time for market rotation?

market rotation

We all understand what the winning formula for the pandemic stock market looks like:  overweight NASDAQ, underweight the Russell 2000;  overweight secular growth stocks with worldwide sales, underweight US-centric business cycle sensitives.

At some point, however, at least one of two things happens:

–evidence starts to build that the worst of the pandemic-induced slump in economic activity is past us.  Companies start hiring again; credit card sales start to pick up; houses begin to be sold…   or,

–the valuation difference between safe havens and pandemic losers becomes so great that contrarians begin to sell the former to buy the latter.

In either case, the market rotates away from what has been successful so far into something else.

Two questions:  when and toward what.

On the valuation front, year to date NASDAQ is down by 3% (among heavyweights, MSFT is +12%), the Russell 2000 is -27%.  Yes, this is the trend we’ve seen through most of the economically toxic Trump administration.  But the magnitude is different.  This is a huge gap in a short amount of time.

Nevertheless, despite the fact I would really like to shift my holdings away from recent winners, price action isn’t giving me the slightest encouragement to do so.

For me, the “toward what” isn’t really clear either.  So it may be that professional investors will take the very unusual step of simply raising cash and waiting.

As for me, I’m staying on the sidelines with the same tech/cloud-heavy portfolio.


a third factor 

A cardinal rule for investment success during my 40+ year involvement with stocks has been to avoid worrying too much about politics.  Think calmly and objectively instead.  It’s becoming difficult to ignore the increasingly bizarre and worrisome actions of the Trump administration, though, which are also taking on more and more of a 1984 tone.

Lack of attention to education, retraining workers and aging infrastructure–failings of both major political parties–are bad enough.

But now there’s Trump’s doubling down on his worst-in-the-world response to COVID-19, which has so far cost the US more deaths than all our armed conflicts since WWII.  (According to the Financial Times, 90% of these deaths were preventable had Trump not continually asserted the pandemic was not real.)

Then there are his recent threats to bar Chinese students from US universities and to deny Chinese-made goods entry to the US–more signature shoot-yourself-in-the-foot moves.  Perhaps more important in a pragmatic sense, Trump threatens a lot but does nothing.  To me, this is the worst of all possible worlds because it exposes his underlying weakness.

Finally, as an Army veteran I’m particularly disturbed that Trump is destroying the career of the Navy captain who rescued his crew when he found his aircraft carrier a coronavirus hotspot.  At the same time he’s pardoned a convicted war criminal and is now trying to have charges dropped against former General Flynn, who confessed to lying to the FBI to conceal his work as an agent of the Russian government.  In other words, Duty, Honor, Country and the content of one’s character mean nothing.


A rant, yes.  But there is a point.  The Hitler vibe is certainly not a positive for potential buyers of US goods and services in foreign markets.  Nor are indifference to human life and race hatred a big draw for foreign investment or tourism here.













restricting portfolio investment in China

According to press reports, the Trump administration has ordered a government pension fund not to hold a non-US equity index fund, about 4% of whose value is Chinese stocks, on the grounds that the Chinese shares represent a national security threat.  Because the board of the fund has ignored this order in the past, Trump is asking Congress to remove a majority of its members and replace them with his loyalists.

If there is a conceptual argument for this action it is that buying shares in Chinese publicly-traded companies, albeit indirectly, potentially lowers the firms’ cost of capital, making it easier for them to expand–and that ultimately this expansion might be somehow bad for the US.  This is a real stretch.  As a practical matter, whether this fund owns the index the board figures is best for pensioners or one like it that excludes Chinese shares won’t make much difference, either to China or to the fund.  Why inject politics into the decision, then?

I see three possibilities:

Assuming Congress allows the change of board members, Trump can force the change he wants and has a talking point about taking action against China at a time when others are ignoring him.  Or, the idea may be to establish the principle that Trump can control the fund’s investment decisions.  Maybe then the fund would like to take over a hotel lease in Washington, or a golf club in Scotland, or pump money into an underground coal mine in West Virginia.  Or it could be this is a tiny first step in a plan toward barring all American investors from buying Chinese shares.  If this last, it would likely only result in Americans’ moving investment accounts to, say, Canada, losing Washington tax revenue.



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


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).







Disney (DIS), Berkshire Hathaway (BRK) and the discounting mechanism


This is Wall Street jargon for the investor process of factoring into today’s prices the effects of anticipated future events.

old school

Pre-2009, legions of experienced securities analysts and portfolio managers pored over company SEC filings and put that information together with their industry and business cycle knowledge to make reasoned projections of future company profits–and of possible stock performance if their guesses were right.

In bear markets, investors paid little attention to the future.  In bull markets, this is the time of year investors would begin to adjust their thinking not only for this year’s possible profit gains but next year’s as well.


in the AI world

I don’t know yet.  But I think this is a crucial thing to try to figure out.

recent data points

BRK had its annual investor event last Sunday.  When I entered the stock market in 1978, CEO Warren Buffett, professional investor and disciple of Benjamin Graham, was already an investing legend.  This was based on his earlier-than-everyone-else understanding of the value of intangible assets like brand names and distribution networks.  The last fifteen years or so have not been especially kind to Mr. Buffett, but he remains a legend nonetheless.  Anyway, at the meeting Buffett announced that BRK had sold its entire $6 billion stake in major domestic airlines.

Those stocks fell by about 10% on Monday.  Why did he sell?  My simple answer is that airlines need to sell an average of 70% of their available seats to break even on a financial reporting basis.  That’s impossible to achieve while social distancing protocols are in effect–and unlikely, I think, even when those are lifted.

But who didn’t know that before Sunday?  Monday’s price action indicates there certainly was someone.


DIS reported March-quarter results after the close yesterday.  Y-ear-to-date, DIS has underperformed the S&P, although wildly outperforming other leisure and entertainment companies (softer fall, more muted rebound).  This is partly, I think, (justified, in my view) admiration of the company’s transformation under CEO Bob Iger, partly the possibility that the DIS streaming service will be a success.  While investors haven’t been particularly positive, press coverage has been uniformly upbeat.

In yesterday’s conference call, the financial press”learned” that the company’s theme parks are closed, movie theaters are shut and ESPN is showing reruns of old spelling bees and writing about Korean baseball because there’s no live domestic sports.  the company also decided to halt the dividend for now.  Financial press coverage has turned sharply negative.

in early trading today, DIS is flattish.  It will be interesting to see how it finishes out the day.

serving more bleach: debt default

Two disturbing reports came out of Washington last week.  Both are linked to Donald Trump’s attempt to recast his failure in handling the coronavirus threat as being the result of a sinister plot by China to hurt the US.  I’m not sure that saying you’ve been tricked by China into ignoring world health officials is any better than just having ignored them, but…  Trump is, in his usual 1984 style, spewing disinformation and silencing civil servants who want to tell the truth.

As a human being, the key issue is the many thousands of Americans who have died because of his negligence.  From a near-term stock market point of view, though, what’s more important is the cover-up, being expressed in Trump’s desire to “punish” China for COVID-19.

Two actions are apparently being discussed by the White House.  Both are bad.  The second would be devastatingly so.  They are:

–placing new tariffs on goods imported from China, the main effect of which will be to negate some of the stimulus from Washington and slow economic growth

–defaulting on the national debt–specifically, ceasing either to pay interest on Treasury bonds held by China and/or to refusing to repay principal when Chinese bonds come due.

There has been no reaction so far in the Treasury bond market to leaks from the White House about the (to me) chilling prospect of possible default.  I presume this is because the market thinks no sane person would do something so financially damaging to the US …especially when the country needs to issue tons of new debt to finance the huge deficits the Trump administration is creating.  This, despite the fact that Trump did appear to favor a default strategy, as one he employed in his business dealings (btw, a reason no banks would lend him money), in statements he made during the 2016 election campaign.  

The most obvious consequence of default would be that borrowing costs would go up for the US. The dollar would probably decline. Default would also remove Treasuries from some (most?) clients’ list of permissible investments, putting more upward pressure on rates and downward pressure on the currency.  In theory, foreigners would be quicker to abandon the sovereign debt of a defaulting country than locals.  I’m not sure that would be true in this case.  In 1989, for example, a time of budget and trade deficits and an ineffective administration, domestic bond managers were the first to balk at buying Treasuries.


my bottom line:  It seems to me the trial balloons about default being floated by the White House are enough to have shifted the stock market away from the nascent “cyclical recovery” theme back to “flight capital.”

I’m reluctant to raise a large cash balance (hold in what currency?–probably not US$), which would be the right thing to do if I thought there were any chance Trump could carry out default plans.  But I can do some indirect things now. Dollar-denominated variable rate debt (i.e., bank debt instead of bonds) and business models where costs are in foreign currency and revenues in dollars would be toxic in a dollar default, so I’ll get rid of any I have.  I’ve been trimming tech positions recently and buying domestic recovery names.  I’ll stop that for now.  I should also have a list of what I would sell were Trump’s default idea to start to move forward.