You Can't Hold the Dam Forever (Beware the Nouveau Barbell Strategy)

In 2001, Gordon Chang published a dense-yet-wonderful book, The Coming Collapse of China. The title pretty much sums up Gordon’s thesis: The Chinese economy was on an unsustainable path and going to collapse, soon. Despite showing cracks in its fa?ade, now, approximately eighteen years later, the Chinese economy continues to flourish.

In 2009, Richard Koo wrote an absolutely great book, The Holy Grail of Macroeconomics: Lessons from Japan's Great Recession, the first few chapters of which should be mandatory reading for every economics student in the world. Koo’s book—like most academic works—is backward-looking, not predictive. Richard didn’t have to worry about getting the timing of Japan’s Great Recession correct as it had already happened.

Gordon Chang’s book deserves to be read by anyone interested in Chinese politics, culture, and economics, if for no other reason than it is written well and contains a highly plausible, well-researched argument, supported by a great deal of information. Indeed, most of the contents of Chang’s book remain as pertinent today as they did in 2001, even if his predicted “collapse” has not yet materialized. Yet.

But there is another reason to read The Coming Collapse of China: doing so illustrates one of the great challenges in financial forecasting, which is getting both the outcome and timing correct.

Many—too many—years ago when I began working as a buy-side analyst I made my first presentation to the Investment Committee at my new job. During that presentation I called for a certain stock to reach a certain price by a certain date. After the meeting one of our portfolio managers took me aside, and, in an uncharacteristically pleasant way, gave me some very good—if not wholly cynical—advice. “Never give both a price target and a time-frame. If pressed, give one and obfuscate about the other. Never give both.” He then paused and added in a somewhat less kind tone, “And make damn sure you don’t ever voice a prediction like that again to one of my clients or I’ll have your head on a platter.”

“Never give a price target and a time-frame”—which, in this article I’ll simply refer to as the “Price-Time Rule”—is a virtually immutable truth that Finance Professors neglect to teach. But they should.

While Gordon Chang left himself some wiggle-room regarding the date and specifics of the collapse he predicted, he pretty much broke the Price-Time Rule in The Coming Collapse of China. And, unfortunately for Gordon and the rest of the world, since the Chinese economy has not yet imploded, many of the lessons contained in that book’s pages have gone unread and unheeded.

Gordon got the timing wrong—he broke the Price-Time Rule—and has since (notably in an article written for magazine Foreign Policy) updated his estimate of when the Chinese financial system is going to go to hell. But he maintains—and I wholeheartedly concur—that his argument, research, and conclusions remain solid.

The cancer growing in the Chinese economy can most clearly be seen—and has, by countless others, been correctly identified as resting—in asset and debt prices. The amount of poor-quality credit and untenable guarantees made between individuals, companies, and government organizations is staggering by most estimates. However, the true perniciousness of the problem lies in the systemic opacity of information, and institutionalization of inconsistent retribution. The economic system that has evolved is one that neither has, nor can ever achieve, any true equilibrium. Any claims to the contrary are merely chimeras.

The statements made above are harsh, no doubt about it. Chang’s book (and subsequent articles) are as well. Upton Sinclair's 1906 novel, The Jungle, was also harsh, with good reason.

Calling for the collapse of the Chinese economy is something that will likely offend and probably anger many readers. And it could potentially cause one or more misguided souls to waste countless hours using JMulTi to run various, nuanced vector autoregression models using arcane inputs—metrics like the third derivative of the nth-polynomial estimated longitudinal series of GDP growth divided by CPI divided by the average mean temperature in Tiananmen Square—to show that epsilon is within acceptable bounds, assuming that the topological manifold has an atlas whose transition maps are all k-times continuous, and a thingy of such-and-such has so-and-so attributes, provided that the moon is in the seventh house, and Jupiter aligns with Mars. (My apologies to whoever actually wrote and recorded the song “Aquarius” (The Wrecking Crew?).)

However, before those of you who are already annoyed about my bleak outlook for the Chinese market go running off, gathering data, and composing emails that criticize me or question my sobriety, please note the following two very important items.

First, the fundamental lack of stability we find in throughout the Chinese financial system is in no way, shape, or form related to free-trade or immigration, both of which are thoroughly good for economies, whether they involve China or anywhere else.

And, Second, China is not the only major economic player to be caught in such a quagmire: the United States and the European Union are—albeit for different reasons—right there with the Chinese when it comes to toxic debt and overly inflated asset prices (particularly in the real estate and equities markets). And if the combination of trade tariffs—which are, and should never be viewed as anything but, regressive taxes—and fanatically loose, overly interventionist monetary policy remain unchecked, the eventual, inevitable situation will literally be comparable to the kinds of depressions modern technocrats have convinced themselves are as extinct as velociraptors were before Jurassic Park scientists brought them back to life by misusing genetics.

Much like Gordon Chang, I have been warning of such a dire état de choses for many years now. And, just like Gordon, I’ve been wrong so far—the world is still spinning, stocks continue to reach new highs, and somewhere, for reasons that completely baffle any sane mind, someone or something is buying Bitcoin (along with several other cryptocurrencies).

However, the current lack of fire-and-brimstone doesn’t mean that Gordon or I will not eventually be vindicated. Yes, Gordon broke the Price-Time Rule, as did I during many previous conversations with clients, friends, colleagues, and people who happen to sit next to me on airplanes during long flights. And for that time-tested rule, we should have our proverbial hands slapped. Yet the fact still remains that, according to John Ainger in a December 23rd, 2019 article for Bloomberg noted, “Earlier this year, a third [emphasis added] of all investment-grade bonds—$17 trillion—had rates below 0%...” And, while I may not have ever finished either of the PhDs I was working on in Economics or Finance, I’m reasonably sure that such rampant negative yields are neither the sign of a healthy economy, nor sustainable over the long-term.

A vast, yet growing, minority who work in finance and pontificate of economic topics for a living have been hard pressed to pinpoint what the catalyst for doomsday scenario will be – one of the current odds-on-favor is the coronavirus. (See below chart, which I borrowed from Lev Borodovsky (@SoberLook) invaluable morning read, “The Daily Shot,” published by the WSJ.)

Will these dips prove transitory aberrations? I don't know, and neither does anyone else if they're being completely honest with themselves or anyone else. My forecast matches many other analysts/market-watchers, which is for increasingly low equity returns intermixed resulting in net side-wards movement in indices as the impact of fiscal and monetary stimulus loses its pungency.

Has the scenario I described above already begun? How long will it last? Will a pernicious virus, or student debt, or something having to do with Putin be the catalyst to end this historic bull-run? I haven't a clue. I’ve learned my lesson regarding violating the Price-Time Rule.

I'm not here to predict when investors will have to finally pay their bar tabs. But there are only two alternatives. After binge drinking at the "Bar of Cheap Money," patrons will be left with the same two options every patron faces at closing time: (1) pay your tab (unpleasant though that might be); or (2) try to sneak out the backdoor. And, besides being morally reprehensible, the second option is simply unfeasible except for a very limited number of bar patrons.

So how should investors position themselves if they find credence in my above comments and position? One suggestion that I hear mentioned frequently is what pundits refer to—in one form or another—as “Barbell strategy,” or, implementing a "Barbell portfolio."

Before we go any further, a clarification is necessary. A Barbell portfolio used to be the purview of fixed-income (specifically debt) portfolio managers who would simultaneously overweight long- and short-term bonds. Doing so is a way to play the shape of the yield curve, by positioning oneself to benefit when convexity (aka, the second derivative of the price of the bond with respect to interest rates) changes.

Traditional Barbell portfolios—those involving bonds with different maturities—is a strategy that has been around for quite a while and is based on the infamous Term Structure of Interest Rates (a concept so treasured by academic wonks that many get misty-eyed at the mere mention of it).

But today the old phrase has taken on a new meaning that involves an asset allocation strategy. This strategy is being referred to, with increasing frequency, as a “Barbell portfolio.” Such a portfolio—call it, “Nouveau Barbell”—involves disproportionately going long a combination of “high-risk” assets (usually growth equities and the like; those sometimes referred to as “high-beta” instruments) and very “low-risk” assets (typically cash or high quality, short-term government bonds, possibly even TIPS).

Nouveau Barbell portfolios have gained favor among certain groups over the past months and/or years due in part to the fantastically low global interest rate environment and damn near impossibility of capturing yield without taking on greater-than-appropriate risk. (REMEMBER: By definition, a well-constructed portfolio doesn't give you the highest return, it produces the highest return per unit of risk (usually measured, appropriately or not, in terms of variance)). But, I submit, there is a more powerful, compelling reason for the popularity of such investment approach.

A Nouveau Barbell strategy provides financial advisors a reasonable sounding answer to the question they are bombarded with daily: “What should I invest in that provides downside protection while still leaving me open to participate in the upside?” When I was growing up, questions like this were dismissed by adults with the adage, “How can I have my cake and eat it too.” However, thanks to a tragic misalignment of incentives in the financial advisory industry, such a straightforward response is untenable.

The weakness of, and trouble with, Nouveau Barbell strategies is that as the strategy becomes more widely embraced it simultaneously and increasingly (i) inflates prices of the (so-called) “low-risk” assets (further reducing yield), and (ii) exacerbates the already frothy price of “high-risk” assets. But perhaps even worse, Nouveau Barbell strategies give the patina of safety instead of actually mitigating risk.

My goal herein is not to “explain” the market, or the economy—I’ll leave that task to Jim Cramer, or some other “expert” who possesses the infinite clarity-of-vision usually reserved for God. Rather, the focus of, and motivation behind, this article is to highlight the tenuous, and, as I have argued, fundamentally unsustainable situation in the asset markets.

“Meden Agan”—loosely translates to, “in moderation”—was the inscription the Ancient Greeks chose to chisel over the entrance to the Temple at Delphi (one of the most sacred places of the time). Dante and many, many others have echoed the same basic theme in their writings. Investors would be well advised to heed that warning as well.