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The Case for Active Investing

Created November 2016 by Minyoung Sohn and last updated April 28, 2017

Dear Investor: Our Strategy to Weather this Current Investment Environment is Steadfast: Focus on Fundamental Research with a Patient Time Horizon, and Foster Collaborative Culture.

We Were Living in "The New Normal"

In 2010, Mohamed El-Erian created an Analytical Framework to explain the risk of secular economic stagnation in developed economies.

"First, the international monetary system suffered a “sudden stop” two years ago, the adverse impact of which is still being felt today by millions, if not billions, of people around the world."

"Second, the causes of the crisis were many years in the making and included balance sheet excesses, risk management failures at virtually every level of society, antiquated infrastructures, and outmoded governance and incentive systems in both the public and private sector."

Third, the dynamics coming out of the crisis management phase—particularly the combination of deleveraging, re-regulation, debt overhangs and structural challenges in key industrial countries—are combining with an accelerating secular re-alignment of the global economy to create what US Federal Reserve Chairman Ben Bernanke correctly called an “unusually uncertain outlook”.

The symptoms of these challenges include muted economic growth in industrial countries; persistently high unemployment which is increasingly structural in nature; continuous private sector de-leveraging; large public sector deficits and debt; regulatory uncertainty; and a much greater influence of politics on economics. They also show up in the accelerated migration of growth and wealth dynamics to the emerging world. (Mohamed El-Erian)

<The Stock Market Crash that Never Happened>

This was the 10-year chart for the S&P 500 on September 21, 2016.  The U.S. Housing Bubble and ensuing Financial Crisis precipitated a 56% decline in the S&P 500 from Peak to Trough (March 6, 2009). The stock market stopped falling as soon as Congress approved emergency liquidity (the Bazooka). Contemporaneously, regulators suspended mark-to-market accounting. The Ben Bernanke Fed ushered in the Era of Quantitative Easing and Negative Interest Rates. Markets were initially cautious, and it took a second Easing, now called "QE2", to prop up stocks in 2011. After much thought, I believe that Economic historians will give the Fed strong positive marks and Chairman Bernanke will be replacing Chairman Greenspan as the most significant Chair since Paul Volcker. The Fed has a well-known dual mandate to maintain price stability while also supporting full employment. Because the U.S. Economy was stuck in a low-growth environment, the Fed proceeded with QE3 under the rationale that strong stock markets create wealth effects which would drive consumption. By now, the markets understood that Bernanke was pushing on a string, and stocks proceeded to complete a tripling (+200% off the bottom) as the Fed expanded its balance sheet by $4 trillion.

<The 12-month period ending June 30, 2016 reflective of the battle between Fear & Greed in the markets>

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Investing in the New Normal, Illustrated . . . This is the S&P 500 in the 12-month period ending June 30, 2016. Carter Worth noted that from February 24, 2015 to October 28, 2016, the S&P 500 Index returned a measly 0.5% (never up more than 3.7% at any point) and (down 15% at the worst levels).
"As for market performance, if the unhappy statistics weren't so tragic, they'd be funny" - wrote Carter Worth, Technical Analyst for Cornerstone Macro Research and regular CNBC contributor, in a Strategy piece for Cornerstone

<The Biggest Surprise of 2016>

Cubs Win!

"The End of the World is like the Cubs winning the World Series" -- unattributed quotation

The Bigly Surprise of 2016

@RealDonaldTrump #Election2016 #TrumpPence16

America joined the Populist wave rippling around the world, and the Midwestern voter, at the margin, rejected the clear hands-down Establishment candidate, Secretary Hillary Clinton.

Once the shock of the Election wears off (it will linger for some), Donald Trump pulled off one of the greatest political upsets in modern history. As a Populist candidate, "Businessman" and Reality TV star Donald Trump beat Hillary Clinton. As a Government and Economics Double Major (and a huge history fan), I was fascinated by #Election2016 and studied U.S. Politics very closely.

<The Failure of Polls and Polling>

As measured by the National Polls, Real Clear Politics

<The Failure of the Betting Markets>

This baffles me, fresh off of being dead wrong about Brexit, how could the punters make the Exact same mistake in the U.S. Presidential Election? By now, the mainstream news did discuss the fact that traditional polling techniques were not producing reliable results. Specifically, we learned that some (or many) folks do not answer pollsters truthfully when asked embarrassing questions, such as "Do you favor Brexit" or "Are you voting for Donald Trump." People say "No" to the unknown person calling on the other end of the phone, and then they vote "yes" in the privacy of the ballot box. This is basic human behavior, but until November 2016, an intentional error of omission by "Mainstream Media" and much of the country.

The Conventional Electoral College Math going into Election Night

The Trump Campaign ran a highly surgical campaign which used Big Data to decide - even to the morning of travel - which cities to visit and what messages to send. My key takeaway is the Failure of Conventional Wisdom, Linear Thinking and Putting Your Eggs in One Basket.

Populism Perked over 100 Years Ago when American Farmers were caught in Tough Deflationary Times

William Jennings Bryan may have been the Original Celebrity Politician and he was the Democratic Nominee for President in 1896, 1900 and 1908.

In my opinion, to understand 2016 and what may happen in the year beyond, we must try to understand 1896 and what happened in the years after.

Technology, Friend or Foe?
  • Cyrus McCormicks's Mechanical Reaper greatly increased harvesting efficiency and later led to invention of a self-propelled harvester in 1871
  • Steam engines (later gasoline engines) improved tilling efficiency
"American farmers have often expressed dissatisfaction with their lot but the decades after the Civil War were extraordinary in this regard. The period was one of persistent and acute political unrest. The specific concerns of farmers were varied, but at their core was what farmers perceived to be their deteriorating political and economic status."

Echoes of 1896

"The Middle Class is Losing Ground"

Middle Class Stagnation Has Been An Overlooked Reality for Many Years

Populism Failed in 1896 when Democratic Candidate William Jennings Bryan (the "Cowardly Lion) lost to William McKinley.

The "Cross of Gold" Speech is one of the Greatest Oratorical Moments in American History. In our Twitter world, this original celebrity politician would have set the world on fire as #CrossOfGold would have been amplified 100 million times or more in Social Media. The Message of The Cross of Gold was under-powered by the speed of Analog communications.

Sounds a lot like "America First" and "Make America Great Again"

Instead, the Democrats lost. Although the Populist agenda did influence reforms pushed by Progressives in future years, as a Political Movement, populism withered.

So, despite the historical significance of the late 19th century Populist Movement, we lack any historical precedent for a Populist President.

During Election Night

After markets closed and with CNN turned on around the country, all of a sudden, county-by-county election returns mattered a great deal. North Carolina was the first hole in the dike. Mrs. Clinton had a 5% lead in North Carolina, as measured by every poll in the Real Clear Politics database. The Polls were wrong. Trump beat the Polls by over 5% and captured 15 electoral votes. Markets noticed . . .

Donald Trump wins North Carolina
The Dow Jones Industrial Average plunged 700 points as the Rust Belt votes were counted. Trump won the Presidential Election because he flipped Wisconsin, Michigan and Pennsylvania.
The Dow Jones Industrial Average plunged 700 points as the Rust Belt votes were counted. Trump won the Presidential Election because he flipped Wisconsin, Michigan and Pennsylvania.
(I think that "everything" has changed)

After Election Night 2016

  • Inflation Expectations Have Increased in a dramatic reversal from the lowest forward inflation expectations on record
  • Nominal Interest Rates Have Increased such as the 10-year Treasury where yields have risen from 1.5% to 2.5%
  • Dollar is Strengthening For the third time in 18 months, the Dollar Index has risen above 100
  • U.S. Equity Markets are Setting All-Time Records

Inflation Expectations are Rising

Regarding Inflation, it is the Expectation of Future Inflation that matters. In Finance, one common measure of future inflation expectations is the "5-year, 5-year" which is what the market thinks the Five Year Inflation Expectation will be . . . In five years.

Wall Street dealers, Central Banks and other Financial Institutions use the 5Y5Y as a reference price for complex financial transactions.

Last updated April 20, 2017. This graphics begins in 2009, but since the Creation and Recorded Measurement of the 5Y5Y in 2004, future inflation was expected to range between 2.75% and 3.00%. By the end of 2014, forward inflation expectations plummeted to the lowest levels ever recorded at 1.8%. In 2016 <look at the two red circles>, the market was saying that in 2021, it was willing to price inflation at less than 2%. In my opinion, this is real world manifestation of El-Erian's New Normal construct.

Interest Rates are Rising from Generational Lows, Ending A 30+ Year Secular Decline in Interest Rates

Last Generation, Controlling Inflation was the primary challenge of the Federal Reserve.

When Paul Volcker became Chairman of the Fed in August 1979, Inflation was running at 15%. Volcker's Monetary Policy was to raise the Fed Funds Rate (then 12%) to 20% which also resulted in the 10-year interest rate (depicted below in yellow) to peak at 16% in 1981.

The White Line is the 10-Year Treasury Yield. Interest Rates peaked in 1982, including the 10-Year which peaked at 16%. When Alan Greenspan assumed the Chair in 1987, the 10-year interest rate had already returned to a path to normalization. However, note that with each Bubble and ensuing Financial Crisis, the 10-year yield fell for each successive Fed Chair.

In recent years, the 10-Year Treasury Yield has dipped below 2%, in line with lower inflation expectations. Since the Election the 10-Year rebounded to 2.5% but has since retreated.

Last updated April 20, 2017. How and why would bond investors hold U.S. Treasury securities for a 1.5% return? Recall that, at the same time, the 5Y5Y was making all-time lows.

The U.S. Dollar will follow the path of the 10-Year Interest Rate. All things equal, higher U.S. interest rates (versus rest of the world) will drive dollar strength as Investors buy Dollars to buy U.S. Treasuries (as well as U.S. Stocks)

Mapping the U.S. 10-Year Treasury Yield (white line) with the Strength in the Dollar Index (red line)

The White Line is the U.S. 10-Year Treasury Yield. If forward inflation-adjusted returns on the U.S. 10-Year Treasury looks attractive to other global bonds, such as German Bunds or Japanese Government Bonds, then investors will buy dollars to invest in those securities. This process causes the U.S. Dollar (in the Dollar Index is the Red Line) to strengthen. Recently, the market is focused on the Dollar Index ("DXY") surging over "100." Last updated April 20, 2017

The Dollar Index Peaked in 1984-1985. By 1982, Volcker's Fed pushed the U.S. Into Recession. My best guess is that recession quickly dampened inflation as well as future inflation expectations. Lower inflation makes Bonds more valuable, so as soon as inflation came down, U.S. Treasuries became generational buying opportunities.

The U.S. Dollar Index = 75% Europe + 25% (Canada & Japan)

Last updated March 27, 2017. The U.S. Dollar Index is the trade-weighted value of the Dollar. The basket of reference currencies is dominated by Europe (Euro is 58% and Sterling is 12% and Swiss Franc is 3.6%) with the Japanese Yen nearly 14%. For the third time in two years, the DXY punched above 100, but has failed to breakout.
Expansionary fiscal policies (Infrastructure, The Wall, etc) have boosted the growth outlook which has in turn kicked up future inflation expectations halfway to normal (the 5Y5Y), so if Yields rise and the 5Y5Y is tame, then the expected real return on U.S. Treasuries is better and the dollar will strengthen as foreign investors buy USD.

Consumer Confidence Has Improved

The University of Michigan Consumer Sentiment Survey

Last updated for preliminary reading for April 2017

The Conference Board Consumer Confidence Survey

Last updated March 31, 2017

Car Sales in the U.S. Have Surged to an All-Time Record, with the Strongest December recorded, all happened after the Election

Nothing special to mention here, but there are consensus tail risks going into 2017
  • Inflation (not Real Growth) This risk is best explained by James Bianco, of Biano Reseach. Jim asks the $4 trillion question: Is the market going up due to expectations for Real Economic Growth (in other words, "Are things really better"), or is the market going up just because of Inflation?
  • China Currency Peg and Potential Devaluation (in fact, the Federal Reserve lift-off may put pressure on other Dollar Pegs
  • Geopolitical

CHINA

Remember when all of the discussion was around China's hoarding of US Dollars and its massive pile of U.S. Treasuries?

China's Foreign Exchange Reserves peaked at $4 Trillion in June 2014. Update needed to graphic: China FX Reserves = $3.0 Trilion as of December 31, 2016 = Capital Flight

Slowing Growth for China is Bad, Bad News for "Stability"

China has maintained a Dollar Peg (in various forms) since 1983, thereby tying China's interest rate and monetary policy to the U.S. Federal Reserve.

  • Blue Shaded Area = China Exports to the USA . . . The size of that blue shaded area in 2015 and 2016 is approximately USD $500 billion per year
  • Red Dashes and Red Boxes = CNY Renminbi Exchange Rate Renminbi has been weakening. In the beginning of 2015, it took 6.2 RMB to buy $1 US Dollar. By the end of 2015, it took 6.5 RMG to buy $1 USD. This is a 7-8% weakening of the Chinese currency, which is supposed to be "Pegged" to the dollar.
  • Note that despite the RMB weakening to RMB 6.5 in 2015, Chinese Exports to the U.S. Were Negative (see the red shaded area) and that RMB continues to depreciate.
This is a busy chart, but hopefully it explains the decisions the Chinese must make regarding their Peg to the Dollar. In his memoir, George W. Bush mentioned Hu Jintao's focus on creating 25 million jobs per year. For China, exports = jobs.

All is not well in China

Chinese Renminbi (RMB) is again depicted in the Red Line. In this graph, the RMB is plotted showing the amount of RMB required to buy $1 US Dollar. So as the Red Line is moving up and to the right, it shows how the renminbi is weakening as it costs more RMB to buy a dollar. Bitcoin is shown in the White Line. Notice how Bitcoin has surged to record levels, $1000 per Bitcoin. Does it makes sense? Yes, it does. There is massive capital flight from China and Bitcoin is being used as one way to move value out of RMB. Does it make sense that gold is down as RMB is crashing and Bitcoin is surging?
Those were some of many known risks.
I think 2017 represents a huge opportunity for Investors such as Arrowpoint that leverage focused fundamental research.

The Wall Street Journal had an Extensive Feature on Passive Investing in the Q3 2016 Personal Finance Review

Contrarians Take Note!

What is the Best Way to Make Money Investing during the Trump Presidency?

Forget Conventional Thinking, Stop Passive Investing, Invest in Companies, not Indexes
Empathy, Not Scorn. Midwestern Genius, Not Silicon Valley Genius
The Art of the Deal / Opening Bid / Make America Great Again

Bullish on Digital Worlds, Mobile Personal Computing

Bullish on Gold

(Gold requires, and I guess deserves, an updated Presentation)

Bullish on American Oil & Gas via U.S. Energy Policy

Envision American "LNG Diplomacy" with former Exxon Mobil CEO Rex Tillerson is confirmed as Secretary of State

The sub story here is that Senator Marco Rubio swallowed his pride and confirmed Rex Tillerson, disproving taunts of being #LittleMarco

The money is running out
OPEC has also put in a Compliance Committee consisting of three OPEC members (Kuwait, Venezuela and Algeria) and also two non-OPEC members (Russia and Oman).
I believe that OPEC has Engineered a series of Western-style Beats and Raises
One of my Best Ideas in 2016 = California Resources Corporation debt, purchased at Distressed Price of $40 (now trading $90)
This was my 2nd best investment idea in 2016, more than doubled in price, plus collected two semi-annual interest payments
In 2017, the Opportunity is in the Common Equity
Let's continue the conversation. Thank you for your trust and investments with us.