The Investor’s Dilemma

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August was another month during which asset markets continued to brush off the seemingly ubiquitous geopolitical and other risks facing the global economy. Many markets hit new highs, and virtually every downdraft was met with a wall of buyers eager to join the party.  Japan registered phenomenal growthChina’s economy seemed to be accelerating, and many commodities (as well as shipping rates) pointed to a steady global economy.

Within America, the August jobs report, released on last Friday, captured the dynamic quite efficiently: an apparently disappointing jobs report was cheered by investors that felt the “weakness” may delay the Federal Reserve from raising rates or tightening monetary conditions. Many commentators suggested the employment slowdown was further evidence of a goldilocks economy that was growing steadily without a noticeable risk of overheating.

Japan registered phenomenal growth,  China’s economy seemed to be accelerating, and many commodities (as well as shipping rates) pointed to a steady global economy...

But at the same time, the list of risks continues to grow and intensify, obviously led by North Korea, the rogue regime that has dramatically escalated tensions by firing a missile over Japan and detonating a hydrogen bomb. Disturbingly, North Korea’s state news agency also warned that the weapon could be attached to a missile and “detonated even at high altitudes for super-powerful EMP attack.”

An EMP attack is a risk I’ve previously discussed, and one that I specifically feared might even enter the North Korean arsenal of threats. For a sobering view as to how an EMP attack might impact the world, I’d encourage you to read One Second After. And despite (Ambassador?) Dennis Rodman’s praise of Kim Jong Un's forward-looking leadership approach, the Hermit Kingdom's recent actions suggest the threat is worth taking seriously.

Last month, I paid a visit to the NORAD Command Center and also went into Cheyenne Mountain Air Force Station, entering the bunker through two sets of 25-ton blast doors, designed to protect the facility from a nuclear bomb. I also had a chance to meet with the leadership team of NORAD at Peterson Air Force Base during a briefing with General Lori Robinson, the four-star Air Force general running the place (and the highest ranking female service member in US history), and her team.

Sure, asking the NORAD team what worries them is a bit like asking a gathering of hypochondriacs about their health, but I found it useful to hear what they chose to focus on. Unsurprisingly, North Korea was a top worry, but General Robinson also expressed concern about the militarization of the Arcticfiscal constraints, a resurgent Russia, an assertive China, Iran, natural disasters, space and cyber-related risks, and CBRN risks. Note that this briefing was before Hurricane Harvey dumped biblical amounts of rain onto the Houston area…or before the recent round of threat escalation from Pyongyang.

And lest you think this is a comprehensive risk list, a seemingly irrelevant mountain pass recently pushed India and China to the brink of war. Although 3 months of rising tensions appear to be resolved, the Doklam pass border dispute in the Himalayan mountains raised the possibility of a full-blown war between the two nations. Even if tensions have abated, I’m not convinced the risk of conflict is entirely gone.

Meanwhile, in Europe, last week's Brexit negotiations were grossly unproductive and suggested a very disruptive process. (To get a sense of how recent discussions have gone, read Politico’s summary.) Bottom line: little, if any, progress has been made in recent negotiations, and worse, it seems a contentious process may be in the cards.

And within asset markets themselves, headline highs may be masking a shaky foundation. Market breadth, historically seen as a measure of market health, has gotten narrower and narrower, as fewer and fewer stocks are drive index performance. Weakness is brewing under the surface of market strength, which combined with elevated valuations, suggest a fragility to asset prices. While markets could of course go higher, headwinds are building as tailwinds dissipate.

So what is an investor to make of these dynamics? Those seeking to navigate the cross-currents of asset markets are certain to make errors. It’s simply not possible to invest error-free. But it is possible to choose what type of error one makes, and in this regard, I’d suggest it’s time to make errors of omission rather than errors of commission.

Risks are by definition probabilistic, and many never materialize. Nevertheless, rather than chasing returns, it may be prudent to forego gains if they are accompanied by elevated risks. While we can’t know for certain which spark might ignite the tinderbox, Goldilocks appears to be playing with matches.

UPDATE: Since drafting this note, US Secretary of Defense General James Mattis warned Kim Jong Un about the “many military options” available to the United States; the Chinese indicated that US threats of halting trade with countries that do business with North Korea was unacceptable; and South Korea warned that North Korea is preparing to imminently launch a long-range ICBM.

The Great Disconnect

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The world seems very fragile right now. In the past week, North Korea claimed its missiles could reach the United States, spurring some in Congress to run through the calculus of striking the rogue nation before it attacks us. Pakistani courts ruled against Nawaz Sharif, the sitting prime minister, thereby forcing him to resign; Venezuela created an authoritarian regime that started cracking down on opposition leaders; Polish citizens were marching in the streets to protest proposed changes to the judiciaryHBO announced it had been the victim of a cyber attack that had stolen proprietary information; Russia began seizing American property and evicting US diplomats; and White House turnover continued unabated.

Oh, and Australian authorities stated they had thwarted a terrorist attempt to bring down a passenger aircraft. Last, but definitely not least, India and China flirted with military conflict over an unpaved road in a mountain pass in disputed territory in the Himalayan mountains.

And that was just in the past week!

Earlier in July, Brazil threw it’s ex-president Lula de Silva in prison, Saudi Arabia “reorganized” and installed the young and ambitious Mohammed bin Salman as Crown Prince, and Qatar’s airline was banned from flying in Egyptian, Saudi Arabian or Emirati airspace. Protests threatened instability in Morocco, Nigeria’s president Muhammadu Buhari has been absent for months, and South African president Jacob Zuma is facing a no-confidence vote this month.

Meanwhile, there are early warning signs that the world’s largest economy may be slowing. GM reported a 15% drop in US auto sales (with Ford and Chrysler also disappointing), and Fitch noted that credit card losses have been rising and recently hit a four-year high. And in an effort to address unemployment, Canada announced it’s experimenting with basic income programs. And China’s most recent manufacturing PMI came in below expectations, hinting at the possibility that China may be slowing down (although the country did just open a cinema on a disputed island in the South China Sea).

But despite these facts, financial markets have marched forward. Sure, corporate profits have been generally quite good, but does that justify today’s nonchalant attitude towards these risks? Just look at the CBOE Volatility Index (known among financial types as the “VIX”) hitting new lows. Believed by many to be a measure of fear among investors, the VIX recently fell below 10, a level rarely seen in the past few decades. The implication: investors are not generally worried.

Further, the investment community appears more willing to pay handsomely for the profits companies produce. Consider the cyclically-adjusted price-to-earnings ratio (aka the “CAPE” ratio), an admittedly imperfect, but useful, measure of valuation. The CAPE ratio recently crossed 30x, a level it rarely reaches.

And lastly, we have notable exuberance driving a formidable crypto-currency bubble, eloquently and persuasively documented by Laura Shin in a recent Forbes piece entitled “The Emperor’s New Coins.” Further, according to Coincap, there are currently more than 600 digital coins that in aggregate are supposedly worth more than $100 billion. And while blockchain technology will likely disrupt many businesses in the years to come, Shin’s article sheds light on the alarming speculative instincts that are thriving in the crypto-coin domain. If you haven’t read her article, I encourage you to do so.

So what am I missing?

The world seems to be precariously balanced on the edge, with instability lurking in almost every region of the globe, but financial markets seem not to care. Speculative instincts are running high and valuations today leave little margin of safety. It reminds of the 1980s song “It’s The End of The World As We Know It (and I Feel Fine)” by REM.

But surely there is a reason for the seeming disconnect, no? Might it be the devout faith in market efficiency? Could it be that the developments I’ve mentioned are fully factored-in to market prices? Might it be the powerful and undying love of passive investing that has led to a world in which more and more money is doing less and less analysis? Or does the explanation lie, as eloquently noted by Keynes ("Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally"), in the risk-averse career-driven decision making of those controlling financial assets?  Or perhaps, to use four words that makes anyone who thinks of bubbles shudder, it’s different this time?

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