concept vs. valuation, sort of

I’ve been staring out my window for the last 15 minutes or so, trying to think of a pithy way to put this. No success, so I’m writing this instead:

In the first half of the last century, Saudi Arabia’s economy was supported by taxes on Muslims making the pilgrimage to Mecca. That source of income dried up during the Depression and WWII. So Riyadh opened itself to development of what turned out to be gigantic oil reserves by the major Western petroleum companies in return for a (very small) cut of the resulting revenue.

So, a temporary dearth of worshippers triggered a mammoth, decades-long, worldwide change in the way energy is used in transport and heating, and in the materials out of which everyday objects are fashioned.

I think the pandemic has the potential to be the same kind of transformative event, implying the potential for very high rewards for investors who figure out the twists and turns this story may take as it continues to develop. I don’t think this is a “today” story for the stock market, because the exit from global crisis mode will certainly entail a rise in interest rates. This means equities will no longer be the only game in town, in the way they have been over the past 18 months or so. Another way of putting this is that concept will only get you so far.

…which brings me to what I started out to write about.

My favorite description of the stock market is that it is the arena in which the hopes and fears of investors meet the objective characteristics of publicly-traded companies and express themselves through stock prices. Two criteria: concept (sort of an elevator speech about where a company is going), and valuation (the price of the stock, relative to its expected future).

During the pandemic, my perception is that almost no one has cared about valuation. Everything has been concept. Over the past few weeks, however, I think this has begun to change. Former high-flying stocks of companies that have reported below-consensus earnings–or provided below-consensus guidance for future earnings–are starting to decline on the news. I think this is an important change of tone, away from the all-offense, no-defense mentality that had dominated 2020-21 trading until now.

I think this is a positive sign, since I interpret it as part of a more general return of the world economies to normal operation. At the same time, the price of making a mistake will be much higher than it has been to date.

the usual September stock market selloff this year?

I got an email last week from my brother-in-law, an experienced stock market investor, asking whether I thought we’d have the typical equity mutual fund/ETF September-October selloff in 2021.

I didn’t have a good answer then, and I don’t have a good one now.

On the “selloff” part, one could easily interpret the current market weakness as the start of the annual seasonal decline. Even if that’s not right, I don’t see any reason to doubt that the tax and dividend planning that typically produce weakness during September-October will occur.

On the other hand, I hadn’t realized until I consulted Investment Company Institute data the staggering level of net equity mutual fund redemptions that occurred during the Trump administration. They total $1.4 trillion+, or 7x the withdrawals during the financial crisis of 2008-09. They’re 3.5x the cumulative outflows during the eight Obama years, which seem to me to be mostly financial crisis-related. This suggests to me there’s still a lot of money on the sidelines. (Yes, some Trump-era withdrawals may have gone into ETFs, but total stock ETF issuance is only running at about $150 billion/year.)

So selling, yes. But will sideline money come in to absorb at least part of this? No clue.

Another point: during the latter half of Trump’s term, as the magnitude of his economic incompetence became more evident, the equity market rotated strongly away from companies whose earnings derive from the domestic economy to those with substantial operations outside the US. As the administration wilted in the face of the pandemic, rotation extended to stay-at-home beneficiaries.

Early this year, my sense is that the market began to rotate again, away from stay-at-home and international names toward domestic economically sensitives. This was primarily a valuation judgment, I think, meaning that the motivation came (as it usually does) ahead of a turn in the economic fundamentals and was based on the perception that very good thing that could possibly happen was already priced into the 2020 winners and every plausible bad thing into domestic cyclicals.

Then the delta variant emerged, adding three-plus World Trade Centers-worth of Americans to the dead each week to a total now approaching 700,000 fatalities. Oddly enough, the oath-brothers to the fallen heroes honored at the WTC, first responders who gave their lives so others could live, appear to be major opponents of life-saving vaccinations–choosing to avoid the “risk” of vaccination, but thereby causing others to die. Nevertheless, at some point the market will begin to argue that the worst is already in prices and will restart the rotation toward cyclicals.

Why go on about this? I think it’s curious. More important, after a sharp decline new leadership typically emerges. Because of this, if there is a September-October downward move for stocks, it may well mark the finale for stay-at-home and a resurgence for domestic cyclicals. In any event, it will likely be important to identify both leading and lagging groups–on the way down and on the way up.

So this may be an unusually information-rich selloff, if it happens.

buy now, pay later

Two recent transactions show, I think, that buy now, pay later has arrived as a mainstream purchase/payment option. They are: Square’s proposed acquisition of Afterpay for $29 billion and Amazon’s just-announced partnership with Affirm.

what it was

When I was growing up, we shopped at a local grocery store just up the street. The grocer, Mr. O’Dowd, kept a record of our purchases in a school notebook. When my father got paid, we settled the bill.

Layaway plans, a Great Depression-era device, have had a revival during the Great Recession. In its simplest form, a merchant “lays away” in a storeroom an item that a customer pays for in installments. Once the final payment is made, the merchant retrieves the item and turns it over to the customer.

Key features: no interest payments (at least no explicit interest component in the payments); and, in the layaway case, the customer is assured of its availability but gets the merchandise only after paying in full.

what it is now

It’s either an app the buyer has or a purchase option at online checkout. No interest payments, small amounts of credit, installment payments for a purchase over a month or so, limited if any credit check in advance. There’s also the possibility of an increased credit limit based on on-time payment history. The biggest difference, however, is that the user gets the merchandise right away.

how do BNPL providers make money?

They charge a fee, usually higher than a credit card issuer would, to merchants. Again like credit card companies, they charge late fees. Customer payment history gives BNPL firms an edge in deciding the risk in offering customers longer-term interest-bearing loans.

Merchants sell stuff they otherwise wouldn’t. Apparently return rates are lower, too, for BNPL customers.

the market

BNPL appeals to Millennials and younger, maybe because it’s (for them) new, maybe because of scars from the recession. Something like one in six Americans operates outside the traditional banking system, so BNPL can be a way to get credit services cheaply, as well as develop a credit history that will make traditional credit more accessible.

The big question for me is how dependent BNPL firms are on the current zero interest rate environment. Are they really an innovative disintermediation of traditional credit services or will they wilt away if the cost to them of the short-term loans they make begins to rise above zero.

My guess is that the industry will have more wiggle room than I fear as/when rates begin to rise. Also, this is not a near-term problem.

Cathie Wood on China

I listened to a Bloomberg interview last week in which Cathie Wood, founder of the ARK fund complex, gave her take on the ongoing Chinese crackdown on capitalist tendencies in that country. Measures have ranged from repudiating its agreement with the UK, half way through its term, to grant Hong Kong fifty years as a Special Administrative Region, free from direct political control by the mainland, to punitive measures taken against ultra-wealthy Chinese tech entrepreneurs and their companies.

The latter group were of particular focus, given Woods’ very recent decision to eliminate her holdings of mainland stocks, like Alibaba and Tencent, whose owners had run afoul of Beijing. Her new strategy is, unsurprisingly, to pick through the Chinese stock market carnage to find firms whose clear domestic social purpose will likely insulate them from Premier Xi’s wrath.

The way Wood chose her words suggests she was relatively late in figuring out what was going on. But that’s not what bothered me.

Wood went out of her way in the interview to suggest that the trigger for Xi’s actions was the inauguration of President Biden. This despite the fact that his repudiation of the joint UK-China handover agreement came in early 2019. Also, Jack Ma’s threat to use Ant Financial to radically undermine the Chinese banking system–and his subsequent disappearance–came during the Trump administration. His reappearance came at the beginning of Biden’s.

She also observed that Chinese citizens were tending to leave the US to return to China, suggesting a period of disengagement with the rest of the globe. Her explanation? …our Third-World infrastructure.

Yes, the US has neglected communications and transport infrastructure for decades, and, yes, my Chinese acquaintances remark it’s much easier to do US business from, say, Taiwan. But Wood made no mention of other important causes: the health threat posed in the US by the bungled covid response or Trump’s anti-Chinese rhetoric that spawned a wave of anti-Asian violence, and the Stop Asian Hate movement; and the budding tech war begun by Trump’s attack on Huawei, which has reignited Beijing’s interest in creating its own chip domestic manufacturing capabilities.

To my mind, the white racism and the inject-yourself-with-bleach covid advice are deeply wrong. It’s possible, though, that no matter how ill thought out the Trump initiative, the denial of US intellectual property to China will do some good. My suspicion is that a lot depends on how strong the domestic anti-science movement remains and how long we continue to starve our schools.

When will it be safe to invest in China? …during the next Republican administration, when China will fear the US again.

my take

I have two thoughts about the interview I mention above:

–the view that the Trump presidency has somehow been a good thing for the US economically and that the rest of the world recognizes this is, I think, both deeply mistaken and an opinion held by a significant minority of Americans.

I remember Wood justifying her personal support for Trump on one occasion by saying she approved of his economics (as opposed to the rest of him), which I see as like my high school German teacher opining that Hitler wasn’t so bad because he gave Germany the Volkswagen. As long as this misapprehension (again, my view) doesn’t seep into the portfolio, it’s not a performance problem per se.

–there’s also a typically American view that American culture is the goal toward which every other country is, consciously or not, striving. Think: the Noam Chomsky view that English is the Ur-language, from which all others stem; or the neoconservative view that in the body of everyone in the Middle East there beats the heart of a Republican waiting to be freed by our invading troops.

Countries of all stripes share this kind of idea, except, of course, that their ideal is not American culture but the German, French, British, Japanese, Chinese…one, depending on where you are.

Thirty+ years of investing in markets outside the US have reinforced for me again and again that it’s a ground-level investing mistake to assume one’s own cultural values hold for any other country. Almost as bad is assuming that the stock market in a foreign country runs according to the same principles that the home country’s does.

To my mind, Wood not realizing this is an indication of her relative lack of portfolio management experience. How worried am I about this? Not enough to sell any of the significant (for me) amount of ARK EFT shares I own, but enough not to add to my ARK positions other than ARKF and ARKG.