Sunday, February 21, 2021

A Crowding Theory to Explain the Trade of the Decade

Bold title, I know. Yet while there may be some hyperbole in it, we do face a situation in equity markets quite unlike anything we've seen since the dot-com tech bubble era. 

[Disclaimer: This is not investment advice because I don't know you. I am not analyzing your situation, your appropriateness or suitability for equity or any other investment idea, your goals, or your risk tolerance. This is an attempt to explain what I believe to be the valuation existent in the market today. Read at your own risk.]

I. The Trade of The Decade

Typically with tolerable variation equities are "cheap" or "expensive" at the same time. The Great Recession was a period where equities went on sale, so to speak, for those willing and able to bear the risk. You didn't have to be brilliant; you just had to be brave. Buying and holding throughout the deepest points of the downturn (roughly Oct 2008 - Mar 2009) was a rewarding investment. Make no mistake it was not easy to do this as for years after the market bottomed it still never felt quite safe, but that is what investors generally and equity investors specifically get rewarded for--buying when no one wants to. 

At least they should be rewarded for that. And the expected reward is the "risk premium"--the expected return over and above the return for a risk-free investment. Think of it simply as the premium you should expect to earn for bearing the risk. Every investment has one. Sometimes it is relatively high like for stocks in the early 2010s. Sometimes it is relatively low like for stocks in the late 1990s. That "relative" measure could be in relation to its own history alone, the position of that asset class compared to other asset classes, or both. Current market risk premiums are the foundation behind my hypothesis that a big opportunity/challenge is in front of equity investors today.

The "trade of the decade" I allude to is a relative trade. Unlike so many highly-touted trades in history, this one is fairly simple. I wish to briefly outline it without effectively proving it so as to get to the true purpose of this post: a hypothesized reason for the opportunity to exist in the first place. After all, I am a strong supporter of semi-strong efficient markets theory (EMH).

First, some assumptions:
  1. Markets are generally efficiently priced. This means all important known information is thoroughly and quickly incorporated into market prices. Therefore, an investor should not expect to be able to outperform the market. 
  2. Risk tolerance (degree of risk aversion) among investors and risk outlook (the economic picture going forward) determine risk premia. The world looked very scary in March 2020 and investors' general appetites for risk were substantially lower than usual. 
  3. Risk premiums today are generally low across all asset classes. A couple of ways to say this in everyday language are: equity returns going forward (next ten years) will be lower than what we have enjoyed historically especially in the last 11 years and interest rates look to be lower for longer (lower than historically and for longer than typically has been the case). Caveat: risk premiums can be low and returns look high and vice versa. I am being a bit casual with how I equate risk premiums and future returns as compared to history, but I believe the underlying point holds.
Here is the problem, opportunity, and challenge all rolled up into one. Today certain portions of the stock market look fairly expensive (high valuation) while other parts look fairly attractive (low valuation). To be more concrete about it the high/low valuations are in comparison to those specific equity subclasses' own history. However, adding to the puzzle the risk premia for those asset classes look typical for the expensive group while they likely are desirable for the attractive group. 

Even a sloppy reader at this point is growing quite frustrated by the fact that I haven't identified which groups of stocks I put into the expensive and attractive categories. That is intentional as I don't want that to be the takeaway from this post, but I will now relieve that frustration as long as you know I am NOT effectively proving my case. Take this too as assumption. 

From the perspective of valuation, large-cap stocks in the U.S. (especially growth-style stocks) are expensive compared to their own history. Small-cap stocks in the U.S. (especially value-style stocks) are cheap compared to their own history. International stocks (especially value-style stocks) are also cheap compared to their own history. One way to measure valuation is to look at the current market price compared to the earnings, the P/E ratio. The higher the ratio all else equal the more expensive the stock.

One of the best ways to see this is to look at long-term analyses of real (inflation-adjusted) price/earnings ratios. The most famous of these is Shiller's CAPE (cyclically-adjusted PE) for the S&P 500 index. 

We can then do very similar analysis on various other indices considering important subclasses to see how they compare to the S&P 500 (large-cap U.S. stocks). This analysis [summarized in the table below] is where we see these key differences. Namely, that the riskier areas of the stock market (value-style companies, smaller sized companies, international companies, et al.) look relatively inexpensive.

Risk premiums* [analysis and results not shown] both echo some of the valuation analysis as well as tell a bit of a different story. The risk premium for large U.S. stocks is near the median of where it has been over the last 15 or so years meaning that adjusted for risk these stocks look appropriately priced. The risk premium for small U.S. stocks is far above its own historical median meaning adjusted for risk these stocks look very low priced. To a lesser degree the same low price depiction can be ascribed to international value stocks. The risk premium for international growth stocks is more similar to large U.S. stocks (i.e., it is around its historic median). So we have a general range of stocks from those that look appropriately priced (safer stocks like large companies and growth-style companies) to those that still look attractively priced (riskier categories mentioned before).

The risk premium story is not as sanguine for large U.S. stocks as it may appear. Despite my assumption above that interest rates will remain low for a long time, they don't have to. And they can rise meaningfully above current levels and still be historically low. If they do rise, that will have a big impact on stock valuations. Large growth stocks in particular look very sensitive to this risk as their cash flows come far into the future. A rising interest rate means a rising discount rate applied to those cash flows, which reduces the current value of the stock.

The trade of the decade is to fade away from large U.S. stocks and increase exposure to small U.S. stocks (especially value) and international stocks (especially value). The most acute version of this is for large growth versus small value stocks in the U.S. Specifically we could identify indices like the Russell Top 200® Growth Index and compare it to indices like the Russell 2000® Value Index. The reason I call it the trade of the decade is because my more in-depth analysis focuses on 10-year expected returns and risk pricing as well as the fact that it might take a decade to fully play out. The reason you should heed caution before engaging in this trade is (1) this risk might not be for you (it indeed comes with risk not specified in this post) and (2) this is not an endorsement of reducing diversification (I still advocate exposure to large-growth stocks, etc.).

II. The Crowding Theory

IF I am correct about the different relative risk-adjusted valuations for various equity subclasses such as large growth stocks versus small value stocks, interesting questions emerge. How did this come to be? What explains it consistent with EMH?

I believe two crowding effects have brought this about. Flight to safety is the first crowding effect. Sophisticated money avoiding public equities is second. 

Recall my assumption that risk premia are determined by the general level of risk aversion among investors and the market's risk outlook. The tidal wave of the pandemic that unfolded gradually then suddenly from mid-January 2020 through to the market bottom of late March 2020 was a massive reevaluation of risk that triggered an extreme flight to safety. Note that it was not the entirety of the valuation dispersion between various groups of stocks. For some time now growth has been outperforming value, large has been outperforming small, and U.S. has been outperforming international. For U.S. equities the market's reaction to the pandemic was in fact the dominant portion of the differences we see today. 

From Vanguard: 

Difference in annualized total returns over rolling five-year periods

Difference in annualized total returns over rolling five-year periods

As the risks and worry of the pandemic grew, investors sought refuge in the safest of assets, U.S. Treasury securities. This lowered interest rates to nearly zero across the yield curve. They also derisked in other ways. For those who wanted continued equity exposer, they flocked to the safest equities in the world, large U.S. growth companies. The now much lower interest rate conditions worked in tandem to make these equities more and more attractive. The riskier aspects of the market suffered as investors tended to rotate away from them and into safety. 

So that is how risk premiums for various stocks got so extremely different, but why didn't sophisticated investors step in to absorb the difference? After all, they are supposed to have extremely long (infinite?) time horizons and not be subject to wild swings in risk. 

Sophisticated investors is a bit pejorative on my part. Here I am talking about the so-called "smart money" of institutional investors like endowments and pension funds. They like to think of themselves as cunning lions, but they bunch together like scared, vulnerable sheep. Theoretically, they should be a counterbalance to short-horizon investors who are theoretically much more sensitive to changes in risk appetite and risk conditions. 

For example, a person close to or recently entering retirement should be invested positionally to withstand the risk of market volatility. The same can be said of any investor--they should be so positioned. Yet often times they are not. And even more often they are liable to overreact to bad news leading them to drastically alter their investment positioning as an attempt to predict the future. However, I do not think this is a big effect. It is a behavioral story that isn't necessarily as irrational as it seems--extreme events like the Great Recession and COVID pandemic give us insights into our attitudes on risk tolerance not apparent before. 

At the same time the sophisticated investors themselves are subject to the same types of risk tolerance reevaluation. Rather, to be a counter-balance they need to be in the market. The reason why the “smart money” hasn’t absorbed all the excess risk premium in riskier aspects of the market already is because endowments and pensions have trended far from traditional public marketsEndowments have on average reduced their public market equity exposures by 50% in the past 50 years going from about 60% to less than 30%. They are crowding away from public equities making them unavailable to provide a counterweight. 

To be sure riskier assets have done well in the past few months--small-cap U.S. stocks were up 35% for the three months ending in January 2021. The primary catalyst were vaccine developments in November. Add to that improvement in our understanding of the true risks of the pandemic as well as rapidly improving economic fundamentals. Even still, risk premiums in risky assets (value, small cap, international stocks) are at elevated levels compared to their own history as well as their safer equity counterparts. 

As risk aversion gradually (and perhaps in sudden bursts) returns to normal levels and as the risk outlook continues to improve, my hypothesis is that those assets with outsized risk premiums will perform relatively well (high confidence) and absolutely well (moderate confidence). 

Incidentally while this bodes well for public risk assets, it likely portends poorly for alternatives (private equity, venture capital, hedge funds, et al.). That is a crowded space with not much low-hanging fruit, and what is there is very expensive to be had. 

*The reason I deliberately gloss over the risk premium results is the model I am referring to is proprietary, but more importantly the calculation of risk premia is art and science. Laden with assumptions, it can be very much argued over in fine detail. However, I believe the depiction above is well grounded and firmly supported by a wide range of reasonable underlying assumptions. For more on this topic see Research Affiliates work among many others. 

Thursday, February 18, 2021

It Depends . . .

One-dimensional thinking vs deeper-level thinking (AKA, solve for the equilibrium).

Considering this:One-dimensional thinking concludes:Deeper-level thinking concludes:
To arrive at a destinations sooner one should drive…FasterSlower
A risk-averse investor should consider taking on…Less market riskMore market risk
A successful salesperson…Knows how to get what she wantsKnows how to satisfy peoples’ needs
To increase revenues...Increase pricesLower prices or offer coupons
To reduce the damages of a dangerous vice...Prohibit itNormalize it
To better preserve competitive balance in sports leagues...Restrict player compensationLiberalize player compensation
To reduce the risk of gun violence there should be...More gun restrictionLess gun restriction
To change minds...Speak moreListen more
To increase the income of low-skilled workers...Enforce high minimum wages lawsLower or eliminate minimum wage laws
A satisfied restaurant customer...Cleans his plateLeaves some food uneaten
Basketball teams who shoot poorly (have a low percentage of shots that go in) should...Be highly selective with their shotsShoot the ball a lot more
To help the children who toil in child-labor manufacturing we should...Ban and boycott their productsBuy and enjoy their products

Sometimes the obvious is right, and fast thinking serves us well; sometimes the less obvious is right, and slow thinking serves us better.

Saturday, February 13, 2021

Biden O/U Performance Predictions

Admittedly I’m being too vague to be falsifiable, but set some agreeable terms, and I’m willing to bet (#MoneyWhereMyMouthIs #TaxOnBullshit). 

Here is a partial list of what I predict the Biden Administration's performance will be in a number of important areas. Specifically where will it outperform (Over) and where will it underperform (Under) the conventional wisdom’s current estimation. To be clear this is where it will be better/worse from my desired perspective than the conventional wisdom’s current estimation. 

For example, I think the conventional wisdom is that Biden will greatly raise personal and corporate income tax rates, increase capital gains tax rates, and restore the SALT deduction. Mostly all bad items from my perspective. I think it won't be as bad as assumed. Likewise, it is presumed that he will user in a much better world of trade and immigration policy. I think it meaningfully won't be that good. 

Environmental regulation
Other general business regulation
Minimum wage

Drug policy
Health regulation
Foreign policy (not including hot wars)
Police reform

On Target (bettingwise = no action):
War (actual hostilities)
Demagoguery and divisive politics

Wednesday, February 10, 2021

Fine Art Markets as Taxes on the Rich

I previously explored some of the many problems with art markets and art museums in particular. Let us now turn to the question of the art of taxing art.

The counter to the oft made accusation that lotteries are taxes on the poor might be that fine art is a tax on the rich. What better way for the rich the be relieved of their capital? 

Assuming the rich won't be investing it studiously, using their capital to purchase art at highly inflated prices is preferred to them spending it on goods and services with more tangible resource demands, and perhaps it is preferred to them giving it away to charity. If we don't trust them to invest it well, why would we trust them to donate it any better. 

Of course, we have to think this through. Doesn’t somebody end up using the funds to purchase consumption? Likely in many cases, but as long as they are operating in a closed system (I buy your painting, you buy my sculpture), this needn’t be the case. 

And all the better if the art is fake. Turns out a lot of the art in museums is fake (perhaps +5%), and all the players in the art world are on the take to keep this a secret. If the rich are swapping art at inflated prices that isn't actually authentic art, we have them well occupied spending their wealth, potential demands on resources, on a minimal amount of actual resources. Listen to Michael Lewis' The Hand of Leonardo for more on this. 

Yes, it would push resources into pursuing production/creation of fine art (too many painters and sculptors) but is this really so bad at the margin? 

How should we actually tax it? Tax deductibility for donations to museums is problematic. If I give up a non-income producing asset, why should I necessarily avoid an income tax? And if I give it to an entity exempt from income tax, this is doubly problematic. Should we separate fine art from collectibles (wine vs paintings vs classic cars vs musical instruments, etc.) with the ultimate distinction being those that are value-holding assets (similar to precious metals) versus those that are consumption assets? How much of each quality does a piece of art possess and who decides? This gets pretty fraught pretty quickly. Back to Michael Lewis' podcast above, the compromised ref is very much at risk.

Should we exclude art and collectibles transactions under a consumption tax such as a VAT or national sales tax? These activities aren’t significant resource consumptions. All else equal we want to encourage this swapping as opposed to the funds being spent on actual resources.

If you tax something, you get less of it. My principal is to tax the use of resources and not the creation of resources. A consumption tax does this, but items like art pose problems. Unlike pure capital assets (stocks and bonds for example), collectibles have consumption value and use resources. It looks to me at first glance that most VAT systems distinguish between individuals and firms with only the later subject to the VAT. This makes sense and probably preserves my secondary idea of not unnecessarily discouraging the rich from "taxing" themselves through art.

P.S. Also, see this interesting report.

The Trouble with Art Museums

A few years ago I had the pleasure of visiting the Barnes Foundation art museum in Philadelphia. It is extraordinary, and I highly recommend it. The history of this art collection and why it is where it is today is very interesting. And that's where the trouble begins.

Supposedly, the art collection is worth $25 billion! Wow, that's a big number. If your first thought upon hearing that is, "how would we know?", you are thinking like an economist.

If the museum burned to the ground losing all the art inside, would the loss to society actually be $25 billion? How would we know? Without robust and recent market transactions, we wouldn't. Yet that is just the beginning of the problem. 

The reason the art is in its current location is because in the 1990s the foundation was in financial trouble. One solution was to take some of the art on a world tour and then move the collection, the Barnes, to Philly. Maybe I'm just na├»ve or cynical, but things worth $25 billion aren't that hard to cash flow normally. 

The foundation raised about $150 million dollars to relocate a few miles into Philly from Merion Station, PA building a new facility and presumably using the remainder as an on-going endowment for maintenance. While there are many minor points to reconcile in all the legal and financial battle involving the move, there is a bigger point I'd like to make. Admission to the museum is at most $25. What's more, capacity is very limited--it is a relatively small space with limited hours of operation. At $25 billion in value why isn't there a line out the door and/or a very high-priced secondary market for tickets? Seems like a steal. Well, it is part of the art market; therefore, it probably is . . . just not in the way my questions would indicate. 

The art world is not designed--no system this involved ever is. It is the result of an emergent evolution. The spontaneous order that created it and drives it is not entirely or even largely benign. It is the result of a series of intentional manipulations and unintentional consequences from private, selfish, and in some cases socially-negative ulterior motives. Art museums aren't about public access to refined artistic culture. 

Allow me to begin the disillusionment with an excellent EconTalk, Michael O'Hare on Art Museums. The most forbidden thing an art museum can do is sell any of its collection. Even if it means some art will never be seen, it is somehow better that it stay in cold storage than be sullied by commercial activity. For the short version on why, see this episode of Adam Ruins Everything. For the longer version, see this article from Quartz

Value is like water--it seeks its own level. Interferences with this natural process can be expensive and often are resource destructive. One version of this is politically powerful people, who are otherwise unwilling to put their money where their advocacy mouth is, working to stop market transactions. Consider also cases like when the city of Detroit's bankruptcy reorganization had creditors pursuing the collection at the Detroit Institute of Art

This is the kind of example where preventing "priceless" collections from being sold or commercialized might mean very hard choices for governments facing enormous pension liabilities. If those assets are off limits, there are two big problems. The first is how the liability problem gets solved once a great option (selling off valuable assets) is removed. The second is how well can that same entity be a good steward for the art. They have already gotten themselves into financial difficulty, and now they are additionally constrained by having to at least store the art. 

I enjoy art museums generally and some in particular. The idea of art museums is something I support in theory, but in practice it has become rather fraught with very undesirable aspects. The pretentiousness is not just a bug. It is a feature of a bigger bug. Art museums are about exclusion despite the conventional marketing otherwise. Perhaps they are simply fancy, tax-favored institutions for hoarders? Malcolm Gladwell's Revisionist History makes the case in two episodes

Speaking of taxes, that is yet another troubling aspect of the art market with museums playing a key role. I'll explore that in the next post

Friday, February 5, 2021

One-Two Punch, or . . .

. . . How to go down for the count.

Let's make a boxing analogy for "appropriate" humor: Know your sparring partner; know when it is the real match; there are rules (no below the belt, but the belt moves); stay in your weight class. 

I post this in reflection upon the recent blow up of a comedic tweet by Niskanen Center's now former vice president Will Wilkinson. 

As one who has always been very comedic, I both identify with and fear hitting below the belt. I’ve done it, and I have fortunately always been forgiven when it mattered. I also identify with and fear what got Wilkinson into trouble--not knowing when it was a real match. In other words making a joke in the "wrong" way at the "wrong" time. I use the scare quotes because I've never been big on this concept. It is "wrong" because you the audience (intended audience or accidental audience) didn't like it. 

I am ambivalent on the idea that an honest attempt at humor is wrong. I don't want to offend people, but I know it will have to happen from time to time as both a risk of comedy (and serious argument) and because everyone at one time or another is overly sensitive (or hears things the wrong way). In truth I agree with Scott Sumner that there are no offensive jokes. So my views are simultaneously: I am sorry you have taken offense and Too. Fucking. Bad. 

To one degree or another grown-up comedy (not necessarily “adult” but certainly mature in the sense of developed and sophisticated) makes the audience uncomfortable. The other elements of comedy (surprise and irreverence) are at play here too in that comedy has to push boundaries or it is too childish to be considered “grown up”.

Time and place are tricky, though. Elon Musk has been very active on Twitter either joking or promoting (or both) the GameStop, et al. and Dogecoin trades. Is he humorously trolling? Should he be? 

This is a thorny issue. He uses Twitter to promote serious ideas including his public company. People look to him as an authority figure. We know we lose context and tone in email. That shortcoming is often taken too eleven when on Twitter. Maybe what he is doing is going over my head, and I should see rule #3 below. Regardless, he is an adult speaking to adults . . . yes, rule #3 indeed.

A healthy society allows mistakes. Actually it embraces them knowing they are a cost of progress. If a comedian cannot bomb, he cannot ever entertain. 

Here are two rules we as the audience should follow:
  1. Assume good intent.
  2. Accept sincere apology.
  3. When offended, get over it. - if for no other reason, your own happiness
So back to Wilkinson. His comedic attempt was ruled a mistake by Niskanen who didn't accept apology. We don't live in a world where my rules above are followed. Rather we live in what Arnold Kling calls a Zero Tolerance Culture. And as Jason Brennan perfectly points out, this is a cancel culture with glaring hypocrisy. 

Knock knock
Who's there?
Boo who?
Why you cryin'? It's just a joke.

Wednesday, February 3, 2021

A rose by any other name...

Partial list of things as they really are (these are not all original to me):
  • Universities are hedge funds that run research labs and have football teams. 
  • Fast food companies are real estate firms with kitchens. 
  • Democracies are insurance companies with armies. 
  • Public (government) schools are unions that run day care centers. 
  • Police departments are unions that run protection rackets. 
  • Banks are time-travel machines for assets that tax uncertainty. 
  • Home Ownership is tax-sheltered/favored investment masquerading as industrious virtue. 
  • Public libraries are intellectual social status symbols with warehouses. 
  • Churches are mutual-aid societies that offer moral guidance and tribal solidarity.