Week Ending 3/27/2020 - Bear Rally?

3/23/2020 Monday

I already sold down most of DLR and switched to DLR's preferred's last week. Turns out to be a ninja move. That stock got crushed 11% today. 

Sold a little more DLR today. I did not want to reduce overall portfolio exposure though, so I rotated that money into SBUX and GOOGL.

Even though the market is down some 30%+ (I can't even keep track anymore), there are still very few bargains out there. Some of the names are getting close though - a 10-15% leg down and I'm ready to buy them.

3/24/2020 Tuesday

Whoa, S&P 500 up 9.38% today. This must have been a vicious rally for short sellers. 

It caught me off guard too. I'm still under-exposed for some growth names (UBER, TTD, SQ) and hoping for those prices to go lower. I was just doing some work on EW last night trying to figure out growth runaway and TAM.. I was ready to buy it on a decent drop today! But the stock went up 17.6% instead! 

So this rally is kind of a bummer.

The 1929/30's Depression era comparison continue to pile up - but on the upside this time.

At least one fancy footwork I did kind of paid off. I had switched out of DLR equities into preferred's last week, just before the stock had a meltdown. Then Fed announced they will expand QE to buy corporate bonds also (I expected this but not this soon!). This should calm the credit markets and help the preferred's too.

Overall my portfolio exposure still hover around 60% equities. The moves I did the past 2 weeks are very incremental.

3/25/2020 Wednesday

Late last night congress reached a $2 trillion deal, and the market continued to rally today.

This $2 trillion won't mitigate all the damages the economy will sustain, but it buys time and minimizes the catastrophe. So it's reasonable that markets are already looking out to the other side. 

I am also looking beyond the Covid-19 induced recession. Always have. I'm just not so bullish about it.

I'm not doing much. Added a few shares of SQ. Yes it's up like 50% from the lows.. but it's still below my original purchase price before this whole crisis. So technically I'm averaging down. This is still a small position so whatevers. 

More about those preferred's. The DLR preferred's I bought has done really well but I could have done even better. 

AT&T's 4.75% Series Preferred went up 19% today! I did not buy this one. 

My thought process - as I wrote last week - was that low coupon preferred are less likely to get called so you're not going to get those huge yield-to-calls (in some cases 30-40% YTC). But I forgot low coupon securities have higher duration. 

And that's the point of this trade - own high duration stuff in advance of credit market calming (with a big assist from the Fed buying corporate bonds). 

Being a former fixed-income guy I actually thought about that dynamic but dismissed it. Lesson learned.

3/26/2020 Friday

Market seem to calm down a bit - S&P dropped only 3.4% today after a massive run up.

The more I learn about the fiscal stimulus/relief bill (CARES Act), the more impressive it looks. 

Aside from the various small business relieves, what stood out to me the most is the ~$450bn of Exchange Stabilization Fund as buffer against losses, which can be leveraged up to $4-4.5 trillion of lending by the Federal Reserve. 

The Fed balance sheet already exceeded $5 trillion, and they're talking about doing another $4.5 trillion of lending! 

So we not only have massive fiscal stimulus, but also a massive expansion of monetary base in addition to what already occurred this month. 

The scope, size, and speed of government response is truly historic. I was there in 1Q2017 when subprime blew up and can't remember the government doing anything. This time it's all hands on deck. 

Frankly I was almost looking forward to the Great Depression, but looks like that won't happen. Have I missed an once in a life time buying opportunity? Oh wells. 

Inflation Loops

Edit 1: I bought some DLR preferred at discount last week. Preferred stocks are ultra long duration instruments sensitive to changes in yield. The immediate bet is on credit spreads normalizing, but longer term it's also a bet on inflation. So that's where the below analysis is coming from.

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Consensus is that we are going to a zero interest rate forever, Japan like deflationary scenario. But here's how inflation can happen.

The inflation that markets worry about is not an one-off event, but higher prices year after year. 

For that to persist you need some sort of positive feedback loops. Here's what I think the loops are:

1) the "price increase -> wages up -> price increase" loop. Some initial supply shock raise prices (e.g. coronavirus shuts down supply chains). Higher prices lead to labor demanding higher wages (and with government and politics shifting left, labor is more likely to get higher wages). Higher wages force firms to raise prices. 

The cycle repeats itself as long as labor can raise wages and firms can pass through price increases. That requires:

• a) labor having bargaining power over firms
• Technology and automation decrease labor's bargaining power and lowers wages. Stalling technological advances can help labor here. 
• Politics can also help labor over firms.
• b) firms can raise prices because demand is not the issue, but supply is.

2) The outer loop:  The "price->wages->prices" inflation vicious circle invites government action. Government not only goes to bat for labor, but also intervenes in some heavy handed way (price controls, industrial policies..etc).  This leads to resource misallocation and output shortfalls in the product and services that people actually want. Supply side issues lead to higher prices and the vicious circle reinforces itself. 

Week Ending 3/20/2020: Watching Losses Mount

A day by day account of a tough week.

3/16/2019 Monday

Stock down 12% today!? Funny how I’m so desensitized to 5-8% moves now.

Any random stock gets hit 15% today.

I have several down 20%+ (e.g. SQ, STOR, FNF).

Square's meltdown is entirely expected, I was just too pigheaded to sell before their upcoming investor day.

STOR - the early hits had some elements of reflexivity unwind (this is growth by acquisition after all). But the new hits are due to worries about tenants renegotiating rent deferral or even rent holidays. My view is that's ok, STOR has enough liquidity to survive and thing will be back to normal in an year or so.

FNF was completely shot and I don’t quite get it.

------------------------------

I suppose this is the beginning of a new, prolonged bear market, under which stocks can be down 90% before it recovers.

The past few years I've WANTED a recession. I figured I hold more liquidity than most and can survive and take advantage of the situation. Now that the crisis is in front of me, the mental stress is almost unbearable.

I'm actually fairly calm during the trading hours. The hard part is after market closes and I go through my portfolio and count the losses. That's when it hits home.

I agonize over my own inaction. Even though I'm technically executing my plan. I upgraded my exposure in January and Feb with the idea that should a 2008 style crisis hits I will keep my stocks and ride out the losses.

Well, that crisis is here. I'm executing my plan. I'm just not sure that is the correct strategy...

Will I end up panic sell at the bottom? To fight that instinct I got a list of stocks and the prices I want to buy them at; and I will force myself into buying when those prices hit. Even if it's tiny positions.

Things are starting to looks worse than 2008 - 1929 / Great Depression is now the comp.


3/17/2019 Tuesday

Stock went up 6% today after Mnuchin and Trump talked about helicopter money.

I added 3% to my equity exposure today. 1% each to STOR/FAF(to replace the FNF I sold earlier)/BRKS. They are cheap enough and solid enough that I'm wiling to sit long term and take short term pain.

I added a little to SQ on whim after the Mnuchin speech, but will have to offload that addition tmw - here's why.

After market closes I had time to reflect. Directionally, the helicopter money approach is correct but I came to the conclusion it just be enough. The local restaurant might pay $15k a month in rent. How is $1000 going to help them stay alive when revenue goes to $0?

Some back of envelop calculation: US has $20trn GDP. Let's say 1/3 of that shuts down. And we shut down for 2 months. You got 20/3/12*2=1.1111. That’s $1 Trillion hit to GDP. But GDP doesn’t count intermediate goods, so the real amount that needs to be bailed out is probably a multiple of that.

Ideally, the government says "let's freeze time, everyone stay home, business keep their employees, we'll pay your expense". But that’s going to be an astronomical number that makes US debt/GDP go to unreasonable amounts and USD will totally lose credibility.

All we can hope for is the shutdowns flatten out the disease curve, buy us time so healthcare system doesn’t get over whelmed. Some business will go bankrupt but hopefully you save enough of them that we don’t get a permanent damage to economy that we cant bounce back from.

There is some offset here. Big companies like Facebook are already reaching out to small businesses and employees, in the form of cash grants and product credits. So maybe everyone shares some pain but no one goes under, then we bounce back?


3/18/2020 Wednesday

Another wild day. S&P down more than 5% today. Frankly, I expected worse. Stock futures were limit down the night before so I knew it was going to be ugly.

It now looks like teh fiscal package wont' be enough, and in any case it hasn't passed yet.

The situation deteriorates every minute.

Stock went down 9-10% ..(this is truly looking like 1929), before clawing back to "only" down 5%ish.

My buy limit order for TTD hit at $153 and so I added a little there. But I'm mentally ready for this thing to be down 80% from peak. That would be below <$60.

I don't know when the market will bottom, but I don't want to reduce on the way down and not have enough exposure when it roars back (and given the speed of the decline, its very possible the market recovery will be just as violent)..

So the plan is add on the way down, however incrementally.

TTD, SQ, UBER. I have small positions in these, all are potential 10 baggers if I can accumulate in the right price. Hopefully by the time market bottoms I have a decent position in each of these (and other oligopolies in structural growth markets with strong moats). Then maybe add on the way up?

It's way early to talk about recovery, but I can dream right?


3/19/2020 Thursday

A relatively calm day in the market. Markets went up but this is a very weak looking bounce.

Some of the big shorts names like Hempton, Cohodes came out yesterday and say they're no longer net short. Ackman talked about buying BX.

Yesterday, I talked about accumulating on the way down. As if to demonstrate the rightness of that logic, Uber was up 37% when I checked. Company says 80% of cost is variable, so they will be able to cut cost, survive and come out stronger.

Natera (NTRA, which I don't have) was also up about 40% today. Any glimmer of hope does wonders for beaten down stocks.

The market heat map (below) shows rotation away from defensive/yield names. the market didn't move up too much, so apparently there's no inflow to funds but managers are positioning for a risk-on rally? If so, they risk getting wipsawed and their selling will exacerbate the downward move. This can end in tears.

It's pretty hard to ignore the market, focus and do fundamental research. But i will try to do that today.

Trades

I cut some DLR as it breached MA50. I also sold EQIX. These are expensive stock that have held up but are liable to get hit. EQIX for example has <2% div yield. That makes the valuation dependent on growth, and that means acquisition - so reflexivity unwinds as stock prices go down.


3/20/2020 Friday

Spent time looking at preferred stocks today. There's a massive dislocation in the credit market. Credit spread have blown out and a bunch of preferreds are now trading at discounts to par.

It's tempting to look at Yield to Call (in some cases showing 30-40% upside) but that is not right for preferred trading at discount:

1) companies have no reason to call securities trading at discount.

2) the logic of yield to call is somewhat circular: to get the YTC you need the prefs to get called. But a company will call only when prefs trade at premium, which happens only when market yield comes down to below the preferred coupon.

So the bottom line is to look at current yield for preferred trading at discount, and compare that to the coupon to see how likely you are to get called at par.

------------------------------------
What an exhausting week. This is supposedly the worst week in the market since 1929.

I guess we are all Bayesians updating probabilities as facts emerge. Each day the economic situation look dramatically worse than before, so in retrospect it's not surprising that market took such a drastic downturn.

Some of us see the facts earlier or update probabilities earlier. I am unfortunately one of the slower ones.

Week of 3/13/2020 - Market Melt Down. A New Era?

3/12/2020

The S&P index dropped 9.5%. The market was almost 30% off its peak.

The decade long bull market is officially over.

Throughout 2019 I consciously high graded my portfolio, away from the speculative micro/nanocaps into large caps. At the same time I capped my equity exposure to 80% through most of 2019.

I came into mid-Feb with equity exposure about 65-70% of my portfolio. Then the market hit. Now I'm roughly 60% equities - I sold very marginally, the reduction is mostly because stocks went down so much that they became a smaller percentage of the mix.

What now? I've sold most of what I wanted to sell. I still have some high growth, high multiple names that are liable to take a 70% drawdown, but I've cut them down to small size and readied myself to ride out the pain. (TTD, SQ, UBER).

I even added - very marginally - to companies that I think will not only survive a recession, but will come out stronger by consolidating weaker competitors.  Examples are GOOGL, ILMN, DIS.

So, What now?

It certainly looks like a recession is unavoidable. Indeed the U.S. faces a tough trade-off  - shutting down everything to protect public health means taking economic hits.

So why have I not cut exposure to 0 or even go short?

Some of this is almost Pavlovian - every time I cut in the past 10 years stock roar back higher. It got even more absurd in the Trump era - as soon as stock goes down 10% there's a Fed cut coming.

Shorts have lost every single time because of policy responses.

So what's the normalized valuation going forward? Any low growth company that's not totally cyclical can probably fetch 20x PE. As policy response grows stronger, I wouldn't be surprised if that number goes to 25x (and with fake earning add backs too as in stock based comp).

So I'm holding, under the assumption that the economy may enter a recession, but comes back in 3-5 years - with even more system leverage.

Why The Economy Might Not Come Back

What could go wrong is if the economy just don't come back. Maybe at some point we just can't borrow our way out of a recession anymore?

The trigger could be this reflexive intersection between markets and politics - as markets go down, the chance of Trump losing re-election increases. Imagine Biden wins in November and Democrats take congress, they will likely roll back the Trump tax cuts. Immediate hit to corporate earnings!

Government is already cracking down on big tech. You layer on more regulation and taxes...

Then we can look forward to a decade of stocks going nowhere.

For now though I'm still holding to my 60% equity exposure. I may regret it one day.


3/13/2020

Stock was going nowhere until the last 30 minutes of trading. Trump spoke in a press conference, and talked about telehealth (TDOC stock went flying as he speaks). Then he brought up Google (GOOGL goes up), then Thermo Fisher, then a steady stream of CEOs.

Then he talked about waiving student loan interest, and buying oil for SPR.

Stock went on a rampage toward the close. It was hilarious! A master class by the best stock pumping president ever!

It's as if Thursday never happend.

This is why I'm afraid of shorting stuff.

Thoughts on Cycles

Update 2/12/2019
In my original post below, I talked about the concept that fraud is cyclical. It turns out there are words for it - the "bezzle" and "net psychic wealth" - coined by John Kenneth Galbraith. He explains it much more elegantly than I can:

“Weeks, months or years may elapse between the commission of the crime and its discovery. (This is a period, incidentally, when the embezzler has his gain and the man who has been embezzled, oddly enough, feels no loss. There is a net increase in psychic wealth.) At any given time there exists an inventory of undiscovered embezzlement in – or more precisely not in – the country’s business and banks. This inventory – it should perhaps be called the bezzle – amounts at any moment to many millions of dollars. It also varies in size with the business cycle. In good times people are relaxed, trusting, and money is plentiful. But even though money is plentiful, there are always many people who need more. Under these circumstances the rate of embezzlement grows, the rate of discovery falls off, and the bezzle increases rapidly. In depression all this is reversed. Money is watched with a narrow, suspicious eye. The man who handles it is assumed to be dishonest until he proves himself otherwise. Audits are penetrating and meticulous. Commercial morality is enormously improved. The bezzle shrinks.” 

- John Kenneth Galbraith

So the "fraud is cyclical" thing is certainly not any unique insight of mine. In my post, I further distinguish between frauds perpetrated by management, frauds unknown to management, and unintentionally inflated results from murky data.



Original Post (1/19/2019)
I recently read Howard Mark’s “Mastering the Market Cycle”. It was particularly interesting to see how he reconciles common value investing believes like “can’t time the market”, “ignore the macro”, and so on with more acceptable topics like “where are we in the cycle”. I had always thought the differences are little more than semantics, but Howard Mark pointed out some subtle differences that I had not thought of.

Reading the book also had me thinking through cycles some more. Here are just some thoughts that I will elaborate in this post.

• Why credit cycles do die of old age, and how lack of new borrowings alone would lead to recession. 
• Instead of looking at asset prices and judge whether they are rich or cheap, look at capital provider’s behaviors. Are deals getting done at ridiculous terms? 
• Thoughts on inflated earnings. While most investors are well aware of natural cyclicality, what’s less well understood are various degrees of fraud and “pushing the envelope” behaviors. 

Why Cycles Do Die of Old Age

Bull markets die with the end of credit cycles, which die of old age.

Over the past 30 years debt to GDP ratio throughout the world has ballooned, meaning new borrowings drive an ever bigger share of spending.

Whenever someone take out a mortgage to build a new home - that stimulates the economy. You take out an auto loan to buy a new car, that stimulate the economy.

But how many mortgages and auto loans can I take on? How many houses and cars can you buy? TVs? If you just bought a new house this year, chances are you’re not about to buy another one next year. Not when you’re up to your neck in debt.

As time goes on we approach some natural limit on indebtedness, and new borrowing activity decreases. Instead of borrowing, we have to pay down debt. That means less spending in the economy, and less spending means less jobs are needed.

This may not be obvious to some – less borrowing and/or paying down debt may be prudent, but it causes the economy to contract.

So thus credit cycles do die of old age, and with that, spending and the associated bull markets die of old age.


Look at What Investors Do, Not What They Say. Oversupply of capital

Here’s maybe the most useful thing I learned from Mark’s book – in judging where we are in the cycle, it’s much better to judge investor behavior rather than asset valuation, or even investor sentiment as expressed through media.

Asset valuation is inevitably subjective (7x PE looks cheap but is that peak earning or not? Depends on if you think if a recession is coming soon right?).

Investor sentiment and news flow can also be misleading. News headlines and Twitter can be flooded with panicky takes, but if VC deals are still getting done at 20x revenue then it’s hard to say the market is in capitulation mode.

Much more reliable are investor actions, as expressed through lending terms, M&A terms, IPO terms.

What does this all mean for us now (December 2018)? The U.S. stock market has taken a beating; news flows are undoubtedly bearish (trade wars! Government shut downs!) And we have cyclicals like Goldman Sachs trading at 7x PE. Are we near bottom of the cycle? I would say hardly.

Masayoshi/Softbank’s Vision Fund is buying anything and everything with Saudi money. Companies are still doing large buybacks. Consumer staples are getting into marijuana space at high valuations. Amazon is still expanding into new industries everyday. These are not signs of capitulation.

Intuitively, ease of financing also implies lowers barriers to entry, excess capacity, and crowded competition in the underlying industries. This “creative destruction” is not good for investors.


Frauds (and false profits) are Also Cyclical

I think frauds are important triggers of financial crisis because the “you think you have money, but suddenly you don’t” effect triggers panics and sudden liquidity demands.

It’s no coincidence that scandals like Enron and Madoff get uncovered at end of the cycle. For one, eroding asset values force investors to take a cold hard look at their portfolio, and there frauds are uncovered. Second, the unveiling of fraud alert the market to huge losses, which leads to a more skeptical market and even more unveiling of frauds.

Frauds are cyclical. They may be discovered only after the fact, but some portion of an economy’s output will always be from questionable behaviors. More at top of cycle, less at bottom of cycle; less frequently discovered at the top, more uncovered near the bottom. 

Frauds may have nothing to do with management’s integrity. Frauds can take place while senior managers are blissfully unaware, or even explicitly forbids it. The Wells Fargo scandal from a few years back - where low level branch employees create fake client accounts to meet aggressive sales goals – is an example.

As the economy expands and firms fight for market share, the pressure to improve performance naturally incentivizes all sorts of fraudulent or “push the envelope” behavior that inflates revenues.

Nor does inflated revenue and data need to come from intentional fraud. Ellen Pao’s “it’s all fake” tweet has an interesting discussion here.

It's all true: Everything is fake. Also mobile user counts are fake. No one has figured out how to count logged-out mobile users, as I learned at reddit. Every time someone switches cell towers, it looks like another user and inflates company user metrics https://t.co/tk1PKuvLL6

— Ellen K. Pao (@ekp) December 27, 2018

Unlogged in devices can create confusion and inflate data. I personally have the experience of inflating advertising metrics recently. I played this videogame where I constantly have to play to level up my avatars. So I quickly learned the common practice of building a macro or bot to “auto-farm”. This game is free to play and depends on advertising revenue. So the company is likely selling overstated user metrics when pitching to advertisers (albeit unknowingly).

Nowadays entire business models are based on advertising revenue, which are based on unreliable user metrics. This inflated revenues and earnings will drop when the cycle ends - and not in a controlled, linear fashion that analysts tend to forecast in their models.

12/30/2018 Views- Not Particularly Cheap

I did almost no trading in December, and very little in November. On 10/28/2018 I wrote: “Now that I'm sitting on more cash and bonds than I have stocks, I'm almost cheering when the market goes down“. I still feel the same today. 

The problem is even after the market down turn, most stock valuations are only fairly valued if you assumes no recession in the next 3 years or so.

For example I am considering buying Goldman Sachs, which trades at about $160. Using consensus 2019 EPS, this trades under 7x earnings. Neither does that EPS look particular peakish. Over the past 10 years pretax profit actually held fairly steady, and the explosive EPS gains mostly came from lower tax rate and much lower share count.

So is GS cheap or what? The problem is about 20% of their revenue comes from the “Investment and Lending” segment, with the majority of that being gains from equity securities. In fact, from 2015-2017, this segment contributed 28% of GS’s pretax earnings! 

In estimating a conservative “normalized” earnings, I assumed 0 on those equity gains, and $160 stock price would represent under 12x P/E. This is a good valuation, but not a huge bargain for a highly leveraged, cyclical company prone to political attacks.

In a down cycle, that Investment & Lending “revenue” might not just be zero, it could be negative. Then this $160 price tag might be outright expensive.

Portfolio Positioning and Asset Allocation
Given my inaction, my stock exposure will likely maintain at the current level of 40-50% of liquid portfolio (basically my entire net worth minus home equities). I'm open to more if I see truly compelling value.

The 40-50% equity level is really more about how much cash I want, and less about how much equity exposure. As a full time individual investor, I don’t have regular income and have always maintained plenty of cash reserves. I also wanted to maintain plenty of “dry powder” to go in big in case there’s a recession.

I'd like to think the 40-50% allocation to equities implies a neutral view regarding the stock market. If stocks goes up I would have more than half of my portfolio invested, “net bullish” if you will. If stock goes down I will have ever decreasing exposure while keeping my dry powder high.

Leaning on Currency Trades

In a bull market everyone is a genius. In the month or so I enjoyed profits in all directions – equities, currencies and commodities. The problem is that idiosyncratic contributions are wearing thin and the gains are more and more dependent on market wide movements. So I decided to do another macroeconomic review, starting with currencies.

A quick disclaimer: anytime someone tells you about a “macro trade”, it’s got a lifespan of about 3 months or less. The reason is market moves feedback to real world fundamentals and no one knows how that will play out with any certainty. The trick is to anticipate a sort of decision tree, and ride the trend when real life plays out as you expected, and be ready to do an 180 when events go down a different path. This is why macro guys like Druckenmiller can flip flop all day yet still make money.

With that out of the way, I’m long Russian ruble, Danish krone and USD, short euro, and anxiously watching the USD.JPY pair. I will explain each below.

The Ruble

I've been riding this trend since late November/early December. I actually have no great conviction on the ruble, but I love Russia’s situation –their geopolitical and economic outlooks are clearly improving.

In the 1970’s and 80’s, the U.S. and its allies opened up to China to counter the Russian threat. Now in the 2010’s it’s the reverse. The U.S. will warm up to Russia to balance against China. Trump clearly wants to work with Russia and France could elect Le Pen, who views Russia more favorably. Shinzo Abe in Japan is getting closer to Russia as well.

This all improves the probability that the current sanctions against Russia will be removed. On top of that, Russia is coming out of a recession and oil prices have stabilized. Inflation will likely subside, which can lead to the central bank cutting rates. Russia is also looking to lower its budget deficit.

The combination of lower expected rates, budget consolidation and improving sovereign credit is the best possible set up for bonds and has mixed outlook for the ruble. Unfortunately I have no access to Russian bonds, but I will settle for going long the ruble and Russian equities (which I also have positions in).

Even if the Central Bank of Russia starts cutting rates, the ruble should still be supported by a relatively high rates and portfolio inflows into the country. Once ruble strength start fading, Russian equities could be the next bull market.

Euro: short EUR/USD and EUR/DKK. Get ready to buy French companies

The dissolution of EU is on everyone’s mind but what happens to the euro is anyone’s guess. The euro could strengthen because weak countries like France and Spain would exit, leaving euro as the currency of a very strong Germany. The euro could also weaken because any dissolution requires a long transition period and the ECB will go on a quantitative easing binge while they’re at it.

At least in the next few months, I think the latter is more likely. So I’m shorting the EUR against the U.S. dollar and the Russian ruble.

I’m also shorting the euro to go long the Danish Krone. The downside is low here as I’m shorting a currency that is pegged, yet undervalued.

Denmark has one of the highest current account surpluses as percent of GDP in the world. If you think Germany has undervalued currency because it uses the euro, then the Danish krone is just as undervalued because of the peg to euro. Denmark also has zero interest rates and an overheating housing market. Does that sounds like an economy that needs more QE? If the ECB unleashes another round of QE, I doubt Denmark will want to follow suit, so they have to unpeg and let the DKK float upward.

Finally, a full dissolution of EU would be great for France. Upon completion, I expect French companies to be big beneficiaries as France would have much needed flexibility on fiscal and monetary policies. French companies will also enjoy great operating leverage with that 10% unemployment rate.

Yen: USD/JPY short in the next month could be the next pain trade

We are heading into European elections and there’s a high probability that populism will win out in Netherland and France. This could trigger a global risk-off with international funds pouring into JPY.

On the USD side, Trump's tax/trade/infrastructure plans (it’s all tied together now as you can’t have one without others and not blow up the budget) would certainly not be passed the next few months. So we can see deterioration in USD as expectations are pushed toward later dates.

Any JPY strength would catch the market by surprise. The market is still very long USD. As for yen positioning, “large specs” went from very long JPY to net short to less short (but still net short) in the past few months. This suggests more room for JPY to the upside.

I'm not going to short USD/JPY however. At the time of this writing, USD/JPY is at ~114. More likely I will wait for the pair to drop to 109.5 or even 106 and resume a long USD.JPY position.

Revisiting the Big Picture

I try to hold in my mind several macroeconomic scenarios that are likely to play out, as facts come in and probabilities shift, I rethink my investments themes accordingly. The most bullish scenario (for equities and commodities) is as follows. The time frame I’m considering is next 2-5 years.

The outline of a macroeconomic progression:

1. Higher inflation expectations…

Crude oil has bottomed in the $40-50 range. As energy is a key ingredient in all other commodities, this is likely the end of the commodity deflation cycle. Indeed, other commodities sectors (particularly agriculture), looks to have trough too. If the world then starts eating into the currently very high inventory levels, that would leading to inflationary pressures.


2. …leading to higher yield in long bonds…

As inflation targets are hit, the central bankers will face pressure to hike rates. But hiking short rates would lead to a flat or inverted yield curve, damaging the banking system, so the central bankers have hinted they’ll let inflationary pressure push up longer term bond yields.

In recent weeks we have seen 5yr/5yr forward inflation breaking above 1.8%, and 10 year treasury yield going above 1.8%.

At this point the impact on US equity markets is unclear. Do we have real growth? Or do we just have stagflation? If the former, then inflation expectations lead to more investment and real growth, then equity markets could look up again. If the latter, then stock prices would take a hit because the market assigns higher discount rates with little growth to offset it.


3. …But underlying GDP growth is still weak, prompting fiscal stimulus.    

With rates around the world still near 0, central banker will have a harder time inventing new monetary tricks. But that’s missing the point. Pushing people to borrow don’t work because we have industrial overcapacity everywhere so businesses don’t want to invest. Thus government has to take the lead.

Fiscal stimulus can drive inflation up further. But this time both real and nominal GDP rises. 

 

4. We end up with (still) easy monetary policy and fiscal stimulus. 

In this world, the US dollar would be stable, commodities prices goes much higher than today, long bonds gets crushed, and US equities go through the roof into an unprecedented bubble, setting up for the next crash.

Where Are We

We seem to be at step 2 right now. But note that step 1 & 2 does not necessarily lead to 3 & 4. Alternatively, we could have just easily skipped 1-2 and go straight to fiscal stimulus in an effort to drive inflation.

My view is that inflation cannot sustain itself given the current macroeconomic regime. This is because higher inflation drives Fed rate hike expectations, which (in today's upside down world with quantitative easing) drives the US dollar up and defeats the commodity price rally.

Regardless of how the sequence plays out though, there are certain themes here for investments purposes: fiscal stimulus, commodity price recovery, steeper yield curve, companies with structural growth prospects. 

In the past month, my research have focused on the commodity front, taking a particular interest in the agriculture space. Here the key questions are 1) can price increases sustain itself or is it self-defeating? 2) what has to happen to drive a sustained increase? These will be for another post.

Best Deal I'm Seeing Now Is a Macro Trade: SPY Put Combos

Update 8/4/2016

Looking at this post from a couple weeks ago, I seemed to be making the assumption that low VIX = low option prices. That is a naive view. I have learned a little more since this post and I will try to share here.

1) VIX only covers front month contracts, so options 6 months out are not necessarily cheap just because VIX is low. To get a sense of how expensive options are further out, you can look at VIX futures curve. In this case the VIX futures curve is actually quite steep, showing that options 6 month - 1yr out is reasonable but not super cheap.

2) Ok, so volatility is cheap, but is it calls or puts?  For that you can look at "skew". Barrons is a good source here. For a longer term view, you can look at the CBOE SKEW index. This shows that while demand for puts have came down from earlier in the year, it is about normal relative to recent history.

3) low VIX also benefits from low implied correlation. If the individual stocks in S&P500 are going to go opposite directions in prices, that would balance out index prices and dampen the overall index volatility. We're in the middle of the earning season so the low expected correlation makes sense.

So my post below is incomplete. However, the risk/rewards of the below trades are still what they are. Numbers don't change just because my understanding is flawed. They may not be as cheap as the low VIX would suggest, but I still find them attractive.  

Original Post:

Once in a while a good deal comes your way. That can happen in the single stock universe or in the macro world. At the moment I see one in the latter.

Right now, SP500 put combos offer a high probability trade with 4.5-to-1 upside/downside ratio.

Option prices are based on volatility and that is clearly at the lower end of historical range. Below is the historical chart of the VIX index from 1990. The red line is the latest VIX reading of 12.8 and green line is the 10th percentile level of 12.2.

While the VIX can go lower, any drops below 12-13 level tend to be followed by sharp bounces upwards within a few months. A 6 month option should be long enough.

With the VIX below 13 and SP500 at all time high, this is a good time to buy some SPY puts. Here’s a combo I was able to buy last week (all puts expire Jan 20, 2017).

The payoff diagram at expiration is as follows:

This combo goes in-the-money with SPY at $214 - the chances of SPY falling more than 1% from its current $216 level seems pretty high to me! It's not like the world has no problems! Peaks profitability comes if SPY falls to $203 by Jan 2017. Maximum upside is 4.5x the downside.

More importantly, you spend $2.54 to control a $216 position. That leverage allows you to hedge your entire portfolio with an 1.2% option position.

I started accumulating this last week. If the stock market continues to go up, I plan to take profit and plow it back into more of these trades as they become available. The plan is to be very aggressive if VIX falls to low 12’s or even lower.

Gold Call Options

I bought a small amount of GLD call options today.

I got into the June $115 call for $1.59. I think this is a much better way to gain exposure than going outright long. With GLD trading at $103.5, maximum loss on this trade is only 1.5% of the long exposure obtained. I'm also long USD (currently against NZD and EUR), so some gold will help in case the Fed hike thesis falls apart.

Gold has been beaten down to multi-year lows and I can understand why. The Fed can't stop talking about raising rates. Inflation is no where in sight. Marginal costs for gold producers keep declining over the years, and will get lower if the US dollar strengthens. Jewelry demand, roughly 50% of total demand, will likely be weak in a low growth environment. Finally, after a massive build up over the past decade, ETFs has been decreasing their gold holdings the last couple years.

So why a long position? These call options are a low risk, high reward way to go contrarian on the consensus view that Fed will raise rates in December.

First take a step back. Gold has four functions: 1) as a safe haven/physical currency, 2) inflation hedge, 3) jewelry, 4) industrial use. Right now the only reason for anyone to own gold is the first one - gold as a currency. This is really the flip side of US dollar strength, which has everything to do with market's expectations of a rate hike.

Expectations

It wasn't that long ago (just September!) that the Fed failed to raise rates and cited risks in China and low inflation. Every other day some Fed officials (Lacker, Bullard, Lockart, Brainard...etc) took their turn going rogue on media and gave contradictory statements.

Now, just a couple months later, everyone is supposed to have suddenly fell in line and agree to raise rates? That hardly seems credible to me.

Last year's experience made clear a few things about the Yellen Fed regime. First, the Fed takes into consideration a lot more than its dual mandate of inflation and unemployment. Some of these unstated factors include general market stability, US dollar strength, and yes - China. Second, the Yellen Fed does not like to surprise the market, so October's hawkish Fed statements was just a way for Yellen to raise expectations of a December hike in the market. Put another way, October's Fed statement was just to keep their options open. Finally, we learned that it doesn't take much for the Fed to delay that rate hike -- perhaps permanently.

Given the lessons above, and all it takes is a weak inflation number, a couple bad numbers out of China, or another market meltdown to lower the probability of the December hike.

As for gold, market expectations about the rate hike is what matters. If any of the above happens, the call option will likely be a winner. There's also very little downside. Depending on how macro data comes out, I might increase this option position.

What’s Dragging Down Core Retail Sales?

One of the biggest questions in corporate earnings is how the US consumers are doing. We know housing continues to recover, if in a sluggish fashion. We know auto sales are doing well, driven by light trucks. How about retail sales? 

Headline retail sales have continued to increase but showing signs of deceleration. This number is heavily influenced by auto & auto parts though –which we already know is strong. On the other hand, gasoline prices have dropped significantly and that drags down the headline numbers even though it should benefit consumers.

So I consider “core” retail sales – excluding auto and gasoline sales – as a more accurate reading for U.S consumers. The growth in this number is shown below.





Notice that post 2008, growth in “core” retail sales have hovered around 3-5%, slower than the 5-7% range pre-crisis. So I dug a little deeper to see which sector is dragging this down.

The Census Bureau report divides retail sales into 13 categories - motor vehicles, furniture, gasoline, building materials, and so on. Going through the data, I found the biggest drags come from 2 sectors: general merchandise stores and building materials.

The contributions of these 2 sectors to core retail sales growth are shown below.

The declining growth in general merchandise stores might have something to do with offsetting growth in online shopping (although apparently not enough to offset overall sales since the headline number does include e-commerce.) .

The other major drag on growth is the “building materials & garden equipment & supplies dealers” category. Growth has recovered but has not yet reached pre-crisis levels. The good news here is that new home sales – as shown by the link in the first paragraph – should have plenty of room to grow.


Looking out the next few years, I can see a housing pick up driving core retail sales up toward pre-crisis levels. Gasoline prices will also stabilize and be less of a drag on headline growth.

Australia’s Trade with China: Export Iron Ore, Import Women

Australia’s latest balance of payment data included a special case study on trade with China. Scroll to the bottom of that link and you’ll see some interesting stats. 

These male to female ratio looked a little skewed? Especially we’re talking about China here - a country known for too many men.

And Australia gets them young too.

I knew Australia has a trade surplus with China, but I didn’t know it was this good!

Shorting AUD/USD: on FDI and Reflexive Potential

Summary Reasons for Shorting AUD/USD

• Technical downtrend is intact
• Demand of AUD will be weaker in the future due to lower FDI and portfolio flows. Trade balance is negative but that’s a less important factor in my mind.
• Factors that make AUD’s “reflexive” – price movement here can be self-reinforcing, rather than self-correcting 

Shorting AUD/USD is a fairly popular trade. Here are what I gather as the most cited rationales for shorting AUD/USD. Australia's main exports are iron ore and coal but prices for which have fallen and will likely stay low due to weak demand from China. Trade balance will deteriorate. The Reserve Bank of Australia thinks further depreciation is necessary and will keep rates low or even cut rates to stimulate the economy.

I agree with that line of reasoning, but trade balance and lower interest rates are not the only reasons that AUD will continue to depreciate. Going forward, in my opinion, foreign direct investment and potential for “reflexivity” will be bigger drivers of AUD decline.

Importance of Foreign Direct Investment

In the chart below, I used balance of payments (BOP) from 2006 to 2014 as proxy for historical inflows and outflows. Australia has persistently ran trade deficits and even bigger primary income deficits. What propped up demand for AUD in the past few years were foreign direct investments (FDI) and sometimes portfolio flows.

Note how trade balance is a relatively minor contributor versus other flows. Primary income is mostly stable while portfolio investment is fickle (and likely negative going forward). FDI though, has been consistently strong, but will likely deteriorate drastically going forward.

FDI is concentrated in the mining sector (~roughly 40% of foreign investment in Australia), and that is likely to drop off given prevailing weakness in commodity prices. Demand from China will stay weak given its continued shift away from an investment driven economy.

Reflexivity - Quick Background

But how much of that is already priced in? That’s always tough to know. A different question though, is will lower exchange rates hurt economic fundamentals and lead to even lower prices? i.e. is there a reflexive relationship here? I think so, but first a quick summary of George Soros’ reflexivity framework (as it relates to currencies) is as follows:  

• Prices are driven by different factors of supply and demand. Some of these factors are self correcting, and some are self-reinforcing. 
• Self-correcting means weaker prices -> improving demand vs supply -> stabilization in prices. 
• Self-reinforcing means weaker prices -> deteriorating demand vs supply -> further weakening in prices. 
• To see if a trend will continue, an analyst can break down price into different sources of supply/demand, and determine if self-reinforcing flows outweigh the self-correcting ones. 

In the context of foreign exchange:

• Price = nominal exchange rates. Supply and demand are inflows and outflows in the balance of payments items. 
• Trade balance is typically a self-correcting: lower nominal currency -> lower real currency -> better trade competitiveness and trade balance -> stabilization of currency 
• Portfolio investments tend to be self -reinforcing: lower nominal currency -> expectation of even lower FX -> expected currency losses tend to outweigh interest rate differentials for bonds and detract from equities returns). 
• FDI could be either self-correcting or self-reinforcing 

Analysis

With that background, here’s why I think AUD/USD will be a reflexive situation that keeps driving downward.

1. The main self-correcting flow, trade balance, is a relatively minor factor here (as shown in the BOP chart above). Further, Australia’s trade balance will likely see less improvement from currency devaluation due to its unique situation. Lower prices of main exports (iron ore and coal) is not going to help much if the problem is structurally lower demand from your customer in the first place. Australia’s main competitor in iron ore is Brazil and that currency is even weaker. So Australia is not going to get much of a boost in trade balance from weaker AUD.

2. FDI is likely a self-reinforcing flow in this case – weaker AUD will lead to weaker FDI. Remember again, FDI for Australia is big in the mining sector. With commodities, prices are in USD but local production costs are in the local currencies. When Australia and Brazil’s currency weaken versus the USD, local costs are effectively lowered and that will pass through to lower commodity prices. Would you invest in a mining project when 1) commodity prices will likely stay low or get even worse, and 2) the sector already has excess capacity? I don’t think so.

3. Portfolio inflows are self-reinforcing. For Australia, portfolio flows are mostly debt securities as opposed to equity. 10 year government bonds for Australia yield ~2.85% versus ~2.25% in the United States. What little extra yield you get from investing in an Australian bond could easily be overwhelmed by movements in currencies, which is decidedly negative in this case.

My conclusion is that the downward move in AUD/USD will continue, because the self-reinforcing elements (FDI and portfolio outflows) outweighs the self-correcting mechanism of trade balance.

This may take a while to play out though, and you incur negative carry on the trade. So timing and technicals do matter. AUD/USD hovers around 0.74 at the time of this writing. I am short and have a stop loss around 0.77 and my eventual target is as low as 0.65. The risk is if Australia comes out with massive investment project (develop North Australia for example) and attracts money from abroad. But that is unlikely in the current government and in any case unlikely to offset weakness in mining projects.

Kostolany on What Makes Stocks Go Up; Capital Flows and Technicals

Andre Kostolany on What Makes Stocks Go Up

I was doing some reading on Andre Kostolany and found something interesting. According to him, what makes stocks go up can be summarized in one simple formula: Cash availability + Sentiments = Market Trend. Basically for a market to go up, people need to have cash to buy stocks, and they have to want to buy stocks. Of the two, cash is the more important one, since high liquidity creates a rising market which would then drives sentiments.

Kostolany gave convincing examples where markets go the opposite way of underlying economic conditions. In a weak economy, people scale back consumption which increases savings rate. Since confidence about the real economy is weak, those savings get channeled to the securities market. Likewise, when central banks loosen monetary policy to support a weak economy, much of that extra cash goes to prop up the markets.

In this framework, what makes stock market go up is about monetary policy, available cash on the side lines, international capital flow and FX. Fundamentals are part of the equation, but mostly serve to influence public sentiments and expectations, as well as rationalize prevailing biases. In fact, an improving economy might lead to negative sentiments regarding corporate earnings, if higher labor and input cost lower profit margins.

This all makes a lot of sense to me. As a result I spend some time on macro the past few weeks, particularly on the topics of international capital flow, balance of payments…etc. 

International Capital Flow and Implications

My rudimentary credit analysis on the USA follows. The U.S. has current account deficit running $400-500bn the past few years, it finances that with capital inflows, which represent foreign claims on U.S. assets and effectively depletes national wealth over time. But that national wealth is incredibly high. The household sector alone has ~$83 trillion of net worth, so technically that current account deficit can persist for 150+years before U.S. networth gets depleted.

So solvency is not an issue, but how about liquidity? For now, foreigners are choosing to finance U.S consumption, presumably because 1) political stability, 2) economically U.S. being one of the “cleaner shirts” among nations, and 3) to a lesser extent strong USD appreciation the past year. Political stability will likely stay around in the coming decades, but relative economic position could change. At some point the U.S. may have so much debt that growth is weighed down by interest payments, while recovery in China and Europe can both draw capital away from the United States.

China is not helping either. In the past decade China piled up U.S. treasury bonds in its FX reserves. That helped to keep the RMB down and sustain its trade surplus. But now it seems to prefer exporting capital to other emerging markets, which not only helps the trade surplus but also enhances its influence and prestige abroad.

If capital reverses direction, that out flow could start a vicious cycle. Capital outflows would weaken the dollar, accelerating withdrawals of hot money. The Fed can raise rates in an attempt to attract capital, but that would tighten money and credit and kill the markets. The economy would have to adjust by consuming less - leading to deflation. At that point decades of accumulated foreign capital at the U.S. could rush out the door and a deflationary cycle sets in.

Value investors like to say “no one gets the macro right”. That’s probably true. I do believe though, that you have to be planned for all scenarios instead of just assume things will be fine in the long run. In terms of money management, it’s not so much trying to guess what the economy will do, but planning out how I will react to different scenarios.

A Technical Experiment - Game Planning

“Stock market goes up in the long run” is a mantra that take hold at top of markets, conveniently serve to justify ever higher valuation - “this stock trades at 25x P/E? Doesn’t matter, buy it anyways because over the long run I’ll be fine.” This mentality has two implications, 1) at some point the public become fully invested – there’s no buying power left, and stocks have nowhere to go but down on the next sign of economic weakness and 2) the market increasingly trade on technicals.

I’m convinced that the broader market is trading on macro/technical with “fundamentals” being merely an excuse to buy stocks. According to this report from Factset, market prices have grown at a faster pace than earnings expectations the past few years. Earning expectations have steadily declined since beginning of the year yet the market trickled upward. The same report also pointed out that market is reacting less to earnings beats and misses than the past – an indication that fundamentals have taken a backseat to technicals.

What to do? A sensible thing to do is target stocks that are less correlated to the broader market: small/microcap/illiquid stocks, special situations, turnarounds..etc. A major portion of my portfolio is mid/large cap value stocks though, and there I sense the fundamentals valuations are becoming less relevant – (and will be even less relevant if the market keep marching upward).

I’m in the middle of an experiment in timing the market with technical analysis. I use SPDR S&P 500 ETF (“SPY”) as a proxy for the market. Here’s the plan.

Current Trading range & initial set up

• Current trading range is 205-212 and we’re currently at $212 per share. We are very close to a strong resistance around 212-213, a line that have held up since February. SPY tested that resistance 3 times the past month with no success. If it fails to break through again, my suspicion is that we’re due for a 5-10% correction. 
• I shorted some SPY with 213 as a stop, so that if it breaks upward past 213 my loss would be limited. This short is ~18% of portfolio equity, with w.a. cost basis of 208.3. So I stand to lose 40bps if I get stopped out at 213.

• I left my single names untouched. Some of them have their own stop losses anyways. These single name exposures are about 90% of equity.
• Note that I’m actually violating proper technical trading principals here in the sense I’m jumping the gun even before a clear breakout or trend emergence. As discussed later, I risk being whipsawed)

If SPY breaks to the upside

• My shorts get stopped out so I take 40bps of loss. But my single name exposures would still be there to take advantage of any potential uptrend.
• Should I reverse course and get longer (would put me on leverage)? Only if a breakout proves that it established a new pricing range. That to me requires the emergence of a new support level (say 213-214 area) – mostly in the form of a retracement and subsequent bounce.

If SPY moves down

• My short position would be showing a profit, but probably not enough to offset losses on my single names. I would think about adding to the short. But only if SPY breaks below support levels such as 205 or 200. 

If SPY moves up past 213, but that turns out to be a false move and SPY reverse downward back to say 208. Instead of establishing a new pricing range, that move would have merely expanded the range.

• This would be tough to swallow. I would have incurred 40bps of hedging cost with no gains to show for it. That’s what you get for jumping the gun before a clear trend emerges. Should I risk another 40bps and risk getting whipsawed yet again? Only if there are proof that a downward trend is emerging. That to me requires 1) Negative fundamental news dominating the headlines (perhaps worries about Europe & China), 2) technical indicators that confirms the trend in the form of ADX/DMI, a lower low…etc. 

The way market is going, I could be stopped out of this trade as early as tomorrow. In that case we might be in for a summer “melt up” as in 2014. I will not fight it.