alternative investments, the SEC and Trump

My earliest experience with alternatives was as a rookie analyst in 1979. Among other things, I was covering small oil wildcatters who funded themselves by promoting oil and gas limited partnerships sold through retail brokers. The 1/2″-thick prospectuses laid out terms that were so unfavorable to limited partners that at first I couldn’t understand why anyone would buy them. So I asked the VP Finance of one of my coverage companies. He laughed, and said the offerings were not for people who wanted to make money. They were for people who wanted to tell others at a party that they were wealthy enough to have an income tax problem.

I remember a China-oriented private equity fund whose prospectus touted the promoters’ prowess through their extraordinary history of high returns. The returns were high–but, after fees, they matched almost exactly those of the Hang Seng index. Again, lots of sizzle but…

As part of the financial reform after the financial crisis, and because of widespread improprieties in the alternatives industry–like misstatement of returns, or professional credentials, or size of assets under management …or other stuff I’d call flat-out fraud–many alternatives providers were required to begin filing reports with the SEC, which has since prosecuted a number of high-profile cases of abuse.

Trump is now taking two actions in support of alternatives, both of which seem to me only to be pluses for dubious alternatives promoters. He’s proposing that ordinary investors be allowed to buy alternatives in 401k accounts (they’ve been barred as too opaque and risky). He’s also “solving” the issue of fraudulent reporting by ending the mandate that smaller alternatives firms to file their results with the SEC (removing the threat of Federal prosecution for, say, falsifying returns).

Neither makes any sense to me. Why do this? Maybe the same reason Trump has made no effort to keep his promise to eliminate the carried interest ploy private equity managers use to avoid income tax.

I’m raising a little cash

why not to do this

One of the earliest lessons I learned as a portfolio manager is not to raise cash. How so?

–it’s much harder to figure out whether stock A or stock B is cheap or expensive in absolute terms than it is to figure out that A is cheaper than B. This means the easiest way to beat the stock market is to keep fully invested and spend all of your time trying to find more As and eliminate any Bs

–the penalty for having a large cash balance and being wrong can be severe. One of my former work colleagues, running a high-profile value-oriented portfolio for pension clients, decided one day that the stock market was overvalued and that he would be a hero to clients by raising 40% cash. This is like professional suicide. He did it anyway. For the following two years the market went straight up. Nothing he did could offset the negative effect of that dead-weight cash. And after a short while he was so deep in the hole that he felt he couldn’t admit his mistake and reinvest the cash. It took a huge market downturn to give him an opportunity to buy in again. But all that did was more or less recoup the performance losses he had sustained by raising cash in the first place. Then he was fired.

–personally, I’m very bad at judging market tops. I’m pretty good at bottoms, I think. But I tend to think that the good times can go on longer than they actually can

why I’m doing it anyway

To be clear, I’m only selling about 10% of my portfolio, mostly paring back individual positions by that amount. That’s not enough to fundamentally change my portfolio composition–in other words, the gains/losses from this move may end up only as a rounding error in performance attribution. So it’s more security blanket than anything else.

What’s causing me to act is something I usually don’t like to talk about: performance.

performance

One of my early mentors told me he thought a good securities analyst could find a way to make a 20% yearly gain in almost any economic circumstances. In less folksy style, I’ve come to think of a good year as the market return (S&P 500) plus 5 – 8 percentage points; if the S&P 500 is up by 10%, I’d like to end up in the +15% – 20% range.

So far this year, however, my “capital flight” idea, envisioning the US today as like Mexico in the 1980s, has worked much better than I would have thought. That’s, unfortunately, because the Trump administration has been much more toxic than I could have dreamed. The result is that my portfolio is already many times ahead of my yearend relative performance target (I really dislike writing this last sentence. My experience is the minute you begin to pat yourself on the back, your performance begins to fall apart).

Still, I don’t think the epic wave I’ve been riding can go much farther. That’s probably my strongest belief right now. The only way I can see for present conditions to continue would be if we knew that Trump would be reelected. I don’t want to replace names I know with new ones that are basically the same thing. That’s just the anti-US pro-Trump bet all over again. But I don’t have a firm idea of where to go next.

Hence, 10% cash.

the dollar, gold and bitcoin

the dollar

The biggest influences by far in the currency markets are the large global banks. I view them as playing a very sophisticated game that looks much farther into the future than the one the typical equity person like me is involved in. One consequence is that significant changes in the economic environment often start to play out in the currency markets before spreading elsewhere.

The currency markets aren’t infallible indicators. The dollar dropped by 20% against the euro (which is not a stellar currency, either) during the first year of Trump as president. Since then the euro has been sliding back, as Europe’s internal problems–Brexit, Italy, early, very deadly arrival of the coronavirus–came to the fore.

Despite all this European ugliness, since mid-May the US dollar has been dropping, steadily and sharply, against the euro. It’s now down by about 9% against the EU currency.

How so? mostly Trump’s incompetence, I think. Europe used US medical science to control the pandemic, while Trump’s urging his supporters to flaunt medical recommendations has it raging again domestically. I don’t think the currency markets are as much concerned about the deaths as about the second round of fiscal stimulus that his bungling has made necessary and its effect on the national budget deficit/national debt.

Trump has also compounded the risk of holding Treasuries by his suggestions that the the US may choose not to repay holders he doesn’t like.

There’s no reason to think the bad news is over, either. Trump is insisting that schools reopen on schedule without pandemic safeguards–creating the worry that a third multi-trillion dollar support payment may ultimately be needed. He’s also intensified his campaign of race hatred, drawing comparisons with Hitler’s rise in the 1930s. Then, there’s the test to detect signs of dementia that he keeps mentioning–which can be seen itself as a sign of the disease he insists he is not suffering from.

implications

Currency weakness is good for exporters and bad for importers. It’s also good for the many S&P 500 companies that have foreign subsidiaries.

gold

Gold is up about 12% since mid-May. An old, but still useful, rule about the gold price is that it remains stable in the stronger of the two currencies, US$ and DM (now the euro). In other words, most of the price rise is due to the decline of the dollar. Still, there has been a small upward movement. My interpretation–and I’m about as far away from being a gold bug as one can get–is that this is more a reflection of how pricey everything else is than a genuine desire to own gold

bitcoin

Personally, I think there’s a better case for bitcoin than for gold. There’s been a sharp spike in bitcoin this week, again more, I think, a result of how expensive other things are. Were Trump to be reelected and his fracturing of the US economy to continue, I imagine bitcoin would draw a lot more interest.

Trump underpins tech stocks …for now

The EU has a third more people than the US, has an older population and was in worse Covid shape than the US in early April. Today, however, US daily new cases are about 15x those in the EU; daily new deaths here are 7x those in the EU. The difference? The EU followed the recommendations of US medical scientists; Trump urged his supporters to ignore them.

The economic result for the US is a deeper, longer-lasting downturn than elsewhere in the OECD, huge amounts of Federal government assistance to keep the economy afloat–with a resulting budget deficit that could soon reach $6.0 trillion, vs. $0.6 trillion when he took office.

Rather than try to mitigate the suffering the US is going through, Trump appears to have decided to try to shift national attention away from his central role in creating this tragedy by creating a second, competing disaster. After the armed forces refused to help, Trump organized a gang of from other Federal agencies. Members wear identical camouflage combat gear and carry weapons. No identification on their bodies or vehicles, however. Not a thought about probable cause or excessive use of force, either. In other words, they’re shaped on the Gestapo/KGB/Stasi secret police model. Empowered by executive order and against the wishes of state and local officials, Trump envisions sending these groups into Democratic-leaning cities to instigate violence. Portland is his test case. News reports of the Navy veteran beaten in Portland (he decided to remind Trump’s minions they took an oath to defend the Constitution) show what’s going on. Kristallnacht in America is something no one would have believed possible four years ago. Talk about the banality of evil.

Relevance for the stock market? …a lot.

I’ve been writing for a while about the divergence between NASDAQ and the Russell 2000. The former is the part of the US stock market least tethered to the US by customers, revenues or physical assets; the latter represents the part most closely linked to domestic economic health. NASDAQ is up by about 55% since the beginning of 2018; the Russell 2000 is down by 4% over the same span. I read this 60 percentage point divergence as the stock market’s response to the ongoing economic damage Trump is doing to the US. The spread is very long in the tooth. It’s also so wide that it is begging for at least a temporary reversal of form. So far, however, every attempt at a counter-trend rally has been nipped in the bud.

How so? I think the pro-NASDAQ portfolio configuration has a second motivation. It is also the first step in capital flight from a country moving in the wrong direction.

Recently, coinciding with Trump’s more explicit white racist actions and the resurgence of Covid in the South and Midwest, we’ve begun to see a second aspect of capital flight–a 5%+ decline of the dollar vs. the euro over the past few weeks. The US currency has even lost ground to perennial weaklings sterling and the yen.

It’s hard to know how this all will play out. A Trump win in November is the easier case. I imagine it would create a seismic negative shift in global attitudes toward the US. That would result in a steady outflow of our most productive human and financial capital. The dollar would continue its decline. Maybe, government bonds would begin to sag, too. At some point, Washington would presumably close the border to outflows, a la Mexico 1982. NASDAQ would likely go up, led by firms announcing the relocation of intellectual property-creating operations abroad. Maybe dual listings in New York and China. China and the EU stand to be the big long-term winners.

I think a Trump loss would much more complicated. There’s the issue of repairing the enormous economic, financial and cultural damage he has done to the country. There are also the former heavy industry areas, core sources of Trump strength, which have been ignored by both parties for decades at great national cost. A counter-trend rally might finally happen–maybe even pre-election if a pro-Biden outcome were clear. Would it have legs, if so?