Quarterly Client BRIEFING...investment strategies, not as your sole source of information. Past...

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www.prerequisite.com.au Copyright © 2018 Prerequisite Capital Pty Ltd, Australia. All rights reserved. Past performance is not indicative of future results. Prerequisite Capital Pty Ltd (ABN 42 621 110 736) is an Authorised Representative of First Mutual Australia Pty Ltd (ABN 42 154 012 085), AFSL 423710

30th July 2018 // Quarterly Client BRIEFING

Dear Valued Client,

“What if…?”

One of the biggest mistakes an investor can

make is to assume that the market is ‘crazy’ – or

the predominant group of participants

seemingly in control of a market are ‘nuts’.

Why? Because as soon as you assume

irrationality (even though at a surface level you

may at times be correct), your sincere and

earnest enquiries into the underlying reasons

that a market is pricing in such a manner tend to

cease. If your enquiries into the underlying

drivers of a complex phenomenon cease, so too

does your thinking cease as does your diligence

– you are prone to drawing wrong conclusions

and misunderstanding the broader system that

you think you’re seeking to understand... you are

prone to losing excessive amounts of money.

Rather, it is better to assume a ‘functional’ rationality of participants and markets at all times

– asking yourself; “what context, purposes and practical interrelationships are underlying the

manifestation of these pricing structures and trends?” Sure, groups of participants may

eventually evolve into a ‘foolish’ state, but usually this is an evolved progression stemming

from underlying causes in the broader system that may stay intact much longer than you ever

thought possible – if your enquiries cease into the underlying drivers of a system or market,

then you are robbing yourself of great opportunities to surface profitable insights as an

investor, which ultimately means you are self-sabotaging your potential rewards to your

investment activities.

Before we expand upon this line of thinking and start to look at some of the major markets

(through a “what if” lens), we first need to take a slight detour…

Leading indicators…

Leading Indicators help us to:

a) get a sense for what ‘historical precedent’ might suggest for the immediate future of

some market, and

b) challenge our own thinking about the prospects for some market relative to our own

preconceived ideas.

All rights reserved. Prerequisite Capital Pty Ltd, its affiliates and content providers do not guarantee the data or content contained herein

to be accurate, complete or timely nor will they have any liability for its use or distribution. This is General Information only, and should

not be construed in any way as specific advice or advice to purchase or sell financial securities or products. It has been prepared without

reference to your objectives, financial situation or needs. You should consider the information in light of these matters and if applicable,

buying and inspecting the relevant Product Disclosure Statement (Australian products) before making any decision to invest. Our

publications, ratings and products should be viewed as an additional research resource in contemplating investments and

investment strategies, not as your sole source of information. Past performance does not necessarily indicate a financial

product’s future performance.

“Whenever we have a large number of actors,

each pursuing their own notion of “success”,

there is a potential for a Complexity. Such

complex adaptive systems typically show

emergent behavior, which is neither predictable

from the actions of individuals, nor is it

necessarily the intent of the actors. This

emergent quality means the system has its own

momentum and integrity. It is often mysterious

to those involved, even to those trying their

hardest to modify or "lead" the system.”

...Jerry L. Talley (www.problemsolving2.com)

“…systems thinking is based on the

fundamental shift of perception from the world

as a machine to the world as a living system.”

…Capra, F. (1996) The web of life

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www.prerequisite.com.au


Leading indicators often serve as a catalyst for us to do some more research or digging to

challenge our own thinking… to ask ourselves sincerely and curiously the “what if” questions

that can lead us to the deeper insights we all desire to underpin returns… leading indicators

are best used to start the research process, not to conclude it.

Characteristics of good leading indicators:

• Anchored in common sense & are somewhat intuitive

• Able to digest a large amount of relevant information into a useable form

• Not ‘curve fitted’ (i.e. optimised to ‘first principles’ not engineered to ‘fit the past’)

• Historically robust and consistent

• Utilises data that is readily available and not prone to Government (or agenda-driven)

manipulation/engineering

The primary limitation of Leading Indicators are that they assume a linear, repetitive world…

as opposed to the actual complex ‘adaptive’ (& frequently non-linear) world that we live in.

(In other words, sometimes previously established patterns and relationships break down.)

Some “What if?” questions that matter for our portfolios…

What if the most important ‘macro-variable’ in the world is not the US Dollar, but US Real

Yields?

Could it be that the broader-movements in the US Dollar are foreshadowed by the liquidity

conditions and returns that can be obtained within US Asset Markets, as implied by the real

interest rates (real yields) implicitly imbedded within US Capital Markets?

US Dollar Index

Capital Markets US Real Yield

(advanced in time by 18 months

to show leading relationship,

proprietary directional model)

US 10yr Real Yield

(advanced in time by 18 months,

10yr Treasury Inflation Protected Yield,

shown for comparative purposes)


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What if buying long-duration US Treasury Bonds at circa 3% yields in the face of ballooning

deficits and experimental monetary policy wasn’t “insanity”?

Stated in a somewhat oversimplified manner; If ‘everyone’ is selling, then someone (and

usually some “big” someone’s) must be buying to a similar degree.

Could it be a signal that despite such a ‘large & vocal’ crowd of Treasury Bond sellers over the

last couple of years, that 30-year yields have been unable to breach the 3.25% level in any

material manner?

Could it suggest underlying strength in bond prices (weakness in yields) for some reason?

Could it be that a group of “big someone’s” clearly has a huge appetite to be buying when

bonds trade towards those levels? Why would this group of ‘bigger’ more ‘patient’ money

participants be acting in such a ‘crazy’ manner?

US 30yr Treasury Yield (shown inverted)

Patient Money

Speculative Money

buying

selling

Prerequisite ‘Climactic Buying/Selling’ Activity (calibrated using US Treasury Futures Volumes)

Spread, Speculative vs. Patient Money

(see bottom panel)

>57% in TLT (USD) total return >90% in TLT (AUD) total return

Global

Financial

Crisis

Clearly the Patient Money saw

“something coming” that the

majority of participants didn’t see

coming...

Peak of Euro-zone

sovereign risk crisis

>94% in TLT (USD) total return >66% in TLT (AUD) total return


“If everyone is

thinking alike, then

no one is thinking.”

...Benjamin Franklin

(1706-1790)

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What if the timing isn’t quite right for selling-short the Australian Banks ‘just yet’?

Could it be that this time is different, and that the historic precedent of actual broader credit

conditions will be proven inaccurate?

Could the pessimism crystallised by the Royal Commission be overdone relative to the

unfolding of actual conditions?

Could the Australian Government tighten policy to such a degree that they’d risk killing their

“golden goose” (i.e. the credit/property engine)?

Could the short-interest in Australia’s banks be getting setup to be squeezed even before the

‘obvious’ impending bear market gets underway?

Market Capitalisation of Banks, % of GDP

WBC, NAB, ANZ, & CBA (post 1991)

Leading Index, Australian Credit Conditions

(advanced 12 months)

Loose/

Resilient

Tight

Australian Property Prices, %YOY

% Spread, 6mth BAB vs. RBA OIS 6mth Swap Rate (shown inverted)


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What if China’s bond markets are signalling possible further risks to the broader Emerging

Markets complex and global funding markets?

Could it be that stresses are greater within China at the moment than markets are more

broadly recognising?

Could it be that deeper things are plaguing China than the recent trade war headlines?

Could it be that global Dollar funding markets are about to tighten again?

Chinese Bond Market Money Flows (Combines ‘Passive’ and ‘Speculative’ Money Flows)

Emerging Markets Equity Index


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What if the Gold price was overly inflated over the last 2.5 years as opposed to being

‘suppressed’ (by conspiratorial manipulations to keep it down or contained)?

Could it be that the broader complex system (that is the ‘world’) was actually telling us that

conditions are not yet ripe for a new bull market in gold?

Could it be that conventional (& even Austrian?) theories relating to inflation, money and

instability might not fully capture the entirety of the drivers of the gold price within the world-

wide system regimes of the last few decades?

Could Gold over the last 12 months actually have become overbought relative to actual

broader conditions in the world?

[Knowing that the Gold market is capitalised at only circa $7trillion USD, we maintain a model

to roughly ‘double-check’ the pricing of Gold but using vastly larger capitalisation markets.]

Gold Price (circa $7 trillion

market capitalisation)

‘Bigger Money’ Gold Price derived equivalent (a theoretical model utilising a composite of larger capitalised

market prices – i.e. bigger capital flows and deeper capital markets

reflecting underlying gold pricing conditions – combining inflation-

linked bond yields, equity risk premia and the US Dollar)


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What if WTI Oil and the US Dollar are able to rise together because (just as history

suggests) both do well in environments of rising geopolitical tensions?

Could it be that we’re in similar conditions as say 1998-2002 where oil and the US Dollar both

rose together due to expanding Geopolitical Risk Premiums in Oil?

Do we have further to go in this dynamic or has the market already priced such a set of

circumstances in?

[In July of 2017 we detailed an extensive thesis that the Geopolitical Risk Premium within oil

was cyclically under-priced and among many other things, would likely fuel a bull market in

the price of Oil, below was the primary chart that presented the Geopolitical Risk Premium

aspect of the thesis…]


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What if equity market volatility is already primed to expand once more (in the context of

weak US corporate credit markets & weak foreign markets), just when people are starting

to get excited about the equity market again?

What if the broader Commodity Market complex is poised for surprisingly sluggish

performance in the years to come?

Net

Inflows

Net

Outflows Net Money Flows

(VIX Futures)

VIX

Investigate Selling Volatility

when Net Money Flows rise

to or above this level

Investigate Buying Volatility

when Net Money Flows fall

to or below this level

AUD / USD

CRB Commodity Index

50% Commodity Demand Impulse & 50% Yield Curve

(advanced in time by 3 years to show leading relationship)



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Good Research typically begins with good questions and an open mind…

…and good questions can arise from a broad array of historically compelling leading indicators.

But without a ‘systems thinking’ paradigm that empowers you to make sense of the world that

we actually live in (as opposed to the academic world that we ‘theoretically’ live in), then good

questions and good thinking won’t mean much.

“The approach of systems thinking is fundamentally different from that of traditional forms

of analysis. Traditional analysis focuses on the separating the individual pieces of what is being

studied; in fact, the word “analysis” actually comes from the root meaning “to break into

constituent parts.” Systems thinking, in contrast, focuses on how the thing being studied

interacts with the other constituents of the system – a set of elements that interact to produce

behaviour – of which it is part.

“This means that instead of isolating smaller and smaller parts of the system being studied,

systems thinking works by expanding its view to take into account larger and larger numbers of

interactions as an issue is being studied. This results in sometimes strikingly different conclusions

than those generated by traditional forms of analysis, especially when what is being studied is

dynamically complex or has a great deal of feedback from other sources, internal or external.”

…Daniel Aronson (www.thinking.net)

“Physicists are trained to despise sophistication.

“In Physics, we are looking for simplicity; we believe that to complicate things even a child

can do. To look on reality which is complex and to find out why it is actually simple, that is the

objective. You have to bring a reality that looks really complex to a level where it is just simple

common sense.”

“4 degrees of freedom is too complex. If something looks complex, then it’s only a partial

description of reality… what you’re actually looking at are the effects of a much deeper cause.

You must dig-down through cause-and-effect logic until you are dealing with only one

underlying cause, then you know you’re looking at reality.”

“…common sense is not so common and is the highest praise we give to a chain of logical

conclusions.”

…Eliyahu M. Goldratt (Israeli Physicist)

Writing is an awesome discipline to find out what you think…

We publish copious amounts of investment and market research for several reasons:

• To help formulate our understandings of how the world is unfolding and adapting.

• To make our thinking more objective, our assumptions more transparent (and

therefore more challengeable) – which also helps us to see where and when we’re

wrong faster than we would otherwise.

• To help our clients understand why we are managing & positioning their portfolios in

certain ways.

• To help our clients think more deeply and broadly about the world than their own

paradigms might enable them to.

• Etc

…but ultimately, we tend to publish a large quantity of research mainly because we find the

world fascinating and we love figuring out what is happening in markets with an eye to

identifying possible risks and opportunities that the markets might not properly be

appreciating.

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“An investment in knowledge pays the best interest”

...Benjamin Franklin (1706-1790)

[We typically publish our Research in two formats:

1. ‘Quarterly’ and ‘Interim’ Client Letters (such as this), and

2. Our PCS Reports (or ‘Portfolio Construction Strategist’ Reports) are written for a

more experienced & sophisticated professional investment audience.

Our Client Letters are distributed freely to our Clients and their friends/families, but our

PCS Reports are typically only distributed to:

(a) paying ‘Research & Consulting’ Subscribers/Clients, and

(b) our Portfolio Management Clients who maintain account balances in excess of

$250K within our managed portfolio services

We still occasionally distribute selected PCS Reports to Portfolio Clients on a more limited

basis depending upon the subject matter and also the particular interests and experience

level of the Client in question --- if you would like more information on our Research, please

contact us.]

As always, please feel free to contact us should you have any questions about your portfolios

or the conditions unfolding in the world.

Kind regards,

Daniel & Darren

Contact Information:

Daniel J. Want (Director)

[email protected]

Darren A. Brind (Director)

[email protected]

phone. +61 498 671 505

Prerequisite Capital Pty Ltd (ABN 42 621

110 736) is an Authorised

Representative of First Mutual Australia

Pty Ltd (ABN 42 154 012 085), AFSL

423710

a PO Box 144 Morningside QLD 4170


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www.prerequisite.com.au/managed-portfolios

Copyright © 2018 Prerequisite Capital Pty Ltd, Australia. All rights reserved. Past performance is not indicative of future results.

Prerequisite Capital Pty Ltd (ABN 42 621 110 736) is an Authorised Representative of First Mutual Australia Pty Ltd (ABN 42 154 012 085), AFSL 423710

Prerequisite’s All-Weather Investment Portfolios

• ABSOLUTE RETURNS: The Prerequisite Portfolios are generally designed for those seeking to preserve capital and generate compelling returns in a conservative manner, potentially irrespective of the ups and downs the economy (or the share market) might experience.

• TRANSPARENT & SIMPLE: Our portfolios are totally transparent (using SMA structures) and the returns we generate do not utilize derivatives, leverage or illiquid investments.

• DIRECT SECURITIES: Client funds & investments are safeguarded directly in the client's own name by an independent platform & institutional custodian.

We seek to ‘swim with the tide’ as much as possible by having a longer-term momentum/trend following framework incorporated into our investment management process - in a way that complements our valuation and capital flow analysis frameworks. We adhere to the nineteenth century Rothschild maxim: "Always leave a profit to the other fellow." We are happy if we capture 70-80% of a major trend; if this is done consistently with a reasonable strike rate, strong returns will be achieved. It is generally the first and last 15% of any trend that is most expensive (i.e. trying to pick the tops and bottoms) and people who chase them invariably suffer in their haste. At the same time as seeking to align our portfolios with ‘the major tides of change in the world’, we are also seeking to develop a resiliency to our portfolios that gives us confidence that capital should be preserved even if we are temporarily caught ‘wrong-footed’ in one of our more overweight investment positions.

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