If you’ve been brave enough to turn on financial television in the last 3 months, you’ve heard it. The game is speculating on the “letter” of the recovery as the economy normalizes following the coronavirus. Are you a V-recovery person, who thinks everything will snap back to normal as soon as the virus subsides? Less optimistic? Maybe you’re a U. Expecting a double dip, which would make you a W? Expecting no recovery at all? You’d be a L-shape recovery kind of person. As each day concludes, the virus leaves us with an O, going around and around in a circle with no end in sight. As if this game of recovery letter scrabble wasn’t enough, the government response to the coronavirus has presented business owners, employees, and investors with a dizzying array of acronyms. In the last few months, we’ve been introduced to PPP, EIDL, TALF, CARES, HEROES, and others, all of which are designed to help combat the financial and economic hardship brought on by the pandemic.

While some response was required to combat the “economic induced coma” created by travel bans and forced business closures, what’s lost in this alphabet soup of government programs is that the Fed and Treasury Department have crossed the Rubicon in terms of market intervention. Yes, credit markets froze and stocks plummeted in March. The Fed responded by cutting rates and reinitiating its Term Asset-Backed Loan Facility (TALF) program, which was a great success in its previous incarnation during the Financial Crisis in 2008-2009. TALF provides institutional investors with cheap leverage to acquire AAA rated asset-backed securities, providing a nice return opportunity while stimulating lending markets. This type of stimulus is at least familiar, as it’s focused on stimulating markets through manipulating broad pools of securities. It also leaves security selection to professional allocators.

The subsequent announcements – that the Fed will buy corporate bonds (including those rated junk) through ETF purchases and individual bond purchases are more troubling. The decision to purchase individual corporate bonds as part of the CARES program is a bridge too far. The Fed announces such programs just so it doesn’t have to use them. To instill a bit of confidence in the system. And it worked. But on June 16 (the only day reported thus far), the Fed purchased $207 million of individual corporate bonds as described in its disclosures posted here under the Secondary Market Corporate Credit Facility section. The Fed is building a large book based on an index it created to get around a game of political football. Now that the Fed is operating as a credit fund in the business of owning individual securities and taking idiosyncratic risk, it requires only the tiniest leap for the central bank to start mirroring the Bank of Japan, which continues buying trillions of Yen in Japanese stocks.

Remember the good old days, back when struggling companies had to pay for their capital? Where actions had consequences? In the Great Financial Crisis of 2007-2009, the American taxpayer was at least partially compensated for absorbing the risk of reckless businesses because the federal government took an equity stake in AIG and the automakers. This time around, the airlines just backed up a truck to the Treasury, received billions of dollars in emergency funds, gave up no equity (other than limited warrant packages), did not pay a market interest rate, and made no long-term commitments to its workforce. Boeing, a company whose troubles long predate the virus, at least only used the American taxpayers as a stalking horse before raising funds through a private bond offering, including a 40-year-to-maturity tranche at less than 6% interest. Publicly traded companies abused the PPP program at the expense of small business owners, stopping only after a significant public shaming.

That doesn’t even consider the indirect ways that the Fed’s actions over time have distorted the most basic of investor behaviors. Despite the unprecedented economic uncertainty caused by the virus, both debt and equity issuance are surging. Is this a normally functioning market? Think about this: Hertz Global Holdings filed for bankruptcy, and then its stock went up nearly 10X. What causes that other than investor expectation of an equity-saving bailout?  Some might argue that retail investors are bored and a large number of them bought the stock seeing a deal without understanding the consequences of bankruptcy (your value goes to zero). However, when it was trading above $10 before March 6^th, the average trading volume was in the range of 3-7 million shares per day. Right after it filed for bankruptcy, the share price went as low as $0.40 and for those first three days 609 million shares changed hands. I could be wrong, but that doesn’t seem like it’s just retail. Even now, with its stock price (somehow) higher, it still trades regularly with hundreds of millions of shares changing hands daily as it makes the news. And then the company nearly pulled off the unthinkable, as only a last-minute SEC intervention paused Hertz’ plans to sell nearly $1 billion in new (worthless) stock directly to the market while still in Chapter 11. This is the greater fool theory run amok.

There has been a lot of punditry about the other moral hazards created in the government’s response to the crisis, with many pointing to the working poor making more money through enhanced unemployment than they would at work, and those lucky enough to keep their job still receiving stimulus money. This kick down the ladder is typical of Wall Street. Many ask why the average family can’t withstand a couple months of lockdown; I’ve heard far less outrage that Delta and American Air don’t have a few months of expenses in cash on hand. Hey, stock buybacks fueled in part by cheap debt (the airlines bought nearly $40 billion of their own stock from 2015-2019) and misallocation of resources have consequences. Look, we’re not opposed to stock buybacks. They’re a perfectly reasonable way to return capital to investors in a tax-efficient manner. But this torrid pace of buybacks was a capital allocation decision made by executives, and that it left them so thoroughly unprepared to handle a crisis is a shame. Risk in business and investing is ubiquitous. Equity investors are compensated for taking this risk through owning a share of profits, but if the business falters they take losses or potentially get zeroed out. That is how capitalism functions. Or you could just bank on a bailout.

I’ve heard even less discussion about the decades-long societal trends that have created this fragile of a populace and economic system. That over half of households are unequipped to handle a temporary economic hardship is a tragedy. The death of retirement savings through destruction of the pension system coupled with stagnating real wages, the rise of the gig economy, and punishment of savings through structurally low interest rates have crippled the working class’ ability to withstand a crisis.

America’s 50-year communion at the altar of corporatism has changed the way we define productive businesses, conflating profit and production with a rising stock price. This distorted view of capitalism has left regulators and politicians more desperate to prop up stock prices as a reflection of the real economy. This stock market is valued at levels rivaled only by the start of the great depression in 1929 and the dot com bubble of the early 2000s (based on the Shiller Total Return CAPE ratio, which admittedly has its drawbacks) despite a recession, more than 40 million unemployed at peak, and rising COVID infections day after day. How does one reconcile these valuations with a country which is on a path to more infections, more unemployment, lower earnings levels, and more bankruptcies? It only makes sense if you consider the Fed’s policies and intervention, which it seems has been all that anyone needed to hear in order to feel confident about the markets.

And that’s just the problem. As people become more used to being able to rely on the Fed when times get tough, the Fed will find itself filling that role more often. As we see a market more susceptible to shocks, what sort of arsenal can the Fed continue to employ to keep markets calm? The Fed is supposed to be the lender of last resort, not a tactical corporate bond trading shop. How long until the central bank turns to the equity market to quiet investor pessimism and volatility? How on Earth will they ever unwind this trade? Any objective look at a chart of the Federal Funds rate or the Fed’s balance sheet shows that a full unwind is not really in the cards.

Look, we’re not saying that this is the end of the world. To reiterate, the Fed needed to fulfill its duties to ensure credit markets didn’t lock up. But we don’t like how it’s almost being taken for granted; the expectation is the source of the moral hazard we fear. When everyone starts to go out on a limb so much that the Fed has no choice but to intervene in order to save everyone from themselves, we don’t have true capitalism anymore, but rather a perverse version of it where gains are privatized and we all eat the losses.

Arthur Grizzle & Charles Culver
Managing Partners
Martello Investments

According to legend, he was known amongst his peers for his sense of honor and his integrity in the pit. Though he died from lymphoma at 39 in 1991, there remains a 2-hour video lecture he gave to new floor traders in 1989 available here. I like to watch his lecture for a few reasons. First, it simply makes me feel better that whatever my trading-related headache for the day, I’m glad that I can do it from the relative comfort of a computer screen instead of how they did it back then. In Charlie D’s world, I would have had to call up the broker, scream at a guy through the phone, who would in turn have to scream at another guy to relay what I wanted to do, who would then have to scream at yet another guy to actually get the order done. Complaining about tabs versus spaces in our upload file or repeated pop ups seem like small problems when put in that context.

I know I’m a trading history nerd, but Charlie D’s lecture should be required listening for every trader and financial advisor because it is full of gems. Over 2 hours, he covers trading psychology: when to get out, how to take a loss, how to take a gain, and managing risk systematically. A few examples:

• When speaking about covering losses mechanically instead of praying for the market to come back your way, Charlie D reminds the group that “God doesn’t trade bonds...”
• On understanding sentiment and crowded trades, he says traders must be able to determine at the time they have a position on, “are you short with all the other idiots or are you long with all the other idiots?”

Most importantly, he discusses the value of having a puke point. A puke point is the mechanism that allows you to take your lumps in a losing trade and live to fight another day. From Charlie D:

“You’ve gotta have a puke point. When you’re long at 4, don’t look to buy ’em at 2…You want to get out! You want to throw those contracts up all over your shoes.  That’s a puke point. The people that do the best in here are people that have a low puke point. When you have a position on that goes against you, you gotta get out.”

A puke point is about more than taking a loss in the purest trading sense. It speaks to the way a person processes information. We know from behavioral finance that most investors act irrationally handling gains and losses, opting to cut their gains early and let losses cascade. This has as much to do with banking profit or admitting defeat as it does with addressing how we process new information in a biased way. Our brains are naturally biased against disconfirmatory evidence, opting to place greater emphasis on information that agrees with our preconceived biases. This nasty cognitive defect, which social scientists attribute to our evolutionary need to trust each other, is a contributing factor to the best and the worst of us. Sure, it contributes to our inability to initially grasp when we are defrauded or betrayed, but it also allows us to form meaningful relationships. You win some, you lose some. Those with a low puke point run at the first sight of danger, while those with a high puke point require many shots of disconfirming evidence to change paths.

When we think about the evolution of the market over the last decade, we can only conclude that the market collectively has developed an unshakeable belief in the sustainability of rising prices. This is driven by several factors, not the least of which is the continued faith in the ability of the biggest sugar daddy of them all, the Federal Reserve, to step in and calm markets when called upon. This allows market participants to shake off bad news (an earnings recession in the United States, slowing growth, a weak and temporary resolution to a trade deal, and lately the potential global pandemic in the form of coronavirus) all the while marching to record highs. Some folks call this complacency; Charlie D would call it a high puke point, and he would be appalled to see it virtually everywhere.

The thing about complacency: it’s fine until it’s not. Everything appears normal until the exact moment you throw up all over your shoes. If you have kids, you know. The action over the last two days has laid bare what happens when a very tolerant market is awakened after many quarters of ignoring bad news. The last two days, each of which saw an S&P 500 return down more than 3%, is astronomical by the financial world’s standards. Let’s take a deeper look at that:

The long-run standard deviation of stock returns is roughly 1% daily. According to statistics, a down-three-standard-deviation event should occur approximately once every three years or so (1 in 741 days, or 0.135% of the time, based on 252 trading days in a year). The probability of two consecutive days like that is predicted to be once every 2,117 years (0.135% * 0.135% of the time). And this isn’t the first time we’ve seen these kinds of statistical oddities in the market. In fact, the market has been down three standard deviations for two consecutive days a total of 8 times in just the past twenty years. Unfortunately, the real conclusion here is that reality is a poor match for the theoretical statistical framework under which the entire financial industry operates, but that’s a great topic for another day.

It’s not as though the coronavirus, the headline cause for the increased volatility, appeared out of nowhere over the weekend and spooked the market. The seriousness of the virus has built for weeks while the market was missing its puke point! Only after an announcement of new disease clusters in Europe, South Korea, and Iran did the market even begin to price in the potential global deflationary impact of a pandemic. This will ultimately play out one of two ways. It could, like the swine flu hysteria or the most recent Ebola scare, peter out after a few months when global health authorities get it under control. Or, it could result in a more serious pandemic. It’s obviously impossible to know now. Personally, I believe in the ability of the medical community to find solutions. And the White House recently announced a $2.5 billion plan to combat the virus through additional funding for vaccines, treatments, and protective equipment.

Coronavirus aside, a clear-eyed view of the market leaves us with these sobering truths:

• Leverage feeds instability, and the system is more leveraged than any other time in history
• Overconcentration feeds instability, and the market is as concentrated as it's been in a generation
• Complacency feeds instability, and by many measures we entered 2020 as complacent as ever [link, link, link]

Will this lead to a more significant correction in stocks than the 6% or so that we’ve seen over the last two days? Who knows. Still, the stock market’s inability to price the risk of this virus incrementally should be troubling to all investors. We have seen these increasing risks reflected in the bond market over the last several months, with the US 30-year treasury yield falling to unprecedented levels, touching 1.8% yesterday.  We feel strongly that the market reaction to this news is just the latest example of structural weakness that we have highlighted in many of our previous letters . Whether the texture of the next significant correction for equity markets will look more like 1937, 1987, or 2007 is a complete unknown, but given the seeming inability of the market to process negative information efficiently, we expect that we are in for more events like the last 2 days and the volatility blowup of February 2018, where equities fall sharply in very short periods of time. In such an environment, many traditional risk management metrics like momentum trading or moving averages are, as my grandmother used to say while dealing weak cards in nickel poker, “no apparent help.” Market shocks are necessarily against consensus, that’s what makes them shocks.

Yack.

Be safe out there.

Artie

In fact, one of the dirty secrets of the industry is that terms like financial advisor, investment advisor, financial planner, consultant, etc. don’t mean much in terms of experience. Unlike the term “medical doctor,” where the patient can be reasonably certain the individual performing services has received the requisite amount of training, education, real-world experience, and testing required to obtain the title “medical doctor” – and has been subsequently licensed by the medical board. State and federal securities regulators mandate that everyone is licensed (or exempted, through one of five certifications/accreditations). These licensure tests make sure to cover the law, ethics, and a small amount of finance theory. Knowing and following the law should certainly be a primary focus, but in the case of these tests it is the primary focus. There is no deep dive into financial topics – just a light check to see you know enough to start out in the industry. But not breaking the law does not translate to not breaking the client’s bank account. It is amazing to think that there is no standardized education for the industry; many professionals take their lumps and learn through painful experience, except those lessons learned are almost without exception with clients’ money.But this is not a piece about how the industry needs to rally and root out the bad eggs. It’s more to share with you a simple piece of information that may have slipped by you if you don’t have a thoughtful advisor that is more concerned with wealth preservation and growth than their monthly commission check. If there were a School For Investors, INV 101 would include some version of the chart below. Many advisors refer to this chart when educating clients on the need for diversification, avoiding risk, and limiting loss. Though many professionals have been taught to estimate risk by solely looking at an investment’s volatility (the magnitude of its returns over time, both up and down), even the most novice investor will tell you that his or her real worry is losing money. Long-term or permanent loss of capital is devastating for wealth creation, and it goes without saying that the more an investment loses, the harder it is to get back to even. Here’s a quick example:

Suppose a $100,000 portfolio loses 20% one year and gains 20% in the next. Though the “average return” is zero, the investor actually loses money over the two-year period. In the first year, the portfolio loses 20%, or $20,000, to finish the year at $80,000. The next year, the portfolio gains 20% of $80,000, or $16,000, to finish the year at $96,000. In order to fully recover the $20,000 loss in the second year, the portfolio would have needed to gain 25% on $80,000. If the investor first gained 20% followed by a 20% loss, the end results are the same - $96,000. This effect is more pronounced as losses worsen. A 50% loss, for example, requires a 100% gain (meaning the portfolio must double) to get back to even. Such a large loss generally leads to prolonged recovery periods. In the Great Financial Crisis, the S&P 500 Index lost nearly 51% from Nov 2007 – Feb 2009 and did not recover those losses until March 2012. This means the Index went 52 months without any new gains.

The last two quarters perfectly displayed the impact of volatility drag. The fourth quarter of 2018 was horrible for the stock market; the -13.52% quarterly return for the S&P 500 was the 5th worst quarter in the last 20 years and compares to quarterly returns experienced in the depths of the financial crisis, the technology bubble bust, and the European debt crisis of 2010-2011. In the first quarter of 2019, the S&P 500 came roaring back, mostly due to a seemingly imminent conclusion to the trade dispute with China (which still at the time of this writing has yet to be resolved) and a more cautious Fed, which opted to pause its rate hikes indefinitely rather than continue raising them as it had planned to do. For the quarter, the index gained 13.65%, which is the 5th best quarter in the last 20 years. So, does a -13.52% quarter followed by a 13.65% gain equal a positive return over the 6-month period? No, it equals a 1.7% loss. The market would have needed to gain over 15.6% to fully recover the losses from the prior quarter.

Last month, our friends at CMG (Capital Management Group) did a webinar with ETFTrends and VanEck where they discussed how to survive market volatility. In it, they presented an interesting study by Ned Davis Research which showed that over the last 90 years, markets reached new highs only 34% of the time. The remaining 66% of the time was spent in a falling market (23%) or in recovery from a fallen market (43%). This means that, at least for buy and hold investors, markets were generating new wealth approximately one third of the time, a segment referred to as “New Wealth Creation Opportunities” in the chart below. This is a critical point: if a market is not reaching a new high, it is merely recovering a previous loss and therefore is not generating new wealth.

There are ways to make portfolios more efficient, more resilient, and more primed for new gains. This necessarily revolves around reducing portfolio drawdowns. Minimizing losses keeps an investor’s wealth nearer to its highs, which allows new wealth to be generated more easily. For most investors looking to improve the ratio of wealth creation opportunities, we advocate implementing a mix of the following:

1. Income: Boiled down to its core, investing is about finding neat ways to get paid for taking risk. For example, when you buy a growth stock, you get paid with long-term earnings growth (and hopefully the stock price growth to match) but take the risk that the company won’t make it. Investing in income-producing assets like bonds or dividend-paying stocks ensures that investors are paid tangibly to take risk, and the reinvestment of investment income obviously improves the ability of a portfolio to compound wealth over the long term. In fact, the study cited above is based solely on price performance of the S&P 500 (it does not include return attributed to dividends) and including the income element of stocks would certainly improve the wealth creation characteristics over time but would not fully eliminate the volatility drag of large drawdowns.
2. Diversification: We have touched on diversification in various forms in previous notes, but the loss-dampening effects of including, for example, a mix of stocks and bonds in a portfolio helps insulate a portfolio from the wealth destruction of large losses. Also, frequent rebalancing of a diversified portfolio helps investors take gains from the best performing assets and add to asset classes that have fallen, which takes advantage of the cyclicality of markets over time.
3. Allocations to Alternatives: the term “Alternatives” is a broad brush stroke that can mean any of a number of different strategy types, each with its own risk profile and ability to protect investor capital. We focus on developing and allocating to data-dependent strategies that can reduce risk when market environments are uncertain and in some cases, can capitalize on falling prices. Other investment options that target these same characteristics are certain segments of the hedge fund universe, though hedge funds in general suffered disappointing performance in 2018 and have not bounced back as well along with equity markets so far this year.

No single approach to building portfolios is a panacea, which is why we advocate a blend. Over time, our view is that this focus, implemented in a disciplined format, will help keep investors producing more wealth by avoiding the devastating impact of losses. When it comes to the current market outlook, our data tells us that the picture is mixed. On the positive side, markets are rallying, earnings season is off to a great start, the Fed seems content with its interest rate level for now and has opted to pause its hikes. However, global growth appears to be slowing, with the IMF cutting its 2019 forecast once again. The yield curve in the US remains inverted out to 7-years at the time of this writing and home & auto sales have also been very weak. The yield curve and home/auto sales data are both worrying; these signals are typically indicative of future recession. At the same time, valuations remain near historically extreme levels despite growing earnings. If a recession is accompanied by a bear market, as has been the case several times over the last few decades, losses would likely be significant. To be clear, the immediate and nearly full snapback experienced in the first quarter of 2019 is a very rare phenomenon for equity markets, and investors shouldn’t rely on risk management to continue to come in the form of a soothsaying Fed. Large losses are not typically recovered quickly; as mentioned above, it took buy and hold equity investors over 4 years to recover from the losses in the last crisis, using the S&P 500 as a proxy. In a more stunning example, the technology-heavy NASDAQ Composite didn’t recover it’s February 2000 high until 2014, meaning investors went nearly 15 years without any new wealth creation – and that’s not even adjusting for inflation. If you do adjust for inflation, the NASDAQ Composite didn’t recover its February 2000 high until late 2017. For some investors with an ultra-long-time horizon, maybe that is a risk you are willing to take. For most, though, it may be wise to include other approaches that focus on “New Wealth Creation Opportunities” by limiting the impact of market downturns.Thank you to everyone for your feedback. Please feel free to reach out at any time with questions or comments.

Sincerely,

Arthur Grizzle & Charles Culver
Managing Partners
Martello Investments

Think back to this time last year. Consider how much has changed. Equity markets were ripping to new highs on the back of a stimulative tax cut, whispers of inflation were beginning to surface, and sentiment was reaching historically bullish levels. Now, just a short time later, the S&P 500 plunged over 9% in December to bring 2018 returns to negative – the worst year for the market since the Great Financial Crisis.

Investors are spooked that the Fed has overshot with its rate hike path. More drastic than the stock market, though, is the swift and dramatic change in the niche cryptocurrency market, plucked from relative obscurity to reach full-blown mania in 2017, soon followed by an incredible bust in 2018. The proliferation of cryptocurrency is thought to be a potentially disruptive force in several areas of commerce, but the volatility in the coins using this technology has led to massive sentiment-driven swings in value. After the two most popular cryptocurrencies (Bitcoin and Ethereum) each went up over 10-fold in 2017, both have collapsed during 2018 by over 75% so far, hampered by regulatory concerns and waning institutional interest.

If there is a definitional example of a mania in modern times, the cryptocurrency phenomenon of 2016-2018 rivals only the dot-com bust in the late 1990s-early 2000s (or Beanie Babies, but we’ll get to that later). All the classic signs of a bubble were present from an explosion in ICOs (initial coin offerings – the cryptocurrency market’s complement to a stock IPO) to an increase in fraud and institutional capitulation. Over $5 billion was raised in ICOs in all of 2017 and more than $6 billion was raised through ICOs in just the first quarter of 2018. A study by cryptocurrency advisory firm Statis identified over 80% of these offerings as scams. Several news stories identified companies that added “blockchain” to their names only to see their stock prices rocket higher, despite their unrelated principal businesses ranging from biotechnology to bottled iced tea, which is reminiscent of the “pets.com” madness of the dot-com era. Individual investors with no knowledge of the cryptocurrency market (other than its grand rise) nor the underlying technology found themselves investing their life savings in it.

In addition to the unfortunate individual interest, 2017 also saw institutional interest in the cyrptocurrency market gain steam as several Wall Street blue chips opened market-making operations. New crypto-related indices were created, Bitcoin futures were launched at the CME, and several institutional money managers identified cryptocurrency as a source of “uncorrelated alpha.” As we began to evaluate a few of the exchange-traded Bitcoin products, we learned that they traded at huge premiums to their underlying assets, reflecting insane levels of optimism by speculators. We also learned through industry scuttlebutt that many hedge funds had begun dabbling in trading the cryptocurrencies if not outright mining them, while others were allocating a decent portion of NAV to investing in this new asset class for the long term.

Now, over a year later, many of those institutional crypto desks have quietly shuttered. The volume and open interest of the Bitcoin futures market has failed to show traction, the kiss of death for any new product in financial markets. The previously excited hedge funds have stopped talking about it. This is understandable given that the HFR Cryptocurrency Index is down 66.82% YTD through November. The SEC has rejected several applications for new exchange-traded products based on crypto, a few of which had up to 300% leverage attached. Regulators are cracking down on bogus coin marketing schemes. And some of the most popular coins have plunged in value by more than 80%.

As the fall continues, with Bitcoin breaking below $4,000 USD/BTC after peaking near $20,000, the logical question is where the crypto market is heading. And it’s truly a question; the cryptocurrency market has shown strikingly similar behavior before. Bitcoin went all the way from $117 on May 1, 2013 to $1,151 on December 4, 2013 before making its way back down to $375 on December 6, 2014. The most recent time period occupying the same number of days exhibited very similar behavior: starting May 19, 2017 at a value of $1,988, it peaks on December 16th, 2017 at a closing price of $19,497 (it did briefly touch a bit higher the next day) and follows up with a decline to $4,079 on December 24, 2018.

Looking at the chart above, you can see that this recent bout of volatility is nothing new for Bitcoin and one should not lightly conclude that it has run its course on price action alone, which many are doing. In fact, one could argue that the 2013-2014 period was more volatile and exhibited more bubble-like features than the more recent period because the increase in price happened much quicker than the more recent one. The most recent loss in value is simply its most public one. But, please don’t take this to mean that we think these sudden run-ups in value will become a recurring theme. In financial markets, one rarely finds something that repeatedly and predictably happens. With Bitcoin, we believe that the last time was most likely the last time.

For one, you’ve got the public nature of its crash. My grandmother now knows what Bitcoin is. I mean, she doesn’t understand it, but she knows that it went through a little bit of a “rough patch.” My grandmother doesn’t like to invest in things she knows are volatile. Most others don’t either, and now you’ve got a “fooled me once” mentality among the masses where you did not before.

Second, financial regulators are now more aware than ever of Bitcoin and of the cryptocurrency market in general. They’re starting to crack down on those that advise on it without registering as an investment advisor and those that issue ICOs without going through the formal process of registering a public security. China outright banned Bitcoin trading while the US and EU are forcing Bitcoin custodians to follow Know Your Client and Anti-Money Laundering regulations that apply to all other custodians. The IRS and other tax-collecting entities across the world are beginning to use that data to find and fine those that don’t pay taxes on their cryptocurrency gains. Other three-letter agencies have employed sophisticated technology alongside the information the custodians have been required to provide in order to de-anonymize the owners of Bitcoins and those they transact with. Because of its use of blockchain technology, the government can see whom the owners paid and presume what they paid for from that information and other information they’ve gathered from other sources all over the internet. Wasn’t anonymity one of the major features of Bitcoin?

Third, there are many other options available. Bitcoin was just the first to catch on. For good or bad, there exist plenty of other cryptocurrencies with a variety of features for those that want to plant their stake in the ground on something other than Bitcoin with the belief that it will surpass Bitcoin. Yes, it’s true that it’s possible to create your own cryptocurrency using the same technology that Bitcoin uses. We could easily fork their code and start our own cryptocurrency called MangoCoin, named after Charlie’s dachshund. This would be similar in nature to DogeCoin, an actual coin launched years ago that was ironically named after the internet meme of a Shiba Inu. It currently has a market cap of $276 million U.S. Dollars. There are coins that are more appropriately named and not only match what Bitcoin is able to provide but have been programmed to have features that provide much more in terms of usefulness, like Ethereum or Ripple. Hundreds of coins exist and each has its own unique “selling point” to get users to buy in.

As we briefly touched on earlier, we spent some time last year evaluating the asset class and exchange-traded trust vehicles, which would have fit within our ETF mandate. It is a market that certainly exhibits signs of technical signals, which is a positive feature, but the giant premium to NAV embedded in the trusts presented an obvious problem for our approach.

The biggest issue for us, and one that we continue to grapple with, is how to appropriately “value” Bitcoin or any other major cryptocurrency. Before the crypto enthusiasts hit us with the “but how do you value any currency?” argument, let us be clear about one important factor; we aren’t necessarily confused about how to arrive at a target valuation for a particular coin (we are), but instead question why a given coin should have more or less value than another coin. We’ve seen plenty of arguments, but none especially compelling.

A recent piece on Investopedia entitled “Why do Bitcoins have value?” lays out several assumptions, the first of which reads: “Our first assumption is that Bitcoin will derive its value both from its use as a medium of exchange and as a store of value…if Bitcoin does not achieve success as a medium of exchange, it will have no practical utility and thus no intrinsic value and won't be appealing as a store of value.” Think about that for a second. Being a medium of exchange is what gives it its value. It’s a bit circular –for it to have value, one must be able to pay people with it, but for people to accept it as payment, it must first have value. And it isn’t important that there is actual inherent value, like there is with gold (industrial applications) or fiat currency (pay your taxes). The creators of each cryptocurrency are bootstrapping them by getting people to speculate on their future value via ICO.'

The tax-driven view of money states that what gives currencies around the world their value (or lack thereof) is each government’s ability to tax its people. Governments start their own currency because they themselves need the ability to transact – to direct economic activity. But there’s no single actor requiring payment in Bitcoin or any other digital currency. Bitcoin is not a tool to be used in the economy. Which means that the first large authority to do so with a digital currency just might dictate which digital currency wins the battle. Perhaps one that, instead of anonymity, strips that anonymity from everyone so the purchaser’s identity can be proven. That sounds like something a government would do. Until then, we may see Bitcoin hold onto top position or we may see a different, more agile and capable one, move to the front.

And Bitcoin is probably one of the worst for that government job. Since Satoshi Nakamoto limited the overall supply to a constant number of Bitcoins, 21 million of them to be exact, it would be hard for a government that adopted Bitcoin to expand the money supply to finance its debts or create economic prosperity – a useful feature of fiat currency. At a high level, inflation is a goal of the government – it sets a target inflation rate. Currently it is 2% per year. This allows the government to issue treasury debt that devalues over time. Thus, when the government sells $1 trillion in 10 year notes at 2.668% with a long-term 2% inflation rate, they end up repaying only $1.06 trillion in today’s dollars in total at the end of the ten years rather than the $1.26 trillion they otherwise would without inflation. Without the ability to inflate a cryptocurrency, where does this leave a government’s ability to borrow and repay?

Besides all that, there is governmental risk in owning and controlling a digital currency. Cryptocurrencies still rely on miners to confirm transactions. It would become a national security risk. If the United States went all crypto and did away with cash with a coin that somehow solved the above problem, a foreign power or powers could utilize the 51% attack and reverse transactions and double-spend coins or even worse, hold up all transactions, causing all sorts of chaos. If Russia and China joined up together, they’d put us down with ease. Can you imagine the propaganda? “Mine GovernmentCoin – For Your Country!” And since you must use your own electricity source for this, you’d literally be paying money to support the system of government payment. Maybe there should be tax credits for that.

These are just theories and in the world of free and open-source software where individual freedom, and anonymity are held in high regard combined with the fumbling bureaucracy that oftentimes is the federal government, we wouldn’t expect to see a government-sponsored digital coin show up anytime soon. And if we do see that at any time, we should certainly be asking who in the administration owns the first coins. Nor do we expect to see the kind of currency speculation we’re seeing today ending anytime soon – at least not until either a government does step in and say “we accept as payment for your taxes our fiat currency as well as this digital currency,” or people wise up to the fact that one coin is only good as long as there’s a large group that continues to believe it’s the best coin (which can change as quickly as new software code is written) and votes with their money.

Because of these views, we wouldn’t speculate here with our own money, much less client money. There will always be a core cabal of individuals or groups that hold any given cryptocurrency, which will inherently give it value, but why bother? If you put 5 coins in a digital wallet and forget about them, you won’t have anything other than those coins years later (if your hard drive doesn’t crash). Raw price appreciation. It’s anybody’s guess if the coin’s value kept up with inflation. If I put money in a stock, I’ll know that the company is at least generating revenue and (should I choose wisely) profits which I’ll have a claim on. Perhaps the company grows over time and the stock shows price appreciation as well. This is how value is created; not through popularizing an item so much that its own scarcity leads to an increase in value. Because at the end of the day, what’s the difference between a Bitcoin and a Beanie Baby?

After all, Beanie Babies had value too. Keep in mind this was in the late 90’s/early 2000s: Ty published a Collector’s Value Guide on a regular basis that contained reference market values for each Beanie Baby they had created. Kind of like Beckett for trading cards. It was a real market! One Amazon reviewer commented on a Collector’s Value Guide on July 4, 1999 that “I purchased this book to keep track of all of my investments, and it has done just that. It is a great book that gives you everything that a beanie babie (sic) collector needs to know. But on the downside, it has left out some of the prices for some strange reason. That's why it is only 4 *'s.” People saw Beanie Babies quite literally as investments. On at least one occasion, divorcees were ordered to split their “portfolios” of Beanie Babies under supervision in open court.

And here’s another Amazon review from May 31, 2002 for the Winter 2002 (published November 2001) Beanie Babies Collector’s Value Guide: “I was so upset when I recieved (sic) the book in the mail. Unless the book is wrong, beanie babies are going out of style. The bears (sic) prices have dropped anywhere between 10$ and 60$. It (sic) starting to scare me, I'm wondering if I made a bad investment!?” If you asked one of those individuals that invested their life’s savings in Bitcoin, they’d certainly say that history does repeat itself after all, complete with “theft, fraud, and fakery.” These days, Charlie’s wife uses Beanie Babies at school for bean bag tosses with the children. At least there’s some residual value. What can you do with a digital coin gone defunct?

That’s not to say that the technology currently has no value at all and is completely speculative. In fact, our view is that the blockchain technology that underpins cryptocurrency has disruptive potential in many areas including healthcare, real estate, and finance. The decentralized system that is the main feature of blockchain allows the system to record transactions in a secure, open ledger and in many cases cuts out unnecessary time and middlemen. Ripple (XRP) is already being used as a processing mechanism for international bank remittances. We’ve seen compelling cases for a blockchain-based system to ultimately replace stock exchanges, real estate titles, and health care records.

Ultimately, we think that the best opportunities to make money in the space are probably not in speculating on the value of the coins themselves, but instead through equity investments in transformational growth companies with a strong business case using blockchain technology. We of course aren’t recommending any specific investment and acknowledge the vehicles to access these investments may be out of reach for many investors. In most cases, these companies are private, which means that a specialty private equity fund is probably the most accessible vehicle for most investors. There is much risk here, so we would implore any interested investor to do his or her own homework and seek appropriate counsel. Still, with blockchain-based business still in the early innings, we believe the sector deserves a thorough look.

Thank you to everyone for your feedback. Please feel free to reach out at any time with questions or comments.

Sincerely,

Arthur Grizzle & Charles Culver
Managing Partners
Martello Investments

It’s typically a bad word in finance. “We want more return, and less volatility,” exclaims another firm’s imaginary client. After all, who likes uncertainty, the most basic definition of the word. Volatility has become synonymous with stress, so much so that when a pundit uses the phrase “we’re seeing a rise in volatility” on TV, one understands his or her portfolio probably just lost some money. But there’s another meaning of the word “volatility” once you move past the mundane version. Volatility is itself an asset class — you can trade it, you can hedge with it, and you can profit from it. Once the word volatility becomes a tool you can use, you look at it a different way. Some tools are misused, like we all saw in February when the XIV was delisted and many investors lost a lot of money. Most that bought the XIV did not understand what it was doing and certainly did not read the prospectus, treating it like it was any other equity security rather than a trading instrument meant to give average investors short exposure to the VIX futures market, a potentially dangerous thing. XIV took a lot of blame for exposing the volatility market to individuals that did not understand it, and we heard a good deal about algorithmic investment strategies that caused the problems that occurred that day.

After the market recovered from the February blowup and rebounded to new all-time highs, volatility reemerged in late September. Increasing interest rates and continued fears of a trade war spooked investors, leading to another moderate pullback for stocks. Mild corrections like this are a normal part of healthy markets. So far, this drawdown has been relatively mundane with the S&P 500 peak-to-trough currently less than 6%. Despite this, the selloff caused another flurry of finger-pointing from television pundits, many finding that “programmatic trading” or “the computers” were reasons for the market’s decline. The question of whether computer-based algorithmic trading can actually cause a market decline is complicated, and the debate has raged on since the “portfolio insurance” debacle contributed to the Black Monday crash in October 1987. Portfolio insurance is among the most basic hedging algorithms (when the S&P goes down, sell futures), which is a fine strategy for one person to utilize, but when it becomes so popular that it itself impacts the market, it added fuel to an ordinary selloff to cause a true panic event.

Algorithmic-trading is a buzzword, but behind it is the simple reality that computer programs are constructed by humans, and a program does what it is told by its programmer. Because of that, algorithms are often filled with the same biases and logical traps that cause humans to struggle as investors. Importantly, these strategies are implemented by people that understandably lack the foresight to see that such a strategy could itself affect the market as it becomes widely popular, like portfolio insurance in the 1980s and short-vol strategies today. This mantra was repeated ad nauseam in February 2018, when risk parity shops were outright blamed by some for de-risking during a volatility event and extending a market rout past where it should have stopped.

It is difficult to determine which cohort of trading strategies counts as the type of “programmatic trading” as pointed out by many pundits over the last few weeks. The introduction of computer-driven trading has exploded in popularity over the last two decades, and ranges from simple algorithm-based investment models to highly complicated, auto-adaptive black-box machine learning techniques. Even fundamental equity strategies, where managers screen a universe of stocks for certain qualities (value, growth, etc.) and buy a basket of the most desirable stocks, could be considered computerized trading in today's world.

Our point is that, in most cases, these programs do not in and of themselves cause a market to fall. But, they can certainly impact the violence and severity of the decline depending on the situation. It’s the point that major market moves arrive not simply from algorithmic trading, but from a concentration of lots of money employing the same algorithmic trade. This is no different than if humans did the same; it’s just that computers, in their attempt to be fast and quick to act, may all, at the same time, find the same information material to their investment strategy and may be programmed to take the same action as each other within a much smaller window of time than humans would. Remember, humans used to make decisions based on meeting with members of their firm, contemplating the decision over a period of time, and then finally instructing an institution to execute their decision. All of this expands the trading window from one day to potentially many weeks. This is long enough that many could be doing the exact same thing but as a group would not have a material effect on the market because there would always be someone willing to step in to take the other side of the trade.

Granted, there are strategies that have second-order effects. This is an intuitive idea: some algorithmic trading programs adjust to changing market environments, and therefore could begin selling AFTER a market begins to show signs of deteriorating, further extending losses. Like the 1987 example above. Or any strategy that attempts to target a certain overall portfolio volatility (e.g. Risk Parity) and responds to increasing realized volatility in markets by reducing its positions. This, when combined with the explosion in popularity of those firms that target volatility, could certainly drive the market lower with greater speed than ever before.

One eerily similar characteristic of the recent market pullbacks in February and October 2018 is the positioning of the CTA-complex ahead of the downturn. As a brief recap, a CTA (Commodity Trading Advisor) is a type of hedge fund that trades futures contracts instead of stocks, bonds, ETFs, etc. Trend-following/Momentum is a primary type of strategy employed by CTAs, and one that has grown in popularity over the last two decades; indeed, CTAs delivered incredible outperformance during the Great Financial Crisis of 2007-2009, primarily by being long bonds and short stocks. Société Générale (SocGen) publishes a collection of indices related to CTAs as well as their “Trend Indicator Daily Report” (https://cib.societegenerale.com/fileadmin/indices_feeds/ti_screen/index.html) which is the bank’s Trend-Following CTA replicator at a 15% target volatility. This daily report can give market-watchers a decent sense of how the CTA complex, particularly the trend-focused segment, is positioned at any given time. In October, SocGen’s indicator report showed long positions in stocks, oil, and the U.S. dollar, while carrying short positions in bonds and gold. This is a very similar positioning to the period ahead of the February selloff, and one that is certainly understandable at some level — stock markets have steadily advanced while interest rates have risen, and these funds are structured to bet on a continuation of the trends. The issue for market structure comes, as mentioned earlier, when these strategies respond to increasing volatility by reducing exposure, potentially leading to further volatility. The synchronized reversal of nearly all on-trend positions mentioned above (long stocks, short bonds, long oil, short gold), certainly supports this idea of general deleveraging.

Strategies utilizing artificial intelligence and machine learning have also become increasingly popular over the last several years. In a nutshell, AI-based strategies use available historical data to train an algorithm, and not only process new data as it becomes available but also re-train the algorithms in an attempt to tease out new patterns in the data and build a model that’s used to make investment decisions. The program goes through millions or billions of iterations, looking for the optimal combination of factors to profit in the current market environment. Let’s be clear about one thing, many of these strategies have had tremendous success over time. We know several of the major players in the space, and there is a lot of genius behind the idea. Unlike your basic factor-based equity strategy that focuses on value stocks, every strategy in this space is significantly different, and necessarily so: the results are entirely dependent on which inputs are chosen, the cleanliness of those inputs, what metrics they use as measurements of success when training the strategy, which brand of off-the-shelf or custom software is used, which algorithms they decide to use to refine their results, and believe it or not, which random numbers the computer pops out at any given moment during training. It is impossible to truly know how these strategies contribute to market structure or how they might respond to a shifting market regime. Even many portfolio managers inside AI investment managers struggle to fully understand why the algorithms they use do what they do. This is of course the reason AI exists in the first place: to use the power of advanced computing to make sense of data that humans simply could not do on their own.

AI strategies are only as good as the data you give them. That’s why the good practitioners are religiously cleaning their input data. And the cleaning doesn’t end there. It takes a great team of people to bring in clean inputs in a timely enough manner that the strategy can process the data and act on the new information quickly. But most pay attention to the recent data and its cleanliness. The dirty secret is that for AI to work in all environments, it must be fed data from all environments – and that fully complete dataset simply doesn’t exist. AI’s use in investment markets has exploded over the last few years at a time of relative calm, an interventionist Fed, and reasonably stable correlations. The best, most complete, and cleanest data comes from the same time period. Rates have been falling for longer than firms have complete, clean datasets. As you get further back in time, you see data quality degrade, get less frequent due to lower volume or to a lower recording frequency, and you see entire markets fall off and disappear because nobody thought the data would be useful enough to save. Sure enough, there’s an entire industry making huge profits selling old data to just these types of investment firms. In such an environment, you can imagine that these strategies have learned on their own that buying a pullback in the market is a highly profitable strategy, as the S&P has bounced off its 200-day moving average multiple times in the last year without breaking through in any significant way (the outcome of the current selloff obviously remains to be seen). And, like many of the other alternative strategy types, most AI strategies use significant leverage. The very nature of these models relies on market patterns and correlation assumptions to hold to what they’ve been fed. A potential problem arises, of course, when market conditions change rapidly in an unexpected way due to a regime shift, exogenous shock, or any other factor on which it remains untrained.

Remember, we do not believe these types of strategies cause markets to decline; markets have of course experienced selloffs regularly for hundreds of years before the invention of the computer. Human traders and computer-driven approaches alike are likely to respond to negative stimuli with selling. We do, however, see the increasing popularity of these approaches as potentially speeding up the pace of market pullbacks. Put another way, we believe that the increasing concentration of highly reactive, high frequency strategies increases the overall fragility of markets, and the signs are all around us. It’s no surprise that 5 of the largest one-day VIX spikes of all-time have occurred in the last 2+ years, during a period otherwise characterized by a lack of volatility. We also showed some examples of shocks in the fixed income market back in our May 2018 piece.

Despite the recent pullback, larger macroeconomic indicators don’t seem to be pricing trouble on the horizon. High yield credit spreads have been particularly resilient. This means that market participants still view economic conditions as bullish and that the recent selloff is a temporary phenomenon and not likely to cascade into an extreme scenario. We have not yet seen an inversion of the yield curve, which if inverted would indicate that a recession is statistically very likely to hit. Still, the hidden risks to market structure caused by the prevalence of these approaches should cause investors to consider how they structure portfolios. It calls for diversifying your exposure not only to various asset classes but also to different strategies that behave differently as market regimes change – algorithmic or not.

We’re thankful for your continued interest. As always, please reach out any time with your questions and feedback. Our team spent the last week in New Orleans for a conference with the International Foundation of Employee Benefit Plans. It was great to catch up with some old friends and make many new ones. We have trips planned to Asheville, NC, Northeast Georgia, New York, DC, and Baltimore over the next several weeks before settling in for the holidays. If any of you are interested in getting together while we’re in town, please drop us a line!

Sincerely,

Arthur Grizzle & Charles Culver
Managing Partners
Martello Investments

We are a little late with our monthly piece this time. As most of you know, weather forecasters last week indicated that Hurricane Florence would pass right over us on its way inland. To be sure, a direct hit of the Category 4 storm on this area would bring catastrophic flooding and significant property damage. We spent several days last week reviewing Martello’s disaster recovery procedures, making sure we had backup plans in case we couldn’t make it to the office to trade, and buying cans of sardines. As fate would have it, a high-pressure system caused Florence to weaken materially and its path to shift southward, sparing our area from a direct hit but causing damage, flooding, and unfortunately loss of life in the Carolinas instead. Our hearts go out to those affected by this massive storm and we encourage everyone to find ways to help those affected by the devastating flooding.

One of the staggering things about any severe storm, but particularly a hurricane, is the extent to which the approaching event puts on display the fragility of our modern lives. Think about the convenience that we have been able to engineer as a society. Think about the convenience of the world’s historically most precious commodity, potable water, and how you can just purchase it in a small handheld bottle for just over a dollar at the corner store. But within 24 hours of the first report that Florence would impact our area, most stores had entirely sold out of regularly priced water. Sure, you could make it through Florence on Evian or Perrier if needed, because “premium water” was still available, but water that most people would typically buy was not. This is a pattern I observed nearly every year as a kid growing up in South Florida and have continued to observe with hurricanes here in Hampton Roads.

There seem to be technological and psychological factors that are converging to arrive at this “run” on water – and other products as well – every time a rough weather pattern nears. Modern-day supply chains have evolved into a just-in-time model where the supply chain reacts almost immediately to consumer demand and pushes product out to the store when it is needed. This helps the store avoid stocking too much of any product for too long. These efficient systems have undoubtedly been built with the ability to predict future demand based on historical demand (say, chocolate deliveries increase around Valentine’s Day before the stores come close to selling out). But currently, the lag is a bit too long and the demand too high when it comes to restocking emergency staples. There’s never enough bread or milk in a snowstorm. On the psychological side, this is an excellent example of a “short-volatility” mindset in practice. The system is built for, and consumers are accustomed to, the continuation of normalcy. As I mentioned, clean drinking water is probably the most precious commodity in the world. Yet, our society depends on and expects its limitless and (nearly) free availability at the turn of a tap. The prospect of a major hurricane, surely a volatility event in weather terms, puts these dependencies to the test, causing people to stampede for the few remaining bottles as they wrestle with the reality that no system can engineer away the unexpected.

I’m not a prepper by any stretch, but even I know that it would be incredibly easy for most people to insure themselves against a prolonged period without water. Based on the results of a simple web search, a single person could avoid this scenario with a mere $10 investment, which would buy them about 6 gallons and 6 days of water. For a family of four, the cost is even less per person since you can get a better price for buying in bulk. Why then, do so few people choose to insulate themselves from this possibility? It’s near chaos in the water aisle as the weather approaches. It’s not for lack of warning. These events happen once or twice every year, and it’s the same thing each time. Sure, it would be easy to point to the money required or the wasted space in the cabinet/garage, but the simpler answer is that most people don’t worry about it until the storm is on the way. They’re used to the engineered conveniences of modern life. This is what I meant by the “short-volatility” mindset. By not preparing for such an event ahead of time, the water-bottle-less are betting that an event will not happen, or that even if it does they will be fast enough to the store to guarantee their supply.

-A.G.

We have discussed short-volatility often and in many forms, from the explicit (inverse vol products and strategies) to the implicit (correlation assumptions). To be fair, the short-volatility mindset is proven right most of the time—most days, the hurricane won’t come, there will be enough water, the market won’t blow up, and stable correlation assumptions will hold. It is the unforeseen catastrophe, though, that challenges these assumptions, be it a hurricane or a market shock. Charlie and his wife have an infant son and when they heard the hurricane was coming, they found a hotel with a backup generator and a concrete structure and paid up for it. It went unused after all, but this physical insurance policy was necessary for their peace of mind. This characteristic of shocks being unexpected, rare, and calamitous leaves managers in constant search for the most cost-effective and efficient hedge. In markets, hedges are typically very costly and inefficient. For example, the cost associated with rolling protective put options to protect an equity portfolio is typically prohibitive, as it eats up most of the expected return of a stock portfolio.

Still, for most investors, some form of protection is required in attempt to combat negative outcomes. The thought of a storm-induced water supply emergency highlights one kind of systemic fragility. Luckily, ten bucks and some wasted pantry space is a very cheap hedge. In markets, though, it is pretty much impossible to time the next shock or know where it will come from, but a good guess would be the debt market. By nearly every metric (Business Debt/GDP, Federal Debt/GDP, Margin Debt/Disposable Income), the US is more indebted than at any other time in history, as is a solid chunk of the developed economies globally. A few months ago, we highlighted statistics showing the increased leverage in the investment grade corporate bond market and discussed the potential systemic shock of a widespread ratings migration in the next recession. In addition, credit spreads remain historically tight in high yield fixed income and covenant-lite leverage loan issuance continues to boom, both of which reflect investor optimism about even the least creditworthy borrowers despite record indebtedness across the economic spectrum.

With a potential storm brewing and many forms of hedges prohibitively expensive, many investors are left in a bind about how to best protect their portfolio from potentially large losses in the next downturn. Though it’s pretty much impossible to time the turn of a cycle, we can use disciplined processes to assess opportunities and risks. We’ve highlighted the benefits of this approach in many past posts; suffice it to say we believe that vigilance is more critical now than ever. We know that, despite bullish trends and some positive economic releases, clouds are forming around valuations and debt. As stated above, we are all wired to assume a continuation of normalcy. It’s important to keep at front of mind, though, that valuations are stretched to levels historically only associated with some of the worst crises in US history. At the same time, the system is more levered now than ever. Additional leverage means additional risk, period. This dangerous combination of factors calls for focusing on the risks embedded in a portfolio and looking to reduce exposures at the first sign of trouble. When the forecast calls for clear skies ahead, and it certainly will at some point, we can shift our focus to capitalize on the many opportunities that will surely be available.

We appreciate your time and interest. Please feel free to reach out with questions or feedback, we would certainly enjoy hearing from you. As always, we wish you great health, many successes, and the wisdom to throw a few gallons in the garage for safe keeping!

Sincerely,

Arthur Grizzle & Charles Culver
Managing Partners
Martello Investments

I don’t try to predict where the market is gonna go. It’s like a comet going through the sky. You can’t see the comet, but you can see the tail. We can see the price action, but we can’t actually ever really grasp the market... All we can see is the tail, that’s the price action, the historical prices. You can analyze charts up the ying-yang; you’re looking at the tail of the comet.

John Moulton: Bulls and Bears (1998)

If you haven’t seen the Bulls and Bears documentary from 1998, I’d highly recommend it. I watched it for probably the 10th time last week, and I can confirm that there are multiple versions available on YouTube as of the time of this writing. The documentary follows a group of traders on the Sydney Futures Exchange, and focuses particularly on John Moulton. Bulls and Bears has so many interesting components: the relative infancy of screen trading. Navigating the ups and downs of managing money. The impact of unexpected geopolitical shifts. For those interested in trading (or just the market in general) the film also has several amazing nuggets of wisdom, the most enduring of which is highlighted above.

The “Tail of the Comet” is a logical fallacy. It grips all investors at some level. Unless you are a blind speculator, you certainly incorporate past data to get a sense of current market dynamics and future expectations. Consciously or unconsciously, it’s human nature to do so! We strive to find patterns everywhere. Even fundamental strategies incorporate the past to some extent. For example, recent earnings growth trends to forecast future earnings. But pure technical approaches are driven entirely by the tail of the comet. The simplest example of this is a momentum-based approach, which simply invests in the securities showing the greatest performance. Another example is the use of volatility as a weighting scheme, whereby lower volatility securities are given a higher weight in a portfolio. We have discussed the danger of using these weighting schemes in levered strategies many times.

That’s not to say that these strategies are necessarily inferior to any other. We certainly utilize many technical factors in our strategies at Martello. Particularly for technical strategies, though, we believe it is important to understand when a strategy type should perform well and when it might suffer. In geek speak, this is sometimes referred to as “regime analysis.” It allows a portfolio manager to understand why a strategy might be making or losing money.

Technical strategies, particularly those that use momentum/trend as their primary signal, have two basic weak points: technical shifts and shock risk. Technical shifts are periods where what the strategy predicted was going to happen isn’t happening any longer. Trend/momentum investors rely on an upward-moving security to continue to move upwards to make money when they are long, or a downward-moving security to continue moving down if they are short. But should the security hit an inflection point (the trend reverses), or even worse, encounter a choppy market (whipsaws in an up and down fashion, confusing the algorithm), the strategy will be caught offside until it can detect a new trend, or at least figure out that the old one is no longer there. The timing depends entirely on the algorithm. Some can trade out quickly, while some will require months of evidence that the trend has discontinued.

While technical shifts are more prevalent, shock risks are perhaps an even larger danger to trend/momentum strategies. These happen less often and are characterized by a sudden and unexpected change in trend caused by some unforeseen event. Think a major bank failing, a geopolitical headline, or a surprise from some monetary authority like the Fed. Shocks are called shocks because these types of events almost always happen against consensus. Nobody likes to get shocked. It’s very rare that investors are “shocked” and hold their position. It’s in human nature to panic and protect, so regardless of the speed of your algorithm, if you’re caught offside, you tend to feel the pain.

It’s no surprise that with whipsawing in the equity market this year and in bond markets over the last two years that the current period would be a difficult environment for these strategies. Furthermore, and not to get too political here, the “policy via tweet” stance of the current administration in the US has served to increase shock risk, particularly regarding trade policy as of late. But even though these types of strategies may have not been faring well recently, that regime analysis has indicated that it is a poor environment, and the equity market looks so good on its surface right now, it is still a wonderful idea to include such a strategy in your long-term portfolio due to the way it interacts with other strategies in your portfolio.

As we have discussed many times, using a variety of strategies to allocate capital is an important way to manage the risk in your portfolio. Since Harry Markowitz in 1952 introduced modern portfolio theory, the financial industry has touted the importance of diversification. If you’re like most investors, you’ve surely got stocks and bonds in your portfolio. This diversification of asset classes is a common technique, but with low interest rates beginning to rise and near-record high equity valuations, traditional diversification could falter in the next significant downturn. Our January note highlighted that the correlation between stocks and bonds isn’t reliably negative. Put another way, what if stocks and bonds fall at the same time? Diversifying strategies is a different way to go. You begin with various investment strategies that aim to make money in good times, protect capital when things take a turn for the worse, and most importantly have low correlation to one another. Our research shows that, when you combine them together, you get a portfolio that is greater than the sum of its parts.

Back to the point. Because trend/momentum strategies in general are not highly correlated to stock markets over long periods of time, including such a strategy in your portfolio can help improve returns and reduce volatility – to “smooth the ride,” if you will. Below, we show a chart of 3-year rolling returns of the S&P 500 and the SG Trend Index, which tracks the leading trend-following managers in the Managed Futures space.

At first glance, it’s hard to see any tangible benefit to the Trend Index, as returns have lagged the headline stock market for a long time while both indices have similar volatility (about 14% annualized). Based on the chart above, you’d probably be surprised to find out that these two indices have returned approximately the same over this period. Even better, because they have a negligible correlation to each other (approximately -0.12), a 50/50 blend of them improves the overall return while dampening volatility, significantly improving risk-adjusted return.

To reiterate, this speaks to one of our core beliefs here at Martello: the importance of strategic diversification. Instead of merely diversifying asset class exposure, investors should look to diversify strategies and strategy types. In the chart above, you can see the benefit of combining a static equity position with an uncorrelated trading strategy. Our multi-strategy approach expands on this by combining multiple uncorrelated strategies into a single portfolio. Factors may fall in and out of favor over time, but our research and experience show that combining them in a disciplined framework is the best methodology to avoid chasing the tail of the comet.

Thank you to everyone for your feedback. Please feel free to reach out at any time with questions or comments.

Sincerely,

Arthur Grizzle & Charles Culver
Managing Partners
Martello Investments

Remember to bring a swiss army knife because you never know when you might need one of the tools. Count yourself lucky if the only tool you use is the wine opener at the end of your trip. You plan on having fresh water throughout your 60 miles of backcountry hiking because there are outposts all along the trail, but throw a pack of Aquatabs in your pack just in case you find yourself lost. Always have a backup plan, lest you find yourself in a life-threatening situation that could have easily been dealt with had you remembered to bring that extra cord of rope. Having foresight in the context of your travels could be the difference between having to slog in cotton down a cold, rainy mountain rather than using your flint and steel to start a fire under the cover of a lean-to you put together because you had learned how important that kind of knowledge could be.

Why is investing any different? Just because we all sit at our computers watching the markets prove our ideas right or wrong every day does not mean that we aren’t exposing ourselves to the elements. The danger is real, and it can certainly affect our lives – just much further down the road. Just this weekend, I was at a wedding speaking to a relative who is looking forward to retirement in short order. For the over 30 years he’s been saving, he’s taken a diversified approach and grown his retirement account to allow for this. He said he’s one of the lucky ones; many others in his division are looking at retirement 10 or 20 years later than he is because they elected to invest only in government bonds. The equivalent of not walking the trail has amounted to these individuals finding it difficult to reach any destination. On the other side of the spectrum, one must think of the individual who tried to run the trail as fast as he could, investing only in stocks with an eye to retirement in 2008. Hopefully this individual did not turn in his forms so he can try again five years down the road.

-C.C.

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Many of our recent commentaries have touched on the idea of diversification, but to date we have only discussed diversification in the traditional sense. To many investors, both professionals and the do-it-yourselfers, the idea of diversification is simply limited to the collection of asset classes one uses in a portfolio; the most common method used to achieve a diversified portfolio is to simply mix stocks and bonds. Over the last few months, we have highlighted a few ways that traditionally relied-upon diversification techniques could break down in the face of rising interest rates and overheating inflation. There is, however, another way to think about diversifying, and despite it being very important to what we do here at Martello, we have not directly addressed it to date. What we’re referring to is the idea of strategic diversification—meaning that we use multiple methods of analysis, algorithms, and signals to evaluate each market.

There are multiple benefits to using this type of approach, which notably reduces the potential risk of overloading on one factor. In fact, our research suggests that, perhaps counterintuitively, using multiple strategies in one market is a more efficient diversifier than using one strategy on multiple markets. For the institutional portfolio manager, strategic diversification is a critical element of risk management and portfolio construction. It’s why most institutions, for example, utilize both value and growth managers in equity markets. If you regularly read our monthly notes, you’ve surely seen our comments that refer to our view of risk and opportunity as “a mosaic;” this simply means that we focus on using multiple, uncorrelated models to analyze markets – each one contributing to our overall view. Though our model library covers multiple investing disciplines – volatility, value, yield, trend, momentum, etc. – a substantial portion of our approach is driven by what we call “macro/systemic indicators.” These signals are market-based indicators that give us a sense of the trajectory of the economy in general. A great example of a macro/systemic indicator is credit spreads; as macroeconomic conditions deteriorate, credit spreads generally expand in an accelerating fashion, signaling investor angst and increased fear of defaults. On the other hand, credit spreads generally trend lower when investors are bullish about economic conditions. Therefore, an investor can get a sense of market expectations about the economy moving forward by monitoring the level and changes in credit spreads.

Another macro/systemic indicator used in our models, the slope of the US Treasury yield curve, has dominated headlines over the last few months. As the Federal Reserve continues its path of raising interest rates, the yield curve has flattened to a degree not seen since before the Great Financial Crisis. With the Fed likely to raise short-term rates twice more this year, many pundits believe an inversion of the yield curve is imminent. Yield curve inversion, the phenomenon where short-term interest rates are higher than longer-term rates, is very rare and usually portends a recession. In fact, a recent paper by the San Francisco Fed highlighted that all nine recessions since 1955 have been preceded by an inversion of the yield curve and had only one false positive reading (their paper uses the spread between the 1-year and 10-year US Treasuries). This study also showed that the lead time to a recession after the yield curve inverted ranged from 6-24 months. As of Friday’s close, the current 10-1 spread stands at just 0.46%, the lowest level seen since late 2007. Longer-term spreads are even tighter, with the 30-10 spread standing at a mere 10 bps. The 30-10 spread shows a similarly powerful signal of inverting ahead of a recession.

The study mentioned above clearly shows that an inverted yield curve is a pretty accurate predictor of a future recession, but it’s certainly worth discussing why this is the case. At a basic level, an inverted yield curve signals that investors believe rates will fall meaningfully in the near future. The function of long-term rates being lower than short-term rates reflects the investors’ desire to lock-in this longer-term rate, reducing reinvestment risk, which is obviously higher in shorter-term bonds. A rapid fall in rates is typically associated with a recession, as investors shed exposure to higher-risk assets in favor of safer assets like treasury bonds. Also, fears of a recession could also lead investors to conclude that the Fed would likely slash short-term rates dramatically in effort to dampen economic weakness.

The extent to which an inverted yield curve is merely coincident to a future recession or in fact helps cause a recession is more debatable and related to the impact of an inverted curve on the financial system. It is obvious that an institution that profits from the positive spread between short- and long-term interest rates (most notably banks, community banks in particular) stand to be hurt from an inverted curve. Banks, which pay short-term rates to depositors and receive longer-term rates from loans made, may see an inverted curve as a disincentive to write new loans. To the extent that this leads to reduced lending activity and tightening credit, it could certainly cause further economic weakening. In addition, significantly higher short-term rates impact most floating-rate debt instruments like adjustable-rate mortgages and floating-rate bank loans. As we saw in the housing crisis last decade, the reset of adjustable-rate debt can severely burden borrowers, particularly those that are overindebted. This phenomenon can certainly exacerbate deteriorating economic conditions.

We should point out that the yield curve has not yet inverted, and a recent forecast by Morgan Stanley doesn’t see the curve turning negative until mid-2019. This timeline would put off a potential recession to late 2019 through potentially as late as 2021, if history is any guide (see the San Francisco Fed study mentioned above). And, while an inverted yield curve is a pretty clear indicator of economic weakness ahead, a flat curve environment like we are currently experiencing is less clear. On one hand, the upward trajectory of short-term rates that we have seen over the last year signals investors expect increased inflation, at least in the short-term. The movement in longer-term rates has been more subdued, which could mean investors are less worried about persistently higher inflation over time. We certainly fall into the camp that believes the US faces a prolonged period of structurally lower interest rates, driven by demographic trends and the disinflationary impact of excessive debt, both for the government and private sector, among other factors.

Signals based on the US yield curve only make up a small part of our approach, but an inversion of the curve, should it come, would certainly signal danger ahead for growth-sensitive assets (stocks, real estate, etc.). We know that recessions generally lead to pronounced selloffs in stocks, so an inverted curve signal would be an opportunity to take risk off the table, raising cash to put to work at more attractive levels. The question of timing is certainly a challenge; as we mentioned above, the range of lag time between an inverted curve and recession is 6 months to 2 years, meaning investors cannot use an inverted curve as a short-term trading signal, but can potentially use it to position our portfolios strategically for the medium-term. The US is overdue for a recession; in our history, we have averaged one every 7 years or so, and have not had one since the end of the Great Recession in 2007-2009. One may not come in the next few years, but if it does, it will likely be preceded by an inverted yield curve, making this a worthwhile signal to follow, and one that may give investors ample warning ahead of a potential downturn.

-A.G.

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Thank you to everyone for your feedback. Please feel free to reach out at any time with questions or comments.

Sincerely,

Arthur Grizzle & Charles Culver
Managing Partners
Martello Investments

“The test of a first-rate intelligence is the ability to hold two opposed ideas in mind at the same time and still retain the ability to function.”

SCOTT FITZGERALD “THE CRACK UP” (1936)

The current market environment, maybe more than ever, demands this Fitzgeraldian test of the portfolio manager. For example, how do you build a portfolio that acknowledges, at once, the near-decade sustained bullish trend of equity markets and also valuation levels unrivaled by any point in history except levels prior to the Great Depression and the Dot-Com Bust of the early 2000s? For the trend-follower or momentum trader, the answer is easy: buy stocks. For the valuation-driven or macro investor, the answer is easy: sell stocks. At Martello, we account for this inherent tension between valuation and trend when building portfolios. As an aside, we utilize two different methods to take both the valuation and technical into account: valuation-based overlays and strategy ensembling. These might sound complicated, but in fact are quite straightforward and we believe the sensical way to tackle this issue. In both cases, what this means is that we give weight to both the value and technical factors. When valuations are cheap and the trend is bullish, we load up our exposure. When the picture is less clear, we reduce our exposure to more modest levels. When all signs are bearish, we can throttle down all the way.

In addition to equity market valuation, we continue to see competing signals in different segments of the fixed income market. Any regular reader of our monthly notes knows that we have been harping on the rising risk of traditional fixed income approaches given the prospects of rising inflation in the US, low real interest rates, and the Fed’s expectation of additional rate hikes in the coming months. In the corporate world, years of utilizing cheap debt financing to buy back shares has left companies significantly more levered. As a side-note, research has shown that corporations generally have a bad record of timing corporate buybacks. Most tend to do it to further drive equity prices higher (and it makes sense to buy back rather than increase dividends from the investor’s point of view) but these buybacks often occur near the top of a cycle.

Even in investment grade credit, to quote the famed market philosopher Yogi Berra, “the future ain’t what it used to be.” A recent paper by PIMCO showed that A and BBB-rated credit, the lower end of the investment grade universe, have more than 50% higher leverage today than before the Great Financial Crisis (Figure 1 below) and the investment grade universe is comprised of higher-leverage borrowers (Figure 2). At the same time, interest coverage ratios for this universe (a ratio showing how much money a company makes compared to its interest expense on debt) has fallen to levels near or below the depths of the financial crisis (Figure 3). Think about that for a second; by this metric, the credit quality of these companies is near the same levels as at the bottom of the worst recession since the Great Depression, despite all the economic progress over the last decade. In fact, interest coverage ratios for these companies have been FALLING for years despite steady economic growth, record corporate profits, and historically wide profit margins.

On one hand, you can understand the rationale for companies to do this; levering up when debt is cheap is Corporate Finance 101. If the cost of debt is less than the cost for issuing equity, borrowing makes more sense than issuing stock. The problem with debt financing, however, is that it creates additional inflexibility when things take a turn for the worse; you can reduce or suspend the dividend to your equity holders, but that is not an option when the bondman cometh for his coupon. The likely result of a significant recession, which would almost certainly further impair companies’ ability to service debt, would be what’s known as a “ratings migration.” A ratings migration in this context simply means a lot of companies would be re-rated to lower credit qualities to more appropriately reflect their financial position and leverage levels, and therefore higher rates on debt to reflect this increased credit risk. Depending on how quickly that happens, this could cause significant forced selling pressure from index-based strategies that would be forced to sell if a bond falls below the mandated universe of credit quality.

There are deeper implications for investors here, not only in credit markets but also for stocks. As the chart below shows, equity market volatility and credit spreads are very tightly linked. This isn’t a coincidental phenomenon; if a stock is a claim on a company’s future profits, it would make sense that stocks would become more volatile in times of when debt is more expensive, because more expensive debt obviously imperils a company’s profitability.

While the additional leverage and deteriorating credit quality is concerning on its own, we also see signs of structural weakness that increases shock risk in fixed income markets. One of these signs is the seemingly disorderly reaction of markets to negative events. Jared Dillian of Mauldin Economics covered this in his recent piece “Wall Street Fired Too Many People,” highlighting the price response to the Toys R Us bankruptcy announcement and the recent spike in Italian bond yields after the election. In both cases, which Dillian calls an “instantaneous blowup in the capital markets,” he highlights that these risks should be priced in over time, and the fact that they weren’t shows structural problems in the market. The Toys R Us bankruptcy, for example, should not have caught investors off guard, as credit analysts should have seen deteriorating financials for quarters or years, and this bankruptcy risk would have been slowly priced over time. There are likely several reasons for these structural failings, including the reduction in market making activity in more opaque markets such as bonds; dealer inventory in these securities has plummeted in the years since the crisis due to regulatory factors. Once again, the impact of the passive investing revolution is also at work here; with more and more assets linked to index-based products or quasi-indexed strategies, research on individual securities has been devalued in favor of buying/selling a whole basket.

Back to Fitzgerald’s quote, it is important to remember that this is just one side of two opposing views. Despite our perception of increasing risk in fixed income, some of our models continue to utilize various government and corporate bond ETFs for a variety of reasons including diversification benefit and income potential. As we mentioned above, we build our models by incorporating many factors in combination. However, given the structural issues mentioned above, as well as seemingly deteriorating fundamentals and a poor macro picture for bonds (rising rates, increasing inflation, etc.), investors must be increasingly aware of the hidden risks in their bond portfolios.

We thank our readers, as always, for your time and interest. As of this month, we have stopped generating the usual second half of our monthly write-up, which summarized the previous month’s market returns and recent events. If you would still like to receive this information monthly, please feel free to let us know and we may include it again in the future.

Sincerely,

Arthur Grizzle & Charles Culver
Managing Partners
Martello Investments