Euro-Election Post-Mortem...

UKIP supporters, along with those of the European right are angry. And nostalgic. Nostalgic for ....ummm .....errrr..... Johnny Halliday? Johnny Rotten ? Sir Lawrence Olivier? Georges Pompidou? Chaban-Delmas? Harold Wilson? Ted Heath? Free parking? No traffic jams? A Ford Cortina or a Renault 4? Ten-pounds-a-week rent? Fifty-P a pint? Greasy chips fried in oil t'aint been changed for weeks? Baked Beans 'n'toast for breakfast? Twiggy? Cliff Richard? A white guy (not a Russian) winning at boxing or sprinting? One-piece swimming costumes? Free university? A job-fer-life? Iconic red pay-phones booths smelling of urine? Phones with an umbilical cord? Single-race marriages? The Cold War? Clean beaches? High-streets free from foreign food? Holidays in Blackpool? Turnips and root veg? Chicory drinks? Maybe. B ut I think that they are nostalgic for rising or stable real wages; a settled feeling that accompanies slower technological change; a stable job that pays a good stable real wage, with an indexed pension, and that is not undermined by someone more educated or qualified or enthusiastic, willing to work harder, for less especially if they are foreign; Oh and lower taxes. All of which are under siege. Regretfully, for sensible public policy, this has little to do with Europe, or immigrants, or the decline of religion and general moral standards. But that won't stop the angry cocks from crowing...like THIS.

More Jitney's Needed?

There is considerable debate in the state of New Jersey about whether Newark or Camden is the Garden State's armpit. True connoisseurs of sweat, however, would add another - the one that gave us The Diving Horse: Atlantic City. All three have long-passed their glory days.  AC, remains a hollow shell of its mid-20th century optimistic seaside-self, despite many billions of collective investment by private casino operators and public authorities.  Camden more closely resembles war-torn Mogadishu or the bombed-out Syrian frontline of Homs than it does prosperous archetypical suburbs like Darien, CT or Merion, PA.  Newark, alone, may rise once again, like a Phoenix, recalling Philip Roth's adolescent days, if only a result of its proximity to New York.  Yet, Atlantic City, for all its flaws, retains a pragmatic solution to public transport from which many public transport authorities can learn. It is called The Jitney, and is simply an uber-practical shrunken bus.

Nothing is more galling to a taxpayer than senseless avoidable waste. Cynical fraud can at least be seen in the context of benefits delivered. Some mean-spirited Libertarians see it everywhere. I am more generous, but nonetheless loathe stupidity, rigidity and tolerance for things abysmally-sub-optimal. Where I reside, in the leafy hilly part of Kent County, everyday I see huge, aged, empty buses plying their routes with growling Spitfire-sounding diesel's that would annoy Harley riders, struggling to climb steep grades as they make their way through the lanes and up hills of my area, belching smoke, wasting petrol, blocking or slowing traffic both on major arteries and B-roads, menacing cyclists with their overtaking. And outside of the rush hour/school runs, they are empty -  or appear virtually so given the ratio of passengers to available seats.  Ghost buses. And each and every time I see this, apart from my selfish desire for less polluted air, silence, and budgetary optimization, I feel as if a crime were being committed. And I wonder: where is the Jitney? One would have thought that, if one formed opinions on the basis of hyperbole, the private sector would have ingeniously invented and tailored market solutions that would quickly eliminate (or reduce) the horrifying waste described for all of these are private concessions (Arriva, MetroBus etc.) with, one would presume, the appropriate profit motives.  

France is not without its macroeconomic and social problems. However, when it comes to public sector policy solutions and their execution, be they infrastructure, public works, or healthcare, one should take notice, not because I say so, but because they tend to pursue non-ideological pragmatic solutions to policy conundrums that would baffle ideologues from both the right and left.  In contrast, to the smoke-belching rust-buckets on spartan routes subsidized by my UK County plying their neglected, pot-holed roads, my municipality in France, delivers multiple bus solutions that pragmatically balance efficiency, cost, with public needs in pursuit of the public interest. During busy hours, and in high-demand areas,  the public authority deploys modern quiet, bendy-buses while on smaller routes, they dispatch drivers with modern Jitney equivalents that navigate country lanes without endangering on-coming traffic (and cyclists thankyouverymuch!!) and that can climb hills without draining the public fuel depot and purse. While the agency combines the resources of 13 towns surrounding our main city, the public authority also cooperates and coordinates with the regional transport authority to run convenient routes that cross jurisdictions without, as the case in my UK village, having to change buses just because of splintered geography and fractured concessions. That is even before mentioning cost which is low by any standards, but benefits everyone:   passengers, business, non-passengers (less traffic and congestion on the road) and everyone else by lowering pollution.

Brits are a curious lot. Stoic. Patient. And, in the main, suspicious of collective activity as Orwell highlighted six decades prior, save for self-organizing their curiously peculiar pass-times such as birdwatching, needlepoint or plane-spotting societies. This suspicion of The Group Movement, he pointed out, insured that facism could never gain a foothold over these islands. For the mere sight of goose-steppers on the High Street with their earnestly-shined boots and silly rigid march would elicit derisive mocking laughter - a far greater deterrent than any form of counter-organization. The dark side of this combination of national traits is that the majority of people, and the public's interest  suffer at the hands of more intensely-motivated and greedy parochial interests. Private monopolists abuse inelastic demand curves with an inert and collusive political class and the result: USD$40 a train ticket into London for the scant 24 mile return journey ($50 if you wish to park your car), roads that are hopelessly pot-holed and in dis-repair despite some of the highest road taxes and fuel-surcharges in Europe; bus-service so poor and mis-fitted for purpose it makes you cry. And the people stoically, patiently, say nothing, and do nothing, as the carpet-baggers using the svengali-like mantra  of "free-market is best" empty the purses of the people extinguishing any hope of creating pragmatic efficient solutions to public policy issues. Like deploying efficient Jitney-like buses. Or maintaining authority and rectitude over monopolistic concessions sold or granted in the public's interest, rather than the Public Interest being treated like little fuck-boys of opportunists-run-amok.  And still, the monopolists continue to push, and take, and gorge, not realizing the risk they run for themselves and their investors. Even the Brits have their breaking point and make no mistake, stoic as they are, even though it's been more than eight centuries, they WILL "go postal".

How they managed to run an empire is baffling. In all likelihood, it would have baffled Cyrus and Darius too. Now, the home territories are neglected. Now, there is too little enlightenment. Too little wisdom. Too little pragmatism. And not enough Jitneys...

Edginess or Extrapolating The Unextrapolatable

Edginess. No, I am not referring to the one sought by my daughter by rolling her own and pushing boundaries (fortunately, for a parent, eschewing the tats, for now at least), but as in uneasiness, anxiety, disquietude, restiveness, worry, and an increasing sense of agitation of the type that George Soros wrote about in his journal as a feeling that gnaws at him from within his stomach.  

I am becoming more aware of my growing agitation - and rather than let it gnaw away, I will try to dissect and articulate it in order to share with you for I've been sanguine about equity risk for what seems like a long time, certainly one of the longest periods I've held my pessimism in check. During this hiatus from my natural state, I've derided perma-bears through the recovery -  through the Euro wobbles, US budget concerns, the ridiculous hyper-inflation/QE hysteria, and dismissed those both selling and wishing to buy tail risk insurance after the proverbial horse had bolted suggesting to those interested to heed Bob Litterman and SELL the insurance (SPX puts), rather than buy it. This is not because I am optimistic by nature, or otherwise bullishly inclined. Rather, it was because for much of the last five years -  scarred investors were underweight despite, in plain english, things more or less continually improving on all fronts, albeit not fast enough for those in search of instant gratification. "Up" has been the path of least resistance. Housing/construction/ was diminished, and financials were so cratered, they are still, only now, getting back to something resembling normal index weights. Couple that with much of large-cap tech undemanding at close to single digit forward multiples and the risk, as PensionPulse's Leo Kolivakis presciently called, moved more clearly to the right.  That was then. Over the past four year, investors have been squeezed in - and for the right reasons: absolute and relative valuations, cash-flows and earnings growth - all which have been more-than requited by their materialization, pwning the pessimists!!  

Now, it no longer is obvious that investors are under-invested. Now it appears that they are, en masse reasonably allocated. In the process they've taken forward-looking returns from rather attractive levels with large implied equity-risk premia, down to levels which don't leave much margin for "shit happening".  In the process, investors may very well have done too much of a good thing, inflating ratings (on a forward-looking basis) to pedestrian levels at best, or positively-unattractive ones - implying low to negative forward returns at worst.  In itself, this situation doesn't mean imminent danger, and can continue - given positive sentiment, piss-poor alternatives, supportive monetary and fiscal policy, and the chance that underlying growth may continue unabated (and even accelerate) without undue inflationary pressures, keeping the ratings high as stock prices increase further. For the avoidance of doubt, this is not a bubble in the popular sense of the word. We have indisputably had phenomenal corporate earnings growth justifying and supporting the reversion back to the reasonable from ostensibly cheap crisis levels.  In the process, investors have become comfortable increasing the rating of equities towards more historically-dubious levels, and in extrapolating forward, idiosyncratic boosters to earnings that I do not believe should be extrapolated.

Yes, I am gnawingly concerned  about the blitheness with which many investors assume that major contributions to past earnings growth will replicate themselves going forward, an occurrence that often presages an intersection of bloated expectation with the spartan-ness of a wetter and colder reality.

Imagining a classical "T" account to conceptualize my edginess, I place these positive contributors to earnings growth since 2009 on the left-hand side of my construct: 

* Sustained USD weakness. (USD weakness has flattered USD translated global sales and earnings)

* Constrained capex (Squeezing existing capital stock coincidental to prior capex depreciation rolling-off, dramatically boosts EPS; investors dazzled by and extrapolating EPS growth, but at CF level, multiples are getting heady. Eventually companies will have to re-invest which will hit both operating and bottom lines)

* ZIRPy interest rates. (Low rates have one-off refinancing benefits that benefit bottom line, and remain as long as ZIRP. Corp earnings now short put on rates for refi) 

* Wafer-thin credit spreads. (Ditto above: one-off refinancing benefits to EPS but forward profile is left-skewed risk)

* Buybacks/share count squeeze. (Buybacks - whether from cash-flow or debt have materially goosed EPS over last five years. But, with capex needs increasing, and valuation ratings elevated Co's will find it increasingly difficult to justify maintaing/curtailing buybacks). Yet, only NOW in typical gamma negative behavior are co's leveraging up to buy back stock.)

* Wage restraint (Corporate pricing power coincident to falling real wages will not last forever. With economy hollowed, and jobs already offshored, one would not be remiss forecasting  that we are at or near peak disparity. The wage squeeze has given Co's enormous operating leverage during the last five years of recovery. UK real wages ticked higher than inflation for first time in years, last print. In US, with @6.7% unemployment, the balance of power favoring Co's feels like it petering out. If so, this will hit operating and bottom-lines directly. With Piketty on top of best-seller list, one might also wonder whether this is another tell-tale of the end of the squeeze on labour. ) 

* Tax holidays/optimization.  (Firms are increasingly keeping money offshore and borrowing onshore to buyback stock or pay divs rather than repatriate and pay tax); They consolidate overseas earnings gross of tax, but with increasing scrutiny of avoidance/minimization they will have to bite the bullet sooner or later;  It looks like earnings have grown, but if you can't use them or return tim to shareholders without taking a hit, there appears to be an asymmetric outcome. At best, it is baked into the price; at worst investors have discounted potential liability over-stating realizable cash flows.   

* Pension holidays. (Higher asset prices thanks to recovery have allowed firms to get actuarially onside and reduce DB plan contributions, in many cases reducing contributions that directly flatter both operating and bottom line earnings. Never mind that with asset prices high, the actuarial assumptions of most DB plans are unrealistically optimistic. With so many asset classes fully valued, and forward expected returns low - see GMO forecasts - such holidays will end. And in true to gamma-negative feedback loops, one need only imagine what might be required were asset prices to fall…). 

And In fairness, one must take into account drivers on the other side of the "T" account that may continue to have legs such as: 

* Pricing Power.  (Increasing industry scale, concentration, oligpopoly have materially diminished competition, and created competitive moats that have buoyed both prices and margins across many industries. Toothless regulators, concentrated gain to collusion and diffuse pain make it unlikely that margin gains from such sources will reverse anytime soon. It remains more attractive to collude and bank immediate benefits with certainty than pay fines in the future, in which there is reasonable likelihood, it will go completely unpunished. ) 

* Productivity.  (Benefits from IT and FA, after years of disappointment have finally gained traction. They can continue to surprise to the upside offsetting reversals in the above.) 

* EM Growth. (Volume growth outside DMs has provided meaningful surprises, and may continue to pick-up slack resulting from other erstwhile disappointments).

Despite prolonged meditation, I make no claims that either side of the T-account is complete.  But I suspect that if one took the combined income statement of the SPX, non-exptrapolatable growth boosts explain a large portion of the upside growth Co's have seen in both operating and top-line earnings. Analysts (both top down and bottom up) are well known for more or less extrapolating priors, but I surmise that at precisely the time these are getting harder to reproduce, or are on the cusp of reversing, the ratings are getting extended, and this is a recipe for concern - not because 17x or 18x earnings is an awful return in  tame inflation environment - but because expectations are primed for more of the same dancing juice. This, and the gamma-negativity of some of the variables themselves has the potential to cause a more vicious negative feedback loop, inconsistent with a tame VIX, and extremely low historical vol., and for which markets are neither prepared nor positioned. 

This is why I feel edginess, despite having been a committed "probability-adjusted optimist"… 'till now. With that said, I historically have been early….and what with parabolic-like pops as we saw in Feb/Mar, it is likely there'll be additional opps to temper exposure or put in place more attractive conditional hedges.