What We’re Reading (Week Ending 21 January 2024) - 21 Jan 2024
Reading helps us learn about the world and it is a really important aspect of investing. The late Charlie Munger even went so far as to say that “I don’t think you can get to be a really good investor over a broad range without doing a massive amount of reading.” We (the co-founders of Compounder Fund) read widely across a range of topics, including investing, business, technology, and the world in general. We want to regularly share the best articles we’ve come across recently. Here they are (for the week ending 21 January 2024):
1. Learning from significant investment statistics of the past – Chin Hui Leong
Outfoxed by rising interest rates
Interest rates are another favourite among forecasters. In 2022, the US Federal Reserve raised interest rates from zero to between 4.25 and 4.5 per cent.
As you know, the stock market suffered one of its worst performances during this period.
When two trends coincide with one another, it is tempting to put two and two together and conclude: Interest rates rose, and therefore, that is why the stock market fell. But we cannot say the same about 2023. Last year, rates were hiked again by another percentage point to between 5.25 and 5.5 per cent. This time, the stock market staged a rally.
The contrast between 2022 and 2023 is a timely reminder that correlation is not causation. Given yourself time to learn the right lessons – preferably over multiple years, rather than the past 12 months. If you learn the wrong lessons from past events, then you will be doomed to repeat them in the future.
Outfoxed by GDP growth
Speaking of trends, China’s gross domestic product grew from around US$493 billion in 1992 to an astonishing US$18 trillion in 2022, said the World Bank. The annualised GDP growth rate for this period is almost 12 per cent.
But the same cannot be said about China’s stock market returns. The MSCI China index has recorded negative gains from its inception at end-1993 until end-2023. In other words, the rapid GDP increase did not translate into positive stock market returns even after more than 30 years.
What is the reason for this disconnect?
The underlying earnings per share for the Chinese businesses within the index barely grew for much of this period. Over the long term, stock market returns depend on business growth. Without it, you end up with flat to negative returns, as you see today…
…Invest for the long term
When you hold stocks for the long term, you will occasionally record negative returns. It is the price you pay for a positive outcome. And yet, staying invested for the long haul gives you the best chance of success.
Since 1928, there has never been a 20-year period where the S&P 500 produced negative returns, noted Carlson. What is more, if you missed the five best days (read: positive returns) in 2023, the index’s gain would almost halve from over 24 per cent to 12.6 per cent. Miss the best 15 days, and the returns would be negative.
To put these figures into context, let us assume there are 252 trading days every year. Miss five of the best days or 2 per cent of trading days and your returns could be vastly lower. Miss 15 days, or less than 6 per cent, and you could be sitting on losses.
The good news is: You do not have to do anything to stay invested for the long term. Surround yourself with like-minded friends. As the saying goes: If you want to travel fast, go alone. If you want to travel far, go together.
2. Gucci is cheap and eggs are pricey in Russia’s surreal economy – Kate de Pury
As Russia enters 2024, and the campaign for President Vladimir Putin’s inevitable re-election heats up, the regime is keen to tell a good story about the country’s ability to withstand the war. It can muster a surprising amount of evidence to support this case.
The Russian economy has not collapsed under the unprecedented sanctions of 2022, as some predicted. Oil and gas sales to the West plummeted, but higher energy prices eased the pain and the government found new buyers in Asia. The rouble depreciated sharply in 2023, but has stabilised since. Vast public spending on the war has meanwhile created jobs. Inflation remains stubborn, and a slowdown is expected in 2024 as the central bank keeps interest rates high to fight it, but Putin was able to boast last year, not implausibly, that the economy had grown by more than 3%.
Russia still has to import many products, which a weakened rouble makes more expensive. But those who aren’t poor seem able to absorb the price increases, at least for now. There were initial supply hiccups when Russian banks were first cut off from international transfer systems. But middle-class Muscovites found workarounds, and can now buy Western brands over the internet with little difficulty. usmall, an online marketplace, lists iPhones and Ralph Lauren children’s clothes priced in roubles, which can be bought from third-party suppliers with Russian bank cards.
Moscow shops are well stocked with designer goods. Most Western luxury brands stopped shipping to Russian stores in 2022, but when I visited tsum, the Russian equivalent of Harrods, just before Christmas, a sales assistant was proudly showing customers the newest handbags from Gucci, Chanel and Louis Vuitton. Bought in Europe and carried back to Russia in the luggage of a “personal shopper”, there weren’t many of these new-season items on the shelves, but just enough to justify the sign “2023-24 Collection”.
Some of the items on display were second-hand. The sales assistant showed off an app the store has developed to make it easy for Russian clients to re-sell unwanted luxury goods. Even a used Gucci bag isn’t exactly cheap, but because it’s priced in roubles, fluctuations in exchange rates can make it become, by the tortuous logic Muscovites follow, a bargain in euro terms. “A good deal for the Russian shopper,” the assistant said snippily…
…Elsewhere there are signs that the invasion of Ukraine may have disrupted the Russian economy more severely than the frothy party scene suggests. The Olivier salad, a mayonnaise-drenched confection of root vegetables, sausage and boiled eggs, is a staple at every table during the holidays. This winter the price of eggs suddenly rocketed (no one is quite sure why, but it may have been because farms were short of labour since so many workers have been conscripted or left the country). In some regions people cannot afford a box of six eggs and have to buy them individually. One pensioner even raised this with Putin during the president’s annual end-of-year call-in with the public. Putin promised to look into it.
3. Claudia Sahm: it’s clear now who was right – Robert Armstrong, Ethan Wu, Claudia Sahm
Unhedged: It’s true, unemployment’s great. The most relevant signals of inflation are within spitting distance of 2 per cent. But no matter how you cut it, wage growth is around 4 per cent. Is that a potential problem?
Sahm: I have not, and do not now, subscribe to the view that the inflation we have been living through since 2021 is primarily demand-driven, like Larry Summers and my friend Jason Furman did. Those folks thought we put too much money into people’s pockets and there was too much pent-up demand. If you were in that camp, you thought we needed to jack up rates and see wage growth come down.
Wages are rising at a pace that’s better than before the pandemic, which was a very good time for the economy, but we’ve moved out of the very acute labour shortages. And obviously, we want to get workers off the sidelines. To do that, you’re going to have to pay them more!
I look at inflation and say that’s because of disruptions from Covid and the war in Ukraine. And because those will eventually work out in some way, inflation will come down. That leads to very different policy prescriptions to fight inflation. And it leads to very different views on the things like whether the $1.9tn American Rescue Plan was a good idea; or whether waiting to raise rates was a good idea. If it’s all demand, then you’ve got to destroy demand. But I don’t think it’s all demand.
On wages, too, we have seen some good productivity numbers. If you’re more productive, you get paid more. And that’s coming after the crap productivity growth we had after the Great Recession. If we’re getting better productivity growth, we should not be using pre-pandemic wage growth as the baseline…
…Unhedged: You’ve called for banning the Phillips curve, the economic model positing a trade-off between inflation and unemployment. Now that we have a bit more hindsight, what’s your retrospective on the Phillips curve in this cycle? And if we ban the Phillips curve, what replaces it?
Sahm: This fundamentally goes back to a view about how much of inflation is demand versus supply. If you think it’s demand-driven inflation, you can fight that with the Fed’s tools. But how do you know how much monetary tightening to do, how much unemployment you need to get inflation down? So then you march off to the Phillips curve. There are more sophisticated versions of the Phillips curve that incorporate supply shocks. No one brought those out. The versions of the Phillips curve that were brought out in policymaking circles went back to the 1950s or 1960s — essentially just inflation versus unemployment.
The Phillips curve was used by the same people denouncing the American Rescue Plan to make statements like, “We need five years of 6 per cent unemployment.” But it goes back to why did inflation spike, demand or supply? It’s clear now who was right: it was largely supply. It was completely valid to argue in 2021 that when inflation took off, it was demand. The American Rescue Plan was big, it came after two very big fiscal relief packages and the Fed had been adamant about not raising rates. But the fact this year that inflation has notably come down and unemployment has stayed low only happens if it was mostly supply-driven.
In terms of what other model to use, backing off from the Phillips curve would have been a good idea. And then the thing that economists need to think harder about is how we think about supply shocks. Most of the effort in macroeconomic research goes into thinking about demand disruptions. The [industry gold standard] New Keynesian dynamic stochastic general equilibrium model has wedged into it a Phillips curve that can do supply shocks. But we don’t really know how to calibrate [these sorts of models].
A lot of this is art, not science. The academic stuff looks like science, but what actually is useful in the real world is much more judgment-based. But you ought to have tools that at least don’t do damage. The Phillips curve has done damage.
Unhedged: There’s a lot of worry now about excessive debt and deficits. Olivier Blanchard is saying we need to get r minus g, the real interest rate paid on debt minus the growth rate, on a sustainable trajectory. What’s your perspective on debt sustainability?
Sahm: First off, Olivier is adorable, what a great way to frame it. My view is that it’s completely misguided to have a discussion about the size of the federal debt. The entire conversation about r minus g, while maybe useful for macroeconomists to think about, ignores that it matters what we spend on. If we are on a path for higher productivity growth after the pandemic, the American Rescue Plan, the infrastructure act, the Chips act, the Inflation Reduction Act — they all get a piece of that pie.
4. A beginner’s guide to getting away with accounting fraud, part two – Leo Perry
Now normally the way it works when you sell something is you then get paid. You get cash in return. That’s what money is after all, credit to buy more stuff in return for what you sold (which, most often, is yourself). You might not get paid right away. You might allow a few weeks for your customer to cough up (which is giving actual credit). But in the end you get your money. Otherwise you’re not really selling, you’re a charity (or a slave).
But of course we’re never going to collect on the lemons we invoiced for. And that’s going to start to show on our balance sheet, thanks to the beautifully simple logic of double entry bookkeeping. This says that for every action there has to be an equal and opposite reaction (OK that’s Newton’s Third Law but it’s close enough). Booking a profit increases the value due to owners of the business. And that’s a liability because these shareholders will want to get paid one day (good luck with that). So there must be an asset to match.
In our case that asset is definitely not going to be cash. What we get instead is more and more payments receivable from our customers.
Unattainable cash proved the undoing of Bio-On. In 2019 it was one of Italy’s only tech unicorns. This was back when being a unicorn was a good thing, because there weren’t any adults in the room…
…One thing Bio-On was great at was announcing licensing deals. Collecting on them, not so much, which is why we can learn from it.
By way of example, in July 2015 it put out a press release on a deal with French sugar co-operative Cristal Union (in fact the tie-up was with a joint venture between the two companies, B-Plastic). Bio-On’s 2015 accounts show it booked €3.25mn of license revenue from this JV — and collected none of it in cash. By the end of 2017, €2.75mn was still due from B-Plastic but the accounts for the JV show no liability, or cash to pay it with.
Oddly, Bio-On accounted for its stake in the JV with a €1mn book value at the end of 2015. But it then removed the item the following year, writing off the investment but not restating its 2015 accounts. So Bio-On appeared to have invested €1mn in the JV then written that off — while collecting license fees worth, at most, only half the money it put in.
Not collecting on sales made Bio-On a pretty obvious target for investigation. In the three years to the end of 2018 it reported €65mn revenue. Receivables were €60mn.
A few months after my visit to Bologna, the activist short seller Quintessential Capital published a report that highlighted a few issues at the company. In October 2019, Bio-On’s founding CEO and chair Marco Astorri was arrested on suspicion of accounting fraud and market manipulation, shortly before the company was declared insolvent…
…I first spoke to Quintessential’s principal Gabriel Grego back in 2015, after he published a report on another business I was short, Globo. This was a UK company but it was all Greek to me. Management claimed it had a hugely successful bring-your-own-device app, GO!Enterprise, which allowed you to use your own mobile securely at work.
And apparently this had hundreds of thousands of paying users. I was a bit sceptical because its Google appstore listing showed fewer than 5000 installs. The fact that the corporate website touted Lehman Brothers as a customer in 2013 was also a bit of a red flag
On the face of it, though, Globo was having no trouble collecting on these sales. The results for the first half of 2013 reported trade receivables up by only 4 per cent, despite strong revenue growth. But then, this wasn’t exactly an apples-to-apples comparison.
You see on December 3, 2012, Globo sold control of its Greek operations to local management for €11.2mn and with it went €40mn-odd of receivables. Of course, no one was really going to pay much money for nothing much. But the consideration was deferred, so everyone was happy (for now).
5. Harley Bassman on What Investors Are Getting Wrong About the Fed – Tracy Alloway, Joe Weisenthal, and Harley Bassman
Tracy (03:58):
So I have a question to begin with and this is completely out of self-interest as a journalist who’s had to write about convexity at many times during their career and has always struggled to define it in a way that satisfies my editors who want to encapsulate a financial relationship in as few words as possible, how would you describe it?
Harley (04:20):
Convexity is an X word, so everyone gets a little rattled about that, but it’s actually rather simple. It’s just unbalanced leverage, which was also a hard concept. Let’s simplify it a little bit.
If you have a bet, you’re making a wager where you make a dollar or lose a dollar for equal up and down equal opposite payoffs, that’s zero convexity. If you make $2 and lose one, that’s positive convexity. If you could lose $3 and make $2 — negative convexity.
The reason why we hired all these PhD quants in the nineties was to basically figure out what that’s worth. Clearly, you’d rather own something that makes $2 and loses $1 than is one-to-one. And if it’s lose $3, make $2, you better get paid for that. And so all the mumbo jumbo we go do around pricing out these various paths and payoffs is just to make it a fair bet when you have these different payoff profiles. And that’s it. Convexity just means that the payoff is not linear. It’s not one-to-one…
…Let’s just go one step back. When you’re in the bond market — not equities — the bond market, you have three buttons you could push. That’s it. Duration, credit, convexity. Those are your three risks.
You start with cash, overnight cash, and anything you do past there is taking one of those three. Duration is when you get your money back. Credit is if you get it back, convexity is how you get it back. And what a bond manager is trying to do is move around those three buttons to find the best risk-return, the best value.
Presently, selling convexity in the bond market is the best thing to do out there right now.
What’s duration? It is when you get your money back. So a two-year security will move 1.8 points for a one point move. So if rates go from four to five, a two-year bond will move by 1.8 points. A 10-year by about eight points. A 30-year by maybe 17 points, you’re usually paid more to take longer maturity risk because there’s more uncertainty.
An inverted curve is kind of upside-down land because you’re getting paid less to take more risk. We could talk why that is in a little bit, but right now, duration is a very weird place to take risk right now because you’re paid less to go out the curve and by a 10-year versus a two-year versus overnight cash.
Credit right now, investment grade credit is trading about 57 basis points. So a little over half point over the yield curve. And you get that from looking at these interest rate derivatives on your Bloomberg, it’s going to be CDX five-year. That’s actually tighter, [a] smaller number than its historic average of about 65, 66. You’re paid 57 now. Junk bonds, you’re paid about 360, 350, 370, which is also much tighter than usual 440, 450, 460.
So going into credit now, that’s not a great bet. I mean, I wouldn’t say it’s a disaster, but I mean, considering we’re concerned about the possibility of over tightening, a possibility of recession which an inverted curve kind of signals. I don’t really want to go and take credit risk. Convexity, right now, the MOVE Index, which is a measure of the price of convexity the same way it’s –
Tracy (08:22):
Which you invented, right?
Harley (08:23):
I did. It’s the VIX of bonds, plain and simple. The VIX of bonds, its average is maybe 90 or 100. It’s trading 120 now, which averages out to about maybe seven, eight basis points a day of market movement. That’s higher, much higher than its historical average. That’s the kind of trade you want to go and do…
…Joe (11:35):
When you say, okay, short convexity, what is the type of instrument that allows any trader or investor to express that idea?
Harley (11:43):
Well, the most simple strategy would be for an investor who owns a stock portfolio to go and sell covered calls. I mean, you’re selling options. You’re selling convexity when you go and you sell covered calls, what are you really doing? You’re kind of converting potential capital gains to current income. You’re limiting your upside. Your downside, of course is still large because the stock can go down a lot.
But you’re basically kind of doing a conversion there of taking risk off the table for current income. And there’s a price where you want to go and do that. And there’s prices where you don’t. When the VIX is at 40 or 50, I mean, you probably want to sell covered calls, of course you won’t do it because you’ll be in a panic. But that’s kind of the idea. And theoretically portfolio managers are supposed to have no blood in their veins, and they can go and do these various trades when the time is right…
… Harley (25:09):
If you go look at, you know, various derivatives, it indicates right now the Fed’s going to cut rates, you know, four, five, six times. So call it 120 basis points of cutting in the next year, which seems kind of crazy unless we crash market, we have a market crash.
I think what’s happening is this, I don’t think it’s the market’s predicting that rates are going to come down by a hundred and a quarter basis points. I don’t think that’s it. I think what’s happening here, it’s like an 85% chance that rates don’t move, and a 15% chance that rates go to 1%, that we have some kind of disaster. It’s a bimodal. And if you add those two things together, that’s how you get the down 125. No one’s saying 125, I think it’s zero and 400 and people are using the two-year rate or the five-year rate as an insurance policy against a bad thing happening. If you think of it in those terms, it kind of makes sense because, we only quote one number, but how do we get that number?
Joe (26:05):
Right. So the idea is if you’re long risk assets, which most people are most of the time, one way to hedge that would be to sort of make big bets on rates coming down sharply. It doesn’t mean that that’s your main view. It just means that if your bullish view is going to go wrong, a way to hedge that is to place big bets on rates.
Harley (26:26):
Yeah, well, that’s why the curve’s inverted. But I mean, I think buying 10-year rates is kind of silly right now. I mean, if you’re going to go and buy this theoretical insurance policy of the Fed doing a massive cut because of a hard landing, you want to buy the two-year rate and that’s why we created another product that’s basically a 5x levered two-year…
…Harley (28:17):
Circling back to the duration, credit, convexity idea. Duration is ‘I buy it here, it ends up there.’ Credit, ‘I buy it here. It ends up there.’ It doesn’t matter how it gets to the final destination. Convexity is path dependent. It matters how you get there.
And so what we’re arguing about now is not where we’re going to be, but how we get there. And I’m saying that we’re going to get there much slower than the market thinks, and I want to go and invest accordingly. And if I do that, this is where mortgage bonds come in.
I’ll say, if you want the big prediction, here it is. The Fed wants a 2% inflation rate. They’ll get it eventually, I presume. They’re going to put the funds rate at two and a half, 50 over for a 50 basis point real return. Historically, if you’re a, bond geezer like I am, funds rate to two-years, 50 basis points. So now we’re at three, 2s-10s, a hundred basis points. So now we’re at four.
So we’re kind of looking at, the 10-year right now is what? 380, 390, 404? Whatever it is. I mean, it’s done. You stick a fork in it, man, the 10s aren’t moving. And I think with the 30-year rate, it probably goes up from here as the curve resteepens again, all the action’s the front end, that’s where all the action is going to be when it happens.
Disclaimer: None of the information or analysis presented is intended to form the basis for any offer or recommendation. We currently have no vested interest in any companies mentioned. Holdings are subject to change at any time.
