5th may 2022 / ANTHONY CHEUNG


In this video, Anthony is joined by Mike Singleton, the founder and senior analyst at Invictus Research. Mike previously worked at Broad Run Investment Management, a private investment firm where he was responsible for leading investments of over $100mln in client capital.

Prior to that, he held investment management roles at Main Street Capital and T.Rowe Price. He is also a CFA charterholder and a member of the CFA Society of Washington, DC.

- Introduction (00:00)
- What do most investors struggle (2:05)
- Growth and inflation framework (3:50)
- The importance of the business cycle (5:17)
- The four economic regimes (6:15)
- Growth cycle and its implications (7:05)
- The relationship between markets and the economy (11:29)
- Equity sector performance over different economic regimes (14:54)
- Equity style factors (17:05)
- Investment risk spectrum (18:11)
- The importance of monetary policy (19:16)
- Confirmation from asset markets (21:52)
- Lessons from Stan Druckenmiller (24:18)
- The growth cycle drives trends (25:26)
- Why analyse positioning and sentiment? (26:58)
- Typical day in tracking markets for Mike (27:46)
- Thoughts on crypto (30:48)
- Where is the market in the four regimes? (33:59)

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In this week’s episode we to Mike Singleton, who's tuned in from the States.

Mile Singleton: Profile and Background

 Mike is a senior analyst in Victor's Research. He is also the founder and senior analyst at Invictus Research. In essence, their goal is to provide research on the business cycle, to keep it really simple and deliver it through short, easy-to-watch videos, sort of like the business section of the newspaper, but from the perspective of a global macro investor rather than a journalist

Before starting Invictus he was working at a private investment firm called Broad Run Investment Management as a senior analyst on the investment team and the chance to lead about $100 million worth of investments over his time there. Prior to that, he worked briefly at TV Press and Main Street Capital.

Here is how Mike explained Macro Investing -

Macroeconomics and data

Most investors, particularly as it relates to macroeconomics in the business cycle, are really all over the place. We're living through a very interesting time in financial markets. Pretty much everyone has access to unlimited data. One might say we're all drowning in data. Retail and professional investors alike. In our view, Invictus Information really has a very little edge by itself.

You have access to the same data that we have. Hedge funds have access to that same data. So if there's no informational edge, where does the edge, why the edges and how do you analyse it? There's a lot of misunderstanding when it comes to macro. Probably more than any other discipline within finance.

The right frameworks

When you have an excess of information like this, what you need is the right framework for putting it all into context. You need mental models, as Charlie Munger might say. So what is a mental model? It's an analytical framework for understanding reality. Good mental models describe reality well. Poor mental models describe reality poorly. If you don't have mental models in investing or in life you will tend to just be overwhelmed by all of the data that life throws at you. The various religions are sort of like mental models. Political parties provide mental models.

Again, mental models are just ways of putting the data that we encounter in everyday life into context and making sense of it all. Also, as noted earlier, mental models are good if they describe your world accurately and they're bad if they don't. And a large part of your journey as an investor is figuring out which mental models are the right ones to make central to your process.

Growth and Inflation framework

One of the mental models that are most central to our process is our growth and inflation framework. What does that mean? Well, it says that growth and inflation are the two primary variables that drive the returns of the liquid asset market. So stocks, bonds, commodities and currencies and nothing else really matters.

Everything else is either a noise or b an input into our growth and inflation outlook. Almost every analysis we do at Invictus whether it's looking at the employment situation or the credit cycle or we're doing some type of market analysis, it's always with the end goal of trying to get a better grasp on the growth and inflation outlook.

Anytime you are presented with new information, anytime anyone, any analyst of the business cycle is presented with new information and you don't know what to do with it, a pretty good first step is to think about how it might change your outlook for growth and inflation.

Growth and inflation drive the asset market but there's more to the story. You can't just look at them willy-nilly. You have to have the right method of interpretation. So we look at growth and inflation in a very specific way. We look at the year-over-year rate of change. So this year versus the same time last year, the absolute level was really less important than the rate of change.

In other words, we care less about growth or inflation being higher or low. We care more about it getting better or worse. And this is sort of logical, right? It doesn't really matter to the markets if growth is high in absolute terms. If growth is about to crash, stocks will do poorly. Likewise, if growth is very low in absolute terms but it's in the process of bottoming then stocks are very likely to do well.

The growth cycle and the inflation cycle

At this point, if you're new to macro, hopefully, you're breathing a sigh of relief because as a discipline, macro has a reputation for being very complicated. But now you really only need to worry about two things.

And it gets even better than that because forecasting growth in inflation will take a step back. Not forecasting, but growth and inflation are not random. They're not unpredictable. They are cyclical, right? And they move in trends. So if you want proof of that, we will go to the next slide here we're looking at the growth in inflation cycles going back to the 1950s and you can see that they look like a sign curve.

If you remember from Trigonometry they trend and then peak, trend and then trough trend and then peak over and over and over again. Growth in inflation is both cyclical and together. That's real growth on the top, not nominal growth. We need to clarify together the real growth cycle and the inflation cycle from what we at Invictus call the business cycle.

The 4 distinct economic regimes

You may now realize that growth and inflation can only go up or down. This creates the possibility of four distinct economic regimes, each of which represents a distinct phase in the business cycle. You've got early recovery, where growth is accelerating but inflation is still going down reflation, where growth and inflation are going up together stagflation, where growth is going down but inflation is going up and deflation, which is when they are both going down together.

So the first two regimes, early recovery and inflation broadly risk on and the bottom two, stagflation and deflation broadly risk-off risk on. You could think of them as being good for risk assets and bad for risk assets. It's just sort of the parlance. We'll discuss more about these regimes but first, let's explore the growth cycle in the US and what the implications are.

The Purchasing Managers Index

Here is why this is important, We think the Ism manufacturing PMI is one of the best cheap codes in macro and yet so many investors still ignore it for some reason. It's a diffusion index. It's something called a diffusion index. It's constructed from the survey responses of purchasing managers at manufacturing companies. So if a lot of you are new to macro, that might not have helped at all. So I'll do my best to simplify it.

But this is only a very slight simplification. It's not really that complicated. Purchasing managers are asked in a survey whether our business conditions are getting better or worse. If they say better then this line goes up. If they say worse, then the line goes down. That's it. It's pretty much that simple. The PMI is indexed to 50. So above 50 means positive manufacturing growth and below 50 means negative manufacturing growth. Although keep in mind we're still more interested in the rate of change here than the absolute level. So the PMI is just another way to measure growth.

 That's how we use it. Indicted. We like it because its high frequency, meaning it's reported monthly rather than say quarterly for GDP. And we also like it because it's a measure of manufacturing growth. Manufacturing is very cyclical relative to services. It's very sensitive to economic conditions, and so it tends to lead to other measures of broader growth, like, say, GDP. In any case, the important takeaway from this slide is simply that the Ism manufacturing PMI measures economic growth. It's a way of tracking the growth cycle.

So if you want evidence that it tracks growth, you can see the PMI next to the year of your rate of change in GDP. They look very similar, and that should make a lot of sense because they're both reflections of the same underlying growth dynamics in the real economy. Of course, GDP is reported quarterly, like we just said, instead of monthly, and that makes it less useful despite the fact that GDP essentially gets all the headlines. But that's just in the US. Right?

This is a really interesting chart. Looking at the PMI again, and we're comparing it to the OECD index for global growth. And you can see that the US growth cycle and the global growth cycle actually track each other shockingly closely in my mind. Why is that? Well, we live in a very globalized world, especially with regard to commerce.

The US and the Global Business Cycle

The US by itself has an enormous impact on the global business cycle. First of all, it accounts for about 20% of global output and accounts for a larger percentage of consumption. The US tends to be a significant consumer of global goods and services. And on top of that, the US currency, US Dollar is the primary global reserve currency. So the US Business cycle has a significant impact on every other country's business cycle. And as a result, the US. And the global business cycles are largely synchronized.

All right, here's another interesting chart. The PMI against the CRB Commodity index, which is essentially like the S Amp P 500, but it's for commodities. So oil, natural gas, corn, copper, gold, and wheat. And you can see there's a fairly close correlation there as well, which should make sense, right? All else equal. As gross increases, so does aggregate demand for commodities.

Think lumber for homes, copper and steel for cars, oil for power, and industrial activities. That boost in demand, in turn, pushes up prices. The prices, anything is just a function of supply and demand, and the PMI represents demand, so all else is equal. Faster growth should mean higher prices for commodities. So, in short, just from looking at the Ism manufacturing PMI, you can get really valuable information about the US. The growth cycle, the global growth cycle, the commodity cycle, and all of this are just from looking at one diffusion index. That's a pretty good bang for your buck there.

And if you're interested Ralph Paul actually has a great video covering a lot of this on YouTube.

Relationship between financial Markets and the Economy

Let’s now discuss the relationship between the financial markets and the real economy. The financial markets are a reflection of the underlying economy because of growth and inflation trend and cycles. So the financial markets and the financial markets do so because the economy does so. It's also important, just on a high level, to understand that each business cycle resembles prior business cycles, not just in terms of growth or inflation going up or down. That's obviously true, but also in terms of the asset market's reactions. Why is that? Well, because similar assets will always react in similar ways to similar economic conditions in aggregate, not specifically.

All right, so if you want evidence that markets reflect the economy, this slide should be pretty clear evidence of that. On the top is the Ism manufacturing PMI, which we just talked about quite a bit, and it's overlaid with the year-of-year rate of change in the S Amp P 500. Obviously, that's a very close relationship. It's a very logical one.

When growth is accelerating, when the PMI is moving up, stocks tend to do better. And when growth is decelerating going down, when the PMI is going down, stocks do worse. It really is that simple. Don't overcomplicate it. Economic activity drives trending stock market performance. On the bottom, there is the CRB Commodity Index, which we just talked about too. It's a basket of commodities. We're looking at the year-on-year rate of change versus CPI inflation, which by the way, is also measured in year-over-year terms usually.

And they look very similar. Why is that? Well, the price of commodities is certainly an input into inflation, so that's part of it. But commodity prices are also the most liquid and economically sensitive constituent of inflation, right? When there's an economic shock, what typically will react first the cost of your rent or the market prices of freely traded commodities? Well, obviously it's the latter. The markets frontrunner reported economic data for about three months. Markets are forward-looking. They are what a classic investor would call a discounting mechanism and that's extremely important to understand. The markets take economic information and they price it in advance.

Recovery, reflation, stagflation and deflation.

All right, back to the four market regimes. We have early recovery, reflation, stagflation and deflation. Now let’s get into the back test for the various equity sectors against those four economic regimes. If you look at the data, you may find it to be extremely common sense when the market is pricing in better economic conditions, faster growth, healthy inflation and whatnot you'll see riskier, more cyclical exposures, that tend to outperform stuff like technology and consumer discretionary stocks and financials. Why is that? The market is discounting.

 People are going to buy new iPhones, new cars, and new houses, they're going to be taking out loans. When the market is pricing in worse economic conditions, it's the defensive exposures that tend to outperform utilities, healthcare, and consumer staples and again, that should be very logical, right? Most people don't stop paying their electric bill or their health insurance premiums or stop buying toothpaste even if there's a recession.

That said, here is a word of caution back test because we think everyone in the finance industry has sort of a thing for backrests and anything quantitative. We think there's the sentiment that because something is quantitative it's handed down by God and that's not true. All back tests are highly sensitive to your back test parameters where you set dates, how you're defining growth, et cetera.
The differences across business cycles

Every business cycle is different. So I'll give you an example. Real estate is generally defensive, right? Which again should be logical. It should pass the common sense test. Most people and companies really have to be in trouble before they stop paying their rent. But if you look at 2000 and 789, that was a risk-off market. But real estate underperformed the broader market, doesn't that contradict the back test? Yeah, it does. But of course, if you remember or if you've seen a big short, there is a real estate crisis going on. So if you just bought real estate stocks in 2007 because the back test said that they were defensive, you would have gotten your clock cleaned. So the best way to view these back tests is that they are just guidelines. They are for setting expectations, they're not for predicting the future.

The economic regimes: Style factors

Next, we're looking at the same economic regimes but instead of looking at equity sectors, we're looking at style factors. The style factor, it's just a way of grouping together stocks that have similar characteristics and therefore usually to some extent trade together as a group. So think small caps versus large caps, high beta, low beta, defences versus cyclical, and so on and so forth. Again, this slide should make a lot of sense intuitively. The top half of that square is risk on early recovery and reflation. When growth is accelerating, that's risk on. So in those regimes, you should be seeing riskier exposures outperform small caps, cyclical, high beta, high leverage, low liquidity, etc. Or on the bottom, you have the two risk off regime.

So you should see largely the opposite large caps, outperformed defences, outperform low leverage, high liquidity. And also another high-level comment. If you see a back test that doesn't make any sense economically or intuitively, it's probably not a great backtest. Common sense is a very important skill when interpreting a back test.

The next slide is just another way of visualizing those same back test on the prior two slides. Two things that needs to be pointed out here in particular, because they might be a little bit surprising right now with inflation where it is in developed markets, think largely the US. And Europe. Risk appetite, liquidity, and strong performance from risk assets are all pro-cyclical with growth and inflation. Drawdown risk moves left on this chart drawdown risk increases, growth and inflation flow together.

And there are a variety of explanations for this which we can maybe touch on later. But on a high level, the reason is that developed markets are rife with naturally deflationary forces. So over the last 40 years or so, when inflation has kicked up, it's been largely benign and at least relative to pre-1980. So deflationary forces have been deflationary. Shocks have really been the larger risk to the markets since around 1980 versus inflationary ones.

The Monetary Policy

The monetary policy is set by the Federal Reserve. The reason we talk about this last after growth and inflation are twofold. First, growth and inflation are primary. That's really, really important to understand. They drive the majority of price action across the global asset markets. And second, growth and inflation largely drive central bank decision-making. Nevertheless, it's still important to talk about this separately. Luckily, understanding monetary conditions are much easier than most people make it out to be, particularly if you're equity-focused.

So first, what do we mean by monetary conditions and victims? We define it as the impact that the Federal Reserve has on liquidity through the financial markets. Let me see the water real quick. We call it inorganic liquidity because it's a result of an exogenous force, not free market behaviour. In terms of stocks, all you really need to know is at the bottom of the page there at the bottom left. A tighter policy means higher discount rates for discounted cash flows and lower asset valuations. Think of the price-to-earnings ratio. In the case of stocks, easier policy means the opposite lower discount rates and higher asset valuations. And this is all equal, right? Obviously, there's never just one-factor affecting stocks.

The best way in arguing to measure monetary conditions is through real-time market indicators like the dollar relative to other currencies' mortgage rates, mortgage spreads above and beyond the risk-free rate, the relative performance of growth, equities, real rates, yield, and curvature. You can also look at some reported data, like the Fed funds rate or the Fed's balance sheet.
But you have to understand that those data sets will always, always lag the market. In summary easier policy, lower discount rates, disproportionately help, high growth, high valuation, and riskier exposures. Of course, the flip side to that is when liquidity is taken away, they tend to crash, which is what you're seeing in certain parts of the stock market right now.

Confirmation from the asset market

All right, that brings us to another important part of our process, what we call confirmation from the asset markets. So it's one thing to understand the economic data and build a model, and we certainly do a fair amount of that Invictus, but there's a second part to a process, and this is actually the more important part. We have a fundamental view from our bottom-up work that growth or inflation will go this way or that, but we will not invest in that until the asset markets are confirming it.

We want validation from the asset markets before we start underwriting new investments with real capital. Why is that? Well, it's because human beings, including us at Invictus, might forecast the business cycle incorrectly, but the asset markets as a whole will never forecast the business cycle incorrectly. Never. Moreover, as we mentioned earlier, the asset markets will actually front-run the economic data every time, with virtually no exceptions. So you'll give yourself a huge edge in terms of forecasting and more importantly, portfolio management by studying the bond market, the stock market, the commodity market, the forex market, and learning what they have to tell you about growth and inflation. So here's some quick evidence of what we're talking about.

 On the top there, we've got a ratio of small-cap stocks to large-cap stocks. In the middle, we have the spot price of copper versus the spot price of gold. And in the bottom, we have the US ten-year yield. And a lot of people have never seen a chart like this before, but they're surprised to see that they have a very similar profile over time.

And the reason is that they're all trading on the same underlying macro dynamics, more or less, namely growth. All three of these indicators largely trade on the rate of change in economic growth. So if we were to do sort of a thought experiment here, if we believe, based on our fundamental outlook, that growth is going to accelerate, we would like to see all three of these indicators going up, confirming faster growth. Over the last year or so. We've actually seen a historic divergence in these charts.

You can see usually they move together. Right now they're kind of moving in opposite directions. It sort of looks like a Neapolitan ice cream carton, but we can talk about that later if you want maybe a conversation for another time. If you want more evidence that studying the market will refine your forecasting and more importantly, help you make that better investment decision. And look no further than Stan Druckenmiller, probably the most successful hedge fund manager of all time

Stan is one of the most successful hedge fund managers of all time, famously compounded his client's capital at 30% per year for 30 years with no down years and t's maybe like one or two down quarters, possibly making him the best head fund manager of all time. And who knows if anyone will ever recreate a track record like that. But Stan says by far the best economic predictor we have met is the inside of the stock market. What does that mean in practical terms? Well, basically it means what we just talked about.

He has his own expectations for growth and inflation, but he respects what the market is telling him. He respects things like the copper-gold ratio, small cap, large cap ratio, and performance of cyclical stocks versus defensive ones. He wants validation from the markets before investing. If you've ever listened to Stan talk on YouTube or whatever, you know how seriously he takes market internals. Alright, one last mental model before we wrap it up. First, we need to answer a question. The question that we haven't addressed explicitly, and that's on the topic of time horizon. So what’s the time horizon is the market? Are the markets an accurate reflection of underlying economic activity? To use around number at Invictus, we say about a month, although obviously that's not a rule, it's just sort of a principle.

 But generally speaking, any market moves longer than a month is a reflection of some economic development, the most important of which is always growing. Another way of saying that the growth cycle drives trending performance in the asset markets, and probably always will. What about the shorter-term moves? What about the seemingly random noise in the markets? Well, a lot of it is noise, it doesn't mean anything. But we associate a lot of that noise with positioning sentiment and psychology. So the mental model here is trending moves are driven by economic fundamentals and short-term moves are driven largely by positioning sentiment psychology.

And the good news is that analyzing sentiment and positioning data is fairly straightforward in principle, although it's more challenging in practice. The reason it's straightforward in principle is that it tends to be mean. Reverting positioning tends to oscillate from bullish to bearish. In a perfect world, we want to be adding exposure when everyone is bearish and reducing when everyone is bullish. And obviously, the reason we would want to do that is better returns when positioning is really stretched in one direction. Even small counter consensus surprises can cause big moves in price. We have it in the quote there. But think of it like a rubber band. The further it stretches, the more violently it will snap back on a catalyst and victims. We use a number of sources to evaluate positioning and sentiment including investor surveys, flow funds, data from the Fed, which is longer-term data, and the weekly commitment of Traders Report from the CFTC. And we also look at a lot of options data. So that's the overview of the Invictus process

To touch on a few things the first being; what is your daily? Because they're thinking about careers as well. So I'm trying to tie in that element. What does a typical day look like for you then? Because if you're eliminating out. Let's say.

The kind of bluster and all the headlines that are coming out every single day. How much is it following tracking? Single items of major news flow like a central bank speaker saying X or a company stock coming out with an earnings report y or to then looking at data and just looking at the growth and various different or looking at the other types of information that you said with market internals. What's a typical day in your life look like from your analyst perspective? That's a great question. And it's funny; a lot of investors really like Warren Buffett, right? And Warren Buffett famously says he spends all of his day reading. He says he subscribes to eight different newspapers. And so within the industry, there's this thing that everyone wants to read newspapers and be on top of the news. So here's the perception that there's some edge from that.

However, we don't think his edge actually comes from reading the newspaper.

 Mike thinks it's best to sort of separate my professional work and analysis and reading the news. There are a few reasons for that. One is that the news is written by journalists and journalists tend to be backward looking just because the nature of their profession is backward looking. And so the worldview that an investor has is just very different from a journalist.

And so that's part of the value-added Invictus is we're looking at the world the way an investor looks at the world, not the way a journalist looks at the world. And maybe that seems like a fine distinction, but as an investor, where you get your information is really important because in subtle ways it can affect how you think in terms of what you actually spend your time looking at. Almost all of our information is taken from basically column government reports, the BA, and the various Federal Reserve surveys in the markets. So that's where we get information that we use for making investment decisions.

Next, let's look at crypto as an asset. The most important thing to understand is that crypto is a risk asset that trades with financial conditions very closely with financial conditions. Let’s break this down in a way that makes sense. There are two constituent parts to financial conditions excuse me, not used to talking this much.

There are two constituent parts of financial conditions. There are economic conditions and there are monetary conditions. Right? They're the two inputs into liquidity. So liquidity gets better when economic conditions improve, which should make sense, right? And then the second constituent to liquidity is the inorganic liquidity that we talked about earlier. That's basically the Fed, right? So Bitcoin does better in risk on regimes where economic conditions are improving, people are feeling good, they're buying a car, they're investing in Altcoins, they're getting stimulus checks, whatever.

And crypto is also an asset with zero cash flows, which sort of de facto makes it a very long-duration asset. So it's very sensitive to the discount rate. So when the Fed is raising rates, that's really bad for crypto and when it's easing monetary policy, reducing rates, particularly real rates, crypto tends to do very well. So right now, our outlook on crypto, bitcoin, Ethereum, the altcoin complex is bearish. And the reason is the Fed is explicitly saying it wants to take the wind out of risk assets.

And there's only one institution in the world that has the credibility to say something like that, and it's the Fed. So if they're promising us they're going to do it, we believe them. And we have some precedent for this. Right? If you look at a chart of real rates and a chart of the price of bitcoin, they look fairly inverse. And if you look at the last hiking cycle, the last policy cycle which ended in 2018, you can see that as real rates went up, bitcoin crashed, saying it wants to do the exact same thing. It wants to take rates above neutral.

 It’s impressive how well bitcoin and crypto generally are held up considering that it's likely to be down a lot more. It's still down a lot. That’s probably important to keep in perspective. But as long as the Fed is saying we want to tighten, we want to bring rates up, we want to bring real rates up, we want to take the wind out of risk assets, bill Dudley is saying stocks need to feel more pain. Okay. And then the final one was where you have the what wet was really excellent break up with the four regimes.

Where are we now in the regime?

Where do you see where we're at right now in the regimes? We were talking about a month to kind of let things and trends materialize and so forth, and a bit of time for that to see through. But how do you see where we're at in the context of right now and that transition, but then also with what the market is kind of aware of, with where we're heading, with the soon to be tightening policy and the subsequent impact that we could have then for the second half of the year? That's a very good question.

 Let’s refer to the framework we use in our last monthly market outlook. There are three parts to our thesis right now. One, we expect growth to continue declining. It's already declining. We expect that to continue. The asset markets are clearly pricing that in. Two, we expect inflation to decline in the coming months.

Obviously that has not happened yet. We think the April print is very likely the first decline in year-over-year rate of change terms. I'll add the asset markets aren't totally pricing that in yet. Right. Inflationary exposures are still doing quite well. So we don't really have validation from the asset markets on that part of the thesis. So we're not short inflationary exposures yet because we don't short up trends. We don't short strong momentum.

Our back tells us it's a horrible idea, so we don't do it. And I've certainly lost money betting against those things in the past. And then the third thing is tightening financial conditions, which is, like we just said, the Fed saying it's going to tighten, it's happening. Yield curves are inverting, and rates are moving up or have been moving up across the curve. We saw the Dixie Dollar indexes moving higher, mortgage rates are spiking. Clearly, financial conditions are tightening.

Eventually, that's going to break something. That's sort of the history of central bank policy-making in the Western world. And when that happens, that will happen through crushing demand. So that'll push growth down further and it will also reduce inflation. So that's around the corner at some point in terms of when it actually happens. We're watching closely, and we would guess it's going to happen in the next couple of months. But really, part of being a good investor is keeping an eye on things and changing your mind when information changes.

And right now, the market is still saying stagflation, faster inflation, slower growth, and tightening policy. We expect that to transition into deflation, but we leave it to the market to tell us exactly when that is cool. All right.

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