By Eric Peters, CIO of One River Asset Management
“Markets are not that complicated in these moments,” said the CIO. “This is the endgame - we are entering the hyper speculation phase."
These markets are intellectually uninteresting. “Being contrarian, subtle, nuanced, none of that makes money in these kinds of markets,” he said. “The more nuanced you are intellectually, the less money you’re making.” It is as irresistible as it is unstable.
“A healthy market has those who can see both sides of the trade, and they may differ in how they weigh the risks, but they acknowledge they exist.”
“Few people are equipped to trade these markets,” continued the same CIO. “Most believe that engineers prevail in finance, but there is a time in every cycle where you want your money managed by artists,” he said.
“That is the liquidity-driven part of the cycle where bubbles develop and if you have the wrong mindset this can be a terrible time – for most people, this time in particular will be completely discombobulating.” The cojoining of monetary and fiscal policy combined with the political, social and technological changes underway have no precedent.
“What engineers tend to do in this part of the cycle is to try to structure safety,” explained the CIO.
“Snowflake is trading at 50x revenue, so they convince themselves that buying some pre-IPO company at 30x revenue is safe,” he said. “That’s an illusion. Both companies should probably trade at 10x. So the engineer made a big illiquid trade to make 20%,” he said.
“The engineer has effectively sold vol and taken on negative convexity, when he should be buying vol. The artist finds unique trades that can triple, and thus makes smaller, safer bets.”
The team at GMO publishes seven-year forecasts for annualized real returns. Some say they are too bearish and won’t ever be right. Those people tend to need +7% returns in perpetuity or else acknowledge they are insolvent. I admire GMO’s forecasting discipline and recognize that the more dramatically markets outperform historical norms in the near-term, the weaker their future real returns. Anyhow, GMO forecasts US Large Cap Equity 7yr average annual real returns to be -6.2%, US Small Cap Equity -7.9%, Int’l Large Cap -1.6%, Int’l Small Cap -0.6%, Emerging Market Equity -5.0%, Emerging Value Equity +5.0%, US Bonds -3.1%, Int’l Bonds Hedged -4.4%, Emerging Debt -1.1%, US Inflation Linked Bonds -3.6%, US Cash -0.8%.
What probability do you assign to the above forecasts being wildly wrong? Half wrong? Mostly right? Dead right? Well, the solvency of the US pension system requires that those forecasts be so wildly wrong that you must change their sign from negative to positive. That is mathematically impossible for bond returns – you’re not going to get a +1.34% 10year nominal yield to generate a +3.1% real return with the Fed determined to overshoot its +2% inflation target. Could you change the sign of US Large Cap Equity returns from GMO’s -6.2% forecast to +6.2%? Highly improbable, a terrible bet, but I suppose anything is possible.
Policy makers are unwilling to allow negative nominal asset price returns, lest they spark a recessionary feedback loop and thus a deflationary spiral. They will ultimately resort to policies that generate material inflation, attempting to solve the dilemma via the money illusion. Digital asset prices are already front-running this policy. And in such a world, trend-following strategies will perform very well (these have started to run). Correlations will change. Factors will perform in ways that appear unusual. And equity sector dispersion will rise as politicians pick winners and losers, funded by historic deficits. The process is inherently unstable, volatile.