–one of my former classmates, an incredible artist, made her thesis film about several of twenty-something contemporaries who had left Italy permanently. Someone pointed out that she’d given no motivation for the moves. She was shocked, because she thought the situation was obvious. Italy has had no economic growth in the past quarter-century, she said, so why would anyone with a choice stay?

Recently, worries about the solvency of weaker euro members like Italy have popped up again, evidenced by the premium buyers of their euro-denominated sovereign bonds are demanding. One consequence of this, I think, is increasing interest in US Treasuries, which offer not only higher nominal yields but the chance of a currency gain. If that’s correct, the Fed will likely have less trouble than might be anticipated in paring down the massive Treasury hoard it has amassed through quantitative easing.

This despite Europeans being appalled at US gun violence, auto deaths, drug addiction, science denial and the echoes (intensely worrying to people who lived through the real thing) of the rise of 1930s Fascism in today’s Republican party apparatus. Btw, despite being in a flatlining economy, Italians live on average five years longer than Americans–mostly because of fewer violent deaths

–I read a brokerage strategy report the other day saying that the valuation differences between large cap stocks (expensive) and small caps (cheap) in the US have reached extreme levels. I don’t know the author’s methodology (I just read the headline) but I’ve felt this way for a while. For me, it’s more cash or cash-like assets rather than eps or current eps growth. It’s also the way the market cycle works: in up markets, investors are willing to swing for the fences; in bad markets they look for a walk.

–the Fed made it clear at Jackson Hole that the 10-year Treasury note is headed for 4% and that its ultimate inflation target is 2%. I think the real, meaning achievable, inflation target is 3%, but for now I think that’s just a quibble. Rates barely moved on the news, meaning these figures are already in every professional’s plans. If so, most of the pain of higher rates should be already baked into today’s price. Most doesn’t mean all, so it will be important to observe the market reaction to further hikes in the Fed Funds rate. This will presumably tell us how close to all we actually are.

–a half-century ago I was a soldier. I spent my first two years+ in the infantry and then reverted to the military intelligence branch, where I ran a counterintelligence office before resigning to return to school (a whole boring story in itself). Anyway, with this latter perspective, I was floored when I read the kind of classified material that Trump had taken from the White House and had lying around unsecured in his Florida golf club. If the press accounts are right, the documents found, included: reports from highly placed officials in foreign governments who are (or maybe now were) revealing secrets to the US; and communication intercepts by the NSA.

The content of the former would presumably either reveal the identity of the spy or narrow the source of the leak to only a few. The latter could show that communications a foreign government thought were secure actually aren’t. Potentially very damaging; in the first case, possibly lethal.

This could end up being a lot messier than it seems now.

Last Monday INTC announced a deal with BIP, a publicly-traded infrastructure limited partnership. The partnership’s purpose is to build and own two semiconductor fabs that INTC is in the process of constructing in Arizona.

Terms: INTC will contribute its semiconductor fabrication expertise plus everything it has done so far on the project, which it values at $14 billion+ and will own 51%; BIP brings $14 billion+ in cash to the table for its 49%.

The glitzy slides of the investor presentation explaining all this, as well as the turgid prose of the agreement itself, can both be found on the SEC Edgar site. The bottom line as I see it, though, is that instead of getting a bank loan at, say, 5%, or using its A+ credit rating to issue bonds, INTC is ceding almost half the project to BIF for the financing it needs to complete it.

What does this mean?

(highly subjective) background

In the 1990s, the semiconductor business was transformed by the emergence of ARM Holdings and Taiwan Semiconductor Manufacturing Corp. ARM makes semiconductor design tools that allow small groups of semiconductor design engineers to create chips without having to work for the industry behemoths, like INTC or Samsung. TSMC makes these designs into functioning chips in its fabs. This industry development meant that, for the first time, INTC had serious competition for its we-do-everything model.

Though INTC chips are bigger and throw off more heat than ARM/TSMC products, the company kept itself competitive by the ability of its fabs to stay a couple of years ahead of TSMC in the race to “shrink” chips, that is, to etch chip structure on ever smaller pieces of silicon.

Three or four years ago, that changed, however. TSMC pulled even with INTC in fab sophistication …and then moved clearly ahead. The stock market picked this up right away. From the beginning of 2019 until last Friday, INTC shares have lost about 30% vs. a gain of 411% by long-time rival AMD (a user of TSMC fabs).

I find INTC’s response to its less favorable positioning to be curious. Yes, there is a several billion dollar per year increase in capex. But that’s dwarfed by $40 billion in stock buybacks during 2018-20. And there’s the steady outflow of $5 billion+ a year in cash from the dividend INTC chooses to pay.

back to the Brookfield project

I don’t know enough any more about the ins and outs of INTC to be more specific, but generally speaking I see three possibilities–not mutually exclusive–for INTC’s decision to find outside capital to complete the Arizona project rather than use its own money:

–the project itself is a clunker, at the very least in the sense that it will offer lower returns than anticipated. So it would make sense to turn to someone like Brookfield, which does things like building toll roads for cash-strapped municipalities, to get the capital to complete it

–INTC finally realizes how far behind ARM/TSMC it has fallen over a decade of complacency (apparently Only the Paranoid Survive is no longer required reading for board members) and now has a sense of urgency in trying to catch up. Not a great sense of urgency–it is still paying out about $6 billion in annual dividends, dulling the positive impact of Brookfield on cash flow–but still more than two years ago

–a variation on the first. It may be that INTC no longer has the easy access to inexpensive borrowing that its pristine credit rating would suggest. It may also be that directors would balk at a stock offering today, thinking (incorrectly, in my view) that this would make their buyback decisions of past year look even worse

the stock

To me, INTC feels like DIS as it stagnated under Eisner in his last decade. For DIS, of course, what followed was the spectacular rebound under Iger. Whether Ishrak is the new Iger or not, and therefore whether INTC is a classic value stock today, I don’t know. But the BIP deal suggests it’s more thinkable than before.

…actually, sports commentary in general, not just baseball. But it was while I was watching the Mets-Phillies series over the weekend, I was struck by the high quality of of the commentators. In this case, Ron Darling, with play-by-play by Gary Cohen. Darling, a former Mets pitcher, was an All-Star, Gold Glove winner and World Series champion. The third member of the crew is Keith Hernandez, a 5-time All Star, MVP winner and 2-time World Series champion. In addition to being deeply knowledgeable, the three are very analytical and articulate.

At around the same time, I happened to be reading a featured article in the financial press. Although couched in perhaps and maybe terms, its thrust is that the US stock market is substantially overvalued today. How so? Stocks were correctly priced three years ago. The US economy is in rockier shape now than it was then, yet stocks are a third higher .

This conclusion may turn out to be correct. Still, there’s not a whole lot of nuance to the supporting argument. There is a nod to the fact that the US indices contain exposure to non-US economies, but not, I think, to the reality that about half the S&P eps total comes from abroad (note: this is most likely a really bad thing right now). And, as is the case in most/all places with stock markets, huge swaths of the US economy have little/no direct representation in public trading–housing, autos, government come to mind. Publicly traded companies tend, generally speaking, to be the best and the brightest.

Nor is discounting addressed–whether market participants have correctly anticipated future company developments, good or bad, and already factored these into current prices. Same thing about the relationship between stocks and bonds–what level of interest rates does a 17x multiple imply?

Anyway, it struck me as revealing that we expect seasoned pros in the broadcast booth but are satisfied in the financial arena by and large with commentators who have never played the game.

There’s a chicken/egg aspect to the slowdown in financial markets during the north-of-the-equator summer. Part of this has to do with the heat that motivated traditional industry, pre-air conditioning, to close factories and send workers on vacation during the dog days of August; part is the resulting general understanding that August is for vacation, not work. In any event, the physical flow of goods and raw materials has tended to slow during July/August, as well as financial markets where traders are at the beach with everyone else.

Markets tend to pick up just after Labor Day, or, less frequently, just before. The deep underlying idea is that factories reopen and people go back to work, which sounds kind of anachronistic in a WFH world. But old habits die hard. Quickly, though, equity investors begin to worry about fiscal year-end (October 31st) selling by mutual funds (here’s why).

I’m not sure there’s going to be a cascade of sell orders this time around, though. NASDAQ is down by 20% since last October and the S&P 500 is off by about half that. Energy is the only clear winner among the eleven S&P sectors. So it’s hard to see where the gains to be paid out as dividends will come from. Also, the positive signal that a dividend supposedly gives will likely pale in comparison with the capital losses shareholders will have experienced.

I decided to look at the financials of the main ARK fund, ARKK. The latest balance sheet data I could find–either on the SEC Edgar site or on ARK–are from January 31st. Presumably a new set will be out shortly. Anyway, ARKK ended its first half with investments of $12.97 billion, having an aggregate cost basis of $20.67 billion. This implies a net unrealized loss of $7.7 billion as of back then. If there’s a mention of realized gains or losses in the semi-annual report (meaning losses established through actual sales–this fiscal year or before), I’ve missed it. So total losses as of 1/31 may be different, depending on whether any net sales made a profit or not. ARKK is down by 40% since then, with net assets today of $8.5 billion (a figure that implies net inflows during the year). Still, it seems to me that the net loss situation has not improved.

What does this mean?

First of all, ARKK, an ETF, apparently has a tax year that ends in July. So it wouldn’t necessarily be involved in pre-Halloween selling. But its situation is probably a high-beta portrayal of the pickle any techy portfolio manager is in.

–given the tech carnage of the past 18 months, it may be hard for bleeding edge growth investors, especially those whose funds haven’t been around forever, to generate a net gain for the fiscal year, even if they wanted. And fund graybeards would probably elect to hold on to seasoned issues like MSFT. So this time, mutual fund selling could be a non-event. Potential sales by banks, brokers, insurance companies and any other taxable investors with a December year will likely be more important.

–if the $7.7 billion is indicative of ARKK’s total (realized + unrealized) loss position today–simple arithmetic argues that the current figure is closer to $10 billion–this potential tax benefit is probably the biggest single asset it, or any similar fund, has.

Henry “Dr. Doom” Kaufman, former Goldman economist, still working (in his own firm) while his personal odometer approaches three figures, was perhaps the most important Fed interpreter on Wall Street during the Paul Volcker era.

In a “recent” interview with the Financial Times, published yesterday, Kaufman compares Jerome Powell’s performance as head of the Federal Reserve unfavorably with that of Volcker in the early 1980s. The former, in Kaufman’s view, has so far only slapped the financial markets on the hand, in a situation where the latter did what was needed and punched them in the face.

Ultimately, no one is going to buy fixed income instruments unless they, at a minimum, preserve the real value of the owner’s purchase. As Kaufman put it, interest rates need to be higher than inflation. Yes, the 10-year Treasury yield has moved from 1.6% on New Year’s Day to as high as 3.5%, before a recent decline to around 2.9%. That’s a long distance from its March 2020 low of 0.54%. Fed Funds are at 2.5%. But headline inflation is at 8%. Therefore, either inflation comes down or rates have to go up.

I think this last is exactly correct. If we imagine that the long-term inflation target is 3%, then the 10-year should end up somewhere in the 4%-5% range, depending on what investors determine the real return should be.

I think the current situation is substantially different from the 1970s, however. So while a stern expression and a harsh voice may be needed, I wonder whether a punch in the face is the wisest course.

The differences I see:

–for the 1970s as a whole, yearly inflation averaged just under 7%. This strengthened the belief back then that inflation was an enduring phenomenon. Certainly, a lot of loony things happened in the late 70s, as inflation began to accelerate–like lots of industrial companies borrowing heavily to buy gold mines (thinking the real value of fixed-rate debt would decline while gold would only rise) or to explore for the newest super-metal, molybdenum. Yes, this was really stupid, but it shows how panicked even the adults in the room were about accelerating inflation. In contrast, the great macroeconomic fear of the past two decades has been that the Fed’s best efforts have been unable to get inflation to rise as high as 2%

–consumer ideas about future inflation are substantially different now than in the 1970s, when large yearly price rises, accelerating into double digits, were commonly expected to occur. In contrast, the NY Fed’s consumer surveys indicate people expect current inflation to gradually shrink to just above 3%

–the 40x rise in the price of oil, a global situation made worse by the US decision to protect an inefficient, gasoline-guzzling auto industry, was a key factor in both inflation and in setting inflation expectations. Today, “peak oil” no longer means the day demand will outstrip supply, however, but the opposite

–a decade of politically expedient too-loose money and the failure of the country to modernize the industrial base after WWII–not to mention Watergate–meant that by the end of the 70s the rest of the world had lost faith in the US. The Treasury was forced to issue bonds in German marks and Swiss francs to attract foreign buyers who feared accelerating inflation and a declining dollar. Today, in contrast, a strong dollar has attracted lots of foreign buyers–meaning they don’t see a parallel between today and the 1970s–and that’s despite the January 6th coup attempt, which makes Watergate look like a schoolyard prank.