Articles

MID Q2 Market Update

5/22/2022

The S&P just had its 7th consecutive week of losses, which is only the fourth time in history including 1970 (8 weeks), 1980 (7 weeks) and 2001 (8 weeks).

We thought last week would be up especially when the S&P climbed 2% on 5/17 (advancing 4% from its close on 5/12) despite scary results from Walmart which drove a 11% drop in its stock (its worst daily decline since Black Monday of 1987.)

But then came Target, which echoed Walmart’s negative comments on the consumer, compressing margins and surging unsold inventory. Their stock dropped 25% (their worst daily decline as well since Black Monday of 1987) and drove the S&P down 4% on 5/18.

Results from Home Depot and Lowe’s did not alleviate investor concerns about a slowdown in the housing market which generally precedes recessions. Both names are now down ~30% from their record highs in December of last year and declined 3-5% during the week.

And finally, disappointing results by technology stalwarts Cisco (down 13% for the week) and Applied Materials (down 5% for the week) sent those stocks even lower despite only a 13-14x PE ratio versus 17x for the S&P. Both are now down over 30% from their all-time highs. This punished related large cap technology names (QQQ down 4% for the week) which are now down 29% from their all-time highs.

Furthermore, a collapse in a so called “stable-coin” in crypto did not help more speculative technology names. TerraUSD (UST), an algorithmic (not asset backed) crypto that was supposed to be pegged to 1 US dollar, is now trading near zero ($1.00 to $0.05). The collapse of UST and LUNA led a crypto market sell off which wiped out $400 billion in value at one point.

As a result, the S&P/Nasdaq on Friday 5/20 closed -0.7%/-0.1% below their prior 52-week lows on 5/12. However, China technology names were quite strong with $KWEB (China internet ETF) up 8% from 5/12. Unlike most other stock markets, many of China’s stock market woes are self-inflicted driven by: 1) their drive to common prosperity, 2) heavy regulation of technology companies, and 3) zero-Covid policies locking down major cities. But there are signs that the regulatory pressure is nearing its end along with some more flexible Covid policies. $KWEB is down 74% from its all-time record highs versus the Nasdaq which is down 30%. We have a large long position in $KWEB which we hedged with short positions in big cap US technology names last week before earnings results. The QQQ (Nasdaq 100) fell 5.7% from its highs on 5/17 to its close on 5/20. We have since covered those shorts.

The market is near oversold levels and we have technical metrics that will hopefully help us take advantage of the usual bear market rallies on the way lower:

There were 5 rallies in the S&P of 18-21% during the Global Financial Crisis and bursting of the tech bubble while the S&P ultimately dropped 49-57%.
Bear market rallies typically get back 70% of the losses of the prior move lower with over a quarter of the rallies gaining back over 100%.
We currently still think the next 5%-10 move in the stock market is higher
CNN’s Fear and Greed Indicator currently has a reading of 11 on a scale of 0-100, which indicates extreme fear with 6 out of 7 of its individual components registering extreme fear. Only the volatility component is at neutral.

Several of our 17 technical metrics flashed oversold during the lows on the S&P on Friday. Unfortunately, the late day rally negated most of those oversold metrics which require a closing oversold condition for more certainty of a bear market rally.

But we believe the next 10-15% move in the stock market is lower. A recession combined with inflation above 3% is now our base case for 2023 with a 30-50% drop in the S&P from peak to trough.

Since World War II:

Inflation (CPI) over 5% has preceded a recession every time. It is now over 8%.
Oil prices doubling relative to the prior 2 year average ($54 in this case) has preceded a recession every time. Oil at one point breached $120 and is still over $110.
10 of the 13 prior recessions have been preceded by a tightening cycle by the Fed. We believe rates will be closer to 4% before this tightening cycle is over versus just 1% at the high end today.
10 of the last 13 recessions have been preceded by the 10-year yield going below the 2-year yield. This occurred on 4/1/22 and was -7 bps.

Any one of the above has a great track record in predicting a recession but all of them have now occurred. During the prior 3 recessions that also had high inflation from 1968-1982, the S&P dropped between 27-48% on a price basis.

Additionally, during high inflation environments, the trailing PE for the S&P is much lower than average:

From the 1972 peak to 1974 trough, the trailing PE went from 20x to 7x as CPI rose from 2.3% to 12.7% with the S&P losing nearly 48% from peak to trough.
For nearly the last 70 years, whenever CPI has been above 3% the trailing PE has averaged 15x. Whenever CPI has been above 5%, the trailing PE has averaged 12x.
Despite the CPI at 8.3%, the trailing PE today is 20x which we hope will only compress to ~15x at its low point.
For the first time since the Volcker led Fed of 1980s, the Fed is your enemy and will likely unwillingly force the economy into a recession to slow inflation.

We believe that the key to building long-term wealth boils down to avoiding crushing losses. Following the 48% price decline in the S&P that started in early 1973, it was almost a decade before the S&P stayed above that level. Therefore we focus on capital preservation and steady performance over-time that is minimally correlated to the stock market.

On a positive note, we believe there will be an incredible buying opportunity at some point in 2023, particularly for technology names when the market hits its ultimate low for this down-cycle during the next recession. In the meantime, all the best to you and your family during these challenging times.

Sincerely,
Dan & the Satori team

15 Comments

Market Thoughts Following Q1

4/7/2022

7 Comments

Introduction

The markets are in a volatile and dangerous place as of now. As a hedge fund, it is our job to actively consume, evaluate, and re-evaluate as much market data as we can every day to best manage portfolio risk. We know many individuals are too busy with their jobs to actively manage their portfolios or read this article in its entirety, so we have included a summary (see SUMMARY) for readers with limited time as well as an in-depth dive into our thoughts following Q1 (see FULL ARTICLE).

Summary

“Don’t Fight the Fed”- Investors are forgetting that it works on the way down as well as the way up. The Fed expanded their balance sheet by $4.8 trillion since the start of the pandemic while the US government added ~$5.5 trillion in stimulus. Combined stimulus of roughly half of US GDP of $20.5 trillion is the major driver of why the prices of stocks (along with homes, cars, boats, crypto, art, NFTs, etc) all went up over the past two years during a global pandemic. Now, the Fed dot plot shows 10 rate hikes in less than two years and they will be cutting trillions off the balance sheet probably starting on May 4th along with a 50 bps rate hike.

Stagflation is our base case for 2023. We continue to believe that the S&P will see a correction of at least 20% over the next one to two years as the Fed is more aggressive than expected to deal with inflation running higher than expected and easy money begins to decrease. Since World War II,
1. Every time Inflation (CPI) is over 5% a recession has occurred
2. Every time oil prices have doubled relative to the prior 2-year average ($54 in this case) a recession has occurred
3. 10 of the 13 prior recessions have been preceded by a tightening cycle by the Fed
4. 10 of the last 13 recessions have been preceded by the 10-year yield going below the 2-year yield

Any one of the above has a great track record in predicting a recession but all of them have now occurred. During this decline, we expect there to be several bear market rallies as people continue to call the bottom too early while fundamentals continue to worsen. We are expecting multiple negative preannouncements in early April and lowered guidance when companies report as well as more than one 50 bps hike by the Fed this year starting on May 4th. Additionally, Russia’s invasion of Ukraine is likely to lead to 1) higher mid to long-term inflation given disruption to both energy and agricultural supply; and 2) increased risk of a US recession in 2023.

We like companies that 1) benefit from economic reopening (not pandemic beneficiaries); 2) are profitable with good cash flow; 3) have growth but at a reasonable price; 4) benefit from higher-than-average inflation; 5) benefit from multi-year secular tailwinds. We foresee tailwinds in:
1) datacenter, office enterprise, and 5G infrastructure.
2) reopening plays such as airlines, cruise lines, travel, rideshare, and dating services as people adjust to covid becoming endemic.
3) banks which should benefit from higher interest rates.
4) alternative energy as geopolitics and fallout from the Russia-Ukraine War drives investment in the space.

We foresee headwinds for pandemic beneficiaries particularly in the PC and smartphone spaces while we see benefits for the services sector as economies continue to re-open and we learn to live with the pandemic. We would also note that inventory has built rapidly on company balance sheets as customers have been buying what they can get while waiting for what they cannot get. Unfortunately, as demand switches from the purchase of goods (only thing you could do during the pandemic) to services (what you want to do after being stuck indoors for ~2 years), you are likely to see demand disappoint. This is likely to cause an inventory correction as companies are finally able to get that last part they were waiting for.

To manage risk in this market, we are trading around our long-term positions as well as evaluating data daily. When we get moves that are statistically out of the ordinary, we trim our long positions on surges and likewise reduce our shorts on drops. Additionally, we try to recognize whether the facts have changed. In that case, we try to admit our mistake and remove the position at a loss and move forward to avoid greater losses later. To quote John Maynard Keynes, “When the facts change, I change my mind. What do you do, Sir?”

For retail investors that do not have the time to trade the market DAILY, we recommend cash until inflation, Fed tightening, and economic slowing run their course over the next one to two years. As a hedge fund, we trade around our long-term positions & evaluate data daily. Stock prices and information change daily and so do we. We try to invest when the risk adjusted possible returns are in our favor. For example, we may believe that the S&P will drop at least 20% this year, but we will have more longs than shorts when our 17 technical metrics indicate the market is oversold. We recognize not everyone has the time to do this which is why cash was one of our top 5 picks entering the year. Most of the time, cash is a terrible investment especially in a high inflationary environment, but if you are unable to actively manage your positions, it is better to lose 6-7% to inflation this year than 20%+ in a stock market drop. With the Fed being this far behind the curve on inflation, we will find out how much froth is in valuations as the Fed starts tightening as growth continues to slow.

For retail investors who would rather not sit in cash, we recommend these investors hedge their longs by shorting broad ETFs or megacap names as well as actively managing their portfolios. This will mitigate the dangerous potential for “unlimited” losses in single stock short positions, like “meme” stocks.

May your portfolio and your health be safe in these uncertain times,
Dan

FUll Article

We continue to believe that the S&P will see a correction of at least 20% over the next one to two years as the Fed is more aggressive than expected to deal with inflation that remains higher than expected.

Recession Indicators
Since World War II,
1.    Every time Inflation (CPI) is over 5% a recession has occurred
2.    Every time oil prices have doubled relative to the prior 2 year average ($54 in this case) a recession has occurred
3.    10 of the 13 prior recessions have been preceded by a tightening cycle by the Fed
4.    10 of the last 13 recessions have been preceded by the 10-year yield going below the 2-year yield

Any one of the above has a great track record in predicting a recession but all of them have now occurred. Stagflation is now our base case for 2023 with at least a 20% drop in the S&P from peak to trough over the next year. We would expect more than one 50 bps hike by the Fed this year starting on May 4th.

Bear Market Rallies
We would note that roughly ~25% of bear market rallies get back more than all of the losses of the prior leg lower before going to new lows. On average the rallies get back about 70% of the prior drop. We saw 4 double digit rallies as the S&P went down 49% on a price basis during the tech bubble and 5 double digit rallies during the Global Financial Crisis as the S&P went down 57%. In fact, 5 out of these 9 rallies were between 18-21% and each time people were quick to call the bottom even though the economic fundamentals were still getting worse. This time the S&P declined 9% from 2/2/22 through 3/8/22 and gained 11% from there to 3/29. This recent rally is not out of the ordinary.

Economic Fundamentals
But fundamentals are still getting worse and we expect multiple negative pre-announcements in early April and lowered guidance when companies formally report. We have already seen several high profile companies that had February quarter ends talk about the Russia invasion that started on February 24th affecting their business in Europe. Adobe (-36% from 52-week high), Restoration Hardware (-55%) and UIPath (-76%) come to mind. All of these stocks were hit hard (between 9-26%) on earnings results despite being well off their 52-week highs already. For companies whose quarters ended in March, they will have a full month of extra impact.

Russia’s invasion of Ukraine is likely to lead to 1) higher mid to long-term inflation given disruption to both energy and agricultural supply and 2) increased risk of a US recession in 2023. Stagflation is becoming our base case for 2023. There are 3M more job openings than people unemployed and unemployment is already at 3.6% versus a 70 year average of 5.8%. The leisure and hospitality industries still have ~1.5M less jobs than prior to the pandemic. As we all learn to live with Covid and start travelling, vacationing, going to indoor entertainment, etcetera, these jobs coming back will add even more to wage increases. Corporate costs on average are roughly 2/3rds driven by wages and 20% driven by supply chain and energy costs. Lower supply chain & commodity costs by year-end will not go down enough to offset rising wages keeping inflation higher than anticipated.

The growth of pandemic beneficiaries continues to slow and we still do not know where they will bottom, particularly if we enter a recession in 2023. This is leading to massive stock selloffs of pandemic beneficiaries exposed to e-commerce, digital payments, video conferencing, video streaming, digital learning, online exercising etc. As an example, in Q1 of 1999 Amazon had revenue growth of 236% y/y. That revenue growth went to 0% by Q3 of 2001 despite e-commerce being in its infancy as the US economy entered a recession. Amazon’s stock went from a peak of $106 to a bottom of $6 during this slowdown.

The most recent pandemic beneficiaries that are seeing a slowdown seem to be in the PC and smartphone space. Smartphone units shrank in 2020 (-10%) for the 4th yr in a row as replacement cycles lengthened but grew 6% in 2021. We are concerned about 2022. For PCs, demand was flat to down for 5 out of 7 years prior to Covid but saw double digit growth for the past 2 years due to purchases that enabled consumers to work from home and learn from home during Covid. The PC market is ~60% consumer and ~40% business and the consumer piece is now slowing down. Our shorts are concentrated in this sector currently and in retailers that sell stuff and not services.

The economy has also gone from “sell me stuff” to “sell me services”. US consumers have accumulated over $2 trillion in excess saving during the pandemic between the Fed and government free money. We bought “stuff” during the pandemic eg. Peloton bikes, smartphones, PCs, and furniture. Consumers now want “services” to start travelling, go on vacation, go to restaurants, go to sporting events, etcetera as the pandemic risk becomes a normal cost of living life.

The Federal Reserve
The #1 concern for investors in 2022 should continue to be that the Fed is so far behind the curve on dealing with inflation that they will have to be much more aggressive than in prior tightening cycles despite high inflation & geopolitical risk. Stagflation in 2023 is becoming our base case in which case market multiples should go to below average. According to the Taylor rule which used to be a guidepost for central bank policy prior to the Global Financial Crisis, the Fed funds rate should already be above 9% versus the current level of 0.25-0.5%.

Valuations
Unfortunately, most valuation metrics are near record highs such as the market cap of the entire US stock market divided by US GDP is at 1.9x versus a peak during the tech bubble of 1.4x and an average of 0.8x. We would also note that market multiples are typically below average in periods where inflation was over 3%. Despite 50% earnings growth from 1972 to 1974, the stock market declined by ~50%. Slowing growth and high inflation crushed market multiples with the trailing PE ratio of the S&P500 going from 20x to 7x. The trailing PE multiple today is 23x.

Investments

This is the Jerry Maguire stock market. It has gone from a “sell me the dream” to “show me the money” as:
1) the Fed becomes aggressive to deal with inflation and 2) growth rates slow due to high inflation & the removal of easy money. Today, companies need to be able to show profitable growth at a reasonable multiple versus before when rosy forecasts of huge markets a decade from now were sufficient despite huge current losses.

Ideally our portfolio companies would have all of the following characteristics:
1)            Benefit from economic reopening (not pandemic beneficiaries)
2)            Profitable with good cash flow
3)            Growth but at a reasonable price
4)            Benefit from higher than average inflation
5)            Benefit from multi-year secular tailwinds

Most stocks will not be able to withstand a 20%+ decline in the S&P
As such we are counting on: 1) our shorts to deliver positive the returns for the year, 2) outperformance of our longs versus an expected market decline of at least 20%, and 3) aggressive rebalancing of shorts triggered by the 17 technical indicators we use to avoid bear market rallies. We raise a high degree of cash on market rallies by covering shorts and then re-short on bounces.

Three simultaneous investment cycles: 1) datacenter for the large internet companies, 2) enterprise as workers come back to the office, & 3) 5G infrastructure as this becomes the dominant technology for smartphones.
-We own a basket of names such as Cisco ($CSCO), Ciena ($CIEN), Nokia ($NOK) and Ericsson ($ERIC) that should all benefit from these trends. There are other communication infrastructure stocks that would fit as well and we are constantly adding and subtracting names from this list based on or perception of risk to reward. For example, we bought Nokia and Ericsson during the latest market drop in March given their proximity to Russia hurt them more than other names in the infrastructure space. We also believe the risks to Ericsson from their latest disclosures around illegal payments are overblown given this issue was somewhat addressed in their fines in 2019. These names though are hurt by higher inflation affecting their costs.

Loan growth picking up & treasury yields going higher
-$KRE: We believe 10 year treasury yields will reach ~3% in 2022 and loan growth will pick up as easy money from fiscal & monetary policies get dialed back. As easy monetary and fiscal policies get dialed back in 2022, corporations and individuals will increasingly have to turn to the banking system for their financing needs going forward. In addition, as rates head higher in 2022, this will allow banks to lend at higher levels and increase their profitability. Regional banks also avoid the geopolitical risks involved with the larger international banks. The big concern for the future is default rates going up when we enter the next recession which we believe is in 2023. Also a flattening yield curve is not as good for the net interest income of banks as when it is steeper. These are factors to watch. Banks though do not have multi-year secular tailwinds though and argument could be made for rising interest rates after a ~40 year downtrend since the 1980s. They are also hurt by new financial innovations like buy now pay later (BNPL) unless they are investing as well.

The world learning to live with Covid & re-opening by year-end
-During the recent decline, we started buying a basket of re-opening beneficiaries including in airlines ($LUV), cruise lines ($NCLH), hotels ($H), travel ($ABNB), ride-share ($UBER), with many crushed even more due to Europe exposure or rising oil prices. There are many other names that would fit as well and we are constantly adding and subtracting names from this list based on or perception of risk to reward. We believe by year-end, we will all accept catching Covid to varying degrees as acceptable risk to living life. China is a wildcard in this regard as they continue to pursue a zero-Covid policy but by year-end we believe they will also go down this path. We also believe Russia’s invasion of the Ukraine will be resolved in Q2.

Geopolitics driving a resurgence in alternative energy investment
-We own a basket of stocks in this sector. $ICLN which is down ~35% from its highs in early 2021 is a good way to get diversified exposure to the space. Europe’s dependence on Russia for energy in particular should drive a multi-year investment cycle in the sector. We also have exposure in the Uranium sector as nuclear gets reconsidered.

On March 2nd, we tweeted from @DanielTNiles that we removed $USO from our 2022 Top5 Picks following a gain of 39% year-to-date which tracks WTI Oil prices which were at $111 up 86% year-over-year!
-There is an adage that “the cure for high oil prices is high oil prices.” It slows economic growth, increases recession risk & reduces oil demand. We are looking to get long oil again in the $90s. Oil demand in 2022 should still surpass the record levels seen prior to the pandemic while OPEC+ spare capacity is low and supply remains restricted by environmental concerns. Russia’s invasion of Ukraine cuts available capacity even more over the longer-term. When there is eventually some sort of peace agreement (we expect this in Q2), all commodity prices will most likely get hit hard and that is when we plan to get long in a big way again.

SEVERAL TIMES, we have been short the $USO (which tracks the West Texas Intermediate oil prices) as a trade, since Russia invaded the Ukraine. Commodity prices are not like stocks. Commodity prices cannot go up infinitely (especially oil) given higher prices kill demand which drives the price back down. This is unlike stocks that can keep going higher as the economy expands and they take market share. Despite our long-term bullishness on oil prices, when prices moved quickly to levels that we perceived were too high following Russia’s invasion of the Ukraine, we sold our long. We then put on short positions but covered on big drops. This is despite our long-term goal to own the $USO or related energy names on a resolution of Russia/Ukraine that should send most commodity prices initially lower.

Managing The Risk in Your Portfolio

As a hedge fund, we trade around our long-term positions & evaluate data daily. Stock prices and information change daily and so do we. We try to invest when the risk adjusted possible returns are in our favor. For example, we may believe that the S&P will drop at least 20% this year, but we will have more longs than shorts when our 17 technical metrics indicate the market is oversold.

When we get moves that are statistically out of the ordinary, we trim our long positions on surges and likewise reduce our shorts on drops. We will also replace names with others in the same sector if we believe there is a better risk adjusted return in those names. We trade multiple stocks every single day. Sometimes it is making a current position bigger or smaller. In shorts this is particularly important. Stocks in general do not go to zero so when you get a multi- standard deviation move lower, you should cover.

You should view commentary on a sector as a way to think about the space and not focus as much on the individual names. A rising tide lifts all boats. Sometimes the best boats are only obvious after the fact so broader exposure to an investment theme is better, especially in the early stages. That is why we try to give a thought process around investments and tend to recommend ETFs that track a sector for more retail-oriented investors given the company specific risk in owning any individual stock.

Adjust your positions as fundamentals change or play out. You should evaluate each position every day. Your cash is valuable. You should be only willing to risk it in your best ideas. With double digit percentage moves that are happening daily, especially as we enter the Q1 earnings season, your best ideas might be changing daily. Sometimes, your best longs (mostly in the commodity sector) also become your best shorts after a surge higher. But you must trade and watch it daily. If not, stay out!

“When the facts change, I change my mind. What do you do, Sir?” - John Maynard Keynes. This is particularly important when you have lost money in an investment. We always have things we get wrong every year. What we try to recognize is whether the facts have changed. In that case, we try to admit our mistake and remove the position at a loss and move forward. $FB (heightened competition from TikTok) and $KWEB (Chinese government continuing to increase regulation on internet companies) are two of our biggest mistakes this year where we took the beating and sold at a loss when we realized that their fundamental backdrop had changed. This avoided a much bigger loss later on.

For retail investors that do not have the time to trade the market DAILY, we recommend cash until inflation, Fed tightening and economic slowing run their course over the next one to two years. Cash was one of our top 5 picks entering the year. Most of the time, this is a terrible investment especially in a high inflationary environment, but it is better to lose 6-7% to inflation this year than 20%+ in a stock market drop. With the Fed being this far behind the curve on inflation, we will find out how much froth is in valuations as the Fed starts tightening as growth continues to slow. For retail investors who would rather hedge their longs rather than sit in cash, we recommend shorting broad ETFs or megacap names. This will mitigate the dangerous potential for “unlimited” losses in single stock short positions, like “meme” stocks.

May your portfolio and your health be safe in these uncertain times,
Dan

7 Comments

Covering Shorts & Putting Cash to work

1/23/2022

9 Comments

We are writing this article to more fully flesh out our comments on CNBC on Friday (1/21/22) and subsequent questions that we received.

Human beings are wired terribly for investing. The tendency is to buy at highs given greed and to sell at lows given fear. Last week had the largest weekly drop in the S&P in nearly 2 years. We covered essentially all of our shorts by the end of the week. This is despite having more shorts than longs earlier in the month given our belief in a 20% correction in the S&P. We also invested 15% of the assets in the fund on Friday and used available cash in the fund to do it. However, we still have a large cash position remaining. Remember that cash was one of our Top 5 Picks coming into the year.

So why did we cover our shorts and put cash to work? We use technical tools to essentially protect ourselves from our normal human emotions and to statistically up the odds of achieving better risk adjust returns.

From their all-time record highs, the Russell 2000 is down 19% from 11/8/21 while Nasdaq is down 15% from 11/22/21 and the S&P is down 9% from 1/4/21. We used available cash sitting in the fund on Friday (1/21/22) to put 10% of the portfolio into a small cap basket & 5% into regional banks (-9% in 4 days). 31% of our 17 technical indicators were near-term oversold. We prefer this closer to 50% but some of our favorite indicators are at oversold levels. For example, the VIX (fear gauge) curve is now negative indicating investors are willing to pay more for near-term protection than longer-term protection. The selloff was also on volume that was ~60% above the 20-day average. There were more puts being bought than calls while typically ~40% more calls are bought than puts. The TRIN ratio which is the number of advancing/declining stocks (Advance Decline Ratio) divided by advancing/declining volume (Advance Decline volume) was ~1.5 versus an average of 1.1 over the past five years. This indicates a lot more urgency in the selling of stocks going down than the buying of stock going up. 51% of the S&P hit a new four week low. Despite our belief that the next 3-5% move in the S&P is higher, we believe the S&P is still ultimately down at least 20% from peak to trough due to persistently high inflation, an aggressive Fed & slower growth. (See our post on 12/28/21 for detailed reasoning.) We plan to put our shorts back on at higher levels.

Two of our larger remaining technical concerns are: 1) close to half of the worst one day crashes in history have happened on a Monday typically following a bad week ending on a bad Friday which is what just happened, and 2) the VIX closed at 29 which is below the 40 threshold we prefer to see.

Rallies within brutal bear markets are common and we hope our technical indicators help our shorts avoid the worst of these and enable us to buy longs at statistically favorable times. We have analyzed eight different bear markets but would note the statistics for the following periods which we think have similarities to the current period of time. During the Global Financial Crisis, the S&P had 11 rallies in the S&P that averaged 10% while there were 12 declines averaging 15% over nearly a year and a half. The total price decline was 57%. During the Tech bubble bursting, the S&P rallied 7 times averaging 14% while falling 8 times averaging 17% over 2 ½ years. The total price decline was 49%. And finally, over nearly two years in the early 1980s when Fed chairman Paul Volcker was fighting inflation, the S&P rallied 7 times for 8% while dropping 8 times for an average of 10%. The total price decline was 27%. This in our view is the most comparable bear market. Even during the one month 34% sell-off during covid in early 2020, there were 4 notable rallies that averaged 7%, but given 3 of them were one day moves, we do not believe they are as relevant.

In summary, we think we are close to a near-term low and wanted to reposition to take advantage of that in both our short and long positions. For those that want to stay focused on the long-term and do not have the time to manage your investments daily, we think the lows for the market still lie ahead.

9 Comments

Update on VIACOm ($VIAC)

1/2/2022

1 Comment

At the end of every year, I try to look back at some of the biggest mistakes to learn from them. Viacom ($VIAC) is certainly one of those. I have also received many requests on social media for an update on my thoughts and at times 280 characters can be a bit too restricting.

RECAP of $VIAC

Back in 2020, I talked about VIAC being a more value centric way to participate in the excitement around streaming. VIAC’s stock surged and reached $100 on 3/22/2021 from $37 to start the year. In hindsight, much of the move in this name was driven by relentless buying by Archegos Capital Management, a ~$20B hedge fund. VIAC’s stock quickly retraced those moves as an extremely well-timed capital raise by VIAC and the high-profile liquidation of Archegos drove VIAC’s stock down to an intraday low of $40 on 3/26.

To us, this move lower created a very interesting buying opportunity which we talked about subsequently on air. But as of year end the stock is even lower at $30. So, what happened?

Fundamentally, VIAC rev expectations have been drifting up through 2021 driven by streaming revs that have also been going higher. Given the losses in Viacom’s streaming business, this has driven EBITDA and EPS expectations lower which is natural as they gain scale in streaming. As discussed later, streaming leader Netflix (NFLX) lost money for eight years before 2020 and should be cash flow breakeven in 2021. Obviously NFLX’s stock has done well over this time driven by subscriber growth, the most watched metric. But obviously subscriber growth did not help VIAC’s stock price this year. So what happened?

In our minds, there were two main driving forces after the Archegos meltdown that drove VIAC’s stock price even lower: 1) the leaders in the streaming space started missing their subscriber expectations and 2) treasury yields started to rise this year creating a greater focus on profits versus just growth.

Driving Force 1:
Subscriber Misses by Streaming Leaders

In 2021, NFLX missed both Q1 and Q2, Disney (DIS) missed Q3, and Roku (ROKU) missed Q3. Traditional media company Discovery (DISCA), which is also pushing hard into streaming by merging with AT&T’s Time Warner division, missed their Q3 as well. When the leaders in a particular space miss, investors typically assume that the smaller players will suffer even more. If you believe that growth is slowing at the leaders like NFLX, DIS, or ROKU why wouldn’t growth at a smaller player like VIAC eventually slow as well especially when even their peer DISCA missed? Furthermore, there is less career risk as a portfolio manager for owning an industry leader like DIS or NFLX than VIAC if all of their stock prices decline. As a result, sentiment for VIAC soured as well as for the other players in the streaming space.

Driving Force 2:
Rising Treasury Yields & focus on profits

As interest rates started to rise from 0.9% on the 10-year treasury to roughly 1.5% at year end, investors started to focus more on the profitability of companies in addition to their growth in all spaces. While streaming is a fast-growing business, it burns a lot of cash. For example, the free cash flow (FCF) of streaming leader NFLX was negative $3.3B in 2019. In fact, FCF was positive for the first time in nine years at $1.9B in 2020. But even that profit was due to an unsustainable decline in content production and a surge in subscribers both driven by Covid. In 2021, despite 214M subscribers as of Q3 and expected revs of $29.7B for the year, NFLX’s FCF is expected to be neutral as production expenses ramp back up and subscriber additions slow down. On a positive note, FCF is expected to be positive every year thereafter.

For VIAC, they have had upside to their subscriber expectations for the past nine months, but they have not disclosed their: 1) FCF losses from streaming; or 2) the timeline for these losses to peak or turn positive. Given streaming leader NFLX is just at FCF breakeven with 214M subs, investors are understandably nervous about VIAC which has 47M streaming subscribers with an additional 54M advertising supported streaming subscribers from Pluto TV. Additionally, EBITDA expectations have drifted lower in 2021 as VIAC has made the prudent business decision to invest more in streaming given the growth they are seeing in subscribers.

Predictions looking forward

Q4 results for VIAC should breakout 1) their three separate divisions (Direct to Consumer, Studios, and Networks) and 2) their operating profits/losses for the first time. We believe the company will increase their subscriber forecasts for the long-term given the positive momentum in this business. We see VIAC both adding more streaming subscribers in Q4 than Q3 and in 2022 than in 2021. But we forecast that the losses in their streaming business will increase through 2022 as they invest to launch in Europe in the second half of 2022 with losses peaking at some point in 2023/24. We expect EBITDA/EPS expectations to be reduced as a result. Given the strength in their streaming business in contrast to others which disappointed such as NFLX, DIS, ROKU or DISCA, we believe this is a good investment for the long-term. Unfortunately, if the current sentiment persists, there is risk the stock may go lower in the short-term much like it did on Q3 results despite strong streaming rev growth of 62% y/y.

Conclusion

I am an investor that likes stocks with growth at a reasonable price. VIAC trades at 8x CY22 PE despite their streaming revenues up 62% y/y. This is incredibly cheap compared to streaming leaders NFLX (46x PE; revs up 16% y/y in CQ3), DIS (~34x PE; streaming revs up 38% y/y in CQ3), and ROKU (~121x PE; revs up 51% y/y in CQ3.) These streaming leaders are all growing their streaming revenues slower than VIAC yet fetch much higher multiples. In addition to VIAC's asymmetric growth vs. valuation profile, VIAC’s $1.1B in streaming revs in their September quarter grew to 16% of overall company revenues. NFLX is trading at 10x trailing sales. VIAC should do close to $5B in streaming revs this year, so it does not seem unreasonable to assume $50B is a reasonable valuation for this business alone. However, all of VIAC has a market cap of only $21B with ~$10B of net debt assuming current announced deals close.

From a subscriber perspective, NFLX had 214M subscribers at the end of Q3:2021 with a market cap of $267B. A valuation of ~$1,250 per subscriber. VIAC now has 47M streaming subscribers with 54M ad supported streaming subscribers from Pluto TV with a market cap of $21B. Just the value of the pure streaming subscribers for VIAC is $59B on this metric.

While we have admitted our mistake and cut our position in VIAC to take a tax loss for 2021, upcoming Q4 results and the outlook for streaming losses hopefully sets a bottom for the stock and sets the name up for a good rest of 2022. Investors may want to go to the sidelines until guidance is given on Q4 results or sentiment reverses for the company.

Today VIAC is viewed as a melting media ice cube and streaming loser. We believe VIAC will slowly become recognized as a contender along with NFLX and DIS in the streaming wars. VIAC has one of the broadest offerings of all the streaming services with sports, movies, news, unscripted, adult, and kid content. This should lead to a higher multiple much like we saw with DIS when their streaming business really took off. We believe the stock is still significantly undervalued long-term based on their streaming momentum. Time will tell.

Best wishes for your investments in the New Year.

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Top 5 stock picks for 2022

12/28/2021

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Recap of our top 5 Stock picks for 2021

Our top 5 picks for 2021 are up a solid 25% on average through 12/28/21 following a powerful 60% return in 2020 for our Top 5 picks. While our top 5 picks for 2020 were technology focused ($AMD $DIS $FB $LITE $NVDA), our top 5 picks for 2021 had a value reopening bias and were $XLE $JPM $ORCL $MGA $BETZ (replaced $GAN on 1/19/21)

$XLE (up 48% YTD) benefitted from oil prices that rose over 50% in 2021 as investors gained more confidence in the world surviving the global pandemic and slowly reopening. We see Covid by late 2022 being more transmissible but less lethal with each mutation as is common with most viruses. Furthermore, we will have the development of more vaccines, including oral pills, and home testing capabilities. A year from now, we see Covid being viewed much like the flu which still kills 30-40K people each year in the US but is an acceptable risk of living life. When global mobility returns and manufacturing bottlenecks ease, crude consumption of roughly 96M barrels per day in 2021 could rise in 2022 to surpass the pre pandemic record of 99.6M in 2019. At the same time, supply will be restricted by environmental considerations. This should pressure oil prices higher in 2022. We continue to like this sector but with a different investment as you will see in our Top 5 Picks for 2022.

$JPM (up 25% YTD) benefitted from 10-year treasury yields that rose from 92 bps to 148 bps as investors gained more confidence in the world surviving the global pandemic and slowly reopening. As easy monetary and fiscal policies get dialed back in 2022, corporations and individuals will increasingly have to turn to the banking system for their financing needs going forward. In addition, as rates head higher in 2022, this will allow banks to lend at higher levels and increase their profitability. Valuations at a discount to the S&P combined with solid dividend yields should enable the sector to be also more defensive during market turbulence. We still like exposure to the banking sector for 2022. We continue to like the financial sector but with a different investment as you will see in our Top 5 Picks for 2022.

$ORCL (up 37% YTD) saw investors rerate their valuation multiple higher based on improving prospects for their cloud business as we predicted. Their pending acquisition of $CERN has disrupted the upward momentum in their stock driven by their cloud business. However, we believe at some point the stock will bottom and have a solid 2022 given the longer-term merits of the acquisition on their earnings, cloud revenues and healthcare business.

$MGA (up 13% YTD) surged to start the year (up 47% by 6/4/21) as a cheap play on Electric Vehicles but gave back most of those gains as semiconductor shortages affected production. We still like exposure to the EV theme over the longer-term but are exposed to it through a long position on $GM (0.6x 2022 EV/Sales) hedged with shorts on the more speculative EV car manufacturers (OEMs) (~25-30x 2022 EV/Sales.) These shorts we trade frequently given their high volatility and retail investor driven moves. Overall, we believe that EV industry revenues will continue to grow at over 25% per year for the next 5+ years as countries and OEMs try to reach their EV goals. We prefer a value-oriented approach to investing in the EV space in 2022 as Central banks raise rates which is likely to compress multiples in the market for long duration, unprofitable names with high valuations. In addition, even industry leader Tesla had to struggle with issues when they ramped manufacturing. Supply chains today are still challenging with the traditional car manufacturers all trying to ramp their EV vehicles as well. This is likely to create manufacturing issues for the newer pure EV public companies.

$BETZ (down 5% YTD.) We replaced $GAN, up 16% from 12/31/21-1/19/21, with $BETZ, up 11% from 12/31/21-1/19/21 (see danniles.com/articles/01-19-2021) as a top pick given our concerns around $GAN or any individual investment in the space. The combined return was flat YTD ($GAN up 16.4% from 12/31/21-1/19/21 minus $BETZ which lost 14.4% from 1/19/21-12/28/21). In hindsight, we should have been more concerned. $BETZ was our worst pick and went from being up 27% on 3/15 to down 5% YTD. This was due to a combination of: 1) a high tax rate in New York on online sports betting; 2) intense price competition for customers; 3) greater variability on sports book profits; 4) pushed out profitability on greater investments; and 5) China regulatory and Covid related issues in Macau. In particular, the increasing focus on profits by investors in 2021 offset the positives of ongoing strong revenue growth of the industry. For example, sports betting bell weather $DKNG should see revenues roughly double this year while the stock is down 39% YTD. We also think tax loss selling and window dressing by portfolio managers has also punished the space into year-end. However, we still see many tailwinds for the sports betting space despite stock price performance this year. State legalization of sports betting is at nearly 30 states today with roughly 20 allowing online betting. Continuing legalization and more in game sports betting will be a tailwind for the next several years. Much like the surge seen in e-commerce names following the shakeout during the tech bubble ($AMZN’s stock went from $106 to $6 from peak to trough) we think the same recovery will occur in online sports betting as the space continues to mature and the path to profitability becomes clearer for the long-term winners. Internally, our investments are more focused on the data providers to the sports betting companies hedged with shorts in the unprofitable sports betting operators.

Top 5 stock Picks for 2022

As we look into 2022, our portfolio is built around 4 themes: 1) inflation remaining higher than expected following multi-decade highs; 2) the removal of unprecedented stimulus and subsequent raising of rates; 3) the stock market valuation compressing from record levels; and 4) the acceptance of Covid as endemic.

With this as our backdrop, our top 5 picks for 2022 are: 1) $USO, 2) $KRE, 3) $FB, 4) $GOOGL and 5) cash.

$USO: As noted earlier in our recap of the $XLE, we believe oil prices will continue higher as demand in 2022 could surpass the record levels seen prior to the pandemic while supply remains restricted by environmental concerns. We debated staying with the $XLE for the reasons noted earlier in our recap but note 43% of the ETF is comprised of just $CVX and $XOM which are up 50% and 41% YTD, respectively. This is not the same setup as in 2020 when they were absolutely hated and down 30%/41% respectively versus the S&P gain of 16%. As a result, we recommend the $USO which tracks the price of West Texas Intermediate crude oil as a top 5 pick for 2022.

$KRE: As noted earlier in our recap of $JPM, we believe rates are headed higher and loan growth will pick up as easy money from fiscal & monetary policies get dialed back. We debated continuing with $JPM as a top pick for 2022 given our belief that it is the best run bank in the world. However, we prefer more domestic banking exposure this year to avoid any potential pitfalls from divergent central bank policies globally. In addition, there is the growing risk of international conflict with: 1) Russia over the Ukraine; 2) China over Taiwan; and 3) Iran over nuclear. $JPM has roughly 25% of its exposure to international markets. Super regional banks are certainly an option which is how internally we have created our exposure to the banking sector. However, there is company specific risk. As a result, we recommend the $KRE which is a regional US bank ETF which is well diversified with a 2% position as its largest holding for those investors who want diversified, less risky exposure to financials. Most investors track loan profitability by watching the 10-year minus 2-year or just watch the 10-year as a shortcut. However, we would recommend watching the 5-year minus the 3-month treasury yield which more closely tracks loan profitability. The second factor to watch is loan growth which should pick up with easy monetary and fiscal policies being reduced.

$FB: If you believe in the metaverse, why not invest in the company that has gone “all in” on the space. Facebook’s expense guidance for 2022 is being driven by investments in the metaverse with operating costs for 2022 guided to $91-97B, up ~33% from 2021 while capital expenditures of $29-34B were guided to rise ~66%. However, with street expectations for revenue growth of just 19% this has driven EPS growth expectations to just 3% in 2022. Historically, Facebook has guided conservatively and therefore we believe expense growth will come in lower than expected. Furthermore, the monetization of newer properties such as Reels and Shopping will help drive revenue growth in 2022. Additionally, the stock has a depressed multiple at 22x that is roughly the same as the S&P at 21x. This is due to: 1) expense concerns; 2) ad tracking issues; 3) engagement concerns due to competition such as TikTok; and 4) regulatory pressures from the US and abroad. We believe most of these issues will slowly improve as 2022 progresses resulting in multiple expansion.

$GOOGL: As economies reopen, Google will benefit from Covid affected industries, that comprise 10-15% of revs, fully re-opening by the end of 2022. In 2021, Google suffered from increased regulatory pressure and ad revenue from travel, leisure, and services space still being impacted due to Covid. By the end of 2022, we believe people will adjust to Covid being endemic much like the flu which kills 30-40K people every year in the US. As a result, we believe Google will benefit from the complete reopening of industries that are currently being impacted by Covid. Google also has a CY22 PE multiple of 23x that is only at a slight premium to the S&P at 21x. In addition, Google offers exposure to other high growth themes through its “Other Bets” division such as Artificial Intelligence (DeepMind), Health (Fitbit and Verily), and Autonomous Driving (Waymo.)

Cash: We believe that we will be able to pick up great stocks at much better prices in 2022 and that the value of cash is highly underestimated during periods of turmoil. Despite cash being a poor investment in a high inflation environment, it is probably our favorite investment to start the year due to the flexibility it will give us later in the year to invest at better prices. We believe that in 2022, the S&P will see a significant correction due to: 1) inflation staying uncomfortably high; 2) a Fed that is behind the curve on inflation and more aggressive than expected; and 3) most valuation metrics near record highs that are likely to compress. For example, the market cap of the entire US stock market divided by US GDP is at 1.9x versus a peak during the tech bubble of 1.4x and an average of 0.8x. We would also note that market multiples are typically below average in periods where inflation was over 3%. We plan to invest this cash later in 2022 in a more value-oriented name in a sector such as networking, streaming, or e-commerce.

Best wishes for your investments in 2022,
Dan

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Market Thoughts: Update

9/24/2021

21 Comments

Summary of Market Thoughts
We believe the #1 question right now for investors is how the stock market will react as the Fed starts to taper probably in November. In 2011, 2015, 2018, and 2020, the stock market fell 10-20% over 1- 5 months during periods when monetary stimulus was flat to down. And the current daily amount of stimulus is roughly 10x what it was pre-pandemic given there was $3.2 trillion of stimulus over 11 ½ years following the GFC versus $4.3 trillion in just 1 ½ years since the pandemic. This would not matter nearly as much if 1) most valuation metrics were not at record levels, 2) inflation was also at decade highs, and 3) growth forecasts were getting cut due to the delta variant, cost pressures and supply chain issues.

Details
The year the pandemic started, the S&P500 was up 16% in 2020 on a price basis and so far it is up another 19% in 2021 despite the pandemic being ongoing. The annual historical price return for the S&P is 6% since inception so either the Pandemic is 3-4x better for the world than a normal environment or something else is driving returns.

What the past couple of years have proven is tremendous stimulus, like a powerful drug, can overwhelm the normal reaction to a cataclysmic event like a global pandemic but eventually a price will have to be paid. In this case we think the price will be persistently high levels of inflation. And the resultant necessary withdrawal of that stimulus causing the inflation will cause some powerful withdrawal symptoms. Our portfolio construction is driven from this thesis on both the long and short side.

All good things must come to an end and rising persistent inflation after 13 years of easy money policy since the GFC, marks that end.

Inflation continues to be strong and at decade highs in many cases. Headline CPI of 5.3% and core CPI of 4.0% are at their highest levels in over a decade. We view inflation as more persistent rather than “transitory.” Wage increases and rental costs should continue to drive high levels of inflation despite some commodity prices retreating from their highs during the pandemic.

June home prices were up 19% y/y, surpassing the housing bubble peak, and is the highest on record since 2000. Home prices typically lead owners' equivalent rent (OER) by a year which is already up 2.6% y/y and is 30-40% of most inflation metrics and larger than food and energy combined for the consumer.

Wage increases (average hourly earnings up 4.3% y/y) are being driven by the strong improvement in the employment picture with 10.9M job openings versus 8.4M unemployed. As a result, the unemployment rate is down to 5.2% versus a 70 year average of 5.8%.

The employment picture seems to meet the Fed’s “substantial progress” hurdle and as a result we expect the Fed to taper in November and raise rates multiple times in 2022 to deal with inflation that is more persistent than “transitory.”

Given the market cap divided by GDP of the stock market is at 2.0x versus a peak during the Tech Bubble of 1.4x and 50 year average of 0.8x, we feel the downside risk is large. Despite 50% earnings growth from 1972 to 1974, the stock market declined by ~50% driven by persistently high inflation and slowing growth crushing market multiples (despite this also being called a “transitional period of cost-push inflation” at the time by then Fed Chairman Arthur Burns).

The longest serving Fed Chairman, William McChesney once said "the role of the Federal Reserve is to remove the punch bowl just as the party gets going." After $3.2T in stimulus over the last 11 ½ years following the Global Financial Crisis, the Fed increased the daily alcohol content by 10x and added $4.3T in stimulus over the past 1 ½ years since the pandemic. But all good things must eventually come to an end and tapering followed by rate hikes in 2022 will force investors to sober up.

Portfolio Positioning
We are trying to maintain as many shorts as longs in the portfolio.

Our favorite theme into year-end is sports betting as represented by the $BETZ ETF. Over 2 dozen states have legalized sports betting, but only 15 states have legalized online sports betting with more coming. In game advertising is being allowed by the NFL for the first time this season for sports betting operators. We believe this is one of the last big markets to go online. This space should grow revenues at over 30% a year for at least the next 5+ years.

We also recently bought $ATVI (one of our top 5 picks last year) given the decline of their stock driven in large part around their legal issues with the stock now down 20% YTD. We believe momentum is strong in the video game space as more people that were acquired during the pandemic are staying to play than expected. While the workplace legal issues are certainly serious, we do not expect it to affect consumer buying habits of video games. Given the lack of next generation consoles available in the holiday quarter last year due to the supply chain issues caused by Covid, we believe video game sales will hold up better than other sectors like streaming or e-commerce this holiday season. People should finally be able to get their hands on the new Xbox and PS5’s that were so hard to get during the peak of the pandemic. A bigger base of consoles will drive more video game purchases this holiday season. We think that online gaming is becoming another big entertainment source for the younger generation of consumers in addition to streaming content and social media.

Our favorite sectors in technology include legacy enterprise tech names that were hurt during the pandemic but should benefit as people go back to work such as Oracle, Cisco and recently added Dell. We added Dell post the sell-off following their quarterly results in anticipation of the VMware spinoff. These names all trade at valuation levels well below the S&P multiple and both $ORCL and $CSCO have solid dividends with a dividend coming from $DELL post the VMW spinoff. They were all hurt by the pandemic last year as businesses cut back spending while their employees ramped up their spending and worked from home. These trends are reversing as economies slowly re-open.

We recently added to Viacom ($VIAC) at a 10x PE given strong momentum in their streaming business which is in sharp contrast to slowing at Disney ($DIS) and Netflix ($NFLX) both at ~50X PEs. Viacom’s streaming revenues were up over 90% in their June quarter to nearly $1B and momentum is expected to remain strong into next year given they are expanding internationally and ARPU should go up. For now, investors still think of them as a traditional media company, but we believe that will change and the difference in results among the relevant players during the upcoming earnings season may help that process along.

In mega-cap technology, our favorite name remains Google ($GOOGL.) They will benefit as economies re-open given 10-15% of their revenues are in the travel and leisure vertical. Revenues are expected to grow 38% this year and even grew 14% last year despite the recession. A 24x PE is inexpensive compared to the S&P at 22x for this type of growth.

We also like the financial sector (best represented by $XLF.) This sector should benefit from being able to lend at higher interest rates given our view that 10-year treasury yields should reach 2% by year end due to high inflation and Fed tapering.

We also own energy names (best represented by $XLE.) Oil prices have held in better than we would have expected despite the cuts to global growth forecasts due in part to the delta variant and supply chain issues. Oil demand should continue to improve as economies continue to reopen.

Against these positions, we are short a basket of names sitting near all-time record highs weighted towards the tech sector and names that benefitted from the pandemic.

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AAPL: From Long to Short

9/14/2021

1 Comment

We have reversed our Apple position from being one of our larger long positions in August to being one of our larger short positions currently. We see upcoming iPhone 13 launch as being evolutionary with some slight changes to the notch size, battery life and camera. This follows the revolutionary 5G launch last year. Also iPhone launch prices will likely go up relative to last year from inflation in the underlying components like semiconductors. As a result, we believe sales in the second half of the year are likely to be disappointing as consumers retrench from pandemic driven sales last year.

Apple has been a big beneficiary from work/learn from home trends since the pandemic. Both Mac & iPad sales were down year over year in the December quarter of 2019 before covid but were up over 70% in CQ1 of this year driven by learning from home. iPhone sales were down in 4 of the 5 quarters prior to Covid but were up 66% in CQ1 of 2021 driven by work from home and the launch of 5G phones.

iPhone revs in FY2020 (September FY end) were 11% below FY2015 levels given incremental improvements led to lengthening replacement cycles. As a reminder, global smartphone units were down for 4 years in a row prior to 2021. Global penetration of smartphones is high at ~50% at nearly 4B users versus an installed base of 1.5B PCs for comparison. Meanwhile smartphone replacement cycles were lengthening prior to Covid as changes were incremental driving this decline in units. In addition, we expect pressure on Apple’s App Store revenues given the recent EPIC lawsuit results and regulatory pressures globally on App Store commissions.

Technically, investors have also had a tendency to “buy the rumor and sell the news” when it comes to Apple product launches. Looking at data going back nearly 20 years, from a technical basis, Apple is typically up about 3/4ths of the time in the month leading up to their product launches but is down 3/4ths of the time the day of the event. The stock also is roughly flat for the two weeks following the product launch before starting to climb again.

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Barron's Live: The Outlook for Tech Stocks

8/2/2021

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China finally worried about drop in stocks: potential bottom

7/30/2021

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COVID, INFLATION, and how to Navigate the Market

7/22/2021

5 Comments

This market is a lot like a duck, it is calm on the surface but there is a lot of churning underneath.

https://www.pinterest.com/pin/146085581632687903/

Image: by Ruslan Khaydarov

As I write this on Thursday night (7/22), the S&P is up 16% YTD and just 1% below its all-time record high on 7/12. However, there has been a violent rotation underneath this seemingly linear move higher in the S&P. Versus their 52-week highs, the Russell 2000 index has fallen 7% and the 10-year treasury yield has gone from 1.78% to 1.28%. The most recent advance in the S&P, however, has been driven by the S&P technology index which was up just 1% till May 12th and since then has advanced 17% in just over 2 months.

A few factors seem to be driving these moves including: 1) a surge in the Delta variant of Covid shutting down parts of the world again, such as no spectators being allowed at the Olympics; 2) peak growth concerns as we lap the worst of the Covid-19 shutdowns a year ago; 3) seemingly more belief in inflation being “transitory” as prices for certain commodities like lumber have gone lower; 4) 10-year Treasury yields retreating from a high of 1.78% to 1.28%.

Since their highs early this year, sectors that were outperforming YTD that were geared to economies reopening and higher inflation have sold off. From their 52-week highs, the S&P energy sector is down 13% (up 29% YTD), the materials sector is down 9% (up 12% YTD), financial sector is down 6% (up 23% YTD) and the industrial sector is down 3% (up 16% YTD).

Our view remains that economies will slowly continue to re-open as more people get vaccinated and reach herd immunity. The Olympics banning spectators was clearly a watershed event given it was already postponed. Having said that, roughly 3.6 billion vaccine doses have been administered worldwide. Our view has been that as the weather gets colder, much like other coronaviruses such as the flu, Covid will also see a pickup in cases. We also believe, much like the flu, that every year we will be getting a Covid shot given coronaviruses are known for rapid mutation. However, close to 30M vaccine doses are being given daily. Given the desire for humans to interact with each other, we think we will eventually develop new ways of socializing despite the presence of Covid, whether it is wearing a mask at events or getting screened before entering venues.

We also believe that inflation will be more persistent than transitory. Headline/Core CPI are at 5.4%/4.5%. These are the highest levels since Aug-08/Nov-91. Core PCE, the Fed’s preferred inflation metric, averaged 1.6% for the prior decade. Any concerns about inflation due to the easy money policies following the Global Financial Crisis (GFC) have been wrong. Our view is that inflation today will be more persistent versus transitory. While clearly some increases are transitory such us comparing oil prices to negative $35 last April, other inflation components like wage and rental price increases we think will be more persistent given structural changes.

“Although incoming inflation data are somewhat elevated, a portion of the increase… appears to have been due to transitory factors.” (6/30/04 FOMC statement). However, what followed was 17 rate hikes over 2 years which took the Fed funds rate from 1.00% to 5.25% that ultimately culminated in the Global Financial Crisis as the Fed dealt with inflation that was persistent not transitory.

We believe wage inflation is going to be the big problem going forward and these increases are persistent and feed through to the cost of final goods and services. Average hourly earnings were up 3-3.5% in the second half of 2019 as wage pressures started to build. Currently, the Job Openings and Labor Turnover Survey (JOLTS) is 9.2M and compares to 9.3M people that are unemployed and an unemployment rate of 5.9%. It took over 8 years for the number of people unemployed and job opening to overlap following the global financial crisis versus just over a year following Covid. Average hourly earnings are already up 3.6%. We believe the unemployment rate will move down rapidly as generous extra unemployment benefits expire in September with over 20 states already starting the process before then. These wage pressures are only going to get worse as we head towards the holidays when more seasonal workers get hired.

The rise in shelter prices is notable with owners' equivalent rent (OER) up 2.3% y/y and home prices up 15% y/y. April home prices, per the Case Shiller index, is up 15% y/y which is the highest since December of 2005. Owners' equivalent rent (OER) is up 2.3% y/y and is 30-40% of most inflation metrics and larger than food and energy combined. OER typically lags home prices by a year so we would expect pressure on rents to continue.

And the Fed looks increasingly behind the curve as the central banks of both Russia and Brazil have raised rates three times each while England joined Canada to become one of the two G7 central bank to start tapering. Inflation has been relatively non-existent since the GFC (and arguably for 40 years) but now is picking up globally. Russia, Brazil and Turkey, are among the 19 central banks that have raised their main interest rates so far this year. In total there have been 29 rate hikes this year already. Russia’s central bank said earlier this year, "the rapid recovery of demand and elevated inflationary pressure call for an earlier return to neutral monetary policy."

We believe the Fed will signal the start of their own tapering process by the August Jackson Hole meeting. The Fed continues to reiterate their belief that inflation is “transitory”, but their dot plot has 2 rate hikes in 2023 and they need only 2 more votes for a rate hike in 2022. In our opinion, inflation data for the next several months will force them to change their stance by the Jackson Hole meeting.

In 2011, 2015, 2018, and 2020, the stock market fell 10-20% over 1- 5 months during periods when monetary stimulus was flat to down.

In 2011, the Fed hinted at not expanding its asset purchase program just before a 19% drop in the S&P 500 over 5 months.
In 2015, talk of balance-sheet shrinkage preceded a 12% S&P decline in just a month.
In late 2018, a comment about the Fed balance sheet un-wind on “autopilot” plus the ongoing trade war coincided with a nearly 20% S&P drop in 3 months.
In 2020, the S&P dropped 10%, with 7% in just three trading days starting on 9/2. The Fed balance sheet had been flat to down since mid-June.

GDP growth will be the best in decades both in the US and globally in 2021 driving even more demand pressure on inflation. US GDP growth following the GFC from 2010 to 2019 averaged 2.3%. This was the slowest recovery following a recession since World War II. As a result, companies continued to cut back on capacity expansion to match the lower-than-expected growth. In 2020 following the pandemic, capex was cut back particularly hard as many companies tried to survive the unprecedented drop in prices. As a reminder, oil got to negative $35 dollars per barrel at one point. However, US GDP growth is expected to be ~7% in 2021, the fastest since 1984 at 7.2%. World GDP growth is expected to be 6%, the highest since 1976, after falling 3.3% in 2020. We believe, this surge in GDP growth combined with low capital expenditures will lead to a persistent, not “transitory”, increase in inflation.

The Fed may need to act in a more disruptive manner than what they have done in the past. Historically, the Fed has acted preemptively to fend off inflation. With their new policy of waiting to see if inflation is present before acting, there is a real risk of having to reverse policy much more quickly than in the past. If inflation turns out to be more persistent than transitory, a rapid tightening in policy might be needed. With valuations at record highs, this might cause a much sharper stock market correction than seen during past tightening cycles, which can lead to slower growth in the future. This might not be a near-term concern, but it is important to monitor, as this can be a portfolio changing event in the long term.

Record valuations magnify the risk to the downside given the total market cap of the US stock market divided by GDP is at a record 1.9x versus 1.4x at the peak of the tech bubble and a 50-year average of 0.8x. This incredible multiple expansion has been driven by the repression of interest rates by the Fed buying bonds. This has driven up valuations of the entire market but especially of technology stocks. We would note that this ratio went from 0.84x in late 1972 to a low of 0.35x in late 1974 due to rising inflation.

It is estimated that by the end of Q1, there was also over $5.4 trillion (6% of global GDP) in excess consumer savings since the coronavirus pandemic began and the US has $2.6 trillion (12% of US GDP.) Given many activities have been halted during COVID-19, the US savings rate exploded to 34% in April 2020 from 7-8% prior to COVID-19. This is more than double the previous all-time high of 15% in 1975. Currently, this rate is sitting at 12%. When global economies reopen, this excess savings is likely to be spent and drive a surge in demand and more persistent inflation.

There are many signs of a bubble, but bubbles can continue for longer than anyone suspects. Meme stock prices, Bitcoin prices, a non-fungible token (NFT) by Beeple (an unknown artist just a few years ago) selling for over $60M are just some signs of excess in this market. Former Federal Reserve Chairman Alan Greenspan famously talked about “irrational exuberance” in the financial markets. Most forget this comment was in late 1996, and the S&P peaked in March of 2000 after having more than doubled from the time of his original statement. When the current bubble eventually bursts, it will take all stocks down, not just the more speculative stocks that are being bid well beyond normal valuation metrics.

Amazon had revenues of $1.6B in 1999 which grew to $3.1B by 2001 but the stock however went from $106 at its peak in 1999 to $6 at its lows in 2001 when the bubble broke. Roughly 4000 other internet related companies went out of business. Some of the most exciting technologies of today such as artificial intelligence, bio-technology blockchain, crypto currencies, digital banking, electric vehicles, green energy and virtual reality, are likely to change the world much like e-commerce did in the late 1990s. This does not mean that investments in this space cannot get crushed if history is any guide.

Our hope is that our shorts will outperform when this bubble breaks and enable us to cushion the portfolio against a correction much like in Q1 of 2020 during the emergence of COVID-19. In addition, our longs are primarily stocks that have growth at a reasonable price (GARP) that we believe will decline much less during a market correction. Risk management for both our long and short positions is key in this environment.

In Summary
The drivers for the US stock market record highs remain the same:

The Fed balance sheet hit a new record of $8.2 trillion and is up 18% y/y after being up 77% last year.
Money supply is up 14% y/y (peaked at a record 27% in Feb) vs a peak of 10% during the GFC and 14% in the 1970s.
Vaccinations & progress towards herd immunity continue.
The macro data is strong with the best GDP growth in decades.
The employment picture continues to improve with weekly jobless claims near 400K for the first time since the Pandemic.
Excess savings during the pandemic will be spent adding fuel to the recovery.
More Federal government stimulus is expected. Looking forward, the Biden administration is trying to pass another $4-5 trillion in stimulus between the Infrastructure Plan and the American Families Plan.

However, history has not been kind to the market when the Fed balance sheet has shrunk in the past and we believe a 10-20% correction in the S&P before year-end is likely.

The market cap of the entire US stock market divided by GDP is at 1.9x compared to the peak of the tech bubble at 1.4x and 50 year average.
Inflation, driven by rising rents and higher wages, is more likely to be persistent than transitory.
Inflation along with higher taxes is likely to eat into future corporate earnings.
The Fed looks increasingly behind the curve compared to other Central banks that have already started tapering or raising rates.
The Jackson Hole Symposium in August could mark a major shift in the Fed’s policies.
World changing technology stocks with the highest valuations may suffer the most during a Fed induced sell-off much like after the tech bubble burst in 2000.

Through year end, we are managing the portfolio carefully with valuations & earnings expectations near record highs. We are favorable to sectors geared towards re-opening ($XLE -energy, $GOOGL- advertising), higher inflation (financials-$JPM) and enterprise demand picking up in technology ($ORCL $CSCO) while consumer demand cools from pandemic highs.

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MID Q2 Market Update

Market Thoughts Following Q1

Introduction

Summary

FUll Article

Investments

Managing The Risk in Your Portfolio

Covering Shorts & Putting Cash to work

Update on VIACOm ($VIAC)

RECAP of $VIAC

Driving Force 1:
Subscriber Misses by Streaming Leaders

Driving Force 2:
Rising Treasury Yields & focus on profits

Predictions looking forward

Conclusion

Top 5 stock picks for 2022

Recap of our top 5 Stock picks for 2021

Top 5 stock Picks for 2022

Market Thoughts: Update

AAPL: From Long to Short

Barron's Live: The Outlook for Tech Stocks

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COVID, INFLATION, and how to Navigate the Market

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Introduction

Summary

FUll Article

Investments

Managing The Risk in Your Portfolio

RECAP of $VIAC

Driving Force 1:​Subscriber Misses by Streaming Leaders

Driving Force 2:Rising Treasury Yields & focus on profits

Predictions looking forward

Conclusion

Recap of our top 5 Stock picks for 2021

Top 5 stock Picks for 2022

Author

Archives

Categories

Driving Force 1:
Subscriber Misses by Streaming Leaders

Driving Force 2:
Rising Treasury Yields & focus on profits