Altus Insight - August, 2015
The Altus Insight
Market news, commentary and relevant topics for today’s alternative asset investor
Date: August 31, 2015
FR: Forrest Jinks
RE: Controlling the Narrative
Some months the difficulty in writing this article is getting my thoughts to coagulate around a particular idea in a manner than can be clearly communicated. Other months the difficulty is whittling down more content that is needed in such a way that something of value can be shared without excluding items also of value. This month definitely falls into the second category. August is supposed to be the quiet month of the year with both the financial industry and political elite (and nearly all of Europe) enjoying vacations at their exclusive enclaves. Not this year. With some aggressive segues maybe I can tie the following threads together.
I really want to say Donald Trump is an idiot. I have caught it about to come out of my mouth several times. So much of what he says as fact simply isn’t. But my realization is he isn’t worried about educating people, he is concerned about being elected, and being the marketing genius that he is he has figured out how to create controversy to hit peoples’ hot buttons. The reality is he isn’t the first politician to lie or change their story…err…use mistruths (see Clinton, Hillary: confidential emails). They do it because they think it benefits their pursuit of power and that their pursuit of power is more important to them than their integrity. But I digress.
Trump makes all sorts of claims, the most emotional of which must be admitted by the impartial observer to not be readily provable by facts. Some of the claims, however, are made under no such illusion.
With the stock market plummeting and panic gripping Wall Street (though oddly absent on Main Street), Trump blamed China for our economic woes, in large part due to China manipulating their currency to allow for cheap Chinese goods to flood US markets, stealing all the US trinket manufacturing jobs. The following comment on China is only one such type of claim:
I think you have to do something to rein in China. They devalued their currency today. They’re making it absolutely impossible for the United States to compete, and nobody does anything. China has no respect for President Obama whatsoever, whatsoever.
Well, you have to take strong action. How can we compete? They continuously cut their currency. They devalue their currency. And I have been saying this for years. They have been doing this for years. This isn’t just starting. This was the largest devaluation they have had in two decades. They make it impossible for our businesses, our companies to compete.
They think we’re run by a bunch of idiots. And what’s going on with China is unbelievable, the largest devaluation in two decades. It’s honestly – great question – it’s a disgrace.”
It is a story that sells, and a story that may have even been true 20 years, but simply is no longer remotely accurate. First of all, the Federal Reserve, though it’s myriad of quantitative easing programs was far and away the largest currency manipulator in recent memory in terms of absolute volume. Second, his very statement is contradictory. Third, if the Chinese have been manipulating their currency they have manipulating it up, not down. How do we know?
1. The US dollar has gotten substantially stronger over the past few years as the economic houses of other first world countries have been either shown to be built of cards (Europe) or have been intentionally and massively devalued (Japan). The Chinese peg to the Dollar has strengthened the Yuan in parallel with the strengthening dollar; costing the Chinese a substantial portion of their foreign reserves and greatly reducing the exporting competitiveness against other East Asian countries, especially Japan. Their reasons for doing so has to do with their desire to sit at the grown up table in world economics and is a discussion for a different Insight.
2. The Chinese didn’t devalue their currency by a mass infusion of cash (a la the Federal Reserve, Bank of Japan, etc.). The Yuan was devalued because the Chinese removed their support of its value. Had the Yuan been undervalued it would have STRENGTHENED not weakened. This is what happened to the Swiss Franc in January when the Swiss Central Bank stopped manipulating its value compared to the Euro. That the Yuan decreased in value means the market views it has less valuable than it had been prior to the removal the Chinese support. Realistically, the Yuan is probably still substantially overvalued. The Chinese central bank is still supporting its value, just at a little bit lower value than it was previously. So Donald, really we should be thanking the Chinese for supporting their currency for the past couple years and blunting the impact of the dollar appreciation. But yes, Mr. Trump, I understand it is all marketing rhetoric and you trying to create a “Narrative” around the election that favors your chances of success. Of that I can’t blame you, of the lies and inaccuracies I can.
Blaming the Chinese stock market on the recent US market correction is only slightly less accurate than Trump’s claim. As discussed here, Chinese markets lost a third of their value in only 21 days in late June and early July. US markets barely blipped. By comparison, the August crash resulted in a 25% drop of the Shanghai Composite. This time the US markets dropped over 10% in three days, a technical market correction. So if it wasn’t technically the market drop in China, what was it?
One exemption to the 1st Amendment (free speech) was ruled to be shouting fire in a crowded theater when there was no fire. I feel like the recent market crash was almost the opposite, where everyone (investment firms) in the theater saw a fire (overvaluations, the third longest time period in US history without a correction, etc.) but no one wanted to say it (fees are earned on invested dollars), so they all started inching towards the door and have been getting closer and closer to the door throughout 2015. When the Chinese central bank let the Yuan devalue someone caved and broke for the door. Everyone else then panicked and followed suit. Ben Hunt, CIO of Salient Partners and author of Epsilon Theory, calls in an investment Narrative. He claims there have been two dominant Narratives that investment professionals have been trading around. One is that the various central banks “have our backs” and in their omnipotence won’t let anything happen that will destroy market wealth. The second is that Chinese economic growth is going to pull the rest of the world through our extended economic malaise. Both of these Narratives took a battering when first Chinese growth was reported lower than economists’ forecasts had predicted and then when the Chinese central bank was unable to stop the fall in the Chinese markets with the two devaluations of the Yuan in two days.
As an aside I don’t know that the market events of the past few weeks could have worked out any better. The correction reduced some of the nervous pressure in the markets and seemed to do so, maybe because it happened so quickly and then stabilized, in a manner that didn’t put a scare into the general public. Like Black Monday in 1987 (the markets fell 30% in the course of a week), there is unlikely to be damage to the economy due to the crash. As has been strikingly evident over the past several years, stock markets and economies don’t run in parallel but there are certainly times where one affects the other. Our current economic recovery is already 7 years old (and thus due for a recession) and is still tepid at best. While there is nothing to say a true stock market crash would tank the economy, I certainly would rather not find out. Only time will tell if my assessment is accurate, and I certainly don’t have a crystal ball.
Investing in a “Narrative” as mentioned above is far different than investing “Value”. This isn’t to say that one is better or worse than the other, they are just different. Warren Buffet is a Value investor. So is my personal favorite Howard Marks of Oaktree Capital. They have crushed it for a long, long time, but didn’t outperform the market over the last several years, and especially not the last two to three years. The last few years, and the last two to three years in particular, have belonged to those trading the Narratives. Value still exists, but (at least in the stock markets) it is taking far longer to become evident and is still being roiled by the large market forced, tied to the Narratives and central bank policy. As Mr. Marks is fond of pointing out, during periods of low volatility investors who take on the riskiest positions tend to have far higher returns than those that don’t, but because of the low volatility it isn’t readily evident which particular positions are carrying the most exposure. Not all returns are created equal.
We had this same conversation within our company this past month. While we have produced a strong track record of performance and investor alignment, we haven’t shown ourselves to be an organization with much marketing savvy. In order to grown our organization we realized we needed to improve in that area and brought in outside expertise to help with that process. Part of the project is figuring out where to shine the spotlight to attract more of our target investor base. Is it highlighting super high returns that included higher leverage and market exposure? Should we be focusing on returns that are lower in an absolute sense but were outstanding from a risk standpoint? How do we even measure the risk? Is being able to measure the risk more important than being able to remove uncertainty (as discussed here)? As an example, we recently analyzed the performance of our Altus Hybrid Growth Fund. This fund strategy produced consistent income, never had debt in excess of 35% loan to value, and produced an investor IRR of approximately 16% (approximate because the calculation is based on liquidation of the assets and current values are estimates). Sixteen percent IRR is an excellent return, especially when taken in conjunction with the yield and low leverage of the investment. However, had our strategy been to use more leverage the investor returns would have been higher. Does that mean we should have included higher leverage in our strategy?
There are so many factors that affect the quality of a return. Risk vs. Uncertainty was mentioned above. There is liquidity, investment structure, yield, investment time horizon, etc., etc. I think the following example is a good illustration:
An “investment” opportunity is offered based on the roll of a dice. If numbers 1 – 4 are rolled the investment amount is doubled. If a 5 or 6 is rolled the entire investment amount is lost. This means there is a 66% probability of a 100% return on investment and a 33% probability of not just a zero return ON investment but a 33% probability of 100% loss OF investment. Is this something you would do? Would I?
If I had to bet my entire net worth on one roll of the dice, there is no way I would make that bet/investment. My wife and I have worked too hard to get where we are and the loss of it would have more than 2 times the negative impact on our life than would doubling have as a positive impact on our life (66% vs. 33%). In fact, even if there was a 1% of loss I probably wouldn’t do it. If however, I could specify the amount to be bet/invested on each dice roll and I had an unlimited amount of rolls, this is a bet I would make all day long, and most likely well into the future. Using a strategy of putting half of my total investment amount at risk and adjusting the investment amount each ensuing roll of the dice means that I could never go entirely broke and over a long enough time period the probabilities would equal out meaning a 2X chance of doubling my money versus losing it. Assuming a $1 Million initial investment amount and that 30 rolls is magic number where probabilities become true, I could lose 100% of the 1st 10 rolls and still end up with over $100 Million in final value, a 100X multiplier on my initial investment, and a darn good return.
What the above example shows it that even in a situation that has fantastic odds of success, it may not be a good investment for everyone. It also shows that with enough time and with a solid enough strategy, known risk that accompanies strong expected returns is worth incurring. Most of all it shows there is no right answer. Just as Altus has to make a determination as to which type of returns will attract new (hopefully targeted) investors, each one of us as individual investors has to decide where our comfort levels and be willing to spend the resources to understand the risks and reduce the uncertainties around any particular investment.