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
“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.
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
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|
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
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
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
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.
“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.
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.
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.
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.
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.
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.
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.
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.
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.
(The bottom panel is the relative strength to the SPDR Retail ETF $XRT.)
Five Below $FIVE
Under Armour $UAA
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.
“Every man is the smith of his own fortune.” – Iranian proverb
“Time is like a sword: if you don’t cut it, it cuts you.” – Arabic proverb
- Global Liquidity
- Investment Themes
- Infrastructure Diplomacy: The Answer to the Rest-of-the-World’s Under Performance?
- US Dollar: What Will the US Treasury Do?
- China: Incrementally Better, Not Worse
- Emerging Markets: Relief Not Reprieve
- Semiconductors: Led On the Way Down, To Lead On the Way Up?
- Saudi Arabia: Emerging Market Indices Inclusion
- Outsiders for Outsized Returns
- Triunfo Albicelestes
- Data Driven Dystopia: “The monetization of every move you make”
- Five We Have Read and Recommend
- Five from Our 2019 Reading List
Note: Our comparable piece from 2018 can be found here.
This post runs quite long, if you prefer you can click here to download the PDF.
As we reflect back on 2018, the year, in a capital markets context, was defined, in our view, by the charging and retarding forces acting upon global liquidity. On the one hand we had the tax reform driven liquidity enhancers, on the other a host of liquidity depressants, including monetary policy driven tightening, pseudo-capital controls under the guise of anti-graft measures, rising interest rates and high oil prices.
In the words of Thomas Joplin, the nineteenth century British banker and merchant, “A demand for money in ordinary times, and demand for it in periods of panic, are diametrically different. The one demand is for money to put into circulation; the other for money to be taken out of it”.
Last January, with global stock markets off to their best start in more than three decades, the world was in the midst of demand for money to be put into circulation far outstripping demand for it to be taken out of circulation. From October through to the end of the year, as markets witnessed a sharp sell-off, demand to take money out far outweighed the demand to put it back. While in the intervening months between January and October, dominance waxed and waned between the two opposing forces.
One of the leading sources of liquidity in 2018 was US companies’ accelerated contributions to their respective defined-benefit pension schemes. The Republican Party’s tax reforms gave American corporations till mid-September of last year to benefit from the higher 35 per cent corporate tax rate when deducting their pension plan contributions from their tax bill. US Companies making contributions through mid-September and deducting them from the prior year’s tax return is not new. The difference last year was that the value of the deduction fell to 21 per cent following the mid-September deadline.
Pension plan contributions by companies in the Russell 3000 Index are estimated to have topped US dollars 90 billion through mid-September last year – more than 10 times the contributions made the year before.
The other major source of liquidity was also motivated by US tax reforms. The reforms, by subjecting US corporations’ offshore profits to a one-time tax of 15.5 per cent on cash and 8 per cent on non-cash or illiquid assets, eliminated the incentive to keep money offshore. In response, US multinationals are estimated to have repatriated more than US dollars 500 billion last year, a significant portion of which went toward share buybacks. The flow of money was not evenly spread throughout the year, however. Corporations repatriated the vast majority of the funds in first half of the year with the amount of cash being brought back dropping off sharply in the second half of the year.
There were many forces working to suck liquidity out of and impede the flow of capital through the global monetary system.
1. Oil and US Interest Rates
Arguably the US dollar and oil are the two most important ‘commodities’ in the world. One lubricates the global monetary system and the other fuels everything else. Barring a toppling of the US dollar hegemony or till such time when the dominance of oil as the world’s primary energy resource diminishes meaningfully, the global economy is unlikely to enjoy prolonged and synchronised economic growth in an environment in which US interest rates are rising and oil prices are high.
In the more than 30 years between end of May 1988 through December 2018, the US 10-year treasury yield and the oil price have simultaneously been above their respective 48-month moving averages for less than a fifth of the time. And only on six occasions have the two prices remained above their respective 48-month moving averages for 5 or more consecutive months. (The periods when both prices are about their respective 48-month moving averages are highlighted in grey in the two charts below.)
US 10-year Treasury Yield Source: Bloomberg
West Texas Intermediate Crude Price per BarrelSource: Bloomberg
2. Policy Driven Tightening
The two dominant liquidity centres of the world, the US and China, moved in 2018 to rein in animal spirits and tighten monetary conditions.
In China, the Communist Party’s, in a bid to bridle systemic risks, clamped down on shadow finance. The tightening of credit conditions, however, has thrown up an interesting twist: interest rates, as opposed to increasing as would be expected, have declined.
China Shadow Financing Growth Year-over-YearSource: Bloomberg
In the US, the Treasury upped issuance of short-term debt to replace maturing long-term bonds just as long-term issues were being worked off the Fed’s balance sheet through quantitative tightening.
The potential ramifications of quantitative tightening and increased Treasury bill issuance bubbling under the surface are difficult to assess. In a monetary system governed by the hitherto untested Basel III framework and the many policy tweaks enacted by the Fed, such as money market fund reform and setting the interest on excess reserves below the upper band of the feds fund rate, following the Global Financial Crisis, it is difficult to grasp what, if any, hiccups there will be in the transmission of monetary policy as the Fed continues to drain reserves from the banking sector.
Nonetheless, the tightening policies employed by the Fed and the People’s Bank of China, have squeezed global liquidity. Using year-over-year growth in money supply (M2) across the US, China and Europe, as a proxy, we can see global liquidity growth fell to multi-decade lows in 2018.
Global Money Supply Growth vs. MSCI ACWI and EM Indices Sources: Bloomberg, European Central Bank
A number of governments across the world have, in recent years, taken drastic measures to crackdown on corruption and the outflow of illicit funds from within their borders. We share a few examples below.
In 2016, in a bid to curtail corruption and weaken its shadow economy, the Indian government announced the demonetisation of all Indian rupees 500 and 1,000 banknotes. It also announced the issuance of new Indian rupees 500 and 2,000 banknotes in exchange for the demonetised banknotes. What transpired following the announcement was as, if not more, surprising than the government’s demonetisation scheme: an estimated 93 per cent of the old notes made into the banking system.
With most of the notes flowing into the banking system, they were now unsullied, legal tender. And little need for capital to flow out of India illegally through the hawala system to be held out of reach of the government remains.
In November 2017, the Saudi government famously rounded up, amongst others, wealthy Saudi businessmen, government officials and members of the royal family in the glitzy Ritz Carlton hotel in Riyadh as part of its anti-corruption campaign. Little of what transpired within the boundaries of the five-star hotel has been confirmed by official reports. We do, however, know that billions of dollars of assets moved from private asset pools to the Saudi government’s coffers.
China, under the leadership of President Xi Jinping, has been pursuing a far-reaching campaign against corruption. Since the campaign started in 2012, Chinese authorities have investigated more than 2.7 million officials and punished more than 1.5 million people, including seven national-level leaders and two dozen high-ranking generals.
As governments across the world have cracked down on corruption and elicited the support of regulators across global financial centres, price insensitive bids for real estate across New York City, London, Sydney and Vancouver have started to dry up. The best gauge of the liquidity impact of the anti-graft measures described above, we think, is Dubai. Long a magnet for Russian, Chinese, Indian, Saudi and Iranian capital, amongst others, Dubai had one of worst performing equity markets globally in 2018.
Dubai Financial Market General Index Source: Bloomberg
In summary, as the forces propelling global liquidity petered out over the course of last year, the squeezes on liquidity overwhelmed global financial markets taking down one market after the other, culminating with the dramatic end to the long-running US equity bull market in December.
Infrastructure Diplomacy: The Answer to the Rest-of-the-World’s Under Performance?
One time series that has intrigued us over recent weeks and months is that of the ratio of MSCI All Cap World Ex-US Index (RoWI) to the S&P 500 Index (SPX). The chart below is a plot of the month-end ratio of the two indices from December 1987 through December 2018. (A rising line indicates the RoWI is outperforming the SPX while a falling line indicates the SPX is outperforming the RoWI.)
Superimposed on the chart are the Fibonacci projection levels based on the relative high of the RoWI, occurring in July 1988, and cyclical low of the ratio recorded in October 1992. (You can learn more about Fibonacci projections here.)
Ratio of the MSCI All Cap World Index Ex-US to the S&P 500 IndexSource: Bloomberg
From a long-term perspective, the drastic under performance of equity markets in the rest-of-the-world relative to the US equity market is obvious. Looking at the above chart, however, we cannot help but feel that a cyclical upturn for the rest-of-the-world is due.
The question then is: What would prompt a correction in the secular trend? We think the answer is a ramp up in global infrastructure investment led by infrastructure diplomacy programmes.
The most marketed, and some might say most notorious, infrastructure diplomacy programme is China’s Belt and Road Initiative. The initiative encompasses the construction of two broad networks spanning four continents:
- The “Silk Road Economic Belt”: A land based transportation network combined with industrial corridors along the path of the Old Silk Road that linked China to Europe; and
- The “Maritime Silk Road”: A network of new ports and trade routes to develop three ocean-based “blue economic passages” which will connect Asia with Africa, Oceania and Europe
The Belt and Road Initiative, however, is not the only global infrastructure investment program in existence today. In 2015, worried by China’s growing influence in Asia, Japan first unveiled its “Partnership for Quality Infrastructure” initiative as a US dollar 110 billion investment programme targeting Asian infrastructure projects. In 2016, the initiative was expanded to US dollars 200 billion and to include Africa and the South Pacific.
In October 2018, the US Senate joined the US House of Representatives in passing the Better Utilization of Investment Leading to Development bill (or Build Act), a bipartisan bill creating a new US development agency – the US International Development Finance Corporation (USIDFC). The passing of the Build Act is being hailed by many as the most important piece of US soft power legislation in more than a decade.
The USIDFC has been created with the goal of “crowding in” vitally needed private sector investment in low and lower-middle income countries. The agency, endowed with US dollars 60 billion in funding, is being positioned as an alternative to China’s Belt and Road Initiative, which has at times been described as nothing more than “debt trap diplomacy”.
We think if the three distinct initiatives propel infrastructure investment across the developing economies and help them integrate into the global economy, create jobs and gain access to much needed hard currency, the rest-of-the-world can once again enjoy a prolonged period of out performance.
Investors, particularly those with an investment horizon of at least three years, should gradually reduce exposure to the US and reallocate it to the rest-of-the-world.
US Dollar: What Will the US Treasury Do?
When the US Treasury issues bills and increases its cash balances in the Treasury General Account at the Federal Reserve Bank of New York, it inadvertently tightens monetary conditions in the global banking system.
For the period starting September 2017 through April 2018, the US Treasury did just that. It increased cash balances with the Fed from under US dollars 67 billion at the end of August 2017 to US dollars 403 billion by end of April 2018. (At the end of last year, cash balances with the Fed stood at US dollars 368 billion.)
The increase in the US Treasury’s cash balances was offset by the loss of an equivalent amount of reserves and / or deposits by the US banking system. Thereby tightening monetary conditions and reducing the availability of US dollars.
The last time the US government faced the prospect of a shutdown, the US Treasury started drawing funds from its cash balances with the Fed to pay for entitlements and other government expenditures. The US Treasury’s Cash balances held with the Fed went from US dollars 422 billion at the end of the October 2016 down to US dollars 63 billion by the end of March 2017. The release of US dollars into the global banking system provided much needed relief, stimulated global risk appetite and weakened the greenback.
US Treasury General Account vs. US Dollar Index $DXY Sources: Bloomberg, Federal Reserve
With the US government shutdown triggered by President Trump entering its third week and with little sign of progress in talks between the Democrats and the Republicans, the US Treasury may once again have to draw down on its cash balances with the Fed. If this does transpire and is similar in scale to the previous draw down, it could again stimulate risk appetite and weaken the US dollar.
We are bearish on the near-term (six to nine month) prospects of the US dollar.
China: Incrementally Better, Not Worse
The year has barely started and the People’s Bank of China has already announced the first reserve ratio (RRR) cut of the year, a full percentage point reduction. Unlike previous RRR cuts in 2018, the latest move is a two-step reduction, effective on January 15 and January 25.
This RRR cut will release approximately Chinese yuan 1.5 trillion in liquidity, part of which will replace maturing medium-term lending facilities during the first quarter. On a net basis, the cut is equivalent to Chinese yuan 800 billion in easing.
On the fiscal stimulus side, the government has already approved new rail projects amounting to US dollars 125 billion over the course of the last month. Beijing refrained from stepping up fiscal spending in 2018. With a slowing economy and the on-going trade dispute with the US, however, the government appears to have greater willingness to loosen the purse strings in 2019.
Beijing, in a bid to shore up credit creation, is even allowing local governments to bring forward debt issuance.
Manufacturing data coming out of China is likely to get worse before it gets better – a hangover from US companies’ accelerated orders to build inventories ahead of the initial 1 January deadline for tariff increases. Nonetheless, given that the official policy stance has now tilted towards easing, we expect Chinese economic activity to improve, not worsen over the course of 2019.
Throw in the prospect of MSCI quadrupling the inclusion factor of Chinese A-shares in its emerging markets index and there is a strong possibility Chinese A-Shares break out of their bear market in 2019.
Emerging Markets: Relief Not Reprieve
A sharp drop in oil prices, a pause in the US dollar rally, signs of increasing fiscal stimulus in China and retreating long-term Treasury yields are providing emerging markets much needed relief. While the structural challenges, particularly on the funding side, faced by many of the emerging economies are unlikely to be resolved soon, the welcome liquidity relief can certainly provide tradable opportunities for investors.
Moreover, as we noted in December, emerging markets have been outperforming US markets since early October, which may well provide further impetus for asset allocators to re-consider exposures and potentially exchange some of their US exposure in favour of emerging markets.
Ratio of the MSCI Emerging Markets Index to the S&P 500 IndexSources: Bloomberg
The simple play is to be long the iShares MSCI Emerging Markets ETF $EEM. And in times of either euphoria or despair, it can prove to be the right choice as there can often be little to distinguish between constituent level returns. Nonetheless, with the rise of China’s tech giant, we think $EEM has become both too tech and too top heavy.
For broad-based exposure we prefer being long dedicated emerging market asset manager Ashmore Group $ASHM.LN. In terms of country selection we prefer being long Russia $ERUS and Indonesia $EIDO. We would also like to be long Hungary, opportunities for direct exposure to the country are, however, limited and is instead better played with some exposure to Austria $EWO.
Semiconductors: Led On the Way Down, To Lead On the Way Up?
We were bearish on the prospects of semiconductor stocks for the better part of 2018. With technology at the centre of China’s trade conflict with the US, and no technology more critical than semiconductors, our thinking was that production capacities, led by China, would rise faster than the market was pricing in.
While China has made headway in gaining market share in the more commoditised segments of the semiconductor market, it has failed to catch up with the leading chip companies in the world. The top-end of the semiconductors market remains tightly controlled by a handful of players.
The Trump Administration’s security hawks and a slowing China, however, have, we think, had a far greater impact on the sharp drop in chip prices than the increases in production capacities.
With valuations for the constituents of the Philadelphia Stock Exchange Semiconductor Index $SOX having corrected significantly and a lot of doom-and-gloom reflected after Apple’s guidance cut, we think semiconductors are well-placed to surprise to the upside in 2019.
Philadelphia Stock Exchange Semiconductor Index Trailing 12 Month P/E RatioSource: Bloomberg
Moreover, if there is to be a favourable outcome to the trade related negotiations between the US and China, we suspect China will pony up to reduce its trade surplus with the US by offering to buy more chips.
Saudi Arabia: Emerging Market Indices Inclusion
Ignoring the human rights grievances, the fallout from the murder of Washington Post columnist Jamal Khashoggi, and the sharp drop in the price of oil, we weigh the opportunity of investing in Saudi Arabia based purely on a technicality. That technicality being the inclusion of Saudi Arabia into the FTSE and MSCI emerging market indices in 2019.
Based on broker estimates, passively managed assets of greater than US dollars 15 billion are expected to flow into the Saudi equity market on the back of the inclusions. The vast majority of these passive flows are set to materialise during the first half of 2019. Given the size of flows relative to average daily traded values of less than US dollars 1 billion, the passive flows can move the needle in a market with few other positive catalysts.
We remain long the iShares MSCI Saudi Arabia ETF $KSA.
Outsiders for Outsized Returns
Here we discuss investment ideas that we think have an outside chance of generating outsized returns during 2019. We see these opportunities as cheaply priced out-of-the-money call options that may warrant a small allocation for those with a more opportunistic disposition.
Argentina, to put it mildly, has a chequered history when it comes to repaying its creditors. It has defaulted on its external debt at least seven times and domestic debt five times in the 202 years since its independence.
Argentina first defaulted on its sovereign debt in 1827, only eleven years after gaining independence from Spain. It took three decades to resume payments on the defaulted bonds.
The Baring Crisis, the most famous of the sovereign debt crises of the nineteenth century, originated in Argentina – at a time when Argentina was a rich nation and its credibility as a borrower had been restored. Argentina had borrowed heavily during the boom years of the 1880s and Britain was the dominant source of those funds. The flow of funds from Britain was so great that when Argentina defaulted on its obligations in 1890, the then world’s largest merchant bank, Baring Brothers & Co., almost went bankrupt. Had it not been for intervention by the Bank of England, the British lender would have been long gone before Nick Leeson came along a century later.
In 1982, Argentina once again failed to honour its external debt obligations and remained in default for almost a decade. Its emergence from default was made possible by the creation of Brady bonds – a solution proposed by then US Treasury Secretary Nicholas Brady as a means for debt-reduction by developing nations.
In the 1990’s Argentina kept piling on debt until it finally defaulted on around US dollars 80 billion of obligations in 2001, which at the time was the largest sovereign default ever. The government managed to restructure 93 per cent of the defaulted debt by 2010; however, Paul Singer’s Elliot Management famously held out and kept Argentina exiled from international debt markets for a further six years. Argentina returned to the bond market in 2016 after settling with the hedge fund and bringing to an end a long-running saga, which saw Paul Singer take extreme measures such as convincing Ghanaian courts to seize an Argentinian navy vessel so it could collects on its debt.
The lessons from Argentina’s history of defaults, however, were quickly unlearned by capital markets. In little more than a year after its return to the bond markets, Argentina successfully pulled-off the sale of a 100-year bond in 2017. The good times did not last very long, however. In August 2018, Argentina was heading to the IMF cap-in-hand requesting the early release of a US dollars 50 billion loan. By end of September the IMF had increased the debt-package to US dollars 57.1 billion – making it the biggest bailout package ever offered by the IMF.
After running through Argentina’s history of debt defaults and at a time when it may appear that its future is bleak, we are here to tell you that Argentina has the foundations in place to surprise to the upside.
The days of “Kirchnerismo”, the legacy of Cristina Fernández de Kirchner’s and her late husband Néstor’s twelve years in power, defined by the concentration of power, unsustainable welfare programmes and fiscal profligacy shrouded under the guise of nationalism, are gone. President Mauricio Macri’s willingness to chart a new course, armed with a robust IMF bailout package, we think, can help revive the Argentinian economy.
What is transpiring in neighbouring Brazil, too, has potential spill over effects on Argentina. If newly elected president Mr Jair Bolsonaro remains true to his word, Brazil is likely to pursue a reformist economic agenda that liberalises the economy from the statist policies that were the mainstay of the Workers’ Party’s rule. If the economic reforms spur growth in Brazil, Argentina should benefit – Brazil is, after all, Argentina’s largest trading partner.
President Bolsonaro’s external agenda is also likely to diverge from that of his predecessors. He has openly criticised China – Brazil’s largest trading partner – and expressed a desire to forge closer ties with the US. If Brazil pivots towards the US, Argentina, as South America’s second largest economy, is likely to be wooed aggressively by China. China’s ambition to dilute the US’s influence in Latina America is an open secret. In China’s bid to acquire influence, Argentina is well placed to attract investments from Beijing.
There are many ways to play this theme be it through the bond market, the currency or the equity market. For the average equity market investor the easiest way to gain exposure is probably through the Global X MSCI Argentina ETF $ ARGT.
Data Driven Dystopia: “The monetization of every move you make”
From The New Yorker’s article “How the Artificial-Intelligence Program AlphaZero Mastered Its Games”:
“David Silver, the head of research at DeepMind, has pointed out a seeming paradox at the heart of his company’s recent work with games: the simpler its programs got—from AlphaGo to AlphaGo Zero to AlphaZero—the better they performed. “Maybe one of the principles that we’re after,” he said, in a talk in December of 2017, “is this idea that by doing less, by removing complexity from the algorithm, it enables us to become more general.” By removing the Go knowledge from their Go engine, they made a better Go engine—and, at the same time, an engine that could play shogi and chess.”
As the leading tech companies have ramped up investments in developing their artificial intelligence – or machine learning, if you prefer – capabilities, what has started to become apparent is that data not algorithms hold the keys to success. The companies that collect the most and best data, not the ones that develop the most sophisticated algorithms, are likely to reap the greatest rewards from investing in artificial intelligence.
One, much maligned, ‘wearables’ company that has been tracking and collecting data on its users’ movements for many years, with little to show for it, is Fitbit Inc. $FIT. The company has fallen out of favour amongst investors ever since the launch of the Apple Watch – particularly after Apple’s health and fitness pivot following the launch of Series 2.
We think $FIT is a viable acquisition target for Amazon.
Amazon, through the Echo, is already collecting data at home and could close the data loop with an acquisition of $FIT. $FIT’s wrist bands and watches can be integrated with Alexa and with a little investment be upgraded to better compete with the Apple Watch. Moreover, Amazon could feature $FIT’s products front and centre on the most valuable retail real estate in the world – Amazon’s homepage.
Five We Have Read and Recommend
- Monetary Regimes and Inflation: History, Economics and Political Relationships by Peter Bernholz
- Time to Start Thinking: America in the Age of Descent by Edward Luce
- Thinking in Bets: Making Smarter Decisions When You Don’t Have All the Facts by Annie Duke
- The Art of Execution: How the world’s best investors get it wrong and still make millions by Lee Freeman-Shor
- Adaptive Markets: Financial Evolution at the Speed of Thought by Andrew W. Lo
Five from Our 2019 Reading List
- Crashed: How a Decade of Financial Crises Changed the World by Adam Tooze
- The Volatility Machine: Emerging Economies and the Threat of Financial Collapse by Michael Pettis
- Efficiently Inefficient: How Smart Money Invests and Market Prices Are Determined by Lasse Heje Pedersen
- The Goal: A Process of Ongoing Improvement by Eliyahu M. Goldratt and Jeff Cox
- These Truths: A History of the United States by Jill Lepore
Follow us on Twitter @lxvresearch
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.
“Europe was created by history. America was created by philosophy.” – Margaret Thatcher
“In America everything goes and nothing matters, while in Europe nothing goes and everything matters.” – Philip Roth, American novelist and modern literary great
MSCI Europe Index vs. S&P 500 Index – Total Return in USD Source: Bloomberg
In the ten years since the global financial crisis, European stocks have underperformed US stocks by a considerable margin.
In the first three years following the global financial crisis, the performance of the two markets were not too dissimilar. For the period commencing end of November 2008 through October 2011, the MSCI Europe and S&P 500 indices generated total returns of 46 and 53 per cent in US dollar terms, respectively.
Since late 2011, however, investors in European stocks have been left frustrated all the while investors in US stocks have enjoyed a long-running bull market. From 29 October 2011 through 20 November 2018, the MSCI Europe Index has generated a total return of 35.8 per cent in US dollar terms – 102.8 per cent less than the total return of the S&P 500 Index for the same period.
Despite, the strong outperformance of US equity markets relative to European equity markets, European stocks have been more expensive, on a trailing 12 month price-to-earnings basis, for the majority of the time since late 2011. Only since late 2017 have European equities become cheaper than US equities on a trailing 12 month price-to-earnings basis.
MSCI Europe vs. S&P500: Trailing 12 Month Price-to-Earnings RatioSource: Bloomberg
At an index level and since the global financial crisis, US companies have grown revenues and earnings at a faster clip than their European companies.
MSCI Europe vs. S&P500: Revenue Growth Source: Bloomberg
MSCI Europe vs. S&P500: Earnings Growth Source: Bloomberg
In terms of annual performance, European markets have outperformed US markets in three out of the nine calendar years since the global financial crisis: 2009, 2012, and 2017. Notably, in 2009 and 2017, European companies’ year-over-year earnings growth rates were far superior to those of American companies. While outperformance in 2012, can be attributed to Signor Draghi uttering those famous words that brought Europe back from the brink: “Whatever it takes”.
European earnings also outpaced US earnings during the years 2010 and 2013, yet US stocks outperformed European stocks. The year 2010 was, of course, when the sovereign debt crisis engulfed the peripheral members – Portugal, Italy, Ireland, Greece and Spain – of the European Monetary Union. While in 2013, although European equities underperformed US equities , it was still a very good year for Europe with the MSCI Europe Index generating a total return of around 23 per cent in US dollar terms versus around 28 per cent for the S&P 500 Index.
Digging a little deeper we compare the performance between US and European markets on a sector-by-sector basis, using the Global Investment Classification Standards (GICS) level 1 classifications.
US vs. Europe: 5- and 10-Year Sector Level Total Returns (USD)
Note: Periods ending 31 Oct 2018, calculated using monthly data, and excludes real estate
For both the 5- and 10-year periods for every sector except energy, US performance has been superior to European performance – we have excluded real estate as we were unable to gather clean data for the sector.
The US energy sector has lagged the European energy sector largely due to the much higher number of listed shale oil companies in the US. Shale oil plays witnessed significantly larger drawdowns as compared to blue chip oil producers following the sharp drop in oil prices in late 2014.
For the 10-year period ended 31 October 2018, the greatest difference in performance between the two markets comes from the consumer discretionary and information technology sectors. The consumer discretionary sector includes Amazon and used to include Netflix – a significant portion of US consumer discretionary outperformance can be attributed to Amazon and Netflix. While the outperformance of the American information technology sector has been broader than that of the consumer discretionary sector, a handful of stocks still have had an outsized impact on US outperformance. These stocks are namely Apple, Google, Facebook, Salesforce.com, Microsoft and Nvidia. (Note: In January 2018 the industry classification of Google, Facebook, and Netflix was changed to communication services).
The most comparable performance between the two markets, for the 10-year period, comes from the energy, materials, consumer staples and industrial sectors.
US vs. Europe: 5-Year Sector Level Revenue and Earnings Growth
The above table details the 5 year (4-years for communication services) revenue and earnings growth by sector for US and European stocks.
Notably, in the US, net margins expanded from 2012 through 2017 across all sectors except energy. While in Europe, margins expanded for six sectors and declined for three – margins declined for the consumer discretionary, utilities and communication services sectors.
Median sector level revenue growth in the US for the five-year period was 20.96 per cent versus -2.26 per cent in Europe. (Earnings level comparisons are not meaningful in our opinion due to the artificially high earnings growth in certain sectors in Europe due to write-downs / exceptional circumstances in 2012 that understate earnings at the beginning of the period.)
The underperformance of European equities relative to US equities over the last five- and ten-years can predominantly be explained by fundamental factors. The challenge at this juncture, however, becomes that of identifying scenarios under which European stocks would arrest this trend of underperformance and begin outperforming the US stocks on a prolonged basis. We outline three such scenarios below.
- If the next ten years are not like the last ten years
If we assume, simplistically and without trying to predict how, that the next ten years will be unlike the last ten years then there should be a preference for non-US stocks over US stocks in general.
In capital markets dominated by passive allocations to market capitalisation weighted indices, the main drawback is that the allocation to ‘go-go’ stocks is at its highest when they are at their peak relative to other stocks in the indices.
With respect to the S&P 500 Index, the information technology, healthcare, financials, communication services and consumer discretionary sectors have gone from representing 58 per cent of the index at the start of 2009 to almost 70 per cent today. And within these sectors the increase in allocation to technology and technology related stocks has been even more pronounced.
S&P 500 Index Allocation by GICS Level 1Source: Bloomberg
The change in sector allocation for US indices has been far more prominent than it has been for European indices – simply because the dispersion in performance between sectors has been much greater in the US. Over the last ten-years the top performing sector in the S&P 500 Index has outperformed the median sector by almost 260 per cent. In comparison, the total return differential between the best performing and median sectors is 63 per cent for the MSCI Europe Index.
MSCI Europe Index Allocation by GICS Level 1 Source: Bloomberg
- Labour not capital is rewarded
“The defining characteristic of economics in the 1950s is that the country got rich by making the poor less poor.
Average wages doubled from 1940 to 1948, then doubled again by 1963.
And those gains focused on those who had been left behind for decades before. The gap between rich and poor narrowed by an extraordinary amount.”
– Excerpt from Morgan Housel’s piece How This All Happened:
In the aftermath of the global financial crisis, unemployment levels shot up across the world. The global economy has spent the last ten-years healing from the damage wrought by the financial crisis. Slack in the labour market has been slow to dissipate and wages have remained stubbornly stagnant.
The corollary of the abundance of labour has been capital owners benefiting at the expense of labour.
As the global economy has healed, unemployment levels have gradually declined and wage pressures have slowly emerged. The European labour market, however, has much more slack than the US labour market – where unemployment levels are reaching twenty year lows and wage pressures are much more significant.
If demand for labour picks up globally, Europe has much more room to reduce unemployment levels before wages have to pick up meaningfully. Whereas the US has limited, if any, room for unemployment levels to drop lower without a meaningful increase in wage inflation. Therefore, Europe has greater flexibility to facilitate an improvement in household earnings without it impacting profit margins.
- Capital investment / infrastructure spending pick ups
US corporations have been far savvier capital allocators than their transatlantic counterparts – they have reduced equity, through share buy backs, and increased leverage during a time when servicing debt has never been easier. The behaviour of US corporations has been facilitated not only by record low interest rates but also by a limited need for capital investment – a deflationary environment incentivises the postponement of capital investment.
If capital investment picks up globally – motivated by inflation, infrastructure development led diplomacy, such as China’s Belt and Road Initiative, or a need to reconfigure global supply chains due to trade wars – European indices, with their much greater weighting to the industrial and materials sectors, are better placed to outperform the more technology leaning US indices in such a scenario.
Moreover, increasing capital investment may spur demand for credit in Europe and support the much maligned European financial services sector, which also happens to be the sector with the highest allocation in the MSCI Europe Index.
“One of the funny things about the stock market is that every time one person buys, another sells, and both think they are astute.” – William Feather, American publisher and author
“When thinking about the future, it is fashionable to be pessimistic. Yet the evidence unequivocally belies such pessimism. Over the past centuries, humanity’s lot has improved dramatically – in the developed world, where it is rather obvious, but also in the developing world, where life expectancy has more than doubled in the past 100 years.” – Bjørn Lomborg, Danish author and President of Copenhagen Consensus Center
“What day is it?” asked Pooh.
“It’s today,” squeaked Piglet.
“My favourite day,” said Pooh.
American consumers are the driving engine of the US economy – consumer spending is estimated to represent about two-thirds of US economic output. If sentiment surveys and retail sales are anything to go by then the American consumer, and by extension the US economy, is in rude health.
Consumer sentiment, as tracked by the University of Michigan, in September jumped to its second-highest level since 2004.
According to the Commerce Department, US retail sales increased by 6.6 per cent year-over-year in August – running well ahead of inflation. Month-on-month growth, however, was disappointing with August sales only increasing 0.1 per cent over July – whilst somewhat unsatisfactory, monthly comparisons tend to have a very low signal-to-noise ratio and are therefore misleading to read into, in our opinion.
Given the robust retail sales and soaring consumer sentiment, one would expect investors to be all bulled up on consumer stocks. Yet, as we compare the level of short interest across the constituents of the S&P500 Index we find that the greatest concentration of shorts (relative to free float) is in consumer related stocks. Investors remain circumspect about the prospects of consumer focused companies due to the potential impact of (i) rising interests on the disposable income of US consumers, and (ii) escalating trade tensions between the US and China on the companies’ supply chains, which in turn could meaningfully increase their cost of goods.
The below chart shows the average level of short interest (as a percentage of free float) by industry group. (Consumer related industry groups are highlighted in yellow.)
Average Short Interest across S&P500 Index by Industry Group Source: Bloomberg
The above chart shows that all but one of the consumer related industry groups has a higher level of short interest than the average level of short interest for a stock in the S&P500 Index. Moreover, the top three most shorted industry groups are all consumer related.
To further dissect the level of short interest across consumer related stocks, we focus in on the constituents of the SPDR S&P Retail $XRT and iShares US Consumer Goods $IYK exchange traded funds.
The average level of short interest for $XRT constituents is 7.5 per cent of free float. The most shorted sub-industry groups are food retail (something we have written about recently in The Challenge for Food & Beverage Retail Incumbents), automotive retail, and drug retail.
Average Short Interest across $XRT by Sub-Industry Group Source: Bloomberg
American department store chain Dillard’s is the most shorted stock amongst the constituents of $XRT with short interest making up a whopping 66.2 per cent of free float. The high level of short interest in the stock has not been rewarded by a declining price this year – the stock has generated a total return of 31.5 per cent year-to-date (as at market close on 19 September, 2018).
A further seven constituents have short interests that exceed 30 per cent of their free float, namely: Overstock.com (45.7 per cent), JC Penney (45.7 per cent), GameStop (39.6 per cent), Camping World Holdings (39.3 per cent), Hibbett Sports (36.4 per cent), The Buckle (36.0 per cent) and Carvana (31.3 per cent). The performance of these stocks has been more mixed with online retail company Overstock.com down 58.8 per cent year-to-date while online car dealer Carvana has generated an astonishing 208.3 per cent return year-to-date.
Many of the heavily shorted retail stocks appear to us to be the companies investors view as the mostly likely to be “Amazoned” in the near term.
Top 30 Most Shorted $XRT Constituents Source: Bloomberg
Total Return Year-to-Date of the Top 30 Most Shorted $XRT Constituents Source: Bloomberg
Generally, being short retail stocks has not been rewarding this year. The price return of $XRT is 14.2 per cent year-to-date versus 9.6 per cent year-to-date for the S&P500 Index.
Scatter Plot of Short Interest versus Year-to-Date Total Return for $XRT Constituents Source: Bloomberg
Note: Chart excludes Dillard’s and Caravan
The average level of short interest for $IYK constituents at 6.2 per cent of free float is lower than for $XRT constituents but still significantly higher than the average for the S&P500 Index. The most shorted sub-industry groups are tires & rubber, home furnishings and housewares & specialties.
Rising mortgage rates and the home buyer affordability index at ten-year lows are the likely reasons for the high levels of short interest in the home furnishings and housewares & specialties segments.
Average Short Interest across $IYK by Sub-Industry Group Source: Bloomberg
Only two stocks amongst the $IYK constituents have a short interest to free float ratio exceeding 30 per cent: B&G Foods (32.7 per cent) and Under Armour (31.8 per cent).
Generally, being short consumer goods stocks has been more rewarding than being short retail stocks. $IYK is down 3.5 per cent year-to-date. (We wrote about our concerns relating to the consumer goods sector last year in Unbranded: The Risk in Household Consumer Names.)
Top 30 Most Shorted $IYK Constituents Source: Bloomberg
Total Return Year-to-Date of the Top 30 Most Shorted $IYK Constituents Source: Bloomberg
Scatter Plot of Short Interest versus Year-to-Date Total Return for $IYK Constituents Source: Bloomberg
There is, we think, no clear playbook when it comes to heavily shorted stocks. Some portfolio managers we have interacted with in the past have occasionally gone long ‘consensus shorts’. Their track record is middling; they have done very well at times but also been burnt badly at other times.
Our approach is to identify heavily shorted stocks where we have a differentiated view on the prospects of near term earnings, valuation or the potential for the company to be acquired and to go long those stocks. (These lessons have been hard learned over time as in the past we have found ourselves far too closely aligned with consensus – as George S. Patton is known to have said: ‘If everyone is thinking alike, then somebody isn’t thinking’.)
In the instances our positioning and views prove correct, the high level of short interest acts like leverage and greatly amplifies returns in a relatively short amount of time.
Earlier this year we went long Under Armour based on our view that consensus earnings expectations had been deflated to such a degree that there was very little chance for the company to disappoint – with the stock price languishing at multi-year lows we deemed there to be little downside even if the company disappointed. As it transpired, the consensus view was indeed far too bleak and the stock quickly re-rated higher as the company outdid lowball expectations.
More recently, on 24 July, we went long and remain long kitchenware and home furnishings company Williams Sonoma $WSM. Short interest for the stock stands at over 20 per cent of free float, the company generated a best-in-class operating return on invested capital of 18.4 per cent in 2017 and trades at around consensus forward price-to-earnings of 15.4 times.
The retail and consumer goods sectors remain our preferred areas to search for heavily shorted stocks where we may have or develop a differentiated view.
“We often plough so much energy into the big picture, we forget the pixels.” – Silvia Cartwright
As highlighted last week, the focus is on equities this week. Instead of the usual text heavy approach, we do a quick run through of more than a handful of US stocks including some that we already hold, would like to add to our holdings, and consider as candidates for the short side.
The approach we have taken is as thematic as we could possibly make it. Stocks that do not fall under a theme have been left out of today’s piece, we will aim to issue a follow-up piece in the next week or two to cover individual stocks that we are monitoring but do not neatly fit under a clear investment theme at present.
[Note that our typical investment horizon ranges from 6 to 18 eighteen months for any position. With the caveat that if a stock significantly re-rates higher or lower due to a material development or otherwise, we may exit the position sooner.]
Semiconductors and Fabrication
Investors often talk about the one dominant factor that drives a stock. While we consider capital markets to be more nuanced than that, if semiconductor stocks have a dominant factor it surely has to be supply – it certainly is not trailing price-to-earnings multiples as semiconductor stocks, such as Micron, have been known to crash when trading at very low trailing multiples. Chinese supply in semiconductors is coming.
While we expect the bull market in tech stocks to re-establish itself sometime this year, if there was one area we would avoid it would be semiconductors.
Supply related concerns and forward earnings expectations reaching unreasonable levels have certainly slowed the upward march of semiconductor stocks; and we are seeing weakness across the semiconductors and fabrication spectrum. We consider the following stocks as potential candidates for shorting.
ON Semiconductor $ON
A spin-off of Motorola, $ON supplies semiconductor products across a wide spectrum of end-uses including those for power and signal management, logic, discrete, and custom devices for automotive, communications, computing, consumer, industrial, LED lighting, medical, military/aerospace and power applications.
As per Bloomberg, there are 21 analysts recommendations for the stock, 14 of them buys, an 5 holds and only 2 sells.
If the company disappoints, as we suspect that it will, a flurry of downgrades could well push the stock much lower.
$CY designs and manufactures programmable system-on-chip integrated circuits, USB and touchscreen controllers, and programmable clocks for the automotive, industrial, home automation and appliances, consumer electronics and medical products industries.
$ENTG designs and manufactures contamination control, microenvironment, and specialty materials products and systems to purify, protect, and transport critical materials used in the semiconductor device fabrication process.
As per Bloomberg, the stock current trades almost 30% below the average target price of the 11 analysts that cover the stock.
Marvell Technology $MRVL
$MRVL designs analog, digital, mixed-signal and microprocessor integrated circuits for storage, telecommunications, cloud storage and consumer markets.
According to data released earlier this week, retail sales rose a seasonally adjusted 0.5 per cent in July from the prior month, well ahead of economists’ forecasts for a 0.1 per cent increase.
Year-over-year retail sales are up a robust 6.4 per cent, tracking well ahead of inflation, as measured by the consumer price index.
Low unemployment levels combined with the windfall from tax cuts is contributing to strong consumer sentiment and high levels of spending across the majority of retail categories.
We have already witnessed Walmart $WMT reporting its strongest US sales growth in more than a decade, which sent the stock soaring higher. We have been long $WMT since September last year and at the time of initiating the positioning, we wrote:
$WMT’s revenue growth has flat lined in recent years as wage growth has been trendless. As wage growth picks up, we expect investors to increasingly come to recognise $WMT’s growth potential
Another retail name we have been long is Dollar General $DG, we initiated a position in the stock in November last year.
We still expect further upside in both $WMT and $DG and continue to hold them. Generally, we continue to see strength across the retail complex and may look to add long positions in at least two more stocks.
Burlington Stores $BURL
$BURL operates more than 630 off-price department stores across the US.
The company is expected to report quarterly earnings on 22 Aug with consensus analyst estimates for earnings growth of 33 per cent for the quarter, and 37 per cent growth for the full year. Annual earnings estimates were recently revised upward.
Dunkin’ Brands Group $DNKN
$DNKN is a restaurant holding company and franchiser of two chains of quick service restaurants: Dunkin’ Donuts and Baskin Robbins. The company franchises over 20,000 Dunkin’ Donuts and Baskin Robbins ice cream parlours in the US and across 60 international markets.
Driven by the rise of global e-commerce and internet-connected mobile devices, physical money is being snubbed in favour of cards and other digital payment options. According to Capgemini, global non-cash transactions are expect to grow at CAGR of 10.9 per cent between 2015 and 2020 and reach US dollars 725 billion.
This secular trend toward ever increasing non-cash transactions is in favour of payment processors – both the near ubiquitous players (e.g. VISA and MasterCard) and niche solutions providers.
We added FleetCor Technologies $FLT to our long trade ideas in June.
$FLT is an independent provider of specialised payment products and services to commercial fleets, major oil companies and petroleum markets.
The company’s payment cards provide significant savings and benefits to local fleets, including purchase controls, lower fraud, and specialised reporting. Penetration levels for the payment cards are relatively low at around 50% and there is significant potential for the company to gradually increase penetration levels.
We continue to hold the stock.
We will be looking to add $CATM as a second name under the payment processing theme.
$CATM is the world’s largest non-bank ATM operator and a leading provider of fully integrated ATM and financial kiosk products and services.
The company owns Allpoint, an interbank network connecting ATMs. Allpoint offers surcharge-free transactions at ATMs in its network and operates in the US, Canada, Mexico, United Kingdom, and Australia.
Allpoint is in the business of supporting any financial institution provide an ATM network to rival the very largest banks. Allpoint today offers more than 55,000 surcharge-free ATMs to over 1,000 financial institutions.
$CATM’s has recently updated its strategy to increasingly focus on expanding Allpoint’s network and penetration amongst financial institutions.
The company’s strategy update has been accompanied by a strong level of insider buying.
Energy Infrastructure and Mid-Stream Services
In April we issued a piece on the opportunities arising out of the infrastructure bottlenecks in shale patch in the US – Oil: Opportunities Arising from Infrastructure Bottlenecks.
At the time we identified two industrial equipment suppliers that could benefit from increased demand originating from the shale patch: SPX Flow $FLOW and Flowserve $FLS. Although the stocks have yet to perform we continue to see significant opportunities in the energy infrastructure space and hold on to them.
Given the scale of the opportunity in the sector, we think there is a lot of room to add additional names to better play the overall theme.
IDEX Corp $IEX
$IEX is engaged in the development, design, and manufacture of fluid handling systems, and specialty engineered products.Its products include pumps, clamping systems, flow meters, optical filters, powder processing equipment, hydraulic rescue tools, and fire suppression equipment, are used in a variety of industries.
UGI Corp $UGI
$UGI is a holding company with interests in propane and butane distribution, natural gas and electric distribution services.
Targa Resources Corp $TRGP
$TRGP is one of the largest providers of natural gas and natural gas liquids in the US. The company’s operations are predominantly concentrated on the Gulf Coast, particularly in Texas and Louisiana.
Digitisation is the process of converting information from a physical format into a digital one. When this process is utilised to automate and / or enhance business processes and activities, it is referred to ‘digitalisation’.
Digitalisation is concerned with businesses adopting digital technologies to create new revenue streams and / or improving operational processes. Digitalisation is not something new, businesses have been actively engaged in digitalising their operations for decades. The rise of big data, Moore’s law continuing to hold true as it relates to integrated circuits and the ever dropping cost of electronic components, however, has meant that its adoption has started to accelerate in recent years.
Amazon’s supermarket with no checkouts is an example of an outcome when a business fully embraces digitalisation.
We currently do not have any open positions under this theme. We are looking to add longs in two names.
$TRMB developer of Global Navigation Satellite System receivers, laser rangefinders, unmanned aerial vehicles , inertial navigation systems and software processing tools. The company is best known for its for GPS technology.
The company provides integrated solutions that enable businesses to to collect, manage and analyse complex information.
$TRMB is renowned for having deep domain knowledge of the industries it provides integrated solutions for and generally caters markets ripe for or undergoing rapid digitalisation.
Zebra Technologies $ZBRA
$ZBRA is in the business of enterprise tracking and manufactures and sells marking, tracking and computer printing technologies primarily to the retail, manufacturing supply chain, healthcare and public sectors. Its products include direct thermal and thermal transfer printers, RFID printers and encoders, dye sublimation card printers, handheld readers and antennas, and card and kiosk printers.
The company achieved an adjusted EPS of US dollars 2.48 a share in the second quarter, up 64 per cent year-over-year. Sales rose 13 per cent to US dollars 1.012 billion. The company beat consensus estimates of US dollars 2.23 in EPS and sales US dollars $989 million.
Software as a Service (SaaS)
We quote from venture capitalist Marc Andreessen’s seminal essay from 2011:
“This week, Hewlett-Packard (where I am on the board) announced that it is exploring jettisoning its struggling PC business in favor of investing more heavily in software, where it sees better potential for growth. Meanwhile, Google plans to buy up the cellphone handset maker Motorola Mobility. Both moves surprised the tech world. But both moves are also in line with a trend I’ve observed, one that makes me optimistic about the future growth of the American and world economies, despite the recent turmoil in the stock market.
In short, software is eating the world.”
Mr Andreessen’s words ring just as true today as they did back in 2011. Software, specifically SaaS, has continued to proliferate and we have increasingly witnessed the rise of SaaS companies that provide solutions tailored to the needs of individual industries or specific functions within a business.
We are looking to go long two names under this theme.
$PAYC designs and develops cloud-based human capital management software solutions to support businesses in managing the entire employment life cycle.
$PAYC is a highly disruptive company that is successfully displacing entrenched incumbents across the payroll management space.
Businesses tend to use software to make their employees’ lives easier and to reduce their day-to-day administrative burden. Ask any business, big or small, they will tell you that compliance is a major headache. And there is a lot businesses have to comply with, particularly in the US. Payroll software allows businesses to comply with tax and other payroll related laws. $PAYC started life as a payroll management software provider.
$PAYC’s software solutions have long since evolved beyond payroll management and include applications for talent management, recruitment and general human capital management. Payroll management is serves as the company’s entry product for new customers and the added solutions provide $PAYC with the opportunity to gradually up sell existing customers.
Veeva Systems $VEEV
$VEEV is a cloud-computing company focused on providing solutions for the sales and marketing functions within the pharmaceutical and life sciences industries. The company’s software helps pharmaceutical companies manage customer databases, track drug developments, and organize clinical trials. The software has been widely adopted by ‘Big Pharma’.
The company’s lower-cost and tailored approach has enabled it to upend the on premise software providers such as SAP and Oracle in the pharmaceutical and life sciences sectors.
While the company maintains its core focus in life sciences, it is gradually broadening its products’ functionality to enable it to up sell existing clients and to potentially enter into new industry segments.
Plenty of names for you to chew on for this week. If you would like to discuss any of the names in more detail or to talk you through our more detailed investment cases, feel free to reach out to us over email or by direct message on Twitter.