Big institutional investors, i.e. pension funds, ETFs and mutual funds, hedge funds…, understand that their full-year performance for 2022 is already set in stone and that any last-minute moves are at least as likely to make things worse than better. So they’ve pretty much all gone home for the year.

For individuals, we typically have positions that can be sold in an instant, rather than over weeks or months, so there’s still time for 2022 income tax planning by recognizing capital gains/losses. By default, we tend to be on center stage between now and yearend. I’ve always liked this period, on the thought that there may be a chance to pick up bargains created by thin trading.

It seems to me that there’s an unusually wide spectrum of opinion about what 2023 will bring for equities. The consensus seems to center around the idea that stocks will be little changed from today’s prices a year from now. Where strategists differ widely is in how we get there, some calling for a sharp decline in the first half, followed by a relief rally, some calling for the opposite.

It seems to me that the idea of no net change in twelve months is the least likely outcome. More about this tomorrow.

I’ve been paying what may be a more-than-healthy amount of attention to stay-at-home stocks like ZM and ROKU. I don’t own either. What interests me is that, while many pandemic beneficiaries have stabilized over the past quarter or so, these two 2020-21 mainstays haven’t. Both reached 52-week lows yesterday.

Is this important? Maybe–not definitely, but maybe.

Wall Street lore says that the bear market isn’t over “until the last bull capitulates.” The idea is that a new up market can only be built on the ashes of the old … after a broad selloff of the previous up market stars. This has by and large happened in 2022 during S&P declines in June and again in September/October. But ZM and ROKU, important 2020-21 bull market stocks, have not stabilized, and have continued to fall since then. Purists would argue that this oasis of residual bullishness is enough to prevent a new bull market from developing. I’d be happier if one or both were bottoming, but my sense is their performance is more an argument that the market in 2023 probably won’t be strongly up rather than that further declines are on the cards. Again, more tomorrow.

where are the big-picture stories?

…like…

Japan, 1980s

The economic and stock market miracle of the 1980s was Japan, a country whose population is something like 20 years older than that of the US. It had been the poster child for cheap-currency, export-oriented growth as it struggles to recover from the devastation of WWII. Early in the decade, however, the US and Europe forced Japan to revalue its currency sharply upward, making local industry much more competitive vs. Japanese exports. This had the desired effect. Revaluation, however, had an immensely positive effect on national wealth, triggering an economic boom and explosive gains for half a decade in industries like banking and property, The Tokyo stock market became by far the largest in the world.

Since then, Japan has experienced three decades, and counting, of economic stagnation. How so? …a hidebound social structure that’s anti-women and anti-immigration, respects age more than competence, and places a very high value on protecting the interests of samurai-founded trading companies in basic manufacturing. The aging workforce peaked in size and began to decline. Without innovation, productivity gains waned as well.

Europe, 1990s

The stock market story of the 1990s was Europe, whose overall population is perhaps 10 years older than in the US. The European Union intended to be a cohesive economic force big enough to compete head-to-head with the US. The main attractions turned out to be: the opening of the entire EU as a market for European companies; cost savings from the elimination of internal barriers to the flow of products and materials between countries; mergers and acquisitions that built pan-European firms large enough to go head-to-head with American rivals; the EU world lead in the burgeoning cellphone industry; and the reintegration of eastern European countries of the Warsaw Pact that had been controlled by the USSR until 1989.

Again, an aging local population, resistance to women workers and to immigration, as well as the ability of countries like Italy or France to craft local anti-growth economic policies–and, later on, Brexit–have considerably reduced the region’s growth potential, and investor interest along with it.

the US and China, 1999 onward

Yes, the 21st century has given us the internet collapse of 2000, the banks’ self immolation in 2007-08 and the covid pandemic of 2020-21. Despite this, the two enduring positives have been explosive growth in the mainland Chinese economy and the dominance of the US in tech industries.

However, the rise of Xi Jinping has slowed Chinese expansion to a crawl. In the US, in many ways the story is a reprise of Japan and the EU–an aging working population, fierce resistance to increasing the workforce through immigration, powerful political lobbying by industries of the past that neuter government support for industrial development. Add to that, organized opposition to the kind of education that prepares students for scientific or other socially useful achievement as adults.

my take on all this

As investors, we’ve been through a long period where high-level concepts, like picking the right geographical area or calling the right currency or the next shortage commodity has been enough to produce reasonable stock market returns. But as they’ve aged, the most advanced economies have, one by one, turned sclerotic–focused on preserving wealth already achieved rather than on growth.

There is still dynamic growth in the world, I think. But it’s now in frontier countries like India or Vietnam or Latin America or Africa, where either regimes are unstable or stock markets are idiosyncratic (translation: rigged by locals), maybe not representative of growth areas and hostile toward foreigners. So the risk of following a top-down economic strategy in markets like these, while depending on AI to sort through the welter of company announcements for good/bad, is likely to be expensive and–my guess–not to work very well. There’s also the issue of whether foreigners are allowed to own stocks.

As for me, I think the best route to success is to find a small number of US-based companies with strong growth prospects and watch them closely.

More tomorrow.

inflation

What I’ve been reading suggests that current inflation in the US can be divided into two roughly equal causes: an increase in cost of goods (i.e., raw materials prices, labor, rent…) and sellers expanding profit margins. For example:

–I mentioned in a recent post that the yogurt I like is 15% more at Costco than a year ago, but up 75% in supermarkets.

–I was driving to an auto dealer maybe 20 miles away from my home. Gasoline in that area was $2.90 a gallon for regular. Back here it was $3.45 or so–except for in the more upscale part of town, where it was $3.85. That’s about 20% more at home than in the car dealer’s town, and a third more in the area that doesn’t really count, where the overall extra expense is not worth the bother of driving an extra mile.

Presumably, as supply chains normalize and as consumers’ major consideration shifts from availability to price, these unusually high markups will become less frequent.

In other words, ex extraordinary markups, underlying inflation may be more like 4% now rather than the headline numbers above 7%.

early last week…

…as Washington announced slightly lower inflation than expected before the Tuesday open, stocks exploded to the upside in pre-market trading. Stay-at-home stocks, clearly out of favor this year, led the charge. ROKU, for instance, was marked up by about 12%

To my mind, backward-looking trading bots bid up the usual pandemic-era suspects. This makes no sense. Maybe they were acting on the idea that looser money policy would breathe life back into these fallen angels the way the dramatic plunge in rates during the pandemic did. At any rate, there was an almost immediate counter action as the market opened. By the end of the day, ROKU et al had lost their early gains. ROKU, in fact, was down.

inventories

Hennes and Mauritz (H&M) and Inditex (Zara) have both recently announced that they have a ton of excess inventory–H&M (no surprise) with more than Inditex. Add them to the long list of retailers, including Target and Walmart, in this situation. (Yes, both TGT and WMT have said that they’re past the worst. But a careful reading of the precise wording used, rather than relying on the impression they have been crafted to create, suggests there’s still too much merchandise on hand. Nothing nefarious here, just the way marketing works.)

It seems to me that merchants in general double-and triple-ordered in 2020 and 2021, just to be sure to get something on the shelves, so potential customers wouldn’t get in the habit of staying away. They likely made extra concessions like no-returns that leave their options limited for dealing with the excess. My guess is that as a result, sales will be higher for retail than expected in the fourth quarter, but profits will be lower. Writeoffs, albeit small ones, are probably on the cards for some time in 2023 for the most aggressive merchants (Target (which I hold)?), as well.

In a pre-bot world, 80%, say, or maybe more, would already be discounted in current prices. Hard to know we are today. Although I own a lot of TGT, I’d be a buyer on weakness. I think Dollar General is well-positioned, as well, although I don’t know enough about it at the present. Another buy on weakness candidate, I think.

a trendless market?

I keep reading/hearing this in stock market commentary. I understand this is bad for managers, especially in fixed income, who try to gain outperformance primarily by predicting and navigating through big macro changes of the type we’ve experienced over the past few years. These “big picture” strategists tend not to fare particularly well in periods where the merits of individual companies are more important. For most equity managers, and for you and me as well, though, a flattish market where outperformance means knowing a lot about a few good companies that post better results than the consensus expects is the best of all possible worlds.

It would also be nice if there were more intelligent anticipation of company/stock performance rather than ignorance + rapid reaction, but we can’t ask for everything.

FTX

Two days ago, the US announced its intention to prosecute Sam Bankman-Fried and he was arrested by authorities in the Bahamas. I thought this might be the final shoe to drop in cryptospace and could cause a bounce in crypto currencies. The absence of one was the only thing worthy of note.

inflation

Yesterday, the government reported a slight decrease in the rate of domestic price rises, just before the Wall Street open. This caused an immense initial bounce in stock prices, one that gradually faded as the day progressed. What was very odd about this, though, was that the biggest risers were stay-at-home stocks, whose merits in today’s world are open to question, at the very least. ROKU, for instance, was up by about 12% at first, but closed slightly down on the day. ARKK was up 8%, but weakened steadily as the day wore on.

Interesting that a set of trading bots would extrapolate from the world of 2020-21 to the present. Interesting, also, how quickly either humans or other bots acted on this error.

Musk

There’s more talk today about the big commercial banks who financed Musk’s takeover of Twitter wanting him to repay $3 billion of the loans they recently issued to Twitter to buy in its stock. He would reportedly do so by using money he would raise through a margin loan issued by the same banks, and secured by, say $6 billion, of his TSLA stock. Musk reportedly has already used a big chunk of his TSLA shares to secure other margin loans, but he also has stock options on $40 billion? more. So, although possibly risky for Musk if he’s highly leveraged already, a margin loan is presumably doable.

But why in the world would Musk do this?

The only thing that I can come up with is that Twitter is either now, or may soon be, in violation of loan covenants that specify minimum levels of operating performance the company must meet–or face the possibility of ceding control of Twitter to the banks.

Same question, though …why in the world would the banks want to take over Twitter?

Sounds like a classic game of chicken to me.

the market

The last couple of weeks of the calendar year are usually uneventful. Most professionals are closing their books right now. Retail investors are trying to figure out what tax losses to generate. During the days after Christmas unscrupulous fellows often try to make small, illiquid stocks dance in a way the boosts their performance bonuses.

My hunch is that more than usual is going on now, that what we’re seeing in days like yesterday is a harbinger of what 2023 will look like. So I think the patterns in current winners/losers will have much more information than is usually the case.

Twitter

As I read them, the most recent SEC filings for Twitter say the company has been generating about $5 billion in yearly revenue, over 90% of which comes from advertisers. This generates about $1.5 billion in operating income.

Earlier this year, Elon Musk bought the company for $44 billion, or close to 30x current operating income. At first blush, and maybe for much longer than that, this seems to be a very iffy financial move, since it implies the expectation of red hot profits growth rather than the more pedestrian pace Twitter has set in most years.

To finance the purchase, Musk sold a chunk of his TSLA stock and tapped friends willing to chip in a few billion, raising about $30 billion thereby. He asked the big commercial/investment banks for the final $13 billion he needed to pay shareholders of Twitter, through loans they would make to Twitter would make the instant he took control.

TSLA

Press reports indicate the banks balked at first and offered Musk a margin loan instead, meaning borrowings secured by something like (my guess) $25 billion of his TSLA shares, about a third of what he owns.

The risks for Musk in this arrangement are obvious:

—he personally, not Twitter, would be responsible for repaying the loan, and for the interest expense;

–a margin call (that is, a demand for more collateral) triggered by a fall in the TSLA share price could develop into a really ugly situation–in the worst case, the banks could sell off the TSLA stock into the weakness and close out the loan;

–professional short-sellers might find this margin arrangement a tempting target to exploit by trying to trigger a chain reaction of margin calls by aggressively shorting TSLA;

–you might even imagine circumstances where GM or F would scoop up TSLA shares as they were being pummeled, and end up larger holders than Musk–and maybe even in control of TSLA.

I wonder if Musk took this “offer” as a personal insult or simply a ploy to make a subsequent offer look better than it was.

the banks

In any event, the banks ultimately made a firm commitment to a series of loans to Musk-owned Twitter totaling about $13 billion, with annual interest payments capped at something like $1.5 billion. Put a different way, interest on these loans would suck up all of Twitter’s operating income. And that’s assuming Musk wouldn’t give free rein to hate speech by white supremacists or anti-Semites, thereby driving away advertisers. Knowing that this last was what Musk seemed to be intending, it’s not hard to imagine a sharp drop in Twitter’s operating income that would leave it unable to make required interest payments. Hence, I think, the idea of a margin loan, with much more severe consequences for Musk, instead.

The banks, nevertheless, ended up committing to provide the $13 billion in loans. They apparently did not plan to keep the loans on their books, but instead to sell them on to (gullible, in my view) fixed-income portfolio/hedge fund managers, collecting fees for acting as a middleman.

Two things happened that threw a monkey wrench into the banks’ plans.

–for some strange reason, Musk quickly signed an ironclad contract to acquire Twitter for $44 billion basically “as is,” meaning Musk waived his right to do any checking into the accuracy of Twitter’s financials, its public statements, the quality of its products, its assets or how business was going–or anything else, for that matter, and

–Musk subsequently spent a considerable amount of time, without success, trying to wriggle out from the contract Twitter had artfully prepared and he had signed. During this time, interest rates rose considerably, making the interest payment cap look unattractive, even to yield-hungry bond fund managers.

The result is that in a world where fixed income investors will seemingly buy almost anything, the banks have been unable to find anyone willing to take the Twitter debt off their hands at a price they would accept.

other stuff

Twitter had just over $6 billion in cash at 6/30/22. Offsetting that, the change of control triggered the redemption of $3.6 billion in convertible debt and an offer to redeem $1.7 billion in straight debt. The company also had to settle outstanding employee stock and stock option grants. Let’s say that the net result was that the new Twitter started out with more or less no cash.

During the first half of 2022, R&D plus sales, general and admin expenses totaled $1.8 billion. Let’s assume that’s all salary, of which about a quarter ($459 million) was paid in stock. On a cash in – cash out basis, Twitter made about $1.2 billion in the first half. Were the company to pay employees completely with cash rather than including stock, its cash generation would have been about $740 million. Full-year cash generation would be just under $1.5 billion, all of which would presumably go toward interest payments on the bank debt.

A situation like this, where interest expense is devouring all the money operations are generating, is perilous. The best solution would be to grow revenue. But this takes time, and the Musk strategy of giving free rein to ate speech isn’t one that will necessarily draw more advertising …or more users. The alternative is to cut expenses. In this case, the latter means personnel expense. And the situation may be made more difficult if employees are unwilling to be paid through stock grants and want cash instead.

Musk seems to me to have clearly taken the cost-cutting path in a major way. Over the past couple of days, discussion of a possible bank margin loan has popped up again. This may simply be idle speculation. Were there any truth to the rumor, it would suggest Musk is having more difficulty generating revenue at Twitter than is generally undeerstood.