Mean Reversion and Momentum

1 min
January 23, 2023
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Markets have two ‘modes’ – momentum and mean reversion. Last year of course was a huge momentum year for the Macro Traders. On the negative side. They made their huge profits from a short position in Bonds, Equities, Metals and Currencies (against the $). Medium term asset allocators meanwhile took the pain in their 60:40 portfolios, something we have discussed a lot recently. There has also been some capitulation amongst retail investors, with Goldman’s estimating that US Retail has now sold all the stock it accumulated during 2019-2021.

The year has started with mean reversion, which means it has been particularly good for International equity markets, most of which are up double digits in $ terms (gaining a tailwind rather than a headwind from the currency, unlike last year), as portfolios are rebalanced and ‘underweight’ positions attract inflows (something we discussed in the latest Friday Market Thinking). Equally, overweight is now attracting outflows. The BoA survey shows that US Equity Allocation as the lowest since 2005 (chart shows % overweight).

Meanwhile a number of our year ahead themes, European Banks, Global Miners, Chinese Internet stocks etc are up a few percentage points more than that. The commentariat are still divided as to whether there will be a second leg to the bear market, but it looks to us like it will be mild, or rather much more sector specific. Also interesting to note this week has seen a mean reversion’ in the outperformance of equal weighted to market cap weighted indices on the S&P and Nasdaq.

The Fed are now paying the Banks, not the government

We prefer European Banks, not least for the fact that they haven’t paid out dividends or bought back shares, unlike their US counterparts, but that doesn’t mean some of the US Banks aren’t in a sweet position now that the Fed has flipped on rates. One thing that has been somewhat overlooked is that for a number of years, the Fed has been paying its ‘profits’ to the US Treasury at around $100bn a year, but that, thanks to rising interest rates, that Profit has now turned into a loss. This obviously is something that the Federal Budget will have to take into consideration, but it also reflects a shift in power; the Banks are now able to expand their balance sheet, borrowing cheaply off their depositors while running a nice carry trade into ‘risk free’ government paper. The flip side of this of course is that there are a record number of companies in the Russel 3000, where interest Expense is greater than EBITDA. This blog does not give stock advice (it is for information and entertainment purposes only), but it does without saying that screening these Zombies out of portfolios remains a key part of Financial Housekeeping.

Peak Davos?

As we noted last week, there is a feeling that we may have reached ‘Peak Davos’, in line with a shift in the belief system away from Macro, top down, ‘solutions’ proposed in response to Macro, top down assertions of ‘problems’ . What used to be known as the ‘throw a brick through the window, then sell them a burglar alarm’ approach. This shift of attitude has come with the growing realisation that most of the problems that have arisen have in fact emerged as the unintended consequence of other top down policy actions. We are of course thinking mostly here of our old friends the Triple Zeros, two of which, Zero Interest Rates and Zero Covid are now consigned to history, leaving the third policy error of net Zero to do all the heavy lifting at Davos.

Davos is, in essence a caricature of our Western Political system – an unlikely alliance of Centre Left European Socialists, with a French ‘dirigiste’ mindset and US style corporate lobbying. Neither side has much time for the messy issues of democracy, which is why none of the three Zeros was ever part of a democratic mandate or political manifesto. Mutual self interest brought them together and Klaus Schwab made no secret of his business model – if you are charging delegates $250k for a ticket, they had better believe that they are getting something for their (company’s) money. It used to be known as ‘a meeting where Billionaires tell an audience of millionaires what the ordinary people are thinking’ and while there were apparently still 116 billionaires attending, this year’s list felt distinctly ‘second tier’. In previous years the crowd have seen the likes of Trump and Xi, but this year there was only one G7 ‘leader’, Olaf Shulz of Germany and obviously no Putin, or Xi, but no Bill Gates, nor George Soros either. Although we did have John Kerry and Al Gore to hype up the climate change bit. In fact the most important thing to come out of the week (in our opinion) was the announcement from Saudi Arabia on accepting payment in other currencies for their oil. Something very much not in keeping with the New World Order.

We also sense a split appearing in the ranks of the Davosians, as ‘Saint Greta’ railed against the pursuit of profit, while the dreams of the true Globalists like Tony Blair and Mark Carney are extending far beyond their Net Zero agenda into multiple other areas. Look at this year’s agenda, which was dominated by one phrase:

  • High inflation, low growth, high debt economy in the context of a new system for investment, trade and infrastructure.
  • The current geopolitical risks in the context of a new system for dialogue and cooperation in a multipolar world.
  • The current energy and food crises in the context of a new system for energy and climate
  • The industry headwinds in the context of a new system for harnessing frontier technologies for private sector innovation and resilience.
  • The  current social vulnerabilities in the context of the new systems for work, skills and health-care.

Of course, each of these ‘New Systems’ is one designed by Klaus and his friends and is basically one of tax and subsidy. With them in charge. As the FT wryly pointed out, the leaders of the EU countries would probably have preferred to hear Ursula Van de Leyen’s plans for yet more Green Subsidies (to compete with Joe Biden’s) before she told them to 600 odd CEOs that had paid Klaus $250k for the privilege. To date, these CEOs have largely been on board with the Green Agenda as it has been profitable to do so, but they are very unlikely to think the same about this further power grab. Building new systems involves throwing out old ones and that harms a lot of vested interests.

Meanwhile, just as Davosian inspired ESG is getting push back in investing circles, so it looks to have hit resistance in the upper echelons of Banking. It was interesting to see that Fed Chairman Jerome Powell caused something of a stir last week with his speech in Greta’s native Sweden, where he repeated his standpoint that the Fed’s independence means it is not going to be a policy maker on climate (something the hugely powerful climate lobby has been demanding).

We are not, and will not be, a “climate policymaker.”

Meanwhile, the Federal Reserve Banks themselves are increasingly vocal about ESG, most notably the Capo Di Capo, Jamie Dimon ,in contrast to WEF stalwart Larry Fink of Blackrock, who might also be wondering about how one part of his business – the one that borrowed at floating rates to buy up swathes of housing – might be faring as the other side of the trade of rising short rates that Jamie Dimon and his fellow bankers are now benefitting from.

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The 99 States of America

The multi-polar world emerging is producing a new 'Dollar Zone' of NATO plus Japan and S Korea. Investors need to start thinking what this will mean for capital flows.

First slowly....then all at once.

SVB was a shock as everyone assumed everyone else had done the due diligence, but in reality it is a simple story of a bank that became a bond fund and failed to manage its duration and funding risks only to be hit with the equivalent of a redemption as its almost entirely corporate deposit base asked for their money back. By contrast Credit Suisse is hardly a surprise, but coming at the same time, and also in options expiry week, helped to create an exaggerated sense of a banking crisis. There isn't one. Both banks are the collateral damage of the shift to a new New Normal, where interest rates are set at 'normal' levels and normal companies can make normal profits (while great companies can make great profits). Investors should use the sell off from expensive end of fair value to cheap as an opportunity to renew or place their bets on the likely winners under this new paradigm.

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