Another new year is upon us, and it’s that time again to reflect on what went wrong since the last time we reflected on what went wrong. The goal is to relearn the same lesson we relearn every year: Nobody, including myself, has any idea how macroeconomic and sociopolitical events will play out, nor how they will affect the markets.
A look back at the markets
At the end of 2015, the federal open market committee increased its key interest rate for the first time in nearly ten years. A simple prediction would have been that bond prices would fall (inversely related to interest rates). They rallied. In early 2016, oil prices plummeted. A simple prediction would have been that equity markets would rally (lower cost of inputs – higher corporate profits). They crashed. In mid 2016, the UK voted on whether or not to leave the European union. This vote was framed as “a pretty bad idea” and a simple prediction would have been that it wouldn’t pass. It passed. Finally, at the end of 2016, the US presidential election. A simple prediction would have been that markets would plummet if Donald Trump was the victor. Markets rallied. The night of the election pundits where explaining why markets were reacting poorly to Trump, the next morning they were explaining why markets were reacting positively to Trump. Sensemaking at its finest.
This is a simplification, but it captures the mood of the year. What was up was down and what was down was up. In reality, there is no up or down, we just use the concepts to rationalize and make sense of a complex world. What should happen next? I don’t know is probably the best answer, but sadly it doesn’t make a compelling narrative.
As far as my investments, I continue to take a conservative approach, favoring special situations and deeply out of favor industries. My investment in ARLP performed better than expected, in part due to the republican win. The original thesis assumed a strong clean air act and a continued collapse in the economies of coal. The former doesn’t seem likely anymore, but the latter remains true.
The spread on the Monsanto risk arbitrage play has tightened in my favor, also in part due to the republican win. Special situations are tricky in that they hold little correlation to the market as a whole. So if the market is rallying, as was the case at the end of 2016, they tend to underperform. The Monsanto play was no exception. In such environments, the real question is are we more comfortable holding the market as a whole, or the underperforming asset with better perceived downside protection. At this point in time, I’m going with the downside protection.
Going forward, I’m about 20% in cash and I am focusing on special situations. I am currently looking over the Steel Excel buyout. SXCL is currently trading around $15 with a $17.80 preferred share offer paying a 6% coupon. That would be a 7% yield at today’s price with little risk of insolvency (based on a superficial look at the balance sheet of the acquirer). That looks appealing in an uncertain world. Of course, liquidity and rising interest rates are always a factor with preferred.
I’m also looking at some sectors that I think have gotten a little ahead of themselves in the post-election rally. Namely the regional banks. Within a month, it was priced in that interest rates would only go up and regulations would only go down, both being a boon to a bank’s bottom line. Things rarely play out that smoothly.
I have already spoken at length about the folly of making predictions, so naturally, let’s make some predictions. The market will fall sometime in the next 20 years. Reversion to the mean will always win out. Twenty year predictions aren’t cool?
Well here is a black swan prediction (oxymoron) for 2017: a much bigger flash crash, initiated by some algorithm run amok, and magnified by the reduced volume of a passive investing world, will cause a systemically important financial institution to fail. Michael Lewis has written about the transfers of authority that seem to occur every decade or so in the financial marketplace. In 1987, the instinct fueled wall street traders were replaced by the academics. In 1998, with the collapse of long-term capital, the academics were absorbed into the big wall street firms, beginning their decade of rule. In 2008, the big wall street firms blew up, ceding power to the flash boys and a passive investing renascence. It’s been about 10 years since that, so why not have it blow up.
Should we modify our investment process to account for this possibility? No. Should we look forward to an exciting new year? Sure.
2017 Speed Round
Over-hyped: The self-driving car/Tesla/Uber narrative.
Under-hyped: The amazon eating everyone else’s lunch narrative.
Over-hyped: Populism leading to the next Hitler narrative.
Under-hyped: The CRISPR genetic engineering golden age narrative.
Over-hyped: The Donald Trump business boon narrative.
Under-hyped: The Donald Trump business boon narrative.
The main takeaway from all this is that I have no idea what the markets will do in 2017. I barely have an idea of what the markets did in 2016. As such, the only real strategy is to develop a robust investment process that can weather whatever storms may come. In other words, cover the downside and the upside will take care of itself. Chasing lottery tickets and falling in love with narratives reinforced by confirmation bias is always a good way to have a bad year.