This note was originally published at 8am on September 04, 2014 for Hedgeye subscribers.
“If you try to fail, and succeed, which have you done?”
In theory, investing is very straightforward. You buy stocks in great companies and the stock prices goes up. You short stock in bad companies and the stock prices go down. Practically, of course, that’s never really how it happens, except in fundraising power point presentations.
A real paradox of investing is that there are periods in which the stock prices of “weaker” companies actually dramatically outperform “stronger” companies. Over the last three months, stocks in the highest quartile of short interest have outperformed low short interest stocks by 240 basis points over the last three months - +5.5% vs +3.1%. In part, this is facilitated by so called short covering.
Our lives are, of course, replete with paradoxes, so a little paradoxical market action should on some level be easy to stomach, right?
Some notable paradoxes of different genres include:
- Paradox of voting - For a rational, self-interested voter the costs of voting will normally exceed the expected benefits, so why do people keep voting?
- Fenno's paradox - This is the belief that people generally disapprove of the United States Congress as a whole, but support the Congressman from their own Congressional district.
- Hedgehog's dilemma – This is the paradox that human intimacy cannot occur without substantial mutual harm (This is maybe the best philosophical defense for long term bachelors like myself!)
- Archimedes paradox – The paradox that a massive battleship can float in a few litres of water
Lastly is one of my personal favorites - the St. Petersburg paradox.
According to the St. Petersburg paradox, a casino offers a game of chance for a single player in which a fair coin is tossed at each stage. The pot starts at $2 and is doubled every time a head appears. The first time a tail appears, the game ends and the player wins the pot.
Thus the player wins $2 dollars if a tail appears on the first toss, $4 if a head appears on the first toss and a tail on the second, $8 if a head appears on the first two tosses and a tail on the third, $16 if a head appears on the first three tosses and a tail on the fourth, and so on.
What would be a fair price to pay the casino for entering the game?
Back to the Global Macro Grind...
As it relates to recent events in Russia, the term circus comes more to mind than paradox. Yesterday Russian President Putin introduced a hastily patched together seven point peace plan at a press conference. This came shortly after President Obama upped the rhetoric in terms of the U.S.’s willingness to support Ukraine (and also NATO countries in the region) and ahead of a two day NATO summit that begins today.
By some pundits, this “ceasefire” was perceived positively. But the ever thoughtful George Friedman from Stratfor (the largest non-government intelligence agency) had a more paradoxical take and wrote the following:
“This rapid turnaround on the battlefield (in reference to the recent thwarting of a Ukrainian offensive) had two main purposes. The first was to assert Russian military power and convince the West that Moscow would not be afraid to use it in spite of the economic consequences. The second was for Moscow to use its military gains to make it appear that the West was utterly irresponsible in trying to wrest Ukraine out from Moscow's shadow. Now, by dangling an ambiguous cease-fire before the Americans, Russia is essentially telling the United States that to defeat Russia it must fight Russia directly, knowing that NATO is loath to engage directly with the Russian military.
That deal goes well beyond a cease-fire. Russia wants its buffer in Ukraine recognized and respected, along with sanctions lifted so it can get on with repairing its economy. And with winter approaching, Russia also has the means to turn the screws on Europe's natural gas supply at the same time it holds a clear military advantage on the Ukrainian battlefield.”
Of course, the real news in Europe this morning are the monetary moves from the ECB and not that geo-political move from Russia yesterday. In an announcement that was a surprise to most, the ECB cut interest rates from 0.20% to 0.05%, cut the deposit rate by 10 basis points to -20 basis points, and also cut the re-fi rate and marginal lending rate by 10 basis points.
Although this isn’t necessarily monetary shock and awe, with the Euro trading down about 80 basis points, Draghi was seemingly able to get his point across with this move on some level. Practically speaking though, it is not clear that this will necessarily be a catalyst to ignite European economic activity.
Certainly a negative deposit rate incentivizes banks to lend out their money and sovereigns such as France, with a negative short term borrowing rates, have benefitted. That said, at least based on the initial foray into a negative deposit rate early this summer, this policy move has not lead to increased lending to businesses that are willing to invest in and grow the European economy.
All eyes will now be on Draghi’s press conference where he is likely to now introduce a QE type plan that also surprises to the dovish side. But the paradox of these surprises moves from such low levels is related to the answer to the St. Petersburg paradox, which is: infinity. Unfortunately infinite monetary policy moves from zero do not grow an economy.
Our immediate-term Global Macro Risk Ranges are now:
UST 10yr Yield 2.33-2.43%
Shanghai Comp 2232-2316
VIX 11.34-12.95 (bullish)
WTI Oil 92.51-96.53 (bearish)
Gold 1264-1296 (neutral)
Keep your head up and stick on the ice,
Daryl G. Jones
Director of Research