Pendulum

“But I don’t want to go among mad people," Alice remarked.
"Oh, you can’t help that," said the Cat: "we’re all mad here. I’m mad. You’re mad."
"How do you know I’m mad?" said Alice.
"You must be," said the Cat, "or you wouldn’t have come here.” 
Lewis Carroll, Alice in Wonderland
 

“We're waiting for the pendulum to swing back again, which I am absolutely confident it will”.
D. Bluth, Animator & Film Director
 

As a stock picker and value investor I rarely get involved in discussing macro issues during Investment Committees or during meetings with clients. Anyway, since talking about Trump, Macron, volatility and US Non-Farm Payrolls seems to be fund managers’ main occupation, I’ll try my best… But please, as grandpa Warren once told us, always remember:  “Market forecasters will fill your ear but never fill your wallet”.

The swings of economies and financial markets resemble the swings of a pendulum. They spend most of the time oscillating near the average, swinging toward or away from the extremes of the arc. But when they reach one extreme you can be sure that sooner or later they are going to swing back to the midpoint. That’s because the effort needed to reach the extreme is the premise for the swing back. It goes without saying that investors don’t have to get caught in that movement (…and hopefully profit from that).
But, and there is one big fat “BUT”: no one can constantly and correctly predict the timing of the “swing back”.
The only thing that we can do is trying to figure out what the market conditions are at present.  In better words: “We may never know where we’re going, but we’d better have a good idea where we are” (H. Marks).

BUT… How can we have a sense of where do we stand?
With the help of Howard Marks, let’s build a simple framework to assess the current market environment.
You’ll find listed a number of market characteristics. For each possible answer, check off the one you think is most descriptive of today (the underlined ones are my guess on where we stand).  The mechanism is very straightforward: if you find that most of your checkmarks are in the left-hand side, as I do, hold on to your wallet, and even if staying cash in this Mad World (as the British band Tears for Fears would say) means bringing home a slightly negative return.

What is evident to me is that the centre/right column answers I gave are the ones concerning the “sentiment” of the average market participant…
As our CIO, Peppe Ganci, highlighted in his last monthly commentary: “if we are trading at, or close to, market highs, why there are so many fund managers (… and private bankers) advising cautiousness? This is a tricky question”.
Yes Peppe, it definitely is.

I came to the conclusion that the industry is just advising cautiousness. Hold on with me for the next few lines. 

1. Resignation
What apparently is missing here for this bull market to die it’s the final stage: the “euphoria”.  Well folks, it is not missing. It’s just dressed up as resignation. That’s extremely true in the fixed income world.
Credit, as funny as it may sound today, comes from the Latin “crÄ“dÄ•re” which means (drum roll please…) “Trust”.  As an investor the more you trust someone the less interest you’ll ask to lend your money to him. Take a look at the yields offered by govies and corporates, at least in Europe and US, and you will agree with me that Trust has been substituted with Religious Faith, investment choices with NO alternatives,Euphoria with Resignation.
I am confident in saying that 80% to 90% of the positions held by fixed income managers are not “best ideas” with absolute satisfying risk/reward profile, but relative value calls in a world dominated by resignation.
In summary: fund managers and private bankers are advising cautiousness but they are not implementing it in their clients’ portfolios.

2. Volatility
And now, wearing my armour, I will face every risk manager and quant guy in this world talking about the most miss and over-interpreted market statistic: volatility.
During our days as students, we have always been taught of volatility as the universally used proxy for risk… sorry Professor you’re dead wrong. I’ll tell you a little secret of the real world outside your fancy office: in the real world upward volatility is welcome aaaaaall day long.
Folks let me tell you this: risk means more things CAN happen than WILL happen (E. Dimson). Period. Say goodbye to your risk manager la-la land made of σ, MPT, VaR, etc… even the dictionary definition of risk works better than the business school one: “the possibility of loss or injury”.

Anyway, to make a long story short: when you see low vol what you can say for sure is that Mr. Market is underestimating the fact that more things can happen than will happen. 

To sum up: I don’t know where do we exactly stand in the cycle but I have a strong feeling that the pendulum it’s not in the mid-point of its arc. And for those like me, that are facing the everyday criticism that holding cash means negative return, try to think it this way…
Consider sitting on cash as a call option (with a veeeery reasonable premium) on every stock, bond (…or asset class) in the world. This call option has NO fixed expiry and NO fixed strike price, you decide both.  Now your 60% gross exposure sounds better… right?

If you are sitting on cash it’s deadly wrong to say that your money isn’t doing anything. You are just waiting for the pendulum to swing back. And I am absolutely confident it will.

Edoardo Matarrese