Special Purpose Acquisition Companies (SPACs) and speculative fever

SPAC is a new name for an old capital-raising form. The first instance I’m aware of is a mention in Extraordinary Popular Delusions and the Madness of Crowds, a famous 1841 book on the craziness that happens in financial markets at times of speculative fever. The author, Charles Mackay, cites an operator during the eighteenth-century South Sea Bubble in the UK. He writes:

“…the most absurd and preposterous of all, and which shewed, more completely than any other, the utter madness of the people, was one started by an unknown adventurer, entitled ‘A company for carrying on an undertaking of great advantage, but nobody to know what it is.’ Were the fact not stated by scores of credible witnesses, it would be impossible to believe that any person could have been duped by such a project.”

According to Mackay, the “adventurer” set up an office, issued shares and then disappeared.

I came across this form early in my investing career, when the vehicles were called blind pools. They’ve also been called blank check companies. My reaction was the same as Mackay’s. Now, as SPACs, the name is fancier but the idea is the same, as far as I can see. An entrepreneur offers to use his skills to make shareholders a lot of money by means not specified in the offering document. Unlike the case in 18th-century London, the adventurer doesn’t simply close up shop and disappear. My impression is that the entrepreneur mostly pays himself fees while he looks. I have no idea about the ultimate outcome from such blind pools, but the fact that promoters don’t seem to point to past glories suggests that results aren’t that great–for shareholders, at least.

The current reemergence of blank check offerings is important to me in only one sense. They appear at times when speculation is rampant. They serve as an unambiguous signal that government policy is too stimulative. In other words, they typically signal market tops.

In the present case, I’m not so sure. Even before the pandemic, Trump had somehow managed to get a vibrant US economy to grind to a halt. Now, a second tour de force, as Canada and the EU are opening up again–crediting this outcome to having followed the advice of US medical research–the coronavirus is spiking again here. Why? …because Trump pressuring state and local governments to ignore medical protocols. Sort of Trump’s Atlantic City debacle twice over, only a lot worse.

The upshot is that while I can imagine more economic stimulus from Washington, I can’t see the punch bowl being taken away any time soon.

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.

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.

 

 

 

 

 

 

my take on Disney (DIS)

Post the Fox Studios acquisition, DIS remains in three businesses:  broadcasting, theme parks and movies.  December 2019 quarterly operating income from the three (ex direct to consumer) was roughly $5 billion.  Of that, just under half came from theme parks, a third came from broadcasting and the rest from movies.

All three business lines have their warts:

–ESPN, the largest part of broadcasting, has long since lost its allure as a growth vehicle; ABC is breakeven-ish; I think there’s some scope for boosting results from Fox.  Pencil in slow/no growth

–theme parks are (were?) booming, but they’re a highly business cycle sensitive business.  We’ll see that, I think, in March- and June-quarter results.  so even though it’s Disney we should apply a discount multiple to these earnings

–movies are traditionally a low multiple business because of the irregularity of new releases and their typical hit-and-miss nature.  DIS has been exceptionally good for a long time under Bob Iger (it was pretty awful before him), but this is still inherently a low multiple enterprise.

 

This is the main reason the stock spent years bouncing around the $110 level with flattish $10 billion, $6 a share, in earnings.  In the era of human analysts, it wasn’t just the earnings that held the company back.  It was also knowledge of the slow demise of ESPN, the (in hindsight too conservative) sense that theme parks were nearing a cyclical peak, and the idea that the company’s incredible movie hot streak might come to an end.

Then there’s the streaming business, where–to pluck a number out of the air, DIS is spending 10% of its operating income to develop.

 

A couple of months ago no price seemed too high for Wall Street to pay for Disney+, with the stock peaking at $153.    If we say $25 of the rise was due to streaming, at the top the market was valuing Disney+ at $40 billion+, or roughly a quarter of the value of Netflix.

The stock has fallen by about 40% since.

Now, hang onto your hat:

If we assume that the implied value of Disney+ has fallen in tandem with NFLX, it’s now valued at $32 billion.  This gives a residual value for the rest of DIS of about $140 billion.

That would imply a multiple of 13x current earnings–or, alternatively, an assumed 20% decline in profits.  The decline would likely be mostly (I’m assuming entirely) in the parks and movie divisions, implying that area’s income would fall by somewhere around 30%.

So–in this way of looking at things, we are assuming substantial success for Disney+ and a decline in the most cyclical businesses of roughly half what the market is assuming for companies like Marriott.  It would be cheaper to create a “synthetic” DIS out of NFLX + MAR shares, although what would be missing would be the Disney brand.

My conclusion:  Mickey and Minnie aren’t screaming “Buy me.”