KEN GRANT - Zen and the Art of Capital Preservation
Zen and the Art of Capital Preservation
October 28, 2018
“You look at where you're going and where you are and it never makes sense, but then you look back at
where you've been and a pattern seems to emerge.”
-- Robert M. Pirsig: “Zen and the Art of Motorcycle Maintenance”
After yet another difficult week, arguably the most difficult week in a string of difficult weeks, and in light of the gratifying reception of last week’s “Hitchhiker” piece, I really have no alternative other than to continue on with what appears to be a winning formula. So I draw this edition’s inspiration from a book whose binding I’ve never even cracked: Robert M. Pirsig’s “Zen and the Art of Motorcycle Maintenance”. It was written in 1974, more or less at the outset of my, er, coming of age. Like the “Hitchhiker’s Guide”, reading it was something of a rite of passage for my generation. One could hardly walk through a late ‘70s/early ‘80s college quad without seeing dog-eared copies of the original’s pinkhued cover in partial view within backpacks, or bulging out of back pockets of cargo pants.
But I never bothered to read it; never even tried. Don’t ask me why.
But now I’m not so sure I made the right choice. Consider, if you will, the purloined quote under this week’s headline. It kind of has a ring of authenticity to it n’est ce pas? In fact, one could argue that with respect to the trail of tears upon which investors currently travel, Pirsig was right on the money.
The major drivers of anguish and anxiety in the capital markets hardly bear reiterating, but reiterate we must. Our equity indexes were crushed this week, and even the ~4% drop in the SPX fails to document the portfolio carnage. Those with finite intestinal fortitude should certainly avert their eyes, but for the few that can bear it, I offer the following chart:
While the underlying math is a bit sketchy, the bottom line is that the contributors to the massive performance databases collected by Hedge Fund Research Inc. (HFR) have combined to manifest an 8.3% drop in performance this month.
And, for better or for worse, there’s still three days left to endure before we take those adorable little ones in their Firemen and Cinderella costumes out for trick or treat, and close the book on this horror show of an October.
I’m not sure, however, that the ushering in of November is going to bring much relief. More likely, and in keeping with my consistently documented prognostications over the last several weeks, the volatility bands – at least for the equity complex – are likely to remain agonizingly stretched – through at least the first full week of the fast-approaching month, and perhaps beyond.
The big question, of course, is why? If Pirsig is indeed correct (and I think he is), we can only truly identify patterns by looking in the rear-view mirror, but: a) that never stopped us (or me, at any rate) from spitballing in contemporaneous time; and b) we’ve probably travelled far enough down this lonesome road to draw some retrospective inferences.
As I stated last week, it’s not terribly difficult to find catalysts for the carnage, but for me, it all boils down to one concept: risk aversion has set in, the risk premium has risen substantially, and it has become very difficult for all but the irrational (or the irrationally lucky) to invest with even a modicum of confidence. Moreover, in a world where the blessings of stasis seem to have been lost upon our forlorn species, lack of investment, almost by definition, means divestment.
October ’18 was always destined to be a wild ride, and certainly, on that score at least, it can hardly be said to have disappointed. I think this was inevitable, particularly because of the deep instabilities that have bled from the geopolitical into the realm of the capital markets. Tensions associated with the former are as high as any time since 1968, and also are giving the years 1938, 1918 and even 1858 a run for their money. Public opinion – in this country and beyond – is both divided, and, paradoxically, set in stone.
Oh yeah, there’s an important election coming up in 10 days, and we’ll just have to hope for the best. I reckon when the dust settles, not much will have changed: the House will probably flip while the Senate stays red. This would be about the best realistic outcome for the markets that I can currently envision.
But as I suspected, the run-up to the election has been a risk management disaster. The investment community, and, for that matter, the electorate, has had its senses assaulted by matters too numerous to inventory, including dubious trade wars, outright warfare on judicial nominees, attempts – both successful and otherwise, at small-scale genocide. And a desperate struggle on each side of the spectrum to see which can outflank the other in terms of hysteria.
It’s all highly political, and very difficult to swallow, but if I had to point to one catalyst for the disintegrating investment environment, it would be the one-sided war of words between our Commander in Chief and the Chairman of the Federal Reserve Bank of the United States. Apparently at a loss for other demagoguery targets, Trump decided to add his own appointee: Jay Powell, to his list. To the best of my recollection, this little took hold began early in the summer, and from that point on, the effort to turn investor capital into investor returns has, for the most part, come up empty. While I won’t reprint it, the HFR index captured on Page 1 has been pretty much a one-way ticket down since that time.
Now, understand me here brothers and sisters: Trump may be right or he may be wrong with respect to his economic analysis (he is, after all, a Wharton graduate, which could be taken either way), but I think his modes of expression have been highly destructive to valuations. The Fed is organized to be independent and apolitical. No good can come of it being viewed as either doing the President’s bidding or working against him. By adopting the rhetorical course he has taken, he has cast doubt upon the indolence and tactics of domestic monetary policy, and whatever Powell decides to do – particularly in December – through no fault of his own, will be viewed by investors with a jaundiced eye.
And again, slapping multi-hundred billion tariffs on key trading partners, their retaliation in kind, irreconcilable viewpoints on economic policy are all, shall we say, less than helpful. But if you ask me why, as a mid-term election approaches, investors don’t know which way to turn, I point, first and foremost, to the White House/Fed squabbles. And I should point out that all of these views are coming from a guy, who if not an outright MAGA-ite, at least roots for the success of the Administration.
So I believe that investors can be forgiven for viewing the upcoming election as the monkey wrench in the spokes of the market motorcycle. And I’d also point out that the 2016 voting outcomes were such a statistical improbability, it is perhaps wise of risk takers to consider the tails of the electoral outcome distribution, and travel light until the results are known. Because, truly, anything could happen Tuesday week.
But in the meantime, we’ve been forced to endure an exceedingly unpleasant cycle of downward-biased volatility, not just in the U.S., but around the world. Contemporaneously, a great deal of capital has migrated to the safety of government bonds, again not only those issued by our Treasury, but also by the Bundesbank, Bank of Japan, and even the stalwart but tottering Bank of England.
For similar reasons, and perhaps also owing to the very pleasing 3.5% Q3 GDP print, capital is flowing noticeably into the warm embrace of our Dead Presidents:
My guess is that these flows will continue -- again until we gain a little bit of clarity as to how the latest round of political battles resolve themselves.
Because truly, there’s no other place to hide. With investors justifiably acting like scared rabbits, why on earth would anyone want to load the boat on riskier asset classes?
Answer: they wouldn’t. At least not here. Not now. And not yet.
We are, of course and in addition, in the midst of the Q3 earnings cycle; halfway through the sequence, while the numbers have been strong, they haven’t been strong enough to offset the other nonsense plaguing our senses. I will cop to being among the crowd that in the wake of the unfolding equity selloff, half hoped and more than half expected that the market would be bailed out by tech leaders. But it’s been a mixed bag thus far. In a touching nod to the nostalgic days of dog-eared copies of “Zen”, the positive hit parade was led by two old school tech companies: Microsoft and Intel, but even here investors weren’t overly impressed.
Then those new-age darlings, our current objects of infatuation: Alphabet and Amazon, took to the podium on Thursday and managed to disappoint. Both stocks sold off hard on Friday, giving the lie to the false bottom hopes that manifested in the preceding session.
Next week brings further profit tidings, including those from Zuck (FB) and Cook (AAPL), but unless they blow the doors off (doubtful), investors are more likely than not to view the slightest blemishes as further reason to bail – on these names and on the market as a whole.
If you want further visuals of what this looks like in micro pricing terms, I give you the following:
Suffice to say that for now at least, investors are in no mood to view beats or even positive guidance with a great deal of enthusiasm. For all of the above, the market seems unambiguously oversold here, and I’ve not much doubt that by mid-week at latest it will have experienced one of those melt-ups that bring hope to every risk-taking heart. But just like Thursday’s encouraging rally, I would caution against extrapolating the bids. Among other matters, any rapid-fire rally will feature a healthy dose of short squeezing.
I think that recent events have probably lowered the multi-quarter ceiling on valuations, but overall, they should trend upward. However, they are unlikely to V bottom; the next sustainable rally cannot, in my judgment, take hold until the volatility subsides. At that point, the prudent among us are likely to identify good entry points and load in.
But we’re gonna have to wait a spell for that happy contingency. In the meantime, I’d recommend that you take a zen-like approach to portfolio construction, reducing grosses wherever possible (like the Buddha living on rice), and holding fast to the core themes in your book that represent – let’s face it – you’re best if not your only chance to get paid.
I might have more to say on this topic further down the road. But not now. First I’ve got to read Pirsig’s book. And, for what it’s worth, I also need to do some work on my Harley Hog. The engine won’t kick over no matter what I try, and, for neither love nor money can I figure out the reason why.