The Best Present is Presence

No, this isn’t a commentary about putting your phone away and turning off the TV so you can spend quality time with your family by being truly present. Look, if you get knee-deep in a bottle of bourbon to make it through the holidays, who am I to judge? My Uncle Paul used to say that drinking heavily doesn’t just make women prettier, it makes family tolerable. Well said, Uncle Paul, well said. 

This commentary is about spending your time and resources to better understand what is happening right now, rather than relying on forecasts to manage your portfolio. 

Just like Captain Prediction from last week, Wall Street research is also in the business of telling you what’s going to happen months in the future. As you’ll see, using Wall Street forecasts to make investment decisions is about as effective as using a Magic 8-Ball. 


Cannot Predict Now

Even with the sophistication and technology in meteorology these days, weather patterns can’t be accurately predicted further out than 72 hours. I’d say getting it right the next day is a stretch. 

If weather patterns can’t be accurately predicted, does it make sense that anyone can accurately predict what will occur in a system as vast and complex as the global economy months ahead of time? 

At their core, economics and markets are the study of human action, which is highly subjective and can’t be accurately reduced to computer models. There is absolutely no way to accurately predict economic and market developments that are influenced by an infinite number of factors.

Most investors have limited insight into what’s really happening in terms of fundamentals. What’s more, any intelligence that could be behind their decisions is often obscured by their emotions. 

The fundamental gravity of a given economy should dictate an investor’s behavior, not the actions of others. If you follow the investing herd, which determines market price movement, you cannot earn superior returns.

But this reality hasn’t stopped Wall Street firms from publishing their top trade recommendations for next year during the stretch of time between Thanksgiving and Christmas. These research reports attempt to predict economic activity and the direction of asset prices months into the future, with the key word being “attempt.”

Looking at Goldman Sachs’ top six trade recommendations for 2017, their number one trade idea is to be LONG the U.S. dollar. What I find interesting is that another of their top trade recommendations is to be LONG emerging market equities; specifically, they like Brazil.

So out of one side of their mouths they suggest the USD will continue to strengthen from here, and out of the other side they’re saying get LONG a market that will be severely hampered by a strong greenback. 

Sounds to me like they are hedging their bets so that either way they can come back next year and say, “Look how accurate our crystal ball was last year!”

Outlook Not So Good

Being present and understanding what’s happening right now tells me this recommendation is suspect for two reasons. First, it’s common knowledge that emerging market equities typically struggle with a stronger U.S. dollar. Second, not all emerging markets will struggle equally. Brazil happens to be more susceptible to trouble than other emerging economies because of what’s happening in its fundamental gravity. 

The primary components of Brazil’s fundamental gravity that make it one of the more “at risk” economies are that it’s running a current account deficit and that its amount of U.S. dollar-denominated debt, as a percentage of GDP, is more than 60% of its foreign exchange reserves. 

Being an emerging economy that runs an account deficit while carrying a burdensome amount of USD debt in a strong USD environment causes extreme financial tightening. This tightening dramatically reduces liquidity, which wreaks havoc on equity markets. 

This is the economic equivalent of finding yourself in an episode of Criminal Minds, being pulled apart on the rack by a guy whose momma didn’t hold him enough as a child. Eventually, you need the BAU to bust through the door and save you, or you’re a goner. 

Unfortunately for Goldman’s trade recommendation, the Fed isn’t going to bust through the door and save the Bovespa (the Brazilian equivalent of the S&P 500) by easing policy. Quantitatively, the Bovespa could decline 16%, which is almost a “crash,” and still be bullishly positioned. So a deep correction is almost assured, and would in fact be a healthy development for a market that is way overbought after gaining 50% during 2016.

Fundamentally, the USD has significant tailwinds: a strengthening economy and hawkish Fed policy. Quantitatively, it doesn’t get more bullish than the greenback’s current gravity. The behavioral gravity is the only thing about the current USD rally that looks remotely suspect. Compared to historical levels, investor positioning and sentiment has gotten lopsided towards the bulls, which is why I expect a pullback to $98.00 before the next leg up. 

Being present and understanding what’s happening right now tells me to be LONG the USD and to short equities in emerging economies that will find themselves on the rack if the USD continues to grind higher. 

So, I like GS’ recommendation to be LONG the USD next year, but I would do the opposite of what they suggest for Brazilian equities. I would strategically SHORT Brazilian equities in anticipation of the Bovespa declining to 50,000 next year. 


Reply Hazy, Try Again

I’m not just picking on GS. Bank of America Merrill Lynch is also recommending a trade that is sure to be a widow maker. 

BOA thinks you should be LONG U.S. small caps and SHORT U.S. technology stocks, as a pair trade, during 2017. This has got to be one of the worst trades you could put on right now. I don’t mind the LONG small caps portion of it per se, but why in the world would you SHORT U.S. tech stocks with U.S. growth starting to accelerate higher after five consecutive quarters of slowing? You won’t, if you understand how a market’s fundamental gravity impacts its price and you understand what’s happening right now in the U.S.

The U.S. economic data over the last month have shown improvement across the board. Most people pay attention to headline numbers, but the real insight is in what’s happening on the margin. 

For instance, all of the doom and gloom websites picked on last week’s industrial production report, which showed the 15th straight month of contraction. But they missed the most critical aspect of that report, which is that industrial production has now improved, getting “less bad,” for four straight months. 

Keep in mind that economic data points aren’t good or bad, as many people describe. Economic data points improve or get worse, period. Right now, most U.S. economic data points are improving, paving the way for further growth in Q1 2017. 

When U.S. growth is improving, as the data tells us it is, U.S. technology is one of the best performing sectors. The only thing you’re guaranteed by SHORTing the U.S. tech sector while growth is accelerating is getting your face ripped off. 

U.S. growth has slowed and then re-accelerated three times since 2011 and it’s beginning the fourth such re-acceleration. In the six months following the start of those previous re-accelerations, technology stocks have returned 18.8%, versus 18.7% for U.S. small caps. 

So at the very best, BOA is offering you a trade idea that nullifies itself, because what you gain on the LONG side, you lose on the SHORT side. But again, I circle back to my original question about this trade recommendation. If U.S. growth is accelerating right now, why in the world would you SHORT a market that in similar circumstances has historically gained almost 19% in six months?!

More importantly, the starting point of these two markets is very different this time around. In the last three “re-accelerations,” both small caps and tech stocks declined in the two months leading into the start of the reacceleration, before putting up those monster returns. Contrast that with the last two months this time round, when U.S. small caps have gained 11.1% and U.S. tech is up 3.3%. 

I don’t know how this election rally will impact their future returns, but my guess is that this time small caps won’t gain anywhere close to 18%. Put simply, the 11% return over the last two months is likely to steal from future returns. 

Being present and following my 3G framework, I would be LONG the U.S. technology sector at current prices. If we get a decent pullback I would consider also getting LONG U.S. small caps. Chasing markets higher or lower is a sure-fire way to kill your portfolio with a thousand cuts. 


You May Rely On It

Wall Street has an uncanny ability to do the exact wrong trades at the exact wrong times, and that tendency highlights a very important point. If you want to be a successful investor, you can’t rely on forecasts to manage your portfolio. No one, especially Wall Street, knows where markets or economies will be in six months. Understanding what’s happening right now is how you sidestep danger and get paid. If you want to be a successful investor, you must follow a disciplined process that is data-driven and rooted in being present.