Altus Insight - July, 2015

The Altus Insight
Market news, commentary and relevant topics for today’s alternative asset investor

Date: July 31, 2015
FR: Forrest Jinks
RE: Dichotomies Unresolved      

Dichotomy [dahy-kot-uh-mee]: Division into two mutually exclusive, opposed, or contradictory parts (as defined by

Since the beginning of recorded history there is evidence that man has created explanations to set his/her mind at ease when events or circumstances were otherwise unexplainable. This phenomena wasn’t limited to what was considered the “known” world in the Middle East and around the Mediterranean. Consider Pizarro’s conquest of the Incan Empire, the largest advance of which was made with only 168 soldiers, but with equipment, weapons, and ‘godliness’ completely foreign to the Incans. The Incans, by filling in their knowledge gaps with incorrect assumptions, doomed themselves to a rapid fall from what had been a great empire. 

Consider also Christopher Columbus’ supposed difficulty in getting people to buy into the round earth concept. The idea of a flat earth had been prevalent in Europe for centuries despite no more evidence that the earth was flat than it was round, AND historical knowledge from the Arab scholars that had inhabited many Spanish cities during the days of the Moorish control centuries earlier that the world was indeed NOT flat. The flat earth idea easily filled a hole in most Europeans’ knowledge so it was accepted as truth.

In the current economic and investing environment there are a lot of things that don’t make sense. Not just to me, but to the titans of the hedge fund industry whose millions (and sometimes billions) of income each year are granted because someone believed they KNOW. But right now, no one does know, or at least if one claims to know their explanations for the gaps in what “makes sense” are easily dismissed as rubbish with a little research. In these unsettled times our human psychology may try to fill in the gaps in our understanding to relieve the pressure on our psychology of lack of understanding, but the assumptions that are made, and the paradigms that could be created, are likely far worse that the discomfort of living in an unknown world. And there are lots of examples of these unknowns in world today.

Greece and China: Many people claim that Greece isn’t a large enough economy to matter to the world economy. Maybe this is true, but if it is true, then why are so many of the political elites spending so much time trying to squeeze blood from a rock? If Greece doesn’t matter, then aren’t there more important things for these people to be doing than late night meeting after late night meeting? Greece is gone, maybe not in name, but Greece is gone. I have yet to see anyone explain using reasonable assumptions how Greece will ever be able to get its debt back to a manageable level short of some sort of default. But the advanced world doesn’t want to let Greece default and apparently the Greece politicians also aren’t willing to default because yet another last minute deal was reached. Not solving the problem mind you, just kicking it further down the road at the expense of continuing the Depression that currently grips Greece. And it is every bit of a Depression.

Meanwhile, the Shanghai Stock Exchange, China’s largest stock exchange and the third largest stock exchange in the world fell almost THIRTY PERCENT over the course of 21 calendar days. THIRTY PERCENT in 21 days!!! By comparison, the stock crash that shook the foundations of the US financial system was ~45% but occurred over a full year. In October 2008, over the course or roughly a month, the US stocks also fell about 30%, and it is worth repeating, that stock market crash is said to have nearly wiped out the world’s financial systems.

During roughly this same time the S&P fell a measly 3% but then stabilized back to around its previous levels.

In summary:

  1. Greece, which is said not to matter, but obviously does, shows that an eventual default is unavoidable and, at least for a while in June, looked imminent. With that default fears of contagion across the Eurozone were real.
  2. The world’s third largest stock exchange and the main stock exchange in the world’s second largest economy (first if the effect of currency is adjusted out and a main US trading partner) enters a full market implosion.
  3. The US stock doesn’t blink.

In the interrelated financial and economic world in which we live, this is my definition of a dichotomy.

US Expected to Lead World Growth: Nearly all mainstream economists’ outlooks for the world economy are upbeat, and if not upbeat at least optimistic for continued economic growth over the next several years. The US economy is expected to be the bell cow for that growth and drag the rest of the world along. But the US economy is performing terribly. Yes, I know, it is growing at a little over 2% year over year but we are 6 years past the trough and into our recovery. This puts it as one of the most morbid recoveries in history and below even the average growth rate of the country. The economy grows in either one of two ways, more people working or a higher productivity from the people that are working (or a combination of both).

It has been mentioned in this publication previously – the US business birth/death rate turned negative in November of 2014 for the first time in the history of the country. Despite having an ever increasing population size more businesses are closing their doors than are opening them. Historically close to 100% of job growth has been from new businesses. Additionally, the work force is the smallest it has been since the 1970s, again, despite a growing population. The World Bank, who is funded in large part by the US government, recently ranked the US as only the 46th easiest country in the world to open a new business. Of course the overall ease of opening a business varies greatly within the borders so you know states like California and Illinois are even more difficult. 46th!

The US economy is sputtering along and the savior to the world economy…dichotomy.

Stock Prices: It seems as if the stock market knows no upper bound. Technically, it shouldn’t. If company profits were increasing at high enough rates and the future looked rosy enough…then stocks should continue to go up. But what if stock prices kept going up when profits didn’t? And that is exactly what is happening.

Industrial production is expected to decline more in Q2 than it did in Q1. The Q1 decline was originally blamed on the poor weather. Assuming the Q2 numbers are expected it will be the first time since 2009 of two quarter industrial production decline. Additionally since the second half of 2013 post tax, net depreciation and inventory deltas for the largest 5000 public companies in the US is down 13%. Since this is a far better measure of true long term profitability than EBITDA, the obvious implication is stock prices are going up even while profits are declining. Additionally, over the past four years worker productivity has increased only .6%, the lowest rate since the early 1980s, a time when the work force was rapidly expanding, not contracting as it is today.

From an economic standpoint it makes sense that in a stable earnings environment Price to Earnings ratios would increase as interest rates dropped as investors looked away from bonds or savings for their investment returns. But if earnings are not increasing, and if the interest rates are no longer falling (they haven’t been falling for several years) it doesn’t make sense that the PE ratios would continue to expand. Falling results, increasing valuations…dichotomy.

Construction and Real Estate: Last month I mentioned that home prices in Northern California appear to be flattening and activity was dropping. This after a few months prior Southern California markets trended the same direction. With another month in the books my belief that the market is slowing down has only strengthened. I spoke with dozens of residential real estate professionals and outside of some of the pockets of privilege (Sonoma, CA as an example) everyone is seeing a slowdown and some price declines. Commercial is harder to gauge. Purchasing activity is not directly caused by economic activity but rather financial considerations and so while purchasing interest has seemed to stay high I am not seeing an up swell of economic activity to support it. On one of our office buildings in the North Bay we have had very little interest in a couple empty suites that we have, despite marketing at a much lower rental rate than our market survey had implied even 12 months ago. In Sacramento a Class A office building which we have been offered an opportunity to purchase has struggled to gain traction and obtain tenants despite being newly renovated and located in a fantastic location. I continue to hear of tenants in the market place but so far as I can tell it is relocations, not new companies or expansions. I have even been told by apartment brokers, an area that has been possibly the hottest of all real estate sectors, that activity has tailed off.

So, if real estate activity is down, why is construction suddenly so hot? It is like someone turned on a valve and all of a sudden everyone in the construction world is fully booked. Some of the subcontractors we have called claim to be booked out 12 months. If there is no demand for real estate product, what are these contractors doing?

If this construction swell has staying power it could bode well for the US economy. In normal times construction and real estate make up a large part of the GDP. Increases in construction means increases in employment, and as we can attest, increases in compensation. In a vacuum both of those items would lead to a stronger economy.

 I don’t feel comfortable speaking with any authority as to what this means for investors but find myself returning again and again to the same strategies to deal with the uncertainty. 1. Have very short positions in more liquid assets (measurement of liquidity is a discussion for another day), 2. Have very long positions without negative cash flow, and preferably with positive cash flow. 3. Have multiple exit strategies. 4. Be willing to either quickly pull the plug and take a loss or ride price declines with faith in the quality of your asset. 5. Be prepared to take advantage of the distress caused by the inevitable fall out.

And so we wait in curiosity to see which shoe is the next one to drop, or even if one will drop at all.

Happy Investing,


Forrest Jinks