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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

8 Comments

 

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 $GAN on 1/19/21)
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$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

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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.
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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:
  1. The Fed balance sheet hit a new record of $8.2 trillion and is up 18% y/y after being up 77% last year.
  2. 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.
  3. Vaccinations & progress towards herd immunity continue.
  4. The macro data is strong with the best GDP growth in decades.
  5. The employment picture continues to improve with weekly jobless claims near 400K for the first time since the Pandemic.
  6. Excess savings during the pandemic will be spent adding fuel to the recovery.
  7. More Federal government stimulus is expected. Looking forward, the Biden administration is trying to pass another $4-5 trillion in stimulus between the Infrastructure Plan and the American Families Plan.
However, history has not been kind to the market when the Fed balance sheet has shrunk in the past and we believe a 10-20% correction in the S&P before year-end is likely.
  1. The market cap of the entire US stock market divided by GDP is at 1.9x compared to the peak of the tech bubble at 1.4x and 50 year average.
  2. Inflation, driven by rising rents and higher wages, is more likely to be persistent than transitory.
  3. Inflation along with higher taxes is likely to eat into future corporate earnings.
  4. The Fed looks increasingly behind the curve compared to other Central banks that have already started tapering or raising rates.
  5. The Jackson Hole Symposium in August could mark a major shift in the Fed’s policies.
  6. World changing technology stocks with the highest valuations may suffer the most during a Fed induced sell-off much like after the tech bubble burst in 2000.
Through year end, we are managing the portfolio carefully with valuations & earnings expectations near record highs.  We are favorable to sectors geared towards re-opening ($XLE -energy, $GOOGL- advertising), higher inflation (financials-$JPM) and enterprise demand picking up in technology ($ORCL $CSCO) while consumer demand cools from pandemic highs.
5 Comments

Employment surge likely to pressure fed

6/20/2021

1 Comment

 
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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.
1 Comment

Thoughts into the Fed statement on 6/16

6/14/2021

2 Comments

 
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 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.

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.

2 Comments

Inflation and S&P Multiples

5/18/2021

1 Comment

 
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