As I write this, a Category 4 hurricane is bearing down on my old home of Houston, Texas and environs. The American Red Cross will certainly need your help – please consider donations and assistance if and when called for. We have included several longer pieces in this week’s reading list. It may take time to get through the expose of Carl Icahn or the text of Janet Yellen’s Jackson Hole speech, but both are well worth it!
Here is a curated list of important stories outside the main headlines that caught our attention this week.
Carl Icahn’s Failed Raid on Washington (The New Yorker). This is a long read, but a fantastic one, and important for anyone investing in the US right now. The story relates the saga of Carl Icahn’s push to help an oil refiner he owns by changing EPA regulations. Any business owner lobbies to get an advantage in the marketplace or to mitigate disadvantages, but Icahn, as a special advisor to President Trump, may have overstepped legal bounds when he did so. The article goes into detail about why this may be so and explains the background of the case, but in short, Carl Icahn seems to have used his position as “Special Advisor to the President for Regulation” to push President Trump to reverse some specific regulations that raise costs for Icahn’s energy business. The author of this piece alleges that Icahn actually wrote an Executive Order to reverse the regulations and made an enormous speculative bet on something called Renewable Identification Numbers (RINs) that ended up paying off handsomely. If true, the US is in danger of descending into the kind of business environment typical in Banana Republics – a worrying state for the world’s largest economy!
China’s Robot Revolution May Affect the Global Economy (Bloomberg). This is a short summary of a longer report that is available to subscribers of the (very expensive) Bloomberg terminals. Even though it is short on details, it is thought-provoking. Chinese companies bought about one-third of the world’s supply of robots last year – China was far and away the largest purchaser. Even with the large purchases, robotic installation density is lower than other countries, but Chairman Xi has made catching up in this area a national economic priority. This trend has a few important implications. First, it’s clear that Xi is positioning his country to continue to be an export giant even as the demographic effects of Mao’s One Child Policy cuts the number of working-age people. Second, it signals a coming shift in the wealth generated by exports from workers to owners of capital. This shift has not started yet from a statistical perspective – Chinese wages are still growing very quickly – but eventually, that shift is inevitable. Third, in terms of domestic initiatives, I think it is amazing that President Trump is talking up Foxconn’s move to the US – a move that will potentially employ thousands of US workers in low value-added electronics assembly tasks – while China is attempting to shift in exactly the opposite direction. China’s economic strength has always been associated with its ability to throw thousands of people that would otherwise require expensive tools and machines. It is trying to move toward greater efficiency while we are moving to a model of decreasing efficiency to boost domestic employment. (By the way, this article was originally brought to my attention by Axios – a service that provides brief, helpful news stories. I’ve fallen in love with this free news source!)
Autos Put Economic Downside Risks on Full Display (Bloomberg). It looks like trouble is brewing in the US auto industry. According to data in this article, inventories are very high – 3.9 million unsold light vehicles versus 325,000 last August – a time when inventories are usually at a seasonal low. Previous Framework Reading lists have talked about these inventory builds, especially in the context of the sub-prime auto loan market, and this statistic really stuck in my mind. Inventories are 12x higher than they were just a year ago! In the investment analysis business, we have a (derogatory) term for that: “Channel Stuffing.” We thought Ford was a reasonable, speculative investment until we saw that the company was essentially loaning money to its own customers to pull revenues forward. Channel stuffing is a bad sign because it suggests about the demand environment and what it says about the strength of the businesses that rely upon that demand. Above and beyond the weakness in autos, the author of this article points out that political risk and uncertainty is acting as a restraint on companies spending on capital equipment and new software. Obviously, this is a point I have made numerous times over the last ten months.
New Home Sales Hit ‘Disappointing Bump’ in July (US News and World Report). One month’s worth of home sales data does not have much predictive power, but this article hints at an interesting dynamic in the US. Demand for new homes (measured by how long a new home is offered before being sold) is high and inventory is relatively low – both are supportive of higher prices. At the same time, fewer lower priced homes (less than $200,000) are being built, so fewer first-time buyers can afford to move from renting to owning. This theme was echoed by Bloomberg later in the week, as it reported that U.S. Sales of Previously Owned Homes Decline to 11-Month Low. Within the article, Bloomberg points out that contract closings fell even as median sales price rose and inventory of homes decreased. There may be some effects of seasonality within these numbers, but both new and existing home statistics were taken as a surprise by the market.
Investors seek more protection against risk of a Wall St plunge (Financial Times). We do not talk too much about quantitative measures at Framework, preferring to focus on fundamental aspects of using options as investment vehicles. However, in some instances, understanding a bit of the quant side of things is helpful in understanding what other market participants are thinking (this is, in fact, the motivating principle behind our “BSM Cone” diagrams shown in our research that we teach about in the Framework 103 Course). In recent days, the “skew” of option contracts on the S&P 500 has been increasing. I’m happy to go into the issue of skew during one of our Office Hour conference calls, but in short, when skew increases, it means that Out-of-the-Money options are in greater demand than those closer to At-the-Money. Demand pushes up price, and increased prices translate into elevated “implied volatility” figures. In other words, investors are betting that larger drops in the market are relatively more likely than smaller ones. A prominent hedge fund manager, Ray Dalio, founder of Bridgewater Associates, has revealed that he is reducing risk (FT reporting) due to his perception of increased political risk in the US.
The Market Is Behaving Much The Way It Did In the Past (Bloomberg). This is an opinion article written by a University of Oregon economist, Tim Duy. It is popular to talk about imminent stock market crashes due to Fed tightening, especially this week as Fed economists meet in Jackson Hole, Wyoming. Duy points out that, in fact, the economy is growing, and that the stock market is more reflective of economic growth than it is sensitive to short-term reference rate changes. This observation underscores Framework’s perspective on valuation: growth is the most important factor. If you are worried about Fed tightening affecting stock prices, you might be interested in a study that I did and published on Forbes back at the end of 2015: Don’t Sweat the Fed.
Financial Stability a Decade after the Onset of the Crisis (Federal Reserve). There is a lot of revisionism occurring already with regards to banking regulations after the 2008-2009 Financial Crisis. Dodd-Frank and the Volker Rule have affected the way banks can do business – requiring them to keep more capital in reserve, assuring that capital collateral is of higher quality, and preventing proprietary trading backed by bank customer deposits. The effects of these rules is to 1) reduce the leverage of banks and 2) reduce potential volatility in bank results that might threaten depositors’ funds. If both of these things sound like positive developments, you are clearly not a bank executive or lobbyist. The banking industry has chaffed at the stricter capital requirements because, frankly, it’s harder for the executives to generate bonuses that are quite as huge as they were when they could use more leverage. Lobbyists have worked hard and if the phrase “free market” was a rug, it would be threadbare for all the walking that’s been done on it. In this eloquent, speech, however, Fed Chair Janet Yellen offers a splendid refutation to the point of view that regulations are impeding economic activity. The argument, in fact, relates to options in a round about way. Yellen points out that academic research into the effect of banking regulations on economic activity have shown mixed results. Even if stricter banking regulations have a slight negative effect on economic activity, the protection that these regulations impart are valuable, and the value of the protections more than offsets the economic headwinds. In essence, this is the description of a protective put option. Our economy is paying a small amount to insure against a catastrophic loss of value. The speech is long, but is well worth reading through.