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ANNUAL REPORT COMMENTARY 2013 & 2014: Closing, Reflection, and Five Bad Trades To Avoid Next Year

r December 12, 2013

To our Clients and Investors, Our investment process continues to focus on filtering highly favorable reward-to-risk opportunities. Yet the last 12 months have presented an interesting anomaly. Looking back and reflecting on 2013, we find a year inordinately cluttered with apparent opportunities that turned out to be bad trades. More so, in fact, than any other year we can remember. In 2013, avoiding bad trades contributed more alpha to an investment portfolio than identifying great opportunities. Not losing was the new winning. Too many investors, prodded by the unrelenting monetary zeitgeist or their own emotions (or both), voluntarily entered these traps, at one time or another, throughout the year. Identifying the bad calls in advance, and implementing a basic filter, saved a great deal of financial and mental capitaland kept us in the race. Looking through our global macro lens, we list some of these potholes in chronological order: First among them was the universal belief starting around 4Q12, and lasting well into 1Q13, that Emerging Markets were going to be the star performers this year. Then by March, the latest fashion was to sell the British Pound on coming devaluation. Moving into April, Copper and Materials became a favorite short to play the Chinese downtrend. Several faulty assumptions behind that logic chain, to be sure. By late June, the rage was to short Bonds on taper talk. Emerging Markets were declared dead. As July came, the Dollar was breaking out, and was a must-own. As September approached, economists had reached near-universal agreement on an imminent Fed taper. Few bothered to listen to what the Fed was actually saying, for the better part of three months (then proceeded to blame the Fed for poor communication). Fortunately, we had the courage to avoid (and even fade) these top trades. Other pockets of frenzied consensus, to our surprise, managed to hold up and in some cases, became even more misaligned. The Great Rotation actually came to pass, as retail investors managed to dump their Bonds at the lows only to pile into Stocks at the high. Never mind who lifted those Bonds from them, and sold Stocks to them. Precious metals and the miners broke after everyone said they would, then promptly disappeared from the investment menu. Selling Yen after May, Selling Bonds and Gold in late June, all struck us as really bad trades. Most havent gone anywhere, yet their proponents are even more convinced the gains are coming. This bizarre contrarian Moebius strip has disguised several bad trades as good, for now. Even for the mighty S&P, 70% of the years gains were clocked in by late May. Chalk it up to Mr. Markets convincing tricks, and investment mandates where patience has been cut to zero. Having long believed patience to be correlated with alpha, as we transition into 2014, we cannot envision a better time to keep a cool head. In hindsight, perhaps one of the greatest lessons of 2013 was the importance of Japan to the macro discussion. To any market practitioner (economists not included) who has glanced at a 50-year chart of Japanese Equities, the Yen, and U.S. 10-Year Treasury Yields, we believe these trends happened together for very important, fundamentally separate but systemically inter-related reasonsall of which are too important to fit in a brief reflection note. Suffice to say, if an investor thinks that one of these two trends (Japan/U.S. Rates) has turned for a period relevant to their time horizon, they should take the time to study what the fundamental and systemic implications are for the other. Apparently, most investors have not. Without further delay, let us return to the discussion on deceptive opportunities that become bad trades, as we ponder the coming year.

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Five Bad Trades To Avoid Next Year BAD TRADE #1 For 2014: Ignoring Mean Reversion The stock market had a great year. Supposedly, history favors a good follow-through. We disagree. The chart below shows the S&Ps annual returns for the 20 years that followed two consecutive double-digit annual gains in the stock market. Over nearly a century, the third year posted a significantly smaller return than the historical median/average (84% less than the median return, and 65% less than the average return):

Here are the 20 thumbnail charts of those years for quick perusal, in order from the performance bars above: 1937 (-39%) 1973 (-17%) 1946 (-12%)

1977 (-12%)

2000 (-10%)

1981 (-10%)

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1953 (-7%)

1990 (-7%)

2011 (0%)

1984 (+1%)

1987 (+2%)

1956 (+3%)

1965 (+9%)

1952 (+12%)

1944 (+14%)

1951 (+16%)

1999 (+20%)

1998 (+27%)

1945 (+31%)

1997 (+31%)

Nearly every chart, with the exception of perhaps 1945 and 1997, favored mean reversion. In short, buying on January 2 and holding just may not cut it in 2014. Those levering for a repeat of 2013 in U.S. Equities are likely walking in to a meat grinder. As for the lessons of 2013 on currencies, commodities, and even Emerging Markets, please read the first page of this note. Trends were fickle, and we expect plenty of encores in the coming year. As a side note, the most bearish outcome for 2014 would be a gravity-defying big return (net of the meanreverting swings we expect). From the eight best years above, three came in 1997-1999and we know what followed. Worse, without these three bubble years, the median return falls to 0%, and the average to -1.45%.

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BAD TRADE #2 For 2014: Which-flation? This debate is also related to mean reversion. Below is a 15-year chart of U.S. CPI with relevant Economist magazine covers marked in vertical lines (to the nearest month). The covers read:
May 24, 1999: June 19, 2004: May 24, 2008: Nov 9, 2013: Economy Wars Starring Alan Greenspan, Inflation Fighter Back to the 1970s? Inflation returns, worldwide Inflations back but not where you think The perils of falling inflation

As per above, there are only wrong answers in this eternal debate. If we were to guess, the Fed may finally get their inflation on target next yearas inflation tends to considerably lag economic activity anyway (roughly 2-4 quarters) and 2013 was on balance an expansion year. Inherent lags could easily drift CPI (and Core) back to 2% or higher, throwing a wrench in all the central planning models. Speaking of which, below is the last gasp (white arrow) in Core CPI during the previous cycle, with a 50-month moving average for guidance. Is a repeat coming?

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If the question seems outlandish, the below chart shows the last seven U.S. Recessions, and Core CPI (white) relative to the same 50-month moving average (blue). The S&P is in yellow. Periods of Core CPI trending above its long-term average all led to poor economic and investment outcomes:

Looking to yet another time for guidance, in late 1989 stocks (yellow) made new all-time highs just as Core CPI inflation (white) stabilized around its long-term average (blue)identical initial conditions observed today. Inflation then rose for a year, while stocks were put through the meat grinder from September 1989 to September 1990. Ultimately stocks fell 20% as recession hit.

Below we overlay the U.S. 10-Year Treasury Yield (green) against the same Core CPI (white) for that period. Here, yields rose for a few months in tandem with inflation, but by year-end 1990 yields were right back to where they had started. Mean-reversion at its finest:

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In a classic repeat of history, 2014 could see a late cycle (last gasp) rise in inflation of 50-100bps, and a Fed once again looking through the rearview mirror of a lagging indicator to set policy. As seen from the previous charts, this alone would present a whole new set of problems for asset prices. And of course, no one would see it coming, as the magazines already suggest. As for interest rates, here are the same magazine covers placed over a chart of the U.S. 10-Year Treasury Yield. By the end of 2014 the current deflation scare may look a bit silly. Where Bond prices end up, and how they get there, remains to be seen. Between now and then, there will be no shortage of economists with consensus forecaststry to ignore them.

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BAD TRADE #3 For 2014: Forgetting Late Cycle Dynamics Inflation isnt the only late-cycle theme that has disappeared from the investment discussion: Large investors turn cold on commoditiesFinancial Times, December 5 After two years at the helm of the worlds worst-performing asset class, managers of commodities funds could be forgiven for feeling unloved. Wall Street analysts, big-picture strategists and powerful consultants have turned cold on oil, metals and grain futures as a decade-long rally peters out. And investors are listening, with many now reluctant to commit further funds. Some are heading for the exits. [] A Commodities Rally Isn't Carved in StoneWall Street Journal, December 2 If the market had its own Ten Commandments, near the top would be "thou shalt revert to the mean"or, what goes up must come down and vice versa. Commodities bulls betting on this lifting their favorite investment out of its funk need to ask themselves where that mean is, though. [...] Above all, in historical terms, prices for copper, oil and gold aren't even that cheapthey only look so compared to recent dizzy peaks. Somewhere in those alternative commandments is another instruction for investors: Thou shalt not catch a falling knife. [] Interest in the Commodities space has been plumbing the depths throughout most of the yearand the market (as measured by the S&P GSCI index) has, unsurprisingly, gone nowhere:

Copper has also returned as a favorite short to play China. The grand thesis is that Chinese policy is shifting from industrial to consumption-driven growth. So the consensus is to short Copper into the next Plenum. Well pass. The idea that Commodities are dead, as we noted with deflation also dominating the economic debate, seems to offer fertile ground for a temporary surprise next year.

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BAD TRADE #4 For 2014: Blind Faith In Policy Markets break rules. Investment aphorisms that gain enough believers usually stop workingright when they are counted (depended) on the most. On Page 1 of the market rule book stands, alone, Dont fight the Fed (with a nod to Marty Zweigwho probably would have cringed at how ubiquitous the phrase has become and who also said the problem with most people who play the market is that they are not flexible). Central bank credibility is like any other asset. It swings in and out of favor, in fairly predictable cycles. The time to go long Fed credibility was five years ago. If we could sell global central bank credibility, we would do so today:

There are no good options for late-cycle monetary policy. Central bank mandates have an inherent structural flaw. They are tasked with controlling inflation and unemployment, both of which lag the real economy. That is, when both inflation and unemployment are stable and improving, and policy is accommodative, Dont fight the Fed works rather beautifully. Straight lines work wonders in economic models. Unfortunately at the turns, modeldriven policy tends to fall behind the reality curve. Lest we forget, 2007-2008 was a classic example. As the below chart shows, accommodative policy didnt arrest the crash of 2008, the tech bust in 2000, the recession and bear market of 1990-1991, the double-dip recession of 1982, or the crash of 74. Perhaps 2014 will see the Fed digging itself into the same late cycle hole, temporarily reducing accommodation just as unemployment troughs and inflation perks up. The models wont like thatand we worry for those following blindly at the turn.

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BAD TRADE #5 For 2014: Reaching for Yield During Late Cycle Moodys maintains a handy high-yield credit spread model based on rating changes. For the first time in this 5-year credit expansion cycle, predicted high yield credit spreads have crossed rather significantly above actual. It worked quite well as a leading indicator during the crisis. Overall, the history of these gaps does not bode well for sustained spread compression:

The above also suggests that placing blind faith in monetary policy (as we discussed previously), as the sole driver for further spread compression, may ultimately disappoint credit investors. Ignoring credit quality deterioration in late cycle is simply a bad trade.

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Add Covenant Lite Issuance at 60% of loans, far surpassing the 2007 highs

And PIK issuance off the charts (nearly a third to pay dividends)

In both cases, we have a picture of investors who do not appear to be carefully analyzing individual credit risk. Further, companies are not levering up to invest in future growth, but to feed their shareholders. Call it the pillaging of corporate balance sheets, by the very insiders charged with steering the ship. Incidentally, just as they are (in aggregate) directing their companies to buy back shares and pay dividends (courtesy of savers, prodded by the Fed), only 17% of recent individual insider transactions have been purchases. According to Prof. Nejat Seyhun of the University of Michigan, this is the lowest level since 1990, when his database begins (the average runs at 38%). What could possibly go wrong?

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As we enter a new year, we thank you for the opportunity to be a part of your investment process. May we together figure out the pieces of the market puzzle. May 2014 be rewarding for the patient, diligent investor. As we like to say, imagination, innovation, understanding, and action are pillars shared by all successful investors. When some of the best opportunities come from doing nothing, the markets message is one of great informational value. The value of avoiding big mistakes in 2014 may be greater than ever before. And with a long list of potentially bad trades already competing for investors attention at the opening gate, we will prepare for the coming year in careful study and thought. Happy Holidays and onto 2014.

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