Two Certainties: Yield and Certainty of Yield by Stephen Duneier
I touched on this subject recently in What Makes High Yield Energy Different (July 10, 2016), but I’m not sure whether the power of the theme got lost in the details of the specific example. So, I thought I’d emphasize the point.
As I’ve argued numerous times over the past several years, we are experiencing one of the most risk averse moments in the history of markets. Evidence of it can be found in the behavior of the three key players: CEO’s, the mega-wealthy and pension fund managers. This has been the case since the crisis, even though it runs in direct opposition to the moral hazard many expected to occur on the back of massive bailouts (see Moral Hazards Lesser Known Twin).
Many have argued that record low yields is the undoing of my thesis, but it ignores proportionately. In other words, looking solely at the yield differential alone turns a blind eye to the level of the risk-free rate. Should it matter, and if it does, why have we ignored it for so long? Of course it should matter. An extra 50 bps of yield when you can earn 1400 bps in 10 year US treasuries is hardly an incentive to take any additional risk. However, that extra 50 bps is far more attractive when the 10 year is paying just 200 bps. The reason is proportionality. So, why have we ignored the ratio of returns in favor of the spread for so long? The answer is, we haven’t seen rates this low in 70 years, therefore it hasn’t been so impactful. While the majority of analysts are incessantly chattering about a blind search for yield without regard for risk, the charts below show risk aversion is actually on the rise; rapidly approaching crisis peak levels. In fact, this is what is making the central bankers’ job so difficult.
So how do I reconcile this with the recent rally in everything high yield? Well, there are brief moments (read: small sample sets) when market participants have seen correlations breakdown between things like high yielding energy debt and oil, commodities and emerging markets, and other pairs that typically have a strong relationship. During those moments, observers proclaim a yield grabbing free-for-all, as though an aversion to risk no longer exists. It is a classic case of the price action driving the narrative, and the reason so many institutional investors have performed poorly over the last 6 years. It also comes down to the second part of the equation in this “search for yield”. It is the certainty of both the yield and the invested capital. What is happening when it appears as though caution is being thrown to the wind is that market participants are instead focusing on the question of certainty. As it relates to high yield energy, for instance, because so many in the industry have moved their cost of production down to $45, anything above that is “safe”. In other words, if oil is above the cost of production, whatever yield a producer is offering is likely to be paid far into the future. So there is both yield and certainty of yield. Even if oil drops from $55 down to $45, the certainty of yield remains. Which is why you get these periods where it appears as though the correlation has broken down and everyone is piling into yield blindly.
If, however, oil falls below that cost and threatens to go back to the very long run range again, panic sets in and the correlation goes from negative to high beta positive. So around the demarcation line (roughly $40), volatility of the derivatives (ie high yield energy; see JP Morgan’s Alerian MLP Index) spikes, for every tick higher means certainty and every tick lower is interpreted as uncertainty.
This is the case for all commodity related high yielders including emerging markets themselves. Keep this mind if/when positioning in emerging markets. You will likely continue to see a high correlation among all of them when commodities are in the Safe Zone, but a collapse of that correlation when they are selling off on the back of commodities falling into the danger zone. Sour on Sugar One of my favorite crosses to watch is corn versus sugar, ever since ethanol production became a significant factor in the demand for both. The last time I used this to get into a position was the summer of 2012 when the “50 year drought” led to a spike in corn, leaving sugar in the dust (see Corn 5 for details). It’s back on the radar again thanks to the drought in India, only this time in reverse.
Stop Playing with It In October of last year, I made the argument that the world only appears more uncertain because we are hyper focused on every single tick in price action, and creating a rational argument for each and every one (see Why the World Appears More Uncertain for details). The mistake is made up of two components. First, investors are skipping the step where they form a view based on the evidence. That makes the second flaw, seeking meaning in every tick, more likely. See the graphs of the S&P 500, with price action displayed over the past 6 years, but with increasingly greater time between ticks to see how much more volatile it appears when you see more ticks.
The next time a macro manager tries to tell you there aren’t any readily identifiable trends these days, show them those charts, as well as the ones that follow.
About the Author For nearly thirty years, Stephen Duneier has applied cognitive science to investment and business management. The result has been the turnaround of numerous institutional trading businesses, career best returns for experienced portfolio managers who have adopted his methods, the development of a $1.25 billion dollar hedge fund and 20.3% average annualized returns as a global macro portfolio manager.
Mr. Duneier teaches graduate courses on Decision Analysis and Behavioral Investing in the College of Engineering at the University of California.
Through Bija Advisors' coaching, workshops and publications, he helps the world's most successful and experienced investment managers improve performance by applying proven, proprietary decision-making methods to their own processes.
Stephen Duneier was formerly Global Head of Currency Option Trading at Bank of America, Managing Director in charge of Emerging Markets at AIG International and founding partner of award winning hedge funds, Grant Capital Partners and Bija Capital Management. As a speaker, Stephen has delivered informative and inspirational talks to audiences around the world for more than 20 years on topics including global macro economic themes, how cognitive science can improve performance and the keys to living a more deliberate life. Each is delivered via highly entertaining stories that inevitably lead to further conversation, and ultimately, better results.
His artwork has been featured in international publications and on television programs around the world, is represented by the renowned gallery, Sullivan Goss and earned him more than 50,000 followers across social media. As Commissioner of the League of Professional Educators, Duneier is using cognitive science to alter the landscape of American K-12 education. He received his master's degree in finance and economics from New York University's Stern School of Business.
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