The S&P 500 was up 18% on a total return basis in 2020 driven primarily by a 77% expansion in the Federal Reserve Balance sheet to $7.4 trillion from $4.2 trillion and nearly $4 trillion in government stimulus. The fastest drop in history from an all-time high to down 30% for the S&P was rapidly regained and forgotten.
Simple way to think about the fed
The Federal has multiple ways to stimulate economic growth including: 1) The Federal Funds rate, 2) the purchase of assets such as bonds (Quantitative Easing) which shows up on the Federal Reserve Balance Sheet, and 3) regulation, including capital requirements like the Supplementary Leverage Ratio (SLR), on banks that lend to corporations and individuals. Simply, there is the rate you can borrow loans at, the amount of loans available to borrow, and the restrictions on how to get the loans. The reason low interest rates are a way to stimulate the economy is because it makes debt cheaper to borrow to finance spending for corporations as well as consumer purchases of goods like homes and automobiles. However, even if interest rates are low, if the Fed restricts the ability of banks to lend, while loans may have a low interest, they are harder to come by. This effectively begins to “taper” the easy money policies that have been in effect since the Global Financial Crisis and particularly since the advent of Covid.
One easy way to measure the impact of Fed policy is by looking at the supply of money in the market (M2). If the money supply is up a lot year-over-year, then it is easy for consumers and corporations to get money. If the supply of money starts to contract, then it gets harder. Money Supply (M2) is up 26% y/y vs a prior record of 14% set in the 1970s, and a high of 10% during the global financial crisis.
THe Recent Sell off
As I write this today (3/19), the S&P hit another record high on 3/17 (up 5.8% YTD) with stimulus checks and Fed balance sheet expansion driving it higher. Stimulus checks from the $1.9 Trillion Covid relief package reached consumers this week. According to a Deutsche Bank survey, retail investors planned to put 37% of any forthcoming stimulus checks directly into stocks, which could represent $170 billion. In addition, the Federal Reserve Balance sheet hit a new record high of $7.7 trillion on 3/17 (up 65% y/y.)
The market sold off to end the week following the Fed meeting and their decision not to extend the SLR which to us starts the process of a stealth tapering. The SLR was an emergency move put in a year ago by the Fed that allowed banks to exclude U.S. Treasuries and reserves at the Federal Reserve from the Supplemental Leverage Ratio calculation. Simply put, this allowed banks to hold less capital and lend more money during the recession caused by Covid. The Fed, in our opinion, signaled on 3/17 that they might not extend the Supplementary Leverage Ratio (SLR) when they hiked the Reverse Repo counterparty limit from $30 billion to $80 billion. This is in sharp contrast with the comments by the Fed which were clearly meant to be very accommodative. The Fed said on 3/17, “the fundamental change in our framework is that we're not going to act preemptively based on forecast for the most part, and we're going to wait to see actual data." However, their actions on the SLR to us were the beginning of a stealth tightening process despite what they said.
To us, the Fed actions speak louder than words, so we positioned ourselves accordingly. On 3/18, we added a large short on against our bank longs in addition to our prior shorts, including on the S&P500. These additional shorts proved useful as on 3/19 where before the open, the Fed announced that they would not extend the SLR and financial stocks got hit. We covered the recent shorts on the S&P500 on Friday following the selloff over the prior 2 days.
Outlook on the Future
We see a rate hike coming in the future and believe the fed will have to taper their $120B in bond purchases per month before the end of the year. 4 Fed members see rate hikes possible in 2022 up from 1 in Dec. Also seven of the 18 policymakers expect see one or more rate hikes possible by 2023 up from five in December. If the Fed wants to raise rates, obviously the Fed will need to taper bond purchases first. If they are moving up the timeline on rates going up, by implication, so is the timeline on tapering. Our belief is that the Fed is slowly trying to get the market adjusted to this tapering through their actions even if their words are different.
Stimulus has been incredibly important during this last decade for markets and when it needs to be tapered due to inflation concerns, this could be an issue as we have seen in the past. 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.
Why we plan to add to our $JPM position (Top 5 Pick for 2021 and up 9% year-to-date through 1/19/21)
$JPM beat across most Q4 metrics and the backdrop for the industry on bad loans was positive. The main issue for the stock was mixed results from its peers, high expectations, and trends around earnings.
Positive Industry Backdrop on Bad Loans:
All four of the big banks ($JPM $C $WFC $PNC) that reported on Friday (1/15/21) morning posted loan loss benefits during Q1 which is a positive. This follows higher than expected loan loss provisions during the prior three quarters for most banks due to Covid-19. Simply, banks thought there would be more troubled loans in the first 3 quarters of last year than they do now.
Mixed Company Specific Results:
All four of the big banks ($JPM $C $WFC $PNC) that reported on Friday morning beat consensus EPS expectations. However, experienced investors know the composition of the EPS beat is what is important. Net Interest Margin (NIM) and Net Interest Income (NII) are two of the most important metrics. $PNC & $C both missed expectations for Q4 NIM and $C rev guidance was also below expectations. $WFC’s 2021 forecasts for NIM was below expectations and forecasts for expenses was above expectations.
Expectations were high going into their earnings releases on Friday morning. As of the close of 1/14/21 (Thursday), YTD: JPM +9.1%, S&P financial sector +4.7%, S&P500 +0.3%.
Trends around Earnings:
JP Morgan historically has a tendency to decline the day of earnings with all the gains between earnings. JPM’s stock has actually declined 52% of the time over the past 10 years the day of earnings while the stock has almost tripled since the end of 2011. The tendency of others like $WFC is much worse on the day of earnings.
How we managed the Risk Around Earnings:
Our goal is to manage risk to produce the best rewards relative to the risk we are taking on. With the stocks going straight up into earnings when they historically have a tendency to sell-off the day they report, we decided to hedge the positions by shorting the $XLF (Financial Sector ETF) and $KRE (Regional Bank ETF) near the close on Thursday.
We plan to remove these hedges at some point post earnings and plan to buy more $JPM given their superior results relative to their peers. We note that all four big banks went down on Friday including $JPM. We like strong management teams and believe Jamie Dimon, the CEO of JP Morgan, is one of the best in any industry. This is why JPM is our favorite pick in the financial sector though we own others as well.
Why we sold our $GAN position (Top 5 pick for 2021 and up 16% year-to-date through 1/19/21) and recommend investors swap into $BETZ instead
$GAN has gone up significantly since we first mentioned it in late December. However, recently the exercise and sale of ~$2M in long dated options by the CCO following sales by other executives in December has us concerned.
Investing with Management:
One of my rules for investing is to invest with management. I love to see senior management buying stock when it is getting hit. As an example, Jamie Dimon bought $25M of stock in February of 2016 with the stock down nearly 20% to start the year due to concerns about a global recession. In fact, some consider his stock purchase as marking a bottom for the entire market at the time. The stock finished 2016 up 30%.
Conversely, the exercise & sale of options with years to expiration concerns me. This happened last week as $GAN’s Chief Commercial Officer exercised and sold about ~$2M worth of options that were not due to expire till 2028 and 2029. This option transaction also occurred after the close of Q4 with the stock being up 16% YTD to $23.61 after more than doubling last year. This follows an offering the company did at $15.50 per share in late December to help fund their acquisition of CoolBets. Included in the offering, there were 383,500 shares that were also sold by selling shareholders including some from top executives.
We thought GAN was potentially less risky way to play online sports betting given the stock decline near year’s end:
When we put out our top picks for 2021 on December 29th, $GAN’s stock had declined 33% from a closing peak of $27.58 on 7/2/20 to $18.54 on 12/28 given some concerns over their biggest customer FanDuel (~40% of revs). At GAN’s closing price today (1/19/21) of $23.61, the stock is up 27% from the close of 12/28.
But we believe there is even a less risky way for those who want to invest in online sports betting through the $BETZ ETF:
In newer internet related markets, valuations are often high and the online sports betting space is no exception. This market essentially came into existence only a short time ago when the Supreme Court legalized online sports betting in May of 2018. As a result, much like with other online markets there are dozens of names that are all competing to become category killers in online sports. Many of them will not live up to the current hype but some will with returns that will more than make up for the rest. As a result, we believe for an individual investor who is more interested in the bigger picture trend of sports betting moving to the internet, that a diversified ETF like $BETZ (a Sports Betting & iGaming ETF) is their best choice. We believe one or more of those names held in the $BETZ ETF will become a category killer: This ETF is up 11% year-to-date through 1/19/21 versus $GAN which is up 16% YTD.
$BETZ replaces $GAN as one of our Top 5 picks through year-end:
Regardless of the promise 10 years from now, the individual stocks will go through ups and downs and the $BETZ ETF should help diversify that risk. We remind investors that even Amazon’s stock went from $106 to $6 when the internet bubble burst in 2000 despite revenues almost doubling over two years. But this was better than the thousands of companies that went to zero during that time. Obviously, we have our favorite stocks and we still own six names related to online sports betting in the portfolio creating our own ETF versus owing $BETZ. But the sizing and individual positions are always changing as we get more data and the market matures. However, is easier for an individual investor to participate by owning $BETZ. The largest position in that ETF is 5%, but the ETF contains most of the names that we have owned over time or currently own in the space. We would be shocked if one of them was not the Amazon for online sports betting in the future.
Similarly, an investor could just as easily own the $XLF or $KRE instead of owning $JPM or other individual bank stocks. Unlike the online sports betting space, the banking sector is obviously mature and $JPM has proven that they are one of the winners.
Hedging with ETFs:
For those that like owning individual names instead, an ETF can be used to hedge instead of selling the underlying position. This is something we like to do in the fund. At some point in the future, we may short $BETZ to hedge our specific online sports betting positions over the short-term rather than selling the individual names. For example, we shorted the $XLF and $KRE instead of selling our individual bank stocks like $JPM going into earnings season.
I try to pay attention to most asked questions on my twitter and website. Many of you seem to have questions on AT&T and so I wanted to do this quick write up for you.
I am sticking to my long in AT&T despite negative developments over the past 3 weeks but am willing to move on if things do not improve.
AT&T’s acquisition of DTV in 2015 is why this name has one of our favorite short idea off and on over the past five years. AT&T has been a melting ice cube ever since their acquisition of DTV in 2015. They bought this business for $48.5 billion in 2015 and $64B including debt. During their recent attempts to sell all or part of it, the bids were coming in around ~$15B including debt. What an incredible destruction of value during that time. In addition, the company borrowed heavily to do the deal.
My fundamental view has been for quite some time that consumers will continue to cut their satellite/cable TV services in favor of streaming services. In 2015, there were roughly 100M US households with a PayTV service such as satellite or cable. That number is estimated to drop to just over 80M in 2020. During this time, Netflix has gone from 80M global subscribers at the end of 2015 to 195M in Q3:20 with 73M in the US/Canada. It is estimated that close to one-quarter of US households do not have a pay TV service today. Cord cutting combined with AT&T’s debt level is the core reason I have been primarily short AT&T off and on over this period of time.
AT&T’s high debt level is important because it affects their ability to support their dividend. As of Q3, AT&T’s debt to EBITDA was 2.7x. However, after adjusting this like the ratings agencies do for items such as operating leases, pension obligations and post-retirement benefits, it is closer to 3.5x EBITDA.
AT&T in fact did not increase their dividend for the first time since 2005 this year which speaks to their current issues. AT&T’s dividend yield currently is at 7.3% Verizon 4.3%, the S&P 1.6% and ten-year treasury yields 0.9%. These differences are near record levels given investor concerns over the melting DTV subscribers and high debt levels.
However, if HBO Max can ramp enough, this could help AT&T’s multiple expand from 9x CY21 PE versus the S&P at 22x and Verizon at 12x. These valuation discrepancies are also near record levels. AT&T’s streaming service, HBO Max, launched on May 27th, 2020. On December 8th, AT&T’s CEO John Stankey spoke at an investments conference and had some encouraging updates. He announced HBO Max engagement was up 36% in the last 30 days and they had reached 12.6M activated subscribers which was up 4M from the end of Q3. We believe this growth should accelerate given that Wonder Woman 84 streamed and opened at theatres simultaneously on Christmas Day. In addition, all seventeen Warner Bros. movies in 2021 are slated to do the same. There were 28.7M paying customers that had access to HBO Max at the end of Q3 and we think many of them will activate their service.
The recent weakness in the stock has been driven by multiple factors but primarily by a spectrum auction which started on December 8th that already has been ~50% more expensive than expected. The 280Mhz spectrum being auctioned off is considered prime real estate for 5G. As a result, the bids have now reached $70B which is well above the 2015 AWS-3 auction record of $45B. Assuming current assumptions of AT&T spending about one-quarter of the ultimate total is correct (with Verizon closer to 45%) this implies at least an extra $6B of spend beyond what was expected in early December. One way we have tried to hedge part of this risk is by shorting Verizon which needs much more spectrum than AT&T. Since the auction started on December 8th, AT&T is down 6.7% while Verizon is down 4.4% and the S&P is up 1.5%.
Lack of progress selling a stake in DTV has been the second big problem. As we stated earlier, our main reason for disliking AT&T for several years was their ownership of DirecTV given the pressure from cord cutting/streaming. AT&T had been trying to sell a portion of the DirecTV business so they could deconsolidate this business from AT&T’s books but that seems to have been put on hold due to the low bids received of $15B at the high end.
And finally, Wonder Woman 84 and disclosed HBO Max streaming data has not been as detailed as we would have hoped. According to AT&T, Wonder Woman 1984 was viewed by nearly half of the streamer's subscribers on the film's launch date alone. The Niles household was one of them. In addition, it was watched by viewers on services by their partners which was in the millions also. But we do not know how many total subscribers are now on the platform which is really what is important for the stock’s multiple. The stock also did not budge when this data came out.
Cheap stocks can always get cheaper and market reaction to news must be respected. One of the greatest mistakes an investor can make is getting wed to a position and not admitting they made a mistake. At the end of the day, it does not matter what you believe a stock should be valued at but what everyone collectively believes a stock should be valued at. In Disney’s case, they are now considered a winner in the streaming wars. As a result, their PE has expanded from the mid-teens prior to the mid-30s PE on normalized earnings post Covid-19. Disney’s stock is up 25% this year despite revenues being estimated down 20% while AT&T’s stock is down 26% despite revenues only being estimated down 6%. This is despite Disney not paying its usual semi-annual dividend in July or in January 2021.
For the factors cited above (auction expense, stalled sale of DTV, lack of HBO Max data around Wonder Woman release) there is a reason we did not pick AT&T as one of our top 5 picks for 2020. Those top picks are stocks that we hope investors can just buy and hold in an economy that should see the fastest GDP growth since 1984. AT&T, however, requires a restructuring of the company and the way investors view the company. As a result, this requires more active management of the position which remains our largest long position for now. But if investors remain more focused on the expensive C-band auction and lack of progress getting DTV deconsolidated than the momentum in HBO Max, the stock is likely to languish. We will have to admit our mistake and move on.
I hope this was helpful and I wish everyone a Happy 2021.
When Wilfred Frost interviewed me on CNBC a year ago on 12/31/2019 for my top picks for 2020, I chose: AMD, DIS, FB, LITE, and NVDA. Below is how they have performed year-to-date through 12/28/20:
Top Picks for 2020 had a technology bias
However unlike my top picks for 2020, my top picks for 2021 have a value reopening bias. My picks are the following: JPM, XLE, MGA, ORCL, and GAN.
The S&P500 is up 16% YTD (12/28/20) and at an all-time record highs despite Covid-19 driven by both monetary and fiscal stimulus.
However, inflation has been relatively non-existent since the Global Financial Crisis (arguably for 40 years) and is worth watching in 2021. Right now, broad measures of inflation look contained and any concerns about inflation due to the easy money policies following the global financial crisis have been wrong. In fact 10 year treasury yields have been in a bull market for nearly 40 years since peaking at 16% in 1981 and currently are at 0.9%.
Rising Commodity Prices
We find it troubling that prices for industrial metals like copper, nickel and zinc are all up over 20% YTD during a global recession and agricultural commodities such as corn and wheat are up almost 10% YTD. And this is reflected in the price of gold that is up over 20% and bitcoin up over 250%. Even high-priced items like used US cars are up 17% y/y in November and US home prices are up 7%. There has been underinvestment in agricultural, mining and oil for the last decade which has helped drive price increases during a global recession. What might commodity prices do in late 2022 when demand improves after we have had mass vaccinations and global economies are fully re-opened? 10-year treasury yields started the year at 1.9% hit a low of 0.5% and are still only at 0.9%. US GDP is forecast to be up over 5% in 2021 which will be the best growth since 1984.
Potential Rising Interest Rates
It is not a stretch to think 10 year treasury yields could head back towards the 2% level prior to Covid by late 2021 from roughly 0.9% today as global economies reopen. The question is what this does to the record high S&P500 multiple and especially long duration assets such as growth stocks.
Potential Reduction in Pace of Future Stimulus
Stimulus has been incredibly important during this last decade for markets and if it is more subdued as economies get back to normal, this could be an issue as we have seen in the past. 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.
Investment Themes 2021
JPM- banking for higher rates in 2021 as economies reopen
As we look toward 2021, we have more of a value bent to our investments and banks could be the ultimate reopening trade in 2021. The sector should benefit from stronger loan growth from an improving economy in tandem with expanding profit margins, yield curve steepening, reserve releases and share buybacks. This has been the second worst performing sector in the S&P in 2020 (down 5% YTD) and we believe it could be one of the best in 2021.
The S&P financial sector has a CY21 PE of 11x and a dividend yield of 2.1% and is down 5% YTD versus the S&P up 16% YTD, a 22x PE and dividend yield of 1.6%. At one point, this sector had the worst performance relative to the S&P in the history of the data back to the mid-1980s, which includes the global financial crisis and the tech bubble meltdown. We believe EPS growth for the sector could approach 20% in both 2021 and 2022.
In the banking sector, JPM (13x CY21 PE) is our core investment benefitting from a stronger economy driving loan growth and rising treasury yields. We also own Wells Fargo (-44% YTD) as a higher risk/higher reward way to play this theme as well as some smaller regional banks.
XLE- energy for improved demand as economies reopen
The energy sector has been the worst S&P sector (-37% YTD) by far this year but reopening economies will lead to an improvement in oil demand in 2021. We like the energy ETF (XLE) as a diversified way for investors to play this theme where many companies have high leverage/risk. We own a basket of individual names in the sector. Also with the focus on Green energy, the energy sector is hated and therefore valuations are low.
Tech Sector Picks
In the technology sector, we recently added more value oriented names to the portfolio to play our favorite themes such MGA (12x CY21PE) for Electric Vehicles, Oracle for cloud (14x CY21 PE) and GAN (8x EV/Sales) for online gambling.
ORCL – a value play in cloud software
Oracle has had no real revenue growth over the past 3 years with only 2% revenue growth in their most recent November quarter while the software sector has been one of the hottest areas within technology. We think that in 2021, Oracle may finally see revenue growth starting to pick up driven by their Oracle Cloud Infrastructure (OCI) business which grew 139% y/y and their autonomous database business which grew 64%. OCI growth could have been even better if not for capacity constraints. Both businesses combined are $1.5B in revs (4% of total) but are growing at ~100% and should matter to rev growth next year. Given Oracle trades at only 14x CY21 PE relative to the S&P at 22x, any improvement in their growth rate is likely to help their stock price tremendously. Oracle is also very shareholder friendly and has cut their share count by 40% through buybacks over the past 10 years.
MGA- a value play for Electric Vehicle adoption
Unit sales has improved for the auto industry from down 48% y/y in April to down 5% in November. Low interest rates, low inventories, more driving, less flying, has driven auto sales. The focus on green energy has helped drive EV sales as witnessed by the addition of Tesla to the S&P500. But EV industry shipments are only 3% of the total with a lot of growth ahead. MGA already has relationships with Fisker, Waymo (Google) as well as automakers in China and Korea around EV vehicles. MGA a few years ago was reportedly in discussions with Apple on helping them produce EV vehicles. Magna’s JV with LG Electronics announced last week helps round out the components they did not possess. At only a 12x PE, MGA is a cheap way to play the EV trend.
GAN- a value play as Online Gambling becomes the next big internet market (Replaced by $BETZ on 1/19/21 here)
Online sports betting is the next massive internet market driven by state legalization following the Supreme Court legalizing online sports betting in May of 2018. The total Global Gaming market is roughly $450B and growing ~10% per year w/ only 12% on-line. GAN, with their acquisition of CoolBets, now has an online sports betting offering to complement their iGaming products. We believe the multiple will rerate as more states use GAN partners, such as FanDuel, who will be using their technology. The stock only trades at 8x CY21 EV/Sales versus some comparable companies that are over 20x.
I believe ViacomCBS (VIAC) is an under the radar way to participate in one of the strongest trends in the post Covid world - the streaming of entertainment content. But it is also a defensive way (low 7x CY20 PE and 3.3% dividend yield vs the S&P at 25x and a 1.8% dividend yield) to take on this investment risk.
The streaming business of ViacomCBS includes: 1) CBS All Access, 2) Showtime, 3) Pluto TV, and 4) digital ad revenues. The crown jewel within their streaming business is CBS All Access & Showtime streaming subscriber revenues. For the full year 2020, I estimate these subscribers will generate $1B in revenues growing 50% y/y and accelerating throughout 2020. Covid has an increasing number of housebound people searching for content to stream and ViacomCBS has some of the best in the business. This includes: 1) original content like Mission Impossible, 2) live sports like the NFL, and 3) live news for these tumultuous times. I believe total streaming subscribers will grow as a result from 11M at the end of CY19 to 20M by the end of the year.
Additionally, Viacom has PlutoTV, the #1 free ad supported TV streaming service with 27M monthly active users.
Altogether, I estimate total streaming revenues for Viacom should be up nearly 40% from $1.6B in CY19 to $2.2B in CY20. For comparison, Netflix is expected to grow CY20 revs by 23% and has an Enterprise Value/Sales ratio of 8.4x. If I use this multiple on the total streaming revs of Viacom this year of $2.2B, I end up with a value of $18.5B for just this business.
But there are clearly risks related to people cancelling their cable/satellite service, depressed advertising revs during Covid and debt levels that need to be considered. This can be reduced by shorting less well positioned cable/satellite companies and other more highly valued & levered companies affected by Covid. Given these risks, if we assume the rest of the business deserves only a 4-5x price to earnings ratio, this implies a total valuation of $40-50 per share for VIAC versus $29 where it trades today. Furthermore, with over 20% adjusted free cash flow growth to $1.5B in 2020, the risk to reward and potential upside is too compelling to ignore.
Many investors believe in TINA (There Is No Alternative) for a valid rational for the S&P500 to go higher despite high valuations (26x PE) because of how low interest rates are in the US. However, when looking at other developed stock markets such as Europe, Germany (the largest country in Europe,) Switzerland and Japan, that have low to negative ten-year yields, they all have higher dividend yields and lower PE ratios compared to the US. China is here for comparison given they are the second largest economy but their ten-year yields are much higher and their PE is much lower.
Dan Niles is founder and portfolio manager for the Satori Fund, a tech-focused hedge fund.