February 19, 2016

“Difficult to see. Always in motion is the future.” – Yoda (Star Wars)

Part I: The Market

Getting swept up in the Stars Wars excitement, I recently binge-watched the original six films for the first time (yes, I’m the social outcast who had never seen any of them before).   They totally exceeded my expectations, providing a wonderful narrative, suspenseful action and drama, captivating love and romance along with deep wisdom. However, I found the relatively abrupt turn of Anakin Skywalker to the Dark Side in Revenge of the Sith unsettling and confusing. Of course, you could easily foresee the potential for that outcome from the beginning as it was well foreshadowed. But then it happened so suddenly, it almost seemed to come out of nowhere. I couldn’t stop wondering how this person who seemed good at his core was overtaken by complete darkness in a matter of minutes. It reminds me a lot of the current market.

I attended the Harvard Behavioral Finance conference in November where I heard Larry Summers, former Treasury Secretary and professor and President Emeritus at Harvard, speak. He’s brilliant. I’d read about his secular stagnation theory on the economy and attended the conference primarily to understand his thinking better. I came away wholly convinced he’s right. Many people get caught up in the pithy moniker, secular stagnation. They dismiss the concept on the grounds that secular means persisting for long ages (certainly longer than most people’s investing horizon) and people aren’t convinced our stagnation is secular rather than a really long cycle. That misses the point entirely.

Larry’s point is that there is a neutral real interest rate that balances the supply of capital (savings) with the demand for capital (investments). There are secular forces, such as the additional savings requirements of an aging population and the reduced capital requirements of an information technology-based economy along with the trend towards “sharing” (e.g., Uber and AirBnB), which lower the neutral rate. Framed this way, it’s not all that controversial. The Federal Reserve members speak openly about a lower neutral rate. The looming question is how low is it? There are many theoretical frameworks for calculating it and they all give different answers.

These specifics, however, inform your view on whether monetary policy is accommodative, neutral or tight. As a vastly oversimplifying example (ignoring term premiums and other complicating factors), if the neutral real rate for the economy were zero, then any real rate above zero is restrictive and hampers growth. In other words, all this banter of zero at the low end being “unnatural” would be exactly wrong. It would not only be natural, but actually required to balance the supply of savings and demand of investment. It’s like a victim paralyzed in a car wreck who ends up in a wheelchair. If he can’t walk 5 years later, the wheelchair is not an “emergency measure,” it’s a new way of life.

Personally, I came back from the conference convinced that the Fed’s intention to embark on a tightening journey presented a risk to the markets. There had already been an implicit tightening as credit spreads widened and financial conditions deteriorated. These looked manageable on the back of continued economic growth, improvement in housing and employment, and solid corporate fundamentals across most of the market (outside energy, materials and industrials which we did not own in Opportunity Equity.

We spent a good deal of time in December searching for hedges that would protect the strategy in a downside scenario. Given the lasting trauma from the financial crisis, demand for protection remains high so the payoffs aren’t great. Additionally, post-financial crisis regulations have led to banks’ reduced willingness to sell deep out of the money protection. Since we didn’t see any imminent threat in the short-term, we hadn’t yet pulled the trigger coming into January.

We all know what happens next. January started off with its worst performance in over a century. The Dow posted its worst 10-day performance going back to 1897. We got some respite at the end of the month, but retested the lows over the past week. So far, we have held above the January lows. It all happened so quickly on the back of no additional news that much like Anakin Skywalker, I’m left wondering how we got here so quickly.

Most of the explanations cited by commentators are unsatisfactory. China started weakening long ago and from every company and official we speak to, there’s been no additional deterioration in recent months that could explain this sudden and vicious selloff. Falling oil prices add to consumer pocketbooks, and that benefit offsets the hit to energy-focused areas. Even in Texas, energy jobs only represent 3.4% of total employment. The market’s correlation with oil seems more likely to be caused by massive liquidations by sovereign wealth funds and other beneficiaries of strong global commodities over the past decades whose fortunes have recently sharply reversed. The stories of these casualties are just beginning to surface. Combine this with the structural changes Bill recently wrote about causing a dearth of countertrend activity and you get sudden and vicious moves.

So where does that leave us now? We currently see the biggest disconnect between the fundamentals of the companies we own and their stock prices in many years. The market now reflects the risk that the economy may not be able to handle much in terms of Fed tightening. At the same time, the Fed’s own expectations for its tightening path seem to be coming down. In her congressional testimony, Janet Yellen noted the risks to growth from the tightening credit and volatile markets. While market volatility can lead to economic deterioration, current prices reflect this reality to a large degree. Janet Yellen rose to her role as Chairwoman of the Federal Reserve because her forecasts were the most accurate. People labeled her a “dove,” but her muted forecasts proved prescient. It’s certainly possible that her forecasts, which are now more optimistic than the broad market, again trump expectations. Now it’s this possibility the market seems to neglect.

Pessimism has exploded. At the end of January, New York Stock Exchange short interest reached levels just spitting distance from the 2008 high (this level was exceeded in Sep 2015). Put-to-call ratios spiked to levels not seen since the financial crisis except during last August’s pullback. Fear is in the air. Starting points like this create the strongest gains. To paraphrase Warren Buffett: it’s time to be greedy since others are fearful.   It’s impossible to call the bottom, but it’s easy to find great value in this market, so that’s what we are doing.

Read Part II: “The fear of loss is a path to the dark side.” – Yoda (Star Wars)


The views expressed in this report reflect those of the LMM LLC (LMM) strategy’s portfolio manager(s) as of the date of the report. Any views are subject to change at any time based on market or other conditions, and LMM disclaims any responsibility to update such views. The information presented should not be considered a recommendation to purchase or sell any security and should not be relied upon as investment advice. It should not be assumed that any purchase or sale decisions will be profitable or will equal the performance of any security mentioned. Past performance is no guarantee of future results, and there is no guarantee dividends will be paid or continued.

©2016 LMM LLC. LMM LLC is owned by Bill Miller and Legg Mason, Inc.


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