BlackwallPartners 2016 Update: Transient Volatility, Part III May 4, 2016

Learn to Love the Bomb (and Accept Transient Stock Volatility), Part III

Almost four years after we published the last installment of ‘Learn to Love the Bomb’, not much has changed (as we had anticipated). President Obama was re-elected and consequently – our national fiscal policies have stayed the tired, old socialistic train wreck any intellectually honest person (economist or not) would have expected. Our lack of recent commentary is directly related. It took longer than we would have liked, but real change finally is afoot. At present, we are living through the now statistically worst decade for the U.S. economy since the thirties. No surprise to us. The fact voters insisted upon proving this empirically by re-electing the Obama administration is a question for future historians and social scientists. ‘New Deal’, ‘ Fair Deal’ or Obamanomics, all are identical in nature and outcome. Today, approximately ninety-five million (95 million) adult Americans of ripe working age and ability are not working. We are told to believe that these folks have chosen voluntarily to stay at home to “paint”. Those working haven’t seen their wages rise in over a decade. There is virtually no upward mobility and new college grads face the worst job market on record. The current generation now is widely expected to be the first in American history to underperform their parents (and grandparents). If you’re Feeling Japanese… of late it’s because we are with one important caveat (explained momentarily).

U.S. Velocity of Money Continues Grinding Slower

Nearly all sectors of the economy are experiencing revenues that range from stagnant to deteriorating. The resultant prevailing strategy for most of these firms (confirmed by their investor presentations) is to milk the cow dry with outsized dividend payouts and earnings-per-share growth engineered via massive (and we see as wasteful) stock repurchases. The result is a self-fulfilling perpetual recession. The accompanying chart of the velocity of money in America, courtesy of our alma mater the Federal Reserve, captures this tragic economic outcome. For now, short-sighted investors appear willing to punish corporate executives if they were to re-engage in investing in growth, hence the record profit margins and tax receipts via cutting every possible expense (including CapEx) to prop up current earnings. Market participants don’t seem to note this very obvious red herring. For every action (Obama e.g.), there is a reaction (“new norm”) and it’s crippling the economy. Working capital is being unproductively redirected away from investing in growth and blown on current dividends; capital expenditures are wasted on the instant gratification of stock retirement. As for the future? It was Keynes who only focused on his own death and his followers could care less what happens after theirs. Socialism is for the here as in ‘right now.’ So are dividends and

stock repurchases. They are the stuff of “buggy whip” makers. They are not a measure of the potential for a greater future. The markets are riding an unsustainable narrative. The broader stock market anymore is an extension of the bond market driven by ultra-low interest rates and hence unsustainable discounts. Current Fed policy is but a mere reaffirmation and why stocks float higher in-step with the grave economic realities. This is the greatest interest rate risk bubble in mankind’s relatively short, but eventful history. Today, our large city landscapes once again are dotted ubiquitously with construction cranes but conspicuously without underlying growth in the economy to justify their existence. Increasingly, hordes of investors clamor to invest in ‘safe haven’ buildings (REITs) which in it of themselves are rather unproductive allocations of capital. Like bonds and dividend discounted equities, it’s all just part-in-parcel to this rate risk bubble of which we speak. We’re confident the coming dividend discount or “cap rate” valuation reset will make the oil patch bludgeoning look almost agreeable. We now sit atop in excess of $30 trillion (with a “t”) in mostly passive commercial real estate investments in America. The average capitalization rate is estimated at about 3.8%. God forbid we ever again see the U.S. 10-year Treasury note yielding above 3.8%. Under President Obama, it’s below 2%. Almost all the new job openings at say a Goldman Sachs (NYSE - GS) are in their burgeoning real estate groups (we actually track this sort of thing…). The rest are in compliance jobs to keep up with stifling new regulation. Wall Street now may fear the Trump (growth) and prays for Clinton (stagnation). Most fund managers we speak with believe the latter is a shoe-in because thinking otherwise is unnerving to their current portfolio positioning. We might suggest investors should at least consider preparing for a change. Some time ago, we began referring to President Obama as “Captain Zero” for his economic success. It wasn’t intended to be mean spirited. That’s actually the number. As a result of this administration and their policies, the Fed has had little choice but to keep us at or near zero, apropos to what now is the longest and deepest monetary ease ever perpetrated upon a fractional reserve banking system. It’s testing the system and altering capital allocation in a very dangerous manner. The national debt is a bomb… U.S. commercial banks are sitting on roughly $2 trillion in ‘excess reserves’ [above the 3% minimum] in their Fed member accounts and some central bankers, including the Fed, are looking at charging fees on this excessive liquidity, now commonly referred to as “negative interest rates”. Confused? You should be. As if punishing ‘excess reserves’ will alter the supply and demand for credit (leverage) in broken economies now worldwide. Monetary policy is highly limiting after-all. It cannot supplant or overcome socialistic largesse. Consumer bank deposits are sitting at a record $10 trillion, proving stagnation like growth rolls downhill with confidence in tow. Most don’t feel in the mood to do anything productive and who could blame them? Housing has gone nowhere now since 2010. Marriage and birth rates are at Depression-era lows. Why? Nobody feels confident enough in the economy and their job to get married, have a baby and buy a dang house. That is the stuff real economic recoveries are made of… We’re not altogether certain where this president’s Council of Economic Advisors studied economics or if at all. But some voters (the question is whether enough) seem finally to be asking that same question whether they realize it or not. We could have skipped the commentary and merely published the chart of the velocity of money found on Page 1, but we can’t help ourselves. And nobody ever talks about that critical variable. So, we will… As the chart clearly displays, the “churn” or turnover in reasonably liquid capital (M2) has essentially grinded to a halt. It’s actually the lowest M2 stagnation since the measure first was observed. But we actually remain quite optimistic as this still is the largest store of fungible capital in history. It merely needs to be inspired! The very caveat we proposed earlier which differentiates us from our European and Japanese friends. We’re still very very very rich! The Federal Reserve estimates America’s private sector remains quite wealthy – worth roughly $85 trillion, net. While granted, $30 trillion plowed into commercial real estate is a concern; no other economy in the world sports such enormous potential for a turnaround. Thankfully, the years where we were not a practicing “social democracy” have been rather recent. So, the private sector has not been confiscated by the government, yet (this is what Senator Sanders

has his beady eyes on e.g.). And the young (Millennials or “Echo Boomers”) are now the largest group of Americans ever. Thanks to Reaganomics, we’re a young nation. Nobody talks about that either. Our youth need to be inspired! Inspired to get married, have a kid and buy a dang house. Economics is a rather easy subject. It should be an ‘easy A.’ It just happens that there’s a rather large debate buzzing throughout the country this year (once we get past deliberating little hands, big ears and get past an FBI investigation or two). The political debate centers on whether we continue the current strategy or return to the one that worked. That subject used to be an easy A too (the schools in which you matriculated being the risk variable). The following is what we wrote in July 2012 upon a similar proposition in that major election year. We clearly hoped voters had caught on by 2012 but worried that they had not. So, here we go again… We definitely like where the debate is heading – clear contrasts now that we’re down to the final two. -----------------------------------------------------------------------------------------------------------------------------------------------

The second quarter 2012 was a tough one. Suffice it to say, financial stocks were pushed around by global headline risk. The explanation is simple – idiosyncratic fear has returned and resides at all-time highs (yet again). As a follow-up to our recent assessment that many market participants were either neglecting or mistaking altogether systematic risk (“beta”) with diffident and turbulent volatility in financials, we found the following research from Russell Investments (below) very insightful and congruent with our own analysis. Clearly, there is an epic opportunity in the deeply under-valued Financial sector which is currently nothing less than a “three sigma” volatility event. As Russell researchers have illustrated below, beta and volatility can be two very different issues facing fund managers when those metrics become uncorrelated (which is very unusual). Beta captures “systematic risk” or risk relative to the broader market (to changing economic conditions). Aberrant volatility (above or below that of beta) would indicate the existence of intangibles often referred to as “idiosyncratic risk.” Systematic risks are known, while idiosyncratic risks are intangible and thus unknown or at least unpredictable. In fact, idiosyncratic factors perpetuate substantial “market timing” issues as their very existence in a sector will typically push investors away in an effort to avoid the heightened volatility. Such is the issue facing financial stocks today. There is an abundance of macro inefficiencies that exist where the greatest value resides! If low volatility is that which you desire? Then you will pay through the nose for it and risk permanent losses! But if great value is what you seek, it is available… but it comes with transient high volatility caused by idiosyncratic factors.

High-Beta v. High-Volatility Index Sector Exposures (%) Russell Investments 2011

Source: Russell Investments and BlackwallPartners LLC

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Russell 1000 Weight US Larg Cap High Beta % US Large Cap High Volatility %

GREEN arrows represent extraordinary standard deviations above the empirical norm between systematic risk (“beta”) and idiosyncratic risk (excess “volatility”).

In today’s highly volatile climate for stocks, systematic and idiosyncratic risk have become “unhinged” in several sectors and in both directions. This is creating an extremely rare and compelling arbitrage opportunity. This extreme decoupling phenomenon points to the likelihood of extraordinary upside in the Financials, but at the cost of some short-term idiosyncratic-driven volatility, while other sectors showcase hidden systematic risks by their lack of volatility just the same. The Russell analysis highlights the stark disparity between excess volatility and systematic risk (i.e. greater than average market/economic risk) across different sectors within the broader market. As Russell’s research suggests, volatility where it has decoupled from beta – is driven almost exclusively by “less measurable” factors such as political uncertainty which certainly has been the case of late. Russell goes on to say - “ It is important to point out that sector exposure to high-volatility stocks may be more time-period-dependent.” In other words, elevated volatility is event dependent and thus transient and not systematic.

Volatility Index by Sector Exposures (%) v. Price/Cash Flow Multiple

Source: Russell Investments and BlackwallPartners LLC The chart above recasts the Russell findings to compare the valuation of each sector relative to its volatility. This chart speaks volumes. If one wants low volatility stocks, one has to accept extreme valuations for them. If investors want value, then one must accept high volatility. The only sector that strikes more of a balance is Technology. REITs and Utilities are especially expensive. The opposite is true of Financials, they are being given away to avert volatility. The Energy sector looks cheap only if you think that the commodity is stable. And Durables are precarious as the commodity boom and insatiable desire by investors to be long China (as their “risk-on” trade) has created an imbalance in that sector where volatility is too low relative the sector’s empirical beta, suggesting oversubscription or overconfidence in China’s authoritarian economy. Generally speaking, it is the high priced (over-valued) stocks which should be showing the greatest volatility, but not the case currently. This is an idiosyncratic-driven cycle, namely US political uncertainty. It’s masking certain systematic risk (such as interest rate risk) and any sudden change in the political landscape could reverse cash flows very sharply and adversely to those sectors where

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Financials

Cons. Discretionary

Energy

Durables

Technology

Healthcare

Cons. Staples

Utilities

REITs

SPDR Dividend

US Large Cap High Volatility % Price/Cash Flow Multiple (X)

High Valuation; Low Volatility

Low Valuation; High Volatility

low volatility and high valuation coexist, while enormously favorable to those sectors where volatility greatly exceeds empirical beta, namely in the Financials. On balance, investors might incorrectly conclude that recent elevated volatility in Financials is decidedly indicative of new, more pronounced systematic risk. This is not the case. In fact, Financial fundamentals have been substantially improving since the crisis occurred (this is well documented). Nevertheless, investors are currently mistiming the financial sector by unwittingly attempting to avoid transient volatility by running stra ight into the arms of high priced, low volatility sectors. These high-priced sectors are where systematic risk is essentially “masked” merely by the lack of volatility and the trade is getting ever more crowded. This migration of capital flows away from “perceived risk factors” easily can and is (in our view) increasing market timing risk as well as systematic risks for many investors. This includes heightened valuation risk to any change in the economy (especially interest rates sensitive or historical ‘safe haven’ groups as noted). Investors have presumed for some time now that interest rates will never change. As such, they may be zigging when they should be zagging. Chasing sectors with excessive valuation merely as a function of the sector’s low volatility is itself also idiosyncratic behavior. A simple way to read into the Russell analysis is to assume that those sectors where volatility exceeds systematic risk (beta) are the most under-valued (low risk, high reward) while those where systematic risk (beta) is higher than volatility are likely to be excessively over-valued (high risk, low reward). This concurs with our fundamental research and Russell’s analysis proves it empirically. Excess volatility now trumps existential valuation and thus systematic risks now are all but being ignored. The fact that Bonds, Utilities and REIT equities are trading at or near record high valuations (amid record low volatility) are prime cases-in-point. Does their lack of volatility imply less systematic risk to changing economic conditions? What would happen if say – interest rates were to begin to rise even modestly due to changing economic conditions? Would that not incur significant valuation at risk already predicted by their current low volatility relative their empirical beta? We certainly think so. The Internet bubble is a good example or the tulip mania in Holland. Both were examples of systematic risks ignored. Recent short term bond auctions in Germany, France and the United States at negative interest are a “tell” perhaps... examples of a heightened “blind” systematic risk appetite. In each case, the systematic risk ignored was valuation; while the idiosyncratic symptom identified and either welcomed or averted was high transient volatility or lack thereof.

A “Three Sigma Event”… Already Discounted! The presence of this “confusion” between systematic risk and idiosyncratic risk is evident in the current extreme volatility of Financials. This volatility is several standard deviations (“sigma”) above its norm as measured by empirical beta. This has resulted in a severe “volatility aversion” reaction by investors, pushing fund managers out of the sector. This deep under ownership has resulted in record depressed valuations, thus where the extraordinary return potential lies. This “buyers strike” exists despite the fundamental attractiveness of record builds of capital, reserves and cash on bank balance sheets as well as valuations below “going concern value” as we have highlighted extensively in previous musings. The Russell statisticians captured some astonishing findings not particularly surprising to us. Financial stocks represent nearly a full third of the Russell 1000’s volatility despite representing less than 10% of the beta and only one-tenth of the sector’s representation within the index. In empirical terms, Financial stock volatility of this magnitude (250% of its empirical beta) would not be seen 95% to 99.7% of the time. It is a three sigma event (an historical outlier the equivalent of a highly unheard of event). The simple analogy is that a hurricane Katrina had a far higher probable outcome than the current deviation between financial stock volatility and its empirical sensitivity to market risk (beta).

In contrast, REIT volatility e.g. is near ZERO despite the historic level of systematic risk (beta) to changes in interest rates (economy). The attraction for investors is low volatility (and some yield) and thus investors have been clamoring to own REITs despite being currently priced at RECORD multiples of cash flow, implying absurdly low capitalization rates. The same scenario applies to some key bond markets. In these cases, no systematic or economic sensitivity risk is implied in their valuations. NONE! We believe financials offer what perhaps is the greatest disconnect between systematic risk and volatility perhaps recorded. Valuations of financials remain at unsustainably low multiples of free cash flow with implied yields topping 25%-30%. In stark contrast, REITs yield 2%-3% and benchmark bonds well under 2%. As previously mentioned, we view “market timing” as a function of the wide imbalances between beta and volatility across a myriad of sectors in the market to be the larger unspoken risk. This is the same collective “group think” that masked imbalances that gave us the tech stock boom and bust of the late 1990’s. Investors are “crowded” en mass into the same low volatility trade which is masking heightened valuation risks to any change in the economic environment. Investor emotion and “less measurable” factors like political climates have a tendency to distract investors caught in the moment. The current market imbalances between systematic risk and volatility offer an historic risk/reward arbitrage opportunity. For Financials, the “less measurable” or intangible factor primarily is the current politicized attack s on the financial sector. This intangible or “idiosyncratic risk” has been more than “priced-in” to the financial sector and there is no abundance of assurance that the current administration will remain in power beyond this coming November. The unremitting “bank bashing” tactics of progressive governments have become all too politically transparent – the LIBOR scandal and/or the hedging loss at J.P. Morgan e.g. These all serve as mere Kabuki theatrics at a time when incumbent politicians, reeling from weak economies and poor re-election prospects are in dire need of a “straw man.” The idiosyncratic risk reflected in the historic imbalance between financial stock volatility and beta is the direct byproduct of this “straw man” phenomenon. And we are confident that its days are numbered. Regrowth of the economy tends to overtake petty politics come election time as voters have an uncanny penchant for insisting on it at critical moments in our economic history such as 1952 and 1980, where political realignment was necessary. Political realignment is no different than the self-correcting mechanism of the market. The same math (or voting models) can be applied when imbalances this extreme are evident. Candidates invariably are drawn into the center of the empirical electoral distribution or they lose elections. After the 2QTR Sell-Off, Valuations Again Remarkably Favorable… With the average price-to-tangible-book (P/TBV) values for the largest US banks at just 0.66x, the market is not far off recent trough levels of 0.60x reached in March 2009 and well off March 2012 highs of nearly 1.0x TBV. We continue to favor many regional banks trading well below book value and at no deposit premium (no intrinsic value). The bad news emanating from both European and American policy makers is more than priced into the group – setting up for highly favorable reward when any hint of market imbalances show the slightest ray of headline (idiosyncratic) risk abatement. And then there’s that election coming-up soon too… [Well, that part didn’t go the way in which we had hoped]. Regards, Michael P. Durante

Managing Partner Blackwall Partners LLC