Stay Focused On The Big Picture

by: The Heisenberg

Do yourself a favor: spend a little less time on localized trades and a little more time thinking about systemic factors.

An overly narrow approach to investing leads directly to a narrow understanding of the big picture.

Here's an outline of what I believe has been the most important dynamic driving credit and equity markets over the past three years.

I talk (and think) quite a bit about trends, themes, and market dynamics. In other words, I like to focus on the big picture.

Put simply, I want to understand what's going on at the systemic level. Why? Because that's how one can identify systemic risk factors. And identifying systemic risk factors ahead of the moment when they conspire to bring down entire markets is a great way to make a lot of money. Just ask Michael Burry.

Still, most investors seem to live and die by a series of largely vacuous investment axioms that essentially serve to perpetuate the myth that you too can generate steady or even outsized returns if only you're willing to "do your homework" and "stay disciplined", etc.

The truth is, the vast majority of the "guidance" you'll get from "professionals" is pure drivel. No one knows where company XYZ's shares are going to be next week, next month, or next year and I hate to tell you this, but "doing your homework" is overrated. Does that mean you should just buy (or sell) on a whim? Well obviously not, but there are factors beyond your control that will dictate where assets trade and you'll be in a better position to understand those factors if you spend a little more time thinking on a systemic level and a little less time trying to run your own homemade DCF model.

Indeed, even the most respected market mavens make assumptions that are dubious. For instance, pick up any beginner's guide to stocks, mutual funds, and equity ETFs and within the first dozen or so pages, you'll probably get a quote from someone like John Bogle telling you that over time, stocks return an average of ~9%. But that's just how things have played out over the past century or so. Nothing at all says that's how things have to play out going forward. Some tectonic shift could forever change the way we think about portfolio strategy. And that's precisely why I care so much about systemic risk - because it's systemic risk that has the potential to upend conventional wisdom.

Of course not every trend or theme will end up playing a role in some kind of dramatic market transformation. But at the end of the day, I think about it like this: It's always useful to know how things work. If I know how a car works, I'll be in a better position to spot problems early on. If all I know about cars is how to change a tire, I probably won't be any better at diagnosing mechanical problems than the next guy. The same goes for markets. I may be an expert on Amazon, but if I don't spend any time learning about how everything fits together, I'll be in no shape to predict, say, an overnight devaluation of the RMB, let alone what the ramifications of such an FX bombshell might ultimately be.

With all of that in mind, I want to talk about the interplay between central bank liquidity, credit, leverage, and equity prices, as I think the relationship between them has been perhaps the most important dynamic driving markets over the past three years.

First, let me summarize how this works. Central bank flows (liquidity) have artificially suppressed rates (NYSEARCA:TLT), leaving investors with very few options in terms of sourcing high quality assets with an acceptable return. The ensuing hunt for yield drove investors further down the quality ladder, creating demand for corporate credit, first in IG (NYSEARCA:LQD), then in HY (NYSEARCA:HYG) along the way. Companies took advantage of that demand by issuing debt. Corporate management teams then used the proceeds from debt sales to fund buybacks. Those buybacks boosted stock (NYSEARCA:SPY) prices despite a dearth of revenue growth.

Let's visualize things, shall we? We'll start with companies sweeping topline deterioration under the rug with buybacks...

(Charts: Citi)

... which are of course funded with debt:

(Charts: Citi)

That should give investors pause. Instead, spreads have actually come in thanks presumably to the perpetual hunt for yield - even as interest coverage declines:

(Charts: Citi)

As noted above, that hunt for yield is driving demand for corporate debt issuance, the proceeds of which are in turn helping to prop up stocks via buybacks:

(Charts: Citi)

Coming full circle, note the correlation between central bank liquidity and IG spreads:

(Chart: Citi)

See what's going on there? As central banks inject liquidity, IG spreads compress, driving the search for yield and reinforcing the self-feeding dynamic described above.

This is a narrative Citi's Matt King has been discussing for some time now and if you ask me, it explains quite a bit of what we've seen in US markets over the past several years. Take the time to understand how it works and you'll have gone a long way towards increasing your overall market IQ (although you won't learn much about where Tesla shares are headed or about whether Amazon can get to $1,000).

Hopefully this example helps to illustrate why I believe it's important to study the themes and trends that dictate how the market behaves at the systemic level.

And for those who insist on having the ramifications spelled out for them, I'll leave you with one last chart from Citi:

(Chart: Citi)

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.