2015 Market Insights.
I’ve been sending newsletters for Odin River since March of 2015.
Some have requested that I share some of the thinking publicly, so below are the “Markets” sections of the newsletter for 2015.
I plan to make the entire newsletters public at some point in the future as well as share our real-time thinking transparently (as I have for years on Twitter, here on Medium and at ParanoidBull before that).
As expected when we entered 2015, this year marked the top of the Credit Cycle and the beginning of the Contraction. The markets have played out very much as we expected this year with December marking a return of volatility, contracting credit markets and weak equity markets that began earlier in the year.
As a reminder: Odin River is a philosophy about Progress through Cycles.
Progress is Inevitable, but Cycles Matter.
Since the 1990’s (perhaps before) the most important price driver for securities markets has been the Credit Cycle as this has dictated price performance across asset classes. Now that we are in the 7th year following the last Contraction, it is natural that prices are falling again. Distressed credit markets are down ~40% YTD (Altman-Kuehne Index) and default rates are rising. U.S. Equity markets were down slightly and would have been down significantly if it weren’t for a handful of high-growth technology companies.
In 2016, we expect this to worsen and that a deep decline in equity prices could occur at any time but likely before the end of this year as the Contraction picks up speed. Now that the Fed has begun tightening monetary conditions, the Contraction process should gain momentum. It is possible that the decline could be delayed until 2017, but this would be the outside limit of when we expect the Contraction to accelerate given the already weakened state of the markets as we exit 2015.
Falling credit markets combined with little to no earnings growth, collapsing commodity markets and the resultant squeeze from real money allocators makes any upside unlikely. If anything there is more downside than upside risk at this point.
As Odin River letters have repeatedly emphasized since the summer: taking any equity market risk at this juncture is dangerous, and we continue to recommend net neutral to net short positioning. Cash is also a fine asset to hold when markets are in a precarious state like they are today.
The price declines occurring in Credit and Equity markets should cause securities prices across all markets and stages of companies to fall, and we have already seen the beginnings of this as even many so-called early stage technology “Unicorns” have already suffered mark-to-market declines in price.
Of course, these declines will be temporary for many securities and will represent a buying opportunity. We look forward to purchasing securities of private technology companies at Distressed prices in the coming years.
As we’ve been saying in these letters since they began: although Progress is inevitable and the best days lie far ahead, Cycles matter. What is unsustainable will not be sustained and prices don’t just go straight up.
The tension between the long-term inevitability of themes like Equality, Justice and Wellness and the fact that prices will decline as the credit cycle contracts is becoming more evident everyday.
The most important factor for the prices of securities for the last decade has been the Credit Cycle. Today it is becoming increasingly clear that the top of the credit cycle is now behind us. Defaulted debt securities have traded down more than 22% through October (according to the Altman-Kuehne Index). Commodity markets have continued to decline globally. Corporate earnings and revenues are in negative growth territory across the board, with the major exception being extraordinary companies like Amazon, Google, Twitter and others that will continue to grow even as the cycle turns. Progress means that even as old ways disappear, new ways will continue to succeed.
As the distressed credit markets have continued to contract throughout the year, we have seen cracks beginning to emerge as expected in the “Unicorn” part of the private markets with valuations being marked down, IPOs occurring below private market pricing and certain deals being delayed. This should continue and worsen as the cycle turns.
Timing is hard. My base case assumption heading into 2015 was we were nearing the top of this credit cycle and the contraction, or downcycle, would begin sometime in the next 18–24 months as defaults began and accelerated. Throughout the year, as volatility increased leading to declines across most asset classes, I thought that this cycle might be different and equity markets might actually be the catalyst for the contraction in credit markets. October seemed to reduce the probability of that scenario.
Although the markets have rallied in October on the backs of continued stimulus in Europe and China as well as subsiding fears of a deep sell off in U.S. equities, fundamentals have not changed. The reality is that cycles exist, defaults will occur, volatility has begun to reemerge, and risk has been underpriced for half a decade.
To be clear: significant declines across asset classes could begin at any time — we learned as much in Q3. Defaults have already begun in commodity markets, and they will only increase from here. Given the large commodity exposures of many emerging market economies the losses from these weakening end markets could become quite large over time. Furthermore the unsustainable nature of zero interest rate policy is evident and ending soon.
We have seen other signs of the cycle turning in the recent declines in valuations quoted for late stage private companies, aka “Unicorns”. Furthermore many well respected venture capitalists have now openly questioned the so-called “Unicorn” valuations occurring in late stage private companies today.
This has materialized in many ways, some of which make the stomach turn. As Michael Moritz of Sequoia put it: “a good number (of Unicorns) seem the flimsiest of edifices… for the past three or four years private investors have just been more forgiving than their public market counterparts…eventually there is no place to hide.”
Losses across asset classes will be substantial when the downcycle begins. That’s how it works. I continue to recommend net neutral or net short positioning.
But the great thing is: Progress is inevitable. And themes like Equality, Justice and Wellness are beginning to emerge and will continue to reveal themselves in time.
The turn in the cycle and the failure of old ways creates the space for innovation to happen. Many old ways that were propped up by the government after the last cycle shouldn’t exist anymore. This applies to every industry, but it is especially evident in financial services.
Whether in considering the long only mutual fund industry which lacks flexibility, the wealth management industry which lacks fiduciary duty, allocators who use style boxes that overly simplify the challenge of alpha generation — there are many aspects of investment management which seem outmoded. These legacy practices are also driven by the fact that career preservation creates a strong incentive to be more imitative than innovative.
These and other realities are residuals of a system that tried to replace itself in 2008. When the government intervened to save the large institutions, it meant that old styles of operating in giant institutions were preserved.
That said, innovation has also accelerated in financial services — from crowdfunding to Bitcoin to alternative lending. Venture capital funding for financial technology companies is at record levels and will only grow from here.
The future will be transparent, accessible and more equal. This is inevitable in finance just as it is in media, education and healthcare.
It is simple. Information costs fall in time, so it becomes more accessible. Miniaturization leads to mobile devices in people’s hands. Cloud computing and the penetration of high speed data leads to global access. These forces combine to produce services that are more democratized.
Financial businesses are the most scalable and digitizable businesses in the world — so they too will become more democratized. It is only a matter of time.
Checkmate. That is what Janet Yellen conceded in the most recent Fed Meeting. From many observers’ perspectives, it would have been rational for the Fed to “lift off” by raising rates; but she knew that doing so would crush the already weakening financial markets. By introducing an entirely new concept — looking abroad (to China) — the Federal Reserve chairwoman conceded that our domestic capital markets are outside of the control of the Fed.
The Fed threw away 6 years of carefully crafted language and methodology and in doing so, conceded defeat. The credit cycle is turning, and they are trying to stop it by changing their tune.
Think about that: what started as a grand experiment in 2008 has run its course. The theory was that central bankers could control global capital markets and save the system from risk. And it worked…for awhile.
But these things have side effects. Good and bad. Unicorns and bloat.
The U.S. Economy recovered. The wealth that was evaporated in 2008 was recreated. Prices rose. People are happier. Unemployment fell. Innovation accelerated. Underwater mortgages were healed through rising prices. Construction boomed. Art prices soared.
And yet: global debt levels are at all time highs. Prices for many asset classes have blown past previous peaks. Leverage at the government level has become stretched globally. Excesses abound in cranes along skylines. And the dichotomy between the rich and the poor has been exacerbated.
And now…risk has begun to reemerge in the system. What started with commodities, then oil, then the Swiss franc, then German bunds, then China has finally hit home in U.S. Credit and Equity markets.
From here the path forward is fairly straightforward: credit risk will continue to heighten until defaults begin to cascade to magnitudes on the order of trillions at which point the global capital markets will suffer significant collapses in prices. This process of contraction is underway and the only question now remains timing.
By not raising rates, the Fed might have prevented what seemed like an increasingly probable scenario coming out of August: that U.S. Equities would actually lead credit down this cycle. However this scenario remains entirely possible and even likely given weakening earnings and fundamentals.
As continuing weakness emerges in China (auto-sales for Q3 were revised down 5%, Japanese imports fell 8%, etc), this will cause fundamentals to weaken further. Automotive is already under pressure (which was exacerbated by VW’s fiasco); but this weakness will spread to industries like semiconductors and chemicals which have automotive as a key end market. This ignores the plummeting commodity markets across the globe.
Being long equity or credit market risk at this point is irresponsible. I continue to encourage people to hold cash and or to run a long-short strategy with net neutral to net short exposure like the one I’ve discussed with many of you.
The key message is: be careful. This is no time for greed.
The markets have entered truly treacherous waters in the last month.
As we’ve noted since beginning these letters in March, the easy expansion phase of the Cycle ended late last year, and throughout 2015 risk has begun to reemerge across capital markets globally.
What began with a commodity sell off last year, moved to European sovereign markets and then progressed to China where the equity markets have been driven to extremes.
This month the risk finally made its way to what had been the remaining safe area of the markets: U.S. Equities.
Last Monday, the Nasdaq was down over 10% within a few minutes of opening.
Think about that.
What this demonstrated is the undeniably precarious state of the current financial market conditions.
We now believe the credit contraction that we have been expecting to occur in the next 12–18 months could occur at any time.
It also seems possible and perhaps likely that what will happen this cycle is that the equity markets will lead rather than follow the credit markets and economic fundamentals. In other words, the catalyst for the oncoming downcycle might have already begun with last week’s vulnerability, and the next shock to the equity markets might come any time and be the catalyst for a contraction in the credit markets.
When this contraction occurs the prices of everything levered to credit, including equities, private securities, real estate, and other assets will collapse. And these collapses could be quite dramatic.
Our best guess is that equity prices and credit prices will both collapse at the same time, which is particularly troubling for those who have embraced the common wisdom that so-called “passive investing” is a safe thing to do.
If the expected scenario plays out, the many people who have spent the years following the last cycle accumulating wealth will have it wiped out.
There sadly are no easy options for avoiding this contraction, and for most people avoiding securities entirely is likely the right approach. Otherwise running a net neutral to net short hedge fund strategy like the one we’ve discussed with many of you is the best alternative in today’s environment.
The main message is: be careful.
Fortunately, in the long term Progress is inevitable, so innovation won’t stop. If anything it might pick up as the old guard gets swept away. Thus, we are excited with our narrow focus complemented with a complete avoidance of any long securities exposure elsewhere in the capital markets.
We can’t help but continue to monitor and share observations about the markets and the cycle more broadly, so please expect similar updates here and in other forums going forward. And as a market geek at heart, I’m open at any time to share our thinking privately or publicly.
It has been crystal clear since late last year that we are nearing the end of the credit expansion that began in 2009. This cycle’s end has already been violent and will continue to be so as it turns into a contraction in the coming months and years.
This cycle has been driven by extreme government interventions in markets globally. This month was no exception as we’ve reached the point of absurdity. Absurdity or Irrationality are signs of the cycle being beyond the point of sustainability.
Between the public brinksmanship around the “Grexit” to the direct interventions of the central bank in Chinese equities; governments globally have been responsible for driving markets to continued highs in the last few weeks.
We never believed the Grexit was a real possibility as we believe Reason trumps Emotion when hundreds of billions of dollars are on the line. However the public display of the tensions within the Eurozone — especially between Germany, Italy and France — was confirmation that the foundations of that “union” are precarious at best. Much like the U.S. Housing market was built on a shaky foundation of bad consumer credit: the Eurozone financial system is built on a toxic combination of unsustainable basics (the lack of independent Monetary and Fiscal policies in divergent economies) with a History and present of deep cultural and political differences. We continue to believe the most likely catalyst for a large credit event this cycle will emerge through a political fight in this region — most likely in Italy. We are following the timing of upcoming elections and the underlying dynamics of the countries and exposures involved to ensure we are not caught flat footed.
What happened in China in recent months was like 1999 only it ended with a more surreal intervention than the Fed in 2008. For a Government to force people to buy equity market risk is truly beyond the pale.
Think about it: the market literally just exhibited how dangerous it is; and yet the government was so scared about the implications of further losses they concluded that forcing companies and employees to hold risk was less dangerous than the alternative. This either means the government is stupid (unlikely) or they surmised they are in a “damned if you do, damned if you don’t” situation. Let the stock market tank, in which case the transition to a free market economy fails; OR intervene in the stock market in which case the free market truly doesn’t exist.
The implications of what is happening in China are profound and unknowable.
However, what we observe is that since the collapse and intervention in those markets, cyclical industries like automotive, hardware and commodities have shown declines. Can we trace these price movements directly to China? Of course not. No one can. Might it be possible that the collapse of a multi-Trillion dollar market and the decision by the second largest economy in the World to turn its nose up at capitalism will have important ramifications for the global economy and markets? We think so. In fact, it seems almost impossible for it “to be contained”: we learned as much last cycle.
Back home, we should review one thing: Unicorns. Do. Not. Exist.
And yet, for those of us focused on innovation, the word is now used casually to refer to companies of all kinds.
We love innovation. So much that we left our fancy jobs in old places to dedicate our lives to it. We exclusively use Quip for our work, we have a website, we send email newsletters drafted exclusively on mobile devices. We believe deeply in Progress.
We must acknowledge that the absurdity of the me-too’s has reached the shrillness of a breaking point.
This is popping up everywhere: from the fourth Uber imitator to things like a friend mentioning there are “over 100” entrants into the online commercial real estate lending market.
This can’t last.
We will look back at the use of “Unicorn” as an obvious warning sign. But the way these things work, it stays surreal for awhile before the turn.
The warnings have been everywhere: from oil collapsing, to European sovereign yields imploding, to China deconstructing to the commodity markets plummeting.
Risk is back. It never really left regardless what governments might prefer.
And it will only get worse from here.
As such our positioning is increasingly cautious, and as we launch our hedge fund vehicle it will almost certainly be net short.
This part of the credit cycle isn’t as fun, but sadly our values of integrity and humility cause us to stare the reality of the markets in the eyes and act accordingly.
We believe the easy phase of this credit cycle ended in 2014. Throughout the year signs have been validating this conviction, and this month was no exception. As pointed out by our friend Ed Altman at last week’s S&P Capital IQ Conference on Credit Cycles, the typical “benign” or “depressed default rate” time period has historically been 5–7 years. We are in year 6 of a low default rate period today, and in Professor Altman’s words, in the “8th inning, but the score is tied.” He believes we are in the 8th inning because metrics like overall debt levels, credit fundamentals, M&A leverage levels, LBO activity and other statistics are very similar to where they were in 2007. We agree wholeheartedly. He believes the “score is tied” because unlike in 2007, when housing was an obvious impending catalyst, it is unclear where the catalyst comes from this time. Here we disagree.
As we pointed out in our initial letters, European Sovereign spreads had reached a point of surreal instability in March of this year when the majority of credit assets in that region were priced at negative yields. Sure enough, the long end of the curve in those markets sold off violently without warning the following month. This has only continued in recent days, and with the headlines emerging from Greece, the weakness in the credit markets spilled over into equity markets globally.
Similarly, last month we highlighted the unsustainability of the ongoing rally in Chinese equities, and the A-share market was down 20% in the closing days of last week before an interest rate cut stabilized things — for now.
These signs, as well as continued deteriorating fundamentals in Emerging Markets globally indicate that we nearing the breaking point in the Global Capital Markets, which unlike in 1999 is not isolated by region.
We believe sometime in the next 12–24 months, if not before, there will be a significant default or seizure in a market on the order of trillions of dollars, and this will have a cascading effect across global asset classes that will be similar but perhaps worse than 2008. One reason it might be worse this time is that many are vulnerably and irresponsibly positioned in long-only fixed income and equity portfolios after years of reaching for yield, so when these markets sell off, there might be a behavioral effect that causes deeper pro-cyclical contractions as investors attempt to adjust their positions. This combined with the much cited illiquidity in fixed income, ETF and other related markets could make for a violent sell off. As the global capital markets contract, default rates will continue their upward rise, and we will have another deep credit cycle marked by defaults and bankruptcies of various kinds.
The most recent unsustainable data points have emerged domestically where late stage private market valuations and investment activity have reached extremes. When hedge fund managers with no experience in early stage investing are clamoring for access to overvalued illiquid convertible preferred securities of companies with little to no cash flows and no prospects to achieve them anytime soon, it is not a good sign. We look forward to purchasing some of these securities at distressed prices in a few years when these unnatural holders sell in the next restructuring cycle.
The markets are empirically irrationally exuberant notwithstanding the emotional comfort some people feel.
Markets like the short-duration fixed income markets and other unusual suspects will be the area of focus as we continue to decipher the transmission mechanism for risk this cycle.
We believe much like in 2007, there will be asymmetric credit shorting opportunities available as the cycle turns, and we look forward to adding this exposure as a hedge to our core portfolio of individual equity long and short investments.
The U.S. Equity markets continue to be subdued and relatively benign at the index level. However, elsewhere this month has been quite unusual.
As we’ve been highlighting, the European Sovereign markets are in unsustainable territory with yields remaining negative across much of the region. The unsustainability of this situation was highlighted when in late April and early May, the German 10 year and 30 year bunds sold off dramatically, with 30 year bund prices declining more than 12%, or the equivalent of 25 years of yield. The ECB responded quickly by publicly reiterating their commitment to purchases with an emphasis on “front loading” purchases in May and June.
At the same time politics in Portugal and Spain have added uncertainty to the political underpinnings of the region. This dichotomy: a market pricing zero risk contrasted with an increasingly precarious political reality strikes us as deeply troubling.
Beyond Europe, the Chinese Equity markets have been truly surreal with many securities trading much like Nasdaq in 1999, rallying continuously without any regard for fundamentals. Many Chinese IPOs have traded up for a month in a row reaching extreme levels. According to the Financial Times, “Every one of the 29 IPOs in Shanghai and Shenzhen this month have risen by the daily limit each day since. The worst performing IPO from earlier in the year has doubled in price.” One company, Hanergy Solar, reached a valuation of $38 Billion, only to have half of that market cap eliminated in one day. This type of volatility is troubling but expected at this stage of the Odin River cyclical framework.
Back home, real estate markets across the U.S. are showing ebullient signs. As noted by DAL and his ladies on recent strolls around the neighborhood, andconfirmed by a recent New Yorker article, prices in NY real estate are so stretched in desirable markets like the West Village that businesses can’t afford rents. Similarly in Silicon Valley, even software engineers can’t afford to buy a home at the current price levels.
What is unsustainable can not be sustained.
The only question that remains is timing, and with each passing month we feel incrementally closer to the next downturn.
The last month has been a relatively benign one in the markets, with equity markets grinding higher. As discussed in last month’s letter, the central bank bond buying program in Europe has created distortions in the European fixed income markets that have continued to reach truly epic proportions. That we are now getting used to large portions of the bond markets having “negative yields” causes deep concern. Risk exists. That we can witness the continuing drama of the Greek political environment and at the same time watch the credit securities in neighboring countries grind higher as if there is no risk of default in the entire region is mind boggling. But it makes sense: long-only investors incentivized to buy at any price in a market bid higher by a very large buyer will continue to keep buying — until risk emerges.
The sell-off across European sovereign bonds in the last days of April, which echoed into the US equity markets today, gives an inkling of things to come here.
That said recent economic data in Italy has been surprisingly (to us) turning in a more positive direction. Albeit it is off a low base, but this relative strength will likely embolden Draghi and the ECB. It also might mean that the cycle has room to run. As some of you probably remember, our best guess of where credit risk will emerge this cycle is that it will arise through a sovereign dislocation in Europe following an election in a large European country — like Italy. Of course, risk could emerge in other places (like it is currently showing up in Brazil and other emerging markets), but as of now those defaults don’t seem big enough alone to cause a turn in the cycle.
Speaking of defaults, the dollar value of public company bankruptcies was higher in Q1 of 2015 than any quarter since 2009. It is not time to start ringing alarm bells, but this further solidifies our view that we have left the easy phase of this credit cycle and are headed for the next contraction sometime in the next 12–24 months (or so).
This month marked the beginning of Mr. Draghi’s bond buying programme across the Eurozone. As a result of this unprecedented action, which was publicly leaked, then announced in advance, yields across the Eurozone have reached truly epic levels, with more than half of near-term maturity government bonds in negative yield territory. At the same time, equity markets across Europe have rallied strongly with major indices across the region up double digits year-to-date. This is what a “reach for yield” looks like in real-time, and it is amplified by the disruptive and aggressive buying behavior of the ECB in the illiquid European fixed income markets. This will be an important area to monitor for Odin River as we seek to identify the source of increasing credit defaults that we expect to occur over the next 12–24 months. These price distortions can not last forever, and as we have seen recently in Greece, the political climate in Europe is unstable at best; and fundamentals are weak in most countries in the region with little sign of improvement.
Back home, equity market returns have been subdued as expected at this stage in the Odin River market cycle framework. As a reminder, we believe we are in the 5th of 6th stages — what we call the “late expansion” phase. This period is marked by increased volatility across capital markets and the beginning of credit defaults after a period of benign losses over the previous phases of the cycle. We are laser focused on the emerging defaults in the energy and commodity related industries, and as they increase, we become increasingly cautious. Samson Resource was the first large scale player to move towards restructuring. As we head into the second half of this year, we expect more will follow.
During this past earnings season, computer related companies like HP and Microsoft indicated that computer sales are slowing, and IDC now expects PC shipments to fall 5% this year. Falling PC sales were contrasted with a record quarter by Apple as the iPhone had the best quarter in the history of the smartphone industry. This trend highlights one example of the Odin River framework in action: increasing mobility leads to more smartphone sales and less need for stationary computing devices. We expect these trends to accelerate over time, and our portfolio is positioned accordingly.
Having just returned from SXSW, which I’ve attended all but one year since 2008, I can attest to the increased interest and attention that “startups” have today. This focus and energy highlights both the secular and cyclical nature of things: over time, many of these companies will indeed be big successes. However, the near term “tourism” of those attracted by recent performance will likely subside in future years when the cycle turns again.
That being said, I find time spent in discussions with entrepreneurs down in Austin to be one of the most energizing times of year. Even so, unlike previous years when I worked to extend my trip: this year, I cut it short because far more important than SXSW or Odin River, Autumn and Lauren were home waiting.
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