what might cause a dollar swoon

government saving/spending–in theory

In theory, governments spend more than they take in to ease the pain and speed recovery during bad economic times. They spend less than they take in during booms to moderate growth and repay borrowings made during recession.

what really happens

In practice, this occurs less than one might hope. Even so, the Trump administration is one for the books. Despite coming into office after seven growth years in a row, Trump endorsed an immediate new dose of government stimulus–a bill that cut personal income tax for his ultra-wealthy backers and reduced the corporate tax rate from nosebleed levels to around the world average. While the latter was necessary to prevent US companies from reincorporating elsewhere, elimination of pork barrel tax breaks for favored industries that would have balanced the books was conspicuously absent.

The country suddenly sprouted a $1 trillion budget deficit at a time when that’s the last thing we needed.

Then came the coronavirus, Trump’s deer-in-the-headlights response and his continual exhortations to his followers to ignore healthcare protocols belatedly put in place have produced a worst-in-the-world outcome for the US. Huge economic damage and tens of thousands of unnecessary deaths. Vintage Trump. National income (and tax revenue to federal and state governments) is way down. And Washington has spent $2 trillion+ on fiscal stimulus, with doubtless more to come.

To make up a number, let’s say we end 2020 with $27 trillion in government debt (we cracked above $26 billion yesterday). That would be about 125% of GDP, up where a dubious credit like Italy has typically been. It would take 7.7 years worth of government cash flow to repay our federal debt completely. These are ugly numbers, especially in the 11th year of economic expansion.

At some point, potential buyers of government bonds will begin to question whether/when/how they’ll get their money, or their clients’ money, back. In academic theory, foreigners work this out faster than locals. In my experience with US financial markets, Wall Street is the first to head for the door. The result of buyers’ worry would be that the Treasury would need to offer higher interest rates to issue all the debt it will want. To the degree that the government has been borrowing short-term (to minimize its interest outlay) the deficit problem quickly becomes worse. Three solutions: raise taxes, cut services, find some way of not repaying borrowings.

not repaying

Historically, the path of least resistance for governments is to attempt the last of these. The standard route is to create inflation by running an excessively loose monetary policy. Gold bugs like to call this “debasing the currency.” The idea is that if prices are rising by, say, 5% annually and the stock of outstanding debt has been borrowed at 2%, holders will experience a 3% annual loss in the purchasing power of their bond principal.

The beauty of this solution in politicians’ eyes is the ability it gives them to blame someone else for what they are doing.

The downside is that international banks and professional investors will recognize this ploy and sell their holdings, creating a potentially large local currency decline.

The issue with the devaluation solution in today’s world is that sovereign debtors have been trying for at least the past decade to create local inflation–without success.

This would leave either tax increases or default as options. The slightest inkling of either would trigger large-scale flight from the country/currency, I think. Again, Wall Street would likely be the first. Holders of local currency would assume third-world-style capital controls would soon be put in place to stop this movement, adding to their flight impulse.

The most likely signal for capital flight to shift into high gear, in my view, would be Trump’s reelection.

where to from here?

signs of excess

The US is now awash in money being pumped into it by the federal government, both through Federal Reserve buying bonds and offering overnight money to banks basically for free and Congress sending out trillions of dollars in stimulus money. Why? …to combat the enormous and unnecessary damage done to the economy by the pandemic (not by the virus itself but by Trump’s bizarre implosion under pressure–calling the pandemic a hoax, urging citizens to ignore medical advice, fomenting race conflict to cover up his failure).

For the stock market, most of this is in the near-term rear view mirror. There are clear signs that there’s no shortage of cash in circulation. Barstool Sports’ shift from sports betting to day trading stocks is one. The increasing popularity of Robinhood–and the response of traditional discounters in offering trading in fractional shares is another. The weird resurrection of the stocks of bankrupt companies like Hertz (I can’t think of an instance where common shareholders have ever come out of a Chapter 11 proceeding with anything at all).

it’s all about the money (supply)

Yes, these are serious warning. But healing at least some of the damage Trump has done during his time in office takes priority for now, as I see it. And until there’s a change in government policy to “take away the punch bowl,” stocks will likely continue to hold up relatively well. This was certainly the case during the gigantic bull market in Japan during the 1980s as well as in the runup in the US stock market during the Y2K/Internet bubble of 1999.

my biggest question marks today

–is the market rotation toward domestic economy-centric stocks that began in late March over? My guess is not yet.

The winning strategy for Wall Street since the positive effect of the 2017 corporate income tax cut began to wear off in early 2018 has been to hold the US-traded stocks that have the least to do with the domestic economy. From late March to late April, these laggards, as measured by the Russell 2000, began to keep pace with the broader market. For the past 6 weeks or so, thanks (I think) to Washington stimulus, they have been outperforming. A counter-trend rally, which is what I think this is, typically lasts about two months. I regard the start as the end of April, not the end of March. So even though price movement can be read as the R2000 rally being over, my guess is that it still has some weeks to run.

–will Trump be reelected? Former Wall Street economist, Stephen Roach, now teaching at Yale, is the first public figure to be talking about my Mexico-1980s analogy as a possible future for the US. He does so in a Bloomberg article that reads in part:

“Look no further than the Trump administration. Protectionist trade policies, withdrawal from the architectural pillars of globalization such as the Paris Agreement on Climate, Trans-Pacific Partnership, World Health Organization and traditional Atlantic alliances, gross mismanagement of Covid-19 response, together with wrenching social turmoil not seen since the late 1960s, are all painfully visible manifestations of America’s sharply diminished global leadership.”

He thinks a fall in the dollar of about a third is possible.

Although Roach doesn’t put it this way, a very big question to be answered in November is whether the US doubles down on the Trump anti-growth, anti-science, white supremacist agenda or tries to start to repair the damage done to date.

A final point: Mexico in the 1980s was a horrible place economically, where the currency lost 90+% of its value. But because the government did not permit citizens to move assets abroad the stock market there was the best-performing in the world over that period.

more tomorrow

it’s mostly about interest rates

There are three big categories of liquid investments: stocks, bonds and cash. Typically, the progression for individuals as they begin to save is: cash first, then bonds, then stocks.

There’s also an age-related progression, generally from riskier stocks to the steadier returns of government bonds. The old-fashioned formulation is that your age in years is the percentage of savings that should be in bonds, the remainder in stocks. A 30-year old, for example, would have 70% of savings in stocks, the rest in fixed income.

A strong tailwind has been aiding bond returns in the US since the early 1980s, since after the Fed raised short-term interest rates to 20%+ to choke off an inflation spiral spawned by too-loose money policy during the Seventies. The financial collapse of 2008 required another huge dose of money policy stimulus. Recently, Trump has been badgering the Federal Reserve to push short rates below zero to cover up the damage he has done to the domestic economy since being elected, in addition to the big hole he punched in the bottom of the boat this year by his pandemic denial.

No matter how we got here, however, and no matter how bad the negative long-term consequences of Trump’s bungling, the main thing to deal with, here and now, is that one-month T-bills yield 0.13%. 10-year notes yield 0.91%. That’s because during times of stress investors almost always shrink their horizons very substantially. They’re no longer interested in what may happen next year. They just want to get through today.

My sense is that we’re bouncing along the bottom for both short and long rates–and that we’re going to stay this way for a long time. If so, not only is income from Treasures of all maturities substantially below the 1.9% yield on stocks, a rise in interest rates toward a more normal 3% will result in a loss for today’s holders of any fixed income other than cash.

So for now at least, for investors it’s all stocks, all day long.

Looked at this another traditional way, the inverse of the yield on the long Treasury should be the PE on the stock market. If we take the 10-year as the benchmark, the PE on the stock market should be 111; if we take the 30-year (at 1.68%), the PE should be 59.5.

We have to go back to the gigantic bubble of 1980s Japan to see anything similar. If the comparison is valid, then bonds are already in full bubble mode; stocks are halfway there.

the current market: apps vs. features

sizing up the market

In some ways, current trading in tech stocks reminds me of the internet boom of 1999.  To be clear, I don’t think we are at anything near the crazy valuation levels we reached back twenty+ years ago.  On the other hand, I’m not willing to believe we’ll reach last-century crazy, mostly because nothing in the stock market is ever exactly the same.

On the (sort-of) plus side, three-month Treasury bills back then were just below to 5% vs. 1.5% today and 10-year Treasury notes were 4.7% vs 1.9% now.  If we were to assume that the note yield and the earnings yield on stocks should be roughly equivalent (old school would have been the 30-year bond), the current PE supported by Treasuries is 50+, the 1999 equivalent was 21 or so.   This is another way of saying that today’s market is being buoyed far more than in 1999 by accomodative government policy.

On the other, the economic policy goal of the Trump administration, wittingly or not, seems to be to follow ever further down the trail blazed by Japan during the lost decades starting in the 1990s.  So the post-pandemic future is not as cheery as the turn of the century was.

what to do

I think valuations are high–not nosebleed high, but high.  I also know I’m bad at figuring out what’s too high.  I started edging into cyclicals a few weeks ago but have slowed down my pace because I’m now thinking that cyclicals might get weaker before they get stronger (I bought more MAR yesterday, though).

With that shift on the back burner, what else can I do to make my portfolio better?

features vs. apps

Another thing that’s also very reminiscent of 1999 is today’s proliferation of early-stage loss-making companies, particularly in software.

The 1999 favorites were online retailers (e.g., Cyberian Outpost, Pets.com, eToys) and internet infrastructure (Global Crossing) whose eventual nemesis, dense wave division multiplexing, was also a darling.

The software losers were by and large undone, I think, not because the ideas were so bad but because they weren’t important enough to be stand-alone businesses.  They were perfectly fine as features of someone else’s app.  A number were eventually bought for half-nothing after the mania ended, to become a part of larger entities.

 

One 2020 stock that comes to mind here is Zoom (ZOOM), a name I held for a while but have sold.  The video conferencing product is inexpensive and it’s easy to use.  It’s also now on center stage.  But there are plenty of alternatives that can be polished up and then offered for free by, say, Google or Microsoft.

 

Another group is makers of meat substitutes (I bought a tiny amount of Beyond Meat on  impulse after reading about 19th-century working conditions in meatpacking plants).  Same issue here, though.  Where’s the distribution?  Will BYND end up as a supplier, say, to McDonalds?  …in which case the PE multiple will be very low.  Or will it be able to develop a brand presence that separates it from other meat substitutes and allows it to price at a premium?  Who knows?  My reading is that the market is voting for the latter, although I think chances are greater for the former outcome  …which is why I’m in the process of selling.

 

 

 

 

 

 

return on equity vs. return on capital: why this matters today more than usual

ROC vs. ROE

Let’s pretend we live in a world without taxes, just to make things simpler.

Year 1:  A start-up company raises $1,000,000 by issuing stock.  It uses the money to create a business that earns income of $100,000 a year.  Its return on equity = return on capital = 10%.  The firm reinvests all income into the business.

This is a pretty ho-hum business, returning 10% from operations.

Year 2:  Management then raises debt capital to supplement its equity by borrowing $900,000 from a bank at 5% interest.  It uses the extra funds to expand aggressively.

Let’s say it gets the same return as with its initial capital  Using the loan + retained profits from Year 1, it doubles the size of its business.  It earns $200,000 in income from operations  in Year 2 -$45,000 in interest expense = $155,000.

Its return on its total capital of $2 million, after deducting interest expense from operating income, drops, to 7.8%

Its return on equity of $1.1 million, however, rises,  to 14.1%.

The now financially-leveraged company posts 55% earnings growth, not 10%, and sports an above-average return on equity.

To the casual observer it now looks like a dynamo.   …but the transformation is all due to financial leverage.

Year 3:  Including income reinvested back into the business, the company now has $2,155,000 in capital, $1,255,000 of that in equity and $900,000 in debt.  It borrows another $900,000 on the same terms from its bank and puts that into the business.

The $3.055 million generates $305,500 in income from operations.  Interest on $1,800,000   @ 5% is $90,000.  Doing the subtraction, net earnings = $215,500.

Earnings growth is 39%+.  Return on equity is now 16%+.      Again, the difference between being the sleepy 10% grower and an apparent home run hitter is entirely due to management’s financial engineering.

 

What’s wrong with this picture?    In a bull market, nothing.  But the company has exposed itself to two financial risks if business slows.  Can it generate enough cash to pay the $90,000 in interest expense, which amounts to four months’ profits in good times but maybe ten months’ in bad?  Can the bank call part–or all–of the loan?  If so, how does our company get the money, which is the equivalent of nine years’ earnings?

 

stock buybacks:  more financial engineering

A second issue:  suppose the company employs another form of financial engineering and uses the money it borrows at the beginning of Year 3 to buy back stock rather than reinvest in the business.

Why do this?

…it doesn’t improve overall earnings, but boosts earnings per share.  Although framed in press releases as a “return” to shareholders, this also–one of my pet peeves–disguises/offsets the dilution of you and me as shareholders through the stock options management issues to itself.  (I’m not against stock options per se; I’m against the disguise.)  In this case, earnings are $215,500 before interest expense of $90,000.  Interest expense amounts to five months’ profits.  The loan principal is equal to 18 years’ earnings.

 

how/why does financial engineering like this happen?

When there’s lots of extra money sloshing around in the system, banks, the fixed income markets and companies do crazy things.  This was a potential worry several years ago.  Unfortunately, lacking understanding of how the economy or the financial system works, the Trump administration has made the problem worse through the tax and money policies it has pursued.  Instead of taking away the punch bowl, Trump has spiked it a lot more.

 

my take

For us as investors, the point of this post is to distinguish between companies that show high returns on equity because of the earning power of the company business (high returns on capital; these are keepers) from those where financial engineering is the main reason returns on equity are high (low returns on capital; riskier than they seem at first glance and likely to perform poorly in wobbly markets).