wknd notes: Faith, Cynicism, Skepticism

“Congratulations to NASA and everyone whose hard work made Perseverance’s historic landing possible,” said Joe Biden, pointing to Mars, an inhospitable planet that once supported oceans, lakes, a rich atmosphere, possibly life. “Today proved once again that with the power of science and American ingenuity, nothing is beyond the realm of possibility,” boasted our President, 14mm Texans without clean water, the state’s energy infrastructure frozen, failing, earth’s greatest nation one or two days away from hitting 500,000 pandemic deaths.

Overall: “Are we alone in this sort of vast cosmic desert, just flying through space, or is life much more common?” asked the mission’s scientist. “Does it just emerge whenever and wherever the conditions are ripe?” he continued. “We’re really on the verge of being able to potentially answer these enormous questions.” America’s nuclear-powered Perseverance approached the Martian surface travelling 12k mph. A few million lines of code controlled its descent. Tucked inside our rover was a small drone, awaiting its chance to test the alien atmosphere’s ability to sustain robotic flight. All of it truly a miracle. For the first 312,000 monotonous years of Homo Sapiens history, we dreamed of flight. Then in 400 BC someone in China flew a kite. 2303 years later, the Wright brothers flew a plane. In 1957 the Russians launched Sputnik. In 1969 Neil Armstrong stepped on the moon. Human discoveries and inventions stack, compound. The process quite naturally accelerates, so that we were far more capable of advancing in the 12yrs between 1957-1969 than in any prior period. The acceleration did not end there, it hastened, an upward arcing curve, destination unknown. And this leaves us to consider our advances in the 12yrs between the 2008 and 2020 crises. With ever-advancing power of discovery and invention, these years were not lost. We discovered the limit of monetary policy. It is an old technology, perhaps now obsolete, which may seem implausible to most. But when change accelerates along such a steep curve, an open mind is your greatest asset. The world transitioned to the cloud, connected humanity online. We invented blockchain technology. But perhaps most importantly, we turned technology inward, upon our primitive selves. Restructuring how we interact with reality so that there appears to no longer be a single truth. Just tribal networks. And this has politicized and divided us in ways that feel deeply unsettling. Dangerous, destructive. So it is also worth asking, in this vast cosmic desert, whether intelligent life ever makes it beyond this part of the curve?

Week-in-Review (expressed in YoY terms): Mon: US Holiday, Myanmar protests continue for 9th consecutive day, DJT acquitted (43 to 57), Ebola outbreak in Guinea, 7.3 mag earthquake in Japan, Auckland shut down after discovery of 3 COVID cases, extreme cold temperatures cause mass power outages in Texas, Japan 4Q GDP 3% QoQ (2.4%e), Singapore 4Q GDP -2.4% (-3.6%e), Eurozone IP -0.8% (-0.2%e), Israel CPI -0.4% (-0.6%e), S&P closed; Tue: China explores curbing rare earth exports to US, Kuroda says no radical change to asset purchases in upcoming March meeting, Bitcoin trades above 50k, US extends forbearance and foreclosure protections, France unemp 8% (9.1%e), EU 4Q GDP -5% (-5.1%e), US emp mfg 12.1 (6e), S&P -0.1%; Wed: Biden says “bigger is better” regarding stimulus bill, Draghi calls the euro “irreversible”, Trump says GOP senators will not win again if they support McConnell, Fed minutes showed not overly concerned about inflation, cold weather delays vaccination role out in parts of US, Pfizer vaccine has 92% efficacy after first dose (53% previously), Turkey CB unch, US life expectancy drops 1y (77.8) due to covid, UK CPI 1.4% (1.3%e), S.Africa CPI 3.3% (3.4%e), Canada CPI 1% (0.9%e), US PPI 1.7% (0.9%e), US ret sales 6% (1%e), S&P flat; Thur: China returns from Lunar New Year holiday, Facebook stops displaying news articles in Australia in response to bill, Rush Limbaugh dies, Keith Gill testifies to Congress re GameStop, ECB minutes suggest desire for lower real rates via higher inflation, Australia unemp 6.4% (6.5%e), Indonesia CB unch, Sweden CPIF 1.7% (1.6%e), US initial claims 861k (773k exp), US impt prices 0.9% (0.4%e), EU cons conf -14.8 (-15e), S&P -0.4%; Fri: Biden open to talks with Iran, G7 increased support for COVAX, Texas power restoration continues, US House of Reps condemn China and HK for human rights violations, Russia rejects Navalny appeal (unsurprising), US officially rejoins Paris Agreement, Japan CPI -0.6% (-0.7%e), UK cons conf -23 (-26e), UK ret sales -3.8% (2.7%e), solid Euro Area flash PMIs mfg 57.7 (54.3e), UK mfg PMI 54.9 (53.1e), US mfg PMI 58.5 (58.8e), S&P -0.2%.

Weekly Close: S&P 500 -0.7% and VIX +2.08 at +22.05. Nikkei +1.7%, Shanghai +1.1%, Euro Stoxx +0.2%, Bovespa -0.8%, MSCI World -0.4%, and MSCI Emerging +0.1%. USD rose +2.4% vs Mexico, +1.0% vs South Africa, +0.7% vs Indonesia, +0.6% vs Russia, +0.5% vs Yen, +0.2% vs Brazil, and flat vs Euro. USD fell -11.9% vs Bitcoin, -7.7% vs Ethereum, -2.0% vs Chile, -1.4% vs Australia, -1.2% vs Sterling, -1.0% vs Turkey, -0.6% vs Canada, -0.3% vs Sweden, -0.1% vs India, and flat vs China. Gold -2.3%, Silver -0.1%, Oil -1.2%, Copper +7.1%, Iron Ore +0.0%, Corn +0.9%. 5y5y inflation swaps (EU -6bps at 1.29%, US -7bps at 2.34%, JP -1bp at 0.24%, and UK -2bps at 3.59%). 2yr Notes flat at 0.11% and 10yr Notes +13bps at 1.34%.

YTD Equity Indexes (high-to-low): Russell +14.8% priced in US dollars, South Africa +14.3% priced in US dollars (+14.2% priced in rand), Turkey +12.6% priced in dollars (+5.7% priced in lira), HK +12.5% (+12.5%), UAE +11.8% (+11.8%), Taiwan +11.5% (+10.9%), Chile +11.3% (+10.7%), India +7.8% (+7.2%), Netherlands +7.8% (+8.6%), NASDAQ +7.7%, Sweden +7.6% (+8.7%), China +7.6% (+6.4%), Japan +7.1% (+9.4%), Canada +6.8% (+5.5%), Austria +6.7% (+8.1%), Korea +6.6% (+8.1%), Russia +5.8% (+5.1%), Australia +5.5% (+3.1%), UK +5.3% (+2.5%), Hungary +5.3% (+4.8%), Belgium +5.1% (+6%), S&P 500 +4%, Saudi Arabia +3.9% (+3.9%), Indonesia +3.8% (+4.2%), Poland +3.8% (+3%), Euro Stoxx 50 +3.7% (+4.5%), Norway +3.7% (+2.1%), Thailand +3.5% (+3.5%), Finland +3.4% (+4.7%), France +3.2% (+4%), Israel +3% (+4.8%), Italy +2.7% (+4.1%), Czech Republic +2.7% (+2.7%), Singapore +1.1% (+1.3%), Germany +0.7% (+2%), Spain +0.2% (+1%), Denmark +0% (+1.3%), Mexico -0.6% (+1.9%), Ireland -0.9% (-0.1%), Switzerland -1.5% (flat), New Zealand -2.6% (-4.1%), Malaysia -3.1% (-2.6%), Philippines -3.9% (-3%), Greece -4.2% (-3.4%), Brazil -4.7% (-0.5%), Venezuela -5% (+43.2%), Portugal -5.8% (-5%), Argentina -6% (-0.5%), Colombia -9.8% (-5.9%).

Artistry: “Markets are not that complicated in these moments,” said the CIO. “This is the endgame - we are entering the hyper speculation phase.” These markets are intellectually uninteresting. “Being contrarian, subtle, nuanced, none of that makes money in these kinds of markets,” he said. “The more nuanced you are intellectually, the less money you’re making.” It is as irresistible as it is unstable. “A healthy market has those who can see both sides of the trade, and they may differ in how they weigh the risks, but they acknowledge they exist.”

Artistry II: “Few people are equipped to trade these markets,” continued the same CIO. “Most believe that engineers prevail in finance, but there is a time in every cycle where you want your money managed by artists,” he said. “That is the liquidity-driven part of the cycle where bubbles develop and if you have the wrong mindset this can be a terrible time – for most people, this time in particular will be completely discombobulating.” The cojoining of monetary and fiscal policy combined with the political, social and technological changes underway have no precedent.

Artistry III: “What engineers tend to do in this part of the cycle is to try to structure safety,” explained the CIO. “Snowflake is trading at 50x revenue, so they convince themselves that buying some pre-IPO company at 30x revenue is safe,” he said. “That’s an illusion. Both companies should probably trade at 10x. So the engineer made a big illiquid trade to make 20%,” he said. “The engineer has effectively sold vol and taken on negative convexity, when he should be buying vol. The artist finds unique trades that can triple, and thus makes smaller, safer bets.”

GMO: The team at GMO publishes seven-year forecasts for annualized real returns. Some say they are too bearish and won’t ever be right. Those people tend to need +7% returns in perpetuity or else acknowledge they are insolvent. I admire GMO’s forecasting discipline and recognize that the more dramatically markets outperform historical norms in the near-term, the weaker their future real returns. Anyhow, GMO forecasts US Large Cap Equity 7yr average annual real returns to be -6.2%, US Small Cap Equity -7.9%, Int’l Large Cap -1.6%, Int’l Small Cap -0.6%, Emerging Market Equity -5.0%, Emerging Value Equity +5.0%, US Bonds -3.1%, Int’l Bonds Hedged -4.4%, Emerging Debt -1.1%, US Inflation Linked Bonds -3.6%, US Cash -0.8%.

Forecasts: What probability do you assign to the above forecasts being wildly wrong? Half wrong? Mostly right? Dead right? Well, the solvency of the US pension system requires that those forecasts be so wildly wrong that you must change their sign from negative to positive. That is mathematically impossible for bond returns – you’re not going to get a +1.34% 10year nominal yield to generate a +3.1% real return with the Fed determined to overshoot its +2% inflation target. Could you change the sign of US Large Cap Equity returns from GMO’s -6.2% forecast to +6.2%? Highly improbable, a terrible bet, but I suppose anything is possible.

Forecasts II: Policy makers are unwilling to allow negative nominal asset price returns, lest they spark a recessionary feedback loop and thus a deflationary spiral. They will ultimately resort to policies that generate material inflation, attempting to solve the dilemma via the money illusion. Digital asset prices are already front-running this policy. And in such a world, trend-following strategies will perform very well (these have started to run). Correlations will change. Factors will perform in ways that appear unusual. And equity sector dispersion will rise as politicians pick winners and losers, funded by historic deficits. The process is inherently unstable, volatile. 

Anecdote: “Faith, cynicism, skepticism,” said the CIO. “The faithful believe in something, cynics believe in nothing, skeptics find the balance,” he continued. “Western society was built on a foundation of healthy skepticism, and this is quite clearly being lost. It is easiest to observe in Washington which makes sense because the political costs of polarization in today’s world are declining,” he said. “We increasingly see that as people are drawn toward the cynical and faithful wings of the distribution, the cynics develop their own faith, and the faithful develop their own cynicism. And these passions amplify the tribal conflicts that divide us,” he said. “This is beginning to manifest in markets, which we are taught should be immune, rational. Having capital at risk forces one to be sober when considering the possible future states of the world, probabilities, market prices, risk versus reward,” he explained. “But then you see GameStop and the January 6th insurrection. They were the same phenomenon, the same pathology, manifesting in different ways, and each will have lasting consequences, tattooed in ink.” Shorting stocks will never be quite the same. And the radicalization of political protest has entered a new realm. “People don’t want to find common ground, they want to fight. People want to destroy the opposing premise. Go to a Reddit board and see what happens to someone who questions Tesla’s valuation,” he said. “This is spilling over into financial markets more broadly, in ways that fatten the bullish and bearish tails and will increase the frequency of wild outcomes,” he said. “Markets are beginning to take a new shape – driven by the amplification of faith and cynicism. It is ultimately terrible for society, but vital to see clearly if you must navigate markets. And we’re already starting to see things happen that not long ago were unimaginable.” 

Good luck out there,

Eric Peters

Chief Investment Officer

One River Asset Management           

Disclaimer: All characters and events contained herein are entirely fictional. Even those things that appear based on real people and actual events are products of the author’s imagination. Any similarity is merely coincidental. The numbers are unreliable. The statistics too. Consequently, this message does not contain any investment recommendation, advice, or solicitation of any sort for any product, fund or service. The views expressed are strictly those of the author, even if often times they are not actually views held by the author, or directly contradict those views genuinely held by the author. And the views may certainly differ from those of any firm or person that the author may advise, drink with, or otherwise be associated with. Lastly, any inappropriate language, innuendo or dark humor contained herein is not specifically intended to offend the reader. And besides, nothing could possibly be more offensive than the real-life actions of the inept policy makers, corrupt elected leaders and short, paranoid dictators who infest our little planet. Yet we suffer their indignities every day. Oh yeah, past performance is not indicative of future returns.