Intrinsic Alpha Nov 2013 We All Want to Go To Hell
-
Upload
the-actuary -
Category
Documents
-
view
100 -
download
1
description
Transcript of Intrinsic Alpha Nov 2013 We All Want to Go To Hell
Intrinsic Alpha Note – November 2013
“Investing should be more like watching paint dry or
watching grass grow. If you want excitement, take $800
and go to Las Vegas” - Paul Samuelson
“A Texan oil tycoon dies and goes to heaven. He is
greeted by St. Paul who informs him there is no space in
left in heaven. The tycoon asks to say hi to his old
buddies in heaven and shouts through the gates ‘Oil
found in hell!!’. A stampede ensues and heaven is left
empty, St. Paul says, ‘very clever, you can now enter
heaven’. The tycoon turns and replies, ‘you know, there
just might be some truth in that rumour’, and of course,
he goes to hell.” – paraphrased joke.
“They used to tank cod from Alaska all the way to China.
They'd keep them in vats in the ship. By the time the
codfish reached China, the flesh was mush and tasteless.
So this guy came up with the idea that if you put these
cods in these big vats, put some catfish in with them and
the catfish will keep the cod agile. And there are those
people who are catfish in life. And they keep you on your
toes. They keep you guessing, they keep you thinking,
they keep you fresh. And I thank god for the catfish
because we would be droll, boring and dull if we didn't
have somebody nipping at our fin.” – Vince Pierce,
Catfish 2010.
All roads lead to hell
I have not written in a few
months – largely because much
has not changed in the way of
fundamentals, although there
have been many changes. A
brief warning – this note is
lengthy and I recommend you
read it in a quiet place, perhaps your local pub or at
home with the comfort of a beverage.
Look at equities today. It is surreal that the analogue of
the 1995 bull-run leading into the era of Irrational
Exuberance has been echoed this year in the 2013 Bull
Run (Figure 1). I find myself asking whether people are
trying to go to hell? It seems that there was some truth in
the rumours, US equities have been a great investment
post 2008. Or could it be something more interesting is
taking place? I find myself asking whether the fixed
income bubble has resulted in the beginnings of an
equity bubble. Investors fearful of rising rates are
beginning to ignore how to value stocks – they forget you
need to discount future cashflows to equity. Rising rates
reduce this present value, but there is a feedback loop
inherent in the story – rates will only go up if the
economy is doing well, and of course, by “economy”
what we actually mean is the stock market. This is the
proverbial “central bank put option” also known as the
“insert Fed Chairman name here”-put.
Figure 1 data source The Bloomberg
Investors are asking for directions to hell, they haven’t
set off just yet. The important question to ask is when
exactly they will go to hell. If we extend the analogue we
get some potential indication and the truth of the matter
is – it looks like they can rest assured for quite some time
(Figure 2). Let me be clear, I believe we are at the start of
a new secular bull market in equities, a “once in a
lifetime” buying opportunity (or maybe 2008 was the
opportunity?). Buy now while stocks last.
Figure 2 data source The Bloomberg
Asset allocators today reason that equities are a hedge for
the Dollar (despite its trade-weighted strength since
2008), a hedge for monetary base expansion, a hedge for
inflation and a hedge against rising bond yields. US
stocks are all the rage these days, everyone is offering up
reasons to own equities. Of course the memory of 2007/08
Intrinsic Alpha Note – November 2013
has yet to be exorcised from participants’ minds – they
are being careful and there are many warnings out there
surrounding new nominal highs. It’s as though highs
have never been broken before. If you ask me, it is
precisely because people are asking the question of
whether stocks are overvalued that will push them
higher. History shows that it takes very little doubt in the
market’s psychology to force a crash. It is when everyone
is unprepared that we get crashes, not when we are all
hedged and diversified. We will see higher highs ahead –
risk on.
It is no coincidence that the long term log trendline in the
S&P 500 Index (also known as the Meridian) was
breached at the start of 2013 and the breach has been
sustained (Figure 3). The last time it was breached with
the same momentum was at the inception of the 1995
bull-run or the beginning of Greenspan’s Irrational
Exuberance.
Figure 3 data source The Bloomberg, rendering and annotations by Intrinsic Alpha
The gates of hell stay closed for now.
People want to go to hell
What we are witnessing is the largest attempted reflation
amidst a severe deleveraging since the 1930’s US
deleveraging. It took 12 years for US real GDP per capita
to recover to its long-term growth trend. We’ve only had
6 years since the 2007 credit crisis and as you can see,
Bernanke and co. handled this deleveraging rather well –
we are only 7% below trend whilst at the peak of the
1930’s episode, US real GDP per capita stood at 38%
below trend.
Figure 4 data source http://www.measuringworth.com/, calculations by Intrinsic Alpha
The pace of growth of real GDP is naturally increasing
i.e. real GDP should grow exponentially over time. The
main reason for this that gaining some knowledge
(technological advancement) helps us gain more
knowledge later. Despite this, it is early to presume the
worst is over, but there are some signs and we are on the
way to closing the gap via re-leveraging and reflation.
For one the US household debt service payments as a
percentage of disposable incomes has fallen to 1980’s
levels – the US consumer has deleveraged (Figure 5).
There is now far more capacity for consumers to take on
additional debt, which is what drives strong upswings in
real GDP.
It’s the credit – stupid!
In the West, we can count on people to spend, spend,
spend with what they don’t have.
Figure 5 data source Federal Reserve Bank of St. Louis
Credit spends just like money – note to self.
The banking system has also been aggressively de-
leveraged via the Fed’s Quantitative Easing injections.
Intrinsic Alpha Note – November 2013
Figure 6 data source Federal Reserve Bank of St Louis, calculations by Intrinsic Alpha
I have constructed a measure of the total money stock for
the US based on the Fed’s methodology for M3 and taken
the ratio of this to the St. Louis Source Base (base money)
in Figure 6. This provides a neat measure of how much
the monetary base has been leveraged up versus the
monetary base. As is clear – this ratio has been on the
steady rise from a level of 6 times in 1959, all the way up
to 16 times. The system is roughly 4 times less leveraged
than before. The banking system’s function is to short the
monetary base (money created by the Fed) and lend this
money out via credit. Banks create money (credit) as they
can make greater loans than actual money held through
fractional reserve lending. Of course if you default the
mafia bank has a right to your property – the vig interest
rate is what you pay for the privilege. When this money
short is called on i.e. the banks get stopped out leading to
a shortage of reserve currency i.e. US Dollars. This is
what happened in 2008.
Anther take on prices
The price level is where the quantity of money available
meets the supply of goods, services and financial assets
(“stuff”). It is my view that the supply of money versus
stuff is what drives the absolute price level i.e. inflation,
however the composition of inflation (goods, services
and financial asset inflation) is driven by something a
little more sinister – the inherent leverage in the banking
system and wider economy. What we call “money” these
days is also a matter of subjectivity. In practice, credit is
money, because credit spends just like money when it’s
created. Remember, banks and financial institutions
create credit through their ability to leverage the
monetary base.
Figure 7 data source Federal Reserve Bank of St Louis, calculations by Intrinsic Alpha
Figure 7 shows how upon abandoning the gold standard,
the US incurred bouts of increasing leverage coupled
with highly infrequent periods where services inflation
was lower than goods inflation. The green areas show
that falling leverage coincides with lower services
inflation than goods inflation – the services sector
benefits from credit and easy money.
Increasing the ratio of manufactured money (credit
currency via bank-created credit) drives services and
financial asset inflation up at a faster rate than goods
inflation. This is because the services based sectors of the
economy demand the same value in real terms for their
output. Doctors and accountants notice the prices of
goods & services rising and want to maintain their
purchasing power, so raise their fees by more than
inflation. Commodity producers (and manufacturers of
goods) on the other hand are on a negative terms of trade
versus the services sector – they are buying services at a
mark-up to inflation (ultimately, the pecking order for
terms of trade is Services>Goods>Commodities sectors).
In an economic cycle, wealth is directed towards the
services sector (in particular the banking sector) because
they are the first to experience the up-thrust in
purchasing power due to additional manufactured
money i.e. bankers get paid bonuses before businesses
can extract benefits of borrowing before consumers are
given more credit to spend and before financial assets
rise in value. This makes talented university graduates in
Engineering suddenly realise they wanted to become
investment bankers from birth instead of
engineers…money (or inflation) talks.
Intrinsic Alpha Note – November 2013
Figure 8 data source Federal Reserve Bank of St Louis, calculations by Intrinsic Alpha
So the balance of inflation between the goods and
services sectors is not really a balance at all – in this
system it pays to be part of services. Figure 8 shows
services CPI increasing significantly more than goods
and commodities CPI over time – there have only been 5
brief periods since 1959 (none lasting more than 2 years)
where average services inflation has been lower than
goods inflation.
But what about the price level?
In 2007/8 the “-flation” debate centred around whether
all that central bank “money printing” would cause
hyperinflation or whether it was insufficient and we
would slip back into deflation. Everyone was screaming
inflation because of all that money printing!!!! It must be
said that the high inflation scenario was far more
consensual as people looked towards the most recent
data points of the US stagflation in the 1970/80’s. It
wasn’t so difficult to imagine inflation rising quickly,
what with the Chinese economy still growing at 9% p.a.
and commodity prices at all-time highs – people are
victims of the availability bias and valence. The de-
coupling theory prompted investors to think that the
emerging markets would prop-up global inflation
despite a deflating West. They were wrong.
Investor expectations have shifted and most would now
agree we are dangerously close to deflation. Just last
week (ending Friday 8 November 2013), the latest
Eurozone CPI print was published and this confirmed
Mr Market’s view of deflation, 0.7% YoY and Mario
Draghi cut the Eurozone overnight rate by 25bps to
25bps.
Figure 9 data source www.tradingeconomics.com
The US is no prize turkey either with the most recent CPI
figure coming in at 1.2%
Figure 10 data source www.tradingeconomics.com
Have the central banks forgotten their targets?
There is room for more inflation but Mr Market wants to
look the other way. The BofA Merrill Lynch July Fund
Manager Survey polls 238 hedge funds around the world
responsible for a combined $643 billion in assets under
management on various topics. The results for what
these guys consider the biggest tail risk are shown in
Figure 11 So inflation is firmly last in the list. They are
more preoccupied with pontificating on China and its
manufactured nominal GDP numbers and whether it will
be able to sustain its demand for commodities.
Figure 11 data source BofA Merrill Lynch Global Investment Research
Intrinsic Alpha Note – November 2013
What you will commonly hear is that there is a fine
balance in the printing presses – printing a bit more
money than needed will create inflation extremely
quickly, a kind of leverage effect. I don’t buy this. The
reason we haven’t seen high inflation is because the devil
is in the detail.
Figure 12 data source Federal Reserve Bank of St. Louis, calculations by Intrinsic Alpha (right axis in $ Millions, left axis in percentage) Figure 12 shows how the amount of money defined as
M3 + Commercial Bank Credit (that is Fed M3 pre 2006
and my measure of M3 post 2006 – see appendix for how
well these compare) has increased substantially since
2009 but this has not lead to dramatic increases in the
CPI. There is one other important observation from the
chart. It is clear that changes in CPI and changes in
money are weakly correlated (42% correlation over the
period above with a 1 month lag) – my previous assertion
that the stock of money drives inflation requires a caveat.
It is not the stock of money in isolation that describes
inflation. To believe that is to believe that there is no
supply and demand for money. The more accurate
description should read, the stock of money combined with
its percolation through the economy is what drives changes in
price level. This raises another question – where is all that
manufactured money? We will find the answer in the
Fed’s excess reserves and how these are handled.
Figure 13 data source Federal Reserve Bank of St. Louis
Four decades ago, Milton Friedman recommended that
central banks pay interest to depository institutions on
the reserves they are required to hold against their
deposit liabilities. This proposal was intended to improve
monetary policy by making it easier to hit short-term
interest rate targets. The Fed was given this authority in
2008.
This new policy is especially important now that the Fed
has been holding more than $1 trillion dollars in total
reserves from depository institutions for the past three
years (Figure 13). Total reserve balances held at the Fed
include required reserves and any excess reserves that
depository institutions choose to hold on top of the
required reserves.
Under the 2006 Act, Federal Reserve Banks were directed
to: “pay interest on required reserve balances (that is,
balances held to satisfy depository institutions’ reserve
requirements) and on excess balances (balances held in
excess of required reserve balances and clearing
balances)”.
In 2007, required reserves averaged $43 billion, while
excess reserves averaged only $1.9 billion. This
relationship was typical for the past 50 years when the
Fed did not pay interest on reserves with only two
exceptions. Those occurred when the Fed provided
unusual levels of reserves to depository institutions in
September 2001 following the terrorist attacks and in
August 2007 at the onset of the global financial crisis.
Other than those two months, excess reserves were less
than 10% of total reserve holdings, because depository
institutions had an incentive to minimize noninterest-
bearing excess reserves held at the Fed. In other words,
banks are not incentivised to lend out their reserves
when they earn interest on them by keeping deposits at
the Fed. Who would have thought?
Once the Fed was authorized to pay interest on reserves,
the relationship between the levels of required reserves
and excess reserves changed dramatically. For example,
required reserves averaged almost $100 billion during
the first six months of 2012, while excess reserves
averaged $1.5 trillion!
The reason for paying interest on excess reserves is to
maintain the target for the Fed funds rate which is the
rate that banks lend and borrow balances held at the Fed
Intrinsic Alpha Note – November 2013
(reserves) with each other. The Fed sets the target rate in
line with Monetary policy and uses Open Market
Operations to influence the supply of money via asset
purchases (the resulting balances on bank balances
ending up at the Fed as excess reserves) and the interest
rate on deposits to influence the demand for such
deposits. It’s great for the Fed, because the interest rate
lever is another tool it can use to increase or reduce the
amount of these reserves entering the real economy and
hence inflation.
Better the devil you know than the one you don’t
I’m going to be quite clear and direct at this juncture. If
the Fed stops paying interest on these deposits, banks will have
a greater incentive to extend credit to the economy. This will be
inflationary. But of course for this to happen, the demand
for credit needs to be there as well – people have to take
the loans they are offered. Now that the consumer and
companies are ready to re-lever, I say game on.
"Gold is the money of kings; silver is the money of
gentlemen; barter is the money of peasants; but debt is
the money of slaves.”
Is the common phrase. Does this need to be amended to
include, “and Bitcoin will be the money of the Digital
Generation”?
“Altfiat” (alternative to fiat currency) is something the
common man in the streets understands, people have
become distrustful of their governments and central
banks. You don’t need to stretch your imagination much
to conceptualise why, the 99% are angry that the 1% now
command a significantly disproportionate share of global
income and wealth (Figure 14).
Figure 14 source: Thomas Piketty and Emmanuel Saez, "Income Inequality in the United States, 1913-1998," Quarterly Journal of
Economics, 118(1), 2003. See more at: http://inequality.org/income-inequality/
Figure 15 source: Economic Policy Institute, The State of Working America 2011, "Wealth Holdings Remain Unequal in Good and Bad Times." - See more at: http://inequality.org/wealth-inequality/#sthash.2haLtrub.dpuf The rich should understand and sympathise with the
common man in the street for being a bit disgruntled.
The truth is, inequality alone is insufficient to build
mistrust in a nation’s fiat currency. It’s what happened in
2007/8 that was the catalyst, however the storm has been
brewing for quite some time as the US Dollar has lost
most of its purchasing power over time via inflation and
devaluation relative to trading partner currencies. Major
central banks globally took it upon themselves to save
their credit-fuelled financial systems from insolvency by
injecting taxpayer money into their banking systems.
This Quantitative Easing put a fast end to the pain (for
some) of deleveraging in the West – a condition brought
about due to Western economies reaching the tipping
point of where their debt service obligations
overwhelmed growth in incomes. The credit cycle should
have reversed – irresponsible banks should have
collapsed, property values should have halved, equities
should have lost 50%, prices should have fallen and the
system should have found its natural clearing level – just
like in any market. Instead our leaders decided to avert
disaster (and US experience of the 1930’s deleveraging)
and aggressively de-leveraged banks (via reserve
injections and TARP funds) until they could then extend
further credit into their economies and repeat the cycle.
Of course, you can’t pull off the greatest financial rescue
in living memory (or ever) of financial institutions.
People have realised that the fiat currency in their
pockets is not a store of value – it is only a means of
transacting between market participants. A Dollar in
your pocket today is worth less tomorrow because of
Intrinsic Alpha Note – November 2013
inflation, or more accurately, an increased supply of
money relative to the things we buy with that money.
People are gradually opening their eyes to the fact that
popular measures of inflation like the CPI are not
representative of true inflation – instead these have been
massaged towards stability over time.
So what about bitcoin? My views on this can be
summarised as:
• It is a commodity, not a currency – it has
nowhere near any credibility as a medium of
exchange. Fiat is far more dominant and this will
not change – sorry.
• Fiat is issued under law – bitcoin is not. Should
bitcoin pose a credible threat to this status quo,
the authorities will simply make it illegal. Don’t
tell me people will use it anyway. They won’t
because their taxes and wages will be payable in
fiat.
• Supply is not limited – there are many altfiat
crypto-currencies in circulation today. Why not
keep supplying alternatives and make them all
worthless?
• The widespread use of bitcoin today is to
primarily facilitate money laundering, trade in
illicit goods and speculation. That is not a
currency.
• It is far too volatile to be used as a credible
transaction mechanism. I know the dollars in my
pocket do not have a 100% volatility over a day.
Sure they lose value over time relative to stuff,
but this is far slower than bitcoin.
• Bubbles usually reach their peaks when the
fundamentals reinforce the trend. For bitcoin this
has just started.
The truth is, a lot of hype has been created around altfiat.
You can’t blame people – they are angry. They want to
stick it to the bankers. Imagine how upset they will be
when they lose everything on bitcoin. Let’s all pull our
heads from out of the sand and get back to work. Any
asset with no cashflows cannot be valued apart from the
only credible asset in a catastrophe scenario - gold and
other “intelligent metals”.
I have decided to include a brief summary of my main
exposures as part of this series. Full transparency.
As is clear, I am long the over-indebted West, short the
Yen, long inflation with a partial hedge against short
term volatility via a small albeit convex fixed income
allocation. Overall direct Emerging Market exposure has
been kept low but is well maintained via UK equity
exposure. You will notice a long position in Greek stocks
– needless to say I am of the view this represents the
most convex position in the portfolio aside from the
value stock. You will also notice no gold or silver – my
reasoning is that these are undergoing consolidation as
real rates rise. All rates exposure has been maintained
towards the short end of the curve. Hardly any cash to
care about – remember, a dollar today is worth less
tomorrow, real assets all the way.
Exposure % Allocation
1 Eurostoxx 50 Equal Weighted TR Index 15.80%
2 Odey Opus Hedge Fund 14.10%
3 S&P 500 TR Index (USD) 11.40%
4 FTSE 250 TR Index 10.10%
5 S&P US Dividend Aristocrats TR Index 6.90%
6 Value Stock Position (Esure Group) 6.40%
7 DB X-trackers MSCI Japan Index (GBP) 6.00%
8 Lyxor MSCI Greece (USD) 6.00%
9 iShares UK Property UCITS ETF 6.00%
10 FTSE 100 TR Index ETF 5.40%
11 Ossiam Risk-weighted Commodity ex-grains ETF 3.70%
12 DB X-trackers iBoxx Global Inflation-Linked TR Index (GBP) 3.50%
13 DB X-trackers iBoxx £ Gilts Total Return Index 2.30%
14 iShares £ Corporate Bond 1-5yr UCITS ETF 2.20%
15 Cash 0.20%