Tag: Jared Dillian

Let me begin by saying that if you aren’t on Twitter, you’re making a huge mistake. I was encouraged to get on Twitter years ago by a tech-savvy friend. There is a learning curve. It’s not the easiest thing to get the hang of. Used correctly, it can make you smarter. If you could take a smart pill to make you smarter, you would take it, right? Get on Twitter.

So I saw an interesting table on Twitter—someone had taken a photo of a table out of the print version of Barron’s magazine and tweeted it to their followers. I am reproducing it here:

Nasdaq, Then And Now

Below are the top 10 stocks in the Nasdaq Composite Index.

The first thing you notice is that there’s been a huge turnover. Sun Microsystems disappeared, the box business was so bad Dell took itself private, and WorldCom… well, we all know what happened to it.

But the even more obvious thing is the valuations. If I’d told you 15 years ago that big tech companies like Cisco and Intel would end up with valuations in the teens, you would have called me crazy. And even if you had believed me, you probably would have thought that the P would go down, instead of the E going up.

Continue reading “I Heart Capitalism”

 

I first started working in the financial markets—as a clerk on an options exchange—in November of 1999.

Four months before the top.

So over the first three formative years of my career, stocks only went down, not up. Not only did they go down, but they went down relentlessly. Demoralizing everyone. Extinguishing all hope.

So, for pretty much my entire career, I have had a bearish bias.

Some folks in the financial media will really beat up on the bears. Don’t beat up on me! It’s not my fault. I was born this way.

If you had started trading from 2000-2003, you would probably be like this, too.

Shaped by Your Experiences

When I was eleven or twelve years old, I once rummaged through my mom’s VHS tapes and found something called What You Are Is Where You Were When. Sounded like a mouthful. So I sat in the basement of our tiny house and watched it.

The video was by a guy named Morris Massey, a business consultant/sociologist who made a living doing seminars and selling tapes about his particular brand of social psychology. His view was that you were pretty much a fully formed person by age 21, and you weren’t changing much after that. But who you were at age 21 was a product of your experiences in early childhood, middle childhood, and your teenage years.

It was based on events that happened to you, but also what was going on in culture and politics and sports and current events. For example, World War II had an indelible impact on “The Greatest Generation,” or for a more contemporary example, take the relationship between Millennials and technology.

Judging from the videos, Morris Massey was a pretty compelling guy. He’d get really animated and even angry in some parts as he told stories about what he called “significant emotional events,” things that have such a profound effect on you that they will literally change the course of your life.

I thought this was pretty fascinating stuff. Even at a young age, I was interested in social psychology. I ended up incorporating a large part of Dr. Massey’s message into my own worldview, especially as it pertained to markets.

Continue reading “The Morris Massey Market”

 

I am a sometimes gold bug and hard-money advocate, and a hard-core fiscal conservative. I have a pretty bearish outlook on the markets, I am generally skeptical of company management and especially journalists, and I think most investors, even the professional ones, are clueless.

I’m one of those hopeless romantics who pays down his debt (often ahead of schedule), would never ask for a bailout, and would be loath to sign up for unemployment benefits or even Social Security. If I looked hard enough, I could probably find a tinfoil hat that fits.

However, people who fit this profile are not typically big advocates of technology. You can’t use social media after the Snowden revelations, your phone is like a LoJack for the government, and who would trust a self-driving car?

I would. Do you know how much reading you could get done?

I love technology, and in spite of my bearish bent, I am a huge technology optimist and futurist. I was foaming-at-the-mouth bullish on Facebook back in 2008, when it was not yet public, at a $20 billion valuation. I said it would someday be worth $100 billion. People threw rotten eggs at me. It is now worth twice that.

I said it would be worth a trillion. It’s not there yet. Back then, in 2008, in the middle of the gosh-darn financial crisis, people were already talking about the bubble brewing in Silicon Valley.

Seven years later, I think that is a more reasonable discussion to have.

Opulence

But it’s hard to know where to begin.

Let me start by saying the level of opulence in Silicon Valley has far exceeded what was present in the Bay Area 15 years ago. The developers with the $350 ripped jeans and $125 flip-flops have been around for years, but this is different.

Check out San Francisco Magazine’s description of the food court at a well-known tech company:

There’s a produce section that’s forging farm-direct relationships. A whole-animal butcher who makes bone broth in-house. A fish counter that sources its own fish with the help of the sushi bar. Which—by the way, there’s a sushi bar and an oyster depot. Four Barrel coffee and Blue Bottle coffee. The obligatory Project Juice kiosk. A cheese guy. Tapas. Noodles. A wine shop. Ice cream. Pizza. Tacos. A salad bar. A bakery.

You might be deceived into thinking this is normal, especially in San Francisco where you are occasionally forced to dodge sidewalk poop (there’s an app for that), but it’s not.

The real estate market, too, has gone parabolic. See for yourself: pull up Zillow and cruise around Palo Alto to see the two-bedroom ranch houses going for $3-4 million.

But these sorts of things are never reliable signs of a top, because stupid can always get stupider, and it usually does. As I wrote in last week’s piece about trend following, it’s not productive to try to top-tick things anyway. But if Silicon Valley has a meaningful correction, it’s going to send shockwaves throughout the economy.

Continue reading “You Can’t Stop Progress, Supposedly”

The buzz has been building on this trade for weeks. Clients, friends, people on Twitter, everyone I know has been waiting for a chance to pick the bottom in oil.

I’ve heard all this chatter on which triple-leveraged oil ETFs to use (I make a point of not knowing such things). They’ve been waiting for this opportunity since oil was at 80 bucks.

Interestingly, they could have shorted it when it was at 80.

Actually, they could have shorted it at 110.

Or 100.

Or 90.

Or 80.

Or 70.

Or 60.

Or 50. They could have shorted it at 50 and still made money.

But they waited this entire time, watching passively as oil plummeted over 60%, to play a 10-point bounce over the course of a couple of days.

Well, the mean reversion monkeys, as I call them, will tell you that they just made 20% in three days. Annualize that!

Continue reading “Mean Reversion Monkeys”

I’ve been following the activities of Syriza for a long time. They started putting up big numbers in the polls in Greece three or four years ago.

Syriza has a message that’s very popular with Greeks: Screw Germany. The word they use to describe what’s happened to Greece during the period of time since the debt crisis is “humiliation.”

To be fair, if you owe a lot of money to someone, it can be tempting to give them the finger. When Greece’s debt was restructured, it was done in such a fashion that none of the debt was really forgiven, but the maturities were extended far out in the future. Since Greece doesn’t grow (for structural, demographic, and cultural reasons), this is known as extend and pretend. Everyone knew, even back then, that the only hope Greece would have to avoid default would be whatever ability they had to refinance.

Greece has been struggling under the yoke of this debt over the last few years, and the Greeks are sick of being serfs. So Europe gets the bird, although deep down, Greece doesn’t really want to drop out of the euro. They get a lot of benefits from being part of the Eurozone, namely purchasing power and low interest rates.

So naturally, having and eating their cake simultaneously is the goal.

Continue reading “Socialism Is Like a Nude Beach—Sounds Like a Great Idea Until You Get There”

 

Pretend you are a corn trader. As such, you have two choices: have a position in corn futures or own physical corn.

It may seem silly to even consider owning physical corn, because corn futures are easy to trade—just click a button on your screen. But assume you have a grain elevator, and whether you own futures or physical corn is all the same to you. How do you decide which you prefer?

If one is mispriced relative to the other.

If you consider owning physical corn, you have to take into account the cost of storage and any transportation costs you may incur getting the corn to the delivery point. You also have to think of the cost of carrying that physical corn position, or the opportunity loss you incur by not investing the money in the risk-free alternative.

The thing is, there’s nothing keeping the spot and futures markets on parallel tracks, aside from the basis traders who spend their time watching when the futures get out of whack from the physical.

That basis exists in just about every futures market, even in financial futures that are cash-settled. In fact, that was pretty much my life when I was doing index arbitrage—trading S&P 500 futures against the underlying stocks. I was basically a fancy version of the basis trader in corn.

With stock index futures (like the S&P 500, or the NDX, or the Dow), the basis is slightly more complicated. Not only do you have to calculate the cost of carry—which is usually determined by risk-free interest rates and the stock loan market for the underlying securities—but you also have to take into account the dividends that the underlying stocks pay out. Remember, futures don’t pay dividends, but stocks do. At Lehman Brothers, we had a guy whose sole job was to construct and maintain a dividend prediction model for the S&P 500.

So far, so good. However, one of the first things I learned about on the index arbitrage desk was EFP, which stands for Exchange for Physical—a corner of the market almost nobody knows about.

Basically, we could take a futures position and exchange it for a stock position at an agreed-upon basis with another bank or broker. Interdealer brokers helped arrange these EFP trades. The reason so few people know about them is probably because, historically, the EFP market has been very sleepy. The most it would usually move in a day was 15 or 20 cents in the index, or in interest rate terms, a few basis points.

Now it is moving several dollars at a time.

Continue reading “The 10th Man: EFPs and The Unanticipated Consequences of Purposive Social Action”

 

I recently watched the movie Interstellar in the theater. I liked it so much, I watched it again… and again. Three times in 10 days. Next, I’ll get the DVD and see it dozens of more times. It’s my new all-time favorite movie.

I’m something of an astrophysics geek. I think in another life I might have been one of these nerds working for the SETI project like Ellie Arroway in Contact. For my fifth-grade science project, I constructed a planetarium show. When my schoolmates were playing Contra on Nintendo, I was reading about quasars.

Interstellar fascinates me because I don’t understand how someone gets $150 million of financing to make a movie that no one who doesn’t understand Einstein’s theory of relativity can fully appreciate. Christopher Nolan is a stud. There is no other explanation.

I had to smile each time I left the theater, listening to the people walking out. “I didn’t understand any of that!” they would say. I think knowledge of the cosmos is pretty low in my corner of South Carolina.

I won’t spoil it for you, but let’s say there’s a lot of physics knowledge required for that movie. Incidentally, there’s a lot of physics knowledge required for trading too.

The derivatives guys understand this. Most conventional option pricing models are based on something called “geometric Brownian motion,” which was originally used to describe the movement of a particle suspended in a liquid or a gas.

Emanuel Derman, author of My Life as a Quant and contributor to the Black-Derman-Toy model that pioneered the pricing of bond options, started out as a darn good physicist. Then he was hired by Goldman Sachs. Lots of quants (quantitative analysts) are former physicists. Finance and physics really are that similar.

I have my own theories about financial physics.

1. Stocks and bonds are matter. They are things. They are particles. They literally are physical objects—in the old days, certificates. Nowadays, they have a CUSIP. You can clip the coupons. In bearer form, they were worth money. Nowadays, nobody really gets to hold a bond in his hand, but it’s still tangible as far as I’m concerned. The foregoing also applies to currencies. And commodities… well, they are as tangible as you can get.
2. Credit and volatility are not matter. They are forces very similar to gravity. Think about it: credit is the willingness or ability to repay. It’s a feeling, a sensation, a psychological construct. But it is not a thing. It has neither a certificate nor a CUSIP. But credit is directly related to volatility—otherwise the credit guys wouldn’t hedge with VIX call spreads all the time.

The one thing we know about gravity is that it is not constant in the universe. There can be large disturbances, like a black hole, where time can actually slow down—exactly like the gravitational time dilation described in Interstellar. When volatility increases (and credit widens), options decay more slowly. Volatility (“vol”) and time work in opposite directions.

Vvol Is Sky-High Right Now

We are currently experiencing—I’m grinning as I write this—disturbances in the force. Credit and volatility have never acted this way before, and I can quantify it exactly.

Never before has the VIX gone from 11 to 20 in just four days. A few weeks ago, I wrote about the outsize influence volatility ETFs were having on the vol complex, and that remains true. I think this can partially be explained by people panicking out of XIV, the VelocityShares Daily Inverse VIX Short-Term ETN.

But it’s actually bigger than that. Volatility is itself volatile. You can measure the volatility of volatility; traders call it “vvol.” And the only times vvol has been this high since the advent of VIX options were in 2007, 2008, and 2011—all times of serious crisis.

But we aren’t in a crisis now, are we?

Well, we might be, if you think vvol has any predictive power, as I do. Certainly nothing of the magnitude of ‘07,  ‘08, or  ‘11. But when you’re having 700-point intraday round trips in the Dow and vvol is at crisis levels, I think it’s time to start asking the hard questions.

“… Where No Man Has Gone Before”

The bigger picture is: Russia is experiencing a full-blown currency crisis, whether anyone is calling it that or not; emerging markets are in meltdown mode (as predicted by some of my colleagues here at Mauldin Economics); and the price of the single most important commodity in the world has just been cut in half in the span of a month or two.

These are not normal times. And the bull market in stocks is very, very advanced.

Even though I write for a living, I’m a former trader, so I still spend my days staring at the screens. I haven’t seen anything like this before. New territory here—and not in a good way.

But I’m a student of volatility and credit, and I paid attention in early 2009 when no put option was too expensive and no bond was safe. It feels as if something like that might be in our future.

Jared Dillian

 

One of my old rules of trading is that whenever a major asset class, index, or other benchmark has a sudden, rapid move in price, something blows up. Sky high.

That’s because people get used to regimes. They get used to a certain state of affairs with a lack of volatility. They become complacent. Maybe they stop hedging. Maybe they allow themselves to have unbounded downside risk. Maybe they start gambling.

In the last month, we’ve seen massive moves in the dollar and oil—and I assure you, someone is going to get hurt.

So far I haven’t said anything controversial. Energy companies are going to get hurt by lower oil prices. Exporters are going to get hurt by a rising dollar. A chimpanzee could figure this out.

But there are second-order effects. People are starting to figure out that Canadian banks are going to get hurt by the lack of investment banking business from the energy sector, and the stocks are getting punished.

And there are third-order effects too, which people will soon discover.

If you sit around and think hard enough, you can make these sorts of connections. Some people are very good at this. A commodity price moves fast, and they can figure out the point of maximum pain for some company far down the supply chain from the actual commodity.

I’m not that smart. But I’m smart enough to get out of the way when something big and important like oil moves 40%.

Let’s step into our time machine and set the dial to 1994. That was the year when interest rates backed up a couple of percentage points. Remember the bond market vigilantes? They were pricing in Hillarycare and a Democratic Party wish list, and they caned the bond market until interest rates were making borrowers squeal.

But what was interesting about 1994 was that in the grand scheme of things, interest rates didn’t go up all that much. Just a couple of percentage points. Now, if I asked you who you thought would get hurt by rising rates, you might say banks, hedge funds. And you would be wrong. Who got hurt by rising interest rates?

Procter & Gamble.

Orange County, CA.

Mexico.

Why did the first two blow up? Derivatives.

By the way, I’m not referring to derivatives pejoratively. I’ve spent most of my adult life trading them. They’re not financial weapons of mass destruction. What they do is take risk over here and move it over there. So if bank XYZ was negatively exposed to higher interest rates, they were able to offset that exposure to Orange County through derivatives.

Of course, the derivatives Orange County was trading were very exotic and clearly unsuitable for a municipality, but that’s a discussion for another time over a burger and a beer. The point is that rates moved, and they moved fast, and stuff blew up.

But not the stuff you thought would blow up.

Buying Volatility on the Cheap

So I know what you’re going to ask me next: What’s going to blow up?

Who knows? By definition, you can’t know, especially when the risk has been laid off through derivatives.

But this is how it works: Oil moves 40%, the dollar moves 10-15%, and someone’s out of business. It could be someone big. It could be someone systemically important, someone that could really spook the markets. So when stuff like this happens, I get myself exposure to things that gain from disorder (paraphrasing Black Swan author Nassim Taleb).

With the S&P 500 Index (SPX) at 2,050 and the CBOE’s Volatility Index (VIX) at about 15, systemic risk is vastly underpriced.

I’m not saying that stocks are too high, that I’m bearish. I’m just saying that the derivatives markets aren’t pricing in what could be a big unwind based on these oil and dollar moves.

Translation: volatility is cheap.

Is $60 oil bullish for stocks, long term? Absolutely. It is one of the most bullish things I can think of. One of my clients recently told me that this decline in oil will result in $100,000 in annual fuel savings for his business. Multiply that times everyone. So bullish. And the dollar, also long-term bullish. But in the short term, there’s an Amaranth out there somewhere, potentially.

Maybe it’s not a hedge fund. Maybe it’s a company like Coca-Cola (KO) that gets the majority of its earnings from overseas. Maybe it’s the railroads. The person who can figure this out wins the prize.

As I said before, I’m not that smart… just a former trader with scabs on his knuckles. But the funny thing about those traders—especially the ones over 40—is they have a nose for trouble. I’m all in favor of bullish developments, just not when they happen really fast and nobody is ready, which is how people get maimed.

Position: long three-month SPY puts, short Canadian Imperial Bank of Commerce (CM) and Toronto-Dominion Bank (TD) (the US-listed shares).

Jared Dillian

 

When I was in junior high, my friend Scott had this Billy Crystal tape that we passed back and forth to each other. I still like Billy Crystal, but let’s just say he was truly hilarious when I was 13 back in 1987.

He had this routine about old codgers who used to tell you how hard life was in the old days.

“We had no air…” he’d say, in an old man voice. “No food. We ate wool coats and we were happy.”

Then he’d project into the future when he would be an old man, talking about what it was like in the Sixties, about Woodstock.

“We closed down the New York State Thruway, we were crazy… hippie… bastards.”

Battling Deflation at Any Cost

Today’s central banking world kind of feels like Woodstock to me. Lots of long hair, tie-dye, and perhaps a generous helping of body odor. Certainly hallucinogenics are involved.

Think about it. In the old days, as long as we could remember, the job of a central bank was to prevent inflation. Also, to promote economic growth and keep people in jobs, but they weren’t really serious about that. The only thing they were really serious about was preventing inflation—and sometimes they did a bad job anyway.

But around 1980, central banks got religious about inflation and started to do drastic things, like raising interest rates. It worked so well that every couple of years they would raise rates again. As a result, inflation went down over time, to the point where it became a negligible factor in economic decision-making, which was the whole point of the exercise.

Well, with price stability achieved, there wasn’t much left to do, but central bankers get paid too much money to sit around and stare at each other. And the one thing we learned over the last 20 years is that central bankers are only appreciated during a crisis, which is when they get to do stuff, whether it works or not.

So a new crisis was invented: deflation.

Now, you might ask why nobody thought of deflation as a threat before. There are several reasons, but principally, it hadn’t been around in a while until it reappeared in Japan.

The deflation in Japan was quite nasty. Everything was going in reverse. Not only was there deflation, but there were deflation expectations. People expected prices to go down, so they did. Wages went down, too, which sucks if you have a fixed mortgage or car payment.

In deflation, debt gets larger in real terms. But it’s great for savers. If you’ve got money in the bank earning 0% interest, but there’s 3% deflation, you’re actually doing pretty well.

This went on for years in Japan, and is still going on, although they are trying hard to get out of it.

I do find this sudden obsession with deflation peculiar. In the US, inflation has stayed positive except during the financial crisis. In Europe, it’s hovering around zero but is not really negative. There is plenty of inflation elsewhere in the world. And you can go into a spreadsheet program and see how 2% inflation compounds over time, and look at the loss of purchasing power, and you will realize that even low inflation can be quite sinister.

What’s Bad About Deflation?

But here’s the funny thing about Japan. Japan has probably had the biggest boom-bust cycle of any developed country in the modern era. The bubble was bigger than the dot-com bubble in the US in 2000, and the bear market continued for two whole decades. Plus, they’ve had years of this awful deflation, where it gets harder and harder to meet fixed debt service payments.

(Editor’s Note: We will be discussing Japan in some detail in a future issue of Bull’s Eye Investor. But don’t wait till then to join us. In the current issue, we have an in-depth analysis of why investing in airlines is the thing to do now, and a great pick of a hugely profitable airline with no debt and excellent earnings prospects. Click here to get it now.)

And yet, Japan remains one of the richest countries in the world, with a higher standard of living than just about anyone.

There are no shortages. They have plenty of food and fuel.

There have been no riots, no civil unrest.

Stocks were down 80%, but you didn’t hear anyone complaining.

So sure—deflation is annoying. And it’s not ideal. It’s not exactly price stability. But some things are worse.

So if you get too much deflation, you turn into Japan.

But if you get too much inflation, you turn into Weimar Germany, Zimbabwe, Argentina. People die in inflation.

I assure you that, given the choice, you would rather live in Japan than Argentina.

Asymmetrical Response

So the reason that central banks used to care more about inflation than deflation—and still should—is because high inflation has far worse consequences. Their approach to price stability should be asymmetrical.

Say there is 20% inflation. I need to buy some fertilizer for my lawn. I go to Lowe’s and get a bag of fertilizer, but I say to myself, “Wait, maybe I should get another one, because I’ll need it in a few months and the price will be higher. So maybe I should buy two.

“But wait—why don’t I buy all 20 bags of fertilizer sitting here, take them home, and when the price goes up, I’ll sell them to my neighbors?”

So I buy 20 bags of fertilizer and put them in my basement.

Then my neighbor goes to Lowe’s to buy fertilizer, but it’s gone, and the guy at Lowe’s tells him the jerk up the street bought it all. So now my neighbor is pretty angry at me.

There are a lot of angry people in inflation, and shortages of goods. One is related to the other.

Oddly, in deflation, everyone bands together.

Inflation Is Groovy, Man

Today, central bankers are trying to create inflation as fast as they can. It’s happening here in the US, in Europe, in Canada, now in China, even Australia.

They aren’t trying to create just a little inflation—they want above-trend inflation of 3%, 4%, maybe more. It’s like we have complete amnesia about how horrible it was in the Seventies. Nobody is asking the hard questions here. What if you succeed, but succeed too well? What if you can’t reverse it?

Just because we may be surrounded by deflationary forces doesn’t mean that QE isn’t a bad idea. Above all else, the central banks fear the “liquidity trap,” the point at which monetary policy no longer has any effect. They fear this more than anything.

I think one day, 20 or 30 years in the future, we will look back at this point in time and just shake our heads at what crazy hippie bastards we were, collectively. We will teach in freshman economics classes how we used to fight lower prices.

“Did you know there was a time,” the professor says,” when central banks were actually trying to create inflation?”

“Why would they do that?”

He shakes his head grimly. “Nobody knows.”

Jared Dillian

 

After 30 years of declining interest rates, bond investors are beginning to worry that rates will go higher—especially after the events of May 2013.

Back then, 10-year yields went from 2% to 3% on a frozen rope. Things got very dicey in fixed income. Some holders of corporate bonds (like the new Apple bond) were suddenly down 10% just on interest rates alone.

So worrying about rising rates is not unreasonable. People learned very quickly how duration works, after having forgotten for decades. If you’ve never taken a bond math class, all you need to know about duration is this:

1. It is the weighted average time to maturity of all coupon and principal payments.
2. It is an approximate measure of interest rate risk.

With regard to 2), if the duration of a 10-year Treasury note is 8.5 years, for every 1% change in interest rates, the price of the bond will change by approximately 8.5%.

A 1% change in interest rates doesn’t sound like a lot, but an 8.5% hit to your capital if you’re a bond investor sounds terrible.

After 2013, people were looking for ways to mitigate interest rate risk and yet hang on to their bond portfolios. That is hard to achieve, because, well… bonds have interest rate risk!

Unconstrained Bond Funds

So this is the Holy Grail of bond investing: how to create a durationless portfolio that still has a return. People are doing it, with mixed success.

A few years back, people started investing in what were known as “unconstrained bond funds.” As the name implies, an unconstrained bond fund isn’t restricted to a sector or strategy or even a country. Unconstrained bond funds can invest in corporate credit, sovereign credit, currencies, high yield, emerging markets, any and all derivatives, and of course, Treasuries. They can invest in just about anything in any allocation.

Unconstrained bond funds have been known to move very quickly in and out of certain credits, even holding over 50% cash at times. The manager has broad discretion to change his asset allocation to maximize returns and more important, to dodge rising rates.

Unconstrained funds have become very popular. Unsurprisingly, money moved out of core bond funds in 2013 (after people got whacked on rates) and into unconstrained funds, which theoretically shield you from higher rates. Maybe.

That depends largely on the manager. In the old days of bond investing, you would pick a bond fund with a narrowly defined mandate, like “medium-term corporates,” and the bond manager would spend his life trying to outperform the stated benchmark.

For a core bond fund, the typical benchmark is the Barclays (formerly Lehman) Aggregate Index. This index is very heavy on government bonds and mortgages, and in a world of potentially rising rates, nobody wants to be tied to the “Agg,” as it is known.

In an unconstrained bond fund, the manager can hedge interest rate risk with futures, options, or swaps, or even short Treasury bonds or notes, and make up the loss in yield by overweighting credit. In fact, this is what many of them do. Of course, this all comes at a time when credit is very overpriced and there are even more concerns about the valuation (and liquidity) of corporate bonds.

There’s also the idea that the whole point of investing in a bond fund is to diversify away equity risk—bond funds usually do well when stock funds are doing poorly. But high yield actually has equity-like characteristics, so if you’re immunizing the duration and loading up on credit, you are doubling down on your risk profile.

Market-Timing Your Way to Victory

I think it’s kind of interesting that investors are giving so much latitude to the managers of unconstrained bond funds. What they are doing, in essence, is market-timing, something that is generally frowned upon when done by amateurs.

Some people will do it well, but most people will do it poorly. It is very hard to evaluate one unconstrained bond fund against another because you can’t even look at the portfolio on a static basis and judge it on its investment merits. You’re betting purely on the skill of the manager. It’s like betting on jai-alai. The players probably have a better idea of who’s going to win than you do.

In general, the unconstrained bond funds haven’t been doing all that great. If they’ve outperformed core funds, it hasn’t been by much. But they haven’t yet been tested by a rising rate environment. These guys might find that their hedges don’t work in the way that they planned or, at worst, give the portfolio return characteristics that mimic equity funds and other asset classes.

It’s no fun when everything you own goes down at the same time.

You occasionally see these situations in finance, where people want to have their cake and eat it, too. There are dozens of examples, but the classic one is portfolio insurance, where people want to cut risk without cutting the actual portfolio—pretty similar to what’s going on here with bonds.

There probably aren’t any systemic consequences to the proliferation of unconstrained bond funds, except a continuation of the credit bubble and maybe a lot of unhappy investors. If you reduce risk over here, you’re going to end up adding it over there—at least, if you want to achieve the same or greater return. There is no way around it.

At least it’s fun for the managers. I’d much rather be swinging it around with FX and derivatives than trying to beat the medium-term corporate bond index by a couple of basis points.

Plus, the fees are higher.

Corrections/Amplifications: Last week in our discussion about gold, I implied that Barry Ritholtz, CIO of Ritholtz Wealth Management, was permanently bearish on gold. That is actually untrue: Barry was long gold for an extended period of time, starting in 2005, which I was not aware of. His objection to gold has less to do with gold itself and more to do with people’s lack of discipline and risk management with regard to the asset class. My apologies to Mr. Ritholtz.

Jared Dillian

 

I had an instant-messenger conversation with one of my clients the other day. It was pretty annoying—he wrote things like “BULL MARKET, DUDE,” and harangued me about my net-short positioning.

Then he started telling me that the market was going to rip if the Republicans took both houses of Congress in the midterm elections. At that point, I felt like I needed to intervene.

First of all, just about every single piece of academic research on the subject shows that the stock market (and GDP, and many other metrics) outperforms under Democratic presidents.

You don’t need to look very far for a contemporary example, considering that the stock market has done a three-bagger under our current leader, and the economy has recovered.

Wait, that doesn’t make any sense. The current administration is the least friendly to business and private enterprise in recent history—so why have stocks been in a prolonged bull market?

There are a million reasons why, but let’s focus on the biggest and most obvious one: the Federal Reserve.

Shaping the Fed Board of Governors

Lots of people have opinions on the Fed without really knowing the Fed as an institution or how it works.

To review, there are seven members of the Federal Reserve’s Board of Governors who live and work in Washington, DC. They are presidential appointees, and their term of service is 14 years.

There are 12 regional bank presidents, who are nominated by their respective boards of directors. They are not, theoretically speaking, political appointees. Four of them at a time serve on the FOMC, on a rotational basis. The president of the New York Fed is a permanent member of the FOMC. Their term of service is five years.

In the old days, a Fed governor would serve all 14 years, but now they have to go make money on the speaker circuit, so they serve only three to five years if they are lucky. This means that a two-term president has the opportunity to “pack the court” with Fed governors of similar political affiliation over an eight-year period.

I would argue that the power to shape the Fed Board of Governors is even greater than the power to shape the Supreme Court.

Look at the current Board of Governors:
Janet Yellen
Stanley Fischer
Daniel Tarullo
Jerome Powell
Lael Brainard

There are two vacancies, but these are all Obama appointees. Yellen served as president of the San Francisco Fed before joining the Board of Governors as vice chair.

By and large, you can divide up central bankers into two camps: dovish central bankers, who prefer easy monetary policy (low interest rates) and hawkish central bankers, who prefer tighter monetary policy (high interest rates). Dovish central bankers tend to be Democrats. Hawks tend to be Republicans. It’s not a one-for-one correlation, but it’s close.

Everyone currently on the Board of Governors is a dove. (Powell is sometimes thought of as a centrist.) There are some hawks at the regional Federal Reserve banks, since the boards of directors are businesspeople and tend to appoint other businesspeople. Jeffrey Lacker, Charles Plosser, and Richard Fisher are all notable hawks. Inconveniently, though, they only end up on the FOMC once every three years.

George W. Bush packed the Fed, too (Duke, Warsh, Mishkin, Kroszner), but his appointees are all gone now. However, if they had served out their 14-year terms, they would still be around, and we would have a much more balanced Fed.

What Life Would Look Like Under a Hawkish Fed

Even though the presidential election is two years away, I think it’s worth having this conversation today. Seriously, what would happen if someone like Rand Paul became president? And Congress were solidly Republican?

Let’s start with the Fed. Yellen would not be reappointed; that is very clear. Over the course of a few years, the Board of Governors would be reshaped.

It’s hard to imagine in a day and age where every time a relatively benign stock market correction occurs, Fed officials are dropping hints of quantitative easing, but a hawkish Fed wouldn’t go for that kind of stuff. It would allow the market to purge its own excesses. It might even be a little laissez-faire.

We’ve had an interventionist Fed and an interventionist monetary policy on and off throughout the history of central banking, but especially since 1998, when the Greenspan Fed bailed out everyone during the blowup of Long-Term Capital Management (LTCM).

I remember reading articles about the “Greenspan Put” in 2000. That turned into the Bernanke Put, then the Yellen Put, and more recently, the Bullard Put. If there’s a perception that the Fed doesn’t allow the stock market to go down, it is probably because the Fed really doesn’t want the market to go down.

All kinds of conspiracy theories have blossomed from this (the Plunge Protection Team, for example), which I don’t like. But the Fed has nobody to blame but itself.

Under a hawkish Fed, valuations would be sharply lower. “Sharply” is italicized here for a reason. If we get away from QE and ZIRP and back to something resembling a normal rate environment, you’d be looking at the stock market being down 20-40%.

Would a Republican Midterm Win Be Bullish?

Aside from the Federal Reserve, a Republican administration, together with Congress, would completely reshape government, in ways that we can’t even conceive of right now. Would the resulting legislation be more business-friendly? Well, it might be more market-friendly, and market-friendly and business-friendly are two different things.

I think there is a reason that the stock market outperforms during Democratic administrations. Two, actually.

1. Republicans appoint hawkish Fed officials who tend to tank the market.
2. Republicans tend to pass supply-side legislation, which works with a long lag.

I think Reagan should get credit for the massive expansion of the ‘80s and ‘90s, and Clinton should get credit for expanding free trade, but people forget that the early years of Reagan’s presidency were very tough. Paul Volcker unleashed a hurricane-force bear market—the ‘82 recession was one of the worst on record, though the economy recovered quickly.

So, no—I don’t think it’s clear that Republicans winning the midterm elections is bullish at all, aside from what a few computer algorithms will do the day after. In fact, I think it could be the prelude to a lot of pain in the markets.

I’m sure investors will be exchanging some inadvisable fist bumps the morning after Election Day. When George W. Bush was reelected in 2004, the market went bananas, but let’s not forget that he campaigned on lower taxes on dividends and capital gains. 2016 will be very, very different.

Jared Dillian

 

IBM went down hard on its quarterly earnings report this week. This made a splash in the news because, well, it’s IBM, and also Warren Buffett owns it, so it was a rare moment of human fallibility for him. But there is a lot more to the story than that. Very sophisticated people have been keeping an eye on IBM for some time.

In particular, Stanley Druckenmiller—former chairman and president of Duquesne Capital, former portfolio manager of Soros’s Quantum Fund, and, honestly, one of the greatest investors in modern times—went public about a year ago saying that IBM was his favorite short (which says a lot) and that it was the poster child for, well, the type of stock market we have nowadays.

What was Druckenmiller referring to?

Some Quick History

Ten years ago, during the housing boom, the consumer was the most leveraged entity, taking out negative amortization mortgages, cashing out home equity, things like that. The consumer got a margin call, which was ugly—you know the story—and has spent the last six years deleveraging.

While the consumer was taking down leverage, the US government was adding leverage, taking the deficit to over 10% of GDP at one point. But even the government is deleveraging (for the moment), and now it is America’s corporations that have been adding leverage, at a furious pace. We’ve had trillions of dollars in corporate bond issuance in the last few years.

So when corporations sell bonds, what do they typically use the proceeds for?

In theory, the proper use for debt is to finance capital expenditures. Growth. But in this last cycle, that’s not what the money has been used for. It’s primarily been used for stock buybacks and dividends.

Robbing Peter to Pay Paul

Now, there are good corporate finance reasons to lever up a balance sheet and conduct stockholder-friendly actions, like buying back stock or paying dividends. You can read about it in the corporate finance textbooks. For any company, there is an optimal amount of leverage. It’s even possible to be underleveraged.

But you see (and this is the important thing), when you take out debt to buy back stock, leveraging the balance sheet in the process, you may be increasing the optics of how profitable the business is by increasing earnings per share—but you are not actually changing the fundamentals of the business.

You are not actually increasing profitability. You are just rewarding one tranche of the capital structure (common stockholders) at the expense of another one (bondholders).

IBM just happened to be a particularly egregious example. IBM—whose core business was basically flat over six years—well, you’d never know it from looking at a chart of the stock. (Hint: it went straight up for years.)

What happened?

They tripled their debt over time, retiring stock, taking the share count under a billion, ramping up the earnings per share. The goal was to get it over $20, which they abandoned on the last earnings call.

Financial Engineering Works, to a Point

So what can we learn about financial engineering? It works, up to a point. In the short term, you can conceal from investors the fact that your business model is broken and you don’t have a plan. You can conceal it for a number of years, in fact. That is the thing about finance: you can suspend the laws of economics in the short term. But not forever. It will always come back to haunt you.

IBM is by no means alone. There are dozens, even hundreds of buybacks going on as we speak. One of my favorites is GameStop (NYSE:GME). It is an open secret that GME is the next Blockbuster, now that the technology exists for games to be downloaded over the Internet with no interruption of play. Everyone knows that unless there is a radical change in strategy, GME is doomed. But you couldn’t short the stock because of… a buyback.

So with a good portion of the S&P 500 buying back stock, it’s no surprise that it wants to keep going up, and hindsight being what it is, it has been very foolish to try and short it.

This Can’t Go On Forever

There is good news, though (or bad news, depending on your point of view). IBM might be the canary. Put another way, there is a limit to how many bonds can be issued, and for sure, the credit markets have been less accommodative lately. Maybe that is how it ends—the credit markets shut down, no more bonds, no more buybacks.

People kind of forget what it’s like when the credit door slams shut. I remember writing bullishly on Gannett (NYSE:GCI) back in 2008. The stock was in the low single digits. The market was very worried that the company would not be able to refinance an existing bond issue maturing in 2009. GCI did manage to refinance, and stockholders have been rewarded. But it was looking very sketchy there for a moment.

The credit markets are kind of my hobby horse, and it is the right of anyone with a hobby horse to ride that thing as long as possible. There’s been so much debt issued—at such unfavorable terms and at such low interest rates—that the credit markets are more vulnerable than at any point in history. A mild recession, and we are looking at 20% default rates. All it takes is a push.

Just last week, it looked like we were going to get it. A hint of QE4, and the market seems to have changed its mind. We shall see. I tend not to use phrases like “smoke and mirrors” to describe the stock market, because that is very tinfoil-hatty.

Put more thoughtfully, I would say that much of this 200% move in the stock market off the lows has been divorced from economic fundamentals, and based solely on financial engineering, which can be ephemeral.

It’s a self-reinforcing process that has worked for a while, but I don’t want to be around when it stops working.

Jared Dillian