Finance – Page 14

Formulating some thoughts about 2022

Light yellow line is the 10-year Government of Canada bond yield, orange line is the 2-year bond yield:

Over the past week, Omicron fears have triggered a huge demand for long-dated government debt, while central bank talks of tapering have pushed the front end of the yield up.

Indeed, when looking at the BAX futures, we have the following curve (for those that are unfamiliar, these are 3-month bankers’ acceptance futures, of which you derive the rate by going 100 minus the anticipated yield percentage, so a 98 would be equal to 2.00%):

BAX – Three-Month Canadian Bankers’ Acceptance Futures

Last update: December 5, 2021

Month	Bid price	Ask price	Settl. price	Net change	Open int.	Vol.
Open interest: 1,173,941 Volume: 145,981
December 2021	99.455	99.460	99.460	-0.005	136,604	34,223
January 2022	0	0	99.380	0	0	0
February 2022	0	0	99.220	0	0	0
March 2022	99.080	99.095	99.105	-0.015	242,041	25,545
June 2022	98.660	98.665	98.690	-0.030	185,438	16,971
September 2022	98.335	98.340	98.360	-0.025	167,920	15,778
December 2022	98.125	98.140	98.150	-0.015	144,759	17,816
March 2023	97.985	97.995	98.010	-0.020	107,855	13,145
June 2023	97.865	0	97.890	-0.020	62,554	10,228
September 2023	97.795	97.840	97.820	-0.025	69,061	6,586
December 2023	97.510	97.820	97.805	-0.020	38,357	4,960
March 2024	0	0	97.780	-0.005	12,729	386
June 2024	0	0	97.775	-0.010	4,613	181
September 2024	0	0	97.790	-0.005	2,010	162

The spot price is at 0.54%, while the December 2022 future is at 1.85%, which implies that in the next 12 months we will have a rate increase of about 125bps the way things are going.

The 2-year government bond is yielding 0.95% as of last Friday. Using expectations theory, this is roughly in-line, but functionally speaking, the inversion of the yield curve is going to signal some ominous signs going forward.

Central banks are engaging in the tightening direction because of fairly obvious circumstances – there are leading indicator signs of inflation everywhere (labour market tightness AND the inability to find quality labour both count; the first is easily quantified, while the second one is not, and is a very relevant factor for many businesses), input costs rising or even being completely unavailable, energy costs spiking, etc. With governments flooding the economy with deficit-financed stimulus, it is creating an environment where no realistic amount of money thrown at a problem can stimulate productive output.

My guess at present is that tapering and rate increases will go until the economy blows up once again – the evaporation of demand will be mammoth – when these supply chain issues are resolved, the drop-off in demand will commence very quickly. It will likely happen far sooner than what happened in the 4th quarter of 2018 (the US Federal Reserve started shrinking its balance sheet of treasuries at the end of 2017 and the vomit started occurring around October 2018). Indeed, you even saw hints of this economic dislocation occur in late 2019 – there was likely going to be an economic recession in 2020 even if Covid-19 did not occur. Covid instead just masked the underlying conditions, and stimulative monetary policy coupled with shutdowns of global logistics and labour disruptions was the subsequent excuse when fundamentally things were already in awful shape to begin with.

This means that portfolio concentration (other than not being leveraged up the hilt) should be focused on non-discretionary elements of demand.

These are not serious suggestions, but Beer (TAP), Smokes (MO) and Popcorn (AMC… just kidding!) will probably be the last industries standing among the carnage. Even McDonalds (MCD) will not be spared as less and less will be able to afford the $10 “extra value” meals as central banks continue to drain the excess, but Dollarama (TSE: DOL) will thrive.

The conventional playbook would suggest that commodities would fare poorly with a precipitous decline in demand, but this is one of those strange interactions between the financial economy and real economy where hard assets will initially lose value in the face of interest rate increases (this has already happened), but the moment the central banks have stretched the rubber band too hard and it snaps, commodities likewise will be receiving a huge tailwind.

2022 is surely to be a worse year for most broad market investors and the public in general. Returns are going to be very constrained and P/E expansion will be non-existent (other than by reduced earnings expectations!). Watch out, and hold onto your wallets. There will be few that will be spared.

High flying growth companies will badly damage new shareholders

The problem with having a huge amount of anticipated growth baked into your stock price is that the expectations become incredibly difficult to achieve.

High expectations result in high stock prices.

I’ll post the charts of two of these companies which are household names – Zoom (Nasdaq: ZM) and Docusign (Nasdaq: DOCU):

We will look at Zoom first.

At its peak of $450/share, Zoom was valued at around $134 billion. Keeping the math incredibly simple, in order to flat-line at a terminal P/E of 15 (this appears to be the median P/E ratio of the S&P 500 at the moment), Zoom needs to make $9 billion a year in net income, or about $30/share.

After Covid-mania, Zoom’s income trajectory did very well:

However, the last quarter made it pretty evident that their growth trajectory has flat-lined. Annualized, they are at $3.55/share, quite a distance away from the $30/share required!

Even at a market price of $180/share today, they are sitting at an anticipated expectation of $12/share at sometime in the future.

Despite the fact that Zoom offers a quality software product (any subscribers to “Late Night Finance” will have Zoom to thank for this), there are natural competitive limitations (such as the fact that Microsoft, Google and the others are going to slowly suck away any notion of margins out of their software product) which will prevent them from getting there.

The point here – even though the stock has gone down 60% from peak-to-trough, there’s still plenty to go, at least on my books. They are still expensive and bake in a lot of anticipated growth which they will be lucky to achieve – let alone eclipse.

The second example was Docusign. Their great feature was to enable digital signing of documents for real estate agents, lawyers, etc., and fared very well during Covid-19. It’s an excellent product and intuitive.

They peaked out at $315/share recently, or a US$62 billion valuation. Using the P/E 15 metric, the anticipated terminal earnings is about $21/share.

The issue here is two-fold.

One is that there is a natural ceiling to how much you can charge for this service. Competing software solutions (e.g. “Just sign this Adobe secure PDF and email it back”) and old fashioned solutions (come to my office to scribble some ink on a piece of paper) are natural barriers to significant price increases.

Two is that the existing company doesn’t make that much money:

Now that they are reporting some earnings, investors at this moment suddenly realized “Hey! It’s a long way to get to $21!” and are bailing out.

Now they are trading down to US$27 billion, but this is still very high.

There are all sorts of $10 billion+ market capitalization companies which have featured in this manner (e.g. Peleton, Zillow, Panantir, etc.) which the new investors (virtually anybody buying stock in 2021) are getting taken out and shot.

This is not to say the underlying companies are not any good – indeed, for example, Zoom offers a great product. There are many other instances of this, and I just look at other corporations that I give money to. Costco, for example – they trade at 2023 anticipated earnings of 40 times. Massively expensive, I would never buy their stock, but they have proven to be the most reliable retailer especially during these crazy Covid-19 times.

As the US Fed and the Bank of Canada try to pull back on what is obviously having huge negative economic consequences (QE has finally reached some sort of ceiling before really bad stuff happens), growth anticipation is going to get further scaled back.

As long as the monetary policy winds are turning into headwinds (instead of the huge tailwinds we have been receiving since March 2020), going forward, positive returns are going to be generated by the companies that can actually generate them, as opposed to those that give promises of them. The party times of speculative excess, while they will continue to exist in pockets here and there, are slowly coming to a close.

The super premium companies (e.g. Apple and Microsoft) will continue to give bond-like returns, simply because they are franchise companies that are entrenched and continue to remain dominant and no reason exists why they will not continue to be that way in the immediate future. Apple equity trades at a FY 2023 (09/2023) estimate of 3.8% earnings yield, and Microsoft is slightly richer at 3.2%. Just like how the capital value of long-term bonds trade wildly with changes of yield, if Apple and Microsoft investors suddenly decide that 4.8% and 4.2% are more appropriate risk premiums (an entirely plausible scenario for a whole variety of foreseeable reasons), your investment will be taking a 20% and 25% hit, respectively (rounding to the nearest 5% here).

That’s not a margin of error that I would want to take, but consider for a moment that there are hundreds of billions of dollars of passive capital that are tracking these very expensive equities. You are likely to receive better returns elsewhere.

Take a careful look at your portfolios – if you see anything trading at a very high anticipated price to cash flow expectation, you may wish to consider your overall risk and position accordingly. Companies warranting premium valuations not only need to justify it, but they need to be delivering on the growth trajectory baked into their valuations – just to retain the existing equity value.

SARS-CoV-2 / New mutation / Thoughts

Please read my December 21, 2020 post, Mutant SARS-CoV-2 Viruses, Perceived Risk, Actual Risk, which has aged reasonably well since its publication. The only factor I continue to under-estimate at all instances is the notion of “back to normal”, which from the onset of the Diamond Princess I have been consistently wrong with.

I have very consciously been trying to avoid any political discussions of COVID-19 on this site, except when things interfere with the financial markets.

For the most part, the “known unknowns” have been well priced into equities.

However, we might have a game-changer that will require some re-thinking.

Insert today’s scare headline, the B.1.1.529 variant:

The issue here is regarding the psychology of the effectiveness of COVID-19 vaccinations.

Most people believe they work. Indeed, because of this popular support, governments have been able to coerce those that do not into taking them.

The issue is that just like influenza and HIV, you might be able to take something to address the clinical symptoms (which the existing vaccinations have done) versus dealing with the transmission of SARS-CoV-2.

Without preventing the transmission of SARS-CoV-2, vaccinations to mask clinical symptoms of COVID-19 are a delaying tactic at best.

The best analogy I can make here is the advent of computer viruses and anti-virus software. Initially there were programs (McAfee and Norton Anti-virus) that you ran in MS-DOS to search executables for specific code snippets (containing viruses). They worked initially (sometimes producing false positives), and you had to get updates to tell the program the new code snippets of new viruses that were coded and spread around. However, technology advanced (such as auto-modifying code) and conventional anti-virus software is practically useless as a form of computer security (it is beyond the scope of this post to discuss this fascinating matter). Anti-virus software continues to be sold today and all it serves is to slow down the computer system and provide a false sense of protection.

Likewise in the biological world, mutations are rapidly rendering COVID-19 “anti-virus software” (vaccinations) obsolete. You might be able to protect against the “old school” strains, but for the new software versions (variants), you have much less protection.

This is the result of having a population monolithically vaccinated with the same anti-virus software. It doesn’t take much of a code modification to work around it.

What isn’t discussed about the B.1.1.529 variant is whether the severity profile is more or less severe than Delta. This remains to be seen.

Unlike computer viruses, which are engineered to have a specific impact, biological viruses are positively selected for transmissibility, and not for clinical severity. Indeed, too severe clinical symptoms would work against transmissibility, just as it did for SARS-CoV-1.

The changing psychology will be increasing public awareness that the existing COVID-19 vaccinations do a minimal job of protecting against transmission. They were fighting yesterday’s battle. It will be sold to the public as a necessary “first step” to fighting COVID-19, with much more to go, even though it is pretty evident the “vaccinate everybody” strategy that was taken has proven to be incorrect. The correct strategy was to vaccinate those that are at high risk, but now that mostly everybody is vaccinated, there is going to be a new strain that will dominate and this might be B.1.1.529. The question at this point is whether this new variant exhibits increased severity of clinical symptoms.

In the past my ability to predict public reaction to SARS-CoV-2 has been terrible. If B.1.1.529 picks up, from historical reaction over the previous 18 months, the cultural of zero risk will force more sanctions, “to prevent the spread”.

Governments always want to be seen doing something, even if their actions have no effect on the outcome (e.g. outdoor mask mandates).

They will also never admit that their past strategies have been terrible to preserve whatever credibility they have remaining to implement new measures.

My guess at present is that the Covid-sensitive sectors which got hit from March to June of 2020 will probably face another dial-back. Until I see how B.1.1.529 evolves, I’ll reserve judgement on timing.

Headlines are too panicky

There is a cliche and that is that markets do not crash when everybody is fearful.

Glossing over a few headlines today, we have:

‘Global equities are likely to be under pressure in coming months’: Citi

Households that made money in the pandemic should prepare for some financial pain

Eyeing higher inflation and volatility, investors turn more selective: fund managers

Almost nobody out there is saying “buy stocks”.

I’m not saying GME is going to a thousand dollars, but I wouldn’t bet my life on it NOT happening.

When is it time to cash in the chips?

It’s been a good run up in the market in the past month. Just last month I thought I was headed for the first negative quarter since Covid hit. Now it’s a race for the finish in the last two weeks of September.

There’s been a component in my portfolio (you can guess which one it is, I’ve written about it before) that almost has GME-like properties at the moment, albeit the business model is slightly more viable and I think the hype cycle is around the 3rd inning of this particular baseball game.

One always needs to ask themselves when enough is enough.

The trading mechanics of stocks nearing a mania high is punctuated by intense volatility both on the upside and downside.

Gamestop is a perfect illustration of this.

You had a few trading days (look at late January) where it ranged from $200 to $450 in what could be classified as insanity.

Even a week before that, when it spiked from $40 to $100, that was considered insanity.

Nobody wants to be the person selling GME at $40 on its way up to $400, but you had to wait four trading days (not to mention a weekend) to make this happen. Retrospect makes for 20/20 vision, but doing this in the heat of the moment is a hugely difficult endeavour.

What’s funnier is if you set your limit order at $300, psychologically you would have still felt ripped off since you had the potential for another 50% gain ($450)… “If only I set the limit sell price at $400 instead of $300 that day”.

That said, share dispositions do not have to be a binary decision – you can choose to trim tiny amounts as prices rise. This is my personal approach to things, although logically it doesn’t make sense.

Overall, however, we are seeing a commodity-driven boom. There is a lot of forward expectation and you can see this with the single digit P/Es projected in most of these companies.

ARCH, for instance, is trading at 6 times projected 2021 earnings. Coking coal is going crazy and Arch is down 4% today. What gives?

My Divestor Oil and Gas index has Q2 guidance below current spot prices and even with that guidance, companies are trading at EV/(free cash flow) levels of the high single digits (and if you ignore debt leverage, the price to cash flow ratio is even lower). Natural gas is spiking – you’re seeing Henry Hub gas prices this winter heading north of US$5/mmBtu, and AECO is north of CAD$4 and it’s still September.

It’s a really difficult decision to be selling equities that are trading at single digit multiples of cash flows when prevailing investing options for near-safe money is so terrible. You can’t even go to the debenture or preferred share markets, which are more or less a wasteland in my humblest of opinions.

Still, I sold a small holding of Western Forest (TSX: WEF) earlier this year, when they were on track to earn about a quarter of their market capitalization in 2021.

Embedded in each of these companies is an implied bet on the future of specific commodities (met coal, gas, oil or otherwise). There is also an embedded skepticism that current prices will remain in each of the share prices. It could entirely be the case that the market is assigning a gigantic discount to future cash flows for whatever reason. If this is the case then buying and waiting for the returns to flow in is logical. Inevitably, it will happen – the most conservative approach companies make is paying down their debt, and then after that, they will have the choice of raising dividends or buying back stock.

This is unless if the real economy crashes and takes the commodity market with it. Then, those single-digit P/Es will rise very quickly.

As for the title of this post, I do not know. As much as it makes mathematical sense, margin investing always makes me nervous. The proper time to do it is when you are feeling absolutely sick in the stomach to buy and right now it just makes too much damn sense to borrow at 1.5% and buy these single digit P/E stocks. This is why I’m not doing it and am slowly raising cash instead, because the decision to increase zero-yield cash in my portfolio hurts the most. It won’t be an extreme move – just enough to make me a little more comfortable.