The most remarkable thing about Europe is that, as we posted last week, trying to get something positive out of the Eurocrats is impossible. What is sadder still is that throughout the whole of the crisis TMM have not felt such a level of resignation that the Eurozone is about to collapse. This morning the number of folks leaving the stadium thinking it’s all over is at stampede levels. Whether they are right or they are wrong is immaterial at the moment the crush can still kill. Now if you are listening, dear Eurocrats, we are at the point where even YOUR ivory towers are cracking. So how about you do something to restore a little CONFIDENCE? Because that is all it will take to stop this unwind of leverage that is causing all classic money multipliers to dry up within the zone and which you seem so adamant not to compensate with policy change. Though last spring was and then last summer was, NOW is the time for action.
TMM think that’s all we can do really as our bit to make things better. A couple of years back we adopted the ethos of only worrying about things we could change, which actually led to a less depressing life and a new liberation. So, despite the deafening roar of icebergs against hulls, we are going to look at something else to try and take our minds off it.
TMM thought it would be worth discussing some other stuff – namely equity correlation and its cousin, dispersion. One of the sustained features of this crisis is high volatility (both realized and implied) leading to progressively higher levels of equity correlation which makes trading individual stocks much less rewarding. If you regressed the returns of individual S&P equities over the last few years as such:
Return =β*S&P Return + β*Sector Return+residual
You’d probably find that the R-squared or predictive capacity of this regression was strong to quite strong – and probably a lot more strong than in the period prior to 2006. This poses a couple of obvious questions:
- Why bother doing any work on individual stocks if its all RORO and sector risk
- Why bother paying CEOs squillions when their value add seems utterly indifferent between one another?
So when there really isn’t much dispersion to speak of the stuff worth fighting over is macro – spreadsheets, cash flow models and sensitivity tables can take a hike. Its all positioning, economics, and broad based sector sensitivities. This likely explains why some very large funds have done very well over the last few years – the richest pickings have been in things that trade a lazy few billion a day and thus its possible to be very big indeed without being too big (or too weird) for the market.
Volatility and correlation have moved in lockstep and trended higher, arguably since 2007:
There is a pretty clear reason for this and that is that most of the aggregate risk out there is systematic in nature. Back in the 80s or 90s you might have worried about the likes of Microsoft eating your lunch, today the larger concern for corporate is a wholesale breakdown in the banking system, sovereign credit, or the like. Basically, trading DM is like trading EM used to be because like EM did back then DM has a leverage problem.
TMM think that following some – any - resolution of the Euro Crisis that is about to change. Why? Because while deleveraging is continuing, it is slowing in the US and there is a lot of noise - and one letter in Caixin - calling for normalization of interest rate policy in China. Once Europe falls into line (possibly with a few members dropping out) the new reality will be priced in and we can get over crisis phobia and move onto the mediocrity of cyclical growth. Not to mention that most Central Bankers worth their salt know that, “yeah, you know, we probably should keep an eye on that stuff” with the notable exception of the completely discredited JCT/Greenspan faction. To that end the tsunamis of macro volatility are going to get progressively less forceful and micro forces will reign.
This can only mean one thing: TMM are going to have to spend more time talking about industry or intra-industry macro rather than good ol’ Indices-Govvies-FX macro. And that means that the big gains will be made out of disruptive business models and technology – largely the latter combined with the former. You couldn’t manage the resurgence of the horse and buggy in the 1920s if you tried but great tech works best when married with great design as the late Steve Jobs showed on a few occasions. To that end what is TMM looking at?
Consumer: So banal it barely merits a mention but suffice to say if your 15 year old daughter buys everything online guess what – in 20 years high street is going to be gutted. TMM think that longer term physical retail franchises are going to struggle vs online stores in the Amazon fulfillment chain.
REITS and Property: On a related point if high street gets demolished then we will need a lot more warehouse and logistics centres but not much in the way of retail malls.
Energy: Two stylized facts about energy generation have held for some time. One is that the bigger you go the lower your capital costs and cash costs. The second is that coal (and high carbon emissions) are cheapest and best. TMM think this is unraveling fast, firstly due to super-efficient combined cycle gas turbines but perhaps even more so due to the efforts of Bloom Energy. Solar is getting a nice run based upon how cheap it is getting but distributed and scalable gas generation from solid oxide fuel cells is getting pretty silly cheap too.
This poses another really tricky question: if you look at retail power prices for most places the $/kWh bakes in a lot of maintenance capital expenditure on power lines, cables etc. But what happens when power usage starts to go off a cliff because major point users of power go for their own production on site? Well, you get the Bloomberg subscription model problem: as people get fired, you have ot charge more per subscription to get cover your fixed costs. And that to TMM makes grid companies and the conventional grid sound like things that could be due for a major shakeup. Utilities as defensive? TMM are not so sure in the longer term, and it’s that kind of “she’ll be right mate” complacency that is the source of the worst portfolio management accidents.
Finance: If everything gets moved onto exchanges by regulators, what would Interactivebrokers not be able to do better than most investment banks? Indeed.
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