest payments and the return of principal in year 30, your bond account has (roughly) a $190,000 balance. So far so good.

Now let’s think harder about what happens if the day after you invested rates rose from 3% to 5%.

Had you waited until Wednesday – after rates rose – and bought $100,000 of bonds yielding 5%, your account would have ended up with $250,000 at the end ($5,000 of annual interest payments for 30 years, plus the return of principal) – a difference in final outcome of about 30% of total wealth (or $60,000). Before we looked at how early liquidation could hurt you. Now we see that the risk of future wealth could also vary by about 30% even if you hold to maturity over the full 30 years. Once again this is a very large risk: timing of investment makes a 30% difference.

Of course, we won’t see bond rates move 2% overnight. But 1% or 2% changes are well within normal experience. Today, some European government bonds are at negative rates. But in 1980, the coupons of U.S. 30-year bonds reached a high of 14.49%1. In fact, we believe the great “bull market” in bonds of the past 30 years has no thundering bull behind it. It is simply the result of falling inflation, and thus dropping interest rates, over that 30 years.

In our experience, a common error by investors is to think that bonds have no risk, so long as they wait the full 30 years. But, as you can see, the price of long-term bonds you buy today could drop from a 2% move in interest rates. And holding to maturity is no panacea since the future wealth you get could vary wildly depending on when you invest.

Why does this get missed so often? I think you can blame it on Modern Portfolio Theory (MPT) and the Capital Asset Pricing Model (CAPM). MPT and CAPM were designed to try to explain stock prices in the 1950s and early 1960s, the era of slide rules. To do that, they needed a hypothetical investment called the “risk-free” asset.

This was a poor choice of words. What is meant by the asset being “risk-free” is the technical quality that it has no correlation with the stock market. In this context, “risk-free” does not mean that credit quality is high, prices are stable, or payments are fixed. So, what could qualify as “risk-free”? Cash in a savings account for sure. But among other things that might qualify as “risk-free” are short-term junk bonds with enough yield to offset their credit risk, gold, fine art, or even rare comic books.

From sloppy language that gets used in MPT and CAPM orthodoxy everyone has the impression that government bonds are a risk-free asset when it comes to investing. They are not. What they are is fixed income assets because we know the schedule of payments upfront.

But from an investment perspective, bonds can be anything but risk-free. In fact, they can be a very, very risky part of a portfolio – even if held to maturity.

1 Source: http://www.macrotrends.net/2521/30-year-treasury-bond-rate-yield-chart

Goodbye to Stock Analysts: How Technology Will End the Profession and Practice

Lee Kranefuss is Co-Chairman of 55 Capital.

I was recently at a technology CEO conference. At one point, there was a discussion about how some companies no longer want to go public. One seasoned CEO bemoaned the amount of time that goes into analyst meetings when you are a listed company. I pointed out that things might get better fast: the very technologies these CEOs are applying to other problems – neural networks, machine learning, and other tools of artificial intelligence – could completely eliminate traditional stock analysis and analysts. I believe there is no reason it can’t.

When it comes to things like deep machine learning, you may have heard the terms but not yet appreciated the results. However, they are here. Today, you can download free software to build your own artificial intelligence algorithms, in a few minutes, that can detect handwritten numbers with well over 95% accuracy. In the past few years, advances in synthetic vision have allowed driverless cars. (Every time your computer identifies you with facial recognition or a fingerprint it is using that technology.) And Google has processed one hundred million street addresses with an accuracy as good as humans, but faster. They claim they processed all the addresses in France in under an hour.

Investing is not immune to technological innovations. Technology has already changed so much in financial markets that they are barely recognizable from even ten years ago. Only a decade ago, large investment banks had trading floors that were the size of football fields – and stock, options and futures exchanges had bustling pits. Today, those venues and floors are nearly empty – or totally abandoned.

Investing is not immune to technological innovations.

But it goes beyond people. Algorithmic and high-frequency trading has fundamentally changed markets. Every sale of one million shares is electronically broken up into thousands of 100 share trades to make big orders indistinguishable from an individual punting with a few thousand dollars. The real actions are masked by the sheer volume that comes from all those artificially small trades. If nothing else, the visibility of bulky trades, which might signal even larger trades waiting to hit the floor, is lost today.

So how does technology affect stock analysis? Analysts build large spreadsheets from financial data, trying to create a handcrafted forecast of the future results of the business. It is all about being a mile deep and a foot wide: spending enormous effort to try to get the right data about one company at a single point in time to decide if it will outperform or underperform business expectations.

But technology takes data analysis to another level. An algorithm can analyze not just one company at one time – but rather can evaluate every piece of financial data ever reported for every company to find patterns and identify opportunities across firms – and do it all in minutes.

What’s profound is while it used to be that only large, well-funded investment firms could do this depth of analysis, today, the data is available to everyone.
The end result? Algorithmic trading has made capturing trading profits harder, diminishing opportunities to capture alpha. Thus, leading to the rise of Exchange Traded Funds (ETFs) and factor investing. Instead of seeking fund outperformance, investors are focusing on how to combine factor exposures using low-cost ETFs.
Some observers believe we will look back to this decade in 100 years and say the computational changes happening today are as fundamental as when mankind developed electricity, the transistor, the gas engine, or airplanes. Those technologies put the city lamp lighter, the blacksmith, and the Pony Express out of business.

The traditional stock analyst may be one of the next professions to become extinct.