Market Overview Spring 2016

1. BlackwallPartners2016 Update: Transient Volatility, Part III May 4, 2016
Learn to Love the Bomb (and Accept Transient Stock Volatility), Part III
Almost four years after we published the last installment of ‘Learn to Love the Bomb’, not much has changed (as we
had anticipated). President Obama was re-elected and consequently – our national fiscal policies have stayed the tired,
old socialistic train wreck any intellectually honest person (economist or not) would have expected. Our lack of recent
commentary is directly related. It took longer than we would have liked, but real change finally is afoot.
At present, we are living through the now statistically worst decade for the U.S. economy since the thirties. No surprise
to us. The fact voters insisted upon proving this empirically by re-electing the Obama administration is a question for
future historians and social scientists. ‘New Deal’, ‘Fair Deal’ or Obamanomics, all are identical in nature and
outcome. Today, approximately ninety-five million (95 million) adult Americans of ripe working age and ability are
not working. We are told to believe that these folks have chosen voluntarily to stay at home to “paint”. Those working
haven’t seen their wages rise in over a decade. There is virtually no upward mobility and new college grads face the
worst job market on record. The current generation now is widely expected to be the first in American history to
underperform their parents (and grandparents). If you’re Feeling Japanese… of late it’s because we are with one
important caveat (explained momentarily).
U.S. Velocity of Money Continues Grinding Slower
Nearly all sectors of the economy are experiencing revenues that range from stagnant to deteriorating. The resultant
prevailing strategy for most of these firms (confirmed by their investor presentations) is to milk the cow dry with
outsized dividend payouts and earnings-per-share growth engineered via massive (and we see as wasteful) stock
repurchases. The result is a self-fulfilling perpetual recession. The accompanying chart of the velocity of money in
America, courtesy of our alma mater the Federal Reserve, captures this tragic economic outcome.
For now, short-sighted investors appear willing to punish corporate executives if they were to re-engage in investing in
growth, hence the record profit margins and tax receipts via cutting every possible expense (including CapEx) to prop
up current earnings. Market participants don’t seem to note this very obvious red herring. For every action (Obama
e.g.), there is a reaction (“new norm”) and it’s crippling the economy. Working capital is being unproductively
redirected away from investing in growth and blown on current dividends; capital expenditures are wasted on the
instant gratification of stock retirement. As for the future? It was Keynes who only focused on his own death and his
followers could care less what happens after theirs. Socialism is for the here as in ‘right now.’ So are dividends and

2. stock repurchases. They are the stuff of “buggy whip” makers. They are not a measure of the potential for a greater
future. The markets are riding an unsustainable narrative.
The broader stock market anymore is an extension of the bond market driven by ultra-low interest rates and hence
unsustainable discounts. Current Fed policy is but a mere reaffirmation and why stocks float higher in-step with the
grave economic realities. This is the greatest interest rate risk bubble in mankind’s relatively short, but eventful history.
Today, our large city landscapes once again are dotted ubiquitously with construction cranes but conspicuously without
underlying growth in the economy to justify their existence. Increasingly, hordes of investors clamor to invest in ‘safe
haven’ buildings (REITs) which in it of themselves are rather unproductive allocations of capital. Like bonds and
dividend discounted equities, it’s all just part-in-parcel to this rate risk bubble of which we speak. We’re confident the
coming dividend discount or “cap rate” valuation reset will make the oil patch bludgeoning look almost agreeable.
We now sit atop in excess of $30 trillion (with a “t”) in mostly passive commercial real estate investments in America.
The average capitalization rate is estimated at about 3.8%. God forbid we ever again see the U.S. 10-year Treasury
note yielding above 3.8%. Under President Obama, it’s below 2%. Almost all the new job openings at say a Goldman
Sachs (NYSE - GS) are in their burgeoning real estate groups (we actually track this sort of thing…). The rest are in
compliance jobs to keep up with stifling new regulation. Wall Street now may fear the Trump (growth) and prays for
Clinton (stagnation). Most fund managers we speak with believe the latter is a shoe-in because thinking otherwise is
unnerving to their current portfolio positioning. We might suggest investors should at least consider preparing for a
change.
Some time ago, we began referring to President Obama as “Captain Zero” for his economic success. It wasn’t intended
to be mean spirited. That’s actually the number. As a result of this administration and their policies, the Fed has had
little choice but to keep us at or near zero, apropos to what now is the longest and deepest monetary ease ever
perpetrated upon a fractional reserve banking system. It’s testing the system and altering capital allocation in a very
dangerous manner. The national debt is a bomb…
U.S. commercial banks are sitting on roughly $2 trillion in ‘excess reserves’ [above the 3% minimum] in their Fed
member accounts and some central bankers, including the Fed, are looking at charging fees on this excessive liquidity,
now commonly referred to as “negative interest rates”. Confused? You should be. As if punishing ‘excess reserves’
will alter the supply and demand for credit (leverage) in broken economies now worldwide. Monetary policy is highly
limiting after-all. It cannot supplant or overcome socialistic largesse.
Consumer bank deposits are sitting at a record $10 trillion, proving stagnation like growth rolls downhill with
confidence in tow. Most don’t feel in the mood to do anything productive and who could blame them? Housing has
gone nowhere now since 2010. Marriage and birth rates are at Depression-era lows. Why? Nobody feels confident
enough in the economy and their job to get married, have a baby and buy a dang house. That is the stuff real economic
recoveries are made of…
We’re not altogether certain where this president’s Council of Economic Advisors studied economics or if at all. But
some voters (the question is whether enough) seem finally to be asking that same question whether they realize it or
not.
We could have skipped the commentary and merely published the chart of the velocity of money found on Page 1, but
we can’t help ourselves. And nobody ever talks about that critical variable. So, we will…
As the chart clearly displays, the “churn” or turnover in reasonably liquid capital (M2) has essentially grinded to a halt.
It’s actually the lowest M2 stagnation since the measure first was observed. But we actually remain quite optimistic as
this still is the largest store of fungible capital in history. It merely needs to be inspired! The very caveat we proposed
earlier which differentiates us from our European and Japanese friends. We’re still very very very rich!
The Federal Reserve estimates America’s private sector remains quite wealthy – worth roughly $85 trillion, net. While
granted, $30 trillion plowed into commercial real estate is a concern; no other economy in the world sports such
enormous potential for a turnaround. Thankfully, the years where we were not a practicing “social democracy” have
been rather recent. So, the private sector has not been confiscated by the government, yet (this is what Senator Sanders

3. has his beady eyes on e.g.). And the young (Millennials or “Echo Boomers”) are now the largest group of Americans
ever. Thanks to Reaganomics, we’re a young nation. Nobody talks about that either. Our youth need to be inspired!
Inspired to get married, have a kid and buy a dang house. Economics is a rather easy subject. It should be an ‘easy A.’
It just happens that there’s a rather large debate buzzing throughout the country this year (once we get past deliberating
little hands, big ears and get past an FBI investigation or two). The political debate centers on whether we continue
the current strategy or return to the one that worked. That subject used to be an easy A too (the schools in which you
matriculated being the risk variable).
The following is what we wrote in July 2012 upon a similar proposition in that major election year. We clearly hoped
voters had caught on by 2012 but worried that they had not. So, here we go again… We definitely like where the
debate is heading – clear contrasts now that we’re down to the final two.
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The second quarter 2012 was a tough one. Suffice it to say, financial stocks were pushed around by global headline
risk. The explanation is simple – idiosyncratic fear has returned and resides at all-time highs (yet again). As a
follow-up to our recent assessment that many market participants were either neglecting or mistaking altogether
systematic risk (“beta”) with diffident and turbulent volatility in financials, we found the following research from
Russell Investments (below) very insightful and congruent with our own analysis. Clearly, there is an epic opportunity
in the deeply under-valued Financial sector which is currently nothing less than a “three sigma” volatility event.
As Russell researchers have illustrated below, beta and volatility can be two very different issues facing fund managers
when those metrics become uncorrelated (which is very unusual). Beta captures “systematic risk” or risk relative to the
broader market (to changing economic conditions). Aberrant volatility (above or below that of beta) would indicate the
existence of intangibles often referred to as “idiosyncratic risk.” Systematic risks are known, while idiosyncratic risks
are intangible and thus unknown or at least unpredictable. In fact, idiosyncratic factors perpetuate substantial “market
timing” issues as their very existence in a sector will typically push investors away in an effort to avoid the heightened
volatility. Such is the issue facing financial stocks today. There is an abundance of macro inefficiencies that exist
where the greatest value resides! If low volatility is that which you desire? Then you will pay through the nose for it
and risk permanent losses! But if great value is what you seek, it is available… but it comes with transient high
volatility caused by idiosyncratic factors.
High-Beta v. High-Volatility Index Sector Exposures (%)
Russell Investments 2011
Source: Russell Investments and BlackwallPartners LLC
4
9
14
19
24
29
Russell 1000 Weight US Larg Cap High Beta % US Large Cap High Volatility %
GREEN arrows represent extraordinary
standard deviations above the empirical norm
between systematic risk (“beta”) and
idiosyncratic risk (excess “volatility”).

4. In today’s highly volatile climate for stocks, systematic and idiosyncratic risk have become “unhinged” in several
sectors and in both directions. This is creating an extremely rare and compelling arbitrage opportunity. This extreme
decoupling phenomenon points to the likelihood of extraordinary upside in the Financials, but at the cost of some
short-term idiosyncratic-driven volatility, while other sectors showcase hidden systematic risks by their lack of
volatility just the same.
The Russell analysis highlights the stark disparity between excess volatility and systematic risk (i.e. greater than
average market/economic risk) across different sectors within the broader market. As Russell’s research suggests,
volatility where it has decoupled from beta – is driven almost exclusively by “less measurable” factors such as
political uncertainty which certainly has been the case of late. Russell goes on to say - “It is important to point out
that sector exposure to high-volatility stocks may be more time-period-dependent.” In other words, elevated
volatility is event dependent and thus transient and not systematic.
Volatility Index by Sector Exposures (%)
v. Price/Cash Flow Multiple
Source: Russell Investments and BlackwallPartners LLC
The chart above recasts the Russell findings to compare the valuation of each sector relative to its volatility. This chart
speaks volumes. If one wants low volatility stocks, one has to accept extreme valuations for them. If investors want
value, then one must accept high volatility. The only sector that strikes more of a balance is Technology.
REITs and Utilities are especially expensive. The opposite is true of Financials, they are being given away to avert
volatility. The Energy sector looks cheap only if you think that the commodity is stable. And Durables are
precarious as the commodity boom and insatiable desire by investors to be long China (as their “risk-on” trade) has
created an imbalance in that sector where volatility is too low relative the sector’s empirical beta, suggesting
oversubscription or overconfidence in China’s authoritarian economy. Generally speaking, it is the high priced (over-
valued) stocks which should be showing the greatest volatility, but not the case currently. This is an idiosyncratic-
driven cycle, namely US political uncertainty. It’s masking certain systematic risk (such as interest rate risk) and any
sudden change in the political landscape could reverse cash flows very sharply and adversely to those sectors where
2 7 12 17 22 27
Financials
Cons. Discretionary
Energy
Durables
Technology
Healthcare
Cons. Staples
Utilities
REITs
SPDR Dividend
US Large Cap High Volatility % Price/Cash Flow Multiple (X)
High Valuation;
Low Volatility
Low Valuation;
High Volatility

5. low volatility and high valuation coexist, while enormously favorable to those sectors where volatility greatly exceeds
empirical beta, namely in the Financials.
On balance, investors might incorrectly conclude that recent elevated volatility in Financials is decidedly indicative
of new, more pronounced systematic risk. This is not the case. In fact, Financial fundamentals have been
substantially improving since the crisis occurred (this is well documented). Nevertheless, investors are currently
mistiming the financial sector by unwittingly attempting to avoid transient volatility by running straight into
the arms of high priced, low volatility sectors. These high-priced sectors are where systematic risk is essentially
“masked” merely by the lack of volatility and the trade is getting ever more crowded.
This migration of capital flows away from “perceived risk factors” easily can and is (in our view) increasing market
timing risk as well as systematic risks for many investors. This includes heightened valuation risk to any change in the
economy (especially interest rates sensitive or historical ‘safe haven’ groups as noted). Investors have presumed for
some time now that interest rates will never change. As such, they may be zigging when they should be zagging.
Chasing sectors with excessive valuation merely as a function of the sector’s low volatility is itself also idiosyncratic
behavior.
A simple way to read into the Russell analysis is to assume that those sectors where volatility exceeds systematic risk
(beta) are the most under-valued (low risk, high reward) while those where systematic risk (beta) is higher than
volatility are likely to be excessively over-valued (high risk, low reward). This concurs with our fundamental
research and Russell’s analysis proves it empirically. Excess volatility now trumps existential valuation and thus
systematic risks now are all but being ignored.
The fact that Bonds, Utilities and REIT equities are trading at or near record high valuations (amid record low
volatility) are prime cases-in-point. Does their lack of volatility imply less systematic risk to changing economic
conditions? What would happen if say – interest rates were to begin to rise even modestly due to changing economic
conditions? Would that not incur significant valuation at risk already predicted by their current low volatility relative
their empirical beta? We certainly think so.
The Internet bubble is a good example or the tulip mania in Holland. Both were examples of systematic risks ignored.
Recent short term bond auctions in Germany, France and the United States at negative interest are a “tell” perhaps...
examples of a heightened “blind” systematic risk appetite. In each case, the systematic risk ignored was valuation;
while the idiosyncratic symptom identified and either welcomed or averted was high transient volatility or lack
thereof.
A “Three Sigma Event”… Already Discounted!
The presence of this “confusion” between systematic risk and idiosyncratic risk is evident in the current extreme
volatility of Financials. This volatility is several standard deviations (“sigma”) above its norm as measured by
empirical beta. This has resulted in a severe “volatility aversion” reaction by investors, pushing fund managers out of
the sector. This deep under ownership has resulted in record depressed valuations, thus where the extraordinary return
potential lies. This “buyers strike” exists despite the fundamental attractiveness of record builds of capital, reserves
and cash on bank balance sheets as well as valuations below “going concern value” as we have highlighted
extensively in previous musings.
The Russell statisticians captured some astonishing findings not particularly surprising to us. Financial stocks
represent nearly a full third of the Russell 1000’s volatility despite representing less than 10% of the beta and
only one-tenth of the sector’s representation within the index.
In empirical terms, Financial stock volatility of this magnitude (250% of its empirical beta) would not be seen 95% to
99.7% of the time. It is a three sigma event (an historical outlier the equivalent of a highly unheard of event). The
simple analogy is that a hurricane Katrina had a far higher probable outcome than the current deviation
between financial stock volatility and its empirical sensitivity to market risk (beta).

6. In contrast, REIT volatility e.g. is near ZERO despite the historic level of systematic risk (beta) to changes in
interest rates (economy). The attraction for investors is low volatility (and some yield) and thus investors have been
clamoring to own REITs despite being currently priced at RECORD multiples of cash flow, implying absurdly
low capitalization rates. The same scenario applies to some key bond markets. In these cases, no systematic or
economic sensitivity risk is implied in their valuations. NONE!
We believe financials offer what perhaps is the greatest disconnect between systematic risk and volatility
perhaps recorded. Valuations of financials remain at unsustainably low multiples of free cash flow with implied
yields topping 25%-30%. In stark contrast, REITs yield 2%-3% and benchmark bonds well under 2%.
As previously mentioned, we view “market timing” as a function of the wide imbalances between beta and volatility
across a myriad of sectors in the market to be the larger unspoken risk. This is the same collective “group think” that
masked imbalances that gave us the tech stock boom and bust of the late 1990’s. Investors are “crowded” en mass
into the same low volatility trade which is masking heightened valuation risks to any change in the economic
environment. Investor emotion and “less measurable” factors like political climates have a tendency to distract
investors caught in the moment. The current market imbalances between systematic risk and volatility offer an historic
risk/reward arbitrage opportunity.
For Financials, the “less measurable” or intangible factor primarily is the current politicized attacks on the
financial sector. This intangible or “idiosyncratic risk” has been more than “priced-in” to the financial sector and
there is no abundance of assurance that the current administration will remain in power beyond this coming
November. The unremitting “bank bashing” tactics of progressive governments have become all too politically
transparent – the LIBOR scandal and/or the hedging loss at J.P. Morgan e.g. These all serve as mere Kabuki theatrics
at a time when incumbent politicians, reeling from weak economies and poor re-election prospects are in dire need of
a “straw man.”
The idiosyncratic risk reflected in the historic imbalance between financial stock volatility and beta is the direct
byproduct of this “straw man” phenomenon. And we are confident that its days are numbered. Regrowth of the
economy tends to overtake petty politics come election time as voters have an uncanny penchant for insisting on it at
critical moments in our economic history such as 1952 and 1980, where political realignment was necessary. Political
realignment is no different than the self-correcting mechanism of the market. The same math (or voting models) can
be applied when imbalances this extreme are evident. Candidates invariably are drawn into the center of the empirical
electoral distribution or they lose elections.
After the 2QTR Sell-Off, Valuations Again Remarkably Favorable…
With the average price-to-tangible-book (P/TBV) values for the largest US banks at just 0.66x, the market is
not far off recent trough levels of 0.60x reached in March 2009 and well off March 2012 highs of nearly 1.0x
TBV. We continue to favor many regional banks trading well below book value and at no deposit premium
(no intrinsic value). The bad news emanating from both European and American policy makers is more than
priced into the group – setting up for highly favorable reward when any hint of market imbalances show the
slightest ray of headline (idiosyncratic) risk abatement.
And then there’s that election coming-up soon too… [Well, that part didn’t go the way in which we had
hoped].
Regards,
Michael P. Durante
Managing Partner
Blackwall Partners LLC