Valuentum Exclusive Analysis for the Discerning Investor

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The markets rallied hard September 5 on relief that the US and China (FXI, MCHI) will go back to the negotiations table next month. This back-and-forth news cycle is enough to give any investor whiplash. Let’s catch up with the Valuentum Team on the latest developments, not only with the trade war but also with respect to factor investing, possible bubbles and beyond. Let’s kick things off with the following prompt from ForeignPolicy.com, released August 2:

Trump Hired Robert Lighthizer to Win a Trade War. He Lost.

Robert Lighthizer, the U.S. trade representative, agreed to serve in President Donald Trump’s cabinet in order to test his theory: that if the United States freed itself from the shackles of international trade rules, it could use the power of its large market to force other countries to bend to its will. Trump, with his stated love for tariffs and his conviction that the United States had been losing on trade for decades, seemed the perfect leader under whom he could test that proposition.

Now, with Trump having announced that new 10 percent tariffs will be imposed Sept. 1 on the remaining $300 billion in Chinese exports to the United States, that theory has been shredded. The administration has fired almost every salvo it has to force the Chinese into submission, and the two countries are further away from a trade deal than ever before.

Callum Turcan: Generally speaking, I agree with this take. After the US-China trade talks blew up in May 2019, and given that two trade "truces" reached between President Trump and President Xi during two different summits (in December 2018 and June 2019) quickly broke down, it became increasingly clear that a politically acceptable deal between both parties had become nearly impossible to reach. Neither side can give in now, but it's possible the US blunts the impact of tariffs by adjusting what is and isn't hit with tariffs (and when), particularly with respect to the US-China trade war. The odds of a trade deal being reached before the end of 2020 isn't impossible, but any concrete agreement remains pretty unlikely (let's say less than a 25% chance) at this moment.

Brian Nelson: As I mentioned in a prior Economic Roundtable, “I felt following the tone of Trump’s tweets Friday, August 23, that (President Trump’s) staff may have talked him down from something very, very aggressive in response to the retaliatory tariffs from China. The adjustment to 30% from 25% on $250 billion of Chinese goods on October 1, and to 15% from 10% on another $300 billion worth of Chinese imports on September 1, was very, very mild compared to what I was expecting, especially in the context of his tweets.”

It turns out that President Trump’s staff did talk him down as he wanted to double tariffs. Given the latest back-and-forth saga and the upcoming 2020 election cycle, I think Trump is going to do whatever he can to cut a deal soon. It may not be exactly what the US is looking for, but I think whatever the deal will be, he will “declare victory” as he builds talking points for the upcoming debates. I think he knows China can just wait him out, so I expect a much more amenable President Trump at the next round of talks.

On the other hand, the best move for China at this point may be for no-deal, no matter what, and hope that President Trump loses the 2020 bid. If China agrees to anything before 2020, it may boost President Trump’s chances at reelection, and if President Trump is then reelected, it could mean another four years of trade wars, as President Trump may then go for the jugular and get all that he wants from the country. I think President Trump now wants a deal badly, and China is indifferent, knowing that the longer it waits, the better terms it might get.

All things considered, the White House may have fired its last shot when it modestly raised tariffs last month because doing anything more aggressive may ultimately come home to roost as it may drive the global economy into deflationary bust. It is possible President Trump’s political advisors have painted him into a corner. We’ll see what happens at the next meeting, but I don’t think China is ready to put things behind it. I think China will wait until after the 2020 election to determine long-term trade policy.

In other news, I wanted to mention a great article from ThinkAdvisor, Rob Arnott: Factor Investing Is ‘Overhyped.’ I talk a lot about the same concerns in my book Value Trap: Theory of Universal Valuation. Rob says “the biggest risk is that many factors aren’t real. They’ve worked historically, but that doesn’t mean they’ll work in the future.” Rob also shares some of my other concerns, why there are so many factors and why they perform so poorly:

The thing is that every single one (factor) … works in back tests. But all that tells us is that people publish only the ones that did work. It doesn’t tell us that factors work… The factors themselves were identified as a consequence of aggressive data mining.  If you mobilize the entire academic community to search for factors because that’s the easiest way to get tenure and you discover a factor that hasn’t been published before — great! You become the expert on that factor and get tenure! So there’s a powerful incentive to look for relationships that may or may not have merit.

Callum: Rob’s comments on target date funds and asset allocation are quite interesting, as he sees the equity side of portfolio allocation better reflected by a curve (starts low when "young" and grows to ~80% by the time the investor is in his/her 50s, before quickly dropping as the investors hits his/her 60s) than a slope (starts high when young and decreases from there). Arnott is optimistic on emerging markets and bonds in those nations, as he doesn't see those spaces as richly valued as US equity markets, but I think exogenous shocks (trade wars) will put a lot of pressure on emerging market (EEM) economies in the medium-term (including on equity values and credit metrics).

Brian: Bloomberg recently reported that “The Big Short’s Michael Burry Sees a Bubble in Passive Investing.” For those that may not know this name, Michael Burry was catapulted into fame in the movie “The Big Short” as the hedge fund manager that bet big against mortgage backed securities prior to the Financial Crisis.

Burry is now calling for a “bubble” in passive management, and I tend to agree. There are over 5,000 ETFs and by some estimates as many as 70 times as many stock indexers as there are stocks. Anybody that is not calling a bubble in passive may not be calling it straight, in my view. There are simply too many ETF and index providers out there that will continue to push unnecessary products to consumers.

It’s also important to differentiate between something being popular and a bubble. That something is popular doesn’t mean it’s hazardous and can lead to bubbles. However, as indexing and passive proliferates, fewer and fewer investors are paying attention to the value of their stocks, and this sets the stage for bubbles and crashes.

In this case, yes, index popularity can lead to bad things. Even Jack Bogle says that it could lead to chaos. Incentives are in place for index funds to continue to be sold, and I think it just comes down to decades of ill-marketing and investors not getting fee transparency, after all fees. It’s not a good situation for the investor.

Callum: What I think is interesting is that Burry is bullish on some domestic small cap stocks (IJR)--pushing Tailored Brands (TLRD) and GameStop (GME) to buy back stock, while Arnott was bearish on U.S. small caps according to his commentary in another article. Both investment managers are optimistic on emerging markets, but appear to have widely divergent views as it relates to holdings within the Russell 2000 Index (IWM). Arnott sees US equities, especially smaller firms, as way overvalued (versus global markets).

Brian: I think the proliferation of quant is doing many investors a disservice. While there are certainly applications to tilt portfolios according to market caps and sectors and other areas, this shouldn’t happen absent the valuation context. My biggest suggestion for money managers: Don’t let arbitrarily-defined groups of ambiguously-valued companies coupled with faulty logic (in assuming all back tests have validity) impact your thinking about intrinsic values, the anchor for prices.

Matthew Warren: Regarding Tailored Brands, if management thinks they can turn around comps to positive numbers, they should be buying back shares like mad instead of paying out the huge dividend yield they are currently doing. If they are worried about turning around comps (as I am), they should be defending their balance sheet by rapidly storing cash or paying down debt. Either way, the dividend makes no sense to me.

Callum: There's clearly an investment/corporate culture difference between American equity markets (where activist investors are common and management teams are constantly prodded by outside forces to change directions) and East Asian equity markets (where internal decision-making processes are prioritized over outside influence). South Korea's (EWY) chaebols and Japan's (EWJ) family-run conglomerates don't necessarily have to answer to shareholders in most circumstances, but America also has its own giants with tiered shareholder structures (giving the founders or the family of the founders outsized influence via super voting shares), especially in the tech and oil & gas midstream space.

Burry mentions that Korean stocks are perennially undervalued because managers don't treat shareholders as owners, which more broadly means Korean-based firms at-large aren't (in Burry's view) maximizing their future free cash flows effectively (prioritizing projects with returns that handily exceed estimated WACC, and returning cash to shareholders when those projects aren't available). Activist investing in East Asian markets hasn't yielded the kinds of results it has elsewhere, and I question whether Burry's firm would be able to change that paradigm.

Additionally, I think South Korean equities have historically been pressured by geopolitical affairs (whether those concerns are related to North Korea's missile tests, the ongoing Korea-Japan trade war, trade tensions with China in the recent past, the long-time row between China and Japan over a few islands the East China Sea, or other factors) and that's not properly captured in the performance of the KOSPI index over the past decade (a lot has happened on the Korean Peninsula since 2010).

Brian: Great information Callum. In other news, CNBC reported that Ray Dalio is warning “of serious problems and a bond blow off as a repeat of the late 1930s looms.” The LinkedIn post can be accessed here. What are your thoughts Matt?

Matthew: Great article Brian. Stimulating. I am in complete agreement that more quantitative easing (QE) and more asset buying would be like pushing on a string. All it will create is more bubbles and distortions as opposed to much in the way of increased economic activity. Cost of capital is not the problem in the world. Deflationary impulses are. Dalio's right about picturing what deflation would look like in the next down cycle when we can barely find inflation in this upcycle.

If he is right about a bond blow off, there will be a lot of market participants caught offside as they stretch for yield anywhere and everywhere they can find it. If the real cost of debt re-rates higher while economic activity also contracts and deflation mounts, you are talking about a seriously ugly recipe. And yes, politics could worsen around the globe, as if there aren't enough political problems already. This has been talked about as a tail risk for a long time, but I think it is actually a higher probability than I am comfortable with.

I used to debate about whether the TARP/Fed bailout back in the Great Financial Crisis (GFC) was actually going to work or just push the problem down the road. To me, while it had looked like quite a successful thread-of-the-needle in the past decade, I am concerned that it was merely kicking the can down the road. For the life of me, I cannot picture how Europe finds its footing given negative interest rate policy (NIRP) and the “zombie” banks. I think the people buying peripheral bonds are out of their collective minds and are going to get burned very badly.

Draghi said "whatever it takes," but what if that is just a can kick down the road? How can it not be? Can you picture the politics coming together to deal with the excess capacity of the European banking system given all the national champions involved and the knock-on effect it would have on any given country to cull some of their banks? I cannot. The weaker European banks are going to bust sooner or later. Global deflation would get us there sooner.

Callum: On this topic, Ray Dalio is also optimistic on gold (GLD). We've mentioned gold in the past as a safe haven, possibly through an ETF of miners or the commodity itself. To Matt, you brought up global deflation. How does that meld or not meld with Ray Dalio's bullish sentiments on gold? I'm assuming global deflation would see gold sell off, unless it's a case of manic behavior (those gold bugs out there) encouraging the hoarding of gold or something counterintuitive like that.

Matthew: In my view, he doesn't sufficiently explain why gold goes up under the scenario he is talking about, but then he said he is going to explain it further.

He talks about money printing, quantitative easing, and monetization of debt. He also talks about in-country and between country conflict. All of these things are pro-gold, in my opinion.

He then talks about the QE not working and rates backing up. To me, that leads to deflationary bust, which should be gold negative. The only way gold should be positive in a deflationary bust is in the extreme--complete lack of trust in fiat money.

If he is making that argument, I sure as hell hope he is wrong.

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