While many finance superstars have gleefully held the finger to the efficient markets hypothesis (EMH) over the years, few investors can do so consistently across multiple thickly-traded asset classes.
The dynamic is simple: more smart individuals cover Apple Inc. (NASDAQ:AAPL) than, say, Harsco Corp. (NYSE:HSC) (never heard of it? That's the point!), so the aggregation of participant perceptions of AAPL value is likely to be more accurate than that for HSC value. Thus, doing a comprehensive analysis of HSC is more likely to yield a competitive advantage relative to market expectations than a similarly rigorous, (or more rigorous) analysis of AAPL.
Less attention = less efficiency = more potential profit
This holds not only for individual securities, as delineated above, but also for asset classes: a copper futures trader (who is a participant in a relatively small, thin market) can bag bigger hits than a T-bills trader (who is a participant in the world's most heavily traded and thus most efficiently-priced marketplace), assuming constant leverage across the two (if you're a professional trader, you have permission to roll your eyes at my silly simplifying assumption about leverage in, 3, 2, 1...).
Thus the rational global macro investor, whether professional or retail (if there are serious retail global macro investors out there, please reach out to me to confirm your existence, as the term strikes me as paradoxical), is best off devoting disproportionate attention to, well, weird little markets. There's more alpha to be had, and after all, that's why we're all here: to seek alpha. Here I am, telling you where it is. Seek no more! The alpha has been found! It's in the dark corners of financial markets! The places no self-respecting hedgie even bothers to even look!
But wait. That's obviously not true, because by the discounting nature of markets, it cannot be true. There is no panacea... that, after all, is what makes markets so interesting. If the above paragraph rubbed you the wrong way, that means you have good elementary finance instincts. This article is predominantly about why speculating in smaller, less efficient markets isn't the 'free lunch' it may appear to be. I propose that while there may be more differentiation opportunity in 'little markets,' speculation in such markets (paradoxically) requires making implicit bets* on the 'big' (more efficient) markets.
There are three BIG components you cannot afford to overlook, no matter the market in which you operate. They are the following:
- The United States (US)
- The Eurozone (EZ)
No region, no country, no market, no security, no person on earth operates in a vacuum. Everyone, everywhere in the world is impacted (almost always to a pretty significant extent--though it does vary) by the 'Big Three' above. They together constitute over 55% of world GDP, and in the case of China, represent a key (many argue the key, but endogeneity and dual feedback make it impossible to isolate China's contribution, so I won't weight in here...) driver of world output growth.
Concisely: you need a stance on them. Let that sink in.
There are three primary channels (I can think of) through which the 'Big Three' impact global financial market conditions:
- Trade Channel: Company valuations in every country are based on assumptions about growth/appetite in the 'Big Three.' For example, a New Zealand company's valuation (generic ticker: $NZ) is based on some model of how the US, EZ, and Chinese economies will grow over some time horizon, and what the consequent impact will be on import strength. If the US is plodding along at, say 4% (a guy can dream, right?) GDP growth, most simple DCF models extrapolate that rate linearly, so $NZ's valuation is contingent on that rate of growth continuing. If $NZ gets, say, 40% of its revenue from American buyers, your beliefs about the likelihood of continued 4% growth is key if you are independently valuing $NZ. This is but one example of the trade channel at work.
- Discount Factor Channel: Global risk-free rates are mostly determined by the FOMC, ECB, BOE, and BOJ, and their decisions change the discount factors used to value securities. There are other central banks, yeah, but when it comes to global discount factors, they really don't matter. (an unscientific guestimate would put me at FOMC+ECB+BOE+BOJ determining 90% of the global discount factor). A somewhat counterintuitive example would be for, say, a little South Korean company that operates entirely within Korea (all costs and revenues are domestic... what a funny notion!) and whose fundamentals thus have no foreign exposure. There is little to no trade channel at play here because the company cares only about the health of Korean consumers. So you may think you don't need a stance on the U.S. economy. Sorry, but that's wrong. If, say, you perceive a high probability of U.S. recession, you thus anticipate monetary easing and a yield curve inversion. This serves to lower your expected discount rates, and thus boosts the prospective valuation of the Korean company! That's right, a U.S. recession is good for your valuation. Clearly, this is one (bizarre) example. I hope however, that it will serve to make you more aware of similar and related channels throughout the world. I really have nothing more to say than this: pay attention to the denominator in your DCF models, and how it is determined! (i.e. a 5 bps change in that factor can hugely raise or lower your total return)
- Geopolitical Channel: the 'Big Three' play a disproportionate role in the geopolitical state of the world, and thus the institutional and behavioral environment in which markets function. Put simply, if you aren't aware of the geopolitical risks faced by, say, China, or one of the other majors, you run the risk of getting caught with your pants down (read: unhedged) if known geopolitical risks come to fruition. Granted, you can only do something about 'knowable' risks, but something is better than nothing.
A concrete implementation of the dynamics detailed above would look something like this:
- History: Begin formulating your top down view of the world by looking at the history of the 'Big Three' economies. How did today's governments come to be? What is the historical religious backdrop for the country? Is there a strong precedent for respecting private property ownership? The list of questions is boundless. A quick note: while you are fundamentally backwards-looking at this step, you should be doing it all with an eye towards the impact on the future-the historical focus here is not intellectual, it is practical: i.e. what does the occurrence of [insert your event of choice here] in [past year] indicate about likely events in [future year]? This should be your mental template when reading market and country history.
- Mental picture: Then form a clear mental picture of 'Big Three' equity valuation levels, interest rate levels, relative indebtedness, external trade positions, recent growth history, demographic position, exchange rate history/present, etc. At the conclusion of this 'drawing a picture' step, you should have a gut feeling about the three majors-and that's all you need if you are evaluating the 'Big Three' simply for use in a non-'Big Three' market... you can put aside the Taylor rules, DSGE models, etc. for the time being. All you need is a gut feeling and a mental picture.
- Market-specificity: Now you turn to the weird little markets. How can you input your mental picture into the process of the 3 impact channels described above? This stage will be the bulk of your analysis, as you only need to build up your mental picture once, with periodic revisions. This step encompasses all the number crunching, valuation models, due diligence, reading of dry prospectuses, etc. It is here that the you separate the men from the boys, and the Gods from the men.
- Go for the kill: Establish your positions, hopefully with some conviction, and pray that you don't get a 3 AM call from that angry, VaR-obsessed risk manager who's been bugging you. (Maybe this last thing only applies to Macro Bruin)
The above process is no guarantee of investment success. It is just the approach that I take to placing positions. The typical process for discretionary global macro investors is highly unscientific and often involves lots of luck-some of the greatest trades in history (everyone who bought MBS CDS pre-'08, Enron/Worldcom shorts, etc.) have been the product of an errant remark by a politician, a random news headline, or a casual conversation... while it's a great feeling to put on a trade based on chance occurrences such as those, it's not a consistently profitable investment strategy. My approach is a specific enumeration of two basic, and often unnecessarily conflicting objectives:
While an individual analyst can achieve success with only the former, it is almost impossible to be a successful PM without being a generalist (my experience is limited to the discretionary global macro game, so that's mainly what I'm referring to). But along with generalization (looking at the 'big picture') can come a dangerous loss of specific expertise: going back to the EMH framework described above, it is easy to see that only being up to date and knowledgeable about global rates, broad-strokes currency valuation, global geopolitics, etc. is unlikely to yield attractive alpha. At the same time, only focusing on one specific, small market, without an eye to what its place is in the broader world, is likely to result in being caught by surprise. Thus, there would appear to be a very real, very binary trade-off between specialization and generalization. So which is better? Well, neither: my basic framework above urges you to be a thoughtful specialist. Analyze the specific, while keeping the general in the back of your head. This serves to combine the strengths of two very different approaches, while eliminating respective weaknesses. In this sense, following the above steps, while not easy, will shield you from many of the cognitive risks to which others are consistently subject to, as well as help you to find areas to shine.
*If you're interested in hearing more about the phenomenon of implicit bets, I will have a piece out in the next 1-2 days.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.