DAVE JANNY MARCH ONE 2017 INVESTMENT LETTER
2017 VOLUME 5
“MR. ROBOTO AND THE ATTEMPT TO END RISK”
“Mr. Roboto” that name in the title may have caught your attention! Some of you may recall that “Mr.
Roboto” is the 1983 song by rock band Styx. I know I’m reaching way back in the music bin again. It’s not
even a song I particularly like, but the song seems to be appropriate for the modern day technology age
we find ourselves in today. The song was a theatrical “rock opera” piece whose basic theme was kind of
an “anti-tech “message. It portrayed a time where a modern “tech oriented” society banned rock music.
Can you imagine? Give it another listen. You may still not like it but it may transport you from the 1980’s
right to today. The song, also strangely opens up with following lyrics:
“Thank you very much, Mr. Robot
Until the day (we) meet again
Thank you very much, Mr. Robot
I want to know your secret”
The other part of my Investment Letter title that I hope grabbed your attention was “The Attempt To
End Risk”. What a noble and ambitious concept! Imagine if we could actually do that. It feels like we
may have actually done it in the stock market. Just kidding, but doesn’t it almost feel that way?
In this month’s Investment Letter I’ll delve into technology in our society as well as technology in our
investing. I’ll then give you some thoughts and reading links on pertinent market and economic news,
events, signposts and things to watch. In the words of Buzz Lightyear: “to infinity and beyond”.
RISE OF THE ROBOTS
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Warning! There’s a high level of sarcasm in some of the following statements.
It feels like technology and “Mr. Roboto” more and more are taking over the investment world. We have
“robo-advisors” gaining traction in financial planning. Eliminating human emotion from investing sounds
like a great idea but there’s more to it than that (more on that later). In the old days we were hearing
about “program trading”, today it is more like “high frequency trading” and “algo trading”. “Algo” of
course stands for algorithm. It seems like everyone is trading the same algorithm because it feels like
they have apparently successfully banned “sell” orders and banished volatility. You can search the
internet and find DIY courses on how to “build you trading robot”. No, I’m not kidding. I’ll call the
purveyors of that type of trading “robo-traders”. The same types of technology have become pervasive
in the world of hedge funds. Renaissance Technologies is a good example. By the way that’s the name of
a hedge fund company not a traditional tech company. According to Wikipedia, “Renaissance is one of
the first highly successful hedge funds using quantitative trading— known as "quant hedge funds"—
that rely on powerful computers and sophisticated mathematics to guide investment strategies.”
Science and engineering related PHDs are in high demand on Wall Street. In an 8/17/16 Business Insider
article titled “This is The Biggest Trend in The Hedge Fund World Right Now”, the article says “The
humans are losing. The computers are winning and the hedge fund game is
changing.” I’ll call them “robo-hedgefunds”.
Taking this train of thought out even a little further, you could argue that central bankers have become
almost robotic in their allegiance to the Keynesian branch of economics. Keep in mind that economics is
affectionately known as the “dismal science”. I won’t remind you too much that that the economic
growth, promised by historic interventionist central banking since the financial crisis, has been dismally
disappointing. Central bankers’ utter dependence on consumer spending encouraged them to create
negative interest rates last year, affectionately known as NIRP. If low rates aren’t enough, I guess their
“”Mr. Roboto” models suggested it would be better to pay consumers to borrow (NIRP) at the expense
of conservative savers who were discouraged to save in money market and CD vehicles. The mountain
of global debt that continues to be created unabated has proven to be a “glitch in the system” that has
prevented central bank models’ optimistic economic forecasts to come to fruition. In the famous
(possibly at some point infamous) words of head European central banker Mario Draghi, ”whatever it
takes”. The unwritten central bank rule seems to be no more recessions or stock market corrections
allowed. I’ll call these central bankers “robo-central bankers”.
Even the individual “retail” investor has succumbed to robotic tendencies. Record amounts of inflow
into “passive” index ETFs while shunning “active” managed funds is the investment rage on Wall Street
via Main Street. . I’ll remind you that this phenomenon has a tendency of being most popular at the end
of big upward market moves rather than the beginning. Indices notoriously underperform active
managers in the down part of the investment cycle. The 2/28/17 Sovereign Investor Daily wrote this:
“Plenty of respected Wall Streeters have noted similar concerns. Recently, Baupost
Group’s Seth Klarman, whose firm has more than $20 billion under management,
noted “the inherent irony” of market-efficient index-tracking ETFs and mutual
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funds: “The more people believe in it and correspondingly shun active
management, the more inefficient the market is likely to become.”
As you may have guessed, Baupost is not a “robo-hedge fund”, yet they are a phenomenally successful
long term hedge fund. Speaking of long term, it seems to me we tried some version of this “algo trading”
way back in 1998. It was called Long Term capital Management. I’ll let Wikipedia tell you what
happened:
“LTCM was founded in 1994 by John W. Meriwether, the former vice-chairman and
head of bond trading at Salomon Brothers. Members of LTCM's board of directors
included Myron S. Scholes and Robert C. Merton, who shared the 1997 Nobel
Memorial Prize in Economic Sciences for a "new method to determine the value of
derivatives".[3] Initially successful with annualized return of over 21% (after fees)
in its first year, 43% in the second year and 41% in the third year, in 1998 it lost
$4.6 billion in less than four months following the 1997 Asian financial crisis and
1998 Russian financial crisis requiring financial intervention by the Federal
Reserve, with the fund liquidating and dissolving in early 2000.”
Long Term Capital Management, despite all the PHDs and Nobel Prize winners, still required a massive
government led bailout to prevent significant market and economic damage. I’m not anti-technology,
but I guess you could call me “old school”. For a long time most advisors on Wall Street have relied on
computers to generate asset allocation strategies for investors. Inputting risk tolerance, investment
horizons, income and then factoring in cash flow needs, models would give detailed asset allocation
recommendations adjusted for risk. Obviously those inputs are important “need-to-know” items in
making invest recommendations, but where the computers potentially go awry is by basing the analysis
on “backwards looking” data and performance creating ”backwards looking” allocations. Those
allocations may be a starting point but I prefer to think that successful advisor investment experience
coupled with extensive research and reading are necessary “human” factors that can help create a more
“forward looking” investment allocation strategy.
I’ve been in the financial services industry for almost 34 years. I consider and pride myself on trying to
be a “student of the markets”. It is some of that experience that helped me, in advance, identify the
potential for the 2007-2009 financial crisis. The last 2-3 years there have been flashing warning signs
that posit the possibility again for another potential crisis. Thankfully, one hasn’t arisen yet.
Unfortunately all of the “Mr. Roboto” trends I referenced above have all created an environment where
it feels like there has been a suppression, if not elimination, of risk. Importantly, remember it only
“feels” that way. Investors, computers and human alike, are most likely investing with an extreme
underestimation of the level of risk that currently exists in all global markets. The “up” trend could
possibly continue longer than I think, but it doesn’t change the fact that there are many warning signs
that need to be factored into an investment strategy.
In my last Letter I spoke about the long length of the current economic and market cycle (check out my
library of Investment letters at http://fa.morganstanley.com/david.janny/). Coupled with the late cycle
nature of where we are, valuation is certainly one of the concerns. I posted to Linked In (if we’re not
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connected on LinkedIn I urge you to do so) an interesting article by Wolf Richter of Wolf Street where he
shows the extent of P/E expansion in the current market valuation. As you’re reading it, consider that
the case for P/E expansion has been built around low interest rates. With an expected Fed rate increase
coming (more on that later), there may be a re-evaluation of that rationale.
http://wolfstreet.com/2017/03/04/pe-multiple-expansion-at-record-multiple-compression-coming/
As I mentioned in my title, all of the items I’ve discussed in this section create an illusion of risk being
reduced. Thus as I said, “Mr. Roboto” is making “an attempt to end risk”. According to Artemis Capital
Management (a volatility manager), volatility as measured by the VIX, has been at a historical low for
the last couple of years. Volatility is being completely suppressed by many investors actually “selling
short” the volatility. It has been a very successful strategy that has also become too easy. At some point
this trend itself will create unexpected volatility that will surprise and blindside many investors. Who
knows how far away that may be. The point is, this and the other “robo” trends I’ve written about are
actually ultimately creating more risk, not less risk.
To quote Styx’s “Mr. Roboto” again:
“The problem's plain to see:
Too much technology
Machines to save our lives.
Machines dehumanize.”
TECHNOLOGY AND THE ECONOMY
The speed of technological advance is always getting faster. Today’s “cutting edge” technologies include
robotics, artificial intelligence, virtual reality, driverless cars and blockchain. I am no technology expert,
so I won’t go into any detail on the technologies themselves, but I feel it is important to try to grasp the
impact on our economy. Technology has obviously had a major positive impact on the global economy
and society in general. It will certainly continue to do so. Adapting to the change and understanding the
impact of the change is, and will continue to be, a crucial part of the process. Dealing with the
ramifications of these technologies on jobs will be one of those needed adaptions.
One of the key political, economic and market issues today are jobs. Jobs, particularly manufacturing
jobs, were an important part of Trump’s campaign platform. There is certainly a debate as to “what
part” technology and “what part” trade policy played in the decline in U.S. manufacturing jobs. One of
the more controversial aspects of Trump’s economic policies is trade. Trump has made it clear he will
attempt to unilaterally rather than multilaterally negotiate and adjust our trade deals in the hopes of
creating better deals for us and stimulating more manufacturing and other job growth. Tax policies such
as corporate tax reform and the potential Border Adjustment Tax (BAT) will be important factors in the
outcome. Technology that replaces humans will be a hurdle that Trump and the economy will have to
deal with. STEM (science, technology, engineering and math) education, and job training are necessary
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ways to adapt to the coming change, but they require concentrated long term emphasis and plans to
prepare our country to most effectively take advantage of the rapidly evolving technological
advancement. There certainly are different views on how to do so. Tech titans Bill Gates and Mark
Cuban have different views. Check out these two articles on their views to help you frame the
complexity of the “big picture” issues and debates to come:
http://www.recode.net/2017/2/17/14652880/bill-gates-robots-steal-human-jobs-pay-taxes
http://www.cnbc.com/2017/02/22/mark-cuban-basic-income-worst-response-to-job-losses-fromrobots-ai.html
If you’re not familiar with blockchain, I certainly recommend you become so. It has the potential to
change many industries. Here’s a great primer from the Harvard Business Review:
https://hbr.org/2017/03/the-blockchain-willawl-do-to-banks-and--firms-what-the-internet-did-to-media
My Investment Letter is not a forum for specific recommendations but I do like the biotech sector long
term. Technological advancement in the tools to aid drug discovery has been greatly enhanced. Global
aging demographics continue to be a major long term positive for the industry as well. Additionally the
FDA stands to be a government agency that Trump can greatly impact by streamlining the drug approval
process. Cybersecurity is another field in technology that has tremendous long term importance and
opportunity. It’s obviously currently in the news in a big way. Unfortunately, it will almost certainly
continue to do so as hacking is one of the downsides to technological advance.
My final thought on technology is that its’ rapid pace of change has been a very deflationary force in
global economics. Think about what Amazon, Walmart and globalization have done to consumer
product prices. One of the key outcomes to pay particular attention to in the current investment
environment is whether we are entering a reflationary economic period or are we still stuck in a
deflationary trap. Technology and debt are two amongst many factors that lead me to believe we are
still in a deflationary environment. It will be very interesting to see what robotics and some of the other
technologies I mentioned above will do to the job market and society in general in the future. Here are
some interesting thoughts to ponder from John Mauldin’s 3/1/17 “Thoughts From the Frontline”:
“Let’s look at the impact of autonomous (self-driving) vehicles. Estimates are that
by 2030 25% of vehicles will be autonomous.
There are 250 million cars and trucks on US roads today. We buy more than 16
million cars a year, replacing the older part of our fleet. In a world of shared
automobiles, which automated cars will allow, we won’t require 250 million cars;
we will need far fewer. I could see the total numbers being down 50% by 2030.
Autonomous cars are going to be adopted amazingly quickly, especially by Gen X
and Millennials. And this Boomer will be an early adopter, too.
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Let’s think of the impact. First of all, there are 3.5 million truck drivers, 75% of
whose jobs (at least) will be replaced. Ditto for the 250,000 taxi drivers and 160,000
Uber drivers, not to mention the 100,000 Lyft drivers.
Estimates are that automated driving will reduce accidents by 90%. That will
obviously reduce insurance costs but will also decimate the ranks of auto insurance
agents. Each year 1.3 million people are injured in vehicle accidents, with 40,000
deaths. That’s a lot of hospital visits. Eventually, 90% of those injuries will go away,
reducing demand on hospitals and eliminating jobs. We won’t need as many
policeman, firemen, and ambulance drivers at accident scenes, either. In total, we
could be talking hundreds of thousands of jobs.
And then there are the auto repair companies that make a living off fixing damaged
vehicles. There are 500,000 auto repair shops. Obviously, they do more than just
repair wrecked cars, but today’s cars and trucks are lasting longer and need fewer
repairs. And we are moving to electric vehicles, which have relatively few moving
parts, so repairs are becoming much simplified.
There are numerous benefits to autonomous driving, but an increase in total
employment is not one of them. Automated driving will create jobs, just not as
many as it destroys. The total job loss just in the United States might approach 10
million. These jobs are not going to disappear in year one, but from the point of
view of somebody working – and then suddenly not working – in an affected
industry, the change will seem like it hit overnight.
And that is just one industry and one technology. Maybe it’s one of the bigger,
more dramatic examples, but there are literally hundreds of new technologies that
are going to eat up jobs faster than they create them. There are literally tens of
millions of jobs in just the US alone that will probably vanish over the next 20 to 30
years. Of course, we have to remember that many jobs have disappeared with the
introduction of new technologies every decade for the last 200 years, so this is not
exactly something new. The difference is that now it’s happening much, much
faster. Rather than moving from the farm to the factory to the office over 10
generations, we will be creating, destroying, and remaking whole industries in half
a generation, making the always bumpy transition to a new workforce that much
more difficult.
And of course, we need to remember that many new technologies and social
inventions will create whole new categories of workers and job opportunities. The
road ahead will hardly be a one-way street: all job destruction and no job creation.
As we will see, making sure that we create more jobs than we lose is at the heart of
tax reform. I promise you, there is a deep, direct connection between tax reform,
the creation of new businesses, and employment rates.”
THINGS TO WATCH
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We have an interesting confluence of factors on March 15th. Firstly the Fed more than likely will be
hiking rates. Secondly the federal debt ceiling debate starts as the deadline from the last agreement in
late 2014 will expire. Lastly we have the Dutch presidential election. I’ll share some thoughts on each.
I’ve been intimating in my last couple of Investment Letters that the Fed may have some political
motivation to raise rates in response to Trump’s expressed views on the Fed in last year’s presidential
campaign. I also feel that the Fed should have been trying to “normalize” rates for more than just the
last couple of years, so in my view they’re way behind the curve. Interestingly though, by waiting till
now, we seem to be stuck with declining GDP numbers. According to the Bureau of Economic Analysis
Q4 2016 GDP was 1.9% bringing the 2016 number to a whopping 1.6%. I recently posted articles on
LinkedIn referencing the rapidly dropping GDP estimates. On the big 3/1/17 “up” stock market day,
coincidentally Goldman Sachs and the Atlanta Fed cut their Q1 2017 GDP estimate to 1.8% each, J.P.
Morgan to 1.5% and Bank of America to only 1.3% Here’s the story:
http://www.zerohedge.com/news/2017-03-01/q1-gdp-estimates-tumble-goldman-atlanta-fed-cut-18bank-america-sees-only-13
Amazingly, this week of March 6th, the Atlanta Fed cut its Q1 GDP estimate two more times to 1.2%.
Wow! By the way, the Atlanta Fed’s original estimate at the beginning of the quarter started at 3.4%
Things aren’t exactly humming. There’s some talk that some of the cuts were based on inventory
depletion which may actually be a plus for Q2. We’ll see, but in either case our 3Rd rate hike in 3 years
will be ironically coming with less than stellar GDP numbers. The future guidance, more than likely, will
also remain hawkish. I’m not sure our economy can withstand too much rate increase with the debt load
we’re already carrying. Again, we’ll see.
http://www.zerohedge.com/news/2017-03-08/q1-gdp-now-just-12-according-atlanta-fed-rate-hikeimminent
The debt ceiling debate along with crafting an Obamacare replacement could prove to be major
distractions and time wasters for the Trump fiscal stimulus agenda. From a near term standpoint, the
market is very fixated and dependent on policy implementations in the way of fiscal stimulus and tax
reform. We‘ll get a chance to gauge how patient the market will remain should there be delays and
even political discord. Can you imagine political discord in Washington?
Geert Wilders is the Dutch “populist” candidate in Wednesday’s Dutch presidential elections. The “polls”
had him leading until very recently. Remember how accurate the Brexit and U.S. elections “polls” were.
This coupled with elections in France, Italy and Germany should make 2017 a very interesting year in
Europe. Additionally, according to Marketwatch, ECB head Draghi is tapering his monthly QE bond
purchases starting in April from 80 billion euros per month to 60 billion per month. By the way he can
now purchase bonds yielding as low as -0.4%. No, that’s not a misprint. Yes, that a negative number.
Lastly according to Investing.com, crude oil prices broke out of an approximately $52-56 multi-month
range and as I write this is trading with a $48 handle. OPEC’s production freeze at was perceived to be
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high levels may not be helping lift prices in what looks like an oversupplied market. Perhaps weaker than
anticipated global economy and demand?
CONCLUDING THOUGHTS
“Again, quoting from Styx’s “Mr. Roboto”:
“You're wondering who I am (secret secret I've got a secret)
Machine or mannequin (secret secret I've got a secret)
With parts made in Japan (secret secret I've got a secret)
I am the modern man”
In the Styx song,” Mr. Roboto” was actually found to be a man not a robot when he was unmasked.
Technology is a wonderful thing in many ways and there is a lot more change to come. Be careful
though in potentially misinterpreting some of the technological advances in investing as risk
reducing vehicles. Risks can’t be eliminated even when it feels like that it is what is happening, as it
does now. As I write this Letter today it is March 9th 2017 which is the eighth anniversary of the
post-financial crisis stock market low on 3/9/09. Happy Anniversary! If you read my last Letter,
“The Semi-Circle of Life” you’ll know that eight years is a very long length of a cycle. There certainly
could be more upside potential, but the higher we go the more caution will be warranted despite
the difficulty in accurately identifying a top. Appreciate the benefits of “Mr. Roboto” but beware the
danger as well.
David Janny
Senior Vice President
Senior Portfolio Manager
Financial Advisor
NMLS# 1279369
Morgan Stanley Wealth Management
200 Nyala Farms Rd.
Westport, CT 06880
203 221-6093
Visit my website http://fa.morganstanley.com/david.janny/
Connect with me on LinkedIn: https://www.linkedin.com/in/david-janny-ba2734115
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