March Madness

It’s that time of year again, the best 3 weekends of college basketball. As we enter the final weekend, with the Final Four and the Championship game, I’m praying to all deities, including Oprah and Tom Cruise for my Wildcats to make history. And I’m also struck by the similarities between the financial markets and March Madness.

March Madness There are the obvious similarities like not being able to predict the future and the fact that the supposed “experts” are no better at filling out a bracket than your 70-year-old mom who fills out a bracket based on the colors of the schools or the mascots she likes best. But the similarity that stands out most to me between financial markets and March Madness is that no matter what anomalies you might see in the first 2 weekends, the majority of the time, the 4 teams left standing at the end of March are all chalk.

For those not familiar with the term “chalk” it refers to the favored team when betting on sports. As it relates to the NCAA tournament, “chalk” refers to the four No. 1 seeds and I also include No. 2 seeds. So, while you may see a 12 seed upset a 5 seed and occasionally a 14 seed beating a 2 seed, when it all shakes out, the Final Four is made up of 1 and 2 seeds. There is a lot of noise in the first 2 weeks of the tournament.

As I’ve discussed before there is a lot of noise in the financial markets too. And just like when filling out your bracket, often times more information does not lead to better decisions. We are inundated on a daily basis with seemingly important news, new investing fads, and a myriad of gurus, half of whom are telling us everything is great and the other half is telling us the world is ending. I would label most days as being a part of the first 2 weeks of the NCAA tournament, simply noise. The reason being is that all major price cycles are driven by on 2 things: economic conditions and how central banks respond to those conditions.

One of the primary effects of the monetary policy regime we have been under since the Financial Crisis, is that it encourages speculative investors to take more risk than they normally would and conservative investors reach for yield. This increased appetite for risk and yield inevitably leads to a slew of investment fads popping up to cash in on the opportunity.

One of the most glaring examples of this type of investment fad is the concept of crowdfunding to invest in oil and gas projects. For the uninitiated, “crowdfunding” is funding a project by raising money from a large number of people.

This type of funding has become very popular in recent years and is now a $15B industry into itself. There are currently two different companies offering this wildcatting opportunity to individual investors, one of which is Energy Funders (EF).

EF launched last July and has already recruited 800 investors. It should be pointed out that the company launched last July and oil prices peaked on June 20. In hindsight, the launch could have been seen as a contrarian indicator. Look, I’m all in favor of investors having access to alternative investments.

I make my living running an alternative investment but the key difference is that investors in my fund have to meet certain criteria that indicates the prospective investor understands all the risks involved. The Energy Funders website has all of the signs of an investment fad and potentially dangerous one at that. The first thing that jumps out at me is the slogan “Make an oil and gas investment in 5 simple steps.”

Do you think oil and gas legend T. Boone Pickens would tell you that you could make oil and gas investments in 5 simple steps? I doubt it.

The site also claims that you can “win at any price.” I assume the statement is referring to the price of oil but no matter what its referring to, the statement seems down right fraudulent.

The CEO of Energy Funders recently said, that his firm “allows small oil and gas operators to get funds when large institutional investors are turning away from the industry.” Let me get this straight. Energy Funders is essentially promising anyone with $5,000, that they too can win at oil and gas speculation at a time when institutional investors, the “smart” money, is avoiding those types of investments? This situation can’t possibly end well.

Another current, albeit less dramatic example, which I have discussed before, is theWisdom Tree Europe Hedged Equity Fund (HEDJ). This fund, as the name implies, is a Eurozone equity fund that is hedged against a decline in the Euro. HEDJ has handily outperformed its unhedged counterpart, Vanguard’s Europe ETF (VGK).

So far this year, HEDJ is up 20% versus 6% for VGK. Obviously, being long Eurozone equities and short the Euro has been massively successful this year. That’s why HEDJbrought in $4.6B in new assets in the first 2 months of the year.

That new capital inflow accounts for 34% of the fund’s entire asset base, which means that HEDJ has increased assets by 50% in just 8 weeks. Performance chasing much?

Now, I’m not saying that HEDJ’s strategy won’t continue to outperform being long Eurozone equities in Euro terms. But whenever outperformance is that dramatic and money flows in that quickly, it gives me cause to pause. 

In addition, I’ve mentioned repeatedly how the Long USD trade is the most crowded trade in the world right now, based on how large and small speculators are positioned in the futures markets.

HEDJ is simply a derivative play on the bullish posture of the USD. So what happens to HEDJ’s absolute and relative performance if the USD’s consolidation over the last couple of weeks proves to be an intermediate term top for the greenback? Nothing good.

What happens to those investors who ran headlong into HEDJ AFTER the outperformance? Nothing good.

Over the last 75 years of the NCAA tournament, only 3% of the time has a team seeded lower than No. 10 made the Final Four. In a world filled with insignificant data points, investment fads that come and go and perma-bull and perma-bear gurus, focus on chalk.

In investing, the chalk is economic conditions and monetary policy. An investment process that includes a heavy dose of chalk will substantially outperform a process that relies on 15 seeds to be profitable.