August 08, 2024
Q2 2024 Investment Commentary
A famous story emerged in the wake of the Archegos blow up of March 2021 regarding a cool-headed Rich Handler, CEO of Jefferies Bank. To catch you up to speed, Archegos was an investment firm handling the wealth of its founder, Bill Hwang, who reportedly managed $36 billion at its peak, and focused on highly concentrated bets on companies like ViacomCBS, Baidu, Tencent Music Entertainment, and more. Hwang took out extremely high amounts of debt to fund his investments and when ViacomCBS announced negative news in Q1’21, the stock sold off, taking Archegos’ position with it. This led to a cascade where his lines of credit from various banks all began to call in their positions, requiring Hwang post equity or risk losing them. To keep a long story short, he was too levered and indeed lost his shirt. Cumulative losses totaled over $10 billion when the dust settled, and Hwang was later arrested and tried for racketeering and wire fraud.
Jefferies Bank was one of Hwang’s trading counterparties, which meant they were also providing him debt. At the first word that there might be trouble for Archegos, Handler, who was on vacation in Turks and Caicos at the time, called in his trading desk to give them a single directive. He told his staff, “I’m going to get a spicy margarita and I’m going to be back in about 15 minutes. When I come back, just give me one number and it’s the amount of money we lost. I want the whole thing down by the time I come back.” The bank lost $38 million in the Archegos debacle while Credit Suisse, Nomura, and Morgan Stanley lost $9.3 billion collectively.1
This is a great story because you have a guy that just knew. Handler’s strength was being able to collect himself in the midst of a firestorm, calmly remove emotion, grab a libation, and make a determination. A great lesson in crisis management. Hwang’s biggest problem was that he wasn’t very smart (clearly), but also that he bet the farm on an outcome that he could not control–the whipsawing of a handful of single stocks. I take away three lessons from this story: 1) be emotionless in the face of risk, don’t let fear crowd out good decision making, 2) don’t concentrate your portfolio, your risk becomes asymmetric, and 3) leverage can put you out of business.
On being emotionless
One can only dream of being as stoic as Handler was during the Archegos implosion, but frankly, most of us are not long-tenured bank CEOs that have seen it all and lived through it all. In fact, most of us are just simply trying to make it over the finish line, retire comfortably, leave a legacy for our families, and avoid financial ruin. Given the stakes, we tend to fight or flight when it comes to market volatility, so in order to avoid emotional decisions we need to be armed with data and make informed decisions.
Like clockwork, when things get dicey for stocks and bonds, as they have in the past few weeks, clients start calling us and asking when we should just go to cash and wait it out. The answer is invariably never, unless your time horizon for needing cash is imminent (in which case you probably should not be invested anyway…). Here is an interesting data point on market volatility.
This chart goes back almost an entire century to show how many years the market has experienced at least a drawdown of x%. In 94% of cases, the market has seen a -5% drawdown or worse in any given year, which means that a year in which we do not experience meaningful volatility is >2 standard deviations from the mean!
We should expect choppiness, sometimes it is rattling, but it is simply a feature of investing. A quote that comes to mind is “volatility is the price you pay for performance. The prize is superior long-term returns.” If anyone tells you otherwise, check out what type of yacht they own–they have something to sell you.
On being concentrated
Hwang owned exactly 11 stocks, most of which were US and Chinese telecom, media, tech companies. This degree of concentration is obviously very dumb – especially on extreme leverage – however, this goes for any asset class: real estate, bonds, equity, you name it. Even “safe” asset classes have had their days in purgatory.
If you held a concentrated portfolio of fixed income for 2 years between YE20 and YE22 you lost -20%.2
If you held a concentrated portfolio of real estate for 2 years between YE21 and YE23 you lost -30%.3
If you held a concentrated portfolio of stocks for any of the most violent recessions that we have seen in the past 30 years, then you lost anywhere from -20% to -60% peak to trough.
And, what may seem like a strange thing to say, a concentrated cash position can similarly result in a material loss of net worth in the form of missed opportunity (not to mention inflation). Investors who got spooked by the dramatic market selloff of Q3’22 and went to cash, have lost a stunning -50% of upside opportunity by being invested in global equities4 in a short two years.
This might seem somewhat outlandish, but no matter which asset you concentrate in, there are risks of loss –both augmented downside as well as absent upside participation. Cash has been a tantalizing trade for the most recent two years given a compelling yield against a backdrop of macroeconomic uncertainty, however, that 5% nominal yield has come with its own costs.
Had you invested 100% of your capital into bonds during the period where these permabears had the most convincing arguments (right in the thick of the Covid panic), you would have missed out on an average 1.3x return on your money over ~4 years. The lesson here is concentration in any one thing opens you up to asymmetric risk, and sitting in cash because you’re spooked is no exception. You won’t wind up with zero, like Hwang has, but you will wind up with a lot less.
On Leverage
Whether it is portfolio leverage, property-level leverage, consumer leverage, or otherwise, debt can help augment favorable outcomes, while simultaneously exacerbate unfavorable ones. In an era of extraordinary growth in nontraditional investing—hedge funds, private equity, real estate, and credit—investors are keener than ever to wade into the realm of private capital. Drive Wealth is a major proponent of alternative investments as we feel they provide both absolute return advantages as well as potential diversification benefits. We’ve been at the avant-garde of private capital investing long before many of our peers, and our clients’ portfolios reflect this proclivity.
The soup du jour of alternative investing is private credit, or direct lending, which provides the opportunity to extract above-market income from private opportunities in real assets and corporate lending. It’s a great time to invest in the asset class given where base rates are following aggressive Fed hiking, and also a time to beware of extreme and imprudent leverage. We go through painstakingly exhaustive diligence processes to uncover how the full suite of our investment offerings may have leverage in one form or another, going to great lengths to avoid Archegos-type outcomes. It is actually harder than you’d think. Plenty of seemingly risk mitigated strategies employing senior secured lending themselves are beholden to third-party financial leverage, tranched portfolio leverage, and all of the risk that comes with it.
My plea to our clients reading this is to contemplate where you have investments held away from us and if you can articulate the degree to which you are levered. If you cannot answer that question, let us try to uncover that with you and make recommendations on how to build a stable portfolio.
In conclusion, when faced with an emotional decision in the face of market volatility, think about Rich Handler, when tempted to abandon sound principles of portfolio management, think about Bill Hwang, and if you don’t know how levered your portfolio is, give us a shout.
Markets have been exceedingly volatile in the past few weeks, and we think this will persist given rumblings of earnings weakness, a spike in unemployment, geopolitical concerns, escalation in the Middle East, and so on. Let’s spend a few minutes reviewing some macro and market fundamentals to put market moves into context.
Jobs
The chart above shows the Sahm Rule8, a recession indicator that has a fairly accurate history. It was developed by Claudia Sahm and is a real-time indicator that signals the potential for recession by measuring the three-month moving average change in the unemployment rate. If the number rises above 0.5, it demonstrates a fast change in unemployment, which may compel policymakers to provide support to the economy. The current read is 0.53 as of the jobs report last week.
While this is an interesting indicator, I think it’s key to remember that the rate of change is relative to the starting point. We have been at or near historic lows in unemployment, a sudden decline in job creation, leading to a spike in the unemployment rate, will be registered as a higher rate of change in the same way that going from one apple to two apples is a 100% increase in apples, while going from two to three apples is a 50% increase in apples. The integer has not changed—apples or jobs—but the cumulative sum has, which provides nuance to the referenced rate of change.
Excluding the Covid era, unemployment has averaged <4% since ~2016. In both periods prior to the Dot-Com Bubble and the ’08 Financial Crisis, unemployment was comfortably between 4.8% and 5.3%. While we’ve experienced fundamental changes since both recessions occurred, recent history does suggest that equilibrium unemployment could potentially be higher without sparking an economy-wide recession.
Household Finances
Despite the recent unemployment data, wages remain resilient, with average hourly earnings in the US a full 100bps higher than current year-over-year inflation, and cumulative trailing 5-year wages neck and neck with CPI over the same period. I recognize that many households with less dynamic wages are likely not keeping up with inflation beyond the baseline, however, the average household has held up enough that the combination of debt service, insurance, utilities, and other financial obligations (FO) have not eroded incomes9,10. Viewed another way, the total FO as a % of income metric is a more comprehensive household debt service ratio, which at 14% is equivalent to incomes outpacing FOs by 7.14x
Corporate Earnings
While this may appear to show smaller companies languishing, Lipper Analytics reports as of last week that of the 611 companies that have reported earnings (out of 2,000) this quarter, 67% have reported EPS growth above analysts’ expectations, which means that forward EPS expectations figure could materially improve in the small company universe. If you extract energy companies from the index, the earnings growth rate is actually rather robust12.
Our view is that fundamentals are still relatively in tact and our base case is for a “soft landing” by the Fed. That being said, real-time indicators of economic stability are showing signs of stress, and we need to be flexible in our opinion that the market will withstand short-term undulations and bouts of skittishness. If you have any thoughts, questions, or concerns, please reach out directly and let’s have a conversation.