Discover more from Entropy Capital
Or why markets can remain irrational longer than you can stay solvent
I remember some of my postgrad lectures on Sidwick Avenue, where I would remain relatively conscious by fixating on the ubiquitous Keynes portrait, a fixture in most rooms of the Economics department, thinking about anything and everything except about the subject presented.
Keynes’ work or Keynesian Economics and its subsequent offshoots are at the very core of how western governments exercise monetary policy, using interest rates as an instrument and definitely at the forefront in recessions like the one we are in now.
There has been a long detour to neo-liberal policies but post the 2008 crisis, the Keynesian approach has been at the forefront of policymaker thinking even if it has been baptised something else for political marketing reasons.
“I guess everyone’s a Keynesian in the foxhole”
It would be a massive understatement to pronounce his work as merely “influential”; however given he is relatively obscure for many, the following is a good summary.
“The ideas of economists and political philosophers, both when they are right and when they are wrong are more powerful than is commonly understood. Indeed, the world is ruled by little else. Practical men who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back”
-J. M. Keynes
I am not going to make any suggestions about who the “Madmen in authority” may be right now but I would suggest anyone with more time on their hands (and not traumatised by endless lectures on the subject) to actually give it a try to read more of the man’s work or a book about him as it is relevant as ever in understanding the great global economic cycles that govern our lives far more than any politician would like you to believe. While you are stuck at home, you might as well throw in a bit of Thucydides for the geopolitical angle around the pandemic - but more of that on a future post.
Mr Keynes, or JM for short, was not only a brilliant economist but also an active speculator. His wealth was wiped out in the great crash of 1929 (which he did not foresee) but soon he recovered by trading on margin various financial assets, currencies and commodities. He was a believer that market price discovery is not always perfect (you can say that again JM) and he understood very clearly what the role of the speculator was. It wasn’t to understand a theoretical “fair value” but rather understand the positioning and thought process of the herd, to either follow it (trend following) or to trade against it (mean reversion). Or in other words “Successful investing is anticipating the anticipations of others.”
“Professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view. It is not a case of choosing those which, to the best of one's judgement are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees.”
-J. M. Keynes
Furthermore, he posited that when markets suffer big shocks, they don’t automatically self-correct quickly, but instead deflate slowly like a leaky balloon as demand dries up. In the face of massive uncertainly following a big shock, consumers and businesses refrain from spending until the proverbial dust settles. Let’s add fear of an invisible enemy to the 2020 remake of that movie.
What can we learn from these two observations in light of last week’s substantial “bull market” run ?
Any link of current market prices, especially in equities and junk credit, may or may not reflect a correct evaluation of their fair value. I believe participants are in a state of denial about the state of the economy, however it can be argued that the market as a whole is simply anticipating a rapid V-shape recovery. That anticipation, together with the daily barrage of news of the Fed buying an ever increasing amount of assets has put a short term floor and provided a great deal of hope to many.
Is that enough ? Will we see daily queues of people packed outside Starbucks to buy 5-10 dollar coffees next month ? Will people pack like sardines for that budget airline holiday away (luggage mot included, 14 day quarantine possible on arrival) anytime soon ? What about those 20 million unemployed only in the US ? You can ask any number of questions reflecting on your own personal and work experience. I have discussed this briefly in my previous post.
Suffice to say, anticipating there is a good chance of another leg down gives us all an opportunity to rebalance. And anticipating that a lot of investors anticipate a leg down means we can trade further out in asset space for when solvency may be an issue.
What about solvency ? Well, liquidity crises, even when well contained short term by massive money printing, have a bad habit of becoming solvency crises. Until consumers can see the personal benefit of the ballooning central bank balance sheets and as long as the virus is on the loose, demand will remain very low. And that reduced demand will soon mean even the best of balance sheets will suffer a lot. And for the worse balance sheets this crisis will eventually mean insolvency.
Equities: A test of the previous bull market channel is imminent . A failure round 2800-2850 on SP500 would mark the start of another leg down of deflating prices. A solid and sustained move inside the channel to 3000 may be an opportunity to short, especially if driven by short term optimism on crude supply deal (which won’t solve the demand side). In terms of rebalance, value names ETFs like DVP, VLUE, IWN are interesting. Infrastructure names like 3IN a bit lower circa 200p are good value. Simply too many trades to mention here.
Fixed Income: The rally has been impressive, especially in CCC names after the Fed announced that they will buy junk credit. In light of the “liquidity problems becoming solvency problems” narrative avoid CCC. Buy cheap securities that however won’t have bankruptcy as a possibility in a prolonged recession. That means the majority of exposure above BBB and avoiding high consumer exposure names. If there is a pullback to reality (sub 120) on LQD, given the effective backstop to BlackRock by the Fed it becomes interesting.
Convertible Bonds: Twitter 1.5% 2021 converts given the cash position of the company and its pre-eminent position for instant news dissemination during this crisis look interesting. Again too many opportunities to mention here.
Silver: The next commodity to rally after gold - good level to start nibbling.
Alternative Investments: Suffice to say for now the vast majority of hedge funds showed once again they do not hedge anything significant and cannot be seen as providing any significant risk mitigation value. With some exceptions … to be explored fully soon.
Going back to JM, it is is interesting to read an essay he wrote in the last century about life in what is now for the the near future, 2030. In his essay “Economic Possibilities for Our Grandchildren” (free PDF here) he gave a hopeful vision that warrants a quick re-read. Remember this was written 90 years ago just as the Great Depression of ‘29 was starting.
I will just quote some sections; my hope still remains that this crisis will create a better future for all of us, not in 100 years but on the next decade.
We are suffering just now from a bad attack of economic pessimism. It is common to hear people say that the epoch of enormous economic progress which characterised the nineteenth century is over; that the rapid improvement in the standard of life is now going to slow down --at any rate in Great Britain; that a decline in prosperity is more likely than an improvement in the decade which lies ahead of us. I believe that this is a wildly mistaken interpretation of what is happening to us. We are suffering, not from the rheumatics of old age, but from the growing-pains of over-rapid changes, from the painfulness of readjustment between one economic period and another.
We are being afflicted with a new disease of which some readers may not yet have heard the name, but of which they will hear a great deal in the years to come--namely, technological unemployment. This means unemployment due to our discovery of means of economising the use of labour outrunning the pace at which we can find new uses for labour.
The love of money as a possession — as distinguished from the love of money as a means to the enjoyments and realities of life — will be recognised for what it is, a somewhat disgusting morbidity, one of those semi-criminal, semi-pathological propensities which one hands over with a shudder to the specialists in mental disease.
Happy to answer your questions and hear suggestions for subjects to explore. I sometimes post quick markets commentary on Twitter and some markets ideas on TradingView. Feel free to connect with me on LinkedIn.
In these times of uncertainty I am happy to offer all my newsletter subscribers free private 30 min consulting sessions on their portfolios & strategies. Not investment advice but rather strategy building. You can book a slot on my calendar here. I will keep this option open till the end of April.
If you find this newsletter useful or interesting, and want to show your appreciation, the best way to do that would be to sign up, share it on your social media, or forward it to someone you think might get some value out of it.