market rotation continuing

important road signs: a recap

The 10-year Treasury peaked at a yield of 0.52% in the middle of last summer. The benchmark bond then began a slow, steady decline (meaning the yield rose) to 0.93% at yearend–a 40 basis point change in six months. The 10-year hit 1.36% this morning, or a 43 bp rise in yield in seven weeks.

The Russell 2000, a measure of the health of US-based companies making and selling bread-and-butter things to US customers, was in steep decline relative to NASDAQ from the day Trump’s big tax cut for his ultra-wealthy boosters went into effect until the November election. Since then the R2000 is up by 39% vs. NASDAQ’s 19% rise.

my interpretation

For bonds, I’m mostly making up numbers. Let’s say a return to a “normal” economy means US yearly GDP growth of 2.0%, with inflation of 1.5%. And let’s posit that bond holders require a real (after-inflation) yield of 2%. That translates into a nominal annual return of 3.5% for lending money to the federal government for a decade. At a nominal yield of 52 bp last July, Treasuries were locking in a real loss of 1% a year for buyers at that point. Sort of like agreeing to pay a bank 1% per year to store your money.

In my view, this was real despair/panic and was related to the US experience with the pandemic.

A second point: on my numbers, we’ve only begun to normalize interest rates. There’s lots more to come.

As to stocks, my take is that the stock market understood much more clearly than the average American how deeply economically destructive the major policies of the Trump administration were. From January 2018 through October 2020, NASDAQ rose by 59%, while the R2000 was barely in the black at +2%.

I take the reversal since as purely conceptual–that is, not based on concrete evidence that the economy is getting better but simply by the notion that what I’ve called the capital flight trade is over and that the worst of the economic damage is behind us. My sense is that the pandemic is a net neutral. We’ve found that the Trump administration actually did much less than its press releases claimed. On the other hand, the vaccination and reopening schedule seems to no longer be vaporware and to be gathering momentum.

More tomorrow.

signs of Spring-metaphor only

We’re bracing for another 7″-8″ of snow tomorrow, following close to two feet last week. But…

A few days ago, the German government announced that it’s preparing to raise interest rates there in reaction to what it expects will be 3%+ inflation there sometime this year. We should note that Germany’s fundamental economic policy–stop inflation at all cost–is a product of its Weimar-era hyperinflation and differs markedly from that of the US–maximum economic growth with moderate, and non-accelerating, inflation. Also the US is still suffering from years of Trump’s economic incompetence. Still. I read this as a signal that we’ve passed the pandemic-induced low point for rates.

The fact that the US has been an economic laggard under Trump suggests recovery here will be longer in coming than elsewhere. The yield on the 10-year note, however, has already risen from 0.93% on January 4th to 1.30% today. If rates in the EU do indeed rise more quickly than here will most likely mean mild depreciation of the US$. If so, US multinationals with large EU exposure would be beneficiaries.

For what it’s worth, Warren Buffett is reported to have sold a big chunk of his AAPL shares and put the money into Chevron and Verizon. I’ll confess to knowing less about Berkshire Hathaway than about the Mets, or even the Yankees, but I have two reactions. I’ve read in the financial press that AAPL is by far his largest position, so the sale may just be housekeeping. What’s more interesting to me is where the proceeds went. Both VZ and CVX have been severe market laggards, have pedestrian prospects, and sport 4.5%+ dividend yields. Their biggest virtue, it seems to me, is that they probably won’t go down a lot in a stormy market. True, I think the world has long since passed Buffett by as an innovative company-level analyst. But he has an incredible information network through the US-centric businesses Berkshire owns. As a strategist, one’s first question should be whether we’re in an up market or a down one. Buffett’s answer is that an incipient return to domestic economic growth is going to mean interest rate increases–implying sideways would be a great outcome for stocks. If so, it would be good to take in some sail and to have some ballast in the bottom of the boat.

Gamestop (GME), shorting, dynamic hedging, options…

…in other words, random-ish thoughts.

how shorts play out

I was recently reading an analysis of GME by Aswath Damodaran, a finance professor at NYU’s business school, who seems to me to be unusually insightful for an academic. In a recent blog post, he comments that history shows that successful shorts typically run out of steam when the stock being shorted has lost 90% -95% of its value. Not only that, the stock subsequently bounces sharply up. His question: why hadn’t Melvin Capital, the primary target/loser in the recent GME short squeeze run the risk of bankruptcy by not closing a lucrative short bet once it passed its best-by date? One possible answer: Melvin had no idea.

OTC derivatives

Others have pointed out that Melvin should have been shorting through what are called OTC derivatives. These are private contracts between a broker and an institutional client that get the client the effect, for good or ill, of ownership of a financial instrument without actually owning it. That way there would be no public record of Melvin’s shorting.

An example: at one point in my working career I wanted to invest in India. That required registration as a foreign institutional investor with that country’s securities authority. After waiting six months in vain for my legal department to get through what was normally a two-week process, I decided to enter an OTC contract with a broker. I deposited an agreed-upon amount of money with the broker, based on the number of shares of company X that I wanted to buy. My fund would be paid the gains from owning my target stock–and would pay the broker for any losses. The contract would be settled and renewed at the end of each month. (For a publicly traded mutual fund, though, the contract was a pain in the neck to price every day. The charges for the contract weren’t clear, which bothered me. Also, I found I wasn’t becoming mentally linked to the ebbs and flows of Indian stocks in the way I would have been had I owned the actual shares. So I ended the contract after a month or two.)

About Melvin and GME, yes, using OTC derivatives would mean Melvin’s identity would not have been revealed. But that doesn’t mean that there would have been no public record of its shorting. I’m sure that if I weren’t mostly trying to prod my lawyers into action (without success, as it turns out) I would have dug deeply enough to discover this bespoke service was very expensive. Another drawback–the broker would likely be able to end the contract on very short notice.

From another angle, though, Melvin may have wanted its activity to be very visible, in the hope of attracting momentum players into joining its attack. And, of course, for all we know Melvin may have had a whole bunch of OTC derivative contracts involving GME–and betting either for or against the stock–as well

Then there’s dynamic hedging.

dynamic hedging

This is a common statistical technique developed in the academic world and first put into practice in the US stock market in the fall of 1987 (think Black Monday). It works like this:

I establish an OTC contract that gives me the effect of shorting 1,000,000 shares of GME. The broker on the other side of the contract is at least notionally long a million shares. It probably doesn’t want that much exposure. So it goes into the market to hedge its own exposure and shorts, say, 500,000 shares, as quickly as it can without depressing the price (an aside: that 500,000 share short appears in the public record). The broker also has a program that trades around its exposure, shorting more if the stock begins to rise and reducing part of the short position if the stock begins to sag.

In the perfect world for him, the broker will make steady money by trading around the position and my using the funds on deposit. But if the stock starts to move down, the broker will increase its hedge by shorting more …and likely more aggressively. If the stock begins to move up, the broker will cover …and likely more aggressively here as well. In other words, the existence of OTC contracts adds to potential market instability in any stock. It will increase the strength of both upside and downside moves in the stock once it gets going, until it completely de-risks its position..

options play a role, too

This is a lot like OTC derivatives, only these are standardized and publicly-traded–meaning they are cookie-cutter form as regards contract size, strike price and expiration date. For this post, the important common element is that market makers who take the other side of a retail investor contract is that they too use dynamic hedging. So they too may initially hedge only a portion of the obligation to deliver stock to you if you buy a call from them. And their activity can accelerate the rise in price of the underlying stock. As the number of call options in a given name a market maker sells, the hedge ratio for his entire short position begins to rise.

Because of all this, even a small push and quickly snowball.

how the pandemic “bubble” might play out from here

“This time is different” is one of the scariest sentences any investor can utter. That’s chiefly because humans’ capacity for denying unpleasant truths is close to boundless. It’s also that this thought mostly comes up when a market is toppy and is typically a sign that a downdraft in stock prices is near.

In recent posts, I’ve written about the runups to the two big bear markets I’ve lived through that most remind me of where we are today: one was in Japan in 1989, when the Japanese government decided to end a period of wild, and increasingly damaging, speculation by raising interest rates; and the other was in the US in 2000, when demand for internet infrastructure devices and components came to a screeching halt and no Y2K computer glitches appeared. As is the case in any bear market I can think of, the trigger for each was an economic event that had important consequences for financial instruments. In Japan, rising rates; in the US, an unexpected slowdown in a key industrial area.

What’s peculiar (I didn’t say different, but it amounts to the same thing) about today’s situation is that a number of deeply adverse economic events have already occurred without the domestic stock market falling apart: several years of Trump’s growth-inhibiting economic program, the economic devastation caused by his “it’s a hoax” response to the external shock of the pandemic, his violence-laced effort at a coup to overthrow the newly elected government when voters decided to replace him, and the approval/support he continues to get from many leading lights in Congress. It’s like a super bad movie plot of racism and ineptitude–only it’s real.

Yes, the stock market declined by 30%+ last February-March. But it recovered just as quickly and ended 2020 comfortably in the black. That’s because the Fed dropped short-term borrowing rates from 1.5% to basically zero and Congress applied substantial fiscal stimulus. That combination has so far averted a deeper, longer economic and stock market downturn. More fiscal stimulus may also be on the way.

What happens from this point? My guess is that as vaccines gradually get distributed widely, the consumer economy starts to return toward normal. It seems to me there’s already some evidence of this happening in macroeconomic data, although I don’t yet see a strong reaction in the bricks-and-mortar retail part of the stock market.

Three key stock investment questions associated with potential recovery:

–how closely will the new normal resemble the old? This is about which current quarantine beneficiaries get left behind and what consumer names the market rotates into

–when does the economy become strong enough for rates to rise? Not soon, but rising rates implies PE compression

–from a longer-term, more conceptual point of view, there’s the Iraq war, the US-spawned financial crisis of 2007-09 and the damaging Trump administration. The three have conspired to give the US a considerable black eye in the rest of the world. That’s not only as a location for new plant and equipment but also as a place to visit, to research or be educated and as a country whose stocks and bonds one might want to own. One of the hallmarks of the Trump presidency has been the capital flight this has generated. Just look at the spread between NASDAQ and the Russell 2000 during 2018-20. An important long-term question, and only time will tell, is if and how this will reverse, i.e., whether the current surge in the R2000 is the beginning of a new trend or just a strong countertrend rally. Even with a pessimistic point of view, however, my thought is that relative strength of domestic-oriented names will continue throughout this year.