Putting Baby New Year Over My Knee for a SPAC-ing

This will hurt me far more than it will hurt you

Summary:

1. Passive Investing and Market Dynamics: 2023 witnessed a significant impact of passive investing on market outcomes, including the dominance of index investing over stock selection, and the largest stocks outperforming significantly. The direction of this trend was complicated by an unusual positive correlation between value and momentum.

2. Discrepancies in Market Predictions and Outcomes: The year 2023 defied many market predictions, with small caps confirming the economic slowdown story until rebounding unexpectedly late in the year. For all the hoopla, interest rates ending the year almost unchanged, despite all the well-publicized calls for much higher yields on “unustainable” fiscal policy.

3. Active Management Challenges and Specific Stock Cases: The year posed significant challenges for active management — a very narrow market, continued outflows (related), and violent reversals — all contributed to yet another terrible year.

4. SPACs and Methodological Changes in Indexing: The year also brought attention to the role of Special Purpose Acquisition Companies (SPACs) and the influence of indexing methodologies on market events. Unfortunately, the changes in CRSP/Vanguard methodology regarding SPAC transactions escaped notice, despite highlighting the unintended market impacts of passive investing strategies.

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The Main Event

In a wild and wacky year that saw US asset markets soar in the best outcome since 1999, we had bank failures, surging private sector bankruptcies, and a dramatic slowing of both employment and nominal growth. It also brought increasing evidence that the forces of passive investing are driving these outcomes. While awareness is growing and some important revisions are being considered, the general attitude increasingly embodies the Colonel Jessup approach to crisis management.

This seems fine:

I’m not quite ready to embrace the turn into 2024 and write my early 2024 thoughts. The wounds from 2023 are still too fresh. While I ended the year positively, that’s more a reflection of the general inability to lose money in 2024 unless you were dumb enough to stand in front of the shorts steamroller. While I was remarkably dumb about a lot of things, at least I was smart enough to avoid that mistake. But what I WAS dumb enough to do was ignore my own work.

2023: Index investing crushed stock selection, and the largest stocks outperformed by a ridiculous amount. “Value” was not. But interestingly, neither was momentum:

Candidly, the momentum dynamic threw me over the course of the year because an unusual dynamic had developed going into 2023 — value and momentum had become strongly correlated:

By definition, “value” defined as stocks at the cheaper range of Book-to-Market per Fama-French, is almost always negatively correlated with momentum. I owe my career to my youthful naivete in the late 1990s to believing that “valuation mattered” in the context of investment returns. This allowed me to escape the DotCom disaster. To be clear, I still believe this holds over VERY long periods of time, but we can easily disrupt this tautology by introducing systematic strategies that suppress value, e.g. passive investing. Strategies like “systematic value” are largely a portfolio composition trick. By agreeing in advance that I will sell stocks that rise significantly, and buy stocks that have fallen significantly, I have effectively sold calls against stocks INSIDE my portfolio and puts against stocks OUTSIDE my portfolio. If we model the performance of the resulting straddle, it closely mirrors the performance of the value factor. Fama and French indirectly highlight this mechanism in a 2006 paper, Migration.

Doing the math, if Value is short calls on stocks inside their portfolio and short puts on stocks outside their portfolio, the positive correlation between Value and Momentum largely occurs when markets are falling sharply in recessionary conditions. This can be seen in the above chart with the frequency of overlap of these conditions with recession. Unfortunately, it definitely did not work for 2023, even though small caps provided ample reinforcement of these conditions through Oct 27th. As a reminder, the vast majority of stocks were DOWN significantly on the year as of Oct 27th:

And then everyone changed their mind… flows into the IWM exploded (white line), and exactly as my passive theories suggest, all the small caps began to run higher:

As the easily shorted stocks began to turn, panic ensued in the long-short community as entire years were given up in the space of days:

But for all the complaints, my real error occurred way back in March when I missed the opportunity to take profits on my 2-year bonds and flip away from the recession call on the back of the BTFP:

Now 2024 beckons with little evidence that the world is markedly different. In fact, as many have noted, for all the 2023 hoopla about unsustainable interest rates given US deficits… and the inevitability of 13% interest rates

we ended the year with interest rates almost perfectly unchanged:

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The tail end of 2023 brought a flurry of reporting on the challenges of active management in the year; yesterday’s FT was simply superb. There’s a touch of sarcasm in there…

For example, this piece from Jennifer Hughes caught my attention with this language:

Elsewhere, used-car platform Carvana soared more than 1,000 per cent, providing a reminder that painstaking stockpicking can still make a difference. Going into the year, its valuation appeared to be another pandemic boom-to-bust story, with a market value that had shriveled to about $1bn from a peak above $50bn.

Rising interest rates worried creditors, including Apollo. Yet Carvana’s founders managed a debt restructuring that kept their backers on board and by September, they produced a quarterly net profit for only the second time. A booming economy certainly helped — fellow platform provider Car Gurus gained almost 70 percent — but this was one where close attention to developments would have helped to pick the real bargain on the lot.

Ah, yes, careful stock picking based on fundamentals… excuse me for a moment…

Oh… I feel better now…