Category Archives: Finance

Diversification

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There’s been volumes written on the topic of diversification.  The pros, the cons.  What diversification really means?  How many positions one needs to hold to be diversified?  

Here are some good quotes. I doubt I could add anything useful if I tried. However, I mostly agree with the below statement.

“Being truly diversified means that there almost always will be a part of your portfolio that is sucking wind. (Big note: if every piece of your portfolio is working really well, it means one of two things: you’re incredibly lucky or you are not actually diversified. I would assume the latter.)” – De Thomas Wealth Management

Here’s what the holdings look like in my account where I attempt to deploy a broad, diversified, ETF strategy.

Not too much pain here…

I assure you this is a broad mix of ETFs representing equities, fixed income, real estate across U.S., international, emerging markets, etc.  Most would call this a well diversified portfolio.

The fact that almost every fund is pegged up against its 52 week high makes me more than nervous.  The issue is not that these aren’t funds holding diversified assets.  The issue is almost every asset is moving up together and correlations among asset classes are increasing. 

“He notes that the correlation between the yield on the Barclays Global Aggregate Bond index and global stocks currently sits at 0.24—a correlation of 1 means two assets move in lockstep—and has been fairly steady since the market stabilized after the coronavirus meltdown. If the correlation turns negative, which would mean that stocks and bonds move in opposite directions, it could be bad news for equities. “ – Barrons

When did stocks and bonds start moving in the same direction? It used to be, they didn’t.

So how do you diversify when correlations are increasing? 

Well, if most asset classes are going up, then you probably don’t care about diversification as much or the fact that correlations are increasing. Higher correlations mean assets are moving in the same direction. If that direction is up, then I guess higher correlations are good.

However, you will probably start to care about diversification and correlations more if the wheels start coming off. I’ve found this chart helpful in thinking through that problem historically.

Although as the chart says, past performance is not an indication of future performance.

Gaming It

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Looks like Q discovered the stock market.  Some recent comments on Reddit related to GameStop (GME):

“HOLD!”

“WE LIKE THE STOCK”

“DIAMOND HANDS!”

“IF HE’S NOT SELLING, IM NOT SELLING!”

In business school, we had this class that was called Management Game.  We formed management teams for simulated companies.  Each week we made a series of decisions, which were input into a computer simulation.  There were board meetings.  And best of all, there was even a stock market.

Every “player” was given some “game money” to trade.  So, we got to trade with make believe money.  Sort of like the real stock market today.

I remember, I cornered the market in my company’s stock and drove the price way up.  Which was great, as long as I kept buying.  And then I stopped buying….

Turns out I was the only buyer.

It was a good lesson in markets.  The current price is only a reflection of the current marginal buyer and seller.  That’s it.  Don’t read any more into it.

Barely Enough Time to Miss One Payment

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As the impact of the COVID pandemic unfolded, the speed at which the fiscal and monetary responses were rolled out seemed almost too fast.  My thought was that people barely had time to miss one mortgage payment.

Well, the data is in for April and it seems like lots of people did just that.  

“At 6.45%, the national delinquency rate nearly doubled (+3.06%) from March, the largest single-month increase ever recorded, and nearly three times the previous single-month record set back in late 2008.1” 

Data is only available through April.  May will be interesting.

  1. Black Knight’s First Look at April 2020 Mortgage Data  (https://www.blackknightinc.com/black-knights-first-look-at-april-2020-mortgage-data/)
  2. Calculated Risk Blog (https://www.calculatedriskblog.com/2020/05/black-knight-national-mortgage.html)

A Word: Hertz Bankruptcy

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A word on the Hertz Bankruptcy.

One of the most leveraged companies in one of the most impacted industries, managed to limp along and delay the inevitable for almost a full quarter. The Hertz filing is likely just the tip of iceberg…

I wrote previously that the velocity of change is much more difficult for companies to handle than the magnitude.  Hertz had to deal with both.  The travel industry has been one of the most impacted (velocity & magnitude) sectors during the COVID pandemic and response.

Hertz’s fleet of 700,000 vehicles, which are mostly rented from airports, has largely been idled due to the slow down in travel caused by the pandemic.  Complicating the matter is the value of these assets are falling as vehicle sales slow and used car prices fall.

Hertz also has $21 billion in long term debt. 

All of these factors combined into this bankruptcy filing came with lightning speed – relative to filings – adding Hertz to the short list of companies in the “no coupon club.”

Bankruptcy filings are going to be a lagging indicator. And there’s going to be more to come.

The Recession No One Believes In

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The recession no one believes in is here to stay.

My vantage point for the COVID pandemic and response has been somewhat unique – sitting here in Lower Deer Valley Utah since mid-March.  I am fortunate to fall into a line of work that transitioned to work from home seamlessly.  However, that’s not the case for many, especially around here.  No tourists, no work.

The same concept applies to many parts of the economy.  No shoppers, no store sales.  No diners, no restaurant sales.  No vacations, no travelers.  No sporting events, no ticket sales, etc. 

The likely outcome appears to be a fairly broad, deep, and lengthy economic recession (80% probability).  But that expectation looks to be in the minority using the S&P 500 as a proxy of the consensus view.

Source: MarketWatch

There seems to be a disconnect between the reality on the ground and expectations.  I think there are few things going on:

  • Velocity of the pandemic & response
  • Lag in economic data & company reporting
  • Demographics of those impacted by initial shutdowns
  • No single source of issues
  • Hope for a rapid return to normalcy

Velocity: I wrote earlier about the absolute stunning velocity of the global shutdown due to the COVID pandemic.  It’s almost incomprehensible.  It’s like nothing anyone alive today has ever experienced.

Lag: Given the speed of the fallout and the fact that impacts to U.S. companies did not truly start until mid-March, barely any of the financial impact is being reported in Q1 financial reporting.  Q2 results will be telling.  Those won’t be available until July; still two months away.  Same issue with most economic data; it’s a lagging indicator and barely incorporating the impacts yet.

These next two charts are not helpful – folks have barely had time to miss one mortgage payment and it’s not in the data yet.

Demographics: The initial stay at home orders have had a disproportionate impact on certain cohorts.  Many white collar workers (like me) simply picked up our laptops and started working from home.  No fear of lost income.  No major life setbacks – other than Mrs. SFTE zoom-bombing my meetings.  Not the case for many lower wage, retail and service jobs.  

Guess which of these cohorts is more invested in the market?  Hint: The groups not being impacted (yet). So be careful about using their views to assess the current state.

Source:  During the Great Financial Crisis, the source of the issues was concentrated in the financial system.  I’m not sure if the breadth makes the current situation better or worse over the longterm, but it does make it harder to understand.  

Headlines like this are more tangible than hand-made cardboard signs in windows of thousands of small businesses.

“A single death is a tragedy; a million deaths is a statistic.”  ― Joseph Stalin 

Return to Normalcy: There’s also quite a bit of hope for a rapid return to normalcy.  I’m all for hope, but let me quash that notion.  I would love to get back to normal, but that doesn’t exist anymore.  This is like 9/11 in terms of resetting normal.  I will never touch an ATM or gas pump handle with the same innocence again.  There is no f-ing way I am getting on an airplane any time soon. “Any environment that is enclosed, with poor air circulation and high density of people, spells trouble.”  

Mrs. SFTE would fight you tooth and nail if you tried to take her into a restaurant.  Those dentist appointments for mid-Summer, cancelled.  Check with me in six months (and no, I will not have two cleanings back to back so no pent up demand here).  Summer sports camps, ha.  Summer vacation plans, cancelled.  This is all lost income to someone, somewhere.

Yes, we’re a bit weird, but I bet not that weird.  If you haven’t noticed, this virus can kill you.  I’m 101% against being killed.  My guess is so are most people. That is why the data shows trends like this:

Source: FiveThirtyEight.com

So if people did not wait for stay at home orders to alter their behavior, how much will changing those orders affect their behavior? Not enough to make the recession go away.

Here is some economic data we do have:

The Initial Claims graph just broke the y-axis:

Lots of jobs have been lost (stunning velocity):

Unemployment rate is currently worse than at the peak of the Great Financial Crisis:

Approximately 70% of the economy is based on consumer spending, so no good news in this chart:

The handicap to the magnitude and duration of the recession is the amount of fiscal and monetary intervention being deployed.  This also falls into the incomprehensible and unprecedented category. 

However, by and large, these measures do not seem to be creating jobs, simply offsetting the financial impact of the shut downs.  At the end of the day though, it is jobs that matter.  Jobs will drive spending, and spending drives over two thirds of the U.S. economy.

“A better measure for how real people experience the business cycle: the ebb and flow of jobs creation. Losing your job is a recession; finding employment represents recovery. Looking at the business cycle through this lens paints a more complicated picture.

Perception on Main Street is always important for recoveries, and that will be true in the extreme this time. Given the sharp, dramatic jobs losses, which will probably get worse, sentiment in the broad population will be highly relevant for charting the path of the post-recession trend. On that front, jobs will arguably be the most relevant stat.

With that in mind, consider how private employment has fared on a rolling one-year basis in the past. As the next chart below reminds, the labor market often contracts through a recession and for a number of months after the downturn officially ends, based on NBER dates. In some cases, a positive one-year gain in private employment doesn’t arrive until several years after the recession’s official end.” Source: CapitalSpectator.com

Based on history, jobs do not recovery quickly from recessions:

And the jobs picture is likely to continue to deteriorate.  My sense is that there are also a lot of tough decisions going on in corporate boardrooms all across the nation.  You don’t know what Q2 is going to look like for most companies, but by now the current reality is fairly clear for most managers.

This chart is through March:

My investors are encouraging all their portfolio companies to renegotiate leases, defer 401k payments, stretch payments to vendor, and renegotiate contracts.  There is someone on the other side of each of those decisions who is going to be missing some income.

Somewhat obscured by the COVID pandemic is an oil crisis and simmering trade war, each with their own economic fallout. The oil crisis is threatening a major source of high paying jobs in many parts of the U.S.  The opposite was true during the Great Financial Crisis, when the budding shale boom was counteracting that recession

So, as you assess the likelihood of a deep and prolonged recession, keep in mind that the velocity and disproportionate initial impact is creating distortions in the data and news cycle. 

Broader impacts are coming.

Extrapolate This

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You don’t see trends like this every day.

Source: CEFConnect.com

I’m not sure what it going on, but something isn’t right: 41% discount to NAV; 120% yield.

Source: CEFConnect.com

Patience

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Patience is not a virtue I possess in great quantities.  However, I’m working on it.

It’s hard.  Things are happening fast.  And look like big moves.

But are they big moves?

Right.  Patience.  Working on it.

Chart Source: CEFConnect.com

The market went down…

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The market went down…

  1. That’s total bullshit.  I didn’t event know that could happen.
  2. It dropped so much that it’s back to where it was (checks notes)…four months ago.

 Source: https://sentimentrader.com/blog/an-extreme-in-extremes/

Four months of paper gains…gone just like that.  Oh the humanity!

Maybe the bigger story is that the market went up 13% [insert gain of your choosing] in four months [insert time period of your choosing] with no real catalyst?

And please stop comparing this to 2007 / 2008.  People were losing their life savings (this happens when you save more than you spend, strange I know) and their homes (yes, home prices can go down toobut don’t start calling me to Nostradamus yet).