Monday, September 27, 2021

Parrots as economists , "Supply and demand...demand and supply!"

It was once wittily remarked of the early writers on economic problems, “Catch a parrot and teach him to say ‘supply and demand,’ and you have an excellent economist.” Prices, wages, rent, interest, and profits were thought to be fully “explained” by this glib phrase. - Irving Fisher 1907

So, what is wrong with being a parrot? Any story for determining investment returns is simple. Where is demand going? Where is supply? There can be deep narratives with a lot of facts, but it still boils down to simple issues. Can the facts describe a shift in demand and supply? 

If you cannot parrot some conclusions about these shifts, you will not be able to forecast returns. Yet, something so simple can be very difficult to assess in practice. The slopes of the curves have to be addressed. The link between macro and fundamental variables, expectations, as well as capital still must be measured. Of course, for any investment discussion there may be multiple demand and supply curves that should be considered. There is no one perfectly simple chart.

Any market discussion should loop back to supply and demand. Inflation is moving higher. What does that mean for the demand of some financial assets? How will it impact the supply of assets? The Fed will taper at the end of the year. What will happen to the demand for Treasuries? How will supply be affected?  

Give me the good investment parrot and I can be happy. For more on the origins of the parrot phrase see the Quote Investigator.

Evergrande, contagion, and the uncertainty risk of not knowing

During extreme market bull moves, investors think they know too much or don't need to know the details. Everyone has a story for why something should go up. In fact, there is a "don't confuse me with the facts" mentality. I have the story follow the momentum. 

In a bear market, fear of the unknown takes over. We know too little and act accordingly through avoidance. There is a desire for more facts because no detail is too small.  

The Evergrande debt situation is constantly changing not with solutions but with revealing more information on how bad is the situation and where risks are growing.

Some have discussed Evergrande as a Chinese Lehman moment only to dismiss this extreme story. Lehman comparisons are irrelevant. What is critical for most investors is the issue of contagion. An investor may not hold Evergrande but the spillover to other companies will impact my portfolio. There is more than one type of contagion and investors should be aware of the differences. 

One form can be called tangible contagion. A failure of a firm can have an impact in their suppliers, buyers of their services, and banks that lend to the firm. These are direct spillovers. 

A second form of contagion can be associative. There are firms within the same industry which will be affected with negative perception. In this case, other property firms. However, this contagion can have a short life as investors compare and contrast risks. 

The third form of contagion comes from the unknown or intangible risk. There are direct Evergrande risks, but I don't know how this will spill-over to other firms, what will be the rule of law in China, the regulatory environment in China, how dollar debtholders will be treated, the risks for other highly levered firms, or the risks to construction in China. 

All of these are current unknowns that cannot be easily handicapped. This is uncertainty that cannot be measured. Hence, there will be a general exit from any risks that can be tied to the Evergrande environment or ecosystem. This general pullback may not make sense, but it is tangible and will affect global markets. we are seeing this contagion and the process is not over. Some will just call this a risk-off environment. The name does not matter. What matters is that high uncertainty will lead to large rebalancing flows away from risky assets.

Saturday, September 25, 2021

The fire triangle metaphor and the Chinese (New Zealand, Canada, ....) housing bubble

The fire metaphor was used in the book Boom and Bust: A Global History of Financial Bubbles by William Quinn and John Turner perhaps the best historical analysis on extreme market moves over the last 300 years. 

Their framework begins with a metaphor of bubbles as fires that grow based on a classic triangular combination of oxygen, fuel, and heat. With enough of each ingredient, a spark can set off a long-lasting market inferno. We have the metaphor working in excess with respect to global housing. When all of the fire triangle ingredients are in place, the end result will not be pretty for investors.

Quinn and Turner’s analogue to oxygen is marketability, the ease of buying or selling an asset. Marketability includes divisibility, transferability, and the ability to find buyers and sellers at low cost. Assets that lack marketability will never see the broad demand required to create a bubble. 

Marketability is increased by improvements in market structure, low-cost exchange trading, and the introduction of derivatives. A bubble’s fuel is easy money and credit. Without cheap and bountiful funds for investment, there is no opportunity for asset prices to be bid higher. Excessively low interest rates create demand for risky assets as investors reach for yield. 

The final side of the triangle is heat generated by speculation. This is defined as purchasing an asset without regard to its quality or current valuation, solely out of belief that it can be sold in the future at a higher price. 

For this metaphor to work, the market’s catching fire, it must require a catalyst—the proverbial match. There is invariably some cause that creates the strong belief in the prospect of abnormal profits. 

In the case of housing, policies of cheap money with a desire for citizens to acquire ownership created the current environment. Housing is still the number one asset for most households, so governments want to protect this investment for their own political well-being. Investors who funded property companies through bonds or equities have suffered and will continue to feel the pain until markets adjust to normalcy. Bail-outs will occur but not without all parties paying a steep price. 

This is not a new story, but one that has to be relearned. 

Friday, September 24, 2021

Performance versus a benchmark - A better SPIVA year?


It is always depressing for active managers to look at the Standard and Poor's Index versus Active (SPIVA) scorecards. Market efficiency lives! However, there are few managers who can beat the benchmarks. For the last year (mid-2020-mid-2021), 42 percent of large cap funds outperformed the SPX. Of course, over the last 10 years, only 17 percent did better. Managers can win in a given year, but time is not friendly to active funds.

In the case of fixed income, 85 percent beat the intermediate government/credit bond index. Managers seem to be better able to beat fixed income benchmarks; however, on a risk-adjusted basis only 10% outperform the benchmark. 

This poor performance explains why the growth for ETF and index businesses have been so strong and why active bets are often placed with hedge fund managers who may have fewer restrictions.