intrinsic alpha april 2014

Intrinsic Alpha Note – April 2014

Told you I'm never going back...

“Someday, financial markets will again decline. Someday,

rising stock and bond markets will no longer be

government policy – maybe not today or tomorrow, but

someday. Someday, QE will end and money won’t be free.

Someday, corporate failure will be permitted. Someday, the

economy will turn down again, and someday, somewhere,

somehow, investors will lose money and once again come

to favour capital preservation over speculation. Someday,

interest rates will be higher, bond prices lower, and the

prospective return from owning fixed-income instruments

will again be roughly commensurate with the risk.” – Seth

Klarman, Founder of the Baupost Group.

“VINCENT: Seven years in Folsom. In the hole for three.

McNeil before that. Was McNeil as tough as they say?

NEIL: You looking to become a penologist?

VINCENT: You looking to go back? You know I chased

some crews, guys just lookin’ to fuck up and get busted

back. That you?

NEIL: You must have worked some dipshit crews.

VINCENT: I worked all kinds.

NEIL: You see me doing thrill-seeker liquor store holdups

with a “Born to Lose” tattoo on my chest?

VINCENT: No, I do not.

NEIL: Right. I am never going back.

VINCENT: Then don’t take down scores.

NEIL: I do what I do best. I take scores. You do what you

do best trying to stop guys like me.

VINCENT: So you never wanted a regular-type life?

NEIL: What the fuck is that? Barbecues and ballgames?

VINCENT: Yeah.

NEIL: This regular-type life. That your life?

VINCENT: My life? Not my life. My life’s a disaster

zone...”

– Heat, Film (1995), dialogue between Al Pachino

(Vincent) and Robert De Niro (Neil).

“Someday” – just not today

I have tremendous respect for Seth Klarman. He is a

billionaire who founded one of the most successful hedge

funds of all time, the Baupost Group. Their investment

philosophy is more value orientated with a keen focus on

risk management. Today, everyone thinks like Seth.

Everyone is waiting for equity and bond markets to

“correct”. The funny thing is, everyone wants to buy into

these markets when they correct – just not now. Contrary

to popular belief, market participants don’t have short

memories. Seth believes there is too much cheap money

sloshing around the system to make asset values

compelling, hence he is 40% in cash as of his last letter to

investors. It must be strange to Seth to see passive, index

investing approaches produce sharp ratios commensurate

with those of Baupost, but at a fraction of the fee. One more

reason for his complaining tone. Seth has every reason to

be cautious, here are a few:

Bullish sentiment is at all time highs – at the end of

December 2013, all asset managers were bullish on

developed market stocks.

All time nominal highs were recently touched

across most developed market indices.

The Fed is continuing its reduction of asset

purchases, and in her first FOMC press conference,

Janet Yellen said the Fed Funds Rate could start

rising as soon as “6 months from when asset

purchases end at the end of 2014” – so we’re

aiming for Q2/Q3 2015 for the action.

Most valuation measures show the US to be over-

valued e.g. CAPE is around 30% above average.

But there’s something key most market participants are

missing. Explain this chart:

The blue line is 5-year US inflation expectations as per the

TIPS market and the red line is the MSCI Emerging

Markets Index. Notice anything interesting? If we examine

correlations of daily changes in these two series over the

two periods,

Period Correlation of Changes

01 Jan 2002 – 29 Oct 2007 8.6%

29 Oct 2007 – 24 Mar 2014 41.4%

01 Jan 2002 – 24 Mar 2014 13.4%

Correlation is a strange beast – it is stubbornly unstable.

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MSCI EM Index US 5y Breakeven Inflation


Before the MSCI Emerging Markets Index peaked in 2007,

Emerging equities were weakly correlated with US

inflationary expectations. Post-peak, this correlation

increased by a factor of about 4. So what happened?

Figure 1: Jim O'Neil

I have a theory, you might not like, but hear me out. In

2001, Jim O’Neil of Goldman Sachs invented the “BRIC’s” –

Brazil, Russia, India, and China, which set the stage for

what was to become a new bull market in emerging market

stocks:

Going into 2007, investors thought the developed world

didn’t matter anymore – they saw decoupling of emerging

and developed economies. They were blinded by the scale

of China’s economic miracle. The fundamentals

(population growth, lower wages, cheaper production

costs, abundant resources) reinforced the trend going into

2007 – the emerging world was the big story, and if you

doubted it, you were stupid. When developed markets

experienced the Lehman shock of 2008, the emerging

markets realised they had a problem. They were

operationally leveraged – they had built factories, roads,

infrastructure – all to service the developed markets via

cheap exports. In his book, Anatomy of the Bear, Russell

Napier said that 2008 was the year the emerging world

realised it could not keep getting richer selling stuff to the

developed world.

If the developed world stopped buying cheap stuff, this

would destabilise emerging markets via higher

unemployment and the social unrest which accompanies it.

So on 2 April 2009, the G20 came together in London and

agreed to save the world – but really this was more of a G2

meeting, as the US passed the baton to China to rescue the

world. China would embark on a credit creation bonanza

in an attempt to reflate global trade. Hugh Hendry has a

great way of putting this, “China said you guys...you’re

just capitalists, you have such a poor system versus our

planned economy, you’re having a garden variety

recession...and a recession will be followed by a recovery,

so to help pave the way, we as China will help build a

bridge that will take us from March 2009, 2 or 3 years into

the future....and if we have a degree of inflation because of

this, it might take away this incessant pressure for our

currency to rise, and in 3 years you guys will definitely

have a sustained economic recovery...we will again take

over the world”.

The results of this are being noticed now. Global growth

has not been as resilient as China, or indeed the G2 thought

it would be since 2009. There wasn’t much appetite for

credit after the collapse. The system was in need of a

deleveraging. We’re only now hearing people like Charlene

Chu of Fitch, the ratings agency, come forward and make

statements regarding China like “the banking sector has

extended $14 trillion to $15 trillion in the span of five years.

There’s no way that we are not going to have massive

problems in China.”. “China will have replicated the entire

US [commercial banking] system [which took over a

century to build] in the span of half a decade”.

I do what I do best. I take scores...

I can imagine a dialogue between Chinese and American

tacticians like the one above between Al Pachino and

Robert De Niro in the film Heat. For those who haven’t

seen this film, Robert De Niro plays Neil McCauley, a

professional high-stakes thief and Al Pachino plays Vincent

Hanna, a workaholic lieutenant in the LAPD. The men are

the two sides of the same coin, much like the US and China,

the G2, are the two sides of the same coin, the global

growth engine. Both men, like the G2 have their objectives,

they don’t know any other way of life, and both come face


to face to discuss what it would be like if they had to “take

the other down” in a confrontation. When Neil says “I’m

never going back”, this bears eerie resemblance to how

Chinese leaders think of their nation – they’re never going

back, they’re here, they take scores.1

The emerging markets want your wealth, and they’re

eventually going to get it. What they didn’t plan on is that

in attempting to extract wealth from the developed world,

they have created beautiful feedback loops. I’ve laid out the

US/China one below:

The nice thing about these loops, is that if you can ascertain

which stage you’re in and frame this with respect to

expectations across asset classes, you can rather accurately

predict how asset prices will change. The reason for this is

that you can always count on policy makers to behave in a

way that will preserve the momentum of their policies or

their desired status quo.

Enter Neomercantilism

Neomercantilism seeks to control capital movement and

discourages consumption as a means of increasing foreign

reserves and promoting investment. To accomplish this,

the central planners enact polices designed to subsidize or

protect local producers, deter imports, impose structural

1 https://www.youtube.com/watch?v=iITu3Z4i1No

barriers to prevent foreign companies entering the

domestic market and limiting foreign ownership of

domestic assets. These feats can be accomplished via:

Financial repression by keeping domestic real

interest rates negative.

Artificially depressing the exchange rate versus

trading partners.

Maintaining a social order which emphasises work

over pleasure for the nation’s progress – a state of

mild jingoism.

A political structure which allows government or

central planners to interfere in any facet of the

economy, from the amount of credit banks extend,

to which containers have priority at ports.

Suppressing individualism, self-expression and

questioning of the status quo – often seen via

significant spending on police and military

personnel.

The aim of Neomercantilism is to export to wealthy

markets and strategically acquire capital and resources,

while ensuring ownership of the asset base is kept in

domestic hands. Does any of the above sound familiar?

Looking at the IMF data from 1980 to 1994, the Yuan was

devalued by 380% and it took that long for China to build

capacity to embark on a grand export project in line with its

mercantilist plan. When the Yuan finally flat lined, the

momentum had build up and like a volcano erupting the

US current account balance began a secular decline, and

China’s current account mirrored that. From 1980 to 2008,

when China’s current account balance peaked at $420bn, it

had increased by 147,000% in nominal terms or about 30%

p.a. compounded annually. The current forecast is that this

China seeks higher real

GDP

China supresses the Yuan versus

Dollar subsidising

output

Surplus Dollars are reserved in

China held as Treasuries

China imports US inflation and exports

capacity to US

Higher imported

capacity in the US lowers

real wages

Lower real wages result in

more borrowing required to

maintain consumption

US rates need to fall to finance

consumption via borrowing

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1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018

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Forecast China Current Account Balance

US Current Account Balance CNY/USD Exchange Rate

https://www.youtube.com/watch?v=iITu3Z4i1No


nominal level will be exceeded in 2017. Hence it’s all part of

the plan.

Expect more of the same – human behaviour

Are you deeply concerned? Does the above seem

unsustainable? I would have to concede, that the above is

not sustainable forever, but it sure can continue for a while.

Consider if you will, a few thought experiments (please

forgive the questioning tone of these):

1. If I am the issuer of the global reserve currency,

does it make sense that I run a persistent surplus or

deficit? If I run a persistent surplus, then how can

there be enough units of reserve currency to go

around and actually sit in reserve in other nations?

2. If there is a shortage of the global reserve currency,

namely US Dollars, how can the shortage be

overcome? Is printing money therefore such a bad

thing, or is it just part of a simple supply and

demand relationship?

3. If the laws of supply and demand are irrefutable,

then don’t these extend to money and credit –

hence even if a central bank prints money, doesn’t

the demand for money influence whether it enters

the economy and causes inflation?

4. If the global economy experiences a shock, and $10

trillion is wiped out in write-downs, and $5 trillion

is printed, then doesn’t that mean the system is still

short of $5 trillion dollars?

5. Do human beings think in a linear fashion and

aren’t they evolved to simplify a complex array of

sensory inputs and situations into simple, linear

narratives that seem to work most of the time?

6. Are humans overly-reliant on their simplistic

models of the world and cause and effect? After all,

most of the time, a liner model of the world works,

so why fix what ain’t broke?

7. Do people often confuse correlation and causality,

and isn’t this part our nature as pattern-seeking

machines?

And finally,

8. Does being wrong about how the system works in

the past stop people from being certain about how

the system works in the future? In other words,

given the simple, linear models we have in our

minds, is a re-calibration of the model adequate, or

should the model be abandoned in its entirety?

Given the above expose into the human machine and our

biases, it becomes clear that it’s impossible for humans to

avoid imbalance. We just can’t escape it. Humans thrive on

creating surpluses which then have to be met through

deficits in the future – in all facets of life, current accounts

aside. This explains why stock markets can become

overvalued and stay overvalued for a long time, only to

crash out of nowhere. After the crash, it’s obvious there

was a bubble, but during the ride up, the fundamentals

reinforced the trend, and so a linear model of what was

moving prices made sense. That rule applies to anything

with a price.

Expect more of the same – behaviour of humans

The past doesn’t quite repeat itself verbatim, there’s always

something slightly different. In November 2013, I

published an analogue of the S&P 500 Index versus the

equivalent index during the 1995 bull market and noted the

similarity. I even went so far as to declare a new secular

bull market had begun. So far I’ve been proven right:

If my lyrics are wrong, I think I’m at least singing the right

tune. So we could see the S&P hit 2100 by the end of the

year. Central bank puts are still in-tact– they’ve told us,

should another deflationary shock threaten the system,

they are ready to act with more stimulus and

unconventional measures. There’s an objective way of

looking at equity valuations as well. Aswath Damodaran,

Professor at NYU Stern calculates an implied risk premium

for the S&P 500 Index each month using a free-cashflow to

equity discount model. His method is excellent, and you

should read up on it2. The equity risk premium can be

thought of as the return above treasury yields that

2 http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2238064

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1995 Bull Run 2013 Bull Run

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2238064


investors expect from equity, given the level of the index

and information about the cashflows to equity i.e. buybacks

and dividends. The professor calculates the risk premium

each month and publishes it on his website. A borrowed

chart of this is shown below:

As you can see, one needs to escape the CAPE, and go with

something a little more responsive to the market than 10-

year cyclically adjusted price to earnings ratios. The

professor’s risk premium sits at 4.96%, which leaves room

for significant compression to levels I would consider

overvaluation. As you can see, the S&P was a bargain when

the risk premium peaked in March 2009 at 7.7%. Hence I

shan’t mince words – the bull market is still in-tact and one

should use dips as buying opportunities.

Expect more of the same – hedging behaviour of humans

As participants in a global market, one needs to think about

what it is we’re really doing when we buy and sell assets.

Are we just trading expectations? Does it really matter that

the risk premium on the S&P is at its average level, or that

the market is trending up? If the FTSE 100 hits its 200-day

moving average, is that sufficient for me to buy it? What

about if Russian stocks drop 20%, are they sufficiently

cheap at a P/E of 4? Do we just jump in if the market falls

again? Is the best insurance cash? I’ve always thought that

the most important thing, above all, is survival. You

survive by hedging your bets and thinking deeply about

exposures. There is no use being long the S&P, if it drops

15% tomorrow, because it will need to rally 17.6% to break-

even. You might see where I’m going with this – path

dependency. Despite the beautiful S&P analogue with the

1995 bull market, I don’t think our path to future

prosperity will be in a straight line. One needs to be able to

balance the linear narrative of a bull market, with a tone of

caution. What happens if expectations are suddenly

challenged and we have a 15% draw-down? I don’t doubt

for a second that the central bankers won’t do their part to

re-inflate expectations and the world economy. But in the

time between those events, you could very well see a

significant drawdown of capital that may inhibit your

ability to compound returns over time. I’ve thought about

this and an effective way to hedge against such drawdown

at low cost. The answer is volatility.

Over the last 25 years, the VIX index, the market’s

expectation of 30-day volatility of the S&P 500 Index as

priced in option values, hit a low of 8.89% 27 December

1993. The 1995 super bull market would begin just under a

year later on 9 December 1994 when the S&P 500 Index

closed at 445, having planted its roots firmly when VIX

bottomed.

In 2008, when the fundamentals reinforced the trend, the

S&P reached new all-time highs and the VIX had bottomed

a month before – this combination ushered in the massive

drop in the S&P 500. The level of the VIX tells us how

prepared investors are – how hedged they are. If VIX is

low, it’s because there is low demand for volatility or to put

options on the S&P. So in 2008, when holders of S&P were

caught out, they were un-hedged and scrambled to buy

VIX and sell the S&P, exacerbating the move. So the VIX

rose by a factor of 6, from 10 to 60 and the S&P halved.

Dare I say, today, the VIX is cheap by historical standards –

it looks like a bottoming process has already begun. We’re

also at the start of a great bull market in stocks, but

investors just don’t know it yet. Risk premia will be

compressed further and there’s a lot of room for

fundamentals to come in and confirm the trend,

exacerbating the move to the upside. As this starts to

happen, central banks are beginning to reduce their

stimulus measures, which have suppressed the VIX thus

far. So, what am I recommending:

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Monthly Values Implied Equity Risk Premium


Buy the VIX while its cheap (10% of capital) –

volatility is coming back. I guarantee you will

bleed on this position, but if you can catch the VIX

on a low, a small cut is far better than losing a limb.

Buy the S&P 500 Index (25% of capital) – while we

can expect risk premia to compress further, buy the

dip.

Buy the FTSE 100 Index (25% of capital) – it just

bounced at its 200-day moving average and has

everything the S&P has going for it + some

exposure to miners.

Buy Emerging Markets (15% of capital) – China is

going to do more of the same old.

Hold cash (10% of capital) or short term treasuries.

– just in case we get a drawdown on the equity

side. Use this to buy the dip when it comes, and

realise the VIX into cash when it spikes on the dip.

I haven’t yet my mind up about Japan, but you could well

replace the Emerging Markets position above with Japan,

for the same reason that China is going to do more of the

same old.

It’s that simple. You just rotate from protection into risk

when the time comes. You won’t need to ask me when to

do that – all you have to know is that it will be the point

that central banks tighten the liquidity taps because the

fundamentals will reinforce the trend. That could look like

a sneaky rate-rise in the US, or a faster than expected

tapering of quantitative easing. Just remember, these guys

do what they do best, they take scores. They don’t know

any other way of life.

Till next time,

The Actuary

intrinsic alpha april 2014

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