Ever Grander

Lee Adaptive Strategies Update      

Monthly Commentary

September 2021

Equity markets were unsettled in September, with the S&P 500 ending down -4.65% for the month, its largest loss since the grim days of March 2020. Many investors had feared worse. From September 3 to September 21 the S&P lost ground in 10 of 12 sessions, which felt ominous. For the year, the S&P is up 15.92%. Depending on your outlook, that could be either reassuring or a chilling reminder of the potential for further retrenchment.

Last month we wrote that the several things worrying the markets in the spring were more or less unchanged and still worrisome by the end of summer. That theme largely continued as fall approached, although in places the narratives progressed modestly in the direction of a conclusion.

To begin with, there is the logjam in Washington over “infrastructure” spending, what was once thought of as the agenda of a new president, back when this presidency was new. We try to avoid making predictions about politics, but it is hard to find a reason to expect a resolution soon. The stalemate is inexplicable even by Washington standards, seemingly rooted in an inability of the left wing of the majority party to count votes.

Moreover, at this point we are not sure which of the possible outcomes to hope for. A great big dollop of government spending might be good for business and the economy in a general sense, but the increased government debt that would result could be bad for interest rates, inflation, or both. And it is hard to argue that the economy is slowing and requires further stimulus.

Which is not to say that the economy is purring along. It is booming in parts and sputtering in others. The latest shortage-that-is-not-one is in energy, particularly natural gas, whose prices soared in September. Yes, there have been supply disruptions, including an unwelcome reminder that wind, solar, and hydro power are all weather dependent, but this is more of a strong demand story than a weak supply one. In that respect it is similar to recent shortages of semiconductors, ocean transport, puppies, used cars, and toilet paper.

Which brings us to inflation. We continue to marvel at how skeptical most people seem to be about the possibility of a wave of inflation. The supply of US dollars (M2) has grown by 35% over the past 18 months. Did that unprecedented increase have no effect other than stimulating the economy? All this time the Fed had a consequence-free prosperity lever it chose not to pull?

Speaking of the Fed, it continued walking its public relations tightrope, simultaneously sternly staying the course toward tapering while reassuring all that tapering will be hardly noticeable. There was also some discussion in September about the potential re-appointment of Chairman Powell to a second term next year. We wonder if anybody has asked him if he still wants the job.

The closest we came to a new worry this month was China. Of course, the world’s second largest economy has had issues all year, so this source of angst is not entirely new. But the apparent insolvency of China’s second largest property developer inspired anxiety around the world and was partly to blame for September’s mid-month market swoon.

For a few days it was popular to ask if a collapse of Evergrande might be a “Lehman Moment.” This led us to discover how few market observers can remember the significance Lehman’s collapse fourteen years ago. The shock was not that Lehman went under, it had been in obvious trouble for some time, but that the government did not step in to save it or even see that its creditors were made whole. That was a failure of government that is unlikely to be repeated soon, and almost certainly not in still nominally communist China.

China does have a real estate problem, a housing bubble that would feel familiar to most westerners. Only much larger. Real estate makes up 30% of GDP. Housing accounts for 78% of the country’s assets and about half of urban household wealth. And as much as a quarter of China’s housing stock is currently unoccupied. The government has been trying to cool down the speculative frenzy, slowing the rise in prices if not actually lowering them. This was the proximate cause of Evergrande’s troubles.

For us, Evergrande and the Chinese real estate crisis are important reminders about how immature the Chinese economy is. Its capital markets in particular may appear to be fully built out and recognizably parallel to developed world counterparts, but they are not. Households invest so much of their savings in real estate partly because of a lack of alternatives. Evergrande borrowed all it could from everywhere it could, including selling bonds to consumers via advertisements posted in the elevators of its buildings. An American (or Frenchman or Singaporean) seeing such an advertisement would immediately worry about the solvency of the developer. Chinese citizens will be wary next time.

The change of seasons is an obvious, and cliched, metaphor for the transition from one regime to the next. But in this case the cooler temperatures brought on by the arrival of fall really do seem to have ushered in a new attitude in the markets. It may be too early to characterize the new mindset, but the sense of relief and credulous optimism that drove a remarkable bull market over the past year and a half seems to have dissipated.

The Market Sentiment Framework

We use our Market Sentiment Framework to adapt the mechanics and weightings of our full quantitative models to changing market conditions.

The Sentiment Framework gauges the current state of market psychology on two dimensions. Efficiency measures the crowdedness of the market, the volume of participants seeking investment opportunities. Lower levels of efficiency imply more market mispricing. Optimism measures the willingness of investors to take on risk in exchange for distant anduncertain rewards. Higher levels of optimism imply a better outlook for risky asset classes.

Both the Optimism and Efficiency levels were nearly unchanged in September

Optimism began and ended the month at 0.20. Although still relatively low in absolute terms, Optimism is well above its pandemic lows and not that far from its post-COVID high of 0.70 seen in mid-April of this year.

Efficiency fell very slightly, starting the month at -0.24 and ending at -0.26. Efficiency continues to be comparatively low as compared to historical averages, which suggests a market that is still under stress, and indeed increasingly so.

Both measures are higher than where they were in early 2020 but have trended lower since the spring. The current positioning of the Sentiment Framework implies a market that is functioning less than ideally, with modestly optimistic but still fearful investors. This would imply a positive but challenged outlook for the market as a whole, but possibly an opening for value strategies to find opportunities.



The above is the opinion of the author and should not be relied upon as investment advice or a forecast of the future. It is not a recommendation, offer or solicitation to buy or sell any securities or implement any investment strategy. It is for informational purposes only. The above statistics, data, anecdotes, and opinions of others are assumed to be true and accurate however 3D/L Capital Management does not warrant the accuracy of any of these. There is also no assurance that any of the above are all-inclusive or complete.  

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Past performance is no guarantee of future results. None of the services offered by 3D/L Capital Management are insured by the FDIC and the reader is reminded that all investments contain risk. The opinions offered above are as of September 30, 2021 and are subject to change as influencing factors change.

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By: Nathan Eigerman