 We expect unemployment to drop faster than expected. Job openings & the number of unemployed are both at 9.3M w/ extra unemployment benefits expiring, the # vaccinated increasing & in person schooling in the Fall. This will put pressure on the Fed to hike/taper sooner.
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As I write this today (6/14), the S&P is up 13% YTD and at an all-time record high. The S&P recovered from its sharpest sell-off in the S&P (down 4% in three days ending 5/12) since late October of last year. This was driven by inflation data that continues to come in stronger than anticipated. Interestingly, the 10 year treasury yield has declined from 1.75% on 3/31 to 1.49% today and sits at levels from last March.
Statement from Fed officials continue to stress that the current surge in inflation metrics is “transitory” and it seems the market is willing to believe it judging by the decline in treasury yields. Headline CPI now stands a +5.0% and core CPI now stands at +3.8% on a y/y basis. We, however, continue to believe that though some of the increase in inflation is due obviously to “base effects” like oil prices going negative at one point last year, the increase we are seeing in wages is only going to get worse. Some of these wage increases are being affected by the inability to hire enough workers due to generous unemployment benefits, Covid safety concerns and inadequate childcare. But let us not forget that unemployment before the pandemic was at its lowest levels at 3.5% since the 1960s. As a result, average hourly earnings were up 3-3.5% in the second half of 2019 as wage pressures started to build. McDonald’s is currently using signing bonuses to attract workers. These wage pressures are only going to get worse as global economies open up and we head towards the holiday season. The rise in shelter prices is notable with owners' equivalent rent (OER) up 0.31% in May, the largest increase since June ‘19. Given the number of people moving from large cities to suburbs given new work from home flexibility, we find this interesting. OER is over one quarter of CPI, and larger than food and energy combined given housing costs is a big component of the average consumers budget. This increase in OER potentially means home prices which are now up 13% y/y and increasing at the fastest pace since 2005 is offsetting higher vacancy rates in big cities. The drivers for the stock market record highs remain the same: 1) the Fed balance sheet hit a new record of $7.95 trillion and is up 11% y/y after being up 77% last year, 2) money supply is up a record 18% y/y (peaked at 27% in Feb) vs a peak of 10% during the GFC, 3) vaccinations continue and 4) the macro data is strong with S&P EPS now forecasted up 50% in 2021, and 5) the employment picture continues to improve with weekly jobless claims below 400K for the first time since the Pandemic. Looking forward, the Biden administration is trying to pass another $4 trillion in stimulus ($1.8 trillion American Families Plan and $2.2 trillion Infrastructure Plan.) But the central banks of both Russia and Brazil have raised rates multiple times while England joined Canada to become the two G7 central bank to start tapering. Russia, Brazil and Turkey, are among the 14 central banks that have raised their main interest rates so far this year. In total there have been 22 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 at the latest. The Fed continues to reiterate their belief that inflation is “transitory” and say they will not be raising rates through 2023. We believe that inflation data for the next several months will force them to change their stance. Stimulus has been incredibly important during this last decade for markets and when it needs to be dialed back (tapered) due to inflation concerns, this could be an issue as we have seen in the past. The Fed purchases of $40B a month in mortgage-backed securities in particular seems to make no sense. “The housing sector has more than fully recovered from the downturn,” Chairman of the Fed, Jerome Powell, said last month at a press conference. 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 a world with declining inflation since 1981 and especially since the Global Financial Crisis (GFC), bond and equity portfolio returns have both been very strong. Following the GFC, the Fed and other governments around the globe bought bonds to drive down interest rates. By December of 2020, there was over $18 trillion in government debt with a negative yield to maturity as bond returns were super-charged by Central Banks around the globe. With 10-year treasury yields hitting a record low of 0.5% in August of 2020, this in turn drove very strong returns in the equity markets, especially in long duration assets like technology stocks. Inflation has been relatively non-existent since the GFC (and arguably for 40 years) but now is picking up globally. Any concerns about inflation due to the easy money policies following the GFC have been wrong. Core PCE, the Fed’s preferred inflation metric, averaged 1.6% for the prior decade. This has enabled the Fed to expand its balance sheet for over twelve years from $900B before the financial crisis to $8.0 trillion currently. The Fed is currently buying $80B in Treasuries and $40B in mortgage-backed securities per month until there is “substantial further progress” in meeting its goals on employment and inflation. Annualized, this is $1.4 trillion or 7% of GDP in further stimulus from the Fed expected in 2021. Core/headline PCE and CPI are between 3.1-5.0% in the US. 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 just 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 in the past when they do act. Historically, the Fed has acted to preemptively head of off inflation. With their new policy of waiting to see inflation before acting, there is a real risk of them having to reverse policy rapidly versus the gradual pace seen in the past when they do act. If inflation, turns out to be much stronger than expected, a rapid tightening in policy might be needed and with valuations at record highs, this might cause a much sharper stock market correction than seen during past tightening cycles with a higher risk of a sharper slowdown in future growth. This is obviously not a near-term concern but worth keeping in the back of your mind. Money Supply (M2) is up 18% y/y vs. a prior record of 14% set in the 1970s, and a high of 10% during the GFC and 10-year yields are at 1.5% after starting the year at 0.9%. When rates moved up from 1.39% to 1.52% on February 25th with an intraday high of 1.61%, a 7-8 standard deviation event, the S&P was hit for 2.4% and gold was hit for 2% and the commodity index was down 0.3%. This is a problem for portfolio managers if both bonds and stocks sell-off together. There are four large investors that like to have close to a fixed ratio between bonds and equities: balanced mutual funds, US defined benefit pension plans, the Norwegian oil fund, and the Japanese government pension plan. These four alone accounts for ~$8 Trillion in assets. Driven by stimulus, 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 which 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 driven by rising inflation. The trailing S&P500 PE during this time went from 20x to 7x despite earnings rising 50% from 1972 to 1974. The trailing PE today is 30x. The PE is also being held lower by record profit margins and buybacks. Inflation is likely to eat into margins along with the higher corporate tax rates being proposed. But both Treasury Secretary Janet Yellen and Federal Reserve Chairman Jerome Powell seem to be changing their stance on the impact of monetary policy on the economy and the stock market. Earlier this year Treasury Secretary Janet Yellen urged lawmakers to “act big” and not worry about deficits for now, given low interest rates on that debt. However, on May 4th, she said “interest rates will have to rise somewhat to make sure our economy doesn’t overheat.” Federal Reserve Chairman Jerome Powell has also consistently pushed back on the need to even think about raising rates. However, at the Q&A for the FOMC meeting on April 28th he said, “You are seeing things in the capital markets that are a bit frothy, that’s a fact…I won’t say it has nothing to do with monetary policy, but also it has a tremendous amount to do with vaccination and reopening of the economy.” The Q&A following the Fed meeting this week could be very interesting. It is estimated that by the end of Q1 of 2021, 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 curtailed during COVID-19, the US savings rate exploded to 34% in April 2020 from 7-8% prior to COVID-19, and an all-time high of 15% in 1975. This rate is currently at 15%. When global economies reopen, this excess savings is likely to be spent and drive a surge in demand. 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 which dragged down Amazon with it. 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. In Q1 of 2020, while the market went down 20%, we were profitable in large part due to our shorts that we used to hedge against the coronavirus risk. Our hope is that our shorts will outperform when this bubble breaks as well and enable us to cushion against a correction much like they did 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. We advise investors to be careful with the market at all-time record highs and all-time valuation highs going into the Fed meetings coming up between now and year-end. The question is not IF the Fed tapers but WHEN they taper. History has not been kind to the market when the Fed balance sheet has shrunk in the past. Last Friday, news surfaced that forced liquidation of at least one large leveraged Asian hedge fund, forced block sales in several media companies and Chinese ADRs including:
Typically, there is always some collateral damage following these types of intense moves that are lower on heavy volume with some of the names above down more than 50% from their highs just a week ago. At the extreme end, in 1998, the failure of the highly levered hedge fund, Long-Term Capital Management almost caused a collapse in the financial system before an organized rescue by the Federal Reserve. As a result of the large moves lower caused by this forced liquidation, we started nibbling on a few of the names above on Friday (3/26) with the knowledge that there was the possibility of contagion during this upcoming week. More forced liquidations might give us even better prices to fill out our positions. For risk management, we also shorted the S&P to hedge these positions given the 1.7% upward move on Friday, despite the large moves downwards in these individual names and related securities during the week. Viacom ($VIAC) is a name that we mentioned on 9/25/20. The stock was at $30. We thought the stock could rerate higher based on their ramping streaming business. “VIACOMCBS, AN UNDER THE RADAR, DEFENSIVE PLAY ON VIDEO STREAMING” danniles.com/articles/09-25-20 However, as the stock ramped for a variety of reasons over the past six months, we sold the stock and tried to put that money into names in under-appreciated sectors such as energy and financial. Viacom intelligently fortified their balance sheet by raising $3B in capital when the stock reached an all-time record high on 3/24/21. Viacom’s stock has now declined from $100 on 3/24/21 in just 4 trading days to $48 on Friday. As a result, we started nibbling on this name along with a couple of others. In terms of fundamentals, Viacom should see their advertising revenues continue to recover if GDP growth improves to ~7% in 2021. In addition, their streaming business should continue to thrive as more households adopt multiple streaming services beyond Netflix. In terms of risk, the pandemic accelerated cord-cutting, but with the stock now trading at a price to earnings ratio of 11x 2021 EPS compared to the S&P at 23x, the risk to reward to owning the name should be favorable again. Our goal for this next week would be to add to this position (and others) if weakening persists while hedging these positions with additional shorts. 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 fedThe 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 offAs 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 FutureWe 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. High 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.
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AuthorDan Niles is founder and portfolio manager for the Satori Fund, a tech-focused hedge fund. Archives
December 2021
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