Photo Credit: picme1983 || Imagine a hurricane that never stops entirely

This should be a short post. When valuations are high, volatility is typically high as well. When interest rates are low, volatility also is high. Why? A situation has been set up by the functional equivalent of the “Wizard of Oz” where small changes to interest rates or economic activity will have big impact on stock prices.

And so I am telling you, be ready for whippy markets. The sorcerer’s apprentices at the Fed, gamely trying to cover for their bosses (Congress) who have no coherent idea of what to do, will keep short-term, high-quality interest rates low.

And that’s fine, not, as even the slightest variation in wording will make economic agents jumpy. When markets are priced to perfection, even the slightest breeze makes the branches at the top of the tree move hard.

My advice to you is simple. Run a balanced portfolio, and resist the trends. Buy low, sell high. Sell to the greedy, and buy from those who panic.

Final note: as far as economics goes, there is very little difference between the red and blue parties. The purple party controls DC, and all they do is run huge deficits and ask the Fed to monetize them via expanding bank credit. Would that we could vote them all out of office, balance the budget on an accrual basis, and link the dollar to gold.

We are going to have some significant disaster out of the current policy, but I can’t tell what kind of disaster will come. They expected inflation in the Great Depression, and got deflation, as the rich were able to protect their interests. That may happen this time as well. Don’t be too certain that we will get inflation.

Photo Credit: Christiaan Colen || With more intelligent players in the market arbitraging everything that they can, the key question to investors is: “do you want to take risk or not?” Risk is mostly binary now, with a few exceptions.

DIversification has mostly ceased to be a free lunch. I say this because with so many clever investors in the market, most risk assets have become highly correlated with one another.

For those who haven’t read me for a long time, I have often said that asset allocation relies on two concepts: economic performance of the assets, and investor behavior. And lo, though I have never connected it before, these correspond to Ben Graham’s weighing machine and voting machine.

The voting machine in this environment is akin to market momentum, with many making bets assuming that past performance does guarantee future success. But the neglected weighing machine exerts its quiet control, as valuations that are unjustified get corrected mostly slowly, but occasionally rapidly. Cash flows have to support valuations, at least eventually.

Now for the bug in my hat. I read an article at Marketwatch called 10 things you should know about diversification. I don’t have an opinion about the author, though he is better known than I am. I didn’t think the article did a good job. The main reason for that is that past ways of diversifying risk assets have largely disappeared as having a diversified portfolio has become the norm.

Here are the ten main points of t article:

1. What exactly is diversification?
2. The stocks you choose are unlikely to beat the market
3. Your chances of picking the winners are much slimmer than you think (Redundant with point 2)
4. You should diversify among asset classes
5. Even the best equity diversification won’t necessarily protect you from a bear market
6. You can get a lot of diversification in a single package
7. Thousands of authors, speakers, salespeople, brokers and investment advisers will happily give you advice on how to diversify by slicing and dicing stock and bond funds
8. You can diversify time itself
9. You can even diversify your tax obligations
10. There are many levels of diversification

I don’t have much argument with points 1-3, 5, and 9. With 9 particularly, it make sense to diversify the ways that you reduce your taxes, because you can’t tell what the US Government may do in the future. The tax code changes almost every year, usually in minor ways. There is no guarantee that a future US government might not invalidate IRAs, especially Roth IRAs, and tax them in ways that have not happened previously.

Also 5 is kind of my main point: risk assets have become more correlated over time. Safe assets? Safe assets are almost always correlated with each other, or they aren’t safe.

8 is kind of meaningless, as time diversification does not lead to better results.

But point 4, what are asset classes? There was a point in the 80s and 90s where diversification among large and small caps, domestic and international growth and value became common. Up until the mid 2010s, they were mostly correlated. But after 2017 small and large cap in the US decorrelated, as did growth and value. Also, the US outperformed most other countries, and not for any good reason.

As such, think there are three practical risk factors in the market at present.

• Risky vs Safe
• Large Cap Growth versus anything else
• US vs Foreign

As for point 6, I don’t see a lot of investments that diversify these three risk factors in one package. And as for me, I am tilted away from Large Cap Growth, and toward Foreign. The Risky versus Safe is what I don’t change much, as I always stay near 70/30. (Note that neutral at present would be 45/55.)

As for point 7, it is largely true but most of those who do it don’t get how correlated the markets are. They don’t help much, aside from risky versus safe. Aside from that, they are trend followers.

And on point 10, there are not twenty ways to diversify, there are really only three. Make sure you own some small cap value. Own some foreign stocks. Own some bonds, not because they will make you rich, but because they will lose less in a bear market, and you can reinvest in stocks at better levels.

Most good diversification means taking positions opposite to what the market has rewarded. Take your opportunity, and sell some large cap growth stocks now, and reinvest in companies producing significant profits relative to capital employed, even if growth is low.

Photo credit: Dickson Phua || A heavy use of derivatives is like being stuck in traffic… in the short run, you are going where everyone else is going…

I’ve written about this topic a few times before:

• Don’t Become the Market
• On a Concentrated Bond Market
• and, Two Questions on Fixed Income from the Mailbag (the first question only)

What happens when a party or parties take on an investment position that is large relative to the amount they can afford to lose? The above articles handled questions on that for the following crises and mini-crises:

• The London Whale
• Was PIMCO getting too large for the derivatives market?
• The 1993 blowup of the floating rate guaranteed investment contract market
• The demise of The Equitable in 1991.
• Long-term Capital Management
• The Correlation Crisis in 2005 in the CDO market
• AIG and subprime mortgages

But today, the furor is here:

• Softbank bets heavily on option purchases, primarily in tech sector
• The Options-Enhanced Stock Market Money Machine Is Going Global 
• and, Nasdaq Whale Theory for Tech Stock Surge Is Stirring Doubts

Whether it is Softbank taking undue risks to play catch-up in a bad year, or many individuals, hedge funds, etc. jumping on a large cap tech momentum trade using stocks and call options (and total return swaps, etc.), there has been a lot of hot money chasing the trade that has dominated 2020.

In the short-run momentum often persists, until it becomes too expensive to hold the momentum asset. Call prices get too high for new entrants, and real money investors start concluding that it is time to take some profits.

Now, if a market is cheap, the purchase of out-of-the-money options can give the market a kick as the option purchases force those that sold the options to hedge them. Though it makes sense to hedge options with options, eventually someone has to either go naked and not hedge, or hedge using common stock.

But, when the market is expensive, and volatility gets higher, the economics of the trade gets harder until the trade reverses, and the momentum effect goes the other way. Softbank may have been foolhardy or desperate, but if they completed their trade last week, that may have been the end to the non-economic buying that started in early August. They may have put in the top for large cap tech.

The same thing happened to tech in 2000, and financials in 2007-8. Or, in the opposite way, European financials were forced by their regulators to sell US stocks at the bottom in 2002. Forced sellers often create market bottoms. Greedy buyers often create market tops.

And why is that? The last one to respond to momentum looks like a fool. But it seems rational at the time, as he does not want to take more losses, or is sick and tired of missing out on the gains.

The main problem is a crowded trade in large cap tech. The current articles focus on derivative trades around that crowded trade, but that is not the issue. By themselves, the creation of derivative positions does nothing. It’s who holds the derivative positions that matters.

• How well are they capitalized?
• Do they have the capability of holding?
• Do they know what to do in a crisis?

If they are thinly capitalized, or have a short time horizon for other reasons, they will follow the momentum closely. As such, the risk of derivatives is akin to credit risk at worst, and crowding at best. When investors act to prevent a worst case scenario, the selling pressure can be severe.

And so, to that end, I say to you “lighten up on your large cap tech positions.” Those who own those positions have short time horizons, and may bolt. There is no way these companies grow into their valuations, so don’t think you can hold on for years. This is just a mania, and as such, it will meet its end.

Photo Credit: Sarah Burget || Future returns of the S&P 500 will only be a trickle

Dear friends, after some time away, this will be a short post, though I hope to write more soon.

The S&P 500 model is forecasting returns of 2.23%/year over the next 10 years. Even if you compare that to the 10-year Treasury Note yielding 0.66%, that’s not enough of a risk premium. We are in the 97th percentile of valuations.

Now, I know that the Fed is encouraging this. Somewhere, maybe from Bernanke, they picked up the bad meme that the Fed should care about the stock market.

Let me tell you that that way lies madness. The Fed is banging hard on the “voting machine” aspect of the stock market, while the “weighing machine” quietly looks on saying, “You’re going to pay for this.”

Let me put it bluntly: Quantitative easing and policies like it are just blowing asset and debt bubbles. Can the Fed create conditions that lever up the economy, and create prosperity in the asset markets? Yes, but only for a time. Eventually, the markets begin to look through the actions of the Fed and the US Treasury and conclude that the emperor has no clothes. Gold is the silent witness in these matters, as is the value of the US Dollar to a lesser extent.

The Fed should only care about the solvency of the financial system, and act to avoid bubbles. Forget inflation, forget employment forget real GDP growth. In an open macroeconomy where there is a lot of technological change, the Fed can’t affect any of those much. If you are going to have a central bank, it should focus on avoiding financial crises.

And since Greenspan, the Fed has done the opposite of that. Instead of letting recessions liquidate bad debts, the Fed has “rescued” bad corporate and household decisions, by lower rates continually. Well, now we are near the end of this game, and current interest rates and likely future returns are lower than any other time than the dot-com bubble.

For investors, there are a few choices. Go low debt in stock selection, and look at small stocks, value stocks. and international stocks. All offer more future returns than the current FANGMAN consensus of largest-cap growth. Also, even though bond yields are low, short duration high quality bonds will lose a lot less in a panic than other assets.

That is what I am doing. You can do what you want, but this i a time to pay more attention to preserving capital, because even under the best conditions, you aren’t going to earn much in large cap US stocks over the next 10 years.

Photo Credit: premasagar || What a cute kid.

The stock market is acting like a bunch of bored teenagers. At present, we have a number of “Adults in the Room” who are arguing that a crisis will come upon us soon from the effects of C19.

My view is that the more the market is exposed to a concept, the less it reacts to it. Yes, in the initial phase, that is not true — briefly, the more we hear about new concepts, the more impact they have.

But that dies out, and as some Millennials might say : NEXT!

I am surprised at the resilience of equity and corporate bond markets amid the panic surrounding C19. That said, this is similar to how I think the markets should behave. The markets should focus on long-term profitability, not on current period profits.

It is better to think how the expectations of wealthy people and their institutional servants are changing, than to think about the “news” that gets reported each day. The former affects prices; the latter is noise. Focus on the permanent. Ignore the temporary.

Photo Credits: Michael Gray & Brian Turner || And thanks to Pine Tools for concatenating the images

When I was in Eighth Grade, I wasn’t very popular, and in World History class, I sat behind a guy who was even less popular than me, and he was usually quite shy. Still it was my policy not to look down on anyone because I knew what it was like to be lonely, so occasionally I tried to be friendly to him.

Well, one day he came up to me and said: “Have you heard of Hertz Rent-a-Car?”

DM: “Of course.”

Guy: “Have you ever heard of a Hertz Donut?”

DM: “What’s a Hertz Donut?”

He gives me a big hit to my shoulder and exclaims “Hertz Donut?!” [To non-English speakers, the joke is that he was saying “Hurts, Don’t it?!”]

Well, as was common for many jokes with 14-year old boys, there is more energy than brains, so it was less than a week before the joke traveled around the junior high school, running out of victims, and long since bereft of humor, if there was any to start with. What surprises me now is that there is now actually a real meaning to the phrase Hertz Donut — it describes the stock of Hertz in the near future.

The stock of Hertz will, with high likelihood, go out at zero.

Start with this: the firm has filed for bankruptcy. Stockholders mostly get nothing in bankruptcy. Sometimes they might get a little new stock or some warrants to help them save face, because they are delaying the reorganization, but this is usually a trivial amount of money, and implies a big loss to the stockholders.

Second, the bond market is almost always smarter than the stock market, because it reflects the actions of institutional investors who are generally good at assessing risk. There are a large number of distressed debt investors out there, estimating what a reorganized Hertz will be worth. The senior unsecured debt is trading at $38 per $100 of principal. There is no preferred stock, and a minimal amount of second lien debt.

I don’t know all of the complexities of the asset-backed securities that they have issued, but the main physical asset of Hertz is their cars, and the cars secure most of the borrowing of Hertz, via asset-backed securities [ABS]. That means that the hard assets (cars) of Hertz are likely not available to unsecured claimants.

With the senior unsecured trading at such a large discount to par value, it seems impossible that the current stockholders would get much if anything out of a reorganization. Most of their assets are encumbered via ABS. The senior unsecured bondholders are the class of security holders that will receive partial payment, and as such, will likely be the controlling class of securities that will receive the equity in the new Hertz, while the old common stock is either cancelled, or receives some nominal allocation of securities in the new Hertz.

Thus I say to those who hold Hertz equity, sell your shares. Because of mindless speculation, the price is overly high. Take your opportunity, and sell to those who are less wise.

Now, some might ask… what are my motives in writing this? They are purely intellectual. I don’t short stock. It’s a very hard way to make money, and even if you are right, you could get caught in a severe short squeeze, and give up before the stock goes out at zero.

It is really tough to short a stock to zero. It is a “picking up nickels in front of a steamroller” type of play.

So, no, I am not long or short Hertz. Gun to the head, I would short it, rather than go long, but I would size any position to reflect the possibilities of a short squeeze. I.e., I wouldn’t short much.

Full disclosure: no positions in anything mentioned in this article

Photo Credit: GPA Photo Archive || FIreworks over New York City — beautiful, huh?

Though my adopted children were all black to some degree, I had not heard of Juneteenth until yesterday. When I read a little more about it, and the efforts of some to make it a Federal Holiday, I thought, “Okay, if Juneteenth became a Federal Holiday, which other Federal Holiday would likely disappear?”

Now some might ask, “Why not just add another Holiday?” I don’t think there’s a free lunch there — if there is less labor, people would get paid less, and that would affect poor people more than those better off.

Anyway, that made me think of doing a Twitter poll to see what holiday people would be willing to do away with. There are ten holidays and I wanted to make sure that each section of the poll would have a “none of the above” as a possibility.

That meant doing ten little polls with randomized competition among holidays. It was a small challenge to create randomized polls that did not have repeats in the choices for any particular poll, and where none of the ten polls were identical to each other. It’s harder than it seems, but using Excel 2007 I was able to get it done in 20 minutes with aid from the lesser known goal seek command.

All 10 polls are out. I would have done it as one poll, but twitter only allows for four choices, and I wanted to have none of the above as a choice in each poll, so it meant having ten polls with 3 randomized choices each, with no duplicates in choices or polls. Please vote.

— David Merkel (@AlephBlog) June 17, 2020

Note: if you play along with me on these polls, there will be a series of them where each of the ten federal holidays gets equal representation. I'm a quant with expertise in simulation analysis. Part of this is to unscientifically determine the least popular holiday

— David Merkel (@AlephBlog) June 17, 2020

As you can see, one goal of the polling is to unscientifically determine the least popular holiday. There were a few more goals. I thought it would be possible that some might think that Juneteenth and the birthday of Martin Luther King Jr. cover similar topics. Would some people suggest a trade of one for the other?

Also, would “none of the above” get a lot of votes? Are people happy with the current situation? That would indirectly answer the question of how much sympathy there is for Juneteenth as a Federal Holiday.

To that end, I ask my readers if they would be willing to vote on these polls.

Which of the following Federal Holidays would you give up in order to make Juneteenth a Federal Holiday? (Choices chosen randomly)

— David Merkel (@AlephBlog) June 17, 2020

Which of the following Federal Holidays would you give up in order to make Juneteenth a Federal Holiday? (Choices chosen randomly 2/10)

— David Merkel (@AlephBlog) June 17, 2020

Which of the following Federal Holidays would you give up in order to make Juneteenth a Federal Holiday? (Choices chosen randomly 3/10)

— David Merkel (@AlephBlog) June 17, 2020

Which of the following Federal Holidays would you give up in order to make Juneteenth a Federal Holiday? (Choices chosen randomly 4/10)

— David Merkel (@AlephBlog) June 17, 2020

Which of the following Federal Holidays would you give up in order to make Juneteenth a Federal Holiday? (Choices chosen randomly 5/10)

— David Merkel (@AlephBlog) June 17, 2020

Which of the following Federal Holidays would you give up in order to make Juneteenth a Federal Holiday? (Choices chosen randomly 6/10)

— David Merkel (@AlephBlog) June 17, 2020

Which of the following Federal Holidays would you give up in order to make Juneteenth a Federal Holiday? (Choices chosen randomly 7/10)

— David Merkel (@AlephBlog) June 17, 2020

Which of the following Federal Holidays would you give up in order to make Juneteenth a Federal Holiday? (Choices chosen randomly 8/10)

— David Merkel (@AlephBlog) June 17, 2020

Which of the following Federal Holidays would you give up in order to make Juneteenth a Federal Holiday? (Choices chosen randomly 9/10)

— David Merkel (@AlephBlog) June 17, 2020

Which of the following Federal Holidays would you give up in order to make Juneteenth a Federal Holiday? (Choices chosen randomly 10/10)

— David Merkel (@AlephBlog) June 17, 2020

I think highly of my readers. I particularly appreciate the way that most of you who choose to comment at my blog are measured in your comments. I don’t have to deal with a lot of off topic or crude comments.

So, if you have a few minutes of time, go ahead and answer the polling questions. I’ll do a post with the results either tomorrow or Friday. Thanks.

PS — the polls cut off in the 2PM hour tomorrow, US Eastern Time.