Sui Generis Investment Up 9.4% On Shorts
Charlie Munger: Invert And Use “Disconfirming Evidence”
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Friends and Investors,
Welcome back after a brief hiatus. We trust you all had an enjoyable summer and that you didn’t spend too much time worrying about your investments, that’s our job. The Sui Generis Investment Partners Master LP had a solid albeit uneventful summer, returning 2.86% from June through August and taking our year to date return to 9.38% net of all fees and expenses as of August 31st. The Fund has maintained its net short positioning throughout the year and in this note we’ll get into the reasons we believe our stance is prudent now more than ever, though with some important shifts in our macro strategy.
There is a worthwhile exercise for any young aspirant working in capital markets that we believe is one of the time honored traditions of finance, one that many reading this note have likely participated in. Find a veteran of the industry for whom you have a great deal of respect, offer to buy them a drink and pick their brain for as long as you can. Beyond hearing the inevitable stories about the good old days, the conversation isn’t necessarily supposed to yield ideas or stock tips but rather rules of the business and words of wisdom, typically accompanied by some historical reference and the assertion that history does in fact repeat itself. One such axiom that has always stuck with us, likely because it was driven into our psyche from multiple directions over many different conversations is that the bond market does not lie. To clarify, this expression means that while stocks move up and down on a whim and at times can tell a very misleading story about a company or the economy, bonds will give the true picture of the health of the underlying subject. Why does this matter right now? It matters immensely because we believe there has been a shift in the bond market that is shaping the way equities will perform for the foreseeable future, let’s explain.
For a couple years now the bond market has been telling you that economic armageddon is coming via low and negative yielding government bonds, but the stock market has been indicating that all is well. There have been points in time over these years when we contemplated whether or not the predictive nature of the bond market was an irrelevant concept. Perhaps this was a new paradigm where the behavior of the bond market doesn’t actually mean anything to equity investors and this tried and true adage was now antiquated. After all, markets evolve over time and whomever was the first person to utter the line “the bond market doesn’t lie” no doubt had never seen quantitative easing before. Perhaps central bank intervention via the purchasing of bonds had effectively broken the bond market function of signaling inflation expectations and economic strength or weakness. This interference in actual market functions was and still is visible everywhere…like Spain, the “S’ in the famed PIIGS, can borrow 10-year money more cheaply than AAA rated Canada. Given the numerous examples that make as little sense as that fact, one couldn’t be blamed for thinking there was a fundamental breakdown in the relationships upon which most investing frameworks are built, that being the relationship between risk and reward.
Now, we don’t want to be too hard on bonds so rather than calling the market a liar we’ll suggest that central bank coercion made it hard to tell the truth as quantitative easing inflated assets of all kinds, not just bonds. Fear not though, there is an air of honesty around the bond market right now as yields have been on the rise and we believe that the market began sniffing out inflation (as it always does) about two months ago. Remember the date at the top of this page, July 8th 2016 is the day that in unison US, German & Canadian 10-year bond yields hit their all-time lows at 1.35%, -0.19% and .96% respectively. Two weeks later on July 17th Japanese 10-year government bonds hit their low as well at -0.3%; all have been rising steadily since. So while we aren’t prepared to pound the table and call a bottom in yields, the advantage of hindsight allows us to say this makes perfect sense; late this week we learned that United States core CPI (inflation) rose at an annualized 2.3% last month. This is above the Federal Reserve’s 2% target and is an inconvenient fact for those who have bid up defensive sectors to what we see as entirely unreasonable valuations in the chase for yield. The logic has always been that interest rates would stay lower for longer or perhaps forever, and they might, but a bond market selloff is starting to remind investors that yields can rise outside of central bank policy; the market can force them higher.
So what is one to do in this environment? Well, the reasons for the rise in yields is what’s paramount here. If economic growth is pushing yields higher then all is well and one should think about gaining some exposure to cyclical sectors. However (there’s always a however) if the rise in yields is the result of inflation expectations without the commensurate economic growth (the dreaded stagflation) then all bets are off. It’s too early to tell which of these two paths we’re headed down so unfortunately we can’t give a great picture on what we think you should own, only what you shouldn’t. If this upward movement in yields continues or further, forces central bankers to truly consider raising interest rates in a meaningful way, expect utilities, consumer staples, REIT’s and over-levered companies in general to continue their underperformance that began a couple weeks ago. Now, it’s entirely possible that this is a “head fake” to be followed by a rally in bonds and a coincident drop in yields, it’s early days in this move and thus it’s hard to tell. But we would advise caution when chasing yield and suggest that investors listen to the bond market right now, because it’s trying it’s best to tell you something.
The Sui Generis Team