trying to rotate (iv)

If I were still working as a professional money manager, my thought process would be very clear. I’ve had very strong outperformance of the benchmark my customers measure my performance by. I’ve probably long since maxed out the bonus payments I’d receive for my work . Therefore, the most sensible course of action, based on the instructions and the incentives my employers have laid out for me, is to make my portfolio look much more like the index I’m measured by. I wouldn’t gain any more performance. But I wouldn’t lose any of the relative gains I’ve made already. In addition, if I generate too much good performance (yes, there is such a thing in the institutional world), clients may begin to think that I’m taking on too much risk.

I’m only working for myself, however, so I’m not going to do that.

Implicitly, I’m betting that the current economic situation–the pandemic and its aftereffects–will persist for a longer time than most other stock market participants expect. That’s ok with me, since I think that’s what’s going to happen.

I’m also finding it hard to imagine what ordinary life post-pandemic will look like.

In this regard, I’ve already written about the easy part–what’s not going to work. By underweighting the clunker sectors and making my portfolio look like the rest of the market, I stand to gain performance against my benchmark. This is not nothing. Over the 25+ years I’ve worked for others, this high-level portfolio layout has accounted for about half the outperformance I’ve achieved. Individual stock selection, which is much more time-consuming and all about detailed accounting statement analysis and projection, makes up the other half.

Conceptually, I’m trying to divide Consumer Discretionary stocks according to how interesting they might be as investments:

–direct beneficiaries of the pandemic whose appeal will likely endure, like food delivery services, online gaming, entertainment streaming, suburban real estate, outdoor dining, drive-throughs. Amazon, Microsoft. Peleton (?) Etsy (??)

–beneficiaries of the pandemic, but with limited appeal as/when life returns to normal. sellers of sports/ exercise equipment, like bicycles, kayaks, backyard swingsets…

–losers today with unclear potential for recovery. high-rise offices and apartment complexes, densely packed city areas, department stores, big malls, restaurant chains, supermarkets, movie theaters (?). hotels, cruise ships. Traditional value investors will live here

–already big companies that are adapting quickly to new circumstances. Target, Nike, dollar stores Walmart (?)

Feel free to share your ideas

trying to rotate (iii)

Well, it’s longer than two days. Sorry.

I’m really puzzled, though, about the current state of the stock market, and how to transition away from this year’s winners by broadening out into the Consumer Discretionary sector.

For one thing, I think the election matters a lot. We can see in detail from Trump’s leaked tax returns what everyone in New York already knew–that although he excelled at playing the role on TV of a stereotypical heartless businessman, he was a genuinely terrible real estate investor who lost his shirt during a raging bull market. He has brought this “talent” to bear as president: reducing real domestic economic growth to zero, damaging business relations with the rest of the world and refashioning the image of the US from the land of the free to a white supremacist police state (not a look to inspire purchases of US goods by foreign consumers (to me, this is an important reason LVMH wants to wriggle out of its commitment to buy Tiffany, which has a huge Asian business)). If Americans sign up for four more years of this, Consumer Discretionary will look a lot less attractive, particularly high-end goods and services.

(An aside: the financial press doesn’t see things this way. To some degree this may be a result of the Rupert Murdoch strategy of trading highly partisan media coverage in return for political favors. But for whatever reason, commentators seem stuck in a pre-Reagan world where Republicans represent big business and Democrats organized labor. Also, a key facet of Trump operations also seems to have escaped his supporters’ notice (ex farmers)–that invariably the people who believe in and trust him are the worst-hurt victims of his actions. think: his limo ride yesterday or his NJ golf club meet-and-greet with fundraisers, knowing he was infected.)

In an unclear situation like this, where the areas to overweight aren’t evident, the first step, I think, is to identify areas to avoid.

I divide the areas to avoid into three types: left-behinds from structural change, accelerated by Trump’s coronavirus mishandling, like department stores, autos, cable TV, fossil fuels, financials (because they do best when interest rates are rising)…; coronavirus victims, like restaurants (and their suppliers), high-rise urban real estate; and casualties of the loony-tunes way Trump is waging his trade wars, like farmers and farm equipment.

The second step is to look at what’s left and comb through that for positive ideas to invest in. More about this tomorrow.

trying to rotate

This is an elaboration of my last post.

I’ve looked into Nicola a little bit–emphasis on little–more. Founder Trevor Milton’s resignation from the company’s board isn’t exactly a confidence builder. Even more telling for me, however, is his that his endgame for Nicola is not to make money from building hydrogen-powered vehicles but rather by supplying them the hydrogen they will consume when running.

This model is a familiar one. Copier makers, for example, are willing to sell machines at a loss; their profits come from selling ink, paper and maintenance contracts . But it’s also a very tough way to make a living, and not the kind of thing investors are willing to pay an above-average earnings multiple to own.

The revelation that Nicola’s master plan is more or less to run a chain of gas stations–even were, say, convenience stores come with them–has landed with a thud. To my mind, bare-cupboard Nicola is a clear signal that the wild speculation accompanying anything labeled tech is over.

What comes next isn’t clear. What I’m thinking, so far:

–tech itself isn’t over. But the sizzle of being the next, newest, best thing ever probably won’t be enough to drive a stock higher from now on. I think the key distinction investors will begin to draw will be between firms that have a good chance to become successful stand-alone businesses (i.e., the winners) and ones where they’ll at best be a feature on someone else’s product (i.e., the losers). The market may well spend the next few months sorting the former from the latter. This would echo what happened after the Internet bubble burst in early 2000.

–but the market will also begin to look at non-tech sectors/companies in a more serious way. The big question is in what way.

More tomorrow

mutual funds and this September

NASDAQ is down by about 10% so far in September, the S&P is off by about half that. The Dow, a primitive measure that used to be a good yardstick for the health of smokestack America but is pretty pointless today, is down by somewhat less than the S&P.

Despite all the drama about the valuation extremes separating tech from heavy industry–drama I’ll confess I’ve found myself caught up in–this has been a normal September so far. That is to say, I don’t think the market decline is about anything other than the internal workings of the mutual fund industry.

Mutual funds are exempt from income tax on their profits. In return for this privilege, they are required to distribute virtually all dividend income and realized capital gains to shareholders, where they become taxable income to the owners.

For reasons I don’t really get, mutual fund shareholders like to receive distributions, provided they’re not too large. (An aside: I once turned over a small-cap fund I’d been running successfully for a few years to an office-politics virtuoso who had risen to a high position despite having a mental cupboard bare of any trace of equity investment skill. He bemoaned my maladroitness in, for example, holding a large position in QCOM (which rose 10x over the following two years), dumped out most of “my” stocks and remade the the entire portfolio in his own image. The result: in year one, he was down, by 7% (?), in an up market and had created taxable gains equal to about 35% of NAV. Investors were not happy in this case. Hard to believe, but this guy is still working in the business, which is part of the reason people don’t trust investment companies.)

Anyway, the tax year for funds ends in October. So managers tend to sell–both to create gains for distribution and to recognize offsetting losses–from early September through mid-October.

That’s what I think is going on now.

There are much bigger issues in play, unfortunately. But I don’t think Wall Street has yet begun to factor the election results (which I think will be crucially important) into stock prices. My reading is that today’s prices are saying things will pretty much go on as they have been over the past four years. I think that’s the least likely outcome.

How so?

As the Bloomberg news service points out, Trump has been “outthought and outplayed” at every turn by China. He has brought the US economy to a standstill; the country continues to be deeply wounded by his coronavirus bungling, while China is already well into recovery; foreign students, tourists, scientists (those who are not turned away at the border) no longer find the US attractive because of civil unrest caused by Trump’s white racism, plus the high risk of coronavirus infection; tariff wars have left the farm economy in a shambles; despite his rhetoric, the trade deficit with China is significantly larger today than when Trump took office; government debt is ballooning into dangerous territory; his brainstorm of denying US tech firms access to the world’s largest market for their products has given renewed energy to China’s domestic tech research. All in all, an economic train wreck. This is basically Trump’s business career, only writ large–the sole reason to believe he’s not more than a “useful idiot”.

His re-election would mean Americans are ok with becoming a white supremacist banana republic. Emigration of the best and the brightest–something I could never have dreamed of seeing–might surge, except that Trump’s coronavirus mess means other countries will hesitate to accept us.

A Biden victory would mean beginning the painful process of repairing the epic economic damage Trump has done. The “flight capital” market would probably be over (with GM-Nicola possibly being the new AOL-Time Warner). I’m not sure what would replace it, though, other than that air would likely start to come out of tech stocks. (“Concept” or early-stage stocks would be the the worst casualties, but their decline would tend to pull down stalwarts like MSFT along with them.

is the options-driven selloff over?

My guess is that it is.

what happened

Let’s say you buy an exchange-traded call option (which is the usual kind) on XYZ stock through your discount brokerage account. This means you’re entering into a contract, typically with a big brokerage house on the other side, that gives you the right–but not the obligation–to buy (typically 100 shares of) XYZ at a specified price at any point over, say, the next three months. You pay a premium that’s basically a function of the length of time the contract is in force.

The Options Clearing Corporation Corporation makes sure that both sides have the wherewithal to fulfill their side of the bargain–in this case, that the brokerage house is able to deliver the shares if you exercise the option.

The brokerage house typically hedges its exposure by buying either XYZ shares or options or some other derivative instrument but typically not at 100%. Maybe 30% instead. As/if the price of XYZ begins to rise as new options buyers emerge, the broker not only hedges the new exposure but also boosts the percentage coverage to, say, 50%.

If the first option purchase triggered buying 30 shares of XYZ as a hedge, the second triggers buying of 70. If the stock price continues to rise, new options purchases cause the broker to buy increasingly large amounts of the underlying stock. At the same time, the pool of willing sellers of the stock begins to dry up. If this process continues, the result is a melt-up in the stock price of XYZ.

why I think it’s over

Brokers have learned that failure to follow their coverage rules immediately–on the idea that tomorrow will bring a better opportunity than today–is a recipe for disaster. So, like it or not, they act right away.

Once brokers are 100% hedged, the pressure to buy more abates.

Certainly Softbank, if not other option buyers as well, are aware of this phenomenon. Softbank may well have none its gigantic options buy with the intention of forcing, and profiting from, the meltup that happened.

Softbank quickly learned that its shareholders don’t want the company to have stock market speculation as its main moneymaker. For their part, I imagine brokers will be more fully hedged with new options contracts for a while at least, making a new meltup less likely.

what to do now

After dramatic market moves, it’s always good to reassess portfolio structure to see what went well and what didn’t–and fix problems you may find.

Looking for the stocks that are recovering strongly vs. ones that are lagging behind or still falling will give us clues to where the market may be moving next.