Category: Stocks

Decentralized Ponzi

Posted on by David Merkel

Photo Credits: Jared Enos, Stephan Mosel & Pine Tools || Ponzi would have appreciated the cleverness of wallstreetbets

The operation of the “bull pool” at wallstreetbets resembles a Ponzi scheme. There are five things that make it different:

  • It is decentralized.
  • Because it is decentralized, there is no single party that controls it and rakes off some of the money for himself, at least not directly.
  • The assets can be freely sold in a somewhat liquid, but chaotic market. Most Ponzi schemes have time barriers for redemption.
  • They caught a situation where shorting was so rampant, that triggering a squeeze was easy. Situations where the shorts are so crowded are rare.
  • Gamestop [GME] and other companies whose stock prices get manipulated above their intrinsic value can take the opportunity to sell more shares, as can less than 10% holders of the holders of the stock, and even the greater than 10% holders once six months have passed since their last purchase.

You have to give wallstreetbets credit for one thing, and only one thing: wiping out the shorts. It was an incredibly crowded short, and they identified an easy squeeze. But now it is harder to short, margin requirements have been tightened for both longs and shorts, given the market volatility, and even more so for options. That not only applies to individuals but to brokerages, because with the volatility, there is a greater probability of settlement failure, and broker failure. Robinhood faced possible failure and raised capital. What shorts remain are better financed than previously. When volatility goes up, so must the capital of intermediaries, including brokerages.

Ponzi schemes typically need ever-increasing flows of money to satisfy the cash need from the money being raked off. But there is no sponsor here, so what plays the role of the rake? I can think of three rakes for the money:

  • Most fundamentally driven longs have sold. Notable among them is MUST Asset Management of South Korea.
  • Some companies like AMC Entertainment and American Airlines are issuing new shares to take advantage of the artificially high price. Maybe GME will do it next week.
  • And, those who are more intelligent at wallstreetbets know that GME is overvalued, and have booked their gains. This is definitely a place where the old Wall Street maxim applies: “Can’t go broke taking a profit.” or “Bulls can make money, Bears can make money, but Hogs get slaughtered.” (The Hogs in this situation are the ones who buy and hold GME. Buy-and-hold only works for undervalued assets.)

Now, the grand change that has happened in the last two months is that the investor base of GME has shifted from being fundamental investors to momentum investors. There may be more institutional money pushing GME than is commonly understood. That said, institutional momentum longs tend to react quickly and sell when momentum fails, which makes matters even more volatile. They have more of a risk control discipline than naïve retail investors do.

This is similar to what happens with promoted penny stocks. Fundamentals seem not to matter, just the amount of money thrown at the stock. There is the pump; there is the dump. The amounts of money are bigger here. We have only seen the pump. The dump is coming. And penny stocks almost always lose.

There is no magic in markets — stock prices eventually revert to intrinsic value — it is only a question of how and when. Buyers can force a stock price above intrinsic value for a little while, but eventually the price will sag back, and the only winners will be those who sold stock to them.

When I was younger, I made a mistake with a microcap stock, and placed a market order to initiate a position. (Accident: I typically only use limit orders.) The stock was so thinly traded that I got filled at levels an average of 50% above where the bid was. The price promptly fell back to where it was prior to my purchase.  This is what will likely happen with GME, and other situations like it. Mere trading can’t permanently raise the price of an asset.

One last note: those at wallstreetbets and places life it should be careful. If you are communicating with other investors about a stock and you make money as a result of the communication, you may face legal troubles if that is deemed market manipulation. And, given that you have communicated it over the internet, that could be deemed “wire fraud.” This is the nature of a government with vague laws that likes to say “gotcha” when they deem something unsavory as illegal.

Do I think it should be illegal? No. Is it unethical? Certainly. No one should promote anything like a Ponzi scheme. But in US culture now, unethical and illegal get confused, and the ideas of “mail fraud,” “wire fraud,” etc., can be applied to unethical actions that may not strictly be illegal. Such logic has been applied to promoted penny stocks, with significant wins against the promoters.

So, to those at wallstreetbets, I would say that you are living on borrowed time. This isn’t going to work, and you and those that follow you will lose money, whether the government comes after you or not. Just as the Hunts tried to corner the silver market, and failed miserably as people sold their silver sets, and miners mined like crazy, in the same way pushing stock prices too high will only lead to dilution from the corporations, and losses to the buyers who came in late., if not the early ones as well.

Look out below.

GameStop: The Voting Machine Versus The Weighing Machine

Posted on by David Merkel

Photo Credits: Seattle Municipal Archives, Luis Anzo, piepjemiffy & Pine Tools || Truth is stranger than fiction, particularly with the behavior of crowds in markets

Before I start writing this evening, I want to say that what I write here is correct in its major findings, but it is quite possible that I got some details wrong. This is complex, and there are a lot of issues involved.

I’ve had four friends ask me about GameStop [GME] over the last few days. Thus I am writing an explanation as to why things are so nuts here.

As a prelude, I want to tell everyone that I have no positions at present in GME, and have no intentions of taking a position in it ever. Mid-decade, I owned GME and lost a little bit on it. I came to the correct conclusion that their business model no longer worked before most of the market gave up on it. If anything, the business model is worse now than when I sold. I think the true value of GME is about $5/share, unless management does something clever with its overvalued stock. Fortunately, I have written a really neat article called How do you Manage a Company when the Stock is Considerably Overvalued? I’ll talk about this more toward the end of this piece.

One more note: I never short because it is very hard to control risk when shorting. When you are short, or levered long, you no longer control your trade in full, and an adverse price move could force you to buy or sell when you don’t want to.

I can imagine working at the hedge fund, and my boss says to me, “What should I do about GME?” My initial answer would be “Nothing, it’s too volatile.” If pressed, I would say, “Gun to the head, it is a short, if you can source the shares, and live with the possibility of being forced by the margin desk to put more capital.”

Now you know my opinion. Let me explain the technicals and the fundamentals here.

The Voting Machine

Ben Graham used to say that the stock market was a voting machine in the short-run, and a weighing machine in the long-run. In a mania, you can get a lot of people chasing the shares of a speculative company like GME, and in the short run, the aggressiveness of the buyers lifting the ask and buying call options can drive the stock higher.

With GME, there is another complicating factor — there are more shares shorted than there are shares issued. This means that some brokerages have been allowing “naked shorting,” i.e., allowing traders to sell short without borrowing shares. This is illegal, and I wouldn’t be surprised to see the SEC pursue a case against some brokers as a result.

When there are a lot of short sellers in a given stock, if buyers can get the price to rise, it can create a temporarily self-reinforcing cycle as shorts are forced by their brokers to put up more capital, or buy in their short position. This is called a “short squeeze.” I’m pretty certain that has been happening with GME.

Now, beyond that there are several other factors:

  • Longs that are locked because of large positions
  • Use of call options to magnify gains (and maybe losses)
  • Co-ordinated buying by small traders.
  • Possible use of total return swaps
  • Moving shares to the cash account

I’ll handle these in the above order. There are three entities that own more than 10% of GME. Blackrock, Fidelity, and RC Ventures (the investment vehicle of Ryan Cohen, CEO of Chewy.com). Once you own more than 10% of a company, you can’t sell shares until six months have passed since your last purchase. If you purchase more, you must notify the market within two days. If you finally get to the point where you can sell, you can’t buy again for six months, and if you sell you must notify the market within two days.

RC Ventures, which now has three board seats on the GME board, can’t sell GME shares until mid-June, as they bought their last shares in December. I have no idea when Blackrock and Fidelity last bought GME shares but it six months have passed, I would be bombing the market with shares. Since I haven’t seen a filing by either one, I assume they can’t do it for now.

With call options, when a call is sold, the writer of the option must either:

  • Bear the risk in full
  • Buy other call options to hedge, and/or
  • Buy GME stock to hedge, with the risk that you will have to buy more if the stock goes higher, or sell if the stock goes lower.

Buying call options is a leveraged strategy — you can win or lose a lot — usually it is lose. On net, the market is not affected much — for every buyer there is a seller, and derivative positions like calls net to zero. The only time when that is not true is when prices move so fast that margin desks can’t keep up. At that point, brokers take rare losses.

Co-ordinated trading by small traders, perhaps influenced by wallstreetbets at Reddit is something new-ish, though it is reminiscent of the bull pools that existed in the early 20th century. The main difference is that it is a lot of little guys versus a few big guys. Regulations today call a few big guys trying to manipulate the price of a stock “market manipulation,” which is illegal. That does not apply to little guys talking to each other, most likely.

But there is a greater problem here. Even if you are participating with wallstreetbets, how do you know when others will sell to lock in profits.? It’s not as if anyone is looking at the likely flow of future dividends. The dividend has been suspended. Eventually the willingness of the “bull pools” to extend more liquidity will run out. Then there will be a run for the exits — this is a confidence game. Don’t be a bagholder.

With respect to total return swaps, it is the same issue as call or put options. Someone has to take the other side of the trade, and either bear the risk or hedge the risk. There usually should be no net effect.

Finally, there is moving GME shares to the cash account, which means those shares can’t be borrowed in order to short them. There are two points here:

  • There is already illegal naked shorting going on here, so moving shares to the cash account may not do much.
  • If you are a monomaniac, and are pursuing only GME, you might decide to lever your position via margin. At that point it is not possible to move shares to the cash account.

That takes care of the technicals, now on to the fundamentals.

The Weighing Machine

The fundamentals of GME are lousy. How many of you know their debt ratings? I see one guy in the back raising his hand at half mast. Well, let me tell you that GME has two bonds outstanding:

  • $216+ million of a secured first-lien note rated B2/B- maturing in 2023 with a 10% coupon trading in the mid-$103 area for a mid-6% yield-to-worst, which GME can’t likely call.
  • $73+ million of an 6.75% unsecured note rated Caa1/CCC+ maturing in less than two months with a mid-5% yield.

Both of these notes are trading above par, but they still trade as junk. If it were not from the interest of RC Ventures they would trade a lot lower. They did trade much lower before RC Ventures bought their stake — yields for the unsecured debt exceeded 40% annualized.

This is a troubled company that would be teetering on the brink of bankruptcy were it not for the efforts of RC Ventures. As such, I would say that the value of GME is at most the price that RC Ventures is willing to pay for it, and that amount is uncertain. (Did I mention that they are losing money regularly?)

And to the bulls I would add, don’t discount the possibility of a trading suspension where you can’t get out of your positions. I can tell you that if that happens the price of GME will be a LOT lower when trading resumes.

What is not “Advice”

Here is my non-advice for everyone.

For those that own GME, sell now. I said NOW, you waited ten seconds.

For those that are short GME, hold your short to the degree that you can.

To the management of GME, do a PIPE, sell a convertible bond or preferred stock. Buy another company in a stock swap. Do anything you can to monetize the idiocy of the bull pool at wallstreetbets. They are offering you a free lunch. Hey, and as an added incentive, RC Ventures can’t sell right now, but you can. Every bit of monetization that you do will benefit RC Ventures to a degree, and dilute them as well (a plus!).

Take the dopes at wallstreetbets to the cleaners, and show them the power of the primary market as you dilute them. Oh, and while you have the opportunity, pay off your bonds, or at least set the money aside in escrow to redeem them at the call date. That is the rescue strategy for GME: sell stock to the losers who have foolishly bid the price up, and use it to rebuild you business. Even RC Ventures may thank you.

Full disclosure: no positions in GME

Estimating Future Stock Returns, June 2020 Update

Posted on by David Merkel

Image Credit: Aleph Blog || Really, do you want to earn 3 1/2% for the next 10 years?

At present, the S&P 500 is priced to return 3.51%/year over the next ten years. Now if you were buying some ten-year investment grade corporate bonds, you might expect something around 2%. Is that 1.5% over corporates worth it?

Truly, I don’t know. That said, you have choices. The most overpriced segment of the market now is the large cap growth FANGMAN stocks, which accounts for around 25% of the S&P 500. You can choose safer areas:

  • Small cap stocks
  • Value stocks
  • Cyclical stocks
  • Foreign stocks, including emerging markets
  • Financial stocks, and maybe if you dare, energy stocks

Now I know that what I said here embeds an idea that GDP will start to grow again. Even with the lousy economic policy at present, over the next twelve months, under most conditions, the economy will grow as government reactions to the C19 virus decrease.

That said, the actions of the Fed in providing credit zoomed through the markets, and pushed stock prices up. Good for the wealthy, less good for ordinary people. Remember, I don’t think it is proper for the Fed to target the stock market. But that is what they are doing through QE.

Image Credit: Aleph Blog

The graph above shows what returns typically come when expected return level are as low as they are today. You shouldn’t be expecting much here. What?! You think the market will rise to the heights of the dot-com bubble and beyond?

Look, even if the big tech companies are profitable, having the S&P 500 in the mid-4000s is not sustainable. The companies will never grow into those valuations even if the economy recovers.

This is a time to lighten risk positions, or at least to move to stocks that have not been the leaders. Take this opportunity, and lessen your risks. Don’t drive through the rear-view mirror. Look to the mean-reversion that will come, as it did in 2000-2001.

Don’t Lose Your Head

Posted on by David Merkel

Photo credit: David Seibolid || Oh dear, you lost your head!

So we had a hard market day yesterday. Maybe COVID-19 will resurge in the USA. The great thing about the USA is that no one is ever truly in charge. Power is shared. Most of the time, that’s a good thing.

I am not saying that it is time to buy, unless it is small trades. I bought 0.7% of stocks yesterday as the market fell 5%+. My aggregate cash position is around 20% of assets. After buying as the market fell in March, I was selling off stocks in May.

Did I not believe the rally? Sure I did, but there are degrees of belief, and I kept selling bits as the market rose.

Now let me tell you about two former clients. One was retiring, and wanted to move his assets to a firm I had never heard of. He notified me the second day after the bull market peak in February. I did not argue; I just liquidated the account for him. As the market fell after that, he told me to delay selling — the market would come back. I told him he had already sold.

Now, the new manager was incompetent in rolling over the assets. I was astounded how long it took, even with me helping them. As such, the client got a bad idea, and took 2/3rds of the assets and bought an equity indexed annuity decently past the recent market bottom. The insurance company knew how to roll assets. I wish my client had asked me regarding this — EIAs are “roach motels” for cash. They don’t return well, and you can’t get out of them. Your money dies there.

The incompetent asset manager ended up managing 1/3rd of the cash they thought they would. My former client is ill-served both ways.

Then there was the second client. He seemed to be happy and was interested in good long-run returns. In my risk survey, he scored normally. But when the market fell hard in March, he panicked and wanted to liquidate. But he asked my opinion on the matter. I told him that quick moves of the market tend to reverse, and that the securities that he held were well-capitalized, and even if the market fell further, they would not fall as much.

Then he told me that he never wanted the portfolio to fall below a certain level which we were at that point close to breaching. This was new information to me, and I said to him, if that’s the case, you should not be investing in stocks. Either change your goal, or change your asset allocation.

For a day, he realized he should be willing to take more risk. Than the market fell hard again, and he told me to liquidate.

I did so.

And it was the bottom.

So what is the lesson here?

It’s simple. Choose an asset allocation that you can live with under all conditions, and stick with it. This is the same thing that I tell the risk-averse pastors that I serve on the denominational pension board. And if you are not sure that you can live with it, move the risk level down another notch.

A second lesson is be honest with yourself, and also with your advisor, about your risk preferences. Most advisors that I know are happy to adjust the riskiness of client portfolios. There is no heroism in taking too much risk.

As I have said a number of times before, I have run my portfolio at 70/30 risky/safe all of my life plus or minus 10%. I personally could run at a higher level of risk, but I would rather not take the mental toll of doing so.

And when the market moves, I trade against it — but not aggressively. I am always moving in the right direction, but slowly, because I am never 100% certain where mean-reversion will kick in.

Yesterday was tough. Big deal. Days like that will happen. It’s part of the game. As for my second client, he took more risk than he was comfortable with, and ended up leaving the game, which is the worst outcome under normal conditions.

Sun Tzu said the most important task of a general was to understand himself and his enemy. My second client did not understand his own desires, and he did not understand how volatile the market can be.

As such he lost out — as did the first client in other ways. And thus to all I say, “Choose an asset allocation you can live with under all conditions, and stick with it.” You will be happier, and you will do better if you do so.

Saving, Investing, and Storage

Posted on by David Merkel

Photo Credit: Jason Woodhead || Forget the United States Oil Fund — if you want to own oil, buy a tank and store the oil on your own property. 😉

This should be a short post. Buffett likes to own T-bills when he doesn’t have anything that he wants to buy. Why? He is storing value until the time comes when he can buy something that he thinks offers a superb return over the long haul.

And now for something that seems completely different: commodity investing, when it was introduced in the nineties, offered “yield” from rolling the futures contracts from month-to-month. That ended when the trade got too crowded, and the “yield” went negative. The ETFs that pursued these strategies were inventory financing charities in disguise. They still are, even though their strategies are more complex than they were.

Think for a moment. Why should you earn a yield-type return off of owning a commodity? Really, that should not exist unless there is a scarcity of speculators willing to let producers hedge their risk with them. There is a speculative return, positive or negative, from holding a commodity, but in the present environment, where there is no lack of people willing to hold commodities, there is no yield-like return, unless it is negative.

As a result, commodities should be viewed as storage, not an investment. Do you think in the long run that gold will be more valuable than it is today? It might be wise to store some away. That said, you have to be careful here. In inflation-adjusted terms, most commodities have gotten cheaper over time, with occasional violent rallies that convince people to speculate (all too late).

Storage is not investing. Storage tucks something away, and it will not change, even if its price changes because of changes in the economy.

Investing is far less certain — you can lend to or buy equity in a venture which could produce astounding returns, or you could lose it all, or something in-between. With investing, it is rare that you will end up with what you started with.

This is not to say that storage is a bad thing — we exchange our savings in bank balances to store value in a different form. A bank could go bust. If enough go bust at the same time, value could be lost if the government does not back up the FDIC. Holding T-bills preserves value to the degree that the government is willing to pay on its own debts in fiat currency, which is pretty likely.

Holding a commodity with a price you think will correlate strongly with the prices you will experience in retirement is not a bad idea. That said, it is storage. It will not grow your purchasing power the way that investment will.

As such, I encourage you to mostly invest, and store a little. Storage is more certain, but has no return. Investing has returns, both positive and negative, but generally over time provides more value than storage.

PS — owning a home, except in a crowded area that is growing, is not an investment but is storage. You should not expect capital gains in real terms from owning a house. That said, it will provide you with rent-free living for a long time once the mortgage is paid off. (Please ignore the property taxes, insurance and maintenance costs.)

The Challenge for Warren Buffett

Posted on by David Merkel

Photo Credit: Javier || THis is a much younger version of Buffett. Has the present Buffett learned to adapt?

Barron’s ran an article called Why Berkshire Hathaway Stock Has Rarely Been This Cheap. It was written by Andrew Bary, a man that I respect. I wrote a comment at the article, and it reads as follows:

So long as the government & its commercial paper financing arm (The Fed) is willing to create grants and credit out of thin air to rescue businesses, Buffett will not get opportunities to buy stock at the discounts that he has liked to see in the past. The cash pile will grow, & BRK stock will likely muddle.

Buffett’s justification for the cash pile changed at his last annual meeting, saying BRK needed it for catastrophes from their insurance underwriting. He has always faced that risk, and in the past has said that he might need $20B for that. (And he commented that his insurance companies were well-reserved, which is probably true.)

Choices for Buffett: 1) lower his hurdle rates for purchase down to levels where the government starts to act. 2) let the cash pile grow, and buy a huge business with significant moats that he could never dreamed of owning. 3) Start a slow buyback of stock and set a slightly higher multiple of book for where to cut it off. 4) Pay a special dividend, or, start a regular dividend. 5)Tell the managers of the operating businesses to look for decent-sized private businesses that they admire, particularly ones with succession issues. Send Buffett a proposal, and he will send a price. You can make the offer to the firm to join the BRK family. 6) Give Ted and Todd and the operating managers lower hurdle rates for investment. 7) Just muddle along, as it is now.

Order of likelihood: 7, 2, 3, 5, 6,1, 4. I don’t think Buffett will change much.

Why Berkshire Hathaway Stock Has Rarely Been This Cheap

My main contention with Buffett, as I am a shareholder, is that you can’t rely on the past when considering how far the market may fall when there is a crisis.

The nature of the US economy is that the Fed, and maybe the Treasury, or Congress, may borrow money to bail out those in distress, partly because the US economy is so indebted, that they can’t let debts be liquidated, lest we have a depression. Thus, low interest rates, low marginal productivity of capital, and low GDP growth.

In such a situation, the market will not fall enough to offer the values of a lifetime. The Fed will dilute the capital stock to provide a rescue, while Buffett finds himself diluted. Buffett’s money can’t buy a good company at a cheap price.

I sold half of my holdings in BRK recently, after I learned that Buffett did nothing during the recent fall in the stock market. Market values are relative, and there were certainly decent values to be realized in late March. You wouldn’t blow the whole wad, but surely you should have bought something.

I may sell off the rest of my holdings in BRK. Under the right conditions, I would buy more. The question is whether Buffett has an outdated view of how much the market could fall, given the skittish attitudes of economic policymakers.

Full Disclosure: long BRK/B for myself and clients

The Rules, Part LXVI

Posted on by David Merkel

Photo Credit: Heather R || Round and round it goes, where it stops, nobody knows

Don’t bet the firm.

Attributed to the best boss I ever had, Mike Cioffi. I learned so much from him.

I was surprised to see how many times I mentioned at this blog how I considered and dropped the idea of writing floating rate Guaranteed Investment Contracts [GICs]. A lot of effort went into that decision, and unlike most decisions like that, the failures of competitors with a different view happened quite rapidly.

Also, this blog highlighted those that wrote terminable floating rate GICs later, and insurers that wrote contracts that had clauses allowing for termination upon ratings downgrades.

But that’s my own story. What of others?

The best recent example that I can give is oil producers both in 2015-6 and today. When oil prices plunged, many smaller marginal oil producers went broke. Why didn’t they take a more cautious view of their industry, and run with stronger balance sheets that could endure low crude oil prices for two years?

If you are managing for the price of your stock, maximizing the return on equity is a basic goal for many. That means shrinking your equity capital base, and living with the risk that your company could go broke with many others if the price of crude oil drops significantly. Of course, you could try to hedge your production, but at the risk of capping your returns.

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The main idea here is to have a strategy where you stay in the game. This means running with a thicker balance sheet, and hedging material risks. What stands in the way of doing that?

Having a thicker balance sheet might give a firm a lower valuation, and attract activists that will attempt to buy up the firm, partially using the excess capital that aided safety. The antidote to this is to actively sell shareholders on the idea that the firm is doing this to preserve the firm from the risk of failure, much as Berkshire Hathaway keeps excess assets around for reasons of avoiding risk and allowing for the possibility of gaining significant returns in a crisis.

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If you work for a single firm, most would say, “Of course! Don’t bet the firm! What, are you nuts!?”

But incentives matter. Where there are bonuses based on sales growth, sales will happen, regardless of the quality of them. Where there are bonuses based off of asset returns over a short period, you will have managers swinging for the fences. Where there are annual profit goals, there may be aggressive accounting and aggressive sales practices. But who cares about next year, much less the distant future? Who cares for the long-term interests of all who are affected by the firm?

Corporate culture matters. Excellent corporate cultures balance the short- and long-runs. They strive for excellent results while protecting against the worst scenarios. If the firm is able to survive, it can potentially do great things. Not so for the firm that dies.

To that end, incentives should be balanced. Those that play offense, like salesmen, should have a realized profitability component to their bonus. Investment departments should be judged on safety as well as returns. Conversely, defensive areas need to have some of their bonuses based on profits, and profit growth. It’s good to get all of a firm onto the same page nd be moderate, prudent risk-takers.

In closing, the main point here is that there is no reward so large that it is worth risking the future of the firm. Take moderate and prudent risks, but don’t take any risk where you and all of your colleagues may end up searching for new work. It’s not worth it.

Beyond that, to those that structure bonus pay, be balanced in the incentives that you give. Let them benefit from their individual efforts, but also benefit from the long-run safety and profitability of the firm as a whole. That will result in the greatest benefit for all.

The Future is More Variable than the Present

Posted on by David Merkel

Photo Credit: Michael Dales || Futuristic, and with a twist

Well, I am back. This post will test whether images will post or not. My guess right now is not, so maybe I have more work to do.

Once I know that images will post, I will repost the deleted articles. On to tonight’s piece:

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There are many who get annoyed at the concept that the market is rallying while unemployment is soaring.  Though this is not true now, others get annoyed at the market falling when the economy is humming along quite nicely.

My friend Howard Simons said something like, “Stocks aren’t GDP futures.”  There are several reasons for this:

  • When corporate bond yields fall, stock valuations tend to rise. When corporate bond yields rise, stock valuations tend to fall. Corporate bond yields fall when there is economic weakness, and rise when there is economic strength.
  • Stocks react to changes in estimates of future profits (or free cash flow). That doesn’t have much to do with present economic distress or success.
  • When there is a disaster, not all stocks share in the trouble equally. Companies with strong business models. low operating leverage and strong balance sheets get hurt less. The other companies fall into distress. The financial stress on those companies can lead to sales of assets, letting go of employees, and perhaps default. Those getting unemployed often work for a different group of companies than the ones where their stock prices are rising. (Creative destruction benefits society in aggregate, but not everyone benefits. Those who benefit do not all benefit equally.)

The main thing is there is only one present, and there are many possible futures. Shifts in government policy, particularly during times of stress, can rapidly shift estimates of what the future may hold, which makes the market move.

As such, I encourage caution when markets are moving rapidly. We know the future poorly, but in general optimism triumphs so long as there is overall stability. As I said 13+ years ago:

“Moderate bullishness should be the posture of most investors because absent famine, plague, war on your home soil, and aggressive socialism, markets tend to appreciate over the intermediate term.”

Closing Comments for 3-1-07

Now all that said, don’t assume that recent bullishness is fully correct. Valuations are high. Part of that is that corporate bond yields are low. But if anything happens that shifts expectations of profit margins down for a long time, there is room for the market to fall. Treasury yields might fall in a scenario like that, but corporate yield spreads would rise more.

It’s a good time to pick through your portfolio and find what might not survive so well if the economy does not pull together as quickly as we might like. Avoid marginal names that could be subject to distress. For non-financials and non-utilities, one test is to look at the ratio of debt to market capitalization, and consider scaling back positions where the the ratio is over one.

Remember, you are your own best defender. Moderate risk taking generally wins, so trim back the aspects of your investing that don’t fit that.

PS — If you want a “blast from the past” you can read the piece When the Sirens Sing, How to Avoid Giving in… I quote some of my old lost columnist conversation posts from 2006, including one entitled “More Things Can Go Wrong Than Will Go Wrong.” Maybe that could have been today’s title.

Notes and Comments

Notes and Comments

Posted on by David Merkel

1) I still can’t post images at my blog. If you can believe it, WordPress is trying to fix it. The one cost involved is that the last three posts will be wiped out, and all comments since 4/8.

2) I’ve spent the time since my last post improving my models. I played around with a seven-parameter model, but found that it took ~10,000x as much time to converge to a solution, and there were multiple solutions with very different results that fit close to equally well. My conclusion was that they were different ways to amplify noise.

Instead, I created a second model based on the idea that the rate of growth of total cases was exponentially decaying at a rate slower than that of the first model. The new case figures have been coming at rates far closer to the second model.

I’m sensitive to when models keep having errors in the same direction… 2-3 weeks ago, errors were close to even — as many up as down. But since then more new cases have persistently come in than the first model would have predicted.

Austria, Switzerland and Germany are fine, but most of nations I have modeled have a long way to go, if model 2 is closer to the truth. Add five weeks onto getting to the 99% point.

As such, don’t put me in the camp of optimists any more. I recognize my initial predictions were wrong. Some of it stems from increasing testing as time has gone on. Indeed, what will happen if that study in New York is correct (seems to be too small of a sample, and perhaps biased), and maybe 10-15% of the NY population caught COVID-19 with almost no symptoms? That is mostly a good thing, and might even be a testimony to how little reported cases moved up in the face of that — social distancing restrains the spread of COVID-19, particularly with those who would be most harmed distancing via self-quarantine.

3) I think the history books will end up calling this the voluntary recession, where governments chose ham-fisted solutions out of fear, and did not consider the long-run implications of draconian solutions like general quarantine. What are the effects on:

  • Unemployment
  • Division of labor
  • Pensions, both public and private
  • health care for those that don’t have COVID-19
  • Small businesses that run out of resources

Death rates rise from sudden recessions. Might it be more than the lives saved via general quarantine. What Sweden is doing makes more sense. Yes, their death rates are a little higher, but they didn’t close many things at all — their populace has covered up, and kept working. They integrated social distancing into their total lives, including work.

4) But, after the crisis is over, there will be some things that we realize we did not need. Will a video teleconference do as well as a trip to a remote office? How much additional productivity do we get or lose from having staff in a single location? Hay, I can cook for myself! I don’t have to go to restaurants! We don’t need low-end malls! And more… we just don’t know what all will change. That said, never underestimate the ability of Americans to forget.

5) There are charities that help some businesses finance their inventories. They are called commodity ETFs. Long ago, I wrote about the folly of buying ETFs that follow complex strategies. USO always underperformed. This past week was the worst of it.

Negative prices for oil futures are like negative interest rates. If you can safely store paper currency, you will never have a negative interest rate. If you can safely store oil, then a day will come when you can use or sell it.

6) One of my clients asked me what I thought about what the Fed is doing now. My answer is this: they aren’t doing much. The market took their bluff and ran with it. How is this?

  • All of the risk flows back to the US Treasury explicitly or implicitly, via loss of seigniorage.
  • They are mostly financing assets, not buying them.
  • When they are buying assets, they aren’t taking much risk, either in duration or credit.
  • The QE that they are doing is just a closed loop with the banks — it doesn’t get into the general economy.

The Fed makes me think of a nerdy kid who thinks he is being cool, but all the cool kids know he is a nerd. That said, in this case a good bluff can be quite effective if the cash keeps flowing.

Personally, I like the fact that the Fed is taking little risk. That’s the way a central bank should be. But that’s not the way the markets are interpreting the matter — they think the Fed will always rescue them.

7) But at least at present, I don’t think we are using MMT yet, unless you mean that the Fed buys government debt.

To me, the big question is when do foreign entities get sick of owning US Dollar claims? When do foreign governments finally say that they won’t subsidize exporters anymore, and will stop investing in US Dollar claims?

Of the major governments, the US is the “cleanest dirty shirt,” but when will the free ride of cheap capital end? Nature abhors free lunches, and this one has gone on for a long time… pity that the competition is so poor.

8 ) When will we learn that savings doesn’t inhibit growth? Stable households and businesses survive better, and ultimately spend more.

9) 60/40 stocks/bonds as an asset allocation has been maligned, but not for any good reason. Yes, high-quality interest rates are low. The real value of bonds is that they don’t fall as much as stocks. In a stock market where valuations are still high, though not relative to bond yields, stocks should play a larger role, but not so much as to eliminate the value of having assets that protect the portfolio against hard falls.

That’s all for now.

An Optimistic Assessment of COVID-19, Part 4

An Optimistic Assessment of COVID-19, Part 4

Posted on by David Merkel

To my readers: I’m having a WordPress issue where I can’t get images to show up in new posts. Here’s my summary for my article.

Summary

  • The rate of growth of new cases is declining for most nations
  • And, the absolute number of new cases is falling as well
  • About half of the countries that I track are now posting new case counts that are below what the models estimate. Sadly, not the USA… American exceptionalism, you know. We’re #1, in total cases of COVID-19.
  • Most of the developed world hits the 99% mark for cases for the first wave by the end of April. Slower than what I projected earlier, but faster than what most have argued.
  • Will the cost of the COVID-19 crisis be a financial and/or political crisis?

This is all I am writing on this tonight, as I am worn out from trying to fix the blog images.

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