Weekly Edition #73

In this edition:

Every quarter JP Morgan releases a market insights slide deck called Guide to the Markets. It’s a great resource for information on current market dynamics as well as historical perspective on different things. Following are a couple of slides that caught our attention.

The chart above shows S&P 500 yearly returns (gray bars) and its intra-year drop (red dots). This is interesting for several reasons. First, it shows the variability in yearly returns. The average annual return from 1980 – 2021 was 9.4%. However, there are only 4 years which returns fall in +/- 2 percentage points of that 9% (between 7% and 11%). Stocks have historically returned around 9%, but every year is vastly different. Second, most years suffer large intra-year declines, with 24 years suffering double digit declines and 8 years suffering 20%+ declines. Out of these 8 years, 3 years still had positive returns. However, the delineation by calendar year is arbitrary and these numbers could change much if we chose from February to February for example. We prefer to look at rolling 12-month periods, to take out the arbitrariness of looking at calendar year returns.

The chart above shows consumer sentiment (gray line) and returns for the S&P 500 12-months after the reading (blue dots with text). Interesting to note here that market returns tend to be negative (or low) when sentiment readings are high (above average) and positive (and high) when sentiment readings are low (below average). This could be seen in one of two ways: 1. consumers are most negative after enduring the most pain, which is exactly when things start to turn, or 2. consumer sentiment is driven in large part by stock prices which tend to mean revert. In any case, the latest reading of 50 is the lowest it has been since 1971.

Same graph as the first one, except that it’s plotting returns for the Bloomberg US Aggregate bond index (market cap index of treasuries and corporate bonds, MBS, etc.). The index was created in 1976, in its entire history it has only experienced 2 down years and had never suffered a drawdown of more than 9%. This year it’s down 10% for the year and was in a 13% drawdown. Again, we would need to look at rolling periods to see the true maximum drawdown, although we suspect it probably isn’t much deeper than 13% if at all.

Matt Levine often jokes that crypto is re-learning the lessons of traditional finance all over again just that in a much reduced period. Crypto was meant to be this uncorrelated asset class that because of its use of blockchain was transparent so you could see transactions and leverage and cross-party relationships. Well, this hedge fund blowup shows that it isn’t all that was hoped to be.
 
3AC capital was a hedge fund with roughly $3 billion under management. It was extremely levered and lost a ton of money in this crypto crash. It has brought down several crypto firms, such as Voyager, and nearly brought down others (like BlockFi which would have probably gone under if it wasn’t rescued by FTX’s Sam Bankman-Fried). Now the two founders, Su Zhu and Kyle Davies, have gone into hiding. 3AC has gone broke and is currently in bankruptcy proceedings. What happened here was that 3AC took on a ton of leverage and made speculative bets which eventually turned sour. When crypto started falling they lost money, couldn’t meet margin calls and defaulted on their loans. This not only brought them down but also brought down many other firms.
 
Where was all the supposed transparency that you could see everything on the blockchain? Many of their counterparties had no idea how much money they had borrowed from other lenders (much like Archegos a couple of months ago). Where was the supposed non-correlation of crypto to the broader markets? What about Bitcoin’s inflation hedging ability? In the end crypto was a levered play on speculation. And this year that risk assets have had a tough time, crypto crashed right alongside with it.

We almost laughed when we saw these numbers. CalPERS (the giant $440 billion California retirement plan) lost 6.1% in the 12 months ending June 30, 2022, totally understandable since the markets have been very rough these last six months. Their stock portfolio was down 13.1%, their fixed income was down 14.5%, again totally reasonable given what has occurred these last 12 months. What is frankly ridiculous is that they think (yes think because no way do these numbers represent reality), that their private equity portfolio was up 21.3%. Yes, that’s right, how likely is it that public stocks are down 13.1%, and private stocks (which are smaller, more leveraged, and riskier) have outperformed by 34.4% and are up on the year. Does not make any sense.
 
How does taking a company private generate such strong returns? Well, it’s easy, since it’s private it means there is no readily available price since there is no market for these companies. Therefore, the fund managers can essentially say they are worth whatever they want. Sure, they have discounted cash flow valuations and whatever, but a model is only as good as its inputs. And if you control the inputs, you control the outputs. So, if you want a company to be worth whatever you want you just make some “assumptions” about future growth or discount rates or whatever and voila, your small levered private company is up 21% on the year when literally almost every other asset class is down.

A big criticism of index funds and ETFs is that because of their transparency people can front run their trades. This means that if we know an index will buy a stock a day from now, we can buy the stock today and profit when the index buys it. These moves are known in advance because indexes follow very specific rules which announce changes ahead of time. It is also possible to reconstruct these indices and forecast what will be the index changes going forward. This also happened a lot with commodity indices where traders would front-run the index and earn a return. Since commodities investing is done through futures contracts, and futures expire monthly or quarterly, then these indices have to trade quite a bit. The old GSCI indices were infamous for traders front-running them and “stealing” their return.
 
There have been many academic papers which look at the index inclusion effect. Basically, they look at stocks which have been included in an index and look at their returns a couple of days before and after the inclusion in the index. If investors are front running the index what we would expect to see is positive returns before index inclusion and negative returns after index inclusion. Basically, traders buy before it’s included and sell afterwards. And we can see that clearly happens (well happened).

The chart above shows returns before inclusion and after inclusion in three sub-periods 1995 – 1999 (blue), 2000 – 2010 (orange) and 2011 – 2020 (grey). We can see that the effect was very large in the past, but it has been coming down and over the last 10 years is close to zero. This makes sense because as information gets disseminated (like the fact that there was an index effect), the market incorporates it and eliminates the inefficiency. Index construction has also gotten smarter, and some indices have methods of reducing the impact of inclusions and exclusions. We see this often in markets, when an inefficiency is discovered, as more people trade on it, it eventually goes away.

The following graph is very interesting. It depicts annualized returns, both nominal and real, for different asset classes during the 1970s. The 1970s were characterized by high inflation and poor returns for traditional assets (stocks and bonds).

As you can see from the graph, both the S&P 500 and 10-year Treasuries had negative real returns (returns after inflation) during the entire 1970s. The best performing assets were oil (we’re not sure if this is the spot price or futures; if it’s spot it’s uninvestable to the financial investor and futures returns probably would have looked very different because of futures roll costs), silver, and gold.
 
You may want to look at this to get a sense of what could do well in the inflationary times we’re living in now. The inflation in the 1970s was mainly driven by oil shocks and the depegging of the US dollar from the gold standard in 1971. This year oil (measured by the USO ETF which invests in futures) is up ~40%, gold and silver (measured by GLD and SLV) are down ~7% and ~20%. Note that the returns in the graph are annualized returns, which means that oil went up on average of 24.4% every year during the 1970s (in real terms).

Thanks for reading!
 

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