First things first, we have some news!

We are currently finalizing our next SSRN white paper, a piece of work that deals with executive actions of US companies, and how we can identify which companies are being governed with an eye toward long-term success as well as which ones are being hollowed-out for short-term profiteering by and for upper management. This work has led to a quantitative scoring system that will the subject of the SSRN paper, as well as an investment fund strategy that is currently being paper traded and showing major promise. Stay tuned! We’ll have a follow-up in…less than five months this time.
Our first fund, the Global Anomalous Index Allocation (GAIA) fund, is (finally) in its track record stage! Results are still early, but so far the results are hewing very close to expectation, which is the best we can hope for at this stage.
We just wrapped up our first accelerator and will be starting the Southern California cohort of the Founder Institute in a little over a week. These accelerators are helping to crystallize a lot of the needs for propelling Novatero forward into the Seed stage and beyond, and should be extremely helpful in pushing us forward from concept to actualization.
We have information sheets both for GAIA (mentioned before) and the aforementioned second fund, Near-term Response to Corporate Heuristics (NRCH)*. Reach out via the Contact form or email me directly at bryan@novatero.investments if you’re interested.

With the news out of the way, let’s delve into the main subject of this post.

As I write this, I’m watching Marc Hirschi all alone out front on Stage 9 of this year’s Tour de France**. In an effort to keep his advantage on the peloton and various chase groups, he is absolutely bombing down some very foggy and wet descents (for an example, watch the masterclass in descending from Hirschi’s hero and former world-beater Fabian Cancellara). Being aggressive while going downhill can be extremely risky even in the best conditions: one misread of a bend or a momentary lapse of concentration can lead to a crash that can, at best, erase all of the work they’ve done on the stage or, at worse, end your season, career, or life. Still, this is a balance between risk and reward for these cyclists, as a stage victory in a grand tour can make the difference between a successful career and an anonymous one. Former cyclist and Yogi Berra-esque character Jens Voigt summed it up well by stating "If you go (with a break), you can either win or not win. If you don't go for it, you definitely won't win." It is a calculated risk: an aggressive descent can increase your probability of winning, but you also increase the possibility of an accident. However, this risk can be mitigated through actions of the cyclist: staying within your descending skill set, not overexpending effort on pushing your pace, maintaining vigilance the entire way down, and properly preparing ahead of time by reviewing the course profile, weather conditions, etc. can greatly improve favorable probabilities and lower unfavorable ones. This is a reflection of idiosyncratic risk: while many of the riders will experience the same twists and turns and weather heading down the mountain, the way they approach the descent will account for the majority of the risk they take on. It is (mostly) controllable risk: aggressive riders can get down faster but have a higher probability of making a mistake, whereas cautious riders reduce the chance they’ll take a poor line around a bend by sacrificing speed and time.

Why mention this example, other than to point out that I’m the rare American who watches professional cycling? Mostly because I’m seeing a lot of industries treating their current predicament as a risky descent down a mountain, where in-fact they are picking up nickels in front of a steamroller. “Picking up nickels in front of a steamroller” is a finance colloquialism that refers to the almost-obsessive need for some to grab tiny profits in the shadow of massive risk. Think squeezing out market gains in the overvalued markets before Black Thursday (or the bounce afterward), the Dot-Com bubble breaking, or during the PE spike before the Great Recession. The global SARS-CoV-2 pandemic led to a global recession in a historically short amount of time, but markets around the world have seen a substantial rebound back from that nadir. In fact, the S&P 500 just recently shot past the previous all-time high set back in February, despite the very real pandemic still going on across the world. There is a disconnect between the markets and the underlying economics: a market in theory shouldn’t be seeing all-time highs during double-digit unemployment and a very real possibility of mass rental/mortage defaults. Part of this is due to a abnormally large percent of the S&P 500’s capitalization being comprised of a handful of tech stocks: tech companies made out very well during the pandemic due to the fast-track need for digitization and remote capabilities for a majority of companies. However, part of it is due to an intersection of our current society and its complete unfamiliarity with pandemics.

Pandemics used to be much more common in our world; browsing any number of in-depth chronicles of history will see mention of at least one outbreak (the musical Hamilton glosses over some of the pandemics that hit NYC post-Revolution). The global Influenza pandemic of 1918*** was the last major global pandemic, a world-spanning malady that followed on the heels of the first global war. Pandemics and outbreaks haven’t really gone away, with the occasional regional ones (1968 Influenza, 2003 SARS, various Ebola outbreaks in the 2010s) and others that…we just kind of live with now (Influenza, HIV/AIDS). Still, the impact of SARS-CoV-2 is the greatest in terms of breadth and magnitude in a century. Society itself has changed greatly over this time, as has our ability to cope with something like this. Socially, we aren’t able to fully process this impact: we struggle to adapt, lash out at real and (mostly) imagined causes of our predicament, or just refuse to accept the facts around us. It has led to a very weird time in society: we are trying to maintain a status quo that stares back a world that has been altered greatly. This has led to a lot of simulacrum of normalcy: SNL in the format of a Zoom meeting, charging two tickets’ worth of money for the digital viewing of a film that’s already on a paid service, or the humorous absurdity of watching a cardboard fan getting decapitated by a home run. We are all grasping for some semblance of normalcy, unconsciously making the assumption that we’re taking risk akin to an aggressive line on a switchback descent toward the safe, familiar, flat ground of the world we’ve known. However, we’re just pocketing our own psychological nickels in the face of the very real possibility that the world we’re attempting to hold on to will not exist as we know it going forward. This is systemic risk: uncontrollable risk that cannot be reduced through the actions of an individual. Barring a few places, everyone in the world has been affected by the pandemic, no matter how prepared or unprepared they were for something like this.

I bring this up because this strange frame of mind is penetrating into the US stock market. There’s a sense that any positive news, no matter how much smaller in magnitude it is than the global pandemic, will result in an out-sized positive impact on the market. In contrast, negative news almost seems like the status quo at this point, so its impact is minimal and pretty much disappears after a period of time. This stands in the face of the typical behavioral drivers of the market: negative news typically sees a larger impact than positive. This is the basis of Prospect Theory from Kahneman and Tversky, the former of whom won the Nobel Prize for their work. In theory, a gain of $1,000 and a loss of $1,000 should see the same magnitude of impact, as they represent reflective outcomes with an overall utility of $0. However, they found that on average people would only accept a loss of $1,000 if they could potentially net a gain of $2,000, indicating that people feel a loss about twice as strongly as a gain. Needless to say, seeing the opposite occurring in the current market is quite unexpected, and makes me wonder if we’re seeing some sort of “negativity saturation” in the market that leads to positive news being valued more than negative news. Not only is this is leading to people grabbing handfuls of nickels, they might have forgotten that there’s a steamroller hovering right over their heads. Everyone is treating this like risk that can be mitigated via actions, and while this can stretch the market for a time, it will snap back with a ferocity based on the previous distortion.

I’ve discussed the Cyclically-Adjusted Price-to-Earnings (CAPE) ratio on this blog multiple times, mostly because of how structurally sound and robust it is in showing the impact of market over- and under-valuation on the following 10 years of market returns. According to Shiller’s site, the CAPE was 31.47 as of September 4, 2020. That is nearly twice as high as its historical average and is roughly on-par with CAPE at a peak just before the Great Depression. The plot between CAPE ratios and future annualized returns over the following 10 years doesn’t paint a pretty picture for a CAPE ratio of 31.47:

That’s…not looking too promising, though the data past a CAPE ratio of 24 starts to look like it follows two parallel subsets. One of the variations to CAPE is to further divide it by the 10-Year Treasury Rate in order to normalize for a variety of risk-free rates throughout the history of the United States. When we do this, we get the following:

Uff da, The relationship here is even more unified than with the traditional CAPE ratio. By the way, I should mention what the current 10-year Treasury-Adjusted CAPE ratio (CAPE10) is.

It is 48.34, an all-time high and 10.4 times higher than the historical average. In fact, since the beginning of Shiller’s data starting in 1871, this is the first time ever that the CAPE10 has gone above CAPE. We are in “there be dragons” territory on that second chart. This trend was occurring well before this year, but the pandemic has greatly accelerated it. Much like society at large, we are entering into a world that will be superficially similar to what we’ve known, but structurally different. However, this is not a mountaintop descent where all the risk is due to how you read each turn in the road and how aggressively you want to reach the bottom. This is akin to rounding a corner on the descent and finding out the mountain is actually an active volcano that’s covered the road with lava. Idiosyncratic risk versus systemic risk. Controllable versus uncontrollable.

Watch out for steamrollers.

* Say NRCH out loud. You’re welcome.
** Despite pretty much riding a perfect stage, Marc Hirschi eventually got caught with 2km to go due to the combination of a massive push by nearly the entire Team Jumbo-Visma squad the General Classification contenders attacking one another. Sometimes you can greatly reduce your idiosyncratic risk and still get hammered by systemic risk. Still, this long period out in front and aggressive riding to stay ahead on the stage earned him the Combativity Award for Stage 9 (and gives him the inside track for the Super-Combativity Award in Paris). Not a bad day’s work for a promising 22-year-old rider in his first Tour de France. Chapeau Marc!
*** It is colloquially known as the Spanish Flu despite the first cases being reported in the United States and no conclusive evidence of where the virus originated; it received this name due to a perceived elevated impact to the country of Spain.

Updates, the Risk/Reward of Descending in the Fog, and Nickels in Front of a Steamroller