Areté's Observations 7/16/21

Areté (Pronounced ar-uh-tay) 1. Goodness or excellence of any kind. Fulfillment of purpose or function, the act of living up to one’s potential. 2. Effectiveness, knowledge.

Welcome back!

It seems like every day the forecast is the same: hot and humid with a chance of storms in the afternoon. Perhaps it is a metaphor for the market. At any rate, I hope you are staying cool and dry!

If you have any comments or questions, reach me at drobertson@areteam.com.

Market observations

The performance champion over the last month has been Nasdaq and the performance loser has been small caps. I don’t necessarily read a whole lot into the performance one way or another, but it is interesting to observe how quickly sentiment reversed from the reflation narrative in small caps to the duration narrative in Big Tech.

Meme stocks turn boring ($)

https://www.ft.com/content/b42f9901-e836-4b55-a7b2-ca1e0498b3b3

“I always thought the meme stocks would go out with a bang. Instead we’re getting a steady slide. Here is the daily performance of four of the most prominent meme stocks over the past month. All chart data from Bloomberg unless otherwise noted:”

These comments from Robert Armstrong at the FT convey a useful insight into markets. While big, sudden, dramatic moves capture all of the attention, it is often the more mundane but prolonged moves that have the bigger effects on performance. While crashes are hard to avoid because they happen so fast, it isn’t easy to pick the right time to liquidate a position that has been gradually but persistently selling off either.

Labor

It is often hard to adjudicate claims of differences in generational welfare because both sides exaggerate whether intentionally or not. Older people often tell old grandpa stories about how hard things were when they were kids and younger people never seem to be satisfied with the things they have.

All of that said, there are an increasing number of indications the kids have a point. The graph below depicts as clearly as possible the steadily diminishing prospects for economic success and security. This result is all the more striking given millennials are the most educated generation ever.

As a result, claims about reduced economic opportunity for younger people appear to be valid and should be treated seriously; they aren’t just some whiny complaints. This is important partly because it is unfair but also because it shines a bright light on the country’s diminishing (albeit still strong) capacity for growth.  

Credit

One of the interesting aspects of the economic recovery over the last year is it has come largely in the absence of credit growth. Consumer behavior was notable last year for its disconnect with historical patterns. Normally consumer spending (and borrowing) is resilient and becomes supercharged when conditions ease. Last year consumers were notable for paying down their credit cards, not ramping up their balances.

As credit card debt is starting to rise again, it will be revealing to see if it resumes historical patterns of hardy growth or reflects greater sensitivity to economic conditions.

Regulation

Biden wages war on anticompetitive "moats" ($)

https://www.axios.com/bidens-war-anticompetitive-moats-2b94d154-6972-4e87-9bdd-b1aa8b165307.html

“Three weeks after naming Lina Khan to FTC chair, President Joe Biden has made her pro-competition philosophy the centerpiece of a sweeping executive order …”

An interesting story is unfolding in regard to antitrust regulation. After the appointment of Lina Khan to the FTC and her subsequent selection as chairperson, Amazon hit back asking that she be recused from any antitrust investigations into Amazon due to her “bias”. A week and a half later the Biden administration completely ignores the request and instead issues a broad executive order addressing the subject.

The biggest takeaway is it looks like there is a new game being played in regard to antitrust regulation. While little authority accrues to executive orders per se, they can certainly influence thinking. Since “Biden is promulgating Khan's vision of anticompetitive behavior across ‘more than a dozen’ different agencies”, he is metaphorically infusing the government with different DNA in regard to competition. This is playing the long game. It will be very interesting to watch how this plays out. It will be hard for the government to change its narrative on competition, but if it does, it will be hard for Big Tech companies to defend against.

"An Ugly Truth" gives sneak peek as Zuckerberg becomes wartime leader

https://www.axios.com/ugly-truth-facebook-mark-zuckerbeg-sandberg-5db3e2e9-2c9b-4ce9-a9c1-118b1daa33f5.html

“Mark Zuckerberg surprised a council of top Facebook executives in July 2018 by declaring: ‘Up until now, I’ve been a peacetime leader ... That’s going to change’."

“The group [of Facebook leaders], the authors write, ‘had endured eighteen months of one bad news cycle after another. They had been forced to defend Facebook to their friends, family, and angry employees. Most of them had little to do with the controversies over election disinformation and Cambridge Analytica’."

Apparently, Zuckerberg’s statement was based on writings by venture capital titan, Ben Horowitz, which differentiates between peacetime leadership when “a company can focus on expanding and reinforcing its strengths” and wartime leadership when “the threats are existential, and the company has to hunker down to fight for survival.”

Zuckerberg’s decision stands out for at least a couple of reasons. For one, it is a clear break from the ethos of “moving fast and breaking things” so that era seems to be over. For another, words like “existential” and “survival” are rarely associated with Big Tech companies that are regularly chalking up new all-time highs. If survival is even remotely in question, the stocks a lot of catching down to do.

Business strategy

Robinhood’s Challenge ($)

https://diff.substack.com/p/robinhoods-challenge

“Robinhood extracted 9.5% of the value of its customers’ options portfolio for itself in the first quarter, $197.9 million of revenue on $2 billion of assets. That’s a lot!”

“So the profit-maximizing move for Robinhood, right now, is to encourage as many users as possible to switch from buying and holding stocks to day-trading options. But that's not exactly ideal for customers.”

What is Robinhood? ($)

https://www.netinterest.co/p/what-is-robinhood?

“While Robinhood employs the investor narrative in its marketing efforts and claims ‘evidence that most of our customers are primarily buy-and-hold investors,’ it makes the largest slice of its revenue from options … given how much money Robinhood makes from options, its incentives are less around promoting stock ownership and more around promoting options trading … Customers had only 2% of their funds invested in options, yet options contributed 14% to total trades and 47% to transaction revenues.”

By one account, Robinhood is leveraging technology to “democratize” finance. By another, it is luring in unsophisticated investors with below-cost goodies and doing everything possible to get them hooked on the expensive stuff. From this perspective, the business model is analogous to pushing drugs. Give them a chance to show a liking for the stuff and then exploit the heck out of the habit that forms. “Free” trading for stocks is simply the “gateway drug”.

I don’t want to get too sanctimonious about this, but it is important to understand what Robinhood is and what it is not. It is not a unique service that others cannot replicate. It is an organized and concerted effort to manipulate human weakness for profit and it does so under the pretense of the ostensibly responsible activity of investing.

Now, I don’t have any problem at all with salesmanship. At its best, a great real estate agent can match someone up with the home of their dreams. Here in Philly, the cheese mongers at Di Bruno Brothers can make buying cheese for a wine and cheese party an unbelievably entertaining and informative experience. In both these situations, however, the customer has a fair chance to decide what is in their best interest.

I don’t dispute that many other companies pursue a similar course to that of Robinhood. I also don’t dispute there is a lot of gray area between aggressive marketing and exploitation. However, insofar as Robinhood is representative of recent vintage IPOs, it begs the question: Do these companies help the economy grow? Do they add value? In too many cases, the answer is, “No”.

China

Hong Kongers rush to buy final edition of Apple Daily newspaper ($)

https://www.ft.com/content/099347a7-43de-44c4-94ef-e84b95e7a8c7

“Its closure [the Apple Daily’s] has been viewed as a marker of the deterioration of civic freedoms and crackdown on political opposition in the city after China imposed a tough national security law last year following pro-democracy protests in 2019.”

Every once in a while, it helps to take a step back in order to gain perspective. This is certainly the case with China. Last year, I highlighted China’s security clampdown on Hong Kong in the May 29, 2020, edition of Observations and followed up with reports of people preparing for the worst and moving cash out of the country in the June 26, 2020, edition.

The point is it would have been easy to be dismissive of such changes at the time and believe, or at least hope, such changes would be transient. That approach would have proven disappointing, however, and left one unprepared for even more changes to come …

Xi and Washington’s China hawks unite against Chinese tech IPOs in US ($)

https://www.ft.com/content/1105350a-7072-4014-bf76-6dcc26d9935f

“While detailed procedures and requirements have yet to be spelt out, it is clear that Chinese technology champions’ previous freedom to list shares overseas when and where they saw fit has been rescinded. The new policy is also consistent with Beijing’s ‘increasing emphasis on self-reliance and more inward-looking policies’, said Eswar Prasad, a China finance expert at Cornell University.”

One of the comments in the article says it all: “the CAC ‘could become the de facto top authority for approving [tech] IPOs’.” While it is easy to make too much of this, it does contain an important lesson: A risk factor that should always be considered in regard to China is the government can and will do whatever it takes to achieve its objectives. As a result, it is best to keep the government’s objectives in mind and make sure your objectives don’t interfere with their’s.

Oil

Opec ‘gets a pass to lift oil prices’ as hedging losses hobble US shale ($)

https://www.ft.com/content/0d60da9b-54ad-4027-b054-2ff25261e506

“Many of the hedges agreed by operators were signed during the worst months of last year’s crash, when creditors demanded that companies buy insurance against further price drops.”

One of the surprising lessons of investing in commodities-producing companies is the degree to which a company’s fortunes (and cash flows) can vary from underlying commodity prices. One of the most important causes for the differential is the use of debt.

The reason debt can cause such a problem is because interest payments are steady and predictable, but commodity prices (and therefore cashflows) are volatile and unpredictable. When prices decline suddenly and significantly, like oil prices did early last year, producing companies with high debt loads had to do everything they could to avoid insolvency. Typically, that involves high grading projects and hedging oil prices.

The downside, as can be seen in the chart below, is companies forego the upside if prices turn around, which is exactly what they did later in the year. When that happens, investors are left with companies that produce commodities but are incapable of benefitting from improving prices when they finally do come around. There is no magic trick to picking the right stocks in such an environment. The key is to find management teams that can properly calibrate the right amount of debt for their production and commodity profile – and have the courage to stick to the plan.

Source: The Financial Times

Inflation

Pop and Shop, Almost Daily Grant’s, Tuesday, July 13, 2021

https://www.grantspub.com/resources/commentary.cfm

“Up, up and away: This morning’s eye-catching release of the June Consumer Price Index featured no shortage of superlatives.  Headline prices jumped 0.9% sequentially (nearly double the 0.5% consensus) and 5.4% from a year ago, each at their fastest pace since 2008, while the 4.5% year-over-year advance excluding food and energy marked the hottest reading since November 1991, more than double the Federal Reserve’s 2% annual inflation target. Yet perhaps tellingly, interest rate futures betrayed no concern that the current price pressures will disrupt the Fed’s oft-verbalized hypothesis that inflation will prove transitory.”

After the highest inflation numbers in over a decade posted yesterday, the reaction was barely perceptible. One possible explanation is the result was widely expected and is also expected to be a short-term blip. Another possible explanation is inertia is preventing markets from shifting to an inflationary mindset too quickly and too completely. Either way, the disconnect between reported inflation and 10-year Treasuries is becoming conspicuous as John Authers of Bloomberg points out below.

I think there is truth to both explanations which suggests there will be a lot of noise about inflation for some time and it will take time to fully accept and incorporate inflation into behavior. Insofar as this is true, it will give astute investors an opportunity to position for inflation well before it grips the broader market psyche.

Cryptocurrencies

SCHRÖDINGER’S COIN, THINGS THAT MAKEYOU GO HMMM..., By Grant Williams

https://www.grant-williams.com/download/

I don’t want to say too much about crypto here, but Grant Williams exposed a lot of the reality behind crypto operations in this report and he made it free to download. Many of the lessons are classics in equity and financial and accounting analysis. Among the patterns that ought to send off warning signals are those of obfuscation, lack of transparency, and records of shady behavior from company leaders. While there are a lot of interesting concepts and tools arising from the crypto world, once you dig into some of the details of the people and operations, it is not hard to understand why so many experienced analysts are so dismissive of the space.

Implications for investment strategy

One of the most challenging aspects of today’s market is its schizophrenic nature. The mood of Mr. Market can vary from ebullient and carefree to glum and depressed in fairly short periods of time. What investors need is a good mental model to guide them through the mood swings. The best I have found by far is described in the book, The Rise of Carry, by Tim Lee, Jamie Lee, and Kevin Coldiron. I also outlined the thesis in a blog post.

A key implication is the carry regime is necessarily finite; it can’t last forever. As a result, investors need to have a strategy for operating in the carry regime that has its own set of rules and characteristics, and a separate one for when the regime ultimately fails, and the rules completely change.

Within the carry regime, returns are marked by a sawtooth pattern of bubbles and crashes. Bubbles are precipitated by central bank action to infuse liquidity and dampen volatility. Crashes are precipitated by excess leverage or insufficient liquidity so those are the key metrics to watch. Because of this, it is not a surprise that problems often emanate from the shadow banking world.

The beginning of the end of the carry regime occurs when inflation takes hold. This happens because the volatility structure that makes it so profitable to buy dips begins to invert. As this process progresses, dislocations will become normal and investors who robotically buy the dip will get ravaged time and again.

A related issue is that of allocation. The carry regime represents something of a Faustian bargain for investors. While it is in play, stocks produce good returns for investors because of the systematic downward pressure on volatility. That opportunity comes with a price, however, which is that stocks move further and further away from their intrinsic value. This of course means they have further to fall when the carry regime ends.

While this state of affairs elevates the importance of asset allocation, it happens at a time when truly uncorrelated returns are even harder to come by. The graph below highlights the increasing correlation between the Nasdaq and Treasury bonds for example. The graph also highlights what a rare phenomenon this correlation has been in the last fifteen years. Time to prepare.

Principles for Areté’s Observations

  1. All the research I reference is curated in the sense that it comes from what I consider to be reliable sources and to provide meaningful contributions to understanding what is going on. The goal here is to figure things out, not to advocate.

  2. One objective is to simply share some of the interesting tidbits of information that I come across every day from reading and doing research. Many of these do not make big headlines individually, but often shed light on something important.

  3. One of the big problems with investing is that most investment theses are one-sided. This creates a number of problems for investors trying to make good decisions. Whenever there are multiple sides to an issue, I try to present each side with its pros and cons.

  4. Because most investment theses tend to be one-sided, it can be very difficult to determine which is the better argument. Each may be plausible, and even entirely correct, but still have a fatal flaw or miss a higher point. For important debates that have more than one side, I try to represent both sides of an argument and to express my opinion as to which side has the stronger case, and why.

  5. With the high volume of investment-related information available, the bigger issue today is not acquiring information, but being able to make sense of all of it and keep it in perspective. As a result, I describe news stories in the context of bodies of financial knowledge, my studies of financial history, and over thirty years of investment experience.

Note on references

The links provided above refer to several sources that are free but also refer to sources that are behind paywalls. All of these are designed to help you corroborate and investigate on your own. For the paywall sites, it is fair to assume that I subscribe because I derive a great deal of value from the subscription.

Comments

One goal of this letter is to provide fairly dense information content – so you don’t waste your time filtering through a lot of fluffy verbiage. A consequence of that decision, however, is sometimes things may not be as understandable as they could be.

If you have a general question that may also be useful for others to know the answer to, please make a comment in the newsletter and I will do my best to answer the question or make a clarification. If you have a more specific question, please send it to drobertson@areteam.com.

Disclosures

This commentary is designed to provide information which may be useful to investors in general and should not be taken as investment advice. It has been prepared without regard to any individual’s or organization's particular financial circumstances. As a result, any action you may take as a result of information contained on this commentary is ultimately your own responsibility. Areté will not accept liability for any loss or damage, including without limitation to any loss of profit, which may arise directly or indirectly from use of or reliance on such information. 

Some statements may be forward-looking. Forward-looking statements and other views expressed herein are as of the date such information was originally posted. Actual future results or occurrences may differ significantly from those anticipated in any forward-looking statements, and there is no guarantee that any predictions will come to pass. The views expressed herein are subject to change at any time, due to numerous market and other factors. Areté disclaims any obligation to update publicly or revise any forward-looking statements or views expressed herein.

This information is neither an offer to sell nor a solicitation of any offer to buy any securities. Past performance is not a guarantee of future results. Areté is not responsible for any third-party content that may be accessed through this commentary.

This material may not be reproduced in whole or in part without the express written permission of Areté Asset Management.