Observations by David Robertson, 2/4/22
As earnings have been rolling out we are getting some insights into business conditions. That said, monetary policy is still the dark cloud hanging over markets. If you have questions or comments, let me know at email@example.com.
The market rebounded violently a week ago on the 28th and continued through Wednesday of this week. The fact that volatility had risen to relatively high levels and persisted suggested room for a reversal. Boy did it ever reverse! Volatility crashed and stocks took off.
Mike Green tweeted that retail buying was extremely strong last week. The Market Ear corroborated the point: “Net flows into global equity funds picked up in the week ending January 26 (+$17bn vs +$11bn the prior week). Insane numbers! BTD 4-EVER.” (https://themarketear.com/premium, Jan 31 2022 at 02:00).
Retail buying wasn’t the only factor driving the wild swing; derivatives activity also played an important role. While much of the quote below will sound like gibberish to most people, suffice it to say derivatives activity has an enormous impact on the market and played a big role in the selloff and in the subsequent rebound.
The fading short gamma bid ($)
We remain in short gamma land, but absolute levels have diminished as we have bounced violently. Note the SPX is flipping into long gamma land slightly higher. Long gamma is obviously the reverse of short gamma and acts as a "stabilizer". In long gamma environment the dealer will sell low and buy high, thus creating a "shock absorber" for market oscillations. As we move closer to the positive gamma flip level, the buying need will evaporate, and should we enter long gamma land, dealers will become sellers of deltas. Do not forget that short gamma exposure to the downside remains intact, i.e selling need will kick in should this turn lower again. Do you start fading the rip if one of the big drivers of the recent buying flow evaporates?
One takeaway is there are important factors affecting market action that have nothing, or close to nothing, to do with fundamentals. As a result, it is important to not infer too much about the economy or business conditions from price action.
Another takeaway is the pattern of big selloffs immediately followed by big recoveries is consistent with bear market rallies as shown below by The Market Ear below (https://themarketear.com/premium). While I always caution about using historical examples too literally, they can provide useful templates. The experience of the Nasdaq in the late 1990s and early 2000s shows clearly the high level of volatility before its significant capitulation. Volatility was part of the process.
Recent news indicates weakness. The CFO of Paypal reported a “slower than expected finish to the year” and noted a “pullback in spending by lower income consumers” as a cause. Lakshman Achuthan from Economic Cycle Research Institute reported in Grant’s Interest Rate Observer (February 4, 2022), “The entire world’s industrial production is decelerating. It is going to continue at least through the middle of the year if not a bit further.”
There are also signs of improvement, however. The jobs report on Thursday showed jobless claims were down indicating glitches from Omicron are easing. In addition, delivery times and other supply chain metrics are also showing signs of improvement.
Where does that leave things? The most obvious point is there are a lot of cross currents in the economy which are going to continue to make it difficult to read with any great clarity. Relatedly, however, the broader trend is toward weaker growth. While the current climate for additional fiscal spending is not constructive, that is the likeliest source of change should growth get too weak.
Netflix stock market woe is warning to Hollywood ($)
Netflix believers have argued that by adding more subscribers, revenue would balloon while costs would stabilise as it built up its content library.
“The decay rate on streaming content is incredibly rapid. Squid Game? That’s so last quarter”, Michael Nathanson, a top media analyst, wrote last week. “The business model is much more capital intensive than most other models we have seen.”
Netflix has long been an icon for growth stocks and growth investing. The basic argument was that streaming is growing and Netflix would be the first to establish critical mass which would give it a massive advantage.
As is often the case, there is truth in those statements, but they don’t contain the whole truth. The whole truth includes nagging details like increasing competition and increasing content decay. What once seemed like a bold effort to pioneer the industry now raises more pedestrian concerns about return on investment.
For example, cash flow from operations for Netflix the last three years was $392,610,000 in 2021, $2,427,077,000 in 2020 and -$2,887,322,000 in 2019. This amounts to an average of pretty close to zero over that period of time. At the same time, additions to content assets were $17,702,202,000 in 2021 which completely dwarfed net income of $5B give or take.
With such huge investments required to maintain its content base, it is very fair to be concerned about returns. As media analyst Michael Nathanson assessed, “They are replacing a great model for a less great model … By a mile.” This is also true of many other companies reared on the growth philosophy. As the cost of capital goes up and access to capital depends on more than just a good story, the economics of many companies will face challenges to their economics.
Beating Expectations Isn’t What It Used To Be ($)
The toughest job in PPG [the paint company] right now is a plant manager. They wake up in the morning, check their phone to see how many people call off sick, then they get to work. They go through the dock area to see how many trucks didn't get picked up, and then they go to the receiving area and then find out what didn't come in that was supposed to. And then they move it into the plant and the supply chain people are telling me that they're going to have to make smaller batches, because of lack of raw materials.
I saw this quote in John Authers’ morning missive from Bloomberg but it comes from PPG’s conference call. It gives a sense for the operating reality in an industrial company. It is easy for analysts to sit back at their desks and ponder growth rates and margins, but those numbers come from real people doing real work.
To that point, while earnings reports have been pretty good so far, they belie a harsher reality on the ground: Workers have been scrambling for a long time and they are getting burned out. Strained work conditions also increase the chances of accidents and mistakes. This cannot last forever - and therefore it won’t.
Here’s Why Nobody Wants to Work Anymore (Again)
If you’ve ever worked at a restaurant, you’re used to getting blamed for things. It’s practically part of the job. Some customers don’t even want good service. They want lousy service, so they can complain. That’s what they’re really paying for.
American consumers have been used to getting whatever they want whenever they want it, at dirt cheap prices, served to them by underpaid workers, for decades now. They can’t fathom a world without these comforts. Corporations have nurtured entire generations of spoiled consumer-citizens who only care about how much they can get for the least amount of money. They never had to think about the logistics.
I probably wouldn’t have included this piece if it weren’t for having observed an incident of a server being abused by a customer just the day before. At first I wrote off situations like these as aberrations but now I am seeing a trend. I think this story touches on something important.
The bottom line is that the mistreatment of servers and other front line workers is embedded deeply in our society. It is a dirty little secret that is becoming progressively less secret. Further, with numerous supply chain shortages and pandemic-related restrictions, there are progressively more triggers for customers to unload their acrimony on those who are not in a good position to defend themselves. The story’s subtitle says it all: “We’re not lazy, just demoralized.”
This reveals fundamental shortcomings in our social contract with front line workers. More pay and flexibility will help people in those jobs, but they won’t change the pervasive tendency toward exploitation and abuse. This needs to change for a lot of reasons, but not least of which is to maintain an adequate supply of labor.
Getting to War
Truth #1 – All governments, no matter the country or the type of government or the time period, make an effort to mobilize domestic public opinion before doing something risky like starting a war.
Truth #2 – All efforts to mobilize domestic public opinion, no matter the language or the ethnicity or the culture, share a distinctive and measurable grammatical structure.
And yes, the Russian invasion of Ukraine is happening right now … There’s nothing bona fide about the negotiations in the sense that they could result in Russia just bringing the troops home and calling the whole thing off . That cannot happen. The international “negotiations” are 100% designed for domestic Russian consumption.
Just a couple of quick points here. First, it is easy to play arm-chair quarterback to geopolitical events and come up with all kinds of possible policy “solutions”. The problem is, the vast majority of us are not privy to the kinds of intelligence that gives us any kind of an accurate sense of what the reality is on the ground.
Rather, we are mainly subjected to narratives, and very specifically contrived narratives at that. Contrived in the sense of “public opinion mobilization” for the purpose of “domestic political requirements”. As a result, the “information” we get often contains little factual content, although it does often shed light on the motives of narrative shapers. Good to keep in mind as we are likely to be seeing a lot more news of geopolitical conflict.
Rabobank: Russia Is Prepared To Declare Economic War On The West, Inflicting "Huge Economic Pain"
Maçães adds another line I have been stressing since 2017: “We no longer live in the old liberal order where rules must be enforced, and violators punished. We live in a new order where power must be balanced with power.” And the EU has no such power! If only its preparations had been made as far back as 2017 when ‘The Great Game of Global Trade’ came out.
One of the more useful geopolitical theses the last several years has been that of the “Gzero” world by Ian Bremmer. The idea is the United States will no longer play global policeman and nobody else is going to take its place.
I highlighted the issue in the May 21, 2021 edition of Observations by noting, “less effective leadership creates space for more conflict and more challenges in the geopolitical realm.” Well, now we are seeing the implications play out in real time. Lower global influence by the U.S. means less ability for rules to be enforced and violators to be punished. It means more “power being balanced by power”. Russia knows this and so does China. Get used to it; this is the future.
With the Fed’s preferred inflation indicator, PCE (personal consumption expenditures), having shot up close to 5% it is right to question how much of a handle the Fed has on inflation. Martin Wolf expressed his opinion in the FT this week: “Yet the Fed continues to ladle out the punch, even though the party is turning into an orgy.”
This raises a number of questions, not least of which is to what degree is the Fed even capable of appropriately calibrating policy in such a dynamic environment? During his press conference last week, Jerome Powell repeatedly expressed the intention to be “nimble” with policy. And yet … and yet the Fed has been anything but nimble in addressing the soaring PCE. If the Fed wanted to be “nimble”, it could have sent a message last year by stopping quantitative easing and raising rates - immediately.
Worse yet, it is well-known that monetary policy works with a long lag (typically a year or two). As a result, if you want something to happen soon, you need to have started with policy a year ago. In short, it is foolish to even mention the word “nimble” in regard to monetary policy.
Quantitative tightening, redux ($)
The extra layer of problems here is that the Fed is very uncomfortable with the balance sheet. That’s one area where I look at the robust debate among the FOMC [Federal Open Market Committee] and I don’t feel so good. Because they don’t know why it works or how it works. They don’t have enough data points on this working well. They can’t talk about that much in public because they don’t want to unsettle markets or themselves . . . lift-off [of policy rates] is not the tricky thing here. It’s lift-off in a pandemic, it’s lift-off with a big balance sheet. How do you get out of [the QE] business?
This is a great overview by Robert Armstrong, especially of the balance sheet portion of monetary policy. The above is a quote by Claudia Sahm, but there are also great insights by Michael Howell and John Hussman. The bottom line is the Fed doesn’t know what to do with its outsized balance sheet because it doesn’t know how it affects the market. It is only de-emphasizing the balance sheet relative to rates because it understands rates better.
Two big risks come to mind immediately. One, with the Fed being the marginal buyer of Treasuries, it is anyone’s guess as to who will step in to replace the Fed as the marginal buyer and what price that new party will be willing to pay. There is definitely potential for prices to fall and rates to rise.
On the other hand, if demand is strong for Treasuries and rates are steady or even go down, market participants would no longer be compelled to chase risk through financial assets, but would instead be compelled to chase risk through economic assets. Just imagine the money the Fed pumped into financial assets being redirected, by the way of fresh bank lending, to the real economy instead. We would experience growing credit, growing inflation, and declining stock prices. Yikes!
While it is not hard to understand why stocks rebounded so fiercely late last week into this one, it is harder to justify on a long-term basis. The bottom line is the environment is still exceedingly unsupportive for stocks.
The top reason to be cautious about stocks is tighter monetary policy by the Fed. Further, with the ongoing impact of inflation, the Fed does not have the luxury this time of talking big but doing nothing. It must act.
Another good signal is insider selling. For all the fervor retail investors seem to have for buying stocks, corporate insiders have been dumping like crazy. The January 27, 2021 edition of Almost Daily Grants reported a smattering of notable transactions: “Over the past three months, the Tesla and Amazon c-suites have dumped $5.9 billion and $2.5 billion worth of stock, respectively, while the managements of private equity giants Blackstone, KKR and Carlyle cashed out of $1.2 billion, $760 million and $205 million per data from Bloomberg.”
Finally, credit is always a good reality check and it is not bouncing anywhere near as strongly as major stock indexes.
While continued volatility will certainly create trading opportunities, the intermediate prospects for stocks remain quite negative.
Implications for investment strategy
One of the greatest virtues of investing has always been patience and that is likely to be even more the case than usual for the foreseeable future. While big short-term moves can be exciting, they are notoriously difficult to profit from. They also distract attention away from things that are easier to profit from - like longer-term trends and appropriate positioning.
To that point, one of the longer-term trends is the transition away from credit-fueled growth. China needs to restructure its economy away from real estate and infrastructure and the U.S. needs to combat inflation. This means slower growth and less easy financial conditions.
As a result, high stock valuations, slower growth, higher inflation, and geopolitical conflicts are all risks that will need to be contended with. There is nothing easy about this so the expectation should be that things will be harder for some period of time. Ultimately, the resolution of excess is a good thing, though, and can also present amazing opportunities for those who are prepared.
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