Blain’s Morning Porridge – 16th November 2023: Trading vs Investment: communicating shifts and long-term risk transfer
“There are more things in heaven in earth, Horatio, than are dreamt of in your philosophy.”
Markets feel buoyant and happy, and that makes me nervous. What are we missing? How will spot the inevitable shift in sentiment coming? It’s a traders market. Meanwhile, long-term investors are changing the very structure of the market.
Bit of a ramble I’m afraid this morning. I’m looking at markets, thinking they look overly buoyant, but who would listen if I cried Wolf?
The real economy thinks markets are informed, smart and clever. Ask anyone with a real job doing a real thing; like building planes, working on new power sources, digging mines, solving food insecurity, or driving a taxi and they will ask about markets with a sense of wonderment. They are amazed at how we understand and connect what all the noise, data, and information means? How is it we can predict how markets work?
Hah! Time for the great reveal…. We don’t. We guess and make lots of assumptions – which we dress up to make ourselves sound terribly clever and well informed.With perfect knowledge, (and the most powerful computer ever), we might get close to predicting the outcomes of what the infinity-plus-1 inter-reactions, transactions, data, nods and winks, each infinitesimally small change in the economy means. (I am sure a cat in a box would feature somewhere.) We can look for rules, patterns, correlations and trends to guide our thinking. We fill-in the details by pretty much guessing.
On the basis I admit we are guessing, then the natural thing to do is worry when markets feel this confident. I keep looking over my shoulder on the basis I must be missing something critical.
That fear of what I can’t see makes me a bad trader – great traders understand it’s sentiment (not smarts) that drives markets. They succeed by not being overly clever, but staying in touch with how sentiment is playing, and anticipating when it will shift. In many ways the very best traders let the “Force” guide them.
It’s the collective will of the market’s participants – the voting machine that determines if prices are going up or down – that matters. Not the fact a crusty old market strategist’s spidey-senses are a tingle. This is a traders’ market – positive sentiment is in the driving seat for the time being.
So, let’s put on a sentiment hat on this morning: What’s to like about markets. (Rule 1 – don’t try to be too clever, go with the flow and don’t worry about everything that might happen.) Fundamentally, the key points likely to keep driving us higher are:
- Falling inflation (energy and food) clearly reduces the pressure on Central Banks to further hike rates.
- Nothing to worry about in US politics – they’ve just fudged a deal to stop the nation closing down.
- Rate cuts must be coming – even if 6-9 months down road, market expects them.
- The US may be on credit watch for a downgrade – who cares…
- Global tensions are easing as Biden and Xi hold a California Gabfest. Ukraine doesn’t make the front pages anymore.
- Buy bonds, buy stocks.
It never is.
Sentiment is fickle. Inevitably, all it will take is a shock, a miss, a headline, or an event to bounce sentiment. Understanding sentiment means understanding its vulnerability – and how quickly the underlying current can change.
Let me digress a moment: I was amazed and frankly amused when I read years ago about how shoals of herring communicate. They react to the threats around them in a series of coordinated shifts and turns by the whole shoal, making them appear to dance and flash, glinting in the shallow-sea sun like a much larger animal (which is why they were called the “Silver Darlings”). Scientists discovered the herring communicate by farting. Yep, apparently that’s how the group-mind of the shoal operates – powered by flatulence.
How does the market communicate?
That’s the secret everyone wants to learn. If you are going to trade you need not only to play sentiment, but anticipate the sentiment shift. As the news and other inputs change, what signals or intel should we look for? How are sentiment shifts communicated – by analysing the price action? Looking for trends? Guessing the tops and bottoms?
Fundamentally, trading is tactical. It’s all about trading sentiment – which gets flash at times. There is a fundamental difference between trading and investment. Investment is the strategic aspect. Trading is not investment. The business of modern investment has become a multiplicity of different models.
There are real money accounts looking to earn fees by wisely investing your pennies to make sure you retire in some comfort, or your hospital bills are paid. They look to generate the returns they will need to meet their long-term liabilities. Their investment strategies are predictable. (And subject to shock if something breaks – witness the Trussterf*ck.)
There are the funds who understand businesses – being able to work out how sectors and firms will function, thrive and develop. They can figure out which firms have the uniqueness to succeed and which won’t. A great example of how that doesn’t work is SoftBank in Tech. If they invest… run a mile. Pretty much same for ARK. Their “success” was to persuade investors they had “special” insights – when the results show they clearly did not.
There are firms that understand credit – how diversification, security and a clear understanding of how feedstock, offtakes, and markets will generate the funds to repay principal and interest.
There are firms that look to play arbitrage – for instance, buying companies to load up on debt to pay bigger dividends, leaving these companies highly leveraged and weak, but the new owners wealthy. Funnily enough, the news wires are full of warnings about how the Private Equity bubble is about to pop.
And then there are the firms who really understand the possibilities of smart investment strategies – that it’s not just the business of making returns, but the transfer of wealth, power and risk. If you can acquire the first two while minimising the last, that’s real success. It’s happening. (It’s been happening since the invention of banking!)
There is a note in the FT this morning: Blackstone borrows to boost lending power of $52 bln credit fund. Effectively its issuing a CLO – a collateralised loan obligation – secured on the loans made by its private credit lending fund. Effectively, it is selling the “tranched” risk of its own lending to investors. The tranching means investors in the least risky CLO tranches take the lowest risk and receive a lower return.
Such deals, and they are happening around the market, confirms the big private debt lenders are essentially no different to banks. They originate risk and then sell it. They garner the returns, they remain the lenders, and they transfer the risk to other investors. Blackstone keep the equity risk (the most risky “first loss” part of the deal) because that incentivises them to manage the risks, but concentrates the maximum returns in that equity tranche – gaining leverage on leverage!
By being able to sell CLOS to investors Blackstone gains another critical advantage. In the past these funds obtained leverage from the banks.. Now they don’t need the banks. How does that change the world? How does that change how Central Banks think about the risks embedded in the system?
For investors, I can’t help but think diversification of investment approaches is as important as diversification of assets. Perhaps a topic for further discussion.
Meanwhile, I’m terribly excited to read SpaceX plans to IPO Starlink as early as next year. This is something I’ve got to look at – and if I get the time.. guess what I might write about tomorrow!
Five Things to Read This Morning
Out of time, and off to the day job…
Market Strategist and Author of the Morning Porridge