Vertex Pharmaceuticals $VRTX

 

Investment Case

 

  • Vertex Pharmaceuticals is the only pharma company with the necessary regulatory approvals to market medicines for the treatment of cystic fibrosis, i.e. a sub-category monopoly.

 

  • Four approved medicines — TRIKAFTA SYMDEKO/SYMKEVI, ORKAMBI, and KALYDECO — with list prices ranging from $272,000 to $311,000 per annum

 

  • Across the US, Europe, Canada and Australia there are an estimated 75,000 patients with CF

 

  • Vertex’s medicines are presently being used to treat 60% of these patients; in the US, 90% of all CF patients are eligible for at least 1 out of Vertex’s 4 CF treatments

 

  • TRIKAFTA approved by the FDA for people 12 years or older and certain types of CF conditions in October 2019

 

  • Increasing the addressable market for Vertex’s medicines in the US by c. 6,000 patients.

 

  • Added $420m in additional revenue in 9 weeks since approval. TRIKAFTA is Vertex’s most successful launch and one of the most successful drug launches in the last 5 years.

 

  • Vertex has applied for marketing approval for the treatment in Europe.

 

  • Vertex reached deals with the Scottish government (September 2019) and NHS England (October 2019) to make ORKAMBI available.

 

  • Increasing the addressable market for the treatment by 5,350 patients. Minimal revenue in 2019 following the approvals. Management expects strong uptake in 2020.

 

  • In December 2019, the approval for KALYDECO in the European Union was expanded to include infants 6 to less than 12 months in age.

 

  • Strong revenue growth in 2020 driven by (1) TRIKAFTA in the US, (2) ORKAMBI in the UK and (3) the expanded approval for KALYDECO in the EU

 

  • TRIKAFTA contributed more than 10% of sales in 2019 despite only being available for 9 weeks and that too only in the US.

 

  • TRIKAFTA is expected to generate $1.3bn in sales in 2020. All else being equal, that would amount to year-over-year revenue growth of 21%.

 

  • For ORKAMBI assuming an up take by 60% of patients in England and Scotland at a discounted price of $125,000 per annum in 2020 would contribute top line growth of almost 10%.

 

  • Given the above, consensus estimate of 32.5% revenue growth in 2020 may prove to be low.

 

  • Upside risks arising from (1) approval of TRIKAFTA in Europe, Canada and Australia and (2) positive outcomes from clinical trials to expand the treatment’s approval to include patients ages 6 to 11.

 

  • Strong balance sheet — no debt, net cash position of $3.8bn; high levels of cash generation — average free cash flow generation of $1.1bn per annum over last three years

 

Key Risks

 

  • Sales of Vertex’s products depend, to a large degree, on the extent to which products will be covered by third-party payors, such as government health programs, commercial insurance and managed health care organizations.

 

  • Third-party payors are becoming stricter in the ways they evaluate medical products and services and the containment of health care costs has become a priority of federal and state governments, and the prices of drugs have been a focus in this effort.

 

  • The market for drugs that treat CF is currently a monopoly: Vertex owns the rights to the only medicines with marketing approval in the US, Europe, Canada and Australia that treat the rare condition.

 

  • In October 2019, Arrowhead Pharmaceuticals Inc. presented preclinical data at the 2019 North American Cystic Fibrosis Conference on ARO-ENaC, an inhaled RNAi therapeutic being developed as a potential treatment for cystic fibrosis.
    • Arrowhead is currently conducting IND/CTA-enabling studies to support regulatory filings in the first half of 2020 for first-in-human studies.
    • Further progress by Arrowhead, or any other competitor for that matter, in developing treatments for CF are likely to weigh on Vertex’s share price

 

  • In 2019, Vertex began a Phase 2 clinical trial evaluating VX-814 as a potential treatment for AAT deficiency and initiated a Phase 1 clinical trial evaluating VX-864 — a second investigational small molecule corrector for the treatment of AAT deficiency.

 

  • Arrowhead, with its lead drug ARO-AAT, is further ahead of Vertex in developing a treatment for AAT deficiency.Arrowhead’s stock was punished due to Vertex’s progress with VX-814. There could be a reversal of fortunes should Arrowhead’s drug moves further along the FDA’s approval process.

 

  • Given the crossover, rumours of Vertex acquiring Arrowhead have surfaced on several occasions.

 

  • Arrowhead’s market is only ~3.7bn versus Vertex’s ~63bn, the dilution for Vertex shareholder is likely to be limited. Nonetheless, in the event of an acquisition, it could prove to be a short-term headwind to Vertex’s share price.

 

  • Vertex has a partnership with CRISPR to develop treatments for DMD and DM1, which cost the company $175m upfront and potentially up $825m more

 

  • Vertex’s acquisition of Exonics required committing to a contingent liability of $755 million in milestone payments, i.e. if Exonics achieves certain milestones, Vertex will have to make further payments to the shareholders of Exonics at the time of acquisition

 

Company Overview

 

  • Vertex develops treatment regimens for patients with cystic fibrosis (CF).

 

  • CF is a hereditary disease that mainly affects the lungs and digestive system, but it can result in fatal complications such as liver disease and diabetes. The body produces thick and sticky mucus that can clog the lungs and obstruct the pancreas.

 

  • CF can be life-threatening, and people with the condition tend to have a shorter-than-normal life span. There is no cure for the condition, but good nutrition and taking steps to thin mucus and improve mucus expectoration are said to help.

 

  • Vertex obtained approval for TRIKAFTA — the first triple combination regimen for CF — in October 2019. The drug is approved by the FDA for people 12 years or older and certain types of CF conditions — the company estimates that the approval increases number of patients eligible for Vertex’s medicines in the US by c. 6,000.

 

  • The company is working to obtain approval for the drug in ex-US markets and has already submitted a Marketing Authorization Application (MAA) to the European Medicines Agency (EMA).

 

  • List price for TRIKAFTA is $24,000 per 28-day pack (or $311,000 per annum).

 

  • From FDA’s approval on 21 October through year-end, Vertex recorded $420 million in revenue from the drug. Making it the best launch of Vertex’s CF treatments and one of strongest starts for a new drug in the US in the past five years.

 

  • As a result, 4Q2019 revenues came in at ~5x higher than consensus estimates.

 

  • Vertex’s marketed medicines, in addition to TRIKAFTA, are SYMDEKO/SYMKEVI, ORKAMBI, and KALYDECO.

 

  • Approximately 90% of all CF patients in the US are eligible for Vertex’s medicines. The company’s R&D efforts are focused on pursuing other therapeutic approaches to address the remaining 10% of CF patients.

 

  • The company’s four medicines are estimated to treat approximately 60% of the c. 75,000 CF patients in North America, Europe and Australia.

 

  • Vertex reached deals with the Scottish government (September 2019) and NHS England (October 2019) to make ORKAMBI available.

 

  • In Scotland, an estimated 350 patients are eligible for the drug, which has a list price of more than £100,000 per annum.

 

  • While in England, 5,000 children and young adults suffering from CF are now eligible for the drug. (The prices agreed between Vertex and the two parties have not been disclosed.)

 

  • According to the company’s chief commercial officer, during the 4Q2019 earnings call, the two deals did not materially impact revenues during 2019. The company, however, expects revenue from the European market to ramp up in 2020.

 

  • In June 2019, the FDA expanded the approval for SYMDEKO/SYMKEVI to include CF patients 6 to 11 years old.

 

  • The medicine was originally approved in February 2018 for CF patients 12 years old and older. This was Vertex’s third medication to be given marketing authorization.

 

  • An application was submitted to the EMA in 4Q2019 to expand the approval for Europe to include children 6 to 11 years of age.

 

  • The list price for the medicine is $292,000 per annum.

 

  • In April 2019, the FDA expanded the approval for KALYDECO to treat infants 6 to less than 12 months of age

 

  • KALYDECO is the first and only drug eligible for treating infants as early as 6 months of age.

 

  • In December 2019, the approval in the European Union was expanded to include infants 6 to less than 12 months in age.

 

  • The list price for the medicine is $311,000 per annum.

 

  • The company’s strategy includes actively seeking to acquire businesses and technologies needed to advance research in its areas of therapeutic interest as well as to access needed technologies.

  

Acquisitions

 

  • Acquisition: Exonics Therapeutics $245m, Jun 2019

 

  • Exonics is engaged in the development of gene editing therapies to treat severe genetic neuromuscular diseases, including Duchenne muscular dystrophy (DMD)

 

  • Acquisition added gene editing intellectual property, technology and expertise to Vertex.

 

  • Up to $755 million in milestone payments to selling shareholders if future development and regulatory milestones are met for certain programmes.

 

  • Acquisition: Semma Therapeutics $950m, Sep 2019

 

  • All-cash deal

 

  • Semma Therapeutics focuses on using stem cell-derived human islets as a possible cure for type 1 diabetes.

 

Research & Development

 

  • In addition to continuing research to identify additional drug candidates for the treatment of CF, Vertex is also focusing its R&D efforts on developing products for the treatment of serious diseases including AAT deficiency, APOL1-mediated FSGS, pain, sickle cell disease, beta thalassemia, DMD, DM1 and type 1 diabetes.

 

  • Alpha-1 Antitrypsin (AAT) Deficiency

 

  • A condition in which the body does not make enough of AAT, a protein that protects the lungs and liver from damage. The condition can lead to chronic obstructive pulmonary disease (COPD) and liver disease.

 

  • In 2019, the company began a Phase 2 clinical trial evaluating VX-814 as a potential treatment for AAT deficiency and initiated a Phase 1 clinical trial evaluating VX-864 — a second investigational small molecule corrector for the treatment of AAT deficiency.

 

  • Arrowhead Pharmaceuticals, with its lead drug ARO-AAT, is further ahead of Vertex in developing a treatment for AAT deficiency.

 

  • APOL1-Mediated Kidney Diseases

 

  • Focal segmental glomerulosclerosis (FSGS) is a cause of nephrotic syndrome in children and adolescents, as well as a leading cause of kidney failure in adults.

 

  • Apolipoprotein L1 is a protein that in humans is encoded by the APOL1 gene.

 

  • Inherited mutations in the APOL1 gene play a causal role in the biology of FSGS as well as other kidney diseases.

 

  • APOL1 genetic variants account for much of the excess risk of chronic and end stage kidney disease, which results in a significant global health disparity for persons of African ancestry.

 

  • In 2019, Vertex completed a Phase 1 clinical trial for VX-147, its first investigational oral small molecule medicine for the treatment of FSGS and other serious kidney diseases.
    • Phase 2 clinical trial to evaluate VX-147 is expected to begin in 2020.

 

  • Patients with pain can suffer from acute pain (for example, following surgery or an injury), neuropathic pain (when there is damage to a nerve), and musculoskeletal pain.

 

  • Current treatments may not work well or cause significant side effects. In addition, there is the potential for addiction and the practice of over- and mis-utilization, as well as underutilization of current pain medicines.
  • Vertex has discovered multiple inhibitors of the sodium channel 1.8, or NaV1.8, as potential treatments for pain.
    • Obtained positive results from three separate Phase 2 clinical trials evaluating VX-150, a NaV1.8 inhibitor, in patients with three different pain conditions: acute, neuropathic and musculoskeletal pain.
    • Opted to hold off on starting a late-phase trial of VX-150, choosing instead to gather data on the drug’s siblings before deciding which molecule to advance.
    • In the first quarter of 2020, announced the discontinuation of Phase 1 development of VX-961; expected to begin clinical development of an additional molecule in the first half of 2020.

 

  • Sickle Cell Disease and Beta-Thalassemia

 

  • Sickle cell disease is a group of disorders that affects haemoglobin, the molecule in red blood cells that delivers oxygen to cells throughout the body. People with this disorder have atypical haemoglobin molecules called haemoglobin S, which can distort red blood cells into a sickle, or crescent, shape.
    • Characteristic features of this disorder include a low number of red blood cells (anaemia), repeated infections, and periodic episodes of pain. The severity of symptoms varies from person to person. Some people have mild symptoms, while others are frequently hospitalized for more serious complications.

 

  • Beta thalassemia is a blood disorder that reduces the production of haemoglobin
    • In people with beta thalassemia, low levels of haemoglobin lead to a lack of oxygen in many parts of the body. Affected individuals also have a shortage of red blood cells (anaemia), which can cause pale skin, weakness, fatigue, and more serious complications. People with beta thalassemia are at an increased risk of developing abnormal blood clots.

 

  • Vertex is co-developing CTX001, an investigational gene-editing treatment, for the treatment of hemoglobinopathies, with CRISPR. A CRISPR/Cas9-based therapy to treat both beta-thalassemia and sickle cell disease.
    • In November 2019, the company announced positive, interim data from the first two patients with severe haemoglobinopathies treated with the investigational CRISPR/Cas9 gene-editing therapy, CTX001, in ongoing Phase 1/2 clinical trials.

 

  • Type 1 Diabetes

 

  • Type 1 diabetes (T1D), once known as juvenile diabetes or insulin-dependent diabetes, is a chronic condition in which the pancreas produces little or no insulin. Insulin is a hormone needed to allow sugar (glucose) to enter cells to produce energy.
    • Despite active research, type 1 diabetes has no cure. Treatment focuses on managing blood sugar levels with insulin, diet and lifestyle to prevent complications.

 

  • In 2019, Vertex acquired a preclinical program to develop cell-based therapies for T1D through the acquisition of Semma. The company plans to advance this program into clinical development in T1D patients in late 2020 or early 2021.

 

  • Duchenne Muscular Dystrophy

 

  • Duchenne muscular dystrophy (DMD) is a progressive form of muscular dystrophy that occurs primarily in males, though in rare cases may affect females. DMD causes progressive weakness and loss (atrophy) of skeletal and heart muscles.

 

  • Early signs of DMD may include delayed ability to sit, stand, or walk and difficulties learning to speak. Muscle weakness is usually noticeable by 3 or 4 years of age and begins in the hips, pelvic area, upper legs, and shoulders. The calves may be enlarged. Children with DMD may have an unusual walk and difficulty running, climbing stairs, and getting up from the floor.

 

  • In 2019, Vertex acquired preclinical programs to develop genetic therapies for DMD and DM1 through the acquisition of Exonics and the expansion of its collaboration with CRISPR.

 

Appendix I: Product Portfolio

Vertext Products

 

Appendix II: FDA Approval Process

 

FDA Approval Process

  • Clinical trials

 

  • Phase 1 uses 20 to 80 healthy volunteers to establish a drug’s safety and profile (about 1 year).

 

  • Phase 2 employs 100 to 300 patient volunteers to assess the drug’s effectiveness (about 2 years).

 

  • Phase 3 involves 1000 to 3000 patients in clinics and hospitals who are monitored carefully to determine effectiveness and identify adverse reactions (about 3 years).

 

Appendix II: Financial Summary and Consensus Estimates

Vertex FS

 

Vertex Consensus

 

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

Thoughts and Investment Ideas for 2020

Contents

Thoughts and Investment Ideas for 2020

Ideas

Summary

Energy

The Speculative Phase: Software Over Semiconductors

Playing the Strength in US Housing Demand

Founder Exodus: A Reduction in Existential Flexibility

USD

Thoughts

Summary

Macro Risks

Inflation is the Enemy

Valuations

US Treasury Yield Curve

Modern Monetary Theory

Books

Five We Have Read and Recommend

Five from Our 2020 Reading List

 

Thoughts and Investment Ideas for 2020

 

“Can you ask a new question? It’s the new questions that produce huge advances…”

 ― Why Model? by Joshua M. Epstein

 

“A reward-sensitive person is highly motivated to seek rewards―from a promotion to a lottery jackpot to an enjoyable evening out with friends. Reward sensitivity motivates us to pursue goals like sex and money, social status and influence. It prompts us to climb ladders and reach for faraway branches in order to gather life’s choicest fruits.

 

But sometimes we’re too sensitive to rewards. Reward sensitivity on overdrive gets people into all kinds of trouble. We can get so excited by the prospect of juicy prizes, like winning big in the stock market, that we take on outsized risks and ignore obvious warning signals.”

 ― Quiet: The Power of Introverts in a World That Can’t Stop Talking by Susan Cain

 

“Stock prices have reached what looks like a permanently high plateau.”

 ― Irving Fisher (1867 – 1947)

 

The last twelve months, and pretty much the entirety of the last decade, handsomely remunerated the reward-sensitive ― the risk-takers, the optimists, the dip-buyers, the trend-followers, the bitcoin HODLers ― and punished the sceptics, the value-conscious, the doomers and the gloomers, and the short-sellers, without prejudice.

 

The sceptics, and others of their ilk, are quick to remind of the cyclicality of markets even as they lick their bull-horned wounds. That, as surely as night follows day, the years of plenty will be followed by years of famine. That valuations matter.

 

They, the doubters, are, as history shows, not wrong. Markets are indeed cyclical. Valuations do matter, eventually. The record shows, claiming otherwise will surely find you embarrassed, if not immediately, most definitely in due course.

 

There is, however, a wrinkle in the cyclicality argument.

 

All finite, deterministic systems are guaranteed to cycle. Capital markets, however, are neither finite nor deterministic.

 

Finite systems, to paraphrase James P. Carse author of Finite and Infinite Games, are comprised of known participants, fixed rules and agreed upon objectives. Infinite systems or games, on the other hand, are defined by participants both known and unknown, changing rules and an objective to keep the system or game perpetuating.

 

Markets are an infinite system and market participants ― investors, traders, brokers, market makers, regulators, corporations and whoever else that may choose to participate ― are engaged in an infinite game.  To survive in an infinite game, participants must adapt or die. It is this process of adaptation that allows the system to perpetuate but at the same time necessitates that neither the duration nor the form of any given market cycle can be known before the fact. Just because the average bull market may have lasted 7-years or ended within a certain time period following a yield curve inversion does not in any way imply that this or the next market cycle will follow the same pattern.

 

Market participants should not, nay cannot, simply rely on a passing understanding of market cycles. Rather, we must all continuously strive to better understand how the game and the participants are adapting so that we may have a better shot at positioning for that which lies ahead.

 

In this piece, we try to ask questions ― with a bit of luck, some different, if not entirely new, ones ― and share our thoughts and ideas that, we hope, will help you, the reader, better play the infinite game over the coming six to twelve months.

 

Note: Comparable pieces for 2018 and 2019 can be found here and here, respectively.

 

Ideas

Summary

 

  • Energy: Long Chevron $CVX, National Oilwell Varco $NOV and Cactus Inc $WHD and avoid allocations to energy importing emerging markets

 

  • Speculative Phase: Prefer software $IGV to semiconductors $SOXX in the US

 

  • Founder Exodus: Avoid long positions in companies that have recently seen their founders exit such as Alphabet $GOOG, Under Armour $UAA, Chipotle $CMG and Alibaba $BABA

 

  • USD: Below 95 on the US Dollar Index $DXY, short Australian dollar and New Zealand dollar

 

Energy

 

“Rise early, work hard, strike oil.” ― John Paul Getty

 

“Do not waste energy, make it useful.” ― Wilhelm Ostwald (1853 – 1932), winner of the Nobel Prize in Chemistry in 1909

 

Humans have been burning fossil fuels to generate electricity since 1882. Coincidentally, the first hydroelectric power plant also began operations in 1882. Fissioning uranium isotopes has been a source of electricity since 1956.

 

The technology to harness fossil fuels as a source of energy at scale has transformed everything from agriculture to industry, transportation to warfare, quality of life to the environment, and everything in-between. Fossil fuels remain the most concentrated and versatile source of energy that can be converted at affordable cost and high rates of efficiency into heat, light and motion.

 

The quest to harness alternative sources of energy at comparable levels of efficiency, cost and scale as to that of fossil fuels remains just that, a quest. Progress is being made and the political will to turn our collective backs on fossil fuels has never appeared stronger.

 

The rise of environmental, social and governance (ESG) criteria in investing, the US Democrats’ “Green New Deal” on climate mitigation, and the recent unveiling of the “European Green Deal”, are raising the cost of capital for the global energy sector. All the while, returns on invested capital being generated by the sector remain dismal.

 

The potential unintended consequence of a seemingly coordinated desire to penalise the global energy complex and starve it of fresh capital is the prospect of a negative energy supply shock becoming increasingly probable.

 

With the promises of blockbuster shale wells fracking companies made to investors turning out to be a busted flush ― according to The Wall Street Journal wells drilled recently in the four largest US oil regions were on track to produce nearly 10 per cent less oil and gas over their lifetimes than companies forecast ― and the sector facing ever increasing costs of capital, the prospects of a global energy supply shock in the near-to-medium term, we think, are under-priced.

 

Barring a negative-demand shock, or a breakthrough in technology that enables the harnessing of alternative sources of energy as efficiently and cost effectively as harnessing fossil fuels, we think oil prices can head higher, much higher, in the near- to medium-term.

 

We often use the 48-month moving average, for commodities and major currency crosses, to guide our trading strategy. For now, WTI crude prices remain above the moving average. As long as prices do not meaningfully breach the 48-month moving average, our bias is to be long in expectation of prices continuing to climb the ‘Wall of Worry’ over the next 6 to 12 months.

 

1

 

Tactical Perspective

 

President Trump’s decision to order the Iranian Major General Qasem Soleimani’s death via drone attack in Baghdad in the evening on 2 January saw oil prices spike by as much as 4 per cent. Such is the antipathy towards energy stocks that despite a sharply higher oil price, the SPDR Energy Select Sector ETF $XLE closed in the red on 3 January.

 

With that being said, oil may have to work off overbought conditions if and when the geopolitical risk premium subsides. We would hold off till that point to have a full-sized allocation to energy.

 

Ideas: Long Chevron Corporation $CVX, Long National Oilwell Varco Inc. $NOV, Long Cactus Inc. $WHD.

 

Avoid: Energy importing emerging markets.

 

The Speculative Phase: Software Over Semiconductors

 

If the US equity market is in the throes of a market melt-up, or an almighty blow-off, the rally should devolve into becoming increasingly speculative.

 

Last year, software stocks were leading the pack till around mid-year when, as the trade tensions between the US and China thawed, semiconductor stocks started climbing a wall of worry and ended the year at all-time highs. Software stocks were the laggards during the second-half of last year.

 

We think as the rubber of hope meets the road of financial performance semiconductors are likely to falter. Further, given the sensitivity of semiconductor stocks to the trade deal and with a phase one deal between the US and China more than priced in, it behoves the prudent investor to pare allocations to semiconductor stocks. Rather, as growth becomes precious once again, we think, investors are likely to turn to software afresh. And as software incumbents look for new ideas and business models, more than a few acquisitions are likely to be in the offing.

 

For now, in US equities, we prefer software to semiconductors.

 

Ideas: Long Manhattan Associates $MANH, Long Salesforce.com $CRM, Long Avalara $AVLR, Long Slack Technologies $WORK, Long iShares Expanded Tech-Software Sector ETF $IGV

 

Avoid: iShares PHLX Semiconductor ETF $SOXX

 

Playing the Strength in US Housing Demand

 

Falling long-term interest rates equate to more affordable housing and on a relative basis make the economics of owning a home better than of renting one. With US long rates having dropped sharply during the summer, US home purchases have picked up.

 

On an annual basis, sales in October increased 4.6 per month from the same month the previous year, marking the fourth straight month of year-over-year gains.

 

With homeowners in the US remaining in their homes thirteen years on average, five years longer than they did in 2010, and housing inventory estimated to be at an 11-year low, the surge in demand for housing is rippling through to increased applications for and issuance of building permits.

 

The thing about buying a home is that, once you have bought one, it comes a with a long list of mandatory and not-so-mandatory purchases. For this reason, US consumer durable goods spending tends to closely track home sales and housing permit issuance with a lag.

 

2

 

While demand for housing fluctuates with long-term interest rates, once a house has been bought the spending that follows it, will follow irrespective of the fluctuation in interest rates. This makes consumer durable plays, broadly the consumer discretionary sector, a less interest-rate sensitive means of gaining exposure to the robust demand for US housing.

 

Ideas: Long Floor and Décor $FND and conditional on high-levels of risk appetite small caps such as Bassett Furniture $BSET and Hooker Furniture $HOFT

 

Founder Exodus: A Reduction in Existential Flexibility

 

Simon Sinek in a talk about his book The Infinite Game shares an anecdote in which Steve Jobs was almost on a whim willing to pivot Apple Inc., despite the prospect of huge near-term losses, when faced with an existential crisis. He describes this ability to be “existential flexibility”.

 

Founders, in general, are more likely to have the strength of character and conviction to make the difficult decisions ― that is, existential flexibility ― than do managers. A number of prominent companies ― such as Google, Under Armour, Alibaba and Chipotle Mexican Grill to name a few ― have recently seen their founders step down.

 

With the business cycle long in the tooth and regulatory risks, particularly for technology companies, rising, we prefer to avoid investing in companies that have transitioned from founder CEOs to manager CEOs.

 

USD

 

Analysts, ourselves included, have spent an inordinate amount of time and energy in an attempt to ascertain the direction of an asset that has remained in a mind-numbingly narrow range. Such is the importance of the greenback, implicit or explicit, in any investment framework, however, that we would be remiss to not once again touch upon it.

 

Yield Differentials

 

We use Australia and New Zealand, given access to a longer history and better quality of data, and because they serve as good proxies for China and commodity producing emerging markets. The below charts show that on the 10-year government bond yield differential basis there is a strong case to be made for a stronger dollar relative to these currencies. (We also include Indonesia, despite the limited data, as a further example.)

3

 

4

 

5a.png

 

From the Perspective of Select ‘Fragile’ Emerging Markets

 

The real trade-weighted dollar has posted a smaller advance since mid-2014 than the US Dollar Index $DXY, suggesting that the threat to the world from a stronger US dollar is not as great as is often hyped to be.

 

Below we share three charts of select emerging markets that suffered severe crises and saw their currencies plummet versus the US dollar in the 1990’s. Most of these countries are better placed to withstand a stronger US dollar than they were prior to the crises in the 1990’s and at the time of the ‘taper tantrum’ in 2013.

6

7

8

Note: Pre-crisis metrics for 1996 for all countries except India, for India we use 1990

 

While a stronger US dollar would be painful, it would not, we think be apocalyptic barring a a severe spike (10%+ in a matter of months).

 

Ideas: Using $DXY as the guidepost, long US dollar below 95 versus the Australian dollar and New Zealand dollar, given the low cost of carry.

 

Thoughts

 

Summary

 

  • Macro Risks: Using rallies to reduce equity exposures tactically and increase bond allocations, take profits in European equities

 

  • Inflation is the Enemy: Growth shocks and not inflation shocks are probably the bigger risk to diversified portfolios in the near-term

 

  • Valuations: Gold is indicating equity market multiples have peaked

 

  • US Yield Curve: Prefer steepeners and then the short-end of the curve

 

  • Modern Monetary Theory: Probably not what you expect

 

Macro Risks

9

The chart above is of the 52-week moving average of the Citi Macro Risk Index. It is not the magnitude rather the direction of the risk index that acts as a cyclical indicator.  (Rising line indicates increasing macro risks.)

 

With the risks that built up during the sell-off in the last quarter of 2018 and the recession fears that peaked in the summer of last year having been largely unwound, some caution is now warranted. We think equity rallies hereon should be used to gradually reduce allocations to leave powder dry for cyclically more opportune times to go on the offensive.

 

10

 

The chart above is the ratio of gold, in euros, to the Euro Area all shares index versus the differential between 10-year government bond yields of the ‘fragile’ European economies and Germany. (For the latter we use the average of the yields on Spanish, Portuguese and Italian 10-year bonds and subtract from it the yield on 10-year German bonds.)

 

The two series are a means of measuring sovereign, or break up, risk in Europe. Rising ratios imply rising sovereign risks and a rush towards the safe havens of gold and German debt. Recently, with gold having rallied and some form of Brexit related agreement forming, the two time-series have diverged. The yield differentials indicate a declining risk premium while the gold-to-shares ratio indicates a rising risk premium.

 

With the hard work to resolve Brexit still pending and the potential for a flare up in a trade spat with President Trump under-priced, we think there is more than a modicum of complacency on investors’ part with respect to risks in Europe. Profits should be taken on European equities.

 

Avoid: Shorting funding currencies, namely the euro, Swiss franc and Japanese yen, as they can rally sharply during risk-off periods

 

Inflation is the Enemy

 

Generally, the main macroeconomic risk factors that drive expected returns in equities and bonds are growth and inflation. With equity returns being most sensitive to growth and bonds to inflation.

 

Lower expected risk-adjusted returns in equities begin to be priced in when the economy is supply constrained and central banks are tightening monetary policy to lower nominal growth. This also tends to be the more inflationary phase of the business cycle with rising unit labour costs and valuation multiples at or near cycle highs. In contrast, higher expected returns begin to be priced in when the economy is operating below potential and central banks are easing monetary policy to prop-up nominal growth. This generally tends to be a disinflationary phase in the business cycle with unit labour costs falling and valuation multiples at or near cycle lows.

 

11

 

The chart above is of the trailing earnings yield (inverted price-to-earnings ratio) of US stocks and realised inflation rates. Theoretically, since stocks are real assets, changes in the rate of inflation should not have a meaningful impact on stock prices or valuation multiples. In practice, however, the principle does not hold. Historically, US earnings yields have been more closely related to the rate of inflation than to nominal or real bond yields.

 

A comparable relationship between inflation and earnings yields has also been found to exist in many other markets.

 

The expected risk-adjusted return in bonds also tends to be counter-cyclical. Specifically, policymakers are more prone to hiking policy rates when there is little to no slack in the economy and inflation pressures begin to emerge.

 

At a portfolio level, risk-adjusted returns of the portfolio also depend on the correlation of constituent assets over the course of the cycle. Economic theory has it that asset prices reflect the present value of future cash flows. Given that inflation determines the discount rate for both equities and bonds, it also tends to drive both assets in the same direction. At times when inflation shocks dominate, equities and bonds become positively correlated. While, since growth rates affect equities more than they do bonds, growth shocks dominating leads to bonds and equities being negatively correlated.

 

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The chart above is of the US stocks-to-bond correlation and the 6-month rolling average of the annual rate of inflation, as measured by the consumer price index excluding shelter.

 

During the period from 1965 through to 1997, when inflation expectations experienced large swings, the stock-to-bond correlation was almost consistently positive. That is, changes in inflation expectations drove both stock and bond returns and during periods of equity market weakness bond allocations did not make up the difference. For example, in the sub-period between 1973 and 1981, during which there was a negative supply shock from the OPEC oil export embargo, multiple recessions, high unemployment rates and high inflation, equity market weakness coincided with poor bond market performance.

 

The time-series demonstrates how the correlation between equities and bonds is not static. The implication being that bond allocations do not always serve as a suitable diversifier for equity allocations. Rather, it is the prevailing market regime, as described above, that determines the efficacy of bond allocations to lower drawdowns and portfolio level volatility during equity market sell-offs.

 

As the chart shows, the last decade, as all of us already know, was characterised by low-growth, negative growth surprises and low-and-steady inflation. That is, a decade of negative correlation between bonds equities.

 

Asset Allocation

 

A strategic asset allocation framework, it then follows, should contain equity and bond exposure levels conditioned on the phases of the business cycle.

 

Upside inflationary shocks make traditional 60/40 and risk-parity like allocations suffer as bonds and equities sell-off concomitantly.  While periods of benign inflation with the occasional growth shock are well-suited to portfolios diversifying equity exposures with heavy bond allocations.

 

According to our framework, however, the probability of a near-term inflationary shock remains low. Rather, we anticipate the risk of a near-term negative growth shock to be much higher than that of inflation sustainably surprising to the upside.

 

“The driving force for underlying profits is credit growth, and in the process the most conservative among institutions compromise standards and engage in practices that they would not have dared pursue a decade or two ago. The heroes of credit markets without a guardian are the daring―those who are ready and willing to exploit financial leverage, risk the loss of credit standing, and revel in the present casino-like atmosphere of the markets.”

Interest Rates, the Markets and the New Financial World (1986) by Henry Kaufman

 

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An example of growth remaining elusive comes from the Federal Reserve’s recent senior loan officer survey, which revealed that banks left commercial and industrial lending standards mostly unchanged amid weakening demand for credit.

 

Bonds, rather than commodities and other inflation hedges, remain, for the near-term, the most suitable hedge for equity allocations.

 

Ideas: Long Japanese Government Bonds and allocations overweight bonds relative to equities and commodities (excluding gold / precious metals)

 

Avoid: Treasury Inflation Protected Securities (TIPS)

 

Valuations

 

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The chart above is of the S&P 500 Index expressed in terms of gold (in US dollars per Troy Ounce) versus the index’s cyclically adjusted price-to-earnings ratio (as calculated by Professor Robert Shiller).

 

While we use the CAPE to smooth out the effect of the Global Financial Crisis, using annual price-to-earnings multiples would convey the same message. In simple terms, the price of gold is inversely correlated to the price-to-earnings multiple of the index.

 

The price of the S&P 500 in terms of gold suggests that valuation multiples have peaked on a cyclical basis.

 

Ideas: Gold can serve as a hedge for equity market multiple-contraction

 

 

US Treasury Yield Curve

 

“During 1870-1910, the decades of dynamic expansion, German government bond yields were actually declining. German yields did not decline as far as did British, Dutch, and French yields but were low enough to suggest that the savings of the people were keeping up with the financing requirements of a fast-growing economy. Germany was enjoying the benefits of that mighty weapon, a smooth annual accrual of new savings seeking investment in interest bearing securities. In the years before 1914, German bond yields were similar to yields in the United States, another large and fast-growing nation during the period 1870-1914.”

A History of Interest Rates by Sidney Homer (1864 – 1953) and Richard Sylla

 

The chart below is of the US yield curve (10 year minus 3 month) versus private saving less private investment. The latter points towards a further steepening of the US yield curve.

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The chart below is of the de-trended 3-month Treasury bill rate (inverted) ― de-trended by subtracting the 10-year moving average from the bill rate ― versus the US Treasury 10-year and 3-month yield curve. The chart dates from 1962 till today, suggesting that the de-trended 3-month Treasury bill rate contains information about the direction of the yield curve.

 

16

 

The two-time series have a correlation of -0.75 with an r-squared of 57 per cent.

 

(The dashed lines on the above chart are the average de-trended bill rate and levels one standard deviation above and below the average.)

 

The relation between the de-trended bill rate and the yield curve indicates a strong tendency of interest rates to mean revert. The wider the gap between the current de-trended bill rate and its long-term average, the stronger the markets expectation of mean-reversion.

 

This relationship, too, points towards a further steepening of the US yield curve.

 

Ideas: Long yield curve steepeners or alternatively long the short-end of the yield curve

Modern Monetary Theory

 

‘War Board’ Proposed

 

April 13, 1933

 

A plan to mobilize private industry under the government for expansion in the production of articles and materials in normal demand, this expansion to be coeval with the administration’s public works activities, is being developed by the President’s closest advisors and they hope to persuade him to attempt it.

 

Certain types of industry, under the plan, would be assembled and regulated by a government agency reminiscent of the War Industries Board. Competition would be regulated: hours of work and minimum rates of pay would be fixed; and some of the proponents of the idea also would have the government guarantee manufacturers against loss in resuming or increasing the manufacture of prescribed articles and materials.

 

The thought behind the plan is that a public works program standing by itself, even if the five billions is expended upon it, will not sufficiently reduce unemployment or make use of the new purchasing power. It is contended that private industry must, at the same time, be put in a position to absorb the new purchasing power, composed of the billions which the government will be putting in the hands of citizens all over the United States. To do this, it must resume manufacture, and that will restore many to private employment in the factories themselves and in the retail establishments which will dispose of the products of these factories. This will, in turn, give purchasing power to those privately as well as those governmentally employed. A part of the billions will then flow back to the Treasury in various forms of taxation.

 

The argument which seems to have been most effective in bringing the administration to support the public works appropriations is that the deflationary policy has cut down the purchasing ability of the country by seven billions. Of this five billions is in closed banks, one billion in the budget savings and another billion in reductions made by the several State governments.

 

The vast public works program having been definitely agreed upon, with the probability that it may involve an expenditure of as much as five billions, it soon became evident to the architects of administration policy that this plan needed a companion.

 

It was all very well to balance the budget, and, with government credit thus establish, to borrow billions for roads, buildings, flood control and the like. But this question remained: How could private industry get the full use of those billions for purchase? Without some form of government stimulation and aid, it was felt that manufacturers of ordinary consumers’ commodities would wait to clear their stocks, while retailers were clearing theirs, and when the manufacturers did resume production, they would simply proceed at “depression pace.”

 

The result of these considerations was the plan to set up a government agency to induce industrial expansion, to quicken and regulate it meanwhile, to protect it against loss and perhaps even to fix the prices of labor’s product as well as the wage of labor itself.”

In The Nation: 1932-1966, Arthur Krock (1886 – 1974)

 

Modern Monetary Theory (MMT) advocates fiscal measures and the role of government in the creation of money over monetary policy and as such stands in almost complete contrast to traditional macroeconomic theory. A key to understanding MMT is to appreciate the difference between users of currency, primarily the private sector, and the monopoly issuer of said currency, the government.

 

Beginning with the economic assumptions of full employment and full capacity utilisation ― that is, a country facing real resource constraints. Under such a scenario, inflationary pressures can become a genuine and immediate danger and monetary policy can, arguably, play a critical role play to dampen excess demand and by extension inflationary pressures. For instance, by raising the level of interest paid on excess reserves, the central bank could increase the opportunity cost of lending activities, encouraging banks to instead place more cash with the central bank or demand a higher rate of return from potential borrowers. Thereby raising the cost of capital.

 

Proponents of MMT contend that adjustments to the government’s fiscal policy could just as easily be used to achieve the same objective. For example, excess demand could be dampened by raising tax rates, be it income, sales or value-added taxes.

 

The reality today, however, is that few, if any, economies face resource constraints. Rather, interest rates persist at or near historic lows, inflationary pressures have remained transitory at best and the global commodity complex remains largely mired by excess capacity. Monetary policy has proven impotent in reflating the economy and zero-bound interest rates have neither spurred demand for credit nor compelled banks to lend.

 

In the current state of the global economy, MMTers argue, is when the prescriptions of the theory are most potent. Tax cuts, for example, can be utilised to immediately increase private sector disposable incomes.

 

By divvying up the economy across private and public sectors and recognising that the balance sheet constraints across the two sectors are incongruent, MMT perceives fiscal policy as a means to lessen (increase) private sector funding pressures, when the economy is operating below (at or above) capacity.

 

In a fiat currency system, the government has the flexibility to affect changes in private sector behaviour by fine-tuning its budget deficit. At a time when the private sector is deleveraging, if government fails to offset this by widening its budget deficit, it effectively starves private sector activity. In a fiat currency system, it is government, not the central bank, that creates new liabilities that become the assets of the private sector.

 

So, at any level of income, if the private sector decides to deleverage, the public sector must by definition, end up saving less by running a larger budget deficit or shrinking a budget surplus. In an ideal world, any shifts in the private sector’s propensity to save would be matched by an immediate change in the tax rate, and the combined income of the public and private sectors would remain stable. A key policy prescription stemming from MMT, then, is to keep monetary policy steady and to manage the economy by adjusting the tax rate.

 

The Practical Implications

 

Most discussions on MMT devolve into either how it spells the end of the US dollar, or fiat currencies in general, or how it will spur uncontrollable inflation and therefore one must own gold or bitcoin or both. With time these proclamations may prove correct. The thing about capital markets, however, is that for the most part it is the path not the endgame that matters.

 

And as far as the path is concerned, it is not unreasonable, in our opinion, that, initially, MMT, or any other form of government led fiscal activism, reinforces deflationary not inflationary forces. That is, by opening up the fiscal spigot policymakers continue to keep cost of capital artificially suppressed thereby further delaying the inevitable impairment of excess capacities, zombie companies and unproductive debts.  Ever increasing advantages would then continue to accrue to large companies, with access to low cost capital, at the expense of small and medium enterprises, further compounding the issues of inequality and declining productivity. Such a deflationary death spiral is what, we think, precipitates the endgame, not a sudden burst of inflation.

 

Books

 

Five We Have Read and Recommend

 

  1. Surfing the Edge of Chaos: The Laws of Nature and the New Laws of Business by Richard Pascale, Mark Milleman and Linda Gioja
  2. The Match King: Ivar Kreuger, The Financial Genius Behind a Century of Wall Street Scandals by Frank Partnoy
  3. The Man Who Solved the Market: How Jim Simons Launched the Quant Revolution by Gregory Zuckerman
  4. The Great Rebalancing: Trade, Conflict, and the Perilous Road Ahead for the World Economy by Michael Pettis
  5. How Global Currencies Work: Past, Present, and the Future by Barry Eichengreen, Arnaud Mehl, and Livia Chitu

 

Five from Our 2020 Reading List

 

  1. The Education of a Speculator by Victor Niederhoffer
  2. The Model Thinker: What You Need to Know to Make Data Work for You by Scott E. Page
  3. Micromotives and Macrobehavior by Thomas C. Schelling
  4. Clash of Empires: Currencies and Power in a Multipolar World by Charles Gave & Louis-Vincent Gave
  5. Energy and Civilization: A History by Vaclav Smil

 

Thank you for reading and please share!

 

 

This document should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

The January Effect

“Trying to change before you’re ready isn’t likely to be productive. For example, most New Year’s resolutions don’t last because people spring into action without being prepared for the work it’s going to take. Forcing change based on a date on the calendar, rather than a true readiness to transform, can be a setup for failure.” ― Amy Morin

“Another lesson I learned early is that there is nothing new in Wall Street. There can’t be because speculation is as old as the hills. Whatever happens in the stock market to-day has happened before and will happen again. I’ve never forgotten that. I suppose I really manage to remember when and how it happened. The fact that I remember that way is my way of capitalizing experience.” ―  Reminiscences of a Stock Operator, Edwin Lefèvre,

Please note, this will be the last weekly piece for the year. The next piece will be sent out between 6 and 8 January.

The beginning of a New Year seems like a great time to take stock of the last year and set goals for the next one. Unfortunately, by February an estimated four-fifths of people have failed to stick to the goals they have set for the year. Life-changing commitments are just hard to, well, commit to. The corollary of most people being unable to stick to their goals for more than six weeks, is that most of us are almost surely going about the process of setting goals the wrong way.

We do not know, or profess to understand, the reasons that most people fail to stick to their New Year’s resolutions or how to correct the process. It’s probably a combination of factors and life just getting in the way. That does not mean we cannot recognise the repetitive behaviour.

In this week’s piece we discuss the ‘January Effect’, a seemingly repetitive phenomenon occurring in capital markets.

The January Effect

The above is the average price return by month for the S&P 500 Index over a number of different time periods, all ending 30 November 2019. In all of the sample periods, the monthly return for the S&P 500, on average, has been higher in January than the average monthly return over the entirety of the respective period. In the two longest sample periods, January also has the highest average monthly return.

We do not have the same amount of data available for small-cap stocks, but at least for the 10 years, we can see that even in small cap stocks the average monthly return for January was well above the average monthly return for the entire period.

The January Effect is not limited merely to stock market outperformance in January relative to the other months of the year. Rather, it also extends to the type and form of stocks that tend to generate the highest returns during January.

Empirical research published in 2009, Gambling Preference and the New Year Effect of Assets with Lottery Features by Dorian-Jiang-Peterson, found evidence for seasonally high risk appetite at the beginning of the year. The research shows that lottery-type stocks – those with low prices, high volatility and / or high skewness – tend to outperform during January. Moreover, out-of-the-money options tend to be relatively more richly priced than at-the-money options especially when compared to the relative pricing of the options in other months. The most striking relative outperformance in January was found to be that between high volatility and low volatility stocks.  

Notably, the raised gambling appetite at the start of the year is not only an American phenomenon. In China, Chinese lottery-type stocks tend to outperform around the Chinese New Year (rather than in January).

Other empirical research has also identified the following phenomena related to the January Effect:

  1. Small-cap stock risk premia, that is the outperformance of small-cap stocks over large-cap stocks over the long-term, is almost entirely captured during Januaries. January is the time of year to be long small-cap stocks.
  2. High-volatility stocks, on average, only outperform in January and underperform the rest-of-the-year.
  3. Bond term premium – that is, the excess return from being long, longer-dated bonds over shorter-date bonds – is earned almost entirely outside Januaries. January is not the time of year fixed-income investors should be extending duration.
  4. Reversion-to-the-mean strategies tend to, on average, outperform momentum strategies in January. This is probably explained to some extent by tax-loss selling whereby underperforming stocks are sold at the end of the year to reduce tax liabilities and bought back at the start of year.
  5. High-yield debt and the US dollar, on average, tend to fare better in January than during the rest of the year.

Finally, some detailed but somewhat dated studies have found that the bulk of the January effect comes in the first few days of the year – a pattern also found in many other countries, even those where the tax year does not coincide with the calendar year.

Explaining the January Effect

The persistence of the January Effect is somewhat baffling; one would expect it to have been arbitraged away by now. The reasons often cited for its persistence are technical and behavioural such as tax-loss selling and institutional investor window-dressing.

Tax-loss selling puts general pressure on underperforming assets and those exhibiting low-levels of liquidity at year-end. A technical factor leading to the selling at year-end is also likely to contribute to inflated demand for such assets at the start of the year.

Institutional window dressing is the tendency of institutional investors to want to show safe, liquid and outperforming assets on their books when holdings are revealed at the end of the year. Such behaviour tends to drive demand for momentum stocks and government bonds in November and December, which is probably reversed at the start of the following year.

Another plausible behaviour factor is the feeling of starting the year anew and full of optimism. That is optimism is high in January and recedes over the course of the year as reality sets in and risks manifest.

Positioning

“Well, this is a bull market, you know” ― Reminiscences of a Stock Operator by Edwin Lefèvre

The longest bull market on record and probably the most hated is unlikely to go out on a whimper. We expect a few fireworks before its all over and that could make the coming January as exciting as any. For that reason, while we would keep some powder dry (cash on the sides), there is a case to be made to add some volatile names to one’s allocation.

That is why we added Slack Technologies $WORK and Uber Technologies $UBER to our Trade Ideas yesterday.

At the same time, we leave you with one more quote from Reminiscences of a Stock Operator, to remind you to reduce exposure once you are happy with your returns.

“One of the most helpful things that anybody can learn is to give up trying to catch the last eighth—or the first. These two are the most expensive eighths in the world.”

Thank you for your support during 2019!

Tribalism and Consistency in a Volatile Market

A somewhat lengthy piece discussing some of the psychological hindrances all of us face from time-to-time in investing and trading pursuits.

We share one chart right at the end of the piece with little comment, which is the basis of our expectation that the US equity market is to see new highs still.

The Science of Tribalism

 “Everybody wants to protect their own tribe, whether they are right or wrong.”Charles Barkley

While watching television, have you ever looked away or squealed in response to a gruesome scene, the kind that became a regular occurrence on HBO’s Game of Thrones?  Turns out, this is because the imagery activates our brain’s empathy network, which then stimulates brain areas involved in the sensation of our own pain.

Neuroimaging studies have revealed that watching another person in pain triggers brain areas that are active when we feel pain. The neural response to seeing others in pain, however, is not constant; rather it is modulated by context and by allegiances.

Neuroscientist David Eagleman used functional magnetic resonance imaging (fMRI) to measure the response in the brain’s empathy network. He examined the brains of people watching videos of other people’s hand getting pricked by a needle or touched by a Q-tip. When the hand being pricked by the needle was labelled with the participant’s own religion, the participant’s empathy network showed a larger spike of activity than when the hand was labelled with a different religion.

More surprisingly, when participants were assigned to an arbitrary group immediately before the subject entered the MRI machine, and the hand being pricked was labelled as belonging to the same arbitrary group as the participant, the participant’s brain still showed a larger spike ― even though the grouping did not exist just moments earlier!

Participants also exhibited a diminished response in their empathy networks if they believed the pain-recipient has acted unfairly in a simple economic exchange or were told that the victim is receiving a large monetary compensation for undergoing the pain.

Commitment and Consistency

“Consistency is the hallmark of the unimaginative.”Oscar Wilde

Last week we were forwarded a quarterly commentary and portfolio review for a fund managed by a self-proclaimed “old-school value investor”. The commentary was standard fare really, espousing the well-known values of Graham and Dodd and Buffet and Munger schools of investing as would be expected from a value-oriented manager. The fund manager was particularly insistent that they only buy “companies at a big discount to the present value of their future cash flows”.

As we turned to the section listing the fund’s top holdings, that too read like a standard portfolio that we had seen from countless other value managers. There was a lot of Google in the portfolio, a little Apple, a few big-name financial stocks and a not-so-insignificant allocation to General Motors. Except there was one holding which we did not expect, Netflix. And seeing it in the list of holdings, one of top-five in terms of allocation, irked us. Reading the commentary already felt like it was not the best use of our time but after seeing Netflix in the portfolio, the feeling changed to that of being cheated somehow.

Feeling cheated after reading the commentary and seeing the holdings for a fund we are not invested in, strange right?

The following passage is excerpted from Influence: The Psychology of Persuasion by Robert B. Caldini (emphasis added):

Psychologists have long understood the power of the consistency principle to direct human action. Prominent early theorists such as Leon Festinger (1957), Fritz Heider (1946), and Theodore Newcomb (1953) viewed the desire for consistency as a central motivator of behavior. Is this tendency to be consistent really strong enough to compel us to do what we ordinarily would not want to do? There is no question about it. The drive to be (and look) consistent constitutes a highly potent weapon of social influence, often causing us to act in ways that are clearly contrary to our own best interest.

Consider what happened when researchers staged thefts on a New York City beach to see if onlookers would risk personal harm to halt the crime. In the study, an accomplice of the researchers would put a beach blanket down five feet from the blanket of a randomly chosen individual—the experimental subject. After several minutes of relaxing on the blanket and listening to music from a portable radio, the accomplice would stand up and leave the blanket to stroll down the beach. Soon thereafter, a researcher, pretending to be a thief, would approach, grab the radio, and try to hurry away with it. As you might guess, under normal conditions, subjects were very reluctant to put themselves in harm’s way by challenging the thief—only four people did so in the 20 times that the theft was staged. But when the same procedure was tried another 20 times with a slight twist, the results were drastically different. In these incidents, before leaving the blanket, the accomplice would simply ask the subject to please “watch my things,” something everyone agreed to do. Now, propelled by the rule for consistency, 19 of the 20 subjects became virtual vigilantes, running after and stopping the thief, demanding an explanation, often restraining the thief physically or snatching the radio away (Moriarty, 1975).

To understand why consistency is so powerful a motive, we should recognize that, in most circumstances, consistency is valued and adaptive. Inconsistency is commonly thought to be an undesirable personality trait (Allgeier, Byrne, Brooks, & Revnes, 1979; Asch, 1946). The person whose beliefs, words, and deeds don’t match is seen as confused, two-faced, even mentally ill. On the other side, a high degree of consistency is normally associated with personal and intellectual strength. It is the heart of logic, rationality, stability, and honesty.

The fund manager was inconsistent. He championed investing in “companies at a big discount to the present value of their future cash flows” and then went ahead and owned Netflix. The gall of it!

The Incompatibility of Tribalism and Consistency in a Volatile Market

Our vocation is such that we are often engaged in debate. On the merits of buying one security over another. On the signals from one asset class for the prospects of another asset class. On the reaction function of the Federal Reserve to the latest release of economic data. And on many other topics much like these.

Over the last eighteen or so months, markets have been extraordinarily challenging.

US stocks have rallied, sold off, rallied sharply, sold off sharply, rallied sharply and now started to chop. G-7 governments have sold-off with the US ten-year reaching yields of 3 per cent and then rallied to record low yields. The trade-dispute between the US and China has escalated, de-escalated and escalated again on more occasions than we care to recall. Bitcoin lost more than two-thirds of its value, then tripled and then halved. Repo rates spiked for reasons no-one can fully comprehend. Oil witnessed the re-emergence of a geopolitical premium only for it to subside almost instantly.

In our discussions and debates, we have found that a fair share of traders, active managers and asset allocators are, more than ever, struggling to keep up, let alone outperform, broader market indices. Markets are never easy, in these challenging climes even less so. Nonetheless, two of the recurring hindrances to better performance we have increasingly noticed are tribalism and consistency.

Tribalism in Social Media and Investment Decision Making

Tribalism can be easy to spot. Just go on to Twitter and you will find bond bulls re-tweeting bond bulls, goldbugs sharing articles of Paul Tudor Jones stating that gold is his best idea for the next two years, equity market bears praising the analysis of other bearish analysts, Tesla bulls and bears slinging mud at each other, the examples are countless. Worse still, try debating with someone you do not know but disagree with and present factual data that invalidates their view and you are likely to be blocked more often than you would expect.

Tribalism in a social media context leads to filter bubbles and to the consumption of news, views and research that confirms that which we already know or believe. The utility of a social media platform, such as Twitter, to a user is significantly reduced by tribal behaviour. It has never been easier, faster and cheaper to seek out and obtain a variant perception. Investment professionals and traders would be better served and probably see improving performance if they used social media platforms more to seek out non-conforming views rather than searching for the false sense of security that belonging to arbitrary Twitter tribe would bring.

In professional settings tribalism is less of a problem but at the same time harder to spot. At investment firms, it usually manifests in team members with non-consensus views or opinions being cast aside in the investment decision making process.

Tribalism can lead to poor investment decision making when good ideas are rejected because they are put forth by those long belonging to the ‘other tribe’ and bad ideas presented by those belong to ‘our tribe’ are accepted.

Worse still, is the case of tribal behaviour on social media that creeps into professional settings. If you are wondering if it really happens, we recently attended a meeting with a prospective client where one of the analysts quoted recent tweets by three, to remain unnamed, permabears to make a case against an allocation to US equities.

Consistency is the Real Enemy

“Laziness isn’t merely a physical phenomenon,about being a couch potato,stuffing your face with fries and watching cricket all day. It’s a mental thing, too, and that’s the part I have never aspired for.”Shah Rukh Khan, Indian actor, film producer, and television personality

While tribalism can be toxic, it is consistency that can be the real enemy in the investment decision making process.

Since a “high degree of consistency is normally associated with personal and intellectual strength” it usually serves one’s interests to remain consistent. The downside, however, is that this fosters almost blind consistency which is detrimental, and at times outright disastrous, in the process of investment decision making.

Blind consistency, outside of investment decision making, has its attractions. For starters, it frees up our mental resources by giving us a relatively effortless means for dealing with the complexities of daily life that make severe demands on our mental energies and capacities. Having made up our mind about an issue, blind consistency allows us to stop thinking about the issue and when confronted with the issue we only react in a manner consistent with our earlier decision.

Another attraction of mechanically reacting to an issue is that it protects us from the uncomfortable truth that we may be wrong. If we never expend the energy to understand the counter-argument, and reject it off the bat, we never have to confront the possibility that we may wrong.

Consider the following (real life) examples and if any resonate with you.

Bond bulls who will exit their bonds positions to lock in profits but will never go long stocks because a recession is always just around the corner.

– Gold bears that short at the lows because it’s a ‘barbarous relic’ and fail to cover or go long even as real rates are collapsing.

– Federal Reserve critics that see every market jitter as further confirmation of central banker incompetence but have not taken the time to understand the intricacies of the financial system.

– US dollar bulls that never go long another currency against the greenback even as it becomes painfully obvious that a rally has become over stretched.

– Permabears that told you that Apple was done after the ‘failed’ iPhone 5 and now poo-poo over the company’s services narrative.

– The bearish fund manager that identifies the flaw in his framework that led them to catastrophically underperform over the last decade somehow finds that the updated framework indicates that is time to short US stocks.

– The technical analyst that shows you analogs of today’s US market performance versus sometime leading up to the crash in 1929, 1987, 2008 or any other market crash that can be found or compressed to fit the narrative but never one that shows the market going higher.

All of the above examples are of blindly consistent people. In any other context you would respect them. In an investment context, they would have at times cost you money, a lot of it. In many instances it is acceptable to underperform. It is, however, unacceptable to underperform because you were unwilling to do the work or to appear inconsistent.

Improving Liquidity Indicators Suggest New Highs Still to Come

Combine the below with the three charts we shared last week and the prospect of the S&P 500 reaching levels 10 to 15 per cent higher from here is not altogether unreasonable.

Thanks for reading and please share!

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed

Three Macro Charts

 

“We can chart our future clearly and wisely only when we know the path which has led to the present.” ― Adlai Stevenson I, 23rd Vice President of the United States of America

A short piece with three macro charts and limited commentary.

1. Global Risk

Data validating recessionary fears have been the flavour du jour recently. The below is a chart of the MSCI All Cap World Index and the twelve-month moving average of the Citi Macro Risk Index, which suggests that a cyclical upturn in global equities is probable.

It is not the magnitude rather the direction of the risk index that acts as a cyclical indicator.

A similar sell-off to that witnessed in the fourth quarter of 2018 is not inevitable in the fourth quarter of 2019.

2. Cyclical USD

A custom leading index of global financial conditions suggests the cyclical trend for the USD is lower, even as the secular trend of the greenback remains intact.

 

3. Secular Trend in Real Yields

Quoting the National Bureau of Economic Research:

“The large and growing US current account deficits resulted from the large volume of foreign savings pushing in, as indicated by the declining US real interest rates, and not from US ‘profligacy’.”

The below chart is of the sum of foreign reserves held by China and Japan (inverted) and the real US 10 year treasury yield, for the period starting right after the Asian Financial Crisis.

The Asian Financial Crisis set in motion the trend of rising current account surpluses in Asia that were funneled back into the US. One major leg that furthered the trend, Chinese savings being recycled into US assets, has been broken by the protectionist policies of the US and economic challenges China is facing up to domestically.

The recycling of Asian current account surpluses into US assets is coming to end at the same time the US is entering a demographic driven inflationary phase, as argued by the Bank for International Settlements.

The secular tailwinds that drove down real yields in developed economies are weakening.

Thanks for reading and please share!

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. 

Clustered Volatility and the “Momentum Massacre”

 

“But, as with markets, in the ocean the interesting things happen not at the equilibrium sea level which is seldom realized, they happen on the surface where ever-present disturbances cause further disturbances. That, after all, is where the boats are.” ― W. Brian Arthur

 

Financial markets exhibit a temporal phenomenon known as clustered volatility. That is, the existence of periods of low volatility followed by periods of high volatility. Low volatility reigns supreme when the the outcome of the cumulative actions of market participants mutually benefits the majority. And, by extension, reaffirms the confidence the majority of market participants have in their forecast, “investment process”, algorithm or “analytical framework”  ― or, more crudely, heuristics that they use in making their trading or investment decisions. The majority continue to follow their “process” and among the minority that did not benefit in the run up all but the most stubborn gradually adapt their processes to implicitly or explicitly chase momentum. Low volatility begets low volatility.

 

High volatility often occurs when an external agent, such as President Trump tweeting about tariffs or the People’s Bank of China excessively tightening or loosening financial conditions, disrupts the seeming equilibrium in the market. All else being equal, which it never is, the impact of external agents on market volatility, however, tends to be fleeting. For example, the declining half-life of President Trump’s trade war related tweets impact on the US equity market.

 

A structural change in volatility generally occurs when some participants or a group of market participants alter their algorithm ― such as shifting from selling at the money puts to deep out of the money puts ― or investment process or by the entry of entirely new participants with a novel agenda ― like the Bank of Japan buying up ETFs as part of its QE programme ― to the market.

The changing of algorithms or processes may, of course, be in response to the actions of external agents or the impact said actions had on the market. Regardless, this “updating” allows the first movers to  front-run or anticipate the behaviour of the majority, which in turn causes other investors to re-adapt. This adaptive behavior, if it successfully percolates and propagates, moves the market away from its seeming equilibrium and into a state of ‘chaos’. It is this process of re-adapting that tends to precipitate longer lasting bouts of higher volatility.

 

Robert F. Engle, the winner of the Nobel Prize in Economics in 2003,  formally defined this process of random periods of low volatility alternating with high volatility in financial markets as the the generalised autoregressive conditional heteroskedasticity (GARCH) process.  (Heteroskedasticity is where observations do not conform to a linear pattern. Instead, they tend to cluster.)

 

Momentum Massacre

 

From the Financial Times on 12 September 2019 (emphasis added):

 

“The stock market may appear tranquil again after a rollercoaster summer, but many analysts and investors are unnerved by violent moves beneath the surface, reviving memories of the 2007 “quant quake” that shook the computer-driven investment industry.

 

The FTSE All-World equity index has rallied almost 3 per cent already this month, clawing back some of August’s losses. However, many highly popular stocks suffered a sudden and brutal sell-off this week, a reversal that analysts have already dubbed the “momentum crash”.

 

The blow was particularly strong in the US, where strong-momentum stocks — those with the best recent record — tumbled 4 per cent on Monday, in the worst one-day performance since 2009, according to Wolfe Research. Only once before, in 1999, has such a rout afflicted momentum-fuelled smaller company stocks, according to investment bank JPMorgan.”

 

This is massive,” said Yin Luo, head of quantitative strategy at Wolfe Research. “This is something that we haven’t seen for a long time. The question is why it’s happening, and what it means.”

 

The flipside has been a dramatic renaissance for so-called “value” stocks — out-of-favour, often unglamorous companies in more economically sensitive industries. The S&P value index has climbed about 4 per cent this week and, compared with momentum stocks, enjoyed one of its biggest daily gains in a decade on Monday.

 

The chart below is the ratio of the S&P Growth index to the S&P Value index. We are struggling to find the “dramatic renaissance”.

 

SGX Index (S&P 500 Growth Index) 2019-09-18 16-41-52.jpg

 

Of course we are being more than a bit flippant. Nonetheless, we do not think it is time to completely drop momentum or growth stocks and load up on value stocks. Rather we think the market is in a transient phase where participants are updating their algorithms and processes to go beyond momentum.

 

Our prescription from June remains valid:

 

We are increasingly convinced that a barbell strategy should be applied today in managing equity exposures. With tech and other growth names on one side and value names and precious metals on the other. And if tech and growth continue to rally, investors should re-balance  regularly to avoid any lopsidedness in their portfolios.

 

The above has worked well in the recent “momentum massacre” and can continue to work well as long as uncertainty remains high and sentiment viciously waxes and wanes between optimism and pessimism. A slight adjustment to the above, however, is warranted as follows:

 

A barbell strategy should be applied today in managing equity exposures. With tech and other growth names on one side and value names and precious metals energy plays on the other.

 

Do Not Drop Momentum ― Not Completely Anyway

 

Dropping momentum or growth completely would be akin to calling the end of the transition away from actively managed portfolios to passively managed allocations that has accelerated since the Global Financial Crisis. Passive allocations are implicitly momentum seeking strategies. A strong secular trend is not upended by a 4 per cent move, it will take a crisis or a severe re-think of strategic asset allocation by the managers of the largest pools of capital to bring about an end to the trend.

 

The rise of passive investing, along with systematic volatility selling strategies, has contributed to the dampening of volatility since the Global Financial Crisis. A growing share of passive allocations, however, is somewhat like increasing leverage. As passive flows now make up the lion’s share of capital market flows, the actions of active investors are spread over a smaller segment of the investment universe. As the size of the active universe shrinks, in terms of what could be described as, in the case of stocks, free float market capitalisation minus passive allocations, the actions of active investors begin to have an exaggerated impact and give rise to higher volatility.

 

Simply put, the passive flows versus volatility curve is convex. Initially, increasing passive flows dampen volatility but beyond some hitherto unknown level increasing passive flows lead to higher volatility.

 

Why Energy Over Precious Metals?

 

Without delving into the geopolitics of it, the attacks on the Saudi Arabian oilfield should remind major oil consumers ― airlines, refiners, transportation companies and emerging economies such as India and China ― to review their energy security and hedging strategies. To balance future energy needs and to not become hostage to a rising geopolitical risk premium in the price of oil. This should lead to a rise in demand for oil at the margin; commodity prices are, of course, set at the margin.

 

The other angle is that if anything is going to take down the almighty bond bull market its going to be either: (1) fiscal spending by the G-7 governments of the like that we have never seen; or (2) a sharp and sustained increase in oil prices.

 

Lastly on energy, if Iran is, rightly or wrongly, shown to be the perpetrator of the attacks, China may have to reconsider it decision to purchase Iranian oil.

 

 

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

 

Shifts in US Capital Flows and Positioning for a Steepening Yield Curve

 

A chart heavy piece this week in which we dig into the underlying shifts in the capital flows into the United States.

 

We had aimed to issue this piece last week but it took more work and longer to draw out coherent conclusions than we had anticipated.

 

The key takeaways we draw out from the analysis in this week’s piece are (1) the structural shifts in capital flows into the US since the Global Financial Crisis and (2) a flows based framework for charting the path of the US dollar.

 

“Total return has three elements: the interest rate differential, the exchange rate differential, and the capital appreciation in local currency. Since the third element varies from case to case we can propose the following general rule: speculative capital is attracted by rising exchange rates and rising interest rates.

 

Of the two, exchange rates are by far the more important. It does not take much of a decline in the currency to render the total return negative. By the same token, when an appreciating currency also offers an interest rate advantage, the total return exceeds anything that a holder of financial assets could expect in the normal course of events.

 

That is not to say that interest rate differentials are unimportant; but much of their importance lies in their effect on exchange rates and that depends on the participants’ perceptions. There are times when relative interest rates seem to be a major influence; at other times they are totally disregarded. For instance, from 1982 to 1986 capital was attracted to the currency with the highest interest rate, namely, the dollar, but in the late 1970s Switzerland could not arrest the influx of capital even by imposing negative interest rates. Moreover, perceptions about the importance of interest rates are often wrong.

 

The Alchemy of Finance, George Soros (emphasis added)

 

For those of you not wanting to run through the lengthy discussion, jump to the ‘Putting It Altogether’ section at the end of the piece.

 

One Quick Detour

 

Before going on to this week’s piece, a brief comment on bitcoin (or cryptocurrencies, in general).

 

We do not discuss cryptocurrencies or blockchain often and write about them even less. Even so, in our occasional discussions about cryptocurrencies we regularly come across statements along the lines of: “I am bullish on blockchain, not bitcoin,” or “The use case for blockchain technology far exceeds that of cryptocurrencies.” You too might have heard similar such statements from investors, venture capitalists, or other “authoritative sources” in discussions or interviews.

 

This line of thinking, we suspect, has driven capital and resources into developing private blockchains or proprietary databases that are based on blockchain technology. For example, banking behemoths of the likes of JP Morgan and UBS are spearheading efforts to use blockchain technology for settling cross-border trades worldwide with their own “Bitcoin-like” tokens.

 

The arguments in favour of private blockchains over public cryptocurrencies may yet prove prescient and the development of private database-like structures turns out to be the optimal use case for blockchain technology. The below passage from The Hard Thing About Hard Things written by Ben Horowitz, of Andreesen Horowitz fame, about the Internet and competing proprietary networks, is a reminder, however, that the public versus private implementation debate is not new. And a technology that appears to be inferior, insecure or volatile can evolve and supersede a seemingly superior competing solution.

 

“In retrospect, it’s easy to think both the Web browser and the Internet were inevitable, but without Marc’s work, it is likely that we would be living in a very different world. At the time most people believed only scientists and researchers would use the Internet. The Internet was thought to be too arcane, insecure, and slow to meet real business needs. Even after the introduction of Mosaic, the world’s first browser, almost nobody thought the Internet would be significant beyond the scientific community-least of all the most important technology industry leaders, who were busy building proprietary alternatives. The overwhelming favorites to dominate the race to become the so-called Information Superhighway were competing proprietary technologies from industry powerhouses such as Oracle and Microsoft. Their stories captures the imagination of the business press. This was not illogical, since most companies didn’t even run TCP/IP (the software foundation for the Internet)they ran proprietary networking protocols such as AppleTalk, NetBIOS, and SNA. As late as November 1995, Bill Gates write a book titled The Road Ahead, in which he predicted that the Information Superhighwaya network connecting all businesses and consumers in a world of frictionless commercewould be the logical successor to the Internet and would rule the future. Gates later went back and changed references from the Information Superhighway to the Internet, but that was not his original vision.

 

The implications of this proprietary vision were not good for business or for consumers. In the minds of visionaries like Bill Gates and Larry Ellison, the corporations that owned the Information Superhighway would tax every transaction by charging a “vigorish”, as Microsoft’s thenchief technology officer, Nathan Myhrvold, referred to it.

 

It’s difficult to overstate the momentum that the proprietary Information Superhighway carried. After Mosaic, even Marc and his cofounder, Jim Clark, originally planned a business for video distribution to run on top of the proprietary Information Superhighway, not the Internet. It wasn’t until deep into the planning process that they decided that by improving the browser to make it secure, more functional, and easier to use, they could make the Internet the network of the future. And that became the mission of Netscapea mission that they would gloriously accomplish.”

 

A parting thought, consider the oft-cited explanation for the superiority of open-source solutions: “Given enough eyeballs, all bugs are shallow.”

 

US Trade Balance and Foreign Portfolio Investment

 

The below chart consists of the de-trended US trade balance (magenta bars), presented in reverse order and defined as the quarterly trade balance minus the three-year moving average of the trade balance,  and the quarterly foreign portfolio investments into the US on a net basis (orange line).

 

US Trade Balance De-Trended vs Net Foreign Portfolio InvestmentNPI vs TB.pngSources: US Census Bureau, US Department of the Treasury

 

The US, over the last twenty-five years, has, more often than not, run a trade deficit with the rest of the world. That is, Americans have consumed more than they have produced. During the 1990’s and the first five years of the current millennium, a growing trade deficit coincided with increasing foreign portfolio flows into the US.

 

Ahead of the financial crisis, the US trade deficit shrank and was duly followed by a sharp drop in foreign portfolio inflows. During and a few quarters following the Global Financial Crisis, the trade balance and foreign portfolio flows relation was flipped on its head. The US started to run a trade surplus, more on that anon, yet foreign portfolio flows increased rather than retrenching. The safe-haven bid for US assets, specifically US Treasury securities, was sufficiently large to overrun the impulse for foreign capital to retreat as the US went from running a trade deficit to running a trade surplus.

 

In the chart below, international flows into US Treasury securities are plotted against the US trade balance.  The international bid for Treasury securities was strong during the Global Financial Crisis and, following a brief pause, remained strong all the way through 2011.

 

US Trade Balance De-Trended vs US Treasury International Capital FlowsTrade Balance vs Treasury InflowsSources: US Census Bureau, US Department of the Treasury

 

Following the Global Financial Crisis and up until the election of President Trump, the US no longer ran consistent trade deficits and even when it did, they were not as large as they were prior to the crisis. As a corollary, foreign portfolio investments, too, waxed and waned between positive and negative during the time period.

 

The Diminished Role of Oil in Dictating Foreign Flows

 

Prior to the crisis, US oil imports were on a steady uptrend, going from below 5 million barrels per day at the end of 1990 to a peak of more than 10 million barrels in 2006/07. Imports dropped sharply to below 8.5 million barrels per day during the crisis, spiked in 2010, then continued declining through 2015, picked up in 2016 and 2017, and once again started falling from the second quarter of 2018. In February 2019, US oil imports averaged less than 7 million barrels per day for an entire month for the first time since February 1996.

 

US Trade Balance De-Trended vs Price of Brent Crude Oil De-TrendedTrade Balance vs BrentSources: US Census Bureau, Bloomberg

 

The rise of shale and the sharp drop in oil prices in the second half of 2014 has shifted the source and structure of net foreign portfolio investments into the US. The US trade balance, particularly during the commodity super-cycle witnessed during the first decade of the new millennium, was strongly correlated with the fluctuations in the price of oil. Since 2012, however, the correlation has broken down.

 

US Net Foreign Portfolio Investment vs Price of Brent Crude Oil De-TrendedPPI vs BrentSources: US Census Bureau, Bloomberg

 

The US trade balance being less correlated with the fluctuations in the price of oil also coincided with the correlation between foreign portfolio flows and the price of oil declining.

 

The breakdown in the correlation can be understood through the shifting structure of foreign portfolio flows. From the 1990’s  through 2006, the growth in portfolio flows was predominantly driven by increasing international flows into US Treasury securities. Oil exporting nations, particularly those operating US dollar pegged currency regimes, and China, were recycling their US dollar windfalls back into Treasury securities.

 

The rise of shale and subsequent drop in the price of oil has meant oil exporting nations no longer have the kind of excess capital to re-direct into Treasury securities as they once used to. China’s dollar-shortage challenges are, of course, well documented. Consequently, foreign flows into US government bonds have become more sporadic and the relative share of foreign flows into other securities has increased. The relative share of US foreign portfolio flows from other pools of capital, specifically pension funds and insurance companies in Europe and Japan, has also increased.

 

Structure of US Net Foreign Portfolio InvestmentNPISource: US Department of the Treasury

 

The shift, however, in the correlation between the fluctuations in the price of oil and foreign flows into US Treasury securities has not been as dramatic. Suggesting that oil exporters continue to prefer parking excess capital into US government bonds and are not going out on the risk curve.

 

US Net Foreign Portfolio Investment vs Price of Brent Crude Oil De-TrendedTreasury Inflows vs BrentSources: US Department of the Treasury, Bloomberg

 

Putting It Altogether

 

We have gone through some of the high level dynamics of the US trade balance and foreign portfolio flows. To round off the discussion, we outline a framework that can be helpful in thinking about the US dollar and demand for US dollar assets in general.

 

US Trade Balance + Net Foreign Portfolio Investment De-Trended vs YoY Change in US Dollar IndexTB NPI vs DXY (1).pngSources: US Census Bureau, US Department of the Treasury, Bloomberg

 

The magenta line in the above is the sum of the de-trended trade balance and the de-trended net foreign portfolio investment. The line being above zero implies foreign demand for US dollars exceeding the supply of US dollars. For example, the demand for US dollars emanating from portfolio flows exceeds the supply of US dollars being created by the US running a trade deficit.

 

Demand outstripping supply, to state the obvious, places upward pressure on the US dollar.

 

Outside of periods of insatiable demand for safe-haven assets, this flows based framework works well as a tool to chart out a path for the US dollar.

 

Based on this framework, let us consider the scenario of the US undertaking a large fiscal spending programme following the presidential election. If such a fiscal spending programme greatly increases the US trade deficit, supply of US dollars should also increase substantially. This increase in the supply of US dollars will place tremendous downward pressure on the greenback unless accompanied by a commensurate increase in foreign portfolio flows into American financial assets.

 

An increase in foreign demand for American financial assets, in all likelihood, requires higher long-term interest rates. The optimal way for investors to position for it in the current environment, in our opinion, is to be long yield curve steepeners.

 

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. 

 

 

Cheap vs. Expensive | The Threat to Incumbents

 

“Business is the systematic playing of games.” ― Reid Hoffman

 

We gathered some data on the changes in the make up of S&P 500 Index over time and did some good old fashioned number crunching in MS Excel. In this week’s piece we share some of the analysis and insights from this number crunching, which covers the following:

 

  • Price-to-earnings spread between ‘expensive’ and ‘cheap’ constituents of the S&P 500 Index;
  • Return profile of stocks added to the S&P 500 Index between 31 August 2017 and 30 April 2019; and
  • How the largest US companies, in a rush to return cash to shareholders, may be unwittingly setting themselves up to be disrupted.

 

As a disclaimer, the analysis presented below is neither meant to paint a bullish nor bearish picture. We have, however, on a number of occasions in the last year expressed our constructive view on the market, most recently here and prior to that here.

 

Price-to-Earnings Differential

 

The below chart presents the trailing price-to-earnings ratio spread between the 25th and 75th percentiles for the constituents of the S&P 500 Index ranked by their trailing twelve month price-to-earnings ratio.

 

A rising line implies that the spread between the upper and lower quartiles is expanding or simply put expensive stocks, in terms of trailing price-to-earnings, are getting even more expensive relative to cheaper stocks.

 

Differential Between 25th & 75th Percentiles TTM P/E Ratio of S&P 500 Constituents

PE Differential.png

Source: Bloomberg, S&P Global

 

The dashed lines in the above chart are the levels marking +/- 1 and +/- 2 standard deviations from the average TTM P/E ratio differential between the 25th and 75th percentiles.

 

As can be seen in the above, this is yet another market metric reaching levels last seen during the tech bubble.

 

S&P 500 Index Inclusion: Return Metrics

 

For a stock to be added to the S&P 500 Index is quite a big deal. The sheer amount of passive and non-discretionary assets tracking the S&P 500 Index means that any stock included into the index should see an uptick in its trading volumes and a near perpetual bid from S&P 500 trackers and ETFs.

 

What, however, does inclusion mean in terms of returns for investors holding stocks included in the S&P 500 Index? We try to answer that question by looking at a relatively small sample: stocks included into the index between 31 August 2017 and 30 April 2019. We are aiming, in the next two weeks, to extend the sample set to as far back as 1 January 1990 and also to include the impact on stocks dropped from the index.

 

Post Inclusion Alpha
1 Month 3 Months 6 months 1 Year
Average 0.73% -3.46% -3.12% -7.32%
Median 2.54% -1.42% -5.91% -6.39%

 

Based on the analysis of the limited sample, it suggests that one would be better off, one average, selling a stock that has been included into the S&P 500 Index immediately after its inclusion and buying the S&P 500 Index instead.

 

The data set used for the above calculations can be found here.

 

Research & Development

 

According to alternative assets data provider Preqin, at the end of 2018 the amount of dry powder committed to private capital funds and investment programmes stood at US dollars 2 trillion, of which approximately US dollars 400 to 450 billion was committed to angel investing and venture capital funds. To put that in context, the amount dry powder available to angel and venture capital investors as recently as 2014 was estimated to be in the range of US dollars 100 to 150 billion dollars.

 

An estimated three-fold increase in the amount of capital gives venture capitals a lot of money to throw at a lot of problems.

 

We recently listened to a podcast featuring famed venture capitalist Bill Gurley in which he passingly mentioned something along the lines of incumbents being more at risk of being disrupted today than ever before.

 

This got us to thinking that what if US corporations were prioritising returning capital, through buybacks and dividends, to investors to such a degree that it was coming the expense of the future profitability of the respective businesses?

 

While we do not have an answer to our question, we do have some interesting data to shares.

 

R&D Expense as a Percentage of Net Sales (Average) for S&P 500 Constituents 

RD Exp Sales.png

Source: Bloomberg

 

There appears to have been a structural step down in the amount of money, as a percentage of net sales, that has been invested in research and development following the Global Financial Crisis. There was a spike up recently, we suspect that is due to US tax reform and the repatriation of non-US profits.

 

Year-over-Year Growth in R&D Expenses (Average) of S&P 500 Constituents 

RD Exp Growth.png

Source: Bloomberg

 

Similarly, even in terms of absolute dollar amounts, there has been a slowdown in growth of absolute dollars being invested in research and development by the constituents of the S&P 500 Index. This is all the more surprising given the makeup of the S&P 500 has shifted in favour of healthcare and technology companies over the last decade. Healthcare and technology companies are generally known to be heavy investors in research and development. Businesses operating in the more “old economy” sectors are, it seems, investing even less in research and development.

 

Average Cash and Marketable Securities Balances for S&P 500 Constituents

Cash.png

Lastly, the above chart is of the average cash and marketable securities balances of S&P 500 constituents, excluding major financial services businesses.

 

The largest corporations in the United States are draining their cash in financialisation at a record pace just as their predators in the venture capital industry have been building up their war chests. The picture gets even worse once you exclude the major technology companies with large piles of cash ready to be invested in acquiring and developing up and coming technologies.

 

Low interest rates did not encourage large US corporations to invest, rather they encouraged financialisation. The unintended consequence of which may be the death of the incumbents.

 

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. 

 

Durability of the US Bull Market

 

“Having insurance doesn’t guarantee good health outcomes, but it is a critical factor.” ― Irwin Redlener

“Seeing the bigger picture opens your eyes to what is the truth.” ― Wadada Leo Smith

As the key indices in US equity market are once again approaching all-time highs, we look to assess the durability of the bull market in the face of a plethora of negative headlines and rising valuations. We also identify a few leaders in the retail sector as long ideas.

 

Technology Leadership

 

When a bull market is turning over, the tell tale signs can usually be found in the segment that has led the bull charge. And as we all know, technology has been the clear leader in the most recent incarnation of the US equity bull market.

 

The below monthly chart is a ratio of the NASDAQ 100 Index to S&P 500 Index. The ratio is now in territory witnessed during the tail-end of the tech bubble. The difference this time ― ominous last words ― being the steady, as opposed to parabolic, rise in the ratio.

 

 

NDX Index (NASDAQ 100 Stock Inde 2019-06-13 09-39-55

 

The quarterly rate-of-change of the above ratio, shown in the chart below,  is another way to see the stark difference in the relative rise of the NASDAQ 100 over the last ten years as compared to the relative rise during the tech bubble.

 

NDX Index (NASDAQ 100 Stock Inde 2019-06-13 10-22-11.png

 

What the rate-of-change, or momentum, chart does suggest is that the recent waxing-and-waning in technology stocks, be it due to slowing earnings or fears over antitrust action against the mega-capitalisation technology companies, is still within the normal bounds of volatility.

 

If the NASDAQ 100-to-S&P 500 ratio fails to make new highs in the coming weeks and months or there is a marked deterioration in the ratio’s momentum, we would become concerned about the durability of technology’s market leadership.

 

Growth and Value

 

Other ratios in tech bubble territory are those of the S&P Growth Index-to-S&P 500 Index and the S&P Growth Index-to-S&P Value Index.

 

SGX Index (S&P 500 Growth Index) 2019-06-13 10-17-07

 

 

SGX Index (S&P 500 Growth Index) 2019-06-13 10-16-27

 

We are increasingly convinced that a barbell strategy should be applied today in managing equity exposures. With tech and other growth names on one side and value names and precious metals on the other. And if tech and growth continue to rally, investors should re-balance  regularly to avoid any lopsidedness in their portfolios.

 

Heavy Truck Sales

 

The below chart compares the S&P500 Index (magenta) to heavy truck sales in the US (orange). Heavy trucks sales are a barometer for economic activity in the US. Heavy truck sales rolled over in 2000 and in 2006 ahead of the cyclical peaks in the US equity market. Heavy trucks sales have thus far remained strong.

 

USASHVTK Index (United States He 2019-06-14 14-46-20.jpg

 

Cyclical to Defensive Stocks

 

The below chart is a ratio of the MSCI USA Cyclical Stocks Index to the MSCI USA Defensive Stocks. We see this ratio as a gauge of ‘animal spirits’. A rising line suggests a preference for profit over preservation.

 

The ratio has recently broken out to fifteen year highs. This is a but surprising given that Treasury yields have come in quite a bit in recent months, which should have benefited defensive sectors such as consumer staples and utilities.

 

MU704866 Index (MSCI USA Cyclica 2019-06-13 15-24-54.png

 

We would avoid or reduce allocations to bond-proxies such as utilities and REITs for now and search for alternative sources of diversification for portfolios with growth and technology heavy allocations.

 

The Smart Money Flow Index

 

The technology led rally from the lows recorded in February last year was not accompanied by a recovery in the Smart Money Flow Index. Rather, the index was hitting new lows just as the NASDAQ 100 was approaching new highs.

 

The rally in 2019, however, has coincided with a rebound in the Smart Money Flow Index. If the index starts retreating again we would be concerned.

 

SMART Index (Smart Money Flow In 2019-06-13 14-03-59.png

 

Corporate Yield Spreads

 

The below chart is the yield spread of Corporate BBB bonds to the US 10 Year Treasury.

 

Corporate yield spreads remain below the levels reached during the “volmageddon”on 2018 despite the sharp drop in oil prices in recent weeks. If yield spread breach the 1.65 per cent level in the below time series, we would think about scaling back equity exposures. Moreover, if we see exuberance take yield spreads below 2018 lows, we would worry that we are entering the “melt-up” phase in the bull market and also look to sell into strength.

 

CSI BBB Index (US Corp BBB_Baa - 2019-06-13 13-10-40.png

 

Consumer Leaders

 

If the Federal Reserve cuts interests rates, the US consumer will benefit from lower debt servicing costs on its mortgages and other debt. This should boost consumer spending, at least at the margin. We identify retail leaders that we add to our ideas on the long side.

 

ETSY  $ETSY

 

(The bottom panel is the relative strength to the SPDR Retail ETF $XRT.)

 

ETSY US Equity (Etsy Inc) Retail 2019-06-14 14-59-54

 

Five Below  $FIVE

 

FIVE US Equity (Five Below Inc) 2019-06-14 15-00-53

 

Under Armour $UAA

 

UAA US Equity (Under Armour Inc) 2019-06-14 15-00-22

 

 

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

Two Ideas: Advanced Emissions Solutions & A Bitcoin Proxy

Panic causes tunnel vision. Calm acceptance of danger allows us to more easily assess the situation and see the options. — Simon Sinek

Advanced Emissions Solutions $ADES

In Environmental Concerns: Ideas on Long Side we discussed the lack of progress in reducing global emissions since the Paris Climate Agreement was signed by 190-plus countries in December 2015. At a high level we suggested Advanced Emissions Solutions as a potential long idea that could benefit from increased regulatory pressure to control emissions.

$ADES owns a 42.5 per cent stake in a joint venture with Goldman Sachs and Nexgen Refined Coal called Tinuum Group. Tinuum is awarded tax credits when it produces refined coal — coal that has been processed to reduce emissions when burned.

In the American Jobs Act of 2004 there was a provision to encourage the use of chemically treated coal to reduce the emissions from US power plants. To qualify for the refined coal tax credit, producers “must have a qualified professional engineer demonstrate that burning the refined coal results in a 20 per cent emissions reduction of nitrogen oxide and a 40 percent emissions reduction of either sulfur dioxide or mercury compared with the emissions that would result from burning feedstock coal”. The tax credit was designed to increase with inflation and was valued at US dollars 6.91 per short tonne produced in 2017 and US dollars 7.10 per short tonne in 2018. As an added bonus, some operating expenses incurred in running a refined coal facility are also tax deductible, making the tax credit’s effective value in 2018 as much as  US dollars 9 a tonne.

The tax credit, as originally structured, was not easy for refined coal producers to take advantage of. The policy required producers to increase raw coal’s market value by 50 percent to qualify for the tax credit. This clause made cost-conscious utilities unwilling to buy refined coal.

A policy edit to the structure of the tax credit in 2008 by senators from Montana and Iowa, two coal producing states, however, removed the market value clause. The removal of this clause made it possible for refined coal producers to benefit from the tax credit even if they sold their product at a loss. This shift in policy incentivised  the creation of Tinuum and other refined coal producers like it.

Tinuum financed the construction of facilities to produce refined coal situated next to coal-fired power plants. The window to construct these facilities closed in 2011 and the tax credits expire in ten years from commencement of operations. Republican Senator John Hoeven from North Dakota, also a coal producing state, has, however, introduced legislation to extend the tax credits by another ten years.

On average, each facility cost between US dollars 4 and 6 million to construct.  Tinuum constructed 28 of them, making it the second largest operator in the refined coal space.

How does Tinuum benefit from the tax credit? 

1. Power plants lease refined coal facilities from Tinuum at say a rate of US dollar 4 per tonne of refined coal (plus, at times, additional royalty commissions) — 42.5 per cent of which goes to $ADES

2. The refined coal facility is used to process feedstock coal and generate a tax credit at the prevailing inflation adjusted rate. Operating the refined coal facility costs power plant owners a further US dollars 3 per tonne.

3.  Power plant owners receive the ~US dollars 7 per tonne in tax credits and at the same time the operating expenses  incurred in running the refined coal facility and the lease payment to Tinuum are tax deductible. At a marginal tax rate of 21 per cent, the power plants tax bill is reduced by approximately US dollars 1.47 per tonne.

Tinuum presently has 20 of 28 refined coal facilities (representing 55 to 65 million tonnes of refined coal capacity) contracted to the owners of coal-fired power plants.  In 2019, it has an opportunity to increase the utilisation of its idle facilities. A number of tax advantaged refined coal facilities that began operations in 2009 have seen or will see their tax advantaged status lapse during the year. One of the 20 operational facilities was contracted and brought online in January 2019. Management expects a further 12 millions tonnes of refined coal capacity to be contracted over the course of 2019.

Based on the 20 contracted facilities through 2021, when the tax credits expires, $ADES’s share of net refined coal related cash flows from Tinuum is estimated to be between US dollars 200 and 225 million. To put that into perspective the market capitalisation of $ADES is US dollars 248.8 million.

What other areas does Advanced Emissions Solutions operate in?

In December 2018, the company acquired ADA Carbon Solutions (ACS). ACS owns and operates an activated carbon manufacturing plant focused on “mitigating mercury emissions” from coal-fired power plants.

In its first full quarter since acquisition, ACS contributed US dollars 14.6 million in revenue to $ADES.

Management’s plan is to cross-sell ACS’s solutions to existing customers and also expand the mercury mitigation solutions services into other adjacent segments. One adjacent market they intend to target is the municipal water treatment market, a highly fragmented sector “comprised of many producers and re-sellers”.  Management does not expect the entry into adjacent markets to require incremental investments to be made by the company.

Investment Thesis

$ADES currently trades at trailing twelve months earnings of 6.9 times and a dividend yield of 7.50 per cent with return on equity of 46 per cent.

Given the majority of the company’s market value is covered by its share of Tinuum’s contracted cash flows, we see $ADES as a cheap call option on (1) the potential increase in tax credit by another 10 years, (2) contracting of Tinuum’s remaining 8 refined coal facilities through 2021 and (3) the activated carbon segment.

A Bitcoin Proxy

Famed short-seller Jim Chanos, using his Twitter alias Diogenes (handle: @WallStCynic) recently tweeted:

“How the F is this bitcoin nonsense being resurrected again? Are people really this stupid?”

We do not know if buyers of bitcoin are being clever or not so clever. We do not know what is driving the buying. Maybe it is the employees of Lyft, Uber, Zoom or Pinterest, newly minted as millionaires, using a portion of their winnings to buy bitcoin. Or Chinese capital fearful of an imminent devaluation of the renminbi finding a way around capital controls by buying bitcoin. Or [insert here whatever is the narrative du jour for crypto-aficionados or crypto-sceptics].

What we do know is that it has been going up and it may go higher still.

Our aim here is not to argue for or against bitcoin. There are far smarter and far more informed people on both sides of the argument for any contribution we may have to make the debate to be value accretive even at the margin. Rather, we have found the process of buying and selling bitcoin somewhat cumbersome and want to suggest a proxy for those that may want to trade bitcoin and not necessarily own it.

The below is a normalised chart of bitcoin and The Bitcoin Group ($ADE.GY) starting 31 December 2016. The Bitcoin Group is a holding company focused on investing in businesses and technologies in the fields of cryptocurrency and blockchain. Presently, the holding company owns one asset: 100 per cent of the shares of Bitcoin Deutschland AG, the only German authorised trading platform for bitcoin.

XBTUSD Curncy (XBT-USD Cross Rat 2019-05-16 10-53-39.png

So if you want to trade bitcoin but find the whole process a bit cumbersome, The Bitcoin Group might be worth a look. As the chart seems to suggest, it has been a pretty good proxy to buying bitcoin, at least since the beginning of 2017.

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.