Down the Rabbit Hole - Frank K Martin

https://frank-k-martin.com/2020/07/10/down-the-rabbit-hole/#more-5283

As I wrote to you on October 19, 2017, Edward Chancellor and I met soon after I read his prescient and literarily superb book, Devil Take the Hindmost: A History of Financial Speculation (2000). We have stayed in regular touch, including attending a Berkshire Hathaway annual meeting together. This is his fifth appearance as guest writer. Just yesterday he sent me the following fable from Breakingviews which, with his permission, I am posting as it captures the zeitgeist of the times like few others are able to do.

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Alice was tired of studying for the CFA exams, the figures in the spreadsheet were blurry, she laid her head on the desk…

Her first day at Tweedle Asset Management was going to be a busy one. She was escorted around the offices by a young staffer named, Otto. Their first visit was to the bond team. Fixed income was Alice’s keenest interest.

“Do you hold bonds for income?” she eagerly asked. Everyone laughed. “Are you dreaming?” the desk head replied rudely. “The coupon is subtracted from the principal, not paid out. If it’s income you want, you should we take out a Danish mortgage, they pay very well. Or sell short Swissies.”

“But why own a bond, if it doesn’t pay interest?” replied Alice who’d read her Homer and Sylla* assiduously.

“As long as yields continue declining, even at negative rates we hold bonds for capital gains. If you want dividends, go ask the equity folks.”

“I see,” said Alice doubtfully, hoping that stock-market investors would prove more sensible. At least, they valued investments by discounting future income streams. But on opening a door marked “Fundamental Active Equity,” she came across an empty trading floor. 

“Oh, we closed down that team last month – they’d been underperforming for decades,” said Otto.

“What was their problem – did they buy overpriced stocks?” Alice asked, keen to show off her knowledge of Fama and French**.

“That’s exactly what they didn’t do!” replied Otto scornfully. “They stuck with value, and as everybody knows value sucks. If you want to outperform, you’ve got to show your FANGs.”

This didn’t sound quite right to Alice, who wondered how Otto ever passed the CFA exams.

“If you’ve sacked all your fundamental investors, who manages your equity portfolios?”

“Nobody, exactly. All the money is passively invested in index funds. As they say, ‘if you can’t beat the market, at least you can replicate it.’”

“But that means nobody is assessing the stocks’ fair value. It sounds like the market’s on autopilot,” she commented.

“Forget about equities, Alice,” Otto advised kindly, “that’s no longer where the action is. If you want to meet real investors, go visit the VC team.” So, a week later, Alice pushed through the swing doors to enter Tweedle’s fancy offices in Menlo Park. Everything was just as Alice had imagined, complete with bean bags and free candy-vending machines.

“What type of companies do you invest in?” asked Alice of the young VC, named Anna, who showed her around.

“We invest in unicorns,” replied Anna smartly.

“That must be difficult, because unicorns are mythical creatures,” Alice joked.

“Well, there are hundreds of unicorns in Silicon Valley – a unicorn is just a company with a fabulous valuation. Still, the business side of affairs is pretty mythical,” she added with a smirk.

“What do you mean?” asked Alice, more dumbfounded than ever.

“Well, most unicorns are just black boxes. If you open the box, it turns out to be empty.”

“That doesn’t sound like a very wise investment,” said Alice primly.

“True enough, but they make very good speculations. Besides our aim isn’t to find companies that do anything useful or will ever make a profit. No, we look to get in at an early funding stage and exit at the IPO. That’s where the real money is made.”

A few days later, Alice spent the day with the private equity team, Tweedle’s highest-compensated employees.

“How do you add value?” she asked to get the conversation going.

“There are only three things you need to know about private equity: leverage, leverage and leverage,” replied a slick young man in a bespoke Savile Row suit. “Our business is financial engineering.”

“But isn’t it risky to load companies with too much debt?” asked Alice whose vague understanding of Modigliani-Miller***  taught her that you can’t create value just by adding debt.

“Oh, all the risk is carried by the creditors – we stuff them with covenant-lite loans, payment-in-kind bonds, and the like. They’ll take any dreck for the tiniest slither of income. And when the proverbial hits the fan, we refinance.”

“Everything seems so strange,” Alice thought to herself. “I don’t think I’m cut out to be an investor, after all. Perhaps I’d enjoy economics research more.” 

That’s how she came to find herself knocking on the door of Dr. Oirob, head of Tweedie’s monetary and economics department.

“The highly abnormal is becoming uncomfortably normal,” intoned the doctor, trim beard and bespectacled with a shrewd, playful look on his face. “Interest rates have been pushed down to unimaginable levels. There is something vaguely troubling when the unthinkable becomes routine.”

 “At last, here’s someone I understand,” Alice mused, slipping into an empty chair.

“Central banks have stepped through a mirror,” continued Oirob excitedly. “They used to struggle to control inflation. Now they can’t push it up. They used to oppose wage increases, now they urge them on. It’s the same with fiscal expansion. We were taught that inflation was monetary, and that economic activity was real, but now it seems that inflation is real and what we thought was “real” turns out to be purely financial. Everything is upside down.”

Alice now wondered whether she understood any of this. To change the subject she asked,

“Isn’t Modern Monetary Theory the cure to all our problems?”

Alice really was au courant with the latest trends in economics. 

“Why those snake-oil peddlers,” replied the sage, showing an irascible side, “would have us believe six impossible things before breakfast – government debt doesn’t matter, deficits are the cure not the problem, governments don’t have to raise taxes or issue bonds, they can just print money, blah, blah. It’s the most complete nonsense!”

“Here’s the root of the problem.” Oirob*** continued, his eyes burning intensely, “For two decades or more, central banks have played around with interest rates, pushing them lower and lower. They meant well but didn’t understand they were messing with the price of time. If you set the clock – the tempo of capitalism – to run backwards the normal order of things breaks down: companies turn into zombies, herds of unicorns appear, investment discipline disappears. Wealth becomes virtual. Inequality is unleashed. Society melts down, markets melt up…”

At this point, Alice opened her eyes. Her face glowing in the reflection of the monitor. It had all been a dream, a most wonderful dream. Now, it was back to dull reality.  She clicked on the Reuters website to see if anything had happened while she slept. Nothing remarkable, it seemed, just a story about a new strain of the cold virus spreading in central China.

Dysfunktionen i systemet allt mer blottlagt.

FED köper högränteobligationer  och "räddar" felallokerad placerare, Carl Icahn varnade för en kris på högränteobligationsmarknaden för 5 år sedan.

Negativa priser på olja, negativa räntor....

Centralbankerna delar ut pengar till alla invånare.

Detta är förstås bara en del av en policy som pågått i snart 10 år:


Fyfan vad obehagligt allt detta är, desperationen för att hålla ihop systemet är tydligt. Kanske fixar dom det, bara gud vet. Varför har centralbankerna slutat att intervenera dagligen nu när börsen går upp? Det är förstås självklart om man betraktar ovanstående citat.

 Vad händer om det visar sig att ekonomin inte kan återhämta sig omedelbart efter 22 miljoner nya arbetslösa/permitterade i USA? Eller folk i gemene är skrämda och tillväxt inte återgår på 9 månader?

Vad är nästa steg? Ska Centralbankerna börja göra direkta stödköp på börsen? Skicka ut 10 000 USD till alla tiggare? Köpa upp all olja som produceras i USA för att bygga upp de nationella nödlagren (kanske en av de mer vettiga åtgärderna de kan göra nu)? 

I allt väsentligt syns dysfunktion tydligare nu än tidigare.

Should it be a surprise that stocks go straight up and then crash straight down? Which part of “record prices, record valuations, record leverage, record derivatives trading and record complexity” should investors be excused from understanding? Any outright long investor who is not waking up in the middle of the night sweating and worrying whether there will be a next leg of the bear market (despite the desperate and gigantic policy moves) is either Cool Hand Luke or oblivious.

We are not in the business of calling market turns. Why did most managers, economists, strategists and policymakers miss it? Certainly as the virus was getting underway, advisors should have been incorporating it into their thinking. Certainly as the global economy started shutting down, advisors should not have been upgrading their recession probability forecasts “from 20% to 25%” and modestly downgrading their Chinese growth forecasts “from 6.1% to 5.6%.” Maybe investors DIDN’T miss it. Maybe they actually thought that no matter what happens, the authorities want stocks to go up, and that is all you need to know.

The central bankers, particularly at the Fed, should be ashamed of themselves for fostering that belief, and for allowing the policy mix to be so skewed toward free and (overly) plentiful money. The solution is now pouring unlimited money into the boiling cauldron. MMT has come along just in time to justify everything. Not in productive ways, not in the building of useful infrastructure, not doing a better job of educating our workforce so we can grow like crazy, but just to save the screwed-up system that we have, just to hold things together. Helicopter money has made the job of active investing harder, and the suppression of interest rates by central bankers lowers the forward rates of return for everyone. You might say, “But it has enhanced the to-date rate of return.” We would retort, “That is true, but despite the artificially enhanced to-date rates of return in bonds and stocks, net debt has skyrocketed, pension plans are universally underfunded and developed world infrastructure is oriented toward political pet projects and is inadequate to support needed economic growth going forward." (Paul Singer)

"As for me, with the yesterday’s Fed announcement of unlimited QE and its “will buy or support almost anything,” along with the pending passage of a $2-2.5 trillion stimulus package, this is the end of the capital markets as we have known them. We have now entered unlimited QE and MMT where there is no escape. It is the Roach Motel all over again. In Chairman Bernanke‘s 2010 Washington Post op-ed, he argued that QE would lead to a virtuous economic cycle; therefore, the Fed would eventually be able to exit from its QE operations. I argued that once initiated, a reversal would be impossible. It would be like the Roach Motel, “You can check in, but you cannot check out.”

With the initiation of the Fed’s complete takeover and control of the US financial economy, there is now absolutely no accurate pricing discovery in the capital markets and we have entered a period of total manipulation. In light of this, the only markets I have an interest in are those where the heavy hand of government is not involved or only minimally involved. This leads me to rare commodities and collectibles. The public equity and debt markets are now nothing more than greater fool markets that are led by the greatest fools of all, the Fed and the Congress. US capital markets, RIP!" (Robert Rodriguez)

Tänkvärda ord om centralbanker

Q3 2013 Shareholder Letter

"Is it possible that the average citizen understands our country's fiscal situation better than many of our politicians or prominent economists?

Most people seem to viscerally recognize that the absence of an immediate crisis does not mean we will not eventually face one. They are wary of believing promises by those who failed to predict previous crises in housing and in highly leveraged financial institutions.

(...) When an economist tells them that growing the nation's debt over the past 12 years from $6 trillion to $16 trillion is not a problem, and that doubling it again will still not be a problem, this simply does not compute. They know the trajectory we are on.

When politicians claim that this tax increase or that spending cut will generate trillions over the next decade, they are properly skeptical over whether anyone can truly know what will happen next year, let alone a decade or more from now.

They are wary of grand bargains that kick in years down the road, knowing that the failure to make hard decisions is how we got into today's mess. They remember that one of the basic principles of economics is scarcity, which is a powerful force in their own lives.

They know that a society's wealth is not unlimited, and that if the economy is so fragile that the government cannot allow failure, then we are indeed close to collapse. For if you must rescue everything, then ultimately you will be able to rescue nothing.

They also know that the only reason paper money, backed not by anything tangible but only a promise, has any value at all is because it is scarce. With all the printing, the credibility of our entire trust-based monetary system will be increasingly called into question.

And when you tell the populace that we can all enjoy a free lunch of extremely low interest rates, massive Fed purchases of mounting treasury issuance, trillions of dollars of expansion in the Fed's balance sheet, and huge deficits far into the future, they are highly skeptical not because they know precisely what will happen but because they are sure that no one else--even, or perhaps especially, the  policymakers—does either." (Klarman, Q3 2013)

2012 letter Seth Klarman

"If economics were a hard science like chemistry, you’d mix a little of this with a bit of that and the concoction would lead to strong economic growth, full employment, rising home prices, buoyant financial markets, and low inflation every time. But economics is a soft science, and real life simply doesn’t work so predictably. Though economists might wish otherwise, economics is, at its core, behavioral.  Modern economies are too complex to be reliably modeled; their connections and correlations are lose and imprecise, the second- and third-order effects largely immeasurable the fickle vagaries of individual and aggregate human behavior utterly unknowable. Put an economist in a powerful government job and provide levers that can be pulled to start the printing presses, set reserve requirements, fiddle with the Fed funds rate, expand the Fed’s balance sheet, and deliver indecipherable communiqués, and that economist will feel compelled to pull those levers. He or she, like a monkey with a typewriter, might even give us Shakespeare (or Adam Smith) on occasion. But mostly that economist will spout gibberish, a mélange of untested and potentially counterproductive measures that unleash all manner of unintended consequences." (Seth Klarman, 2012 letter) 

Preliminary Thoughts – The New World Order

The following letter was sent by Bob Rodriguez to his friends and colleagues yesterday, as well as to Bob Huebscher. Bob Rodriguez has graciously allowed us to publish it.

Robert L. Rodriguez was the former portfolio manager of the small/mid-cap absolute-value strategy (including FPA Capital Fund, Inc.) and the absolute-fixed-income strategy (including FPA New Income, Inc.) and a former managing partner at FPA, a Los Angeles-based asset manager. He retired at the end of 2016, following more than 33 years of service.

He won many awards during his tenure. He was the only fund manager in the United States to win the Morningstar Manager of the Year award for both an equity and a fixed income fund and is tied with one other portfolio manager as having won the most awards. In 1994 Bob won for both FPA Capital and FPA New Income, and in 2001 and 2008 for FPA New Income.

The opinions expressed reflect Mr. Rodriguez’ personal views only and not those of FPA.

Dear friends and colleagues,

Though the virus pandemic has been tumultuous, challenging and with little precedence, from a capital market perspective, this market collapse was quite predictable. Capital market excesses became pervasive in ways that were also unprecedented. Zombie companies, corporate operating strategies that elevated financial risk to extreme levels and consumers who also became highly leveraged were the accepted actions of the day. Prudence was an extremely rare virtue. Many times I expressed the opinion that I thought the various equity markets were at least 40-60% over valued. Recent events would tend to confirm my assessment.

Back in 2009, in my Morningstar speech, and then after I returned from my 2010 sabbatical, I argued that, if we did not get our economic house in order, we would experience a crisis of equal or greater magnitude than the 2008-2009 period and that this would take place after 2017. With the passage of the 2017 omnibus bill and the 2017 tax cut, along with a continuation of unsound and insane monetary policies, this speculative excess period was able to be extended. We knew there would be a pin that would prick this unbelievably speculative bubble but we just didn’t know what it would be. Now we do.

Our economic and financial market systems were not prepared with appropriate “rainy day reserves” to withstand an exogenous shock. Balance sheets were stretched in all economic sectors. The shock to the US economy by the bombing of Pearl Harbor and the beginning of WW2 was more traumatic and of greater magnitude than what we are experiencing now and it would also last longer. However, after 12 years of Depression, the financial system was cleansed of speculative excesses that allowed for a financial re-leveraging of the economy to fight the war. After the carnage was over, the economy was able to grow out of an extreme leverage position. In contrast to then, this is not the case today, given that the economy is already extremely leveraged prior to the onset of the crisis. My worst fears have materialized.

Since 2013, I have been preparing for an economy of monumental excess, where debt and deficits do not appear to matter, along with Fed and other central bank monetary policies that totally distort the fundamental elements of the Capital Asset Pricing Model. With the events of the past three weeks, the perversion and conversion to a dystopian capital market and economic system is virtually complete.

As for me, with the yesterday’s Fed announcement of unlimited QE and its “will buy or support almost anything,” along with the pending passage of a $2-2.5 trillion stimulus package, this is the end of the capital markets as we have known them. We have now entered unlimited QE and MMT where there is no escape. It is the Roach Motel all over again. In Chairman Bernanke‘s 2010 Washington Post op-ed, he argued that QE would lead to a virtuous economic cycle; therefore, the Fed would eventually be able to exit from its QE operations. I argued that once initiated, a reversal would be impossible. It would be like the Roach Motel, “You can check in, but you cannot check out.”

With the initiation of the Fed’s complete takeover and control of the US financial economy, there is now absolutely no accurate pricing discovery in the capital markets and we have entered a period of total manipulation. In light of this, the only markets I have an interest in are those where the heavy hand of government is not involved or only minimally involved. This leads me to rare commodities and collectibles. The public equity and debt markets are now nothing more than greater fool markets that are led by the greatest fools of all, the Fed and the Congress. US capital markets, RIP!

Despite my having avoided 100% of the market carnage and also being profitable, I have to shed a tear for the passing of a capital market that has benefitted the real and financial economy so well for decades. In 2008, when I wrote, “Crossing the Rubicon,” I argued we had crossed over into a new economic order and system. Little did I know that within twelve short years this transformation would be virtually complete. We have entered into a far more dangerous environment where normal rules of analytics will likely not apply. When everything is essentially socialized as to risk, a return vs risk evaluation is essentially meaningless since the risk side of the equation has been truncated. Over a period of time which I cannot estimate yet, I will continue my preparation for a far different economic and financial environment. Capital deployment strategies will likely have to change from what has been the norm in the post WW2 environment. We are in a New World Order.

I hope I am wrong in my assessment, but I doubt it.

Good luck,

Bob

March 24, 2020

Twenty Investment Lessons of 2008 - Seth Klarman

Below, we highlight the lessons that we believe could and should have been learned from the turmoil of 2008. Some of them are unique to the 2008 melt-down; others, which could have been drawn from general market observation over the past several decades, were certainly reinforced last year. Shockingly, virtually all of these lessons were either never learned or else were immediately forgotten by most market participants.

Twenty Investment Lessons of 2008

1. Things that have never happened before are bound to occur with some regularity. You must always be prepared for the unexpected, including sudden, sharp downward swings in markets and the economy. Whatever adverse scenario you can contemplate, reality can be far worse.
2. When excesses such as lax lending standards become widespread and persist for some time, people are lulled into a false sense of security, creating an even more dangerous situation. In some cases, excesses migrate beyond regional or national borders, raising the ante for investors and governments. These excesses will eventually end, triggering a crisis at least in proportion to the degree of the excesses. Correlations between asset classes may be surprisingly high when leverage rapidly unwinds.
3. Nowhere does it say that investors should strive to make every last dollar of potential profit; consideration of risk must never take a backseat to return. Conservative positioning entering a crisis is crucial: it enables one to maintain long-term oriented, clear thinking, and to focus on new opportunities while others are distracted or even forced to sell. Portfolio hedges must be in place before a crisis hits. One cannot reliably or affordably increase or replace hedges that are rolling off during a financial crisis.
4. Risk is not inherent in an investment; it is always relative to the price paid. Uncertainty is not the same as risk. Indeed, when great uncertainty – such as in the fall of 2008 – drives securities prices to especially low levels, they often become less risky investments.
5. Do not trust financial market risk models. Reality is always too complex to be accurately modeled. Attention to risk must be a 24/7/365 obsession, with people – not computers – assessing and reassessing the risk environment in real time. Despite the predilection of some analysts to model the financial markets using sophisticated mathematics, the markets are governed by behavioral science, not physical science.
6. Do not accept principal risk while investing short-term cash: the greedy effort to earn a few extra basis points of yield inevitably leads to the incurrence of greater risk, which increases the likelihood of losses and severe illiquidity at precisely the moment when cash is needed to cover expenses, to meet commitments, or to make compelling long-term investments.
7. The latest trade of a security creates a dangerous illusion that its market price approximates its true value. This mirage is especially dangerous during periods of market exuberance. The concept of “private market value” as an anchor to the proper valuation of a business can also be greatly skewed during ebullient times and should always be considered with a healthy degree of skepticism.
8. A broad and flexible investment approach is essential during a crisis. Opportunities can be vast, ephemeral, and dispersed through various sectors and markets. Rigid silos can be an enormous disadvantage at such times.
9. You must buy on the way down. There is far more volume on the way down than on the way back up, and far less competition among buyers. It is almost always better to be too early than too late, but you must be prepared for price markdowns on what you buy.
10. Financial innovation can be highly dangerous, though almost no one will tell you this. New financial products are typically  created for sunny days and are almost never stress-tested for stormy weather. Securitization is an area that almost perfectly fits this description; markets for securitized assets such as subprime mortgages completely collapsed in 2008 and have not fully recovered. Ironically, the government is eager to restore the securitization markets back to their pre-collapse stature.
11. Ratings agencies are highly conflicted, unimaginative dupes. They are blissfully unaware of adverse selection and moral hazard. Investors should never trust them.
12. Be sure that you are well compensated for illiquidity – especially illiquidity without control – because it can create particularly high opportunity costs.
13. At equal returns, public investments are generally superior to private investments not only because they are more liquid but also because amidst distress, public markets are more likely than private ones to offer attractive opportunities to average down.
14. Beware leverage in all its forms. Borrowers – individual, corporate, or government – should always match fund their liabilities against the duration of their assets. Borrowers must always remember that capital markets can be extremely fickle, and that it is never safe to assume a maturing loan can be rolled over. Even if you are unleveraged, the leverage employed by others can drive dramatic price and valuation swings; sudden unavailability of leverage in the economy may trigger an economic downturn.
15. Many LBOs are man-made disasters. When the price paid is excessive, the equity portion of an LBO is really an out-of-the-money call option. Many fiduciaries placed large amounts of the capital under their stewardship into such options in 2006 and 2007.
16. Financial stocks are particularly risky. Banking, in particular, is a highly lever- aged, extremely competitive, and challenging business. A major European bank recently announced the goal of achieving a 20% return on equity (ROE) within several years. Unfortunately, ROE is highly dependent on absolute yields, yield spreads, maintaining adequate loan loss reserves, and the amount of leverage used. What is the bank’s management to do if it cannot readily get to 20%? Leverage up? Hold riskier assets? Ignore the risk of loss? In some ways, for a major financial institution even to have a ROE goal is to court disaster.
17. Having clients with a long-term orientation is crucial. Nothing else is as important to the success of an investment firm.
18. When a government official says a problem has been “contained,” pay no attention.
19. The government – the ultimate short- term-oriented player – cannot withstand much pain in the economy or the financial markets. Bailouts and rescues are likely to occur, though not with sufficient predictability for investors to comfortably take advantage. The government will take enormous risks in such interventions, especially if the expenses can be conveniently deferred to the future. Some of the price-tag is in the form of back- stops and guarantees, whose cost is almost impossible to determine.
20. Almost no one will accept responsibility for his or her role in precipitating a crisis: not leveraged speculators, not willfully blind leaders of financial institutions, and certainly not regulators, government officials, ratings agencies or politicians.

Below, we itemize some of the quite different lessons investors seem to have learned as of late 2009 – false lessons, we believe. To not only learn but also effectively implement investment lessons requires a disciplined, often contrary, and long-term-oriented investment approach. It requires a resolute focus on risk aversion rather than maximizing immediate returns, as well as an understanding of history, a sense of financial market cycles, and, at times, extraordinary patience.

False Lessons

1. There are no long-term lessons – ever.
2. Bad things happen, but really bad things do not. Do buy the dips, especially the lowest quality securities when they come under pressure, because declines will quickly be reversed.
3. There is no amount of bad news that the markets cannot see past.
4. If you’ve just stared into the abyss, quickly forget it: the lessons of history can only hold you back.
5. Excess capacity in people, machines, or property will be quickly absorbed.
6. Markets need not be in sync with one another. Simultaneously, the bond market can be priced for sustained tough times, the equity market for a strong recovery, and gold for high inflation. Such an apparent disconnect is indefinitely sustainable.
7. In a crisis, stocks of financial companies are great investments, because the tide is bound to turn. Massive losses on bad loans and soured investments are irrelevant to value; improving trends and future prospects are what matter, regardless of whether profits will have to be used to cover loan losses and equity shortfalls for years to come.
8. The government can reasonably rely on debt ratings when it forms programs to lend money to buyers of otherwise unattractive debt instruments.
9. The government can indefinitely control both short-term and long-term interest rates.
10. The government can always rescue the markets or interfere with contract law whenever it deems convenient with little or no apparent cost. (Investors believe this now and, worse still, the government believes it as well. We are probably doomed to a lasting legacy of government tampering with financial markets and the economy, which is likely to create the mother of all moral hazards. The government is blissfully unaware of the wisdom of Friedrich Hayek: “The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.”)