Category: global investing

By Eric Cinnamond via palmvalleycapital.com

Whether it occurs in everyday life or while investing, there’s nothing like finding a free dollar. I enjoy it so much, BOGO (buy one get one free) shopping has become one my favorite hobbies.

A few weeks ago, I was “BOGO-ing” at our local grocery store and noticed a BOGO on one of my favorite desserts—chipwiches! For those less familiar with the wide variety of ice cream offerings, a chipwich is made by rolling vanilla ice cream in chocolate chips and placing it between two chocolate chip cookies. Whoever invented the chipwich wasn’t messing around! Considering it’s one of the most delicious and irresistible ice cream treats on the planet, promotions are very rare. My taste buds and wallet were ecstatic!

A box of four chipwiches cost $4.79. Therefore, for every box I bought on BOGO, I was practically picking up a free $5 bill. As much as I wanted to purchase every box, there are some unwritten rules related to BOGO shopping. For instance, it’s considered rude, or poor “BOGO-manship,” to leave an empty shelf for other shoppers. With that in mind, I placed 10 boxes of chipwiches in my shopping cart, leaving plenty of inventory behind. Even though I wanted to buy more, I was very satisfied with my purchase and return on investment!

As soon as I got home, I opened the freezer to deposit my winnings. I couldn’t believe it! To my surprise there were already 10 boxes of chipwiches stacked in the freezer. Earlier in the day, my wife also took advantage of this special BOGO! What an amazing turn of events. Our family went from owning zero chipwiches to holding a full position (20 boxes). Combined we saved $48—an incredible day of BOGO shopping!

My BOGO experience didn’t end there. After spending the next three weeks consuming chipwiches, I returned to the grocery store to hunt from more BOGOs. On my way in, I weighed myself on the store’s scale and was shocked to learn I gained 10 pounds! Apparently, BOGO shopping is not risk-free 😊.

As a BOGO enthusiast, I’m very attuned to changes in the promotional environment. Based on numerous trips to the grocery store and other retail outlets, I’ve noticed a sharp drop in promotions over the past several months. Recent quarterly results and commentary of the businesses on our 300-name possible buy list support my anecdotal observations. With declining inventories and rising costs, companies have been reducing promotions to protect gross margins and receive full price on their limited supply.

Examples of declining promotions are numerous and broad-based. For instance, on their last conference call, Dick’s Sporting Goods (DKS) discussed declining promotions, stating, “The merchandise margin rate expansion was primarily driven by fewer promotions and lower clearance activity [our emphasis].” Lower inventory and supply constraints have also become a common theme. Management explained, “During Q4, we again remain very disciplined in our promotional strategy and cadence as certain categories in the marketplace continue to be supply constrained.” Management also noted inventories were lower than they prefer (down 11%) and stated certain categories of merchandise were not being manufactured sufficiently.

Carter’s (CRI) had similar comments related to inventory and promotions. Management said, “With leaner inventories, we focused our marketing less on promotions and more on the beauty of our product offerings.” With declining inventory, Carter’s has been less promotional in their retail and wholesale channels. Management’s comments related to their wholesale channel were particularly interesting, stating, “Everybody we sell to actually wants more inventory right now, so I think folks are doing a good job managing their business, getting price realization, higher margins, as we’ve all played it tight and conservative given the uncertainties.”

Another business we follow, Big Lots (BIG), also reported fewer promotions, stating, “As our inventory levels were sold through, we were able to navigate through the holiday period with fewer promotions than last year. This reduction in markdowns significantly mitigated the pressure felt from increased spot freight rates and higher supply chain charges we incurred.” Big Lots’ comments were similar to other companies attempting to pass on rising costs.

Other categories in retail, such as branded apparel, also reported lower inventories and higher average prices. In fact, we’re noticing more companies discussing their efforts to receive “full-price.” During Ralph Lauren’s (RL) recent conference call, management said, “Third quarter AUR [average until retail] growth of 19% was above our expectations, with North America and Europe up double-digits and Asia up high single-digits.” Management pointed to significantly lower promotions, targeted price increases, and improved full-price penetration.

Under Armour (AU) is also focusing on selling full-price inventory, saying, “We are working to evolve concepts to drive more profitable formats, particularly for our full-price brand house locations. Our factory house business is about driving greater productivity in store and reducing our promotional levels…”

Skechers (SKX) commented that they too were seeing more full-priced sales, stating, “Gross margin increased over 100 basis points, primarily driven by a favorable mix of international and online sales and an increase in domestic wholesale average selling price, with higher full-price sell through of several of our innovative platforms.”

Nike (NKE) discussed how supply chain shortages are negatively impacting sales, saying, “Starting in late December, container shortages and West Coast port congestion began to increase the transit times of inventory supply by more than three weeks. The result was a lack of available supply, delayed shipments to wholesale partners and lower-than-expected quarterly revenue growth.” Management also commented on its improved gross margins, partially contributing them to “higher full-price product margins.”

Sticking with the footwear theme, Shoe Carnival (SCVL) commented they were also generating higher gross margins, had less inventory, and were providing fewer promotions. Management explained, “Many investors were surprised by the third quarter upside across the space, which was primarily driven by tight inventory management and, from what we’ve heard, of just a broadly less promotional environment.” Regarding future promotions, management said, “I think that’s going to actually pay dividends as we go forward because as you eliminate those promotional time periods, there’s no reason to reinstate them next year.” They even commented on their version of a BOGO, stating, “We ran a promotion that everybody knows as BOGO. Buy one get one half off, that we eliminated many, many weeks of that and we’re continuing to do just that…there’s just no reason to discount that product to the customer as long as they’re willing to pay full-price.” There’s that “full-price” reference again!

We noticed larger retailers are also reporting fewer promotions. In their most recent conference call, Target (TGT) commented on their improving gross margins, saying, “In 2020…a significant tailwind [to gross margins] of about 150 basis points was driven primarily by the favorability of markdowns. A portion of this favorability was related to promotions, but the biggest single factor was a significant decline in clearance markdown rates as demand in seasonal and other clearance sensitive categories far outpaced our expectations.”

Kohl’s (KSS) reported similar trends, stating, “We discussed on our Q3 call the early success we had in optimizing our price and promotional strategies, and we built on this success in Q4. We continue to reduce the number of general promotional offers and stackable offers…” Kohl’s also noted how fewer promotions, pricing, and inventory management have helped offset higher shipping costs.

Macy’s (M) provided commentary on promotions and full-price sales as well, saying, “We’re also going after pricing and promotions. We’re trying to minimize the unnecessary promotions and markdowns and discounts to achieve a higher full-price sell-through, which will help our merchandise margins and ultimately help our gross margins.”

Tempur Sealy International (TPX) discussed pricing and rising input costs on their last conference call, stating, “We have a history of taking price on products to offset industry inflation. Most recently, we have implemented pricing actions during the fourth quarter that have fully mitigated the anticipated input cost headwinds at that time. However, as we’ve entered 2021, input costs have continued to increase beyond our initial expectations. We continue to monitor these costs and expect to take additional pricing actions as needed.”

And finally, Walmart (WMT) had interesting comments related to inflation and how they work with suppliers. Management explains, “We work with suppliers—if we’re getting cost inflation in a product, how do we potentially change the product? How do we make it less expensive? How do we — can you do that and still keep the quality of the product?” In effect, the price may not change, but the product may. As my dad often said about his tools and yard equipment, “They don’t make them like they used to.” I believe he was right! Many products have been altered over the years to offset rising costs.

Rising costs, reduced promotions, and an emphasis on full-price sales are all inflationary. As such, we are curious how the Consumer Price Index (CPI) has been factoring in these trends. Based on the most recent CPI report, apparently it is not! Specifically, the February CPI less food and energy came in at blistering (sarcasm intended) 0.1% with the core rate up 1.3% year over year. While we don’t spend much time analyzing government economic data, we believe the CPI has some catching up to do!

The current operating environment reminds us of 2018 when businesses were also reporting rising costs and pricing power. Ultimately, the CPI caught up with what we were observing in the real world, rising to 2.9% by June 2018.

Unlike today, in 2018, the Federal Reserve was raising the fed funds rate. Interest rates across the yield curve responded, with the 2-Year Treasury yield increasing from 1.92% on January 2, 2018 to 2.98% on November 8, 2018. Rising interest rates were eventually too much for the stock market to withstand. Small cap stocks fell approximately 25% from their 2018 highs to their lows in December.

Without the tailwind of a rising stock market, the economy stalled, commodity prices declined, and the December 2018 CPI fell back below 2%.

Similar to 2018, we expect the inflationary pressures being reported by businesses to eventually find their way into the government data. Also similar to 2018, we expect rising inflation will place upward pressure on interest rates. Now here is where it gets tricky. Do rising interest rates cause the stock market, economic growth, and inflation to decline like the end of 2018? Or do rising rates cause the Federal Reserve to increase quantitative easing (QE) in an effort to manage the yield curve and keep asset prices inflated? Based on how the Fed responded in 2018 to falling stock prices, we believe they’ll attempt to maintain inflated asset prices.

Assuming we are correct, we do not believe the Fed’s efforts to protect asset prices will necessarily succeed. By artificially suppressing interest rates along the entire yield curve, we believe current inflationary trends are less likely to self-correct and could possibly worsen. In effect, the more money the Fed creates to suppress interest rates and maintain asset inflation, the greater the risk of losing control of real-world inflation and its perceived control of asset prices. Put simply, we believe a policy of endless quantitative easing and a dismissive attitude towards inflation are incompatible.

While we’re fascinated by the box the Federal Reserve has placed itself in, we feel no sense of urgency to act or speculate on how the Fed will respond. As portfolio managers with an objective of generating attractive absolute returns over a full market cycle, we are in the fortunate position to not have to “play the game” and remain fully invested. In our opinion, small cap valuations have never been more expensive and risks never so underappreciated. Getting aggressive here makes absolutely no sense to us. However, waiting for the return of volatility and opportunity does.

We believe our patience will pay regardless of how the Federal Reserve responds to rising inflation. If the Fed acts to fight inflation, we’d expect interest rates to rise, putting pressure on sky-high equity valuations. If the Fed dismisses inflation, its credibility will suffer, risking a revolt in the bond and currency markets. Either way, we expect the Fed’s inflation dilemma will likely lead to an increase in volatility, and in our opinion, opportunity. Given the current backdrop, we like our patient positioning, appreciate our objective more than ever, and believe we are well prepared for future investment BOGOs!

Eric Cinnamond

eric@palmvalleycapital.com

I am not a gunslinger when it comes to investment because I have have learned risk management hard way (loosing my first year salary in the 200 Tech boom). Bill blain has painted a kind of doomsday picture below and I think it is worth reading as we are dealing with a very complacent market.

By Bill plain via morning porridge

The supreme art of war is to subdue the enemy without fighting.”

You could not make this up; an unimaginably complex WW3 Techno-thriller unfolding as markets stumble and global supply chains hover on the edge of anarchy. On the other hand, maybe that’s just the way it was planned.

I am not one for conspiracy theories. But… this morning… If I was a writer of trashy global-techno-World War 3 pulp fiction, and proposed the following scenario where the global economy lurches into an unprecedented period of instability – nobody would believe me:

1)    Global Supply Chains, weakened and struggling after a year of global pandemic, plus a growing shortage of microchips holding back multiple industrial sectors, are plunged into new crisis by a puff of wind causing a box-ship to skite sideways and block the Suez Canal, trapping East-West Trade.

2)    Unstable and over-priced Global Markets are spooked into a frenzy late on a quiet Friday night by the largest margin calls ever ($20 bln plus) as an Asian “family office” dumps billions of dollars of stock into the market. Collateral damage spreads, as other financial firms, (inevitably including Credit Suisse (Switzerland’s very own Deutsche Bank), and Nomura), announce material losses.

3)    As global central banks struggle to restore real growth, while trying to hold interest rates low and support commerce, and acutely conscious of how a market crash could crush global confidence – things suddenly get more difficult as confidence in equity valuations takes a massive knock.

4)    Geopolitical stability wobbles after China lashes back at US criticism in Alaska, and then surprises Europe with sanctions and push back on trade deal – when many has expected China to attempt to reach out to Europe – even as it reaches out to pariah states including Iran, Myanmar and Turkey.

5)    Rumours abound of imminent China action to seize Taiwan – and the potential impotence of US fleets from the Gulf to the Pacific are targeted by long range Chinese carrier-killer missiles – further destabilising markets.

6)    Cyber-attacks across western economies, first uncovered at Solar Wind, but possibly undiscovered elsewhere, raise questions as to how much the West’s digital and financial infrastructure has been compromised.

What happens next?

On the basis I am an optimist, and things are never as bad as we fear, I think it all settles. Who knows? But I suspect one thing is going to become very apparent. China has crossed the Rubicon and will now longer be a rule taker. The rules have changed. China has demands.

What’s different in the above scenario is that it doesn’t necessarily lead to a hot-war. The Beijing leadership see benefit in trade, engagement and the global economy to deliver its pact of prosperity to the Chinese population. They may conclude China’s done enough to achieve its’ strategic economic objectives; parity with the west, and economic primacy across Asia.  Whether the mood turns hot or cold rather depends on how the West responds to the apparent nullification of the USA’s military hegemony achieved by China’s new missile technologies.

These new missiles are a known unknown. The latest versions of the D-26 Carrier-Killer are apparently based on the Tibetan Plateau and can take out US Carriers from the Gult to New Zealand – making any defence of Taiwan look an extremely risky call. Sending the UK’s carrier strike group into the region later this year looks… challenging.

And suddenly you are wide awake and wondering just how crazy this suddenly got…..

*  *  *

On Sunday I spoke with one of my old racing yacht crew who is now doing extremely well in Global Shipping. I asked if there was anything we were not being told, or what the real story of the ship blocking the Suez was. He was cagey but told me.. “If you need Garden Furniture, buy it today.”

This morning it looks like the Suez has been uncorked – the boat has been shifted – but I was asking because I reckon slowing global trade by sending it the long way round Africa isn’t just about miles and time – it’s finding the ships capable and seaworthy for the longer trip, and bunkering them accordingly. It’s not just a matter of a longer voyage. Suddenly everyone wants Air Freighters.

The key-thing is what happened on the Suez demonstrates is just how easy it would be to block the bottlenecks of global trade. Everything from consumer tat to chips would be stressed.

After Archegos Capital, the family office of tiger-cub and convicted insider Bill Hwang was forced to sell more than $20 bln of stocks in a series of block trades on Friday, this morning – its looking likely to be a risk-off day. Block equity-trades stemming from the margin-calls on Archegos will have sent the market’s spidey senses a’tingle. Who is next?

There will be flows back into the relative safety and comfort of bonds – even if they do yield nothing. In bonds there is truth, and I suspect today will confirm it’s all about fear. Over the past 10-years artificially low rates have eroded the relationship – telling investors low rates are a reason to take risk. Its low rates that have supported today’s frankly insane stock market valuations. Risk is very real again.

While Gold might be on the agenda, I’m not so sure about Bitcoin. The Chinese have made it quite clear they will digitise the Yuan.

Today’s moves will likely also reflect a Q1 rebalancing of bonds vs equities holdings– which have been distorted by the relative yields on asset classes. But I suspect it will just be the start of a trend. Just how big has unregulated leverage in the shadow banking system of investment firms become? How could it unravel impact markets? Or maybe it will be illiquidity as the next duck tumbles and no one is prepared to buy?

Today won’t be much fun for anxious central bankers.

It’s not going to be much fun for the politicians either as they look realise just how vulnerable the West is to a new economic shock, even as we’re still being floored by the self-inflicted economic harm of the Pandemic.

Western Economies are dependent on long exterior global supply chains to fuel demand for more and more consumer goods. We’ve become comfortable to click and deliver being satisfied from China. Stuck in lockdown we’ve heard disembodied voices warning of economic catastrophe, but we’ve been cocooned from the economic reality, relying on governments assurances they can prop up the Covid ravaged economy with subsidy and furloughs. Destabilise our supply lines, and the threat is a run on everything – potentially making last year’s pandemic panic look tame.

Meanwhile, dissent is all the rage across the west, whether it’s the right-wing complaining about their civil liberties, smaller nations demanding independence, or gender and race issues coming to the fore and exposing the inequality and division of society. All of these divisions are fed on a rich oxygen-mix of social media, and targeted with fake news aiming to deepen division. Everyone has a cause, and everyone believes what they want to, but nobody listens. Western society has never been this unstable, polarised and disunited.

Chalk up another win to China.

China’s leaders are satisfied. Their position is secure. China’s economy is exposed to supply chains, but is based on interior lines (and pretty much brand new infrastructure) – better able to weather and internalise a global trade-storm. Its’ society is homogenous and willing to buy the greater prosperity/state control trade off. National pride hasn’t been compromised by the pernicious effects of Wokery.

The economy of the West is bought into the promises of technological change and addressing the environment. Markets are soaring on the back of expectations of increased technological adoption, with a few successes spurring thousands of highly speculative copycats – witness the insane boom in SPACs. But the reality is economies have become increasingly bureaucratic, stultified by regulation, and held back by political gridlock and polarisation. Infrastructure is old and tired. Key skills and capacities have been lost.

Let me present a tiny example – speciality steels. Without speciality steels for the fine work of tech, the economy will ultimately wither and die. We are now entirely beholden to external steel. The UK government put plans to restore mining the key element of steel in the UK on hold. Without metallurgical coal – you can’t make steel. Fact. The UK prefers its steel to be made in China with Australian met. coal so it can say it’s tough on cutting carbon. The facts are simple – make the steel here, less carbon miles and more high quality jobs.. Or…

But, the risks are not just in terms of physical supply chains. The digital economy is even more important and potentially even less protected. We’ve largely remained unaware of just how vulnerable we are. The cyber-attacks on SolarWinds last year may reveal the Trojan Horse is already in the city.

The degree of interconnectedness in the global economy is extraordinary. All the major financial institutions used SolarWinds’ Orion platform. The hackers got into SolarWinds and were able to install malicious code into software updates, accessing thousands of clients’ confidential information. We still have no idea how deep the hack goes. Increasingly companies release its not a matter of understanding their own vulnerability, but the vulnerability of all their suppliers, and hence, the whole digital supply chain.

So… what happens next?

Do the Chinese explode a couple of massive nuclear missiles in space to take down global positioning, communications and spy satellites with an EMP pulse, alongside a simultaneous cyber-attack to crash the Western Financial System, plunging us into limbo? How would Central Banks cope with the resultant market meltdown? What would happen if even a small part of the global payments system crashed?

Sometimes it easier to not over think it.. and just hope it was just coincidence… hope is never a strategy.

** on a risk-adjusted basis

By Maxime clarmont

Today, we will be exploring the fundamentals of Uranium investing. Just like many other commodities, Uranium has been left for dead in the past 10 years. It is about to come back on the mainstream investment shows and portfolios and soon be the town’s talk. Therefore, here is my top reasons to invests in Uranium:

1. Supply & Demand imbalance
2. Consistent lack of Capex investment
3. Price of uranium

As you can see, I am a simple man. I like an investment thesis that is easy to understand.Subscribe

Supply Depletion

This is not your typical “peak oil” supply depletion. This is a factual, quantifiable, and auditable fact. The below table, provided by TD securities, shows us all the current and future uranium supply by their sources. The interesting fact is the total western mine supply keeps declining year after year. I like the below table because it goes into a lot of detail about the different sources of supply.

Uranium bulls were already hyped up about this thesis 3 years ago. The big unknown in the last couple of years highlighted by Mike Alkin from the hedge fund Sachem Cove, the only hedge fund focused on Uranium investing, was the secondary supply from, as an example, Japan. After the Fukushima accident, they were selling the uranium they did not need from the excess inventory they had contracted because they decommissioned nuclear reactors. This, however, is/will soon be coming to an end, and all we will be left with will be a primary supply which is even easier to forecast given that only a few mines in the world produce uranium. If you really want to get deep into the subject, I suggest the following interviews. It is 2 hours long; therefore, that is if you really want to get deep into the subject! I could spend a full article on the secondary supply dynamics. Is that something you would like to understand?

Covid 19

Since 2020, we have further eroded the supply of current mines. As you can see from the below table, the uranium-producing companies are very concentrated. Cameco and Kazatomprom, the biggest producers globally, have both decided to leave some of their production mines offline for the foreseeable future. Cameco, in 2018, put their McArthur River mine in care and maintenance. They said that the closure was due to Uranium’s ongoing low prices and would bring it back in production only when the price would justify it. Kazatomprom, the biggest producer in the world, in their latest earnings call, mentioned that they were most probably going to have to buy uranium on the spot market, meaning at the open market, instead of depleting their mines. In my opinion, this strategy is fantastic news to drive the price up in the future as it will deplete all the secondary supply and force future prices to increase as it squeezes the current supply even more. Looking further to the list of major uranium producers, BHP, last year, decided to stop expanding their Olympic dam mine. Not including this list is the Cominak mine from Orano that will stop its production in March this year.

Demand Imbalance

As mentioned last week, the current total number of nuclear reactors is 440. We will add another 50 reactors that are either being built or contracted by 2025. China, by 2030 will be consuming the total current production of Uranium alone. The big question will be, where will the future supply come from? Twofold, first, mines that are currently on care and maintenance. What the hell does that mean? Mines that are uneconomic at the current price of the uranium but would produce at higher prices. Paladin and Cameco have such mines. The issue of having to restart mines is that it is costly. I feel I repeat myself as we move from one commodity to another, but you cannot simply turn a switch on and off to produce more Uranium/silver/gold/copper/lithium/rhodium and so forth. The projected costs to restart the Paladin mine is 81 million dollars for their Namibian mine.

On the above graph, you can see that the returning production will cover some of the supply/demand imbalance. As we move into the latter part of the decade, however, we will need a secondary inventory source, which will be through new mines productions. John Quakes provided the above graph.

Lack of Investments

The countercyclical nature of commodities investment is usually a simple path to follow. A period of high prices leads to a lot of investment in future productions. This, in turn, will lead to higher production and, in the absence of higher consumption, will lead to lower prices of the said commodity because of the excess supply. If allowed to persist for a prolonged period of time, this situation will lead to a shortage of supply, which is exactly what has happened since Fukushima. So what is the current state of Capital investments in Uranium, you ask? In the chart below, we can see that we are between 20% to 25% of what we used to invest 10 years ago. Given the shrinking supply and the lack of investment to bring new mines to life, this will lead to higher uranium prices. In fact, I think we will see a sustained higher price of Uranium for a much longer period of time following this period of under-investment given the forecasted rising demand in the next 20 years.

The price of Uranium

The price of uranium has been quite stable since 2015, staying below 30$/lbs. Unfortunately, only the best and most productive mines can make a profit with these prices. Looking at the below table, although this is the USA only, it gives you a great understanding of what supply can be mined by price point. Under 30/lbs, there is very little supply that can be mined profitably, as you can see.

Uranium Price chart

If you look at the new projects from future mines for companies that have confirmed resources in the ground, you find that companies will be profitable and able to operate mines with a constant and long-term minimum price of uranium 50/lbs. One of the reasons why the price needs to be significantly higher than the current 30$/lbs is that these companies will need to spend a minimum of 5 years on building a mine and potentially spending upwards of 1 billion dollars in CAPEX. Let pause here for a second. If this was your own money, would you sign contracts with builders, contractors, engage with the governments for environmental studies, knowing that you would ultimately spend 1 billion dollars if you cannot, with a reasonable level of certainty, predict that you would be making a profit? Furthermore, utilities who buy the uranium are price takers and have inelastic price demand for the fuel. Why is that? Utilities, which are usually government entities or government allowed monopolies need to keep the lights on, regardless of the price they pay for the commodity. From last week’s article, we know that nuclear reactors produce 10% of the world’s electricity, and sometimes close to 30% of a country’s total electricity is provided by nuclear.

Summary

Unless another accident like Fukushima happens in the near term, I think that Uranium equities will end up being the best-performing asset of 2020 to 2030 on a risk-adjusted basis. Before you castrate me for not mentioning Bitcoin, I still think we will see another 10x to maybe 20x from the current price. Some of the junior equities will be able to achieve 10x to 50x in the next 10 years and repeat some of the actions that we saw in the late 2000’s bull market. Of course, some start-ups could IPO and give you 10000% return over the next 10 years. A pharma could cure cancer and do the same. Uranium’s difference is that even the biggest and best in class, blue-chip companies with solid management, years of experience will experience an easy 10x increase in market cap. The smaller producers will probably experience a 20x increase in market cap. Simultaneously, the grass-root explorer and project generator might repeat the Paladin story that went from 0.04$ a share all the way up to 10$ per share for a whooping 250x times your money.

https://maximeclermont.substack.com/p/the-best-investment-of-the-next-decade

By Bryce Coward, CFA

It’s no secret that money has poured into passive equity vehicles as investors seek low fees above all else. To date, that has worked out just fine since equity indexes have compounded their returns at acceptable, if not above average, rates of returns. But, the world is different now than it was 10 years ago, and the low-cost advantage of passive investing may now be outweighed by its risks.

In this quick post we’ll address three risks to passive investing that together suggest the riskiness of this strategy may well be the highest it has ever been.

• Taking the S&P 500 as an example, the weighting toward tech-like stocks introduces significant concentration risk. Indeed, the weighting of the technology sector + Alphabet, Amazon, Facebook, & Tesla is a whopping 38% of the total S&P 500. In other words, 38% of passive investors’ exposure is to one risk factor. That’s a lot of chips to put on one bet.

• The valuation for the tech-like stocks is out of control. Taking just the tech sector as an example, it’s trading at 6.2x next year’s sales. This valuation extreme was only eclipsed (barely) in the late stages of the tech bubble. Since valuations inform prospective returns, passive investors in the S&P 500 are basically locking in a below average rate of return since 38% of their portfolio is invested in highly valued stocks. But…the growth. Yes, valuations always need to be calibrated against prospective growth rates. However, tech sector growth rates have been trending down since 2006. For the first time in a very long while, S&P 500 long-term growth is expected to be on par with tech sector growth.

• Tech valuations are highly related the level of long-term interest rates. Much of the “value” in tech stocks is the stream of cash flows that is expected many years from now, which is similar to the payoff profile of a long-term bond. When interest rates rise, the present value of those future cash flows (for bonds and high growth stocks) goes down. Since we’re in an environment in which very long-term interest rates are more likely to rise than fall, this will generally put pressure on tech valuations.

This is kind of hat trick for passive investors. Passive portfolios are highly concentrated in stocks with overlapping risk exposures, the valuation of those stocks is in the 99th percentile, and there is a catalyst for those valuations to compress. Combined, these things add up to a below average rate of return for passive portfolios, even if the average stock does just fine. But the fees are low…

As of 12/31/2021, Alphabet, Amazon and Facebook were held in a Knowledge Leaders Strategy. Tesla was not.

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I have been reading Dylan Grice since his socgen days and this interview just delivered a reality check for every investor.

I have highlighted the important portions in the interview if you are short of time.

Dylan Grice, co-founder of Calderwood Capital, sees frothiness all over today’s financial markets. He thinks valuations in hot sectors like electric vehicles are insane, but he sees investment opportunities in areas like uranium and oil.

Dylan Grice is concerned. The co-founder of Calderwood Capital and former strategist at Société Générale sees smaller and larger bubbles emerging all over financial markets. «There are clear signs of excess», says the author of the monthly «Popular Delusions» report.

Still, Grice characterizes his current investment stance as reluctantly bullish: «Central banks will overcook the economy, everything is set for a few years of overstimulation in monetary and fiscal policy.» This won’t end well, he adds, but until then the equity market boom could continue.

In an in-depth conversation with The Market NZZ, Grice explains how investors could navigate the current environment and where attractive investment opportunities still exist. Grice is particularly bullish on the uranium and oil & gas sectors.

Mr. Grice, in your latest Popular Delusions report, you call yourself «reluctantly bullish». Why?

I like to feel that if I’m underwriting risk, I’m getting well paid for it. And right now I don’t think that’s the case. It doesn’t really matter which segment of the market you look at, risk premia are almost universally tight. Risk premia are back to where they were pre-Covid, in some cases even tighter, and they were already unattractive before.

So if you put on your value investor hat, you can’t see any value?

Generally not. There isn’t any broad value except for some specific pockets. Back in March of last year, we were very bullish. To be clear, that was not because we thought we could identify the bottom, but because we could see panic and dislocation. It is a core belief of mine that you have to take the other side of a market that is in panic selling mode. That’s when you have to be buying.

Many investors were surprised by the strong recovery that has taken place since. What did you make of that?

We remained bullish in the months after March, because you could see that everyone hated the rally. Twitter was full of people who were angry. Angry that the Fed had injected money into markets, angry that the Fed had created all sorts of distortions. All of these arguments, which I have quite some sympathy for, were irrelevant to the investment case. As an investor you must not blind yourself with what you think policy makers should do. You must look at what policy makers are doing, and instead of making a moral judgement on whether that’s good or bad, you have to understand what the consequences of those policy actions are. This anger clouded the judgement of many investors. So, I was happy to be bullish throughout this period.

What has changed now?

My reluctance is because I feel it’s all incredibly frothy now. There are signs of excess, and yet we are still in the middle of a pandemic, we haven’t even started the economic recovery yet.

What signs of excess?

I think that this GameStop fiasco is kind of an indication of wider problems. Also when I look at the exuberance in hot sectors like electric vehicles, which investors seem to forget is a very capital intensive business. Valuations there are crazy, this is getting demonstrably insane. I would completely avoid that. This is not the kind of market which a fundamentally value driven investor should be bullish of.

Is the boom in SPAC issues also a sign of excess to you?

I don’t have an opinion on the SPAC market, I just don’t know enough about it. I know some very smart investors who are investing in it. But I can also see that this is a market which is potentially designed to fuel excesses, given the fact that investors give SPACs money without asking any questions. It reminds me of the Initial Coin Offerings a few years ago. The SPAC sector has the potential to become an enormous bubble, even if it isn’t one at the moment.

Despite your reluctance, you say you are bullish. Why?

Because I think central banks are going to overcook the economy. Ever since Jackson Hole in August, Fed chairman Jerome Powell has made it very clear that they are going to push the economy harder than they have in the past. Powell, in several speeches, has emphasized how devastating it is for low income communities to have high unemployment. The Fed considers it its mandate to make sure that these communities have jobs. Therefore the Fed believes it is doing a good thing by running the economy harder than it has in the past.

They are willingly inflating a bubble?

The Fed sees it as its mandate to create jobs. Consumer price inflation is of no concern to them right now. I can’t imagine a clearer setup for an overheating economy and financial market bubbles. During the GameStop fiasco, Powell was asked repeatedly what he thought of this kind of froth. He said this has nothing to do with the Fed. So, in terms of monetary policy, everything is set for a few years of overstimulation.

And the same thing is happening on the fiscal side, right?

Exactly. Joe Biden is talking about $1.9 trillion worth of stimulus, after we already had $3 trillion last year, which makes it $5 trillion in total. That’s an insane number, about 25% of GDP. There already is an enormous amount of pent-up demand, money that is waiting to be spent. Normally, when you get an overcooked economy and you get inflation, the Fed would step on the brakes. But this time, the Fed has said repeatedly that they will not step on the brakes. So I think the risks here are on the right tail, not on the left tail. This is not a market to be short of.

In a nutshell, you paint a scenario of monetary and fiscal overstimulation, which means this equity market boom could run much further than it already has?

Yes. This is not a big, market wide bubble yet, but we are getting there. And to be very clear, that’s not a good thing. This actually makes me very nervous. Bubbles burst, they always do. We have all these societal cracks that became painfully visible after the Global Financial Crisis of 2008, and central banks just keep blowing up new bubbles to paper over these cracks. This is incredibly dangerous, because inevitably these bubbles burst, and the bandage on the societal cracks rips open again, with the fragmentation, polarization and distrust within our society deepening further.

This pattern, blowing up a new bubble after a previous bubble had burst, has repeated itself several times in the past three decades. What will be the end game of this?

There is no end game, there’s just a cycle. Right now people’s faith in the system is in decline. Trust in institutions – the media, politicians, the «elites» – is in decline, and it seems like distrust is just going to deepen further. What I worry about is what kind of trigger will be necessary to snap us out of this long social panic we’re in, and to start building trust again. I hope it’s not something as extreme as a war.

Do you see the risk of a bond market sell-off, with yields shooting up, which would put an end to the frenzy?

I think at some point the Fed will just step in. They can’t afford to let yields rise too high, because the likelihood of some kind of liquidity event would increase massively. They can’t afford that. So the next stage in the logic of what the Fed is doing would be that they step in and control yields, to prevent them from rising too far, too fast.

You mentioned there are very few pockets of value left. Which ones?

Areas I still like are uranium, oil & gas plus some frontier markets like Bangladesh.

What’s your case for uranium?

Uranium is a scarce commodity, not really correlated with other commodities, because of its unique demand pattern. Nuclear power plant operators typically buy uranium through five to seven year contracts, which means its price does not swing around the economic cycle the way copper or oil do. The price cycle for uranium is driven by the usual, well-known mining cycle. It takes five to ten years to bring new mine supply to the market, and we have long cycles of overinvestment and underinvestment. So far, nothing new. We had a big bull market in uranium in the early 2000s, all the way to March 2011.

Until the Fukushima quake?

Exactly. Fukushima changed everything. It scared everyone to death. The Japanese shut down their reactors, the Germans decided to exit nuclear energy, and so on. We got a kind of a nuclear winter in the uranium mining industry, if you pardon the pun. There was absolutely no investment in mining capacity in the past ten years. Nuclear power generation suddenly was seen as an industry that has no future. Therefore, the commodity cycle turned down in its most vicious form. The mining industry was cut off from any funding. When you see this pattern, a commodity where no one has invested for ten years, you have the setup for a new bull market.

Was the market wrong in its assessment that nuclear power has no future?

Absolutely. That industry has a future. Japan is now using nuclear power again. Globally, the number of nuclear power stations in commission is higher than ever, the pipeline for new projects in North America, China and India is at record levels. The demand for nuclear power is growing, regardless of what the Germans, Swedes and Swiss are doing. I’m not saying anything about whether nuclear is good or bad, I’m just looking at the world as it is: Short uranium, and going into a period of rapid demand growth for uranium. Although, personally, I think that if you want a decarbonized environment, you’re not getting there without nuclear. Nuclear is a perfect case study of the public misperception of risk.

How do you mean that?

We humans have an inability to correctly evaluate a risk once we can associate it with a very salient image. The classic example would be the number of excess car accident deaths after people suddenly got afraid of flying after 9/11. In terms of nuclear power, the salient image we have is Chernobyl, which was undoubtedly a disaster. But we have to remember that the Chernobyl reactors were barely first generation, they didn’t even have the very standard protective measures that today’s reactors have. They don’t even compare. This was the Wright Brothers aeroplane compared to the latest fighter jet. You know what was the biggest power generating accident in history? A dam that burst in China in 1947, killing 147’000. We know it could be disastrous if a dam breaks, but people are okay with it. Hydro is seen as green and sustainable. True, but nuclear is green and sustainable too. So if you care about the environment, you should be in favor of nuclear power.

In Europe, at least, this remains a tough sell.

I know. But again, just look at the commissioning of new nuclear power plants, the pipeline for the next ten to twenty years, it’s off the charts. Demand for uranium is going to grow, and there have been no new mining investments for ten years. This is where explosive commodity bull markets come from.

A multi-year period of declining investment in new production: Is that your bull case for oil, too?

Yes. Pretty much all the majors have cut their capex plans. One image perfectly encapsulates financial markets’ view of the energy sector: The market cap of Tesla today is roughly the same size as that of the entire S&P 500 oil sector, which includes the majors, the independents, the drillers, the service companies and the refiners. The equity market’s view seems clear: Oil has no future, the energy transition is here.

And you’d say that’s not the case?

The energy transition is real, but it’s moving at a glacial pace. The annual Electric Vehicle Outlook summary by Bloomberg projects that EVs will only make up around 8% of the total fleet of passenger cars by 2030. The number of cars is expected to rise from today’s 1.2 billion vehicles to 1.4 billion, but only about 110 million of them will be EVs. So the number of internal combustion engine vehicles by then will be around 1.3 billion, which implies a forecast rise of around 0.7% per year. Moreover, while passenger vehicles contribute around 60% of the global demand for crude oil, the rest comes from heavy duty vehicles, aviation and the petrochemicals industry for which there are, as yet, few alternatives. I’m not saying that this is something I’m particularly happy about, but my job is to allocate capital according to the way the world is, not according to the way I want the world to be. Oil will continue to play a central role in the global economy for decades.

So we’re talking about a misperception of the market?

The market was behaving as if oil was dead. But it won’t be, not for a long time. A second important fact is that the energy transition is a risk which is widely recognized and understood. No manager in the oil business is under any delusion about the reality of the industry. Hence they are scaling down the ambitiousness of their investment projects. A squeeze is coming.

Yet more and more investors won’t touch the fossil energy sector anymore. What do you make of this?

It just makes me more bullish. Oil has been starved of capital, the whole mantra of the industry is that they are not going to grow anymore, they preserve cash and return it to shareholders. Even the American shale producers, who easily have the worst track record when it comes to capital allocation, have got this new religion. This is a bull market in the making. It’s just obvious.

You don’t see the risk of a permanent ESG discount in energy stocks?

I want to live in a clean world, I want my kids to live in a clean world, I want to see a decarbonized world. I have enormous sympathy for the whole ESG thing. But I also happen to think that as an investor, you can’t serve two masters at once. Tobacco is a good example: It became clear in the seventies that smoking causes cancer. It became known that the tobacco companies had been lying about studies, they had been dreadful and corrupt. Suppose you had refused to invest in tobacco stocks back then. On an ethical scorecard, you’ve managed to signal your virtue to everyone. But as an investor, you missed out on a compound return of 20% per year over the next four decades. Tobacco was the best investment during those decades, and the reason for that was because it traded at such a deep discount to fair value because people had moral qualms about purchasing it. And by the way, refusing to own tobacco stocks didn’t stop people from smoking.

So big oil is what big tobacco was in the seventies?

It’s an analogy, and we shouldn’t stretch it too far. The fact is, despite all the capital that’s going to electric vehicles, and despite the crazy stock market valuation of these companies, they are probably not even going to be 10% of the entire stock of on-road passenger vehicles in ten years time. Which means demand for oil is going to grow. I personally happen to think that this is bad for our planet, and I don’t want to fund these companies. But if I go and buy oil drillers, or if I buy Exxon, if I buy their shares on the secondary market, I haven’t given them any money. The people who use oil have funded them, by driving cars, flying in planes and using plastics. That’s the problem to be addressed. An investor purchasing shares of oil companies in the secondary market isn’t.

In this world you see unfolding, what role does gold play in a portfolio?

You should own some, for reasons that are well known and understood. Gold does retain its value, it does protect you against potentially unknown consequences of monetary debasement.

Should we look at Bitcoin the same way we used to look at gold?

I am structurally quite bullish on crypto currencies, but they have had one hell of a run, and they are just less attractive now than they were a few months ago. The thing is, we don’t know how to value Bitcoin, so we have no idea whether at $50’000 it’s overvalued or not.

And if you had to choose between gold and Bitcoin?

I don’t see them as mutually exclusive, but complementary. Gold doesn’t have the upside that Bitcoin has, but it doesn’t have the downside either. Many investors still can’t touch Bitcoin because it could get them fired if Bitcoin drops by 50% in a month – which it does, and which it will. But as Bitcoin becomes more institutionalized and more accepted, which is absolutely happening, its ownership gets more dispersed, and volatility will come down. So the narrative that seems quite reasonable to me is whatever your gold allocation is, have some of that in crypto.

https://themarket.ch/interview/dylan-grice-cental-banks-are-going-to-overcook-the-economy-ld.3651

It’s their move now. They can win if they really want to.By John AuthersFebruary 25, 2021, 10:43 PM MST

John Authers is a senior editor for markets. Before Bloomberg, he spent 29 years with the Financial Times, where he was head of the Lex Column and chief markets commentator. He is the author of “The Fearful Rise of Markets” and other books.

What Just Happened?

Something big just happened in world markets. That I can prove. So I’ll start with the easy part of going through the remarkable events of the week, culminating in Thursday’s great drama, and showing that they’re a big deal. Then will come the much harder questions of why they happened, what might happen next, and what we should all do about it.  

The bond market has been at the center of the drama. Yields are rising, especially in the often overlooked “belly” of the curve, between the closely observed two- and 10-year maturities. An unsuccessful auction of seven-year Treasuries certainly didn’t help, but the trend through the day was inexorable. This is what happened to the five-year Treasury yield:

Beyond the belly, however, which saw most action on Thursday, there has been a move away from duration, the technical term for bonds whose returns are most sensitive to changes in interest rates. Austria’s “century bond” issued in 2017 and not repaying its principal until 2117 is widely taken as the ultimate benchmark for duration; this is what has happened to its price:

While Treasuries, the world’s biggest bond market, understandably command the most attention, this isn’t just an American event. Before the market opened on Monday, Christine Lagarde of the European Central Bank stated that the bank was monitoring longer bond yields, causing them to fall sharply. That reversal didn’t last long. German bund yields are now higher than they were before she intervened (although as they remain negative it’s still a little hard to see why a central banker would feel they were too high):

Serious moves are afoot, then. But it’s worth pointing out that there have been big falls in bond prices before during the post-crisis era. The following chart comes from Albert Edwards of Societe Generale SA:

This is a significant move for the bond market. It needn’t in its own right be anything unprecedented or game-changing. 

Volatility

Bond volatility is also back. Following the brief but terrifying financial crisis that accompanied the onset of the pandemic in March last year, central banks succeeded in effectively anaesthetizing the bond market while measures of stock market volatility remained elevated. This shows up clearly in the spread of the CBOE VIX index of stock volatility over the MOVE index of bond volatility:

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It isn’t evident that central banks need be too uncomfortable with yields at current levels, which remain low. But their success in quashing seemingly all activity in the bond market seems to be over. 

Mortgages

Why does this matter? There are a number of reasons. First, the bond market is central to setting interest rates for Americans’ mortgages. In proportionate terms, the shock to the Fannie Mae 30-year mortgage generally used as a benchmark  for U.S. home loans was truly historic. Outside of one day during the worst of the 2008 crisis, and two days during the Covid shock last spring, it was the biggest percentage rise in mortgage rates on record:

To be clear, the sharp proportionate increase is enabled by the current low rates, although these have been the norm for a while. The rise could still endanger the U.S. housing recovery, a critical reason for optimism about the economy, if it continues:

Currencies

Higher U.S. rates are generally held to be bad news for emerging markets, as they attract flows away from the sector, and also tend to strengthen the dollar. That in turn can weaken emerging markets that are particularly reliant on dollar-denominated debt. Emerging market currencies had been enjoying a resurgence of late — until Thursday, when rising yields in the U.S. triggered their worst fall since March last year, according to JPMorgan Chase & Co.’s widely used benchmark:

Stocks

Last, and deliberately so, we come to stocks. As a whole, taking in all global stock markets, this isn’t yet much of a deal. MSCI’s index of global stocks excluding the U.S. actually rose slightly on Thursday. Even tech stocks, which are under undoubted pressure, are still up for 2021 so far after a great 2020:

Of all the main asset classes, stocks are the least scathed thus far. They’ve still commanded plenty of attention. That is because they matter most to politicians, and the Fed is (in perception at least) ultimately dedicated to making sure they don’t suffer a big fall. This was put beautifully by my late colleague Richard Breslow in the last column he wrote for Bloomberg in October last year:

As far as equities are concerned, they are the golden child. It’s really the only market the authorities care about. It pains me to admit, but they must be your first priority. Ugh. 

The critical question at what point bond yields become too high for stocks to bear, and cause them to fall. The mantra for the last year, as equities have enjoyed their remarkable post-Covid rally, is that stocks remain cheap compared to bonds. This is true, but the people excitedly buying stocks on this basis might be forgetting that the situation can also be corrected by a fall for bonds, and not just by a rise for equities. The rally in stocks has run out of steam for now, but compared to long bonds (proxied by the relative performance of the popular SPY and TLT exchange-traded funds) their outperformance has now exceeded 100% since last March’s nadir. 

Betting on stocks to beat bonds has been a good and well-supported bet. It doesn’t mean we can be guaranteed a stonking equity bull market into the middle distance. It might instead mean watching stocks follow bonds into a vicious bear market. That is the risk of over-reliance on equities’ cheapness compared to bonds when choosing to buy them despite their extreme high valuations compared to their own fundamentals. Just saying.

That risk, to be clear, hasn’t transpired as yet. It might never. Which brings us to the need to explain why all of this is happening. 

Tantrums in Store

The great concern is the impact that further rises in bond yields could have on other asset classes, especially U.S. equities and emerging markets. There is one great prior example of a bond market “tantrum,” which followed comments by then Fed Chairman Ben Bernanke about “tapering” bond purchases in May 2013. The effect on real yields, unprecedentedly negative at the time, was immediate. The following graph compares 10-year real yields in that incident with 10-year real yields over the last six months:

The pattern is obviously very similar to the pattern in May 2013 — but we have far further to go to match the tantrum of eight years ago. 

What would cause this tantrum to go further? Plainly, the market is discounting a lot of reflation ahead, given the strength of the economic recovery that has already been priced in by stocks. All else equal, we would expect bond yields to go up and bond prices to fall, as the expansion to back up these high equity valuations comes to pass. The reason yields aren’t much higher already is that markets assume central banks will act to keep them under control. Lagarde, Jerome Powell and a battalion of other central bank governors have all made that clear over the last week.

For the remainder of this year, and with the market left to its own devices, the trajectory of bond yields depends above all on the course of the pandemic and the vaccination program to combat it. But for now, the issue to the exclusion of all else is to find out what central banks will do to back up their words on keeping yields low. The following comments from a note  by Deutsche Bank AG’s currency strategist George Saravelos put it well: 

central banks are not impotent. This is not an attack on a currency peg with a self-fulfilling depletion of foreign currency reserves. Central bank pockets are literally infinitely deep in their own currency. The most straightforward response to today’s price action would be for the Reserve Bank of  Australia to come in even more aggressively overnight to defend its 3-year yield target. [Which is exactly what has happened.] Similarly, for the ECB, where we have already seen the three most influential executive board members expressing concern. Even for the Fed, it is worth remembering that guidance is couched in terms of current QE of at least $120bn per month, providing in-built flexibility for an increase.

The current volatility – unaccompanied by improving inflation expectations and directly challenging central bank reaction functions – resembles a VaR shock for the market and risks leading to a broader tightening of financial conditions. How much it runs will ultimately be determined by how deep into their pockets central banks are willing to reach. We will find out over the next few days.

To illustrate Saravelos’s prediction about Australia’s central bank, which has already come true, the RBA announced that it would buy A$3 billion ($2.35 billion) of bonds to keep the three-year security to its targeted yield. This is what has happened to that yield, with an initial sharp reaction followed by a rebound. The test is ongoing, but central banks can win it if they really want to:

Emerging Markets

The 2013 taper tantrum had a minimal impact on developed market stocks. It had a briefly cataclysmic effect on emerging market currencies, particularly those of the five large countries with big deficits that went by the now long-forgotten acronym of the BIITS — Brazil, India, Indonesia, Turkey and South Africa. This chart shows why the impression has taken hold that emerging markets need very low Treasury yields to prosper, comparing real 10-year yields to the relative performance of MSCI’s emerging and developed market stock gauges:

Could this happen again? Thankfully for emerging markets, there is evidence that it won’t, or at least not with full force. The following chart from Morgan Stanley shows core inflation and current account deficits for the emerging markets excluding China since 2006. The tantrum came just as they looked vulnerable; on both measures they look far more resilient now:

Another critical point is that the 2013 tantrum came shortly after the peak of a historic bull market for emerging markets that brought capital flowing in. There was plenty of foreign money ready to exit, and it did. This time the opposite is true:

The sell-off in emerging markets foreign exchange on Thursday shows that EM investors are on the alert for another tantrum. This isn’t good news for emerging markets. But the stakes are nowhere near as high as they were eight years ago.

Developed Stocks 

For developed stock markets, the question is whether a spike in bond yields can upset valuations. Tech, which has benefited tremendously from the conditions of the last year, is obviously the source of greatest concern (although to be fair, investors are sitting on fat profits in the sector). SocGen’s Edwards, a well-known bearish commentator, offers this chart, which is an update of research by Dhaval Joshi of BCA Research. Over the last five years, the MSCI World as a whole has shown a tendency to hit a plateau and decline when tech earnings yields drop too far compared to 10-year Treasury yields. That choke point was passed a week ago, and has been followed with this week’s exciting events:

This is decent evidence that bond yields have reached a high enough level to thwart further advances in the stock market. It isn’t yet clear that they would on their own drive a major fall.Opinion. Data. More Data.Get the most important Bloomberg Opinion pieces in one email.EmailBloomberg may send me offers and promotions.Sign UpBy submitting my information, I agree to the Privacy Policy and Terms of Service.

Which sectors are most sensitive? The following work by Quant Insight sheds some interesting light. The vertical axis shows their measure of whether a sector is over-or under-valued compared to current macroeconomic conditions. The lower on the chart, the cheaper.  The horizontal axis shows sensitivity to higher yields; the further to the right, the better news high rates will be. You want to avoid anything in the top left quadrant, which is expensive and due to be harmed by higher bond yields.

On this basis, investors might want to fill up on U.S. banks, U.S. automakers, and European utilities. Banks in particular are already doing well. U.S. retail is, by a country mile, the sector you most want to avoid. This chart was produced before Thursday’s excitement but investors seem to be acting in line with its suggestions so far. 

Those, I think, are the best guidelines for now. In the longer term, the questions over whether bets on reflation are justified will rest on fascinating and profound issues of macroeconomics (and epidemiology). A true bond tantrum could yet turn into the fixed-income bear market that many of us have been bracing for. For now, this is a big market test of the central banks. It’s their move next.

Survival Tips

I never even had the chance to mention that GameStop Corp. rallied again on Thursday. Plenty of you had suggestions for songs for Redditors who are long GameStop. Try Don’t  Let the Sun Catch You Crying by Gerry and the Pacemakers, We are the Champions by Queen (because there’s “no time for losers”), Eve of Destruction by Barry McGuire, Crash by the Primitives (one of my favorites), and Stop in the Name of Love by the Supremes. Then there’s Debaser by the Pixies, and Working for the Clampdown, Revolution Rock and Should I Stay Or Should I Go by the Clash. There was also a vote for Life on Mars by David Bowie. I think we can infer from that playlist that Points of Return readers are skeptical about the continued buying interest in GameStop. I would also add as a useful warning It’s No Game, also by Bowie.

I hope you survive your Friday, which could be a very interesting one, and have a good weekend.

Treasury Bond Tantrum Is a Big Test of Central Banks’ Mettle – Bloomberg

by Sahil Bloom on twitter

A perfect moment for a thread on the Hunt Brothers and their alleged attempt to corner the silver market…

1/ First, let’s set the stage.

The Hunt Brothers – Nelson Bunker Hunt, William Herbert Hunt, and Lamar Hunt – were the sons of Texas tycoon H.L. Hunt.

H.L. Hunt had amassed a billion-dollar fortune in the oil industry.

He died in 1974 and left that fortune to his family.

2/ After H.L.’s passing, the Hunt Brothers had taken over the family holdings and successfully managed to expand the Hunt empire.

By the late 1970s, the family’s fortune was estimated to be ~$5 billion.

In the financial world, the Hunt name was as good as gold (or silver!).

3/ But the 1970s were a turbulent time in America.

Following the oil crisis of the early 1970s, the U.S. had entered a period of stagflation – a dire macroeconomic condition characterized by high inflation, low growth, and high unemployment.

4/ The Hunt Brothers – particularly Nelson Bunker and William Herbert – believed that the inflationary environment would persist and destroy the value of their family’s holdings.

To hedge this risk, they turned to silver.

They began buying the metal at ~$3 per ounce in 1973.5/ Not a conservative bunch, in the mid-late 1970s, the Hunt Brothers began more aggressively buying physical silver.

But it didn’t stop there.

They started buying all of the available silver futures contracts as well.

6/ Typically, these futures contracts are settled in cash, meaning the buyer (the Hunts) just receives cash for whatever the contract is worth at expiry.

But the Hunts were not typical – they wanted the silver!

So planes were loaded and shuttled silver to vaults in Switzerland.

7/ In addition to using their personal cash fortunes to execute this buying, the Hunt Brothers began aggressively leveraging their position.

They used margin (primer below) to expand their buying power in the market.

Their silver position ballooned.

8/ With the flood of demand from the Hunt Whale, silver prices began to rise.

At this point, it was rumored that this was more than a simple bet on silver as a hedge against paper currency.

The Hunt Brothers were attempting – rather successfully – to corner the silver market. 

9/ Cornering a market means an individual or entity acquires enough shares or ownership to manipulate the market price.

The individual backs the market into a corner – the market has nowhere to run.

The cornering party has full control over it.

It seemed like the Hunt’s plan. 

10/ In addition to their prolific buying, the Hunts brought other investors, some of Saudi origin, into the trade.

As prices climbed, a short squeeze was on.

11/ The price of silver skyrocketed from $6 per ounce in early 1979 to over $49 per ounce in early 1980 (a 700%+ spike!).

The Hunt position was now worth ~$5 billion.

They were believed to control 2/3 of the available market – intentionally or not, they had cornered the market.

12/ With prices at all-time highs, the silver frenzy was in full effect.

The price rise was so dramatic that Tiffany’s took out a full-page ad in the @nytimes deriding the Hunt Brothers for their actions and their impact on pushing mom-and-pop silver buyers out of the market.

13/ At this point, the government took notice.

And if there is one thing we learned in the last week, it’s that the rules of the game can be changed at any time.

Unfortunately for the Hunt Brothers, the rules of the game were about to change and pull the rug from under them. 

14/ In January 1980, Federal regulators stepped in.

In “Silver Rule 7,” regulators increased the margin requirements on silver futures, meaning purchasers would need to post additional collateral to support their loans.

The rules had changed – the Hunts were now the hunted. 

15/ What followed was a classic, leverage-induced downward spiral.

The price of silver began to fall.

The Hunt Brothers were issued margin calls on their loans.

To meet the margin calls, they had to sell silver.

The selling dropped the price, leading to more margin calls. 

16/ On March 27, 1980, when news broke that the Hunt Brothers had been unable to meet a $100+ million margin call, the silver market collapsed 50% to under $11 per ounce.

The government even grew worried about the systemic risk to the system if the Hunt’s brokers went under. 

17/ Given their other business interests, the Hunt Brothers were able to secure a rescue package of $1.1 billion from a variety of banks in order to meet their obligations.

While they did later declare bankruptcy to protect certain assets, the family fortune generally survived.

18/ Throughout the government and legal proceedings that followed the incident, the Hunt Brothers denied any wrongdoing.

They maintained that their silver purchases were not an attempt to corner the market but a legitimate investment in a hedge against fiat destruction.

19/ So as the world once again turns its gaze to the silver market, I hope the story of the Hunt Brothers provides an interesting historical backdrop for this week’s show.

As always, do your research and never take undue risks! 

Via gorozen.com/blog

We believe we are on the cusp of a global energy crisis. Like most crises, the fundamental causes for this crisis have been brewing for several years but have lacked a catalyst to bring them to the attention of the public or to the average investor. The looming energy crisis is rooted in the underlying depletion of the US shales along with the chronic disappointments in non-OPEC supply in the rest of the world. The catalyst is the coronavirus.

The initial phase of the crisis that took prices negative is behind us and the next phase which, should take prices much higher, is in its infancy. Global energy markets in general, and oil markets in particular, are slipping into a structural deficit as we speak. We believe energy will be the most important investment theme of the next several years and the biggest unintended consequence of the coronavirus.

Investors’ focus has shifted to how quickly supply can be brought back to meet recovering demand. While most investors believe the lost production will be easily brought back online, our models tell us something vastly different. While OPEC+ production will likely rebound, non-OPEC+ supply will be extremely challenged. Instead of recovering, our models tell us that non-OPEC+ production is about to decline dramatically from today’s already low levels.

Thus far, the slowdown in non-OPEC+ production has come entirely from proactively shutting in existing production. These wells were mostly old and only marginally economic before prices collapsed in 2020. Going forward, production will be impacted by a different and longer-lasting force. Low prices led producers to curtail nearly all new drilling activity. As recently as March 13th, 2020, there were 680 rigs drilling for oil in the United States. In less than four months, the US oil directed rig count fell by 75% to 180 – the lowest level on record.

Shale wells enjoy strong initial production rates but suffer from sharp subsequent declines. Basin production falls quickly unless new wells are constantly drilled and completed to offset the base declines. Considering US shale production was already falling sequentially back in November of 2019 when the rig count was above 700. Today’s 373 rigs all but guarantee production will collapse going forward.

Low prices have led to a sharp drilling slowdown in the rest of the world as well. Between February and June of 2020, the non-US rig count fell by 40% to 800 – also the lowest on record. We have often written about the depletion problem facing the non-OPEC+ world outside of the US shales. Over the last decade, this group has seen production decline slowly and steadily as a dearth of new large projects has not been enough to offset legacy field depletion. By laying down half their rigs, this group ensured that future production would be materially impacted.

Analysts continue to focus their attention on what has already happened (the shutting-in of existing production) instead of looking at what is yet to come. The unprecedented drilling slowdown is only now starting to impact production. Going forward, supply will plummet leaving the market in an extreme deficit starting now.

This blog was an excerpt from our broader white paper Top Reasons to Consider Oil-Related Equities. If you are interested in reading more about this topic, please download the white paper below.

By Harris Kuperman vis Adventures in Capitalism

January 25, 2021

Let me throw this out there; the investing game is mind-numbingly easy. You buy good businesses for less than fair value. Sure, we can all argue about fair value. There are always surprises in the future trajectory of a business. This game has some wrinkles and drama, but at the most basic level, it’s easy. In fact, done correctly, it only involves a handful of decisions each year.

If it’s so easy, why aren’t I wealthier? It’s because I’ve tried to complicate things from time to time and made some very expensive mistakes along the way. Look, I’m human. Fortunately, I learn fast and usually avoid making the same mistake twice. I like to joke that my career is nothing more than two decades of finding creative ways to lose money. That’s not to say that the markets haven’t been good to me—the markets have been amazingly rewarding to me.

When I look back on my career thus far, I don’t dwell too much on the winners—remember how I said buying something cheap is easy? Nor do I think about the ones that didn’t go anywhere, while tying up my precious capital. Instead, I repeatedly relive my most expensive mistakes. Over a decade later, I still ask myself how could I have been so foolish to keep shorting more Research in Motion (currently BB – USA) as it went parabolic? On one hand, I was right about the iPhone displacing the Blackberry. On the other hand, it didn’t matter because I was a year early. I was stubborn and it was my most expensive loss ever. (Thankfully I took the loss when I did, as it more than doubled from where I eventually covered my short).

Over the years, I have learned that it is never the boring compounder that really hurts you—it’s the leverage, the complexity and the shorting that gets you—especially the shorting. There’s a reason that I rarely ever short these days. I even penned a piece on the topic; Stop Shorting “Project Zimbabwe” as I wanted to warn my friends that the market is suddenly quite different from what we were all accustomed to. Having been run over in the past, I have a reasonably good perspective on when other situations can run people over—heck, I sometimes even join in the fun on the long side. Looking back to Tesla (TSLA – USA), it was obvious to get out when I did. I feel bad that so many friends didn’t listen. I feel even worse that I didn’t reverse long—it was that obvious.

I bring this all up while watching the drama at GameStop (GME – USA). Let me start by saying that I don’t care how confident you are that a company will go to zero, when there are more shares short than outstanding, you’re just asking for people to play games with you. When word gets out that a few large funds are individually short 8-figure positions, you know that someone will try for the kill-shot. r/WallStreetBets gets the attention, but there are killer whales out there, silently doing the real work. There’s a price where these shorts will puke it up and the market has a funny way of finding that price.

I don’t want to focus too much on GameStop. I had an Event-Driven long position because July 4^th is always more fun when you buy your own fireworks. I tossed it at $92.50 premarket for a nice score. I’ve also written a pile of puts as implied volatility has experienced a supernova event, but this is still boring GameStop after all. However, this article isn’t about what will happen at GME; my guess is as good as yours. Rather, I want to point out that you have to be a special sort of stupid to stay short when there are more shares short than outstanding. Hubris is dangerous in the investing game. Shorts are extra dangerous. There are landmines everywhere. I don’t care how small the position is, when a short position goes up 25-fold in six months, it’s going to hurt badly. If you didn’t realize that was a risk, you really weren’t paying attention.

Remember how easy this game is? Buy cheap stocks and go to the beach. I’d be a whole lot wealthier today if I had done more of that when I was younger. Instead, we all like to add complexity because we think we’re smarter than the market. We like to add leverage because 50% more of a good thing tends to make it better. We often forget that one big mistake on the short side can bankrupt you. The first rule of investing is to never put yourself in a position where you can lose it all. Having been burnt in the past, I focus inordinate attention today on how I can get hurt; not on where I can make the most money—that part is easy. I like to think that the shift in my focus means that I have matured as an investor. Trust me, I know how frustrating it is to dig out of a self-created hole. As a result, I’m amazed that so many people blindly dismiss the risks out there. That is just asking for trouble.

“Project Zimbabwe” is a brave new world for everyone. Please stop, review your portfolio, stress test everything, think through the implications of 100-sigma events happening each day. No one is ready for what’s about to happen, as it’s mostly right-tail risk—except if you have a financialized book, in which case a move in interest rates may detonate your left tail first. As others blow up their books, your version of complexity may end up as collateral damage. Stop. Think it through. Be extra careful. No one expected GameStop to become a momentum stock. What else does no one expect? What else can happen? Be careful out there. Stop being stupid. A large fund with a great track record, is not immune to these rules—if anything, their position sizing makes them more vulnerable. A lot of rules that we’ve all taken for granted are about to be re-written. NEVER put yourself in a position where you can lose it all.

The shorts at GameStop are probably thinking that Friday was the blow-off top. Instead, they should be asking themselves, “was Friday a base-camp on the way to the real blow-off top?” Remember, in today’s world, any asset can trade at any price. The price of oil went negative. No one thought that was possible, yet trillions of bonds at negative yields should have been a warning that the old rules no longer applied. I want to repeat again for the third time; NEVER put yourself in a position where you can lose it all. The rules for “Project Zimbabwe” are being re-written and they will be full of surprises. In particular, be careful on the short side. GameStop isn’t the first supernova squeeze of this decade and it surely won’t be the last.

Disclosure: Funds that I control are short GME puts of various strikes and maturities.

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January 22, 2021 By Bryce Coward

We’re going to keep this post short and sweet because the charts speak for themselves. Today, preliminary Markit PMIs were released for January. Headline numbers ticked up, which is great and shows a continued expansion into the new year. The release also showed that input prices for services exploded higher again, to another all-time high by a wide margin. However, those input prices have not yet fully fed through to prices charged for services. Given the tight relationship between input prices and prices charged, we would expect prices charged to accelerate higher over the coming months. This makes since since service providers will naturally seek to protect their margins.

Moreover, core personal consumption expenditure prices, which is the Fed’s preferred inflation indicator, also appears set to move considerably higher in order to catch up to input prices. This has obvious implications for Fed policy. Does the taper discussion continue? Do expectations for rate hikes get moved forward? Or, does the Fed sit back and watch as prices move to and through their inflation target? They have told us they will do the latter, and we may soon see how strong their commitment is.

The market implications here are pretty straightforward. Tapering is tightening. Bringing rate hike expectations forward is tightening. Allowing inflation to run hot while doing nothing could be seen as de facto easing, which could give even more fuel to the cyclical trade and make those inflation hedges even more attractive.

Get Ready for Services Prices to Accelerate Higher