A historic time to sell

With stocks near all-time-highs, there is steadily accumulating evidence that this may be a historic time to sell.

PMIs are diving.

PMIs give false signals (eg 2016 was a buy, not a sell) but this is the worst they have looked in a long time. All through the turmoil of last year, and indeed previous scares over the past decade, US PMIs held up. Now they are cracking, with services and manufacturing leading the way.


2. Trade has fallen off a cliff, and this was before the most recent trade escalation with China and now Mexico.

3. Managers remain extended.

Some surveys show increasing bearishness amongst money managers, but only two weeks ago VIX shorts reached record highs, and markets themselves remain close to their all-time-highs. By these markets measures, there is a long way to go.

4. Yield curves have inverted across the globe, especially when measured against US risk free rates. This is notable as there were no false signals from 2010 to now.

Source: Crescat Capital

5. Margin debt looks extended and may have already rolled over.

Margin debt is particularly pernicious, as when investors delever the proceeds of share sales are used to pay down debt, not reinvested in other sectors. This was evident in late 2018. In the first phase, many utilities and staples actually rallied, implying a level of sector rotation. At a certain point, however, they were sold off with everything else.

2007-2009 showed a similar pattern. In the first phases, investors rotated into defensive sectors. When the sell-off intensified, all sectors were sold off sharply. So it was interesting to see utilities rally through most of May, and perhaps suggestive of opportunity.

6. Valuations remain high.

Time has healed some of the excesses, but take the Nasdaq 100 below. EV/EBITDA has risen from 8x in 2011 to 15x now. The Nasdaq could fall 20% and simply move back to the past decade’s average valuation.

7. Long term effects of the trade war

Irrespective of tweets or trade talk outcomes, it’s now abundantly clear to both US and Chinese businesses that they can’t rely on supplies from each other. China planned to build local competitors in all major sectors by 2025. You can be certain that as soon as the US struck at Huawei, one of China’s crown jewels, the pace of this development was brought further forward still.

This is particularly relevant in popular investment sectors like memory. The past two decades saw waves of consolidation, leaving three main players, Samsung, SK Hynix and Micron, who recorded bumper profits in recent years. We would happily wager that very soon, there will be new, state-funded competitors from China with significant market share.

Many other traditional favoured value picks, like specialty manufacturers of lasers, diodes and so on, may also soon face new, well-funded Chinese competition. It is apparently now deeply uncool for Chinese to sport Apple phones. The long term effects of all this do not look priced in.

7. Price movements in crude and copper may be early indicators of week end demand. Crude is particularly notable, as rising Middle East tensions failed to cause a spike in prices. The dog did not bark.

How best to play this?

We’re maintaining our long term investments in technology, biotechnology and innovation. Web traffic data on core positions like Carvana and Afterpay has been extraordinarly positive, and you can be sure we are tracking this closely.

The rally of the past few months has allowed us to build short positions in structurally flawed sectors.

Examples include physical retailers – losing market share to online – and telecoms, which are going through a lengthy 5G investment cycle, with only the promise of high competition at the end.

Many of these firms have compounded their errors by taking on prodigious levels of debt through acquisition or mismanagement. As an example, AT&T may soon be spending a fortune to build what we expect to be a second-rate streaming competitor. Disney’s offering, with their full back catalogue and ESPN, looks far more likely to succeed.

There are also opportunities in macro land. US government bonds have rallied hard, and the ten year still yields 2.3% (note: yields fallen further since I wrote this a few days ago).

This is anomalous in the Western world, and there is a long way down from there to zero rates and QE, which we could easily see in the next crisis. US central bankers have already told us their playbook in a crisis… and buying US Government debt is at the core of it.

Late last year we wrote that the Fed’s last rate hike was a mistake, and their next move would be down. So far this looks on track. The beauty of treasuries is that they pay a positive yield, have a positive expected return and have no credit risk. Ray Dalio combined treasuries with equities to record perhaps the highest hedge fund profits ever, in the largest hedge fund ever. This tool is out of mandate for most modern equity managers, though the old school investors like Soros and Druckenmiller made liberal use of them.

The best part of Government bonds is that they actually benefit from surprise stimulus – like the kind that torched equity shorts earlier this year. If you’re a bear, best to ply your trade in the bond market, in our opinion. Think of how well Aussie Government bonds have done lately, relative to the dull macro theme of shorting high yielding Aussie banks, fashionable for nearly a decade now.

Many investors use cash to manage risk. We would argue that Government bonds are a better option, as they increase in value in serious downturns, which are invariably accompanied by rate cuts and deflation.

There are other opportunities to balance out a long term equity investment portfolio. Junk bond prices remain high, and in a real crisis, can fall almost as much as equities. Unlike equities, they won’t rise significantly if timing is off.

Price chart of HYG, a high yield ETF

As long-time readers will know, we think there’s also something to say for pairing commodity shorts with commodity producers. We expect energy companies dramatically expanding production, generating free cash flow and paying dividends to compound over the long term, in a way that a barrel of oil can not, especially if executed in the futures market, where roll yield and expenses must be taken into account.

These effects are far larger than they sound. Look how much the WTI ETF has underperformed the underlying commodity, WTI Crude. WTI crude tracked energy equities closely, but the ETF significantly underperformed. That ~35% gap is market neutral profit.

Ofcourse, companies that expanded production and reserves, and paid dividends, outperformed further still:

It’s rare to be able to paint such a bleak macro picture, with equity prices so close to all-time highs, credit spreads so tight, and US Goverment bonds yielding so much more than developed market counterparts.

There has never been a better time to have more than one string to your bow.


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