Category: Finance

I am going to review my writings of April 5, 2020, still a time when nearly 95% of the population was locked in their homes about fears of SARS-CoV-2. Of course, with any prognostications, you will get some right and get some wrong, but the material issues of the fallout of Covid-19 I got completely correct. There is a bit of back-patting in my current post but let’s take a look:

Oil in about nine months, maybe six or eighteen will skyrocket. The longer that oil is under $30/barrel, the further the bounce is going to be on the other end when supply/demand dynamics results in a supply imbalance. It probably wouldn’t be the worst of ideas to buy long-dated crude oil futures (December 2022 at US$38.75/barrel?).

Check! This is happening presently. By most accounts October-November 2020 was the non-panicked low for spot crude and after that it has been a pretty good ride up.

The after-effects of this [effective debt monetization] during the 2008-2009 economic crisis came in the form of asset inflation, but this time it will be different. With trade lines cut, it is pretty obvious that there is going to be some high-grade consumer inflation that will be coming. Not now, but in a year’s time, this will be a dominant message, especially with the pending increase in oil prices. Note this is not going to be Weimar Republic inflation, but it will be at rates that we will not have experienced in a long, long time. As a result, interest rates must rise.

My predicted timing was a little faster than reality, but this one is coming to roost. However! In a future post, I’ll give some colour to this.

Despite how dysfunctional the economy may seem to be, equities are going to be the only game in town, especially in a monetization situation. It will confound people that there will be such a disconnection between the stock market and the underlying economy

Check. Bonds, to put it mildly, have offered sub-par returns, and if you had invested in longer durations, you are in the red.

The statistic of “deaths” needs to differentiate between “deaths due to Covid-19” versus “deaths with Covid-19”. There is no practical way that these statistics will be obtained.

Check. The application of this has been totally manipulated for political communication purposes. Initially, it is deaths with Covid-19, and later on, some revisions of “because of Covid-19” when the message suits it. Don’t get me started on manipulations of cause-and-effect claims of vaccination statistics (efficacy and safety).

I always like to think of a “parallel world” example, where you see people lining up to get into the grocery store that are spread two meters apart, versus not having these measures in place – will the death and/or transmission rate truly be impacted in either scenario? Of course, ethics prevents double-blind testing, but I would think the effectiveness of some measures to enforce “social distancing” are completely for show – similar to some procedures that you see around airports in the name of security.

I think the (much attacked, just because the truth really hurts!) Johns Hopkins paper on non-medical interventions pretty much tells the story here. One paper does not constitute a proof, but from the spectrum of governmental responses (ranging from full-blown isolation to relatively open society), the course of the outcome inevitably is the same – you might be able to isolate in a cabin in the woods, but as soon as there is one instance of contact, good luck! (Antarctica, Kiribati Island) – SARS-CoV-2 cannot be contained in any semblance of a normal society. It’s out there, and you’ll get it eventually.

My opinion at present is that the current route that most world governments have taken on Covid-19 will cause more collective damage with stress and economic turmoil (and subsequent spinoff consequences of such) than caused by Covid-19 itself. Political pressure likely forced most democratic governments to shut down, while autocratic ones can put on a semblance of ‘back to normal’ just strictly through misinformation, like how China is basically getting back to work despite there being cases of Covid-19 (the one or two they report is just symbolic, while the actual numbers involved are likely much more). Their “confirmed case” count is likely understated by a magnitude of 10, but came to the conclusion that a lockdown was doing more harm than good.

While my prediction was completely correct that the response to Covid-19 will cause much more damage than the virus itself, the mistake I made here is the implicit assumption that governments (especially authoritarian ones) wanted to move past Covid-19 as quickly as possible. It has become a political tool in many jurisdictions.

And finally…

This might sound a little crazy, but I can see the S&P 500 heading to 4000 before the end of the year.

It was around 2500 when I posted this. Predicting a major index will rise 60% in 9 months is the definition of insanity. Indeed, this was an incorrect call, but it did get up to about 3800 by years’ end.

My main point here, other than a bit of chest-thumping, is to successfully invest you need to have some sort of idea where things are headed, and also know if this is a consensus opinion or not. My opinions in early April 2020 were very much out of consensus at the time and the logical course of action were to proceed on it with a “real world economy”-heavy portfolio.

It’s been almost two years since all of this mania has occurred, and the world is changing once again. In an upcoming post, I’m going to describe what I call “the turn”.

Will asked:

Sacha,

How do you think the oil party will play out, with 50% of lost US production has been recovered (pre covid peak of 13.1 mbbl/d to trough of 9.7 mbbl/d and now sitting at 11.5 mbbl/d) and super majors are going for the shale again. You see it over soon with another round of massive boom (volume wise, if not price)/ bust or players become better at managing prices in a goldilock where everyone makes decent money.

I don’t have much insight on what’s going on in the rest of the world. However, in the USA to maintain it will require a gigantic amount of capital investment and aside from the Permian Basin, most of the top tier geology has been tapped out. When you have 30% decay rates on 10 million barrels/day of production, each year you need to replace 3 million, and that’s a steep order.

You’re up against production declines like this:

What do I mean by “top tier geology”? When looking at a drill map that looks like the following (this is in the Bakken shale in North Dakota):

This is pretty much tapped out on the northwest of this specific map. I’ve seen other maps made elsewhere of entire regions being completely saturated like this.

Just like when picking fruit in an orchard, you go for the low hanging fruit first, and this is what happened in the resurgence of USA shale drilling over a decade ago. Now the geology has been tapped out – you can’t mine these areas again. They will still produce, but at much, much lower rates than the initial drill. Some of Peyto’s monthly reports get to this in detail.

Canada’s oil sands and in-situ (steam-assisted gravity drainage) projects have much better decline profiles. In addition, from what I can tell, our companies are being unusually conservative these days in terms of expanding capacity, especially these days when expanding capacity would be wildly profitable. While we do not have the power to move markets like OPEC, the apprehension is also faced elsewhere in the world, especially when there is gigantic amounts of ESG pressure (see: Exxon board election).

There will be a bust, but not right now. Demand is stronger than ever and the ability to meaningful ramp up supply is constrained. Any meaningful price drops in fossil fuels at this point will be on the demand side (the economic bust scenario), but even in 2020 when the world shut down for a couple months due to Covid, demand was estimated to be about 91 million barrels daily, down from about 100 in 2019.

I will also note that the measuring barometer of oil, the US dollar, should be taken into consideration. Everybody these days is forced to be a macroeconomist to properly invest in these crazy times.

Here is a good story for the “everybody wants to become a day trader” society I have been talking about during the Covid era.

If this article is to believed, some guy told his story about losing US$400k trading options on Robinhood. I will take this article at face value.

By the sounds of it, the person was in some sort of job that was synergistic with investing:

My job involves a lot of researching companies and trying to understand business and economic models. I like to read a lot, and there’s a lot of books on investing.

So the fellow got his start on investing in AMC and tripling it. Then he invested in silver and tripled that. Options are fantastic in that they can offer a degree of leverage that are only otherwise offered in casinos. Straight margin on equity only gets you at most 3x leverage (in addition to pesky interest expenses) so why not just go with the 94 octane?

Then this person took his life savings from his employment and his trading gains and wanted to make a big score, and he chose Alibaba.

Okay, I’m done with this. Now I want to buy a safe bet. And the safe bet was Alibaba. It had fallen from $330 to $245, but I had wanted to find a company where the price-earnings ratio was low, and every single analyst had a buy rating with like a 40-50% upside on it. Looking at all of TipRanks, my understanding was that this was a very, very safe bet with a limited amount of risk.

He found his vehicle: In-the-money call options (note BABA was at US$245):

Then I just went all in on this one single stock option: The $200 strike price call option on Alibaba.

Then he put everything into it, and believed his downside was limited.

I initially invested $300,000 in February, basically every single liquid asset in my account. Not retirement, but everything cash. I didn’t have anything left. My thesis was I might not make a lot of money, but I won’t lose much. The downside seemed limited, and that if worse comes to worse, it would go down to like $280,000.

It didn’t go well. But he decided to add:

Hey, this is gonna rebound. And as my salary came in, I saved another $100,000. So in July, I put in another almost $100,000.

The rest of the story is the trade going to zero and the person beating himself up for it.

It is one thing to learn lessons from your own mistakes. It is much more powerful to learn it from others. These lessons can be learned theoretically by sitting and thinking about it at a coffee shop or in bed, but in these days, thinking hurts a lot of people’s minds.

Lessons:

1) It is damaging for a beginning investor to be immediately successful, especially their first three trades. One will be convinced the game is easy and then proceed to bet more and more aggressively in their over-confidence until it blows up on them. The issue here is that a good investor should have a general sense of why their investments will move in the direction they anticipate. Getting the call itself correct is not good enough because the ‘why’ part of the question tells you what signs you need to look out for to get out.

In every investment, I have a general idea of what I’m looking for, and a general model in my head of what will cause things to rise or fall. Clearly if I’m anticipating an investment to fall, I don’t invest, but if you believe such an investment has longer-term potential, then this is an excellent way of testing your mental model of the company and what the market perceives of it. In general, if the company does something and the market reaction isn’t what you anticipated, it is important to examine why this occurs. There is no “one size fits all” prescription here – the intuition gets developed over many, many years (in my case over a couple decades) and most definitely can’t be learned in a few months of trading on Robinhood.

To summarize this – an investment requires you to get in, and there will be a price where you should be thinking about getting out. The “get out” point actually doesn’t need to be precisely calculated at the beginning – you can model a path in your mind for the company to get to some unspecified higher point – but without an idea of what to look out for throughout the course of the investment, you are flying blind. You might get lucky with a few trades just on sheer luck, but the variables that caused the trades to be successful will have just passed by your brain without being able to apply successful investment methodologies with future investments.

2) All eggs in a single basket. For low amounts of money (let’s say less than a quarter of annual income) I can accept an ‘all-in’ investment, but when dealing with 6-digit figures, then some component of diversification is required for reasons found in any first year finance textbooks. An asteroid might crash into the headquarters of the company. Natural disasters happen. Accounting fraud happens. I won’t talk about the obvious benefits of some diversification. Diversification these days is exceptionally cheap – you spend 10 commissions and can build up your own private ETF of 10 companies. If your portfolio is $10,000 then your one-shot first year MER is effectively 1% which is under most actively traded funds.

This guy put it all into BABA. Even if this guy put half of it into BABA and half of it into almost anything else, there would have been some degree of salvage.

3) Using call options. Options require people to bet against specific sets of variables other than the direction of the stock. If somebody has positive conviction on a stock to that degree, by most accounts it is better to simply buy equity on margin. One justification of using options would be if the options were offered at low volatility, but in the case of BABA this was not so. The usage of call options brings me to my next point, which is…

4) Using deeply in the money call options. If you had to use options and you were bullish on the stock, it makes sense to use out-of-the-money call options, which will result in a lesser amount invested in order to achieve the same delta. The scenario this person was prescribing used the wrong tool for his outlook. In addition, deeply in or out of the money options typically trade at much higher spreads, which increases the cost of trading significantly compared to using equity on margin.

5) Using P/E ratios, analyst price targets, and “TipRanks” as a measure of safety. A low P/E might be one clue, but all other underlying factors have to be examined. Why is the market letting you have this low P/E stock for so cheap? – this question must always be answered. Clearly in the case of Alibaba, a major variable in the valuation that was entirely missed by the person in question was the impact of Chinese government policy on technology firms at the time, and the perception of international investment in the country, rather than the P/E or what some analysts think the price target should be.

6) Adding to a losing position. There are times to add to a losing position. There are times to just leave it. There are times to just jettison the thing when it drops from your initial investment price. The lesson here is that you do not have to make up losses in the same stock you lost money from.

Hopefully these lessons can be ingrained in your investment psyche without having to experience what this fellow did, and if you must learn the lesson by losing money, do it with a much lesser sum of capital.

I’ve been on radio silence lately. There hasn’t been much to write about although I am noting the ‘vapour equity’ market has seen considerable supply pressure this month.

The peak of the dot-com boom (at least as far as the stock market was concerned) was in February of 2000 when the Nasdaq peaked to 5000 and you had a whole avalanche of initial public offerings, the most notable one was the IPO of Palm (which was owned by 3Com at the time).

After that it went pretty much downhill as valuations were not supported and liquidity was sucked out of the markets. Old-value stocks (a good example being Berkshire, but pretty much any company with genuine profits that had nothing to do with fibre optics, dot-com networking or e-commerce) managed to keep their value, and in many cases some thrived in the ensuing carnage.

Investors in 2000 that kept their portfolio away from the previous high-flyer sectors would have survived to participate in the next run-up (which, in the USA, was anything related to real estate). Indeed, a successful investor across multiple market cycles must know which sectors to avoid at any given time – clearly taking permanent capital losses (anybody invest in Pets.com? EToys? CMGI?) depletes your ability to invest going forward.

We fast forward to today, where technology, software and anything related to Covid (virtual work facilitation, vaccines, etc.) is plummeting.

There is a lot to review, but I will keep things to Canada. There’s a lot more going on in the USA (e.g. anything that ARKK owns, for example). Anyhow, the most prominent casualty is the high-flyer Shopify (SHOP.TO), which used to be the #1 ranking in the TSX index, but no longer! They’re now back to #3 below Royal Bank and Toronto Dominion.

In the span of 2 months, they traded at a peak of CAD$2,200/share and are now down to about CAD$1,100, which is a peak-to-trough of 50%.  Anybody invested in the company since June of 2020 would have lost money. Imagine if you had bought shares of this thing at $1,800 and now a third of your capital has vanished…

Another high-flyer has been Lightspeed POS (LSPD.TO):

The peak-to-trough ratio here has been even more extreme – from $160/share to about $37 today – a 77% drop.

Another highly touted IPO was AbCellera (Nasdaq: ABCL) – a Canadian company that IPOed on the Nasdaq.  They went public at US$20/share and traded as high as US$70 on the day they went public, but since then it has been a decline down to $8.50 today – nearly a 90% peak-to-trough loss.

Looking at some other recent TSX IPOs we have, starting September 2021:

CPLF
PRL
QFOR
DTOL
EINC
CVO

Bringing up the charts of all of them, it’s not a pretty picture. One other notable broken IPO I examined in the past was Farmer’s Edge (TSX: FDGE) and they are down about 85% from their IPO. Another one which I didn’t write about but was an obvious avoid in my books was Eupraxia (TSX: EPRX) which I have to commend the underwriters for vomiting out that firm to unsuspecting retail shareholders.

There’s a few lessons to take home here, but one obvious lesson is that just because something has dropped by 50% or 80% doesn’t mean it is still ‘cheap’.

Many of these high-flyers that make headlines are trading at ultra-premium valuations. Take Shopify – down 50% peak to trough. While the company makes money it is still nowhere near a reasonable multiple of its existing market valuation. An investor is still paying a huge premium for assumed future growth – and the company has to exceed this in order for an investor to get a payout (never mind a dividend!).

Even in the case of companies like Lightspeed that are down 80%, it is very difficult to determine whether an investor will be seeing any returns at the end of the day – they are still losing money in their operations.

Many people got their start in investing during the Covid-19 era. A lot of them caught the right stock at the right time (e.g. Gamestop) and probably started having dreams of trading their way to riches. Without the underpinnings of understanding the fundamentals of companies, inevitably these hordes of retail investors simply traded companies on the perception of sentiment rather than any earnings power. Without having a general idea of an entry and exit point, one could rationalize GME at $100, $200, $300, etc., or Shopify at $1,500, $1,700, etc., and are effectively trading blind. One can also make a similar argument for cryptocurrency markets – functionally a zero sum game.

A good question for these new traders is – do they have the discipline to get out? Or will they try to hold on and “break even”? Or will they average down as these high-flyer shares crash back down to earth? If the 2000-2003 model is similar this time around, there will be a lot of people that will be holding onto ever depreciating shares and the current wave of hype will come to a close.

Keep in mind the simplicity that math offers – if something goes from $100 to $50, there is a 50% decrease in value. If you purchase at $50 and it goes down to $25, the result is the same – a 50% loss (and if you were starting at $100, that’s a 75% loss). In many of these cases the companies’ trajectory will head to zero, and it doesn’t matter what “discount to the 52-week high” you purchase the stock at, you will face losses if/when it heads to zero.

The safety in the markets are in those companies that are producing sustainable cash flows. You will still take a considerable hit if the company in question is trading at a very high multiple. The maximum safety are in those companies trading at low multiples to cash flows and those that are not reliant on renewing excess amounts of debt financing. There isn’t a lot of safety out there, but astute readers on this site have picked up hints here and there as to what offers a degree of safety.