Macro

With stocks near all-time-highs, there is steadily accumulating evidence that this may be a historic time to sell. 

  1. PMIs are diving. PMIs give false signals (eg 2016 was a buy, not a sell) but this is by far the worst they have looked. All through the turmoil of last year, US PMIs held up. Now they are cracking with services and manufacturing leading the way. 

Source

2. Trade has fallen off a cliff, and this was before the most recent trade escalation. 

3. Managers remain extended. Some surveys show increasing bearishness amongst money managers, but only two weeks ago VIX shorts reached record highs, and markets themselves remain close to their all-time-highs. By these markets measures, there is a long way to go. 

4. Yield curves have inverted across the globe, especially when measured by the Fed. This is notable as there were no false signals from 2010 to now. 

Source: Crescat Capital

5. Margin debt looks extended and may have already rolled over. Margin debt is particularly pernicious, as when investors delever the proceeds of share sales are used to pay down debt, not reinvested in other sectors. This was evident in late 2018. In the first phase, many utilities and staples actually rallied, implying a level of sector rotation. At a certain point, however, they were sold off with everything else. 

6. Valuations remain high. Time has healed some of the excesses, but take the Nasdaq 100. EV/EBITDA has risen from 8x in 2011 to 15x now. The Nasdaq could fall 20% and simply move valuations back to the past decade's average.

Some equity sectors look more distressed than ever. It is now abundantly clear to both US and Chinese businesses that they can't rely on supplies from each other. China had a plan to build local competitors in all major sectors by 2025. You can be certain that the pace of this development was brought even further forward, as soon as the US struck at one of their crown jewels, Huawei.

This is particularly relevant in popular sectors like memory. The past two decades saw waves of consolidation, leaving three main players, Samsung, SK Hynix and Micron. We would happily wager that very soon, there will be new, state-funded competitors from China with significant market share. 

Many other traditional favoured value picks, like specialty manufacturers of lasers, diodes and so on, may also soon face new, well-funded Chinese competition.

How best to play this?

We are maintaining our long term investments in technology, biotechnology and innovation, but the past few months of short covering have allowed us to build short positions in structurally flawed sectors.

Examples include physical retailers - losing market share to online - and telecoms, which are about to go through a lengthy 5G investment cycle with only the promise of high competition at the end. Many of these firms have compounded their errors by taking on prodigious levels of debt through acquisition or mismanagement. As an example, AT&T may soon be spending a fortune to build what we expect to be a second-rate streaming competitor. Disney's offering, with their full back catalogue and ESPN, looks far more impressive.

There are also opportunities in macro land. US government bonds have rallied hard, and the ten year still yields 2.3%. This is anomalous in the Western world, and there is a long way down from there to zero rates and QE, which we could easily see in the next crisis. 

Late last year we wrote that the Fed's last rate hike was a mistake and their next move would be down. So far this looks to be on track. The beauty of treasuries is that they pay a positive yield, have a positive expected return and have no credit risk. Ray Dalio combined treasuries with equities to record the highest hedge fund profits ever. 

The best part of Government bonds, however, is that they actually benefit from surprise stimulus - especially the kind that torches equity shorts, as no doubt many remember from January and February only a few short months ago. If you're a bear, best to ply your trade in the bond market, in our opinion. Think of how well Aussie Government bonds have done lately, relative to the dull macro theme of shorting Aussie banks - fashionable for nearly a decade now.

Many investors use cash to manage risk. We would argue that Government bonds are a better option, as they increase in value in serious downturns, which are invariably accompanied by rate cuts and deflation. 

There are other opportunities to balance out a long term equity investment portfolio. Junk bond prices remain high, and in a real crisis, may fall nearly as much as equities. And unlike equities, they won't rise significantly if timing is off. 

Price chart of HYG, a high yield ETF

There's also something to say for pairing commodity shorts with fast-growing, cash generating commodity producers. For example,  we are invested in energy companies dramatically expanding production, generating free cash flow and paying dividends. We expect these to compound over the long term, in a way that a WTI crude ETF can not, especially after taking into account roll yield and expenses.

To show how significant these factors are, USO, a WTI ETF, has dropped ~50% more than the WTI spot price over the past ten years. Decent energy stocks have outperformed further still.

There has never been a better time to have more than one string to your bow. 



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Nick Ikonomou

Great article Michael! I think you are right on the money with what's coming in macro markets.