It seems like everyday we get bombarded with loud and contradicting information. . .
One survey will show consumer sentiment booming while the next day the retail sales growth numbers collapse. For investors it is a minefield out there as they are trying to walk along safely.
There was a phenomenal book I read last year by statistician and probability theorist - Nate Silver. It was called The Signal and the Noise. This book helped me understand an important, and common sense, piece of wisdom:
Don't be fooled by noisy data, use a practical tools such as the 'Bayesian' approach to probability, and don't put so much faith in predictive modeling.
Instead of getting caught up with insignificant and meaningless statistics and surveys, which are often unreliable forecasting metric, we need to take a step back and look at the bigger picture.
For example: the consumer sentiment survey is completely subjective and can change in a blink of an eye. How is that something to help reinforce your long term portfolio with?
Instead of focusing on the present, we need to forecast what the future potentially and probably holds. Buying real estate in 2006 because Ben Bernanke said housing prices will probably rise clearly was horrendous.
"Housing markets are cooling a bit. Our expectation is that the decline in activity or the slowing in activity will be moderate, that house prices will probably continue to rise." - Ben Bernanke (Feb. 15, 2006)
Therefore we need to use common sense instead of taking such prestigious talking heads words, such as central bankers, finance ministers, or financial adviser, at face value.
Ignoring the noise and information overload, what can we expect going forward?
Today's hawkish and hyper-optimistic Fed, low volatility, and flattening yield curve aren't unique.
We have seen this before. . .
During Alan Greenspan's years from 2004 to 2006 we had what he famously called the "conundrum." This was low volatility and stubbornly low long term rates in the face of a suddenly hawkish Greenspan and rising short term rates. He blamed it on China's growth and a worldwide dollar "savings glut."
Today Yellen faces the "conundrum redux," as talks of further aggressive rate hikes and Quantitative Tightening have barely moved long term yields higher.
So what gives? Deutsche Bank drew a pretty chart that shows sources which have been keeping longer yields persistently lower.
Their answers? It is these 4 causes. . .
1. "Trump reflation" hopes bursting (pink)
2. Geopolitical Risks (light orange)
3. Slowing U.S. and Chinese economies (grey)
4. increased demand for longer term yields while supplies diminishing (yellow)
What of the correlation that rate hikes precede to recessions?
Or even cause recessions?
Maybe the bond market is pricing in the high chance that such tightening will tip an already anemic and fragile economy into recession and deflation.
In normal economic cycle theory, the economy overheats and then the Fed "cools" it off by tightening. This causes growth to dip and the secondary effects trickle down, sliding into recession. The Fed then loosens and stimulates and the cycle restarts.
Of course, it is never any of the Fed's fault. They're the only ones that can save us.
Or so we are told. . .
There is a forgotten theory that, in fact, the Fed is the cause of the booms and the subsequent bust that follows. This was authored by the Austrian economist Ludwig Von Mises in the early 1900's. Following a logical path of common sense and understanding 'mean reversion', Mises saw the connection.
Suppose the economy is growing steadily at 4% GDP and long term interest rates (30/yr) are at 8%. The Fed decides the economy isn't growing fast enough and rates are higher than liked. The Fed cuts rates to 3% and reduces reserve requirements of the banks, increasing the money supply. The lower rates encourage business borrowing and expansion, especially in manufacturing and higher order goods such as construction, commodities, etc. And also consumer debt expands greatly for the citizens such as student debt and auto loans, credit card debt and mortgages, etc. The added debt and consumption spurs growth higher making GDP increase from 4% to 5.5%, and now because the corporate profits increase and the stock prices of these companies trend higher and higher, making the owner of assets wealthier (the rich get richer effect). Velocity increases in the economy, since more are employed and spending. Therefore inflation rises.
And wah-lah, a boom is here.
This is the Austrian Business Cycle Theory (ABCT) explaining the boom. . .
The bust is the opposite. Rates rise, banks curtail lending, margin trading tightens and the highly leveraged have to pay more in servicing their debt. Assets are sold to liquidate, which further pushes prices downward. Demand drops and so does output as the boom year gluts need to be worked through, leading to rising unemployment and falling tax receipts. Inflation turns into deflation. And so on and on.
You get the idea. . .
It doesn't have to be spot on. But we can all agree that there is an uncanny correlation between rate hikes and recessions. An economy doesn't grow forever. And it has been almost 10 years since 2008. We are due for one sooner than later.
Of the past 19 rate hike cycles going back over a century, 16 of them have ended in a recession. As the economy undertakes its 17th rate hiking cycle, it is hard to ignore to possible implications of an increasing short-term rate courtesy of the Fed - Mikail Johannesson at ValueWalk
And the Fed knows this. At least, they very well should. It's not like they can admit it publicly though.
Just looking at the last 22 years anyone can see the trend themselves. . .
If the Fed can't get rates up to at least 3% before the next recession, how will they be able to stimulate? Cutting from 1.5% to 0% won't do anything. The last two recessions needed 5-6% rate cuts to get any stimulus. Especially post 2008 which needed substantially more accommodations, like the $4.5 trillion in bond purchases by the Fed.
Not only does the Fed plan to keep hiking, but also unwind that massive balance sheet i.e. sell bonds onto the market?
I could only imagine what would happen. . .
Maybe if inflation was over 5% and GDP was averaging over 4% for the last couple years. But it's not.
Further tightening by the Fed could stress an already fragile global economy. And just as Nassim Taleb told us, to survive we need to be anti-fragile. Gain from the disorder instead of being the glass vase that eventually falls off the narrow table and shatters.
Buying long dated, out-of-the-money, CALL options on such assets like gold (GLD) and the stocks that mine gold, such as the VanEck Gold Mining Index (GDX). When rates go negative, or simply back to 0%, as the Fed will do everything they can to stimulate during the next recession, these should have significant payoff.
I also like betting on the implosion of over-indebted, cyclical, capital intensive stocks that are addicted to easy money and low rates. I recently wrote an exclusive article for SeekingAlpha about Avis Budget Group (CAR) which I bought out-of-the-money 1 year PUT options. As I wrote about in my thesis, this company has an ugly balance sheet, needs constant rolling over of debt, and dependent on car prices to not decline. In a recession, all the things it can't afford to happen - will.
Best yet, the crowd is discounting these possibilities as so ridiculous that buying long dated out-of-money options are only pennies.
If they thought it was likely, it wouldn't be so cheap. . .
In December 2015 I bought 1 year Gold Resource Corp (GORO) options that were way out of the money (the $5 strike price when the share price was currently at $1.25) for less than a nickel per share ($5 per contract; .05 x 100 shares per contract). Did I think they had some special catalyst upcoming? No. I just knew if gold went up, they would also.
The worst case scenario? I lose $100 dollars. And I could have bought a new batch at the end of the year.
But instead, I sold them in September 2016 for over 1900% gains. . .
I remember thinking to myself about asymmetry. "Who the hell was on the other end selling me these call options? They lost so much for so very little.
These aren't every year sort of gains. And I know that. But when the market sentiment is tilted in one direction and asymmetric (low risk high reward) opportunities show themselves, be ready.
We don't have to know the exact date. But like buying the GORO options from whoever was selling them - we just need understand what is coming and give ourselves ample time.
Again, like Taleb says, look for favorable optionality and have some damn imagination.
Disclosure: I am/we are long GDX, GLD, VIXM, GDXJ.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I look for investments that have the positive asymmetry (see-saw analogy) and that give favorable optionality. I use a 'tail-hedge' when the opportunity arises. I also am LONG PUT OPTIONS that are "out of the money by 35%" and long dated, 1 & 2 years, on the SPY, TSLA, CAR, XLY which I believe would be affected from a slowing economy and gives me ample time to unfold. At such low prices for these PUTs, the risk is limited while giving me unlimited upside if a volatile situation occurs. I normally use Long dated options for such contrarian opportunities. But with junior miners being micro-cap stocks, they behave like options with no fixed time frames. In further articles I will articulate my other methods I use for investing in miners.