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Sunday, 22 October 2017

Thumb twiddling to the fore as the art of investment proves its worth

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From a trading perspective, Monday might just as well have never happened. What has of late been a trickle of volume in the secondary markets finally dried up and despite some fighting talk from the investment banks, most trading desks were preparing for their PhDs in thumb twiddling.

Broadly, there is a lack of new ideas. We have all established that fixed income returns have become about as uninteresting as they can get and that there is little upside in rates-related products. We are also fairly confident that China is past its best in terms of the velocity of growth and that therefore the commodity game also lacks room to the up-side.

Asset allocation away from bonds and into developed stock markets is the only game in town. However, equity new issuance remains subdued, not least of all because it is so cheap to run balance sheets on debt that, at this moment in time, IPOs and other equity capital raising still look expensive and not worth the effort. This is naturally causing something of a short squeeze in equity markets, which can therefore rally nicely on relatively modest volumes.

However, markets are also tired. They are lacking in that sense of certainty which drove them for most of the past two decades. Models to the left, models to the right – there was a quant solution to each and every problem. In reality, markets are not a mathematical equation and the old cry that investing is an art, not a science, has rarely been more evident than it is in the present.

You can confuse a mathematician with an insoluble equation but not as much as you can confuse him when he of all of a sudden perceives that there is no equation to solve at all. During the weekend I tripped over an old copy of Roger Lowenstein’s book “When Genius Failed”, a study of the collapse of John Meriweather’s Long-Term Capital Management.

Markets are not a mathematical equation and the old cry that investing is an art, not a science, has rarely been more evident than it is in the present

LTCM was the capital market’s equivalent of the Titanic: on paper it was unsinkable. The Titanic’s biggest problem was that it sailed on the high seas and not on paper and LTCM believed that it would take a 22 standard deviation event to bring it down. It was brought down by irrational markets and not by standard deviations. The providers of funding don’t have 22 options – they have just a binary decision to take which is whether to provide capital or not. I digress.

The first quarter has been benign to investors. Everyone has made money although some have actually made out like bandits. The risk-on trade has not been one of leaping in and out of the pool but has been one of gently cranking up the asset allocation to US and European equity markets which broadly still look decent value on a P/E basis.

New York Fed president Bill Dudley did put something of a fly in the fundamental ointment when he stated yesterday that: ”More importantly, real economic activity has yet to be strong enough on a sustained basis to make a big dent in the overall amount of slack in the US economy. While it is true that growth was stronger in the fourth quarter, most of that growth was due to inventory accumulation. Growth of final sales was actually quite weak.

“Historically, a quarter in which inventory investment makes a significant growth contribution is typically followed by a quarter in which that growth contribution is modest or even negative. That appears to be what is shaping up for the first quarter of this year.”

Nevertheless, markets are not driven by fundamentals but by buyers and sellers and at the moment there are more of the former than of the latter. As a credit analyst I was taught at a very early stage not to listen to management pronouncements but to simply “follow the cash”. I guess the same applies to asset prices and investment returns. John Maynard Keynes reminded us not to invest in what is cheap but in what we think is going to be popular. I rest my case. Meanwhile, bond prices are gently crumbling.

Buyside-sellside confusion

By and large, the sellside doesn’t have a clue how the buyside works so it might be time for a reminder. An asset allocation shift away from fixed income and into equities is rarely accompanied by a big selling spree followed by a big buying spree. What will occur is that new cash will be allocated to equities and the fixed income book will simply be starved of new cash. Time decay will left to take care of the rest as redemptions are not reinvested. Hence the roaring silence in our markets.

Even the bond auction related to the triggered Greece CDS couldn’t drive enthusiasm. It really is an event of picking over the bones as the total amount of €2.5bn was tiny, relative to the overall cost of the Greek default. Bonds were auctioned at 21.5 which is a discount to the value of the exchange strip and hence either overcompensates CDS holders who will be paid out 78.5 or it tells us that the exchange bonds are still overpriced. Irrespective, there is quiet satisfaction in the markets that the CDS was unwound in an orderly fashion and that therefore there is some value in carrying sovereign CDS.

However, the to-ing and fro-ing around the sovereign default swaps has probably spoilt them for a lot of people who now will simply sell the bonds or run good old cash market shorts. It works in practice – maybe those unemployed quants can come in again and verify that it works in theory too.         

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