Fund Performance Commentary

Fund Performance Commentary // December 2019

By January 25, 2020 February 1st, 2020 No Comments

Debt, Debt, Debt

December challenged the fund once again as equity markets relentlessly marched higher. The Nasdaq ended the year nearly 46% above its December lows last year (December 24, 2018). The magnitude of the expansion, coupled with the “melt-up” trajectory it took to achieve itrendered 2019 more or less our worst case scenario. The direction the market took was contrary to our positioning and the trajectory made hedging difficult.

We managed to return a small profit this December despite the market moving against us once again. We have maintained our positioning all year in anticipation of a normalization in equity prices, and continue to hold asymmetric positions such that a market correction should allow the fund to benefit disproportionately (i.e. the gains should exceed the mark-to-market losses we have incurred in holding these positions).

We continue to observe the deterioration of leading economic indicators, which we view as supportive to our thesis but also believe have caused the Federal Reserve to be increasingly supportive of asset prices in response. For instance, The World Bank just warned that debt levels are at their highest in 50 years in most developed countries. We have record government, corporate and consumer debt all ready to amplify a downturn. Further, amidst record valuations, 97% of CEOs say an economic downturn has already begun or will occur by the end of 2020 (Deloitte).

One metric I have not discussed previously is total market cap (the value of all stocks) relative to GDP which is at a record high above the highs made at the 2000 tech bubble peak. Currently the ratio, nicknamed the “Buffet Indicator”, is at 153%. For context at the peak of the tech bubble it read 148.5% immediately prior to an 82% decline in the Nasdaq. In the years between 1975 and 1985 the ratio sat largely between 30-50% and at the lows of 2008 the ratio was just above 50%. So we are on average paying 3X more for stocks relative to GDP now vs. then. With GDP as the denominator in this ratio, the quotient is normalized to account for economic growth between now and then.

The Fed propped up falling markets up in 2018 with their pivot from tightening (raising rates) to ultimately cutting rates mid-2019. During the tail end of 2019 they went one step further by adding further liquidity (money printing) via the repo market – causing the Nasdaq to rise nearly 20% during that period alone. The Fed’s unorthodox behaviour this cycle seems to indicate that their strategy is to ward off a crisis by inflating asset prices – by fueling a bubble. Their actions in 2019 have in our view been the primary contributor to asset prices appreciation. There are few other justifications for an appreciation of this magnitude over the last 12 months. The real economy grew anemically and leading indicators continue to show weakening activity and business investment.

The Fed has gone from being a traditionally passive entity who’s role was to support the economy in recessions and to cool the economy near cycle tops. This cycle has seen the Fed take a more interventionist or preemptive approach whereby it seems to aim to prevent the next business cycle by manipulating financial assets. This is certainly not in the Fed’s official mandate but we suspect they are concerned about the potential damage that a downturn would cause at this juncture. The financial crisis is 2008 was caused by poor quality debt being securitized and sold to investors. Today debt levels are much higher.  Further, it seems ironic that eleven years on we solved a debt crisis (the Great Financial Crisis) in 2008 with trillions in additional debt.

What is becoming more and more clear is that equity prices (stocks) are disconnecting from their underlying fundamentals and are significantly overvalued. The prices investors are paying for stocks assume the future is exceedingly rosy. To invest with the requirement that everything turns out perfectly in order to justify the valuation paid makes little sense. Investors typically require a risk premium for investing in stocks. I would go so far as to say that the “risk premium” has nearly evaporated and investors are ascribing very little required return to their investments. This is a recipe for sustained losses in the next part of the cycle. The year 2000 involved a total disregard for valuation or what was being paid for stocks. Investors hoped that “a greater fool” would pay more for their shares in the days or months ahead. Ultimately, those participating in the frenzied stock market saw their capital vanish in the collapse post-2000. We view the current market peaks with skepticism with history in mind.

With regard to our positioning, despite the market being exceedingly overvalued, we are actively employing hedges which help to reduce losses should the market move higher yet again in the months to come. We have maintained and continue to maintain our core shorts, as such our losses are generally unrealized losses, meaning changes in the fund’s value are a result of unrealized losses that we still expect to realize as gains ultimately. The companies we remain short are often frauds, money losing enterprises or simply exceedingly overvalued companies relative to their underlying fundamentals. On the long side of our portfolio we remain invested predominantly in value oriented companies with generally little participation in passive indexes. As such, these companies are orphaned from this equity bull market. Many trade at significant discounts to our estimated intrinsic value. We expect that as investors finally divest growth stocks they will once again seek out value. Value stocks, companies with good margins of safety, have until now been more or less ignored. We expect a convergence between growth and value over time. 

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