Starting over

Three body problem of the markets: Looking at the market through three different lenses

I started this blog at the beginning of the year but it was on a different platform. I thought I would start over but bring back some things that I wrote about before. Here we go.

In my thirty years in the financial markets, I had the great fortune of investing across almost every asset class. I was on the ground investing in Asia, Europe and the US. I point this out because one's investment process is, and should be, a function of their experiences. A fully developed investment process is really never complete, because one must be adaptable while still remaining disciplined. However, in an ideal world, we should all look to add the best parts of what we learn along the way to build the most robust process that we can. This is what I have tried to do. 

The process consists of three parts. From my days in equity long/short, one of the key issues we always faced was how to size an investment decision. As I studied this more, I determined the best way to do so was to break the decision into three parts - the fundamentals, the supply & demand and the catalyst. If an investment had all three things in its's favor, it should be a full-sized position. If only two things, then 2/3 of a position. If it had fundamentals working for it, but perhaps the supply & demand was against it and there was no catalyst, the idea would be on the watch list and not be put on. One of the biggest problems for investors is not being able to find ideas, it is knowing how to size them in the portfolio. Too often the best ideas, the ones with the most going for them, end up being small positions. Bigger, more liquid names, that may not have as much going, tend to be bigger. Does this make sense?

As I began to refocus on global macro, I thought to myself that there is no reason I cannot apply a similar approach to the broader markets, as the first and maybe most critical question one must ask in global macro is whether the markets will be risk on or risk off. The types of investments you would choose in either environment depend entirely upon that. For instance, a long volatility position (e.g. VIX calls) might look relatively inexpensive vs. its own history, however, if we are in a risk on environment, you will bleed money on those. Similarly, for an FX carry trade, the interest rate differential might be extremely wide, but if we are in risk off, you will lose more in capital loss than you hoped to make in carry. Thus, determining what type of market environment we are in is critically important. 

My goal each week will be to break down one aspect of this three body problem for the markets. In astrophysics, the three body problem is the problem of determining the motion of three celestial bodies moving under no influence other than that of their mutual gravitation. No general solution of this problem (or the more general problem involving more than three bodies) was thought possible for over 100 years, as the motion of the bodies quickly becomes chaotic. Only recently has a solution been found. 

Similarly, finding a predictable solution to what will happen in the markets each month, other than assuming a positive drift higher for risk, has been thought to be improbable. Efficient markets defenders will tell you as much and point to the statistics of active managers. However, I aim to do so by exploring what will happen using three different pillars of assessment. I will look at the Fundamentals in week 1, the supply and demand in week 2 and the catalysts in week 3. In the final week each month, I will try to pull it together to give an idea of the market environment as we head into the new month. 

Here we are in the first week of March. Already this year we have seen a negative deterioration in the fundamentals, supply/demand AND the catalysts. This is what wars leading to spikes in energy and food in the midst of a central bank tightening phase can do to you. However, we want to stay objective. This is why I force myself through this long process in an attempt to not get caught up in narratives but to be objective as to what is happening.

I said we have a three body problem of the markets. The first of those bodies is Fundamentals. Without further ado, let’s dig in.

FUNDAMENTALS

The first component of the three body problem is the Fundamentals. Rarely will an investment work for anything measured more than in days if there are not good fundamentals. Yes, there are some that have persisted (I am looking at you GameStop), but the first metric that an investor and not just a trader must concern themselves with is the fundamentals.

In macro investing, the fundamentals are not just for a single investment but for the market overall, for the risky market overall. I have found that the major drivers of the market can be categorized into four areas: relative valuation (of equities relative to other market beta), the economic trend (primarily in the US but I consider the globe too), the liquidity in the market (has always been important but has become increasingly so after the Great Financial Crisis) and the velocity (there can be tons of money but if no one uses it who cares). 

I am a visual person. I like pictures. They tell a big story. As the front page reads, history doesn't repeat but it rhymes. This is why I like to look at a time series.  I like to look at overlays. I don't expect the precision of a quantitative investor, inquiring of the robustness of the R^2 and correlation, investing only on this metric. Instead, I like to look at a lot of things, and from there determine the preponderance of the evidence. It is a diffusion index of sorts. Is there more good information than bad? Is it a lot more? Is it more than last month? This is my goal.  I actually look at far more pictures than I include in this small space, but I want to give you a representation of what I am seeing and thinking. 

(My source for most charts is Bloomberg but I also use the St. Louis Fed FRED database)

Relative Valuation

I always start with the relative valuation. You will notice I am not thinking about absolute valuation. I look at that in the Behavioral section. After all, the absolute multiple someone is willing to pay for an investment, a market etc. is driven by the overall panic or euphoria in the market. It matters, but not here. In this section, I am saying, if someone wants to add beta risk, would they add it in stocks or credit or commodities etc. 

The version of the equity risk premia (ERP) that I use here compares the US credit market yield to the SPX forward earnings yield. It is an apples to apples yield comparison, with indexes (Moody's Baa & SPX) that have a relatively similar credit profile. You can see from this chart over the last 30 years, that there are clear periods when one should prefer credit to equities and vice versa. Late 90s? Equities were clearly overvalued. The period between the tech bubble and post GFC? There was really no strong signal. Right now we are at or near the most attractive relative valuations this century. Want to hate on risk? You should go to the credit market first and not stocks. Thus we should also look to the credit market for where investor panic may come.

Economic Trend

We can't begin a discussion about whether we should take on market risk or not without considering the strength of the economy. The measure for the economy I use in the US and globally is the PMI (ISM in the US). It is coincident with the equity market, which is itself a leading indicator of GDP. The problem with GDP is it is lagging to begin with and then it is subject to revisions. For investors who are forward looking, it is essentially useless.

We started the year with PMI in decent shape but the expectation was a gradual decline lower this year. So far, in the US, the PMI has held up.

 Of course we also care not just about where this number is but where it is going. For this, I look to the internals of the ISM itself and compare the ratio of the new orders to inventories. If orders are coming in faster than inventories are being built, this is a good thing, right? Thus this ratio does have some mildly leading properties with the headline index. I also look at the regional Fed measures of activity. These also have some leading properties of national measures. Both are better this part month but both suggest there could still be some struggles ahead:

Next, I want to put in a few more charts but I won't put as much commentary. 

Leading indicators - good but rolling:

Chinese economy - bad but getting better:

Eurozone economy - good but weakening:

Finally, the US yield curve: not horrible but could clearly be better. However, given the Fed's distortion still of the 10 year part of the curve, I am still hesitant to put as much weight on this as it typically deserves, since the yield curve historically is the best predictor of recession. For now, I will say it is a yellow flag:

I do not want to spend a great deal of time on this section as we are all well aware of the abundant liquidity that has been in the system. However, this is coming out of the system. The question is how quickly it will. Monetary policy acts with a lag of about 12 months. The Fed has only started oh-so-slowly pulling some money out. There is still a good deal of cushion supporting the US economy. One negative is that emerging markets central banks have been tightening for about a year. Thus global liquidity is not as robust as it has been. However, the ECB and BOJ are still out there pulling their weight. For the time being, and this will change this year, financial conditions are still quite loose.

Velocity

Of course, as we saw post the GFC, abundant money means nothing if it is not making it's way into the economy. Using the Quantity Theory of Money (M*V=P*Y), if velocity is near zero, prices and output will also be near zero regardless of the money growth. Post Covid, it has been a different picture than post GFC. Velocity has been much better, some of which is because the Fed is going directly into the markets and not leaving this up to the banks, but partly because we are  seeing demand from companies and consumers to borrow money. This is a combination of opportunity but also the desire to lock in historically low rates. When I look at some of my measures that either proxy or lead the official velocity - C& I loans, mortgages, Small Biz optimism - they have been in a decent spot, much better than official measures of velocity. However, these measures are starting to roll over:

Economy and earnings

Why do I care so much about the economy? The economy drives earnings, earnings drive stocks, stocks are the leading risky asset. Soros understood this and it is core to his view of reflexivity. When times are good, it can be a virtuous circle. When times get bad, it can become a vicious cycle.

I will leave you with one last chart, showing the yoy change in ISM vs. the yoy change in S&P earnings. This will be the critical question we need to answer this year. Will the economy go into recession and bring earnings with it:

Pulling this all together, in the first part of the three body problem, the fundamentals, we see that the picture is still postive at this point in time. There are, though, many signals that suggest we will see a slowdown ahead. The question we must wonder is if this slowdown will lead to a recession or not. If so, earnings are materially at risk and so is the market. If not, and growth can hold together in the face of rapidly increasing food & energy prices, which could be a tax on growth. Overall, in the first of the three body problems, I will call the category as NEUTRAL but the risk right now is that it will become NEGATIVE and maybe sooner than we want to believe.

STAY VIGILANT