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Fasanara Capital

FASANARA CAPITAL INVESTMENT OUTLOOK

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03rd May 2017

Abstr act:

Fake Markets: How Artificial Money Flows Kill Data Dependency, Affect Market Functioning and Change the Structure of the Market
  
Hard data ceased to be a driver for markets, valuation metrics for bonds and equities which held valid for over a century are now deemed secondary. Narratives and money flows trump hard data, overwhelmingly.

‘Fake Markets’ are defined as markets where the magnitude and duration of artificial flows from global Central Banks or passive investment vehicles have managed to overwhelm and narcotize data-dependency and macro factors. A stuporous state of durable, un-volatile over-valuation, arrested activity, unconsciousness produced by the influence of artificial money flows.
  
  • Passive Flows: The Prehistoric Elephant In The Room
  • ETFs Are Taking Over Markets
  • The Impact of Passive Investors on Active Investors: the Induction Trap
  • How Narratives Evolve To Cover For Fake Markets
  • Defendit Numerus: There is Safety in Numbers
  • What Could We Get Wrong

Be Short, Be Patient, Be Ready
    
Markets driven by Central Banks, passive investment vehicles and retail investors are unfit to price any premium for any risk. If we are right and this is indeed a bubble (both in equity and in bonds), it will eventually bust; it is only a matter of time. The higher it goes, the higher it can go, as more swathes of private investors are pulled in. The more violently it can subsequently bust.

The risk of a combined bust of equity and bonds is a plausible one. It matters all the more as 90%+ of investors still work under the basic framework of a balanced portfolio, exposed in different proportions to equity and bonds, both long. That includes risk parity funds, a leveraged version of balanced portfolio. That includes alternative risk premia funds, a nice commercial disguise for a mostly long-only beta risk, where premia is extracted from record rich markets that made those premia tautologically minuscule.
  
Discussion Paper
EU Populism and Smoking Mirrors: the Latest Case of Marine Le Pen
   
We do not buy into the notion that populism is in recess in Europe, as portrayed by mainstream media. However desirable such view may be, hard data are not supporting it. It is politics and electoral laws that prevent the rise to power of populists in Europe, more so than electors themselves.

Without a successful migration strategy and a sustainable recovery in GDP, populism remains on the rise, moving along trend-line. Further chances for regime change will present themselves.

It follows that risk stays high with Europe – political, economic, financial. Until a proper fix is found, and a stable EU set-up, it is possible for an adjustment to occur through creative destruction (never let a good crisis go waste) or populism. A moment of discontinuity looms ahead, as policy inaction and instability breeds insecurity and disruption.

Discussion Paper
Oil: A Weak Present And No Future
  
OPEC/non-OPEC arrangements are only relevant for the short-term, and an extension to the output cut could lend a hand and provide for an ephemeral relief rally. Critically, Oil remains weak on a fundamental perspective, as new technologies both boost supply and crash demand at speed. Supply-wise, oil’s rally last year sowed the seeds for its future structural decline, as it helped producers hedge future production and lock-up profit margins, while they could continue to work on costs compression and productivity gains. As an example, breakeven costs for US frackers are now below 30$/bbl, while some of the Majors look at average operating costs of 10$ per barrel.
Supply is likely to only rise from here, as testified by the increasing count for horizontal rigs , and a staggering number of drilled uncompleted wells (DUCs) await to come onstream – over 5,000 (read EIA and here ). Moreover, new fracking technologies in the US are spreading to super-basins in Mexico and Argentina. Demand-wise, energy efficiency and energy storage (battery technology) inescapably hold the prospect of a future characterized by a lower demand meeting abundant clean and cheap energy.

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Fake Markets
How Artificial Money Flows Kill Data Dependency, Affect Market Functioning and Change the Structure of the Market

These days, it seems acknowledged by most that we live in the age of ‘post-truth’, ‘false equivalency’, ‘alternative facts’ and ‘fake news’. All concepts that revolve around the irrelevance of hard facts, truth, objectivity or accuracy: as frustrating as it is, this refers to the proven and full ability to cherry pick across data – or worse, fabricate them – so to support whatever argument one has, while advancing whatever agenda behind it. Hard facts are a thing of the past, what matters now is what works, what is instrumental to achieve a goal. David Hume’s ‘matter of facts’ are repealed and replaced by opportunism, sophism, or Machiavellianism.  

In financial markets, we may be observing a similar phenomenon. Hard data have ceased to be a driver for markets, valuation metrics for bonds and equities which held valid for over a century are now deemed secondary. Narratives and money flows trump hard data, overwhelmingly. Consider this: US GDP for the first quarter came out at less than a fourth of what was expected only in February, yet equity markets found reasons not to bat an eyelash, and be higher now than they were back then.  US equities are valued at cyclically-adjusted multiples only seen in the two of the most glamorous bubbles featured in history books (1929 and 2000), against levels of potential GDP way lower than back then, yet volatility is at all-time lows: VIX dipped below 10 - to follow realized volatility at 7 - something rarely seen before, except perhaps in days when markets are shut down.. Indeed, amazingly, US equity volatility was lower than long Treasuries volatility, over the last 4 years.
‘Fake Markets’ are defined as markets where the magnitude and duration of artificial flows from global Central Banks or passive investment vehicles have managed to overwhelm and narcotize data-dependency and macro factors. A stuporous state of durable, un-volatile over-valuation, arrested activity, unconsciousness produced by the influence of artificial money flows.
    
  • Fake markets are no longer data-dependent, but rather liquidity-induced and prone to focus minds on any one piece of available good news out there, even if isolated within a minefield. This is to become the dominant narrative: sometimes it is ‘chasing yields’ that matters, and not recession/deflation; sometimes it is ‘chasing growth/reflation’ that counts, and not rising yields/political instability; sometimes it is ‘one quarter of earnings’ only, and not yet another GDP shocker/nuclear tensions.
  • Fake Markets are characterized by the structural underestimation and mispricing of risks: passive investment strategies are the least suited to apply any premia to any risk, as they unemotionally move along and go with the flow; Central Banks on their part are by nature most active when risk is high, thus depressing the price of risk  right when risk abounds.
  • Fake Markets also seem to be associated with evanescent liquidity, the false belief in a deep liquidity that does not exist: as most passive investment vehicles overstate their diversification and oversell their liquidity (way and beyond the capacity of the underlying), liquidity will fast evaporate right when it is most needed, on gap downside movements (see August 2015 on certain ETFs as foretelling of this phenomenon). Market fragility ensues.
  • While giving the impression of stability and resilience, Fake Markets are prone to exasperate bubble-bust cycles: long narcoses followed by fast awakenings, and overcompensation to the downside. Fake Markets have a self-fulfillment element to them: in narcotized markets, passive investors excel in performance while pricing-off risk entirely and going long-only/fully-invested. As more passive investors come to the fore and substitute active managers, the structure itself of the market gradually morphs, in a vicious cycle. However, risk is dormant, not eliminated, and the more it grows – unattended – the more it becomes systemic.
  • Fake Markets have an impact on the price of money, long-term expectations for inflation and growth (self-fulfillment and reflexivity): misallocation of resources in the real economy and malfunctioning of the market economy are thus also potential collateral damages.

  
Passive Flows: The Prehistoric Elephant In The Room

​Let’s give a cursory look at the monumental numbers involved for artificial flows. Since the beginning of the year, BAML estimates that Central Banks - ECB, FED, BoJ, BoE, SNB - have bought financial assets for a staggering $ 1 trillion. Despite entering the tapering phase, this was the largest CB buying in 10 years, at $ 3.6 trn annualized. A ‘Liquidity Supernova’ that trumps all other flows. To BAML, understandably, this was ”the best possible explanation for why global stocks and bonds annualize double-digit gains despite Le Pen, Trump, China, macro.” This alone could be the only flow that matters. But there is more, in fact.
  
Passive money flows have relentlessly grown over recent years, months and weeks, to represent the next biggest buyer: a juggernaut of $ 8 trillions global firepower, long-only, mostly fully invested, often accounting for 90%+ of equity daily flows in the US. This number is arrived at by summing three categories of passive-type investor vehicles: (i) ETFs/ETPs and index funds, (ii) risk parity and volatility-driven funds, (iii) trend-chasing algos.
From our November 2016 Outlook (please get in touch for a copy), we briefly described the unfolding of a dangerous market structure:
    
“One could be excused for thinking that, given the long list of looming risks in the current market environment, for one to be long-only, and fully-invested, one has to be a machine. And the average investor these days is exactly that: a machine. These days, more so than ever before in financial history, market flows are dominated by passive index funds or ETFs/ETPs (at $4trn after leverage, according to Morningstar, Strategic Insight), Risk-Parity funds or Volatility-driven strategies ($3.75trn after leverage, according to RBC), trend-following algos/CTA ($0.5trn). Altogether, after leverage, they represent close to $8 trillions of assets in firepower, across asset classes.
The issue is the most dramatic in equities, where close to 90% of flows can be attributed to passive strategies, from 7% 15 years ago, according to Vanguard/CFA Institute data. Such predominance derives from the fact that average turnover on ETFs is over 10 times bigger than the turnover of the underlying stock positions. By analyzing the 100 largest ETFs, valued at $1.5trn, CFA Institute found out that they turned over an annualized volume of 14trn, while the 100 largest stocks, valued $12trn, turned over 15trn over the same period. According to Horizon Kinetics, turnover rates for two of the most popular ETFs is higher at 3,500%. In 2015 there were 1,594 ETFs, from just 204 in 2005, all the while as the number of listed stocks declined.
The rate of growth here is even more staggering than the absolute amounts, and should command attention (so much as the recent explosion in growth in Corporate China debt does). Only few years back, such elephant in the room was just a Disney’s Dumbo: it grew exponentially into a Mammoth in the very recent past.
And one will be excused for reminding that the day volatility rises markedly or the market trend is compromised - beyond a certain tipping point - they will simultaneously, mechanically and un-emotionally elect to lighten up: a sell avalanche waiting to unload. That herding behavioral pattern alone will determine the difference between a mild correction offering the opportunity to buy-the-dip and a deep damaging correction, between a January 2016-type snorkeling and a Lehman-type deep dive, between a gradual decline and a flash crash.”
  
  
ETFs Are Taking Over Markets

Specifically on ETFs, the tsunami is overwhelming. As of end January, ETFs and passive funds represented almost 30% of AUM in the US. PWC expects global AUM on just ETFs to grow to $7trn by 2021. Morgan Stanley estimated that $87bn were poured into US listed ETFs through the first two months of the year alone, which was impressive given that the average over the past 7 years has been $ 17bn. The product is so hot that Vanguard, to compete, felt compelled to cut fees 3 times from late January to mid-February, in a race-to-zero against rivals.

ETFs are taking over markets. In doing so, they are getting meta, as an ETF on ETFs was launched last month: TETF will be composed of stocks of companies driving the growth of the ETF industry.

Sometimes, ETFs are so big in respect of their underlying reference market that are forced to buy other ETFs. A sought-after Junior miner gold ETF got larger than its index recently. So much so that it was forced to buy other ETFs . Incredibly, there are 10 Canadian companies that this ETF owns where its ownership percentage is more than 18%. For six of those companies, the percentage would be even greater, but presumably, the fund does not want to exceed the 20% level, which, under Canadian rules, would force the ETF "to automatically extend a takeover offer to all remaining shareholders at the same terms," according to a report by Scotiabank.

Oftentimes, ETFs state a level of liquidity difficult to find in their reference market. The ETF Euro Corporate Bond Investment Grade trades with approx. 20 cents bid/offer, while very few of its underlying bonds can enjoy that, and most have 3x that. Interestingly, the ETF Select Dividend lost 35% during August 2015 at a time when its constituencies lost just 2.5%, showing that disconnections work both ways when the time comes. 

ETFs are naturally perceived to offer too high a level of diversification. This is not always true. Take, for instance, the case of one of the largest US Energy ETF, where 50% of the fund is held in just four stocks.

The impact of ETFs on markets has just started to be analyzed in details. JPM here explains what causes the 3.30pm market’s ramp up on US markets: ‘this is because these passive funds have to rebalance by the end of the day, different to active funds that have the discretion to wait before they deploy their cash balances’. It results in 37% of the NYSE trading volumes YTD taking place during the last 30 mins of trading.

A growing body of research blames ETFs for reducing markets efficiency, creating stock markets that are both ‘mindless’ and ‘too expensive’ : researchers D. Israeli, C. Lee and S. Sridharan wrote in a  paper  last month: “Our evidence suggests the growth of ETF may have (unintended) long-run consequences for the pricing efficiency of the underlying securities. A single percentage point increase in ETF ownership has demonstrable effects on an individual stock. Over the ensuing year, correlation to the share’s industry group and the broader market ticks up 9%, while the relationship between its price and future earnings falls 14%. Meanwhile, bid-ask spreads rise 1.6% and absolute returns grow 2%“.

The move into ETFs is clearly emphasizing the role of private investors in driving markets. It should also be noted that, incidentally, private client have historically correlated well with market peaks.

To be sure, ETFs themselves are great financial innovation. What one must consider though, is its implications for price discovery (do they make bubble/bust cycles more extreme?), liquidity (is liquidity overstated?), market responsiveness (is volatility depressed but tail risks bigger?). Specifically to this market cycle, it is worth asking also what happens when the liquidity tide turns on QE ending, or when markets dive.

Most obviously, there can be no certainty that Central Banks, ETFs, passive strategies, retail are necessarily the dominant factor out there driving price discovery in today’s markets. However, those thinking they are not must have a strong argument as to why, big as they are, they do not matter. And if they do matter, how much of them is factored into current prices. And also, again, what happens when Central Banks run out of road (as is happening) and markets move in reverse for any or no reason/catalyst.
  
  
The Impact of Passive Investors on Active Investors: the Induction Trap

It is not those flows alone, but their impact on the investment mentality of what is left of active investors. From the lens of behavioral finance, here is what active investors are likely to deduct from recent market events:
  • Trump was never a risk for the markets, differently than what was priced in the week preceding the event, but rather it was all along a market opportunity to buy-the-dip
  • Brexit was never a risk for the markets, differently than what was priced in the week preceding the event, but rather a market opportunity to buy-the-dip
  • The Italian Referendum was never a risk for the markets, differently than what was thought in the weeks preceding the event, but rather a market opportunity to buy-the-dip
  • October 2014, August 2015, January 2016 were all buying-the-dip opportunities on an undeterred bull market
  • Le Pen was a buying opportunity that never materialized
  • Rising geopolitical risks and confrontational economic policies the world over are no real risks, as at no point were they able to even marginally deter the bull market (the S&P did not correct by more than 3% in several months, despite the most horrendous headlines)

So, this is to say that not only passive investors’ success brings in more passive investors and gradually changes the structure of the markets, but it affects the behavior of leftover active investors too, through ‘recency bias’. It induces herd behaviors, crowd positioning and concentration of risk - which then becomes systemic.

In contrast, we believe that much of the typical market response was indeed influenced by the artificial flows of Central Banks enforcing their put, and long-only passive investors programmed to buy-the-dip.

Also, it can be said that association was not causality. A risk badly priced before a market-positive event (Macron winning) remains a risk that was badly priced. A risk badly priced after a market-negative event (Brexit, Trump, Italian Referendum, etc) remains a risk, waiting to strike.

The illusion of knowledge is one we must find the energy to resist to. From our previous Outlook :

“When we put our human minds to analyze the strong rebounds following sell-offs in Oct2014, August 2015, January-February 2016, June 2016, November 2016 and we attribute it to the narratives shifting rapidly and the market re-assessing the likely consequences of certain catalyst events (like Trump, Brexit, deflation etc.), we may all actually be fooling ourselves a little, thinking so many thinkers are out there are thinking. Within the last very few years, ruled-based passive-aggressive investment vehicles of all sorts joined the investment communities and exploded enormously into the multi-trillions, and are affecting the output we look at and try to use logical deduction upon.”

This induction trap may also help explain why not only markets are as high as they are, in definitive bubble territory when measured against fundamentals on most metrics ever utilized in modern financial history, but also why so few commentators and analysts are compelled to call it as it is: a bubble.

The market is at bubble levels based on, among others, the Buffet indicator ( Market Cap to GDP , “the best single measure of where valuations stand at any given moment”) and the Shiller indicator (CAPE earnings multiple). Professor Shiller even won a Nobel Prize for his studies on market inefficiency (as he discovered that stock prices can be predicted over a longer period). Yet, curiously, neither Buffet nor Shiller do call it a bubble. Far from it. Surely, it is never really popular to call a bubble: it always takes time for it to blow up and, meanwhile, there is too much vested interest and people benefiting from it. Also, you run the risk of being singled out for being non-constructive or for ‘fake news’. Or, perhaps, they truly think this time is different.  
  
  
How Narratives Evolve To Cover For Fake Markets

Investors looking for ex-post rationalizations can hang on to economic narratives. For any market response, there is a narrative that makes it taste and feel like it was bound to happen all along. Narratives evolve and accompany market evolutions, instead of recognizing artificial markets for what they are.

  • First it was all about CHASING YIELDS. As Central Banks enforced financial repression and negative rates, investors were pushed into riskier assets, ending up considering equities at whatever multiples of cyclically-adjusted earnings. The lower the yield, the rhetoric goes, the longer the duration, the more I pay for discounting future corporate cash flows.
  • As of July last year, though, yields bottomed out and started rising. Central Banks have started exiting Quantitative Easing ever since (the FED first, then the BoJ with their yield curve control, followed the ECB) making the rebound in rates in the months ahead more likely. The narrative moved then to CHASING GROWTH / REFLATION, instead of yields, globally. The equity and currency of Emerging Markets rallied powerfully, together with equity globally, in expectation of Trumpflation and incipient fast GDP recovery. Soft data advance impressively to price in the recovery to come, still invisible in hard data.
  • Next then, Trumpflation got downgraded, as Trump boldest moves were toned down or, at least, delayed. Soft data collapsed, flattening out on hard data, which never moved. US credit growth kept decelerating; GDP for Q1 came out at just 0.7% vis-à-vis 3%+ consensus only two months before. Meanwhile, geopolitical red lines were drawn on concrete (not sand), and a nuclear war was being threatened in North Korea. You would imagine some sort of retracement, even a mild 5%. Not really, not an inch. The narrative focuses on CHASING EARNINGS next, the one bit of information that came out well. Which is, therefore, the dominant data and the only one that matters, at present.
  • What will markets chase if earnings do not hold? After all, since 2009, real profits growth was the slowest in 30 years, margins stand at 70-years record levels on rates being at rock-bottom levels (and now rising), there is an ageing working population, slow productivity and global political instability/populism. So, it could be that a new caretaker is soon needed.

More readings:

​INVESTMENT OUTLOOKS:
25th July 2017 - "Twin Bubbles"
17th Jan 2017 - "Transformational Times"
​​​SCENARIOS:​​
7th Jun 2016 
"The Market Economy in 2020"
MEDIA
17th Jan 2017
"Forget fake news, investors should realize the markets are fake"
 
There is a form of spiritual faith within today’s markets that reminds of philosopher Daniel Dennet’s skyhooks. In promoting modern science over religion, Dennet differentiates between ‘cranes’ and ‘skyhooks’. Cranes are explanations that use scientific materialism, while skyhooks resort to miracles or non-material causes to explain things. Cranes would be here a metaphor for historically-tested valuation metrics and fundamentals, while skyhooks are elusive, over-fitting, ever-evolving narratives. There was a narrative for tech stocks in 2000 – they would change the paradigm - and one for real estate prices in 2007 – they never went down on a nationwide basis. In both cases large gap downside risks were ignored, in a form of blind faith in market’s efficiency.

Our take. Don’t pretend this is normal. Admit this is no proper market functioning but you follow flows until it lasts. When it stops, you expect market risks to be mutualized, again, as back then.

As always, narratives are ex-post easy explanations for what happened, obvious only in retrospect. To us, the structure of the market and Central Banking create a tide of liquidity that overwhelms all headwinds, for now. However, over a longer horizon, it historically paid to 1) stick to fundamentals and 2) price risk appropriately. Number crunching leads to the conclusion that prices are very high at the same time as systemic risks are very high. After the longest-lasting streak of US job recovery in recorded history, we are at end-cycle, at best. Central banking is gradually exiting the stage, after bringing long rates to historical lows. Rising rates meet leverage ratios that are now way larger than before. The structure of the market is flaky and dangerous, populated by passive vehicles and retail. This cannot be the ideal setting for buying more bonds and equities, or staying fully invested. 

  

Defendit Numerus: There is Safety in Numbers

Step back: a bit of number crunching to remind ourselves of the extreme valuations of risky assets these days. The bubble in bonds is widely accepted as inevitable, given that major Central Banks are hovering up most net issuance every month. The bubble in equity is not consensus. Most consider current valuations as justified by either forward earnings or goldilocks scenarios, strength in soft data or recovery gaining momentum.

In our opinion, equity markets are in bubble territory, and have been there for some time now, following years of monumental monetary printing by global Central Banks. The ensuing collapsing yields pushed investors into riskier asset classes, such as equity. Since March 2009, equities returned almost 20% annualised in the US (+250% in absolute value), and almost 12% annualised in Europe (+140% in absolute value). Most gains occurred as way of multiple expansions, while real profits growth was the slowest in 30 years. The equity bubble is most visible in the US, where most valuation metrics are out of whack:

  • Market Cap on GVA (Corporate Gross Value Added): 1.70x (only ever higher in 2000)
  • Market Cap on GNP (Buffett indicator): 1.70x (only ever higher in 2000)
  • Market Cap on GDP: 1.10x vs 0.58x historical average
  • Market Cap on Gold: 1.90x vs 1.55x historical average
  • Market Cap on Oil: 44x vs 23x historical average
  • CAPE Shiller Adj P/E multiples: > 30x (only ever higher in 1929 and 2000)
  • CAPE Shiller Adj P/E multiples relative to 10yr GDP growth: 35% above historical levels
  • Price on Book Value: > 3x  (only ever higher in 2000)
  • S&P 500 Price / EBITDA: higher than in 2000 and 2007
  • EV / EBITDA small caps in Russell 2000: almost 30x (from average 15x in last 30 yrs)
  • Net Debt / EBITDA: > 2x (from 1x in 2007)
  • Median Price / Revenue Ratio for S&P components: > 2.5x
  • S&P relative to Velocity of M2 Money Supply: double the levels in 2007 and 2000
  • NYSE Margin Debt at a 85 years high

To be sure, there is one metric out there that may be argued to be less definitive: the comparison between dividend yields and bond yields. Equity premia are decent when measured against minuscule bond yields. Yet, if one concurs bonds are in a bubble (with yields at close to 5,000 years lows), then comparison to a bubble does not make you any less of a bubble yourself.

P/Es are admittedly inflated by the energy sector, where averages are extreme so to incorporate markets’ rosy expectations of a strong rebound in sector earnings to come. We disagree to that too, as we expect Oil to revisit lows in the not so distant future. We expand on it later in this note.

The market tends to forget how much of current valuations is due to Quantitative Easing and financial repression policymaking, at a time in which QE is running out of road, most Central Banks openly evaluate exit strategies, as they are confronted with rising levels of cost-push inflation and lower systemic risks of global deflation (partly due to de-globalisation trends and protectionism). Yields started rising, like the seconds in a clock that resumed ticking, running towards wake-up call time.

Since July last year, indeed, well before Trump won the US elections, rates had started detaching themselves from generational lows. They will likely represent a most important headwind for equity valuations going forward.

In superfluous further evidence of monetary addiction, GMO estimates FOMC days account for 25% of the total real returns in US equities we have witnessed since 1984: if not for returns on FOMC meeting days, current valuations would be much lower.

Despite being in over-valuation territory, signs of complacency abound. For starters, the VIX index trades at just above 10 (it dipped to 9-handle this week), while realized volatility is even lower than that. End April was its fourth only monthly close below 11 in recorded history, after Jan 1994, Jan 2007, Nov 2006. Moreover, short interest on S&P, judging from its biggest ETF, is the lowest it has been in 10 years, in a clear sign of capitulation for bearish players. There cannot be much less doubt in the mind of investors. No vertigo at all-time highs. Only faithful swinging from one skyhook to the next.

Surprisingly to some, European equities are not much cheaper either.

On a forward earnings multiple basis they are only two/three points cheaper than US stocks, for a 20% P/E discount, much in line with historical averages. Over several decades, European equities have typically traded at a discount to US equities.

This is normally explained as due to less economic activism / animal spirit, less efficient crisis policymaking, more bureaucracy and regulations in welfare societies, more dependency on energy and mining, EM and the international cycle. Hardly an unwarranted discount.

Andrew Lapthorne at Société Générale analyses it in further details, (i) across absolute value P/Es, (ii) median valuation metrics so to neutralize most composition arguments (US overwhelmed by tech, EU dominated by financials), (iii) and trend-based earnings denominators (CAPE P/E, trend EPS). He reaches the following conclusion: ”the question comes down to not one of valuation but of profitability. The profitability gap between the US and the EU is largely a function of weakness in financials and a greater use of leverage by US non-financial corporates.”

James Mackintosh at the WSJ interestingly points out that “European cheapness is concentrated in banks, which still scare many, and oil stocks, which only look cheaper because of the collapse in US shale profits.”

It follows that European equities are not much cheaper than US stocks and no more so than historical averages. Then again, if US stocks are in a bubble, European stocks show a small (and historically fairly-sized) discount to a bubble.

Let alone the political instability in Europe, which is on the rise, moving from one narrowly avoided conflagration (French elections) to the next (Italian elections, after a recently failed Italian referendum). We will touch upon EU politics in the next section.

  
What Could We Get Wrong

In our bearish assessment of where we stand, as we consider systemic risks both large and widely ignored, we could well be proven wrong by the course of events from here. Few obvious scenarios proving us wrong are as follows:

  • We underestimated the animal spirit. Signs of M3 out of the US were misleading and the economy was indeed on a strong recovery path. Soft data were right, hard data were wrong. Atlanta FEDnow model was a Cassandra, proven wrong again. It made sense to stay long, as volatility (VIX) was at all-time lows, anticipating great things to come. One could not even say it was not in the cards already.
  • We underestimated the strength of the corporate sector. Earnings kept beating expectations for not just two quarters (and against depressed guidance) in several years but consistently over the course of 2017. Financial tightening proved to be no game changer. Yields rose but only gradually so, supported by amicable CBs. Inflation rose but only mildly so, without the specter of cost-push inflation squeezing profit margins all too quickly.
  • We misunderstood the short-term impact of the Fourth Industrial Revolution on the stock market. We got fooled by parallels to earlier cases of transformational markets, such as the Second Industrial Revolution. That industrial revolution proved disruptive. At the time, the world was indeed changing forever, but the short-term impact on markets and the economy was one of destabilization. It took years for it to equate to growing productivity and wealth, while it went through its implementation phase (see also: ‘electric dynamos were to be seen everywhere but in the productivity statistics’, the modern productivity paradox , the case of the dynamo; and ‘regime transition thesis’  of Freeman/Perez). This time around it works differently, and new technological innovations provoke immediate and widespread wealth. Jobs, consumer spending, tax bills are not destroyed faster than they are replaced, and wealth is distributed evenly. Growth is strong and more inclusive. Politics manages to avoid short-termism and strike just the right balance. Under this blue-sky theory, it made sense to stay bullish, long-only, fully invested with leverage, all along. ETFs were not just right, but a blueprint for the ideal investor 2.0: unemotional, undeterred by fleeting risk factors, stubborn and incurably optimist.
  • We underestimated the upside for Europe. Perhaps, things are not as bad as we think they are, support for EU slow policymaking is not crumbling, populism was a temporary phenomenon, and the Union manages to muddle-through towards a true banking union, a proper fiscal union, while the real economy further improves and allows for more extra time for policymaking. Risk were gigantic all along, but if they never materialized/conflagrated is as if they never existed, isn’t it. And it made sense to stay bullish all along. After all, strategically, if it blows-up everybody suffers: what is a problem shared is a problem halved. So, optimal choice was to stay long anyway, enjoy the music and move along. Go with the flow; follow the irresistible Pied Piper from Hamelin into the river. Seriously.

As always, we will only know with time. We do not believe such scenarios to be likely. Yet, they could definitively materialize. They are plausible.

We think, though, that the blue-sky scenario is consensus. How else could you explain P/E Shiller at 30 and VIX at 10, effortlessly? Talks of the ‘most hated bull market ever’ have always left us baffled. Hated by who, by how many? As visible in where? Is this because P/E are not at 50 and VIX at 5?

The one point we would like to make, then, is that a price for risk is nowhere in the picture here. As big a risk as it is, risk will be zero only upon completion of a successful course of events. We will only know with time. If risk is factored in, however mild a version, a bullish stance at current levels is unwarranted. If risk does not materialize into a catalyst event, it does not follow that risk never existed in the first place. To be bullish at current levels is to be pure gamblers, a case of greed trumping groundedness.


Be Short, Be Patient, Be Ready

Markets driven by Central Banks, passive investment vehicles and retail investors are unfit to price any premium for any risk. If we are right and this is indeed a bubble (both in equity and bonds), it will eventually bust; it is only a matter of time. The higher it goes, the higher it can go, as more swathes of private investors are pulled in. The more violently it can subsequently bust.
  
  
It remains to be seen if it is more of a 2008-type environment, the moment before a steep correction; or rather a 1999-type moment, whereby a melt-up preceded a sudden sell-off. The final outcome remains the same, as quitting years of QE and stimuli will be rough.

For the Fund, the takeaway of all the above is to be able to risk manage positions efficiently so to buy time for the views to materialise: be short, be ready, be patient.

We do concur with most analysts (and Central Bankers) that inflation resurfaced, and therefore yields bottomed in July last year. That is the problem. That will matter, at some point down this road.

The risk of a combined bust of both the equity and the bond bubble is a plausible one. It matters all the more as 90%+ of investors still work under the basic framework of a balanced portfolio, exposed in different proportions to equities and bonds, both long. That includes risk parity funds, a leveraged version of balanced portfolio. That includes alternative risk premia funds, a nice commercial disguise for a mostly long-only beta risk, where premia is extracted from record rich markets that made those premia tautologically minuscule.

It follows that, unusually, balanced funds and their derivatives/surrogates will be the least safe, should this unraveling scenario materialize. Which is to say that such scenario affects no single niche of the industry - like subprime mortgages in 2007, or tech in 2000, or Russia in 1998, or like today’s US student loans, auto loans, China’s shadow banking, property bubbles in China or Canada, etc - but rather it affects head-on 90% of the investing community, on their bread and butter established best practice. Under this theory, we should not worry of any one pocket of trouble to metastasize throughout to create systemic risk, but rather about the system itself, badly positioned for a synchronized deflating of bubbles in equity and bonds.

If we move alongside trend-line, the day will come for a true stress-test to occur, the first one in 40 years. Yields never consistently rose, while spiking, before. Equities never consistently fell simultaneously to that, in decades.

It may never happen but it is a plausible scenario, and to some (us) it is right alongside trend-line from here. The trend-line is drawn on such data points as (i) QE reaching capacity and then QE exit, (ii) yields detaching from zero after a 40 years rally, (iii) equities at stratospheric valuations, (iv) cost-push inflation resurfacing, (v) demographics, (vi) disruption from 4th industrial revolution and crumbling labor participation rates.

This scenario is all the more interesting because it is totally priced out. Nowhere to be seen in pricing, allowing for asymmetric profiles. We positively look at such downside gap risk as the great unchecked opportunity of today’s markets, asymmetrically profiled against little marginal upside from current levels, at a time when very few investors are left standing in the bearish camp.

It should also be noted that, during prolonged periods of bull markets, the financial industry at large has little incentive to wake up, as in the process big fees are earned. Short-term, it does not pay to be unpopular, independent thinkers. Still, if it is the right thing to do, it must be done. Quoting Buffett where Buffett would surely disagree, “markets are voting machines in the short-term but are weighting machine in the long term.” If it is indeed a bubble, assuming it is, it will eventually bust, sooner or later. Longer-term, it pays to be ready.

It also pays to be patient, though. It is not the environment where to bet the ranch on the unraveling of the bubble anytime soon: when it happens it will happen fast but it may take time. To be patient means to dose the amount of outright shorts, so to keep solvent for longer than the markets stay irrational.

Be short: being long today’s is to listen up to Ulysses’ sirens, after having read Homer’s Odyssey. We have all the tools to define a bubble, and yet when it comes before us in plain sight all we can hear is:  “a bubble can be only recognized in retrospect, when it busts”. Something like saying: let me see who wins and I’ll tell you my prognostic. 

There is no point for number-crunching active investors to be long at these levels, neither stocks nor bonds, except for the purpose of earning management fees in the process. Bull positioning is best left to ETFs and robo-investors, robo-advisors: nobody will be able to blame them for not spotting this was a bubble.

This is what we mean when we say: be short, be patient, be ready.

It will happen. When it happens, we are there.
  
  

Discussion Paper:
EU Populism and Smoking Mirrors: the Latest Case of Marine Le Pen

Marine Le Pen lost her chance to become the next President of France in 2017. The existential threat for the EMU is postponed. Disaster averted, again, by a narrow margin.

However, we do not buy into the concept that populism is in recess in Europe, as portrayed by mainstream media. However desirable such view may be, hard data are not supporting it. The ability to cherry-pick amongst ‘alternative facts’ is as frustrating as ever. Yet, to be sure, the same could be said for how bearishly we look at the same data set. Our take on the data set is as follows:

  • For starters, only 49.44% of French voters backed broadly pro-EU candidates (Macron + Fillon + Hamon). 49.31% voted for far-right or far-left ones
  • Moreover, as noted by The Economist, if France were to use the America’s electoral system, Marine Le Pen might be on course for victory

  

This is to say that it is politics and electoral laws that prevent the rise to power of populists in Europe, more so than electors themselves. Do not be fooled. Marine Le Pen is more hated by Melanchon’s supporters than Macron is, same goes for Fillon’s voters: in that alone resides her weakness at the second round of the French presidential elections next week-end.

Political fragmentation helps mainstream parties as grand coalitions between them are more easily formed. A messy situation at French Parliamentary Elections in June is likely to provide further evidence of such fragmentation, together with a picture of un-governability and increased uncertainty.

And what about the Italian Referendum, where approx. 60% of the electorate rejected the ruling party, at the risk of triggering a banking crisis? At the time, critical situations with banks MPS and UCG needed special care and yet, people spoke in dissent. Are those people heard today by pundits claiming populism to be in recess in Europe and therefore complacently continuing on the status quo?

Populism got defeated in Holland, decisively. In Austria less decisively so, the margin was so narrow that it took holding elections twice to get to the right outcome.

Critically, for populism to rise to power under most European electoral laws, a hard to achieve full majority is needed. Yet, one can hardly argue that anti-EU sentiment has not risen to 50%, at best or at worst, over the past years. Rather than propagandistically claiming EU populism to be declining, it seems to us more demonstrable to depict the rising trend of global populism, a by-product of years of non-inclusive shallow growth, or unequal stagnation.

With it, the collateral damage of the inability for governments in Spain, France and Italy to enjoy the proper majorities needed to implement reforms within their respective countries and at the EU level. Stillness wins, again.

Without a successful migration strategy and a sustainable recovery in GDP, populism remains on the rise, moving alongside trend-line, and further chances for regime change will present themselves.

While desirable, without a regime change it is hard to see structural shifts of EU/EMU construct happening: Eurobonds, deposit union, banking union, possibility for parallel currency, democratic elections for EU institutions, fiscal expansion policy, etc. Given the dogmatic approach in the EU to crisis policymaking, imbalances are likely to remain unfixed. Short-termism and political preservation are likely to prevail. Moving from one instability to the next, postponing hard needed reforms of the wacky EU/EMU construct is hardly a successful and sustainable political strategy for the EU. Yet, it is the one being pursued.

It follows that risk stays high with Europe – political, economic, financial. Until a proper fix is found, and a stable EU set-up is secured, it is possible for an adjustment to occur through creative destruction (never let a good crisis go waste) or populism. A moment of discontinuity looms ahead, as policy inaction and instability breeds insecurity and disruption. Here again we look at fundamentals in defining our views, and the harsh reality of imbalances eventually reaching a tipping point as they are let growing. Under Herbert Stein’s law, whatever cannot go on forever, will eventually stop.

Next comes Italy. Last week-end, Mr Renzi was re-elected as “Segretario” at Partito Democratico’s primary elections, and is now ready to plan out for new elections. Either in early 2018 or before that. The critical thing here is that EU-skeptic parties in Italy are dominant, at about 67% of the total, versus 49% in France.

  

Yet, similarly to France, electoral laws may well allow mainstream parties to survive in power. Renzi could strike a deal with Berlusconi’s Forza Italia (who can by then opportunistically supersede its EU skepticism) and narrowly avert disaster. As is clear, the balance is delicate. This time around Mr Grillo could end up striking a deal with other EU-skeptics, pragmatically admitting to its inevitability so to pursue his agenda, and manage to rise to power. The day EU populists learn to strike alliances is the day they stand a true chance of governing: not a day before then. EU political and economic stillness keeps that risk alive and well.

Time will tell.


Discussion Paper:
Oil, A Weak Present And No Future

Our bear case for Oil can be read here ( COOKIE ) and here ( Bloomberg Brief , pag 8). In a nutshell, we believe there is little upside for Oil following an extension of the output cut. Oil is showing all its weakness these days, as is dangerously leaning on a most fundamental support line at 48.60$ / 47$ for WTI. A clean break of such support would open potentially large downside gap risks.
  
  

OPEC/non-OPEC arrangements are only relevant for the short-term, and an extension to the output cut could lend a hand and provide for an ephemeral relief rally. Critically, Oil remains weak on a fundamental perspective, as new technologies both boost supply and crash demand at speed.

Supply-wise, oil’s rally last year sowed the seeds for its future structural decline, as it helped producers hedge future production and lock-up profit margins, while they could continue to work on costs compression and productivity gains. As an example, breakeven costs for US frackers are now below 30$/bbl, while some of the Majors look at average operating costs of 10$ per barrel. Supply is likely to only rise from here, as testified by the increasing count for horizontal rigs , and a staggering number of drilled uncompleted wells (DUCs) await to come onstream – over 5,000 (read EIA and here ). Moreover, new fracking technologies in the US are spreading to super-basins in Mexico and Argentina. Demand-wise, energy efficiency and energy storage (battery technology) inescapably hold the prospect of a future characterized by a lower demand meeting abundant clean and cheap energy.  

Our thematic ‘Short Oil Fund’ looks at banking on this scenario as asymmetrically as possible, while mitigating the downside. Get in touch if interested.

Thanks for reading us today! 
As usual, the ideas discussed in this paper will be further expanded upon via our more frequent publications - ‘COOKIEs’ and ‘CHARTBOOKs’, aimed at connecting market events to the macro views framed here, in either confirmation or invalidation. If you want to be included in these please do get in touch. We will also hold an INVESTOR PRESENTATION in the next month, so to eviscerate the data analysis behind the views here presented.