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‘No Skid Marks’

November 17, 2017 April 30th, 2019

Oh, The Irony!

There’s a classic story on Wall Street that seems to repeat time and time again. It’s the story of a brilliant academician who turns his attention to the markets and focuses all of his intellectual powers on inventing a sort of financial alchemy. For a time, it works wonderfully but, ultimately, it all comes crashing down and in spectacular fashion.

For those of you who have been around the markets for any length of time, Long Term Capital Management probably comes to mind. I had only just entered the business a year or so before LTCM threatened to take down the global financial system but it was such a momentous event and made such an impression on me that I’ll never forget it.

LTCM was just such an example of financial alchemy. The founders, inspired by the mathematical risk models developed by Nobel prize winners Robert Merton and Myron Scholes, had discovered a method to producing minimal profits using derivatives to perform fixed income arbitrage. Then they levered it up. With assets of just under $5 billion, the fund borrowed nearly $125 billion to take positions in derivatives with a notional value of roughly $1.25 trillion. And at that point it doesn’t take much to wipe out your equity which, of course, is exactly what happened.

This might be the single greatest example of intellectual hubris gone wrong in the markets (soon to be overtaken by the central bank bubble aftermath). And I find it terrifically ironic that one of LTCM’s primary architects has now moved on to a new and far more popular version of financial alchemy. The Wall Street Journal reports:

A man once at the center of a world-rattling hedge-fund collapse believes you should think twice before trying to beat the market. Victor Haghani, a veteran of the legendary Salomon Brothers trading floor, is probably best known as a founding partner of Long-Term Capital Management LP, the hedge fund that posted huge returns using leveraged bets in the mid-90s before collapsing 19 years ago so spectacularly that the Federal Reserve deemed it a threat to the financial system. That experience dramatically altered the course of Mr. Haghani’s life, leading to a roughly decadelong break from full-time work, during which he seriously considered a career in another field, such as arbitration or academia… In the ensuing years, Mr. Haghani started pulling his family’s savings from a variety of complicated investments and putting them into index funds… “I feel like the wind is at my back,” he said.

Now if I were a passive investor with any sort of contrarian nature at all this would trouble me deeply. Then again, it’s not possible to be both these days. And when the guy who didn’t see the flaw in leveraging fixed income arbitrage out the wazoo doesn’t see the flaw in joining the most crowded trade in history I guess we shouldn’t be surprised. The wind is certainly at his back for now. Though, if we learned anything from LTCM, it’s that the wind can shift faster than they can adjust their sails.

And speaking of passive investing flaws, Nobel prize winner Robert Shiller came out last week and validated some of my concerns regarding the validity of the strategy in today’s environment:

The problem is that if you are talking about passive indexing, that is something that is really free-riding on other people’s work. So people say, ‘I’m not going to try to beat the market. The market is all-knowing.’ But how in the world can the market be all-knowing, if nobody is trying — well, not as many people — are trying to beat it? It’s kind of pseudoscience to think these indexes are perfect, and all I need is some kind of computer model instead of thinking about business.

Only in a mania can investors enthusiastically and en masse embrace a strategy in which its very popularity undermines its most basic assumption. As I wrote a few months ago, “The markets are only capable of being efficient to the extent that investors, as a group, are efficient in their analytical processes and in how they apply them to the markets. Because more investors have abandoned price-sensitive strategies for price-insensitive ones than ever before the markets have also become less efficient than ever before.”

This widespread inefficiency in the financial markets is on display daily. David Swenson, legendary manager of the Yale endowment, discussed this topic in an interview as part of the keynote session of the Stephen C. Freidheim Symposium on Global Economics:

You have to think about what’s going on in the tails of the distribution. I think that’s incredibly important. We spend too much time in finance class, in business schools or in colleges, thinking about normal distributions. And we know—we know the distribution isn’t normal. If securities returns were normally distributed, the crash in 1987 wouldn’t have happened. It was a 25-standard-deviation event. That’s an impossibility. And when you look at defining moments for portfolio management, they come in 1987, they come in 1998, they come in 2008-2009. And if you ignore that, you’re not going to be able to manage your portfolio effectively. But when you start out, you were talking about fundamental risks in this world. And when you compare the fundamental risks that we see all around the globe with the lack of volatility in our securities markets, it’s profoundly troubling, and makes me wonder if we’re not setting ourselves up for an ’87 or a ’98, or a 2008-2009.

It is, indeed, profoundly troubling. Rising societal acrimony, as a result of growing wage and wealth inequality, is feeding populist and nationalist trends harmful to global peace and prosperity; debt levels are off the charts as a byproduct of the most aggressive experimental monetary policy in modern history; and demographics tailwinds to growth and financial assets are now turning into headwinds.

At the same time, the Financial Times reports we are witnessing the lowest volatility environment for risk assets in at least 50 years. To put an even finer point on it, Charlie Bilello noted that this is now the longest period without a 1% intraday move for the Dow in history. In other words, as real risks continue to rise, risk, as priced by the markets, is nonexistent. It’s a fascinating dichotomy.

Yet this is not much of a mystery when you consider that the markets are, far more than ever before, being driven by strategies that expressly preclude the application of any common sense whatsoever in the analysis of risk. And when you have portfolio managers putting on an unprecedented amount of risk, as noted by the Merrill Lynch Global Fund Manager Survey, without any real consideration of risk you are absolutely setting yourself up for another 1998, which, coincidentally, was the year Victor Hagani learned the greatest lesson in his career. Or did he?

 

Credit Cycle Clues

One of the conclusions I believe it’s safe to come to in light of all of the above is that, to paraphrase my friend Peter Atwater, ‘when the market does finally hit the wall, there will be no skid marks.’ Passive investors, by their very nature, will be totally oblivious to any and all warning signs like those coming out of the credit markets today.

In addition to P2P, auto loans and credit cards are showing signs that the consumer credit cycle has already turned.

Even mortgages look like they’ve now joined the rising delinquency party.

On the corporate side, junk bond spreads started to widen again recently and it looks like they still have a very long way to go.

Mr. Market, of course, won’t notice until his head hits the windshield.

 

The Big Tech Backlash Goes Viral

Over the past few months we have been tracking the backlash against big tech. This week it broadened significantly. The Verge released the results of a massive survey of users about how they feel towards the largest tech players. The opening line of the article accompanying the results says it all:

This year marked a sea change in our attitude toward tech’s largest players — and not for the better. Facebook, with a user base twice the size of the Western Hemisphere, seems to be in the midst of an identity crisis: CEO Mark Zuckerberg spent much of 2017 on a national tour that The New York Times billed as a “real-world education.” Meanwhile, the platform has become embroiled in a national debate that started with fake news and has evolved into an investigation into how the Russian government weaponized the network to influence the 2016 presidential election. Next week, the company will be brought to testify in front of Congress on the matter. Amazon made considerable headway in its quest to serve every part of our lives, from acquiring Whole Foods this summer to rolling out a plan to get keys to our front doors just this week. Apple continues to amass a vast reserve last valued at $260 billion, but its top-tier devices have lost their luster, and it’s been years since the company released a truly game-changing product. Twitter has come under increased scrutiny for harassment and bot armies of nefarious origin, which may explain its tepid user base growth despite becoming the new unofficial platform for American politics. And there’s a growing sense, underlined by this summer’s $2.7 billion EU antitrust ruling against Google, that the entire cabal of big tech companies have turned the corner from friendly giants to insidious monopolies.

It’s hard to overstate how fast and how much people’s attitudes towards the companies are changing. And it’s not just the companies, themselves. It’s the leadership and even the rank and file workers at the companies that are feeling the heat. From the Guardian:

When Danny Greg first moved to San Francisco to work at Github in 2012, he used to get high-fives in the street from strangers when he wore his company hoodie. These days, unless he’s at an investor event, he’s cautious about wearing branded clothing that might indicate he’s a techie. He’s worried about the message it sends. Greg is one of many people working in tech who are increasingly self-conscious about how the industry – represented by consumer-facing tech titans like Google, Facebook, Amazon, Apple, Twitter and Uber – is perceived: as underregulated, overly powerful companies filled with wealthy tech bros and “brilliant assholes” with little regard for the local communities they occupy. Silicon Valley has taken over from Wall Street as the political bogeyman of choice, turning tech workers – like it or not – into public ambassadors for the 1%. “I would never say I worked at Facebook,” said one 30-year-old software engineer who left the company last year to pursue an alternative career. Instead, at dinner parties he would give purposefully vague responses and change the subject. “There’s this song and dance you learn to play because people are quick to judge.”

As for those “brilliant assholes,” there is a new book out that does a terrific job of explaining how our attitudes are changing here. These guys used to be the geniuses who “think different” and, by doing so, change our lives in positive ways. Now they’re just 21st century drug dealers ruining our lives and getting filthy rich in the process. From Irresistible: The Rise of Addictive Technology and the Business of Keeping Us Hooked:

In late 2010, Jobs told New York Times journalist Nick Bilton that his children had never used the iPad. “We limit how much technology our kids use in the home.” Bilton discovered that other tech giants imposed similar restrictions. Chris Anderson, the former editor of Wired, enforced strict time limits on every device in his home, “because we have seen the dangers of technology firsthand.” His five children were never allowed to use screens in their bedrooms. Evan Williams, a founder of Blogger, Twitter, and Medium, bought hundreds of books for his two young sons, but refused to give them an iPad. And Lesley Gold, the founder of an analytics company, imposed a strict no-screen-time-during-the-week rule on her kids. She softened her stance only when they needed computers for schoolwork. Walter Isaacson, who ate dinner with the Jobs family while researching his biography of Steve Jobs, told Bilton that, “No one ever pulled out an iPad or computer. The kids did not seem addicted at all to devices.” It seemed as if the people producing tech products were following the cardinal rule of drug dealing: never get high on your own supply. This is unsettling. Why are the world’s greatest public technocrats also its greatest private technophobes?

And as for the “underregulated” side of things, this may be changing… and soon. The Economist explained the need for an updated antitrust framework for the digital era:

The case for being sanguine about competition in the tech industry rests on the potential for incumbents to be blindsided by a startup in a garage or an unexpected technological shift. But both are less likely in the data age. The giants’ surveillance systems span the entire economy: Google can see what people search for, Facebook what they share, Amazon what they buy. They own app stores and operating systems, and rent out computing power to startups. They have a “God’s eye view” of activities in their own markets and beyond. They can see when a new product or service gains traction, allowing them to copy it or simply buy the upstart before it becomes too great a threat. Many think Facebook’s $22bn purchase in 2014 of WhatsApp, a messaging app with fewer than 60 employees, falls into this category of “shoot-out acquisitions” that eliminate potential rivals. By providing barriers to entry and early-warning systems, data can stifle competition.

State AG’s aren’t waiting around for Washington to take action. The Washington Post reported:

Missouri’s attorney general said Monday that he has launched an investigation into whether Google has mishandled private customer data and manipulated its search results to favor its own products, a further sign that Silicon Valley’s political fortunes may be on the descent. The probe comes after European antitrust regulators levied a $2.7 billion fine against Google in June and as Washington is taking a harder look into the influence of dominant tech companies in American society. Attorney General Josh Hawley said that the investigation will focus on three issues: the scope of Google’s data collection, whether it has abused its market position as a dominant search engine and whether the company used its competitors content as its own in search results. The state has issued Google a subpoena seeking information about its business practices.

Even beyond antitrust action, there are calls to take back some of the power we have individually granted to these data-hogging behemoths. The New York Times reported:

Our data is valuable. Each year, it generates hundreds of billions of dollars’ worth of economic activity, mostly between and within corporations — all on the back of information about each of us. It’s this transaction — between you, the user, giving up details of yourself to a company in exchange for a product like a photo app or email, or a whole ecosystem like Facebook — that’s worth by some estimates $1,000 per person per year, a number that is quickly rising. The value of our personal data is primarily locked up in the revenues of large corporations. Some, like data brokerages, exist solely to buy and sell sets of that data. Why should companies be the major, and often the only, beneficiaries of this largess? They shouldn’t. Those financial benefits need to be shared, and the best way to do it is to impose a small tax on this revenue and use the proceeds to build a better, more equitable internet and society that benefit us all.

The negative sentiment towards these companies and calls for action are seemingly going viral right now. If these trends continue it’s going to be hard to see how these companies won’t be affected and in a major way. And because they are the “super-stocks” of the current bull market this has major implications for the broader stock market as a whole.

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