In our latest Quarterly Reflection, I authored the segment titled The Devil in the Details which contains not only our review of 2019’s 4th quarter and the road ahead but addresses what went right and wrong in our investment strategy. In the report, I mention that one of the most important aspects of maintaining longevity with a career in money management is to humbly remind oneself that we are no smarter than the collective wisdom of the market. As investors, we must be prudent to review and understand what factors and decisions we made and the outcomes they produced, be it intended or unintended. By learning from our rights and wrongs, we can continuously calibrate the investment process which evolves our decision making.
During our coffee today, I want to dive a bit deeper into what we viewed as a miscalculation and underestimation in one of our PIIL Model (Policy, Inflation, Interest Rates, and Liquidity) components; liquidity. So, grab your cup of coffee as we address the liquidity conundrum!
For the high-speed espresso drinkers, here is a quick bullet point synopsis:
- Investment Processes constantly need to be calibrated to produce meaningful market signals
- The recent market rally was purely liquidity induced
- The jury is still out on the viability of the sizable liquidity injection
Our investment strategy is rooted in the belief that financial markets are acutely sensitive to the growth rates (how fast or slow the economy grows) in economic conditions. We assess economic and business cycle growth to help us determine which asset classes, sectors, industries, and factors provide excess risk-adjusted performance at various phases of the cycle. We make our assessments by the use of our DCA’s PIIL Model which calculates the growth rates of monetary Policy, Inflation, Interest Rates, and Liquidity. The interpretation of the model inputs allows us to construct our investment portfolios accordingly.
While our investment strategy successfully navigated the financial markets of 2018 and 2019, it was not always flawless. Any data-driven investment strategy requires constant calibration in an effort to produce meaningful market signals. What we underestimated was the massive Liquidity injection commenced by the United States Federal Reserve in October which caused financial markets, namely the S&P 500, to accelerate to new all-time highs regardless of the growing risks.
To take a step back, lets first review what liquidity means. Over coffee some months back, we discussed that central banks (the financial institution that has control over the production and distribution of money and credit for the economy of a nation) use monetary policy to help stimulate, or at times control, an economy. The various tools of monetary policy are designed to control money supply where the money supply is the amount of currency and other highly liquid investments injected into the market to spur economic growth. While we don’t want to dive into all of the monetary tools at central bank’s disposal, as we don’t have enough coffee to stimulate our minds for that kind of conversation, we will chat about an unforeseen phenomenon that occurred in October 2019.
As mentioned, the Federal Reserve has several tools and methods to enact monetary policy for the benefit of the economy. Our DCA PIIL Model aims to track liquidity which we define as money supply growth based on our research that growth in money supply (liquidity) has profound impacts on the performance profiles of financial assets. While our DCA PIIL Model anticipated acceleration in January 2020 for an acceleration in money supply growth, the Federal Reserve embarked on a massive liquidity injection in October 2019 thus front-running our assessment.
Looking at the chart below you will see the Balance Sheet of the Federal Reserve (blue line) growing, which synthetically injected liquidity into the economy. The S&P 500 (gold line) instantaneously reacted to the increased liquidity evident in the increased positive correlation between the stock market and Federal Reserve.
The method in which the Federal Reserve enacted its liquidity injection was using a tool known as Repurchase Agreements. Repurchase Agreements are designed for central banks to purchase liquid assets, like bonds, from commercial banks in an effort to increase or stabilize money supply (liquidity) for a short period of time. While the use of Repurchase Agreements have not been an uncommon practice, the massive amounts of overnight repurchases have been unprecedented, evident in the chart below.
Identifying the deficiency in our liquidity component allowed us to enhance our PIIL model to incorporate the effect of Repurchase Agreements. In full transparency, we do not believe that the current state of aggressive monetary actions via Repurchase Agreements, which have taken place over the last 3 to 4 months, are long-term solutions given the already elevated balance sheet holdings for central banks. Nonetheless, the markets have responded favorably to increased liquidity injections regardless of the transmission of Repurchase Agreements. We will remain cognizant of central bank actions and liquidity injections as we believe quantitative easing merely puts a band-aid on a much larger structural issue.
Please feel free to reach out with any questions, topic suggestions, or if you want to chat!