This, one of the many old saws that spout from the mouths of professional investors and investment advisors, is about how to achieve stock market success. It’s also an observation about the behavior of US stocks as the economic cycle progresses.

The turn from bearish to bullish tends to take most investors by surprise. Because of this, the first evidence of a change in the current bad fortune tends to result in a tectonic rush to exit defensive positions (whose main virtue may be that they won’t go down much) and to acquire beaten-up cyclical growth names.

Historically, a disproportionately large part of the up that occurs in the new cycle will happen during a small number of very strong days during this transition. This all comes well in advance of confirming evidence in company quarterly earnings reports–and also well before investors–retail or professional–who have raised large amounts of cash or otherwise assumed a very defensive position can convince themselves to react.

Why do things happen this way? I’m not 100% sure.

–one part is certainly relative risk/reward. If defensive stocks are very pricy (so arguably they won’t go up a lot) and more economically sensitive names are really beaten down (and arguably can’t decline much more) it makes sense to take money out of the first group and put it into the second. As first movers act, the relative value relationships change and buyers who were waiting in the wings emerge

–another may be information, high- or low-quality, that radiates out from the world at large (we’re reopening/expanding) or work (we’re hiring/bonuses are back) or just about anywhere else

–for a mutual fund manager, a surge in inflows is typically a sign of at a top for fund performance; a rash of redemptions usually means the opposite

–a typical bear market lasts a year or so

I think we’re more or less in this situation now now.

What I see:

–measured by the S&P 500, the market has fallen about -28% from its high in December 2021 to what may be the ultimate lows this September. The decline in NASDAQ has been more like -35% over the same span. The S&P performance is in the range of a garden variety down market; NASDAQ is a bit worse. The clear, and unusually deep, losers in this market have come from a set of “concept” stocks like those held in ETFs like ARKK, which is off by 70% from its January 2021 high.

There have been three post-WWII bear markets deeper than this one has gotten so far:

—1972-74, which featured the collapse of the post-WWII financial order + the first oil shock + the bankruptcy of the UK; S&P lost 49%

—2007-09, the Great Financial Crisis, with massive fraud by bank employees threatening the solvency of global banking system, causing world trade to grind to a screeching halt, triggering widespread layoffs; S&P lost 57%; and

–the aftermath of the internet bubble in 2000; during which the S&P lost 49%.

The first two of these situations were, to my mind, clearly far worse economically than where we are now. The Internet Bubble comparison is harder to judge.

–what’s similar between IB and today:

—a high level of tech-related speculation, with subsequent market collapse;

—a 25% rise in the crude oil price from mid 1999 to end 2000.

–what’s different:

—– substantial fraud in internet stocks–Henry Blodget of Merrill Lynch, most heralded internet analyst of that time, censured and permanently barred from the securities industry for issuing fraudulent research touting internet stocks;

—–newly public startups begin to run out of money;

—–massive telecom overcapacity develops quickly, as many firms rushed to create fiber optic cable network systems rendered almost immediately uneconomic by duplication and technological advance (deep wave division multiplexing);

—–accounting scandals among major companies (Enron, Worldcom, Qwest, IBM, KMart, Bristol Myers Squibb, Lucent…);

—–Microsoft found guilty of anti-trust violations;

—–2000 introduction of the euro, causing recession in much of the EU;

—–continuing recession in Japan, at that time still a major world economy;

—–9/11/2001 attacks

Summarizing what I think is the essence of Twitter’s current financial situation:

The company has recently been growing revenues–from corporate advertising–at maybe 10% a year. It is generating cash at about a $1 billion yearly rate, mostly because the issuance of $1 billion worth of new shares to workers is a prime component of their compensation.

The Musk takeover has done two things: it has added something like another $1 billion yearly drain on cash, in the form of interest expense from the $13 billion borrowed to close the deal (insiders and the banks presumably know the exact terms; I don’t); and it has considerably reduced the attraction of stock grants as a form of compensation.

Four complementary approaches to fixing the resulting financial dilemma:

–cross fingers; hope and pray everything works out

–increase revenues

–lower costs, meaning total employee compensation

–restructure the debt.

Musk’s tweet about the Pelosi family suggests that keeping advertisers happy isn’t exactly top of mind for him. Press reports suggest least some advertisers have already cut back on their Twitter spending.

Over the first half of 2022, people-intensive operating spending amounted to about $1.8 billion, about a quarter of which was stock grants of some type. This is where Musk appears to have focused for now, with mass layoffs. Even if no advertisers had second thoughts about a Musk-led Twitter, my back of the envelope calculating says that replacing stock grants with money would have left TWTR without much cash, if any.

The banks who lent Musk the $13 billion in cash he needed to close the TWTR deal must have known this.

My mind keeps going back to a banking case I studied in business school. A consortium of international banks lent the government of New Zealand a bunch of money to develop an offshore oil and gas field. The term of the loan, as I recall it, was four years. But production from the field wouldn’t begin until year five. A problem? No.

The lending banks all understood that the loan would need to be renegotiated during year four, meaning another round of fees and higher interest rates. So the structure was a good thing for them. Assuming the NZ government wasn’t chock-full of dimwits, Wellington understood this, too. As it turns out, the only one mixed up about this loan was the professor who presented the case in class, who didn’t know the physical or monetary differences between oil and natural gas.

In the TWTR case, I read the company’s financials as saying that, absent revenue growth, compensation costs have got to be cut more or less in half–without any loss in company efficiency–for the banks to be comfortable they’ll get their money back with the current loan structure. My thought is that the loans are either secured by other assets of Musk’s or that restructuring is Plan B. There’s lots of talk in the financial press that the banks are trying to offload at least some of their exposure to distressed debt specialists. To my mind, this only makes sense if the lenders didn’t bother with any credit analysis before making the loan.

As I see it, securities analysis has an important qualitative aspect to it. The analyst basically makes up a story about a given company, based principally on a close reading of the SEC filings, plus research/media reports, life experience and trying the products or services the company in question provides. Then you test the story as time passes, as the company reports new information and as you continue to interact with what the company does.

This is the story I’ve made up about Elon Musk and Twitter:

Musk started the year owning about $150 billion worth of TSLA stock, plus options for perhaps an equal amount. He also controls private firms like SpaceX, Boring and Neuralink.

my story

Musk began to accumulate TWTR stock early in 2022. I presume this was initially to get enough influence so management would make operating changes he wanted. Apparently not satisfied with TWTR’s response, he made a hostile takeover bid at a very high price in April.

My imagining is that the offer was intended as muscle-flexing, and that Musk didn’t really want to own TWTR. Jack Dorsey called the bluff, however. For whatever reason (bella figura?), Musk couldn’t say “Just kidding!” and signed an ironclad contract to buy TWTR instead. After all, if all else failed, he may have thought, with stock in TSLA worth $150 million (plus options), he could easily get a margin loan to come up with the required $45 billion.

Then TSLA shares dropped by about 40%, and the light bulb went on that this wasn’t as risk-free a move as it had seemed a while before. But Musk couldn’t break the contract. So he cobbled together a number of equity partners plus $13 billion in bank financing to complete the deal.

TWTR financials

–the litigation settlement: There’s a $766 million provision in the 2021 financials for settlement of a lawsuit maintaining that in 2015 a prior CEO and CFO issued false guidance to shareholders to cover up a slowdown in company operations. Neither is with the company any longer, so this is a one-time cash flow statement issue

–operations

—revenues have been growing at about 10% annually–90% of this from advertising–from 2018-20, before rising by about 20% last year and flattening in 2022. A reasonable guess is that full-year 2022 revenues will end up around $5 billion, implying $4.5 billion from ads.

–the income statement shows spotty results. This is mostly due, as I see it, to increases in R&D and sales and marketing expense. If we look at the cash flow statement, though, a large part of those expenses are issuance of stock to employees. Looking only at cash in and cash out, the company seems to be generating about $1 billion per year in cash

—net new debt. TWTR added slightly over $1 billion in net new long-term debt during the first half of 2022. This implies that the previous management was unable to fund operational needs internally.

–post-acquisition

I’ve read that the amount of bank debt TWTR has assumed in the change of control is about $13 billion and that the banks providing this have agreed to interest payments capped at 7.5% of principal. Maybe so, maybe not. If both are true, however (and if they’re not, my guess is that the figures are too low), this would imply about $1 billion in extra yearly interest expense. There may be income tax savings from this extra expense, if TWTR can generate taxable income. If not, paying interest will soak up just about all the cash the company generates. A potential mess, particularly if there’s any decline in cash generation!

my take

Musk’s advertiser-alienating, in-bad-taste Pelosi tweet suggests to me that he had given very little thought to TWTR–and the lack of any headroom between revenue and expenses–before taking control.

Arguably, his best (only?) revenue growth option is to begin to charge subscription fees. It’s not clear to me whether Musk believes that TWTR has gone ex-growth with advertiser revenue or just that subscriptions are a faster route to added revenue inflow

Even though it’s not clear that reducing staff is a good thing, the huge increase in interest expense generated by the takeover–and, at the same time, the reduced attraction of stock in a private company–imply that it can’t be avoided.

I’ve been fascinated by Elon Musk’s acquisition of Twitter. My overall sense is that it was worth the acquisition price to avoid having to confess that he didn’t 100% mean everything he said early in the process of coming to own it. That’s a different post.

Musk’s more memorable early tweets as owner included the suggestion that the attack on Nancy Pelosi’s husband might just be a case of rough gay sex gone bad, and advice that voters cast their ballots for Republicans, on the idea that legislative gridlock is the optimal political situation.

Paul Krugman picked up on this last, in a NY Times opinion column. It’s worth reading.

His main point is that Musk is wrong in adhering to the commonly held view that legislative gridlock is the best outcome for the US economy.

How so? The central government has two policy tools to control overall economic growth: monetary policy (raising or lowering interest rates) and fiscal policy (public spending). During high growth periods, like the US experienced between 1980-2005 as the application of information technology spurred productivity growth, interest rates tend to be high, in order to stop the economy from overheating. Therefore, both raising and lowering rates is possible. That’s enough by itself to keep the economy chugging along. As secular IT benefits began to wane, and as rates dropped toward zero, monetary policy lost its power to stimulate growth. The only tool left was fiscal policy. But during the financial crisis of 2008-09, Republicans in Congress would only authorize about a quarter of the spending needed for the economy to recover. Hence, it took seven years for GDP to recover to pre-crisis levels.

So, Krugman concludes, we have a very recent instance where gridlock was a really bad way to deal with a crisis.

I can understand why Krugman didn’t elaborate any further. The situation back then had a lot of moving parts. And he’d made his case.

I’d like to add two things, though:

–Biden ignored his advisors in 2020 and crafted a pandemic slowdown-fighting fiscal package that turned out to be much too large. My guess is that he thought that too large was a risk but too small was a tragedy. He probably also thought that once the the crisis had peaked, Republicans would block any further spending, so he had to get the money for everything at once. I’m not a big Biden fan, but I think he did the right thing. Where he’s been wrong, in my opinion, is in not saying to the American people that he made a mistake and explaining his reasoning.

–the Republican stance doesn’t come out of nowhere. It arises instead from the neoliberal thinking (a reaction to the perceived excesses of the post-Great Depression welfare state) championed at the University of Chicago in the 1970s. The basic idea is that services the government provides can be performed better and more cheaply by the private sector. The most radical conclusion to this train of thought is that there’s no such thing as a public good.

The best/only way to achieve the efficiencies that come from a shift to the private sector is to take away from the government the money it has available through taxes and borrowing to fund its activities.

Among the unfortunate results of this philosophy have been public infrastructure in the US that visitors find reminiscent of the Third World, and increasingly mediocre public schools.

the employment report

This morning the Labor Department released its monthly Employment Situation report. The Establishment survey, which is the one Wall Street watches, came in at +261,000 vs. economists’ estimates of +195,000. Financial press commentators went on at length about the “bad” news that the economy continues to run too hot, apparently unaware that the 90% confidence interval for this survey is +/- 120,000 jobs.

Put another way, the report says that chances are good that the economy gained between +140,000 jobs and +320,000. That’s out of a workforce of 160 million+, and something like 3.5 million workers leaving jobs–and about the same number starting new jobs–each month. So the spread between job gainers and job losers came in something like 1.7% wider than the average economist’s guess.

And the unemployment rate went up.

Hard to see what the fuss is about.

treasury bonds

The Treasury yield curve looks something like this:

1-month 2-year 10-year 30-year

Oct 24 3.57% 4.50% 4.25% 4.40%

today 3.75% 4.71% 4.14% 4.18%

So the Fed raised the Fed Funds rate to 3.75% – 4.00%. The yield on the most cash-like Treasuries went up, as one would expect. On the other hand, the yield on the longer-dated issues went down.

Yes, the 24th was a local high point for longer-dated bonds. And, yes, I don’t know much about bonds. Still, the 75bp increase in the FFR doesn’t seem to have moved the long bond. I take this as a positive sign for stocks. Not a bet-the-farm good thing, but a positive.

stock market tone

The US stock market peaked last December 1st. The S&P is down by about a quarter since then, NASDAQ down a third. The Russell 2000, which is tied much more closely to the US economy than the other two indices, peaked five months earlier than the S&P and NASDAQ, and has lost since then about the same as the S&P has.

In a plain-vanilla market downturn, the time that has passed since the top and the depth of the subsequent market decline both suggest to me that it makes more sense to begin to look for signs that the worst is over and to figure how to benefit from this, rather than to concentrate on defending against further declines.

To be clear, I think that making one’s guess about the overall direction of the market to be a, or the, key feature of investment strategy is always a bad idea–and now in particular, when the economic situation, both world and US, is, I think, unusually complicated. Add to that the revival of 19th-century violence-prone right-wing know-nothing extremism in the MAGA movement, which is scarcely an inducement to invest in the domestic economy.

Still, I’ve been noticing that, in what’s very volatile daily trading in individual stocks, some beaten down issues are responding in a strongly positive way to good earnings news. The ones I’m noticing tend to have been crushed over the past year. So they now look reasonable on an asset value basis and are reporting positive earnings surprises. SQ and HOOD are two recent examples. My sense is that neither asset value nor earnings strength would have registered with Wall Street six months ago. Yes, these are special situation stocks. On the other hand, they indicate that bullish sentiment isn’t as completely dead as it was even a month or two ago.