Ten Charts and Some Questions

It’s the end of the year, a time to look back.  There is also that annual ritual of forecasting this and that.  You won’t find any of that kind of activity here, but there are some questions to be asked.

Interest rates

Central bank actions affect economic activity and asset prices, and the U.S. Federal Reserve has the most global sway, so it makes sense to start there.  Here is the Fed funds rate since the early seventies, along with the ten-year yield.  The dotted line shows the average expected funds rate over the “longer run” by the members of the Fed (according to the most recent “Summary of Economic Projections.”)

What do you think they mean by the “longer run”?

Is 2.5% a reasonable expectation of short-term rates over that time?

Would a higher or lower forecast change your investment approach?  How?

Correlation

The ten-year yield reappears at the bottom of this chart, with the top panel showing its 26-week correlation with the S&P 500.  You can’t miss the correlation regime change (at least in hindsight).  Since yields move inversely to prices, this shows that the prices of bonds and stocks tended to move together during the first half of the chart — and in opposite directions during the second half.

Why?

What do you expect to be the average correlation between them to be over the next decade?

Again, why?

Bitcoin

There is much debate about whether we are on the cusp of cryptocurrencies “going institutional.”  On the provider side, some firms are actively involved in developing products and positioning themselves for the “gold rush” (ironic name, see the next chart) that they foresee.  Some asset owners have dipped a toe in as well.

The chart shows the history of Bitcoin and the S&P 500 during the last few years, with each panel featuring one of the three elements common to the mean-variance optimization (MVO) approach to asset allocation.  (The upper thrusts of Bitcoin have been cut off in the return panel because they diminish everything else, including the downside periods.)

What methodology would you use (or are you using) to decide your exposure to cryptocurrencies (not just Bitcoin)?

If forced to use MVO, what would your single-point estimates be for Bitcoin’s expected return, volatility, and correlation?

Commodities

Inflation has reared its ugly head for the first time in a good long while.  That has spawned interest in inflation-protected bonds and various “real assets,” including commodities.  On that front, here is the performance for the S&P GSCI sectors for 2021.  The index is heavily weighted to energy, so the total return on the whole index is up over 38%.

You’ll note that precious metals have been going nowhere.  But they had held up better than everything else during the first six months of the pandemic, while most other commodities, especially energy, got crunched.

Is the current bout of inflation transitory?

Commodities were once a popular diversifier, until the financial crisis, when they were more correlated that expected.  Would/do you invest in them now?

Are precious metals an inflation hedge?

China

There are many different strands of concern about China today, including changing regulations for Chinese companies, both in that country and around the world.  But let’s stick with the property companies, since real estate and associated debt often figure into financial crises.

The three companies shown above are under pressure and making headlines.  The returns on their stocks are charted in the top panel and bond prices for representative dollar bond issues for each appear below them.

What are your general views about investing in China given its economic and political system — and the changes that have occurred of late?

Are you more of the mind that any weakness in Chinese stocks should be bought, or that any strength should be sold?

Who provides you with the best advice on investing in China, and how do they add value versus others?

Japan

Notable among the various bubbles of the last half-century is that of the Japanese equity market (with its ripple effects on bonds, currencies, and real estate around the world).  This chart shows the size of that bubble (these are all relative returns) for yen, pound, and dollar investors.

Japan now represents around six percent of most global indexes and is not much of a topic of conversation, with all of that excitement decades in the rear view mirror.  But in a piece in the most recent GMO quarterly letter, John Thorndike of the firm argues that Japan’s fundamental performance has equaled that of the United States over the last decade, while it has not enjoyed a similar surge in valuation as a result.

GMO’s value bent has become decidedly unfashionable as valuations have marched higher.  Does that affect how you think about their recommendation?

The firm defines “fundamentals” as “an average of sales, gross profits, smoothed earnings, book value, and GMO’s Economic Book Value.”  Are you suspicious of a firm that approaches something in a different fashion or intrigued by it?

When was the last time you looked at Japan as an opportunity?

Leverage

As markets go higher and strategies continue to work, leverage is built into the system.  You know some of it is there but hard to see/track, but let’s stick with an obvious case.  This fund is up huge versus the S&P 500 and even against the high-flying NASDAQ 100.  Leverage can be a beautiful thing.

What percentage of the holders know what they are getting?  The sponsor’s website provides the boilerplate about the unpredictability of the results on levered products, including that “returns over periods other than one day will likely differ in amount and possibly direction from the target return for the same period.”

Assets have been flooding into all kinds of leveraged products of late and new frontiers are being colonized.  Witness the Leverage Shares 5x Long US Tech 100 ETP, with the clever ticker of 5QQQ.

What are your exposures to vehicles with embedded leverage?

Which ones can you quantify with certainty?

Where would an unwinding of leverage in the system cause secondary effects on investments that you view as unlevered?

Speculations

It’s been a party, alright.  Here are four areas where speculation has been evident, along with the Goldman Sachs Hedge Fund VIP “bucket” and the S&P 500 shown for comparison.  For the most part, the juicy stuff is down from the frenzy early in the year, although SPACs took a noticeable leg up on news of the Trump deal in October.

Do you view this period as the last speculative gasp of a strong market, an unusual but transitory interlude, or a fundamental change in the nature of market activity?

With a two-year time horizon and unlimited funds, which of these six choices would you short?

Which would you buy?

Margins

Given all of the talk about inflation — and with expectations of higher employee and input costs, as well as the need to temper just-in-time inventory practices that strained supplies during the pandemic — you might think that corporate margins would be under pressure.  So far, they have done quite the opposite, hitting new highs.  (Other markets around the world have had similar increases in margins for the companies in their benchmark indexes, but most not to this extent.)  These are trailing margins, so perhaps they will soften, but that isn’t evident in company projections or analyst estimates yet.

Is this just temporary or will inflation continue to work to the benefit of companies this time around?

Will a more aggressive anti-trust regulatory environment change the long-term trend in margins?

Manager selection

Three mainstays of manager selection are performance, personality, and (increasingly) fees.  This one has them all.  Pimco has been the subadvisor on this Harbor fund since its inception in the late 1980s.  The relative performance illustrates that it was riskier than its index, with intermittent drops during risk-off periods, including at the very beginning.  But the performance crept higher over time as that extra risk paid off during an era of financial assets.

The bottom panel shows a strong period of asset growth for the fund from 2006 to 2011, which was then reversed when Bill Gross was deposed at Pimco and no longer managed the fund.

After three-plus decades, Harbor is now replacing Pimco as the subadvisor.  Bloomberg reported that “the impetus for replacing Pimco began after Chicago-based Harbor Capital did an internal study that showed core plus fund managers were taking an ever larger bite out of the yield their portfolios produced.”  The fee will fall from 43 to 30 basis points.

Would you have made the same decision as Harbor did?

Where in the investment chain within which you operate are fees taking too big a bite out of (conservatively estimated) expected returns?