‘Scared For the Market’

Back in my day. You know, my classmates in high school spent more on perms than they do on their cars these day. I think. I don't think too many people perms nowadays, Mike, at least not like the eighties. At least not like the eighties. Coming anyway, are essential for podcast posts. I don't think you can really be a pie cats howse people trust? I think you're right, Ben, I think right, And we might as well introduce that voice there. That is our guest for the week. Very

happy to have him on the show. He does not have a perm as far as I can tell from the sum video, but his name is Ben Inker. He is the head of asset allocation for GMO, the money management firm in Boston. Ben, welcome to the show. Thanks very much for having me. I think that means once the lawns are open in each of our areas, each of us will be going out and getting perms and will confirm the next time we're all in the same place together. But Ben, we're so excited to have you

on the show. And lately, this past week stocks have been breaking out. The rally has been broadening out. All of a sudden. We've seen smaller companies, value stocks, firms really that have been hit hardest by the coronavirus. Well, they're all of a sudden leading this charge higher. But you over at GMO, you guys aren't buying it. So we're excited to discuss with you why that is and how you guys are going about changing your aff that allocation strategies. Yeah. So, I mean there's part of what

you said that I think makes some sense. Uh, small cap stocks and value stocks were really left behind. Uh in the year up until now, they were underperforming on the way down, they were underperforming on the way up. They deserve to outperform. The thing we find a little bit mystifying is the general upward move for the market. UM, as near as we can see, the uncertainty about the economy really hasn't gone away, and almost all of that

uncertainty is downside uncertainty. Uh. And yet you know, we're we're sitting here with the S and P five hundred downs something like five percent for the year in the worst economic crisis since the Great Depression. That just doesn't seem right, you know. But and I've read that you've Sarah said you've de risked the portfolios at your firm. I think I read the equity allocation of something like right now. So what is the rest in right now? I mean, obviously, Uh, you know, yields are so low

money market yields are barely there. Where do you hide out in this environment? Yeah, that's a great question. And uh, maybe that's an explanation for why the market is going up. Maybe people are saying there is no alternative to owning equities. Uh, we think there is a better alternative to owning the market. UM, which comes back to the smaller cap stocks and the value stocks that we were talking about earlier. UM. Value stocks have had an absolutely horrendous twelve years relative to

the market. They came into this year trading at some of the biggest valuation spreads we've ever seen, and then they proceeded to underperform by double digits. UM. So what we think makes more sense than just owning equities is going along a portfolio of value stocks and short the market.

And the reason why we like that is, well, if the optimists are right in the economy can make a V shaped recovery, Well, those stocks that have just underperformed the market by double digits deserved to outperform the market quite strongly, So you should still make money. UM. And if the world gets disappointed, uh, and we don't make that that miraculous V shaped recovery, UM. Value has a lot of margin of safety here relative to the market. We can get some very bad news and they still

don't deserve to underperform. And so as investors we love having a margin of safety UM. And there's very few assets today which offer a margin of safety. We do think along short portfolio, long the cheap guys, and short the broad market does actually have a margin of safety and deserves to make money in the good times and deserves to probably make money even if things do very badly, if they're really really horrible. Uh, you know, we enter

the second Great Depression. Um, maybe they're not going to outperform in that environment, but they're going to do an awful lot better than a long equity position. So you just gave us a sense of how you guys are positioning. Now you short the broad market, go along the cheap guys. Can you give us a little bit more detail on how you guys are actually going about cutting that equity

exposure though? I mean I get the sense that if you guys are shorting the broad market, then then you have to be pulling out out of a lot of large cap names, maybe those megacap tech names. I mean, how are you going about restructuring these portfolios to get there? Yeah, so you know the megacap tech. UM. I do find a little bit mystifying. You know, the Googles and facebooks

of this world will certainly get through this. UM. But if you were an advertising firm and the world is entering a large recession, I don't think that's very good

for your ad rates. UM. So I don't really know why these stocks should be going up, But UM, I recognize the fact UM that they are much less bothered by a really bad economic circumstance than most companies UH Not only do they have very strong competitive positions they are kind of largely monopolis, but they also have very strong balance sheets, so we don't have to worry about them from that. From that front, the market as a

whole uh has neither of those benefits. UM. But because we didn't come into this owning a lot of US stocks to begin with, UM, we didn't want to take the so called basis risk of owning a bunch of European and Japanese cheap stocks and then shorting the SMP

five hundreds. So what we actually did to take about thirty points of net equity exposure off of our portfolios, we shorted UM a lot of uh IFA stocks, so non US developed market stocks, which haven't had quite as strong a rally as the US but are still up probably somewhere in the mid twenties from the lows UM and are no longer really priced to deliver something particularly close to an equity like return, So we have kind of that value spread trade on in the developed world

outside of the US. UM. We do have a few US stocks UM cyclicals that we bought in April, a few kind of stocks in our special Opportunities portfolio, and we chose to hedge those with S and P s UM. But mostly it's a non US equity portfolio, so our shorts are mostly non US equities as well. So Ben I I certainly share your cause in about this market right now, UH, As Sarah will tell you, I'm a big fan of confirmation bias. So I'm happy to uh to hear you speak a lot of the thoughts I've

been saying to UM. But I would say, you know, if I'm gonna play Devil's advocate here and and lay out the bullish case, it is pretty compelling simply the the amount of money being thrown at the problem by the government and the Federal Reserve. I mean, the FED has basically inoculated the credit markets from the type of real trauma that could really make this a lot worse

economically and and market wise. UM. People on unemployment now are getting in many cases being paid more than they were making before they lost their job, at least until that that federal UH extra help expires in July UM. But then unemployment claims being extended. There's a lot of money being thrown at this problem. Um, is it possible that you know it's it's problem solved given all the support being thrown at this it's definitely problem helped. Uh.

Is it possible it's problem solved? I mean, you know, nothing is impossible, so maybe it's it's problem solved. You know. The reality with the credit markets is tighter credit spreads are helpful, but at the end of the day, what the credit markets need is corporate cash flow. Uh. And corporate cash flow is tough when revenue is down a

ton um. And even as the economy opens up. I don't know whether the economists were the ones who coined this, but they talked about economy right, we can't get quite all the way back. It will feel better than April did, um, But until we can really get the pandemic behind us, we can't go all the way back. And the problem with being a economy is the economy was not built to run at the operational gearing right relative to GDP

of corporate profits is large UM. So if the economy is running at even the drop off in earnings should be a multiple of that UM. But if you look at the earnings forecast. Q four earnings forecast is down six relative to Q four two nineteen, which was really one of the best quarters in history. UM. And that strikes us as wildly implausible. UM. The other issue where I think it's hard to fix the entirety of the problem, UM, is you can throw a lot of money around, but

it isn't so easy getting it to the right places. Uh. And we've seen that with the p p P program, where you know the money was going to the wrong businesses. Bisness is that really were deserving of it. Couldn't get banks to answer the phone, They couldn't get the website to work. The money was not flowing and is still not flowing to the small businesses where it really needs

to be. And frankly, on the unemployment side, the sad truth about this country is the state unemployment benefits have been made in many cases intentionally difficult to get right. You have to jump through a lot of hoops, you have to fill out a lot of forms. People don't understand how, and not everybody who is eligible, not everybody who should be getting the money is getting the money. Uh. And then the last piece that I think is worrying and Frankly, I worry about this more in the US

than I do in the rest of the world. UM. I've been hearing a lot of people talk about the idea of UM resilience and supply chains, and people have learned from this that having a far flung supply chain is an unacceptable risk and they're going to have to do something about it. Honestly, I don't get that. Uh. You know, just in time inventory works of the time, So there's five percent of the time where it doesn't work,

and so you can't produce the stuff you want. But man, the profitability on that five had better be awesome to make up for the higher cost of good soul in

order to have that broadly resilient UH supply chain. On the other hand, the one thing that the US has done over the past twenty years is we've moved to this just in time corporate cash flow management, where most of the corporate system has levered themselves up in a way that works if everything is happening smoothly, and suddenly everything is not happening smoothly, and the wheels will not come off in the first month or two, but over the core of the next nine months, the next eighteen months.

We have an awful lot of capital structures that were not designed to handle even a normal recession, let alone a very severe one. So it sounds like you're not a believer in this whole idea of uh sort of reflation as companies on shore overseas manufacturing again, I mean in a way that's that would be you know, assuming that pandemics or something and we're gonna have to deal with on a semi regular basis, you know, kind of fighting the last war rather than preparing for the future.

I guess yeah, I mean, pandemics are something we will have to deal with periodically, a truly global pandemic. It doesn't matter a ton where your supply chain is, unless we're talking about you know, medical necessities where uh, you know, nationalism may become an issue and you really want to be producing your masks and and your swabs in the country. If everybody is having a mom it doesn't matter whether you're getting your stuff from Michigan or while the world

is a smaller place than it used to be. Um, it's not obvious to me that, oh, pandemics are now something we should expect to happen once a decade, and I think that we can all hope that next time we will all be more prepared, considering now that pretty much every country around the globe has been through this.

But Mike laid out the bowl case for us, and I'm just curious what you think, Ben, I mean, when does that reality actually strike then, of the realization of the depth of the recession that we are actually facing. I mean, I've seen this chart floating around this past week of the price liquidity ratio. So you have the market cap of the SMP plotted against them two money supply and people saying, look, it's below average. There's so much cash flooding the system. There actually is a lot

of room potentially for upside in the market. I with that case, with that argument out there, when when is the reality of the depth of the recession actually take over and hit? Honestly, I don't entirely know. You know, the interesting thing about where we are right that this is we are beyond the depths of this recession. Right. We may get a w we may get an l who knows um, but probably the worst fall was March and April UM So it's a weird recession from that standpoint.

The funny thing is, if you think about past recessions, most of the time, when you are two months into a recession, nobody has any idea the recession has occurred. Right. It is only well after the fact that we say, oh, guess what, this recession started in you know, December two thousand seven, and you didn't know it until September two eight. But the recession was really there. Um. So I think at some level, um, we haven't come to grips with the kind of the depth of the lasting problem here.

There's been so much of a fixation on the acute problem um, and much less on the issue that you know, for all the money that is being thrown around, GDP is down a bunch, right, There is simply a lot less output happening. Um. And again, corporations thrive on output. The other thing that corporations rather desperately need is enough certainty to cause people to want to make investments. Um. And you know, maybe I am the person here who uh is just is kind of has has failed to

drink the kool aid that everybody else has. But if I was running a kind of traditional business right now, I would not want to be doing a lot of investing. You know, I might have to invest in some ppe so people can come back to work or something. But I'm not going to build a new factory, you know, I'm not. I'm certainly not going to sign a long term lease for new office space because suddenly I've realized, well, actually, maybe people can work from home. Maybe that actually is

a thing that can happen. UM. So you know, you know, the two biggest pieces of uh G d P are consumption and corporate investment. UH. And I don't see how corporate investment gets to normal until corporations are truly seeing Okay, I know what the future looks like, and it's good. Um. And frankly, even if currently unemployment benefits are pretty good, uh, I would think precautionary savings should be going up right now. Your certainty about what those benefits are going to be

is pretty low. Um. Your certainty about your job situation is pretty low. I don't know whether. I mean. One of the things, um that could be going on, UM is that this recession, even more than normal recessions, has cost jobs from the lower paid segment of the workforce. UM. And you know, the rich people can work from home, and that's working okay for them as long as they

have some child care somehow. Um. And and so maybe this just doesn't seem so bad if you are if you're working from home and uh, you know you've got some time back on your commute. Um, if you are not sure whether the businesses that you work for are ever going to come back and where your job is going to be Um if they don't. UM, I'd say, even if you're getting a surprisingly good unemployment check, which not everybody is, uh, i'd want to be saving some

of that. You know. It's you make a great point about not having to date this recession or no one's waiting for the NBER to come out and officially officially give us the start date of this one. Um. But you know what I think of the reasons why recessions and bear markets always go hand in hand. Obviously, you know that their earnings damage uh causes valuations to be

less a tractive to investors in the equity market. But I also think part of it might be, you know, stocks for a lot of individuals become sort of a piggy bank where you have to cash out if you had lost your job, you know, maybe cash out some of that retirement money to pay your mortgage, to to pay those tuition bills whatever it is, you know when and on the institutional side, um, maybe you have head hedge funds that you know have to de risk for

a variety of reasons, margin calls and that sort of thing. So I what's weird about this one, and Sarah's written a lot about this, is we keep hearing sort of the opposite that all of a sudden, this retail trader, retail investor is super engaged in this market, uh Matt Levine. Sarah had a funny reference to your one of your stories saying, there's no other entertainment left, you know, everyone's done Netflix. So people are so bored they're they're firing

up there their e trades and their schwab accounts. Um. I think he calls it b MH boredom, market boredom, the market hypothesis. So you know, but I wonder if you've given any thoughts to that, is that sort of you know, the people that are getting a little extra unemployment insurance uh cash, then they would have made otherwise everyone who got their stimulus check from the government. Is that part of this sort of little sugar high we've

seen in this rebound. And if so, I mean to me that seems like it has an expiration date on it that is fast approaching. You know, the federal unemployment supplement I think expires in July. So, um, you know that seems like a little bit of euphoria that could get sapped out of the market pretty quickly. Yeah, I did.

I did. Uh read that peace and quite enjoyed it. UM. In general, day traders don't have a lot of money and are not putting a lot of money to work, So I haven't seen the the hard data on it, UM, but I wouldn't be surprised if they were driving the performance of some of the particularly volatile stocks UM. But for them to be driving the overall market would be an impressive feat. Um. It takes a lot of money to do that. Uh. And And frankly, one of the

things I'm impressed by. In recent years, the only buyer of note of US equities have been US corporations buying back their own stock um, and there has got to be an awful lot less of that going on right now. UM. So I will say I am impressed by the market's ability to go up without its big driver of demand there. UM. But UM, you know, there's the old saying that in the short term the market is a voting machine and

the long term it is a weighing machine. UM. And the biggest reason why markets have a strong tendency to get cheap in really bad economic times, UM is because of the coincidence. And it's not a coincidence, it's it's completely causal. But UM, corporate cash flow drives up at the same time that people's other sources of income drives up. And the reason why there needs to be an equity

risk premium is not just because equities are volatile. It's the circumstances in which equities are going to give you really bad returns UM. And I don't see that there's any way to unhook that in the longer term. UM. If stock prices, you know, stay up and and push higher, well, corporate cash flow is clearly worse. UM. Then I guess it could be that people are prepared to own equities much lower returns than they used to be UM. And and maybe that can work, and maybe that can be sustainable.

We heard that story in two thousand UM part of the pitch for why the stock market made its sense was that there shouldn't be an equity risk premium. Um. Uh. It always struck me as a very strange thing because at the time, if you asked the people who were buying stocks, what returns were you expecting from stocks, they were expecting extraordinarily high returns. They weren't saying, Hey, I think I'm going to get you know, two percent plus inflation,

but I'm good with that. Uh. And I haven't heard anybody saying, you know what, I'm buying Google today because I think it's going to give me two percent real um. And in this world, I'm fine with two percent real. If we were getting that, UM, I would be a little bit less scared for the market. Uh. Then if people are saying, well, look, with the Fed here, the market can't help but go up. And so all I care about is is the short term, I think scared for the market, we can we can leave it at that.

That's your segway. We're living in unique times, crazy times. In the short term. This podcast is your place for thoughtful analysis. It's here in the long term, it's really a place just for crazy market stories that that we've all witnessed. It's so that's what people come for. They want their return on crazy things. So, um, I think we got a call into what goes Up hotline from a listener down in your state of sunny Florida. Let's

give that a listen my neck of the woods. Well, my name is Morgan Hill, calling from Bookerts from Florida. My mestwor is for what goes Up? Uh blue Berg podcast? What's crazy about this market? What I've noticed just here

on Tuesday is uh, the change in which driving market returns. Um, you know through yesterday, Uh, you know youre to day, we witnessed technology really providing the buffer for you know, overalltly returns, and you know through Tuesday, real estate and industrials are kind of leading the way, you know, followed by financials and you know, communication services. So it's it's quite interesting to see the change of of you know, the wave. But I think that's that's pretty crazy. Everybody

has a great week. Yeah, but that sounds a little bit like the value rotation you were talking about, right, Uh, financials industrials at least, Um, I guess you'd throw energy into into that group as well. Yeah, I would. Uh, And and again that's the economic reflation trade. And I don't know whether it's right from a timing perspective, but I mean, there is something weird about a market where tech was leading on the way up, tech leads the way down, and then tech leads on the way up again.

There's at some point that has to end. And the groups he was talking about, our groups that have been pre beaten down and we'll recover at some point. Um whether we have enough data to say, oh, few the worst is behind us. Uh, let's go off to the races now with the more economically sensitive ones. You have to be you have to have a better crystal ball than I to be confident that that's the right thing to do. But a change of leadership in the market, my god, is at least well overdue. Is what we

saw this past week. Do you think it's uh what it might look like for the market on the way up? Just a bit too soon? I mean, considering how you describe how you guys were positioning earlier on in the show, even though you are reducing your net equity exposure, I mean, is this what we should expect? Though, once we do get to that point when we're out of the woods, it certainly could be a lot of it depends on what the world looks like when we finally can see

our way through. UM. But ordinarily, in you know, the recovery from a bear market in recessionary low, it would be the smaller cap stocks, uh, and the more economically sensitive companies that would lead the way. So that that does make some sense. UM. It does not necessarily mean the markets, right, but it would make sense. Alright, Sarah, let's see you make sense with some your craziest thing, alright. So, UH,

I have a statistic. We talked about the speed a lot of the recovery that we've seen and really just how unbelievable it has been. And this statistic comes from Sundale Capital Research, and this past week we saw the SMP move not only above three dolls in, but also above it's two hundred day moving average. And what they found was that typically, on average, if you fall in from a high, the time it takes to get back above that two hundred day moving average is typically over

two hundred days. Well, this time we've done it in fifty six days, fifty six trading sessions. UM. So that kind of just shows you how quick the snap back really really has been. And then I also have one that's a bit more fun. Uh. The SpaceX launch moved to Saturday. But I think we're all sitting back waiting with bated breath on the launch. And I mean pretty crazy that we're going to have the first launch with an American company off of US soil UM to the

International Space Station. Since even that is pretty cool. That's pretty cool, I gotta admit. And I don't know if they warned you about our gimmick, but have you seen any crazy stories in the market this week? Nothing? Nothing

that specific this week. I mean the craziest action I think I have seen, uh this year other than oil going negative, uh, is what happened to Wayfair, which is a company that there is that one of the pms of my firm has quite liked UM and from the middle of January to the middle of March it went down something like eight uh. And he was scratching his hat. He's like, I don't understand why they're why it's doing this, because these guys should be beneficiaries of stay at home, right.

If you can't go to furniture stores, you have to shop for your furniture online. Uh. And well, they're all they're all sourced out of China, though right mainly not everything is sourced out of China, And it would have been weird if that had driven them to bankruptcy. M But speaking of the speed of recovery, um, from that low in the middle of March of twenty three and a half, it then went up to a hundred and

ninety in less than two months. Um. And I mean, if that is not a market with some kind of a d h D problem, I don't know what is, you know. I think it was wayfair. Uh that was advertising to me on Instagram this past week with pictures of saunas and big saunas to have in your homes. And I always think of furniture, and I'm like, what is is sauna now being classified as stay at home furniture? You can't get out to your sauna. I really was

intrigued by it. Well, I'm witing for our air conditioner to be services, so it's kind of like a sauna here in my house. Hopefully they'll they'll get out here soon. Um. Well, that's a good one, Ben, I like that wayfair stock a d h D. That's a pretty good one. Sarah I'll give you mine, But first, Sarah, I gotta say. I reached out to our chief crazy things correspondent, vil Donna Hirich and and because she'd really been slacking on the job, I hadn't heard a single crazy thing from

her since the pandemic hit. And her response was, Oh, that's unfair. I've been feeding Sarah crazy things this whole time, like three yesterday, And I'm like, what what, Mike, You know what it is. She just she trusts me with the content more more than she does with you. But yeah, we've we've been we've been wrong and uttered that I'm I also have outswerced my crazy thing this week, um

to a listener in Buenos Aireas, Argentina. And yes, this is partially just a flex on our part that we have listeners in Argentina, which I think is really cool. So a little bit of a flex. As the kids say, hope, hopefully I'm using that that right. Um, you're using it right, Mike. You know, I like to illusion that I'm a young hipster.

His name is Manuel Goody Luque. He's a lawyer at Baker Mackenzie and Buenos Aireas, and he points out in Argentina, rather than worry about the effects of UH low oil prices on the economy, they just pegged the price of oil at at forty five dollars of barrel. They called the barrel creola CREOLEO. I'm not I'm not pronouncing it right, but the barrel creoleo. UH. And the government's basically pegged oil at forty five So if you're a refiner in UH refinery in Argentina, you have to pay forty five

bucks of barrel. And the idea is to sort of support UH. You know they're big their domestic industry. YPF is the big producer. Um ben I don't know about this though. UM, you support your your upstream oil production. But you look at the Argentine pays so what it's been doing lately, and you're gonna make it basically unaffordable to fill your tank. I think in Argentina, what what do you make to that move? Unfortunately, that doesn't sound that far out of the norm for Argentina. UM, I

have a good point. Argentina has done a lot of things like that over the years. Right. They used to have people coming in before the economists were calculating UH. The inflation rate to reprice goods in stores UM, which would then be repriced exactly afterwards. UM. So Argentina unfortunately doesn't necessarily want to live in the world as it is, but the world that they would like it to be. UM, and that may have something to do with why they seem to have now just defaulted for the third time

in the last twenty years. Well, it's uh, it's certainly interesting. But I am highly certain that we won't have forty five pegged oil here in the US at any time in our lifetimes. Likely I'll agree with you on that, although whoever thought we'd see negative oil prices, so who knows? That's also true. That's also true. But with that said, Ben Ankara, thank you so much for coming on the show today. We really appreciate it. Thanks very much for having me. What goes up? We'll be back next week.

Until then, you can find us on the Bloomberg Terminal website and app or wherever you get your podcasts. We love it if you took the time to rate and review the show on Apple Podcasts so more listeners can find us. And you can find us on Twitter, follow me at at Sara pont Sech Mike is at Reaganonymous and you can also follow Bloomberg Podcast at podcasts and

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