3065 Rosecrans Place #203
San Diego, CA 92110
4-1-2020 and 4-9-2020
Part 1:
None of the below is investment advice. This goes out to Ed, my long time client, friend and spirited doctor, who recently tested positive for COVID-19. This also goes out to my sisters, who have both been laid off, leaving them with children and mortgages to keep happy. These are hard times, and we should avoid risks wherever we can.
Most of this memo will be conceptual in nature, differing from my normally quantitative approach.
But first, a quick allegory:
A little over a month ago, I woke up with a tickle in my throat. Laura quickly rushed out and got everything she thought that I needed for what she thought was my sickness. We thought it may be the virus. This would be awful, since I have never been more productive than I was in 2018 and 2019 and I borrowed significantly to take advantage of the upswing. Over the next several days, I experienced different symptoms and my doctor told me I not only had that sickness, but I had two others that would both, on their own, reduce my productivity for weeks if not months. Unfortunately, I simply couldn’t afford to miss work with huge piles of bills to pay, so my family gave me money to get through the hard times ahead, borrowing from a local bank. One week later, fearing that I would be unproductive for longer than expected, my family began telling the bank that I was absolutely fine and I would be back to work in no time. With bills rising, my family borrowed even more money to stabilize my financial situation through the hardship, painting bankers a very rosy picture to get the best possible terms on further debt, telling them throughout only of the one sickness and not the other two. However, it has now become clear to the bankers that I am not as healthy as my family tells them and now my family is experiencing a loss of credit, something like a ‘rating downgrade’. Throughout all of this, the bankers never saw me or spoke with me directly and believed everything they were told. So, here we are over a month into my being out of work and I can’t tell if I will be able to get better before the money runs out and my family defaults on the money that they borrowed. Bankers understand the trade off now and interest rates must be higher to account for the speculation involved.
This is the over-simplified story of nearly every country in the world today and/or possibly in the short term future.
We are watching every country in the world experience a truly debilitating sickness and while many of us want to invest because we believe the yearslong productivity will continue, it is probably much too early to say. With such high stakes on the line, it seems hard to believe what we have been told by people other than experts in different capacities. Thus, I would expect that unless reports are audited or something close to it, there is too much of a chance for misinformation.
We could go on and on about the details, who said what and I could bash you over the head with infinite statistics, but let’s take the higher road. After all, we are being deluged every minute of every day anyway, leading me to one point that I must make.
It certainly takes time to adjust to the dislocation of global economies. And then there is the media that has a perverse incentive to create panic. Over the last weeks, I have watched an historic bounceback, fueled only by speculation, which resulted in several retired clients asking me to go risk on again. Frankly, if I were retired without the ability to make up any losses, I couldn’t invest in this market without more information. It’s boring not to take risks, but I’d rather be safe than sorry. If there wasn’t a bubble before the media dug in and before the enormous new fiscal and monetary policies, there almost has to be now.
But what is a bubble? Primarily, it’s formed by debt around income producing assets. It becomes more obvious over time with higher unemployment, increased pessimism, and many other classic fallouts. One poignant item last week was South Africa being downgraded to Junk by Moody’s.
Just as in the allegory above, bailouts really don’t benefit anyone unless the ‘ailing’ party has skin in the game; otherwise there is no incentive to increase productivity. This is highly theoretical and I say that more from convenience than hard and fast science. In the allegory, what if that bank that my family borrowed from asked nothing in return? That bank loses credibility and profitability. Why then, do I see Boeing and airlines on the verge today of turning down the bailout money? This seems to be negotiations, though the reputation of those companies in the minds of sophisticated investors will almost certainly be sullied for years to come.
If you know Michael Burry from the movie “The Big Short”, he currently has a brilliant trade outstanding against ETF’s and Mutual funds. When I read about it last September, I realized that he was correct. Unfortunately, last week the SEC made an allowance against his trade that is, in my opinion, despicable. The WSJ article (seen here) describes a system wherein a mutual fund or ETF that has massive sales against it can make up the sales by borrowing from the parent of the fund. This is technically a bailout technique as described, but I feel it’s more of a Ponzi structure. Sorry that your brilliant trade was disallowed Michael Burry.
Last note on bailouts and the stimulus – the money granted/lended will have a very low return for the economy, since the money will be used for consumption rather than investment, and also the increased debt loads will encourage businesses to pay off debt rather than purchase new investment with future cash flow. These are important concepts showing why recessions persist for long stretches and of course must be true economically.
Finally, if you are thinking about investing in the market at these levels, trust me, you aren’t alone. I keep getting reports from other advisers talking about dogmatic buying for weeks now. Media talks all the time about panic selling, but not panic buying. Panic selling is selling on fear of a drop. Panic buying should therefore be buying on a fear of a rise. Buying simply because you don’t want to miss out is not investing. Consider if the stock chart was flipped upside down and your decision to buy near the top becomes a decision to sell near the bottom….
Stay safe and Bless you all.
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Part 2
Happy Easter to everyone. This time of the year is normally a time for rebirth, but I feel it will be more punctuated by the continuance of the undead.
Jokes abounded at the beginning of the virus – at least the infected did not become zombies…. I’m here to tell you that corporate America has.
In this memo, I discuss economic and corporate theory. More specifically, the value of many related global assets, the sentiments from the top down and bottom up, the causes of current conditions, and the effects of current conditions. Please note that the truth is both dynamic and arcane and I do not know a lot of it. My duty is to inform clients of what I am seeing. Many times, I feel like a doctor trying to diagnose a dying patient without seeing inside. To think any other advisor is in any better shape is probably a fallacy. There’s a lot to cover, and there are many things that I don’t know about the current environment.
But first, you must understand that the virus provided a platform for bailouts that were needed anyway. So if you hear that assets are jumping in value, know that it has nothing to do with virus developments. Know also that bailouts are important and necessary to recoveries, historically.
So, let’s begin with the buzzword of the day – bailouts. Here are some headlines :
Senate approves historic $2 trillion stimulus deal amid growing coronavirus fears (3/27)
Fed Expands Corporate-Debt Backstops, Unveils New Programs to Aid States, Cities and Small Businesses (4/9)
Trump Calls for New $2 Trillion Infrastructure Bill (3/31)
- Fed Ramps Up Bond Buying, Indicating Much Larger Purchases Are Likely (3/19)
After Three Coronavirus Stimulus Packages, Congress Is Already Prepping Phase Four (03/29)
What the Fed’s Near-Zero Rates Mean for You (3/17)
- Stimulus Package Renews Spotlight on Universal Basic Income (4/2)
Why the Fed had to Backstop Money-market Funds, Again (3/21)
- New York Announces More Relief for Student Loans During Coronavirus (4/9)
How to Suspend Your Mortgage Payments During Coronavirus Turmoil (4/6)
- Fed Eases Wells Fargo’s Asset Cap to Lend to Small Businesses Harmed by Coronavirus (4/9)
- The Fed is going to buy ETFs. What does it mean? (3/30)
These are a few from the US. I choose not to read about other countries because it’s more frightening than AMC’s The Walking Dead to read what the developing world is going through.
From today: The Fed will now accept triple-A rated tranches of existing commercial mortgage-backed securities and newly issued collateralized loan obligations. One corporate credit backstop to support new debt issuance of highly rated firms will be expanded to include so-called “fallen angels” that were investment-grade in mid-March but have subsequently been downgraded one notch, from triple-B to double-B.
But what does it all mean? It means the government is bailing every party in the economy out, accepting all possible risks for years to come. As a devoted American, I feel strongly that this isn’t the best route, even if stocks are higher (and will probably continue higher).
Meanwhile, at the Pentagon, Glenn Fine has been fired as head of monetary policy tarp money supervision and replaced by, you guessed it, the Environmental Protection Agency chief. A very senior contact that I have at the Pentagon tells me this is a very bad look for democracy, wherein the gesture was received by the Pentagon as dictatorial. As an aside, my opinion on the EPA since 2016 is disheartened – we have DOUBLED production of oil at a time when oil, according to Directors in Saudi Arabia, “has no future”.
But, anyone that gets in the way of spending and bailouts will be crucified as a political pariah. Yes, this includes you, Chuck Grassley.
Ok, let’s move on.
“I’m not sure that now is the time to buy, but now is a time to buy.” Howard Marks wrote this on March 4, 2020. Boy was he right. This is bold, courageous thinking from someone that faced huge adversity. Without knowing earnings, without knowing the effects of inflation, he moves forward. There is something very American about that.
On April 7th, Marks reiterated his ‘buy’ rating in a somewhat heated memo, saying “Given these new conditions, I no longer feel defense should be favored,” arguing that the bad news has been priced in. Again, very bold thinking in times of adversity.
Then again, he is conflicted in the sense that many of his stakes require constant reinvestment and he has a near infinite warchest of cash at his disposal. Let’s get the perspective of someone who has a different set of conflicts.
From Wall Street Journal, April 9 “Coronavirus Tests Viability of Home-Flipping iBuyers”-
“But ‘when you have cities that are shutting down where commerce has come to almost a complete halt, you know that you can’t predict the market for selling a house,’ Redfin Chief Executive Glenn Kelman said in an interview. ‘In the absence of that predictability, it becomes very easy to decide that you’re not going to buy houses,’ he added.”
Kelman could just keep investing aggressively like Howard Marks, but he seems to think things won’t get better. For Redfin (which I short in my own account), which has lost more and more money every year yet still trades at an enterprise value of $2 Billion, there aren’t alternatives to losses. So the conflict for Mr. Kelman/Redfin is to stay alive, he must avoid risk. (Keep in mind, however, that although Redfin isn’t generating revenue, has laid off 40% of staff, and sold hundreds of millions of stock at lows, the share price has gained 80% from its recent lows- your typical zombie).
So you see where we are in the world. The wealthiest people that have mountains of cash find all times to be ‘a time to buy’ and still be alright, while those that don’t have any money will either die or go bankrupt. This juxtaposition has been my issue investing and why my clients have been mostly in cash, especially those that can’t afford the risk.
The parallels between the working class and corporations should not be ignored. As unemployment ticks up, the weaker of the working class are allowed to figuratively die. As I have mentioned before, wage growth in the working classes has been a problem, mostly because the bottom majority were included in the force but never meaningfully increased their relative profitability. The primary goal of a working class should be an increase of relative profitability, which is why I believe America is so great – the productivity we engender naturally begets profits.
So, as defaults tick up, the unhealthy zombie companies that have likewise dragged down the profitability of corporations should be allowed to die. This allows less competition to the productive and profitable corporations over time while at the same time provides a large jump in relative productivity immediately. These are healthy prerogatives.
**But bailouts allow the lower, unprofitable workers and consumers survive in spite of the empirical goals set by the very same working class and corporate class. Can it be that our primary goal in a democracy is to include these unhealthy participants at a huge cost to the detriment of profitability? Thus, the issue we have is much bigger than financial – it’s a metamorphasis of American goals. Additionally, the healthiest corporations do not participate in the bail out and are therefore penalized by it in many ways.
(To be fair, the current yield in US stocks at around 3.5% by my estimation doesn’t warrant the risk of the zombies dragging down the rest, and so I am conflicted too because I want to invest in the US stock market.)
Is it that easy? Let me paint you a picture.
Bailouts:
The banking industry touches more market participants than any other industry, including consumers, mortgage lenders and borrowers, corporate debt lenders and borrowers, government debt lenders and borrowers all while being primarily devoted to their own profitability.
Banking profitability works in a couple of ways – maintaining proprietary accounts for equity positions allows for growth and net interest allows for income. Let’s focus on income. Lenders pay savers interest (around 0% today) and lend that out to borrowers (around 3% today) to earn a net interest income (~3%). In a high price environment, banks have no choice to reach further to find borrowers, often taking higher risks while wanting to pay borrowers less. This is why lower interest rate have set up a boon for banks, but that is at risk.
What happens when those loans they made begin to default? The mortgages and corporate loans held as assets are likely to default in the current environment, which would obviously cause the net interest income to become serious losses in debt impairments. Meanwhile, consumers need cash to pay bills while unemployed, causing the banks largest debts (deposits) to come due immediately.
This death spiral was already a priority on my watchlist coming into 2020, but now, all bets are off, as the government has effectively done all of the following:
- Bailed out consumers with beefed up unemployment benefits (issued by states)
- Bailed out consumers by delaying taxes
- Bailed out consumers by forbearance (which is due in total a few months from now as a balloon payment
- Bailed out consumers by issuing a check to the poorest citizens
- Bailed out consumers by relieving student loans for wide swaths
- Bailed out consumers by paying for hospital visits and tests (this is an obvious one, but hospitals will profit on those visits)
- Bailed out small businesses by providing 1% loans*
- Bailed out small businesses by beefing up employment, allowing them to layoff workers more easily.
- High percentages of people being laid off didn’t need to be laid off
- Bailed out banks by buying most newly issued and existing small business loans
- Bailed out municipalities by buying trillions in debt (including bonds issued to increase unemployment)
- Bailed out corporations by buying newly issued and existing debt*
- Bailed out Corporations by dropping interest rate to 0%
- Bailed out corporations by putting a 3 month ban on tariffs (something Trump said he would never do)**
- Bailed out banks and business lenders by buying corporate debt
- This includes all debt down to BB junk status
- Bailed out banks and mortgage lenders by buying mortgage debt
- This includes Mortgage Backed Securities bought for almost face values
- Bailed out net USD denominated- debt holders by printing trillions of US dollars – (debt cost less with weaker dollars)
- Bailed out pensions by buying municipal debt, of which pensions invest heavily.
- Bailed out money market funds by indemnifying against ‘breaking the buck’
- Bailed out ETFS by allowing ponzi-type loans from “related funds”
- Bailed out creditor nations by buying all sovereign debt at record amounts (the $20 trillion deficit will get MUCH larger)
- Bailed out everyone for generations by providing the set up for easy money without risk of failure.
About $5 Trillion already (30% GDP)…. And we are only one month in.
*The likelihood of the government forgiving the debts of these corporations in a default is high based on current posture.
**Removing tariffs is an enormous red flag – it’s the only victory Trump claimed in the yearslong fight with China, making the fight an enormous waste of money for the US and an enormous windfall for China.
Thus, the government is assuming all possible risks in the economy, and I expect in a couple weeks an announcement that the government will give everyone two year’ salary, because… well, why not?
If I were running a fund of say, $1 Billion, and I lost $100 Million due to losses in my equity bets caused by the coronavirus, I’d be very upset, but I’d still be managing $900 Million. Well, the government tells me they feel bad about the loss and agree to buy all of the $900 Million portfolio for $1 Billion of newly printed money. This is effectively the bailouts above. The riskiest gambles are being bought at face value by printing new money.
The precedent set is dangerous psychologically and economically. Can we print enough money to make all markets rise artificially? You bet! It is therefore EXTREMELY important that you look at a bailout as it is – an acquisition at top dollar, funded by taxpayers. This is a huge transfer of wealth to the already wealthy and flexible like Howard Marks from the underprivileged and inflexible like Redfin.
“The Big Short” was a wonderful tale of people that got paid off for courageous, well informed bets. But what if the government bought all of those toxic mortgage backed securities before they defaulted at face value? Those bets would be worth 0 and those investors would be ruined. There’s wisdom in playing the game of bailouts.
Kudos to all those corporations and banks that bought back their stocks with borrowed money over the last decade. What an incredible call that was enormously successful. I can’t underestimate how successful the buyback bet was. You see, to take out debt in USD and buy stock with it- stock that is income producing; stock that holds real assets that appreciate versus a weaker dollar – you benefit when times are good, but now, in the time of the bailout, you make more money on those buybacks than you could have ever forecasted. Again, what an incredible bet – there was no downside risk!!!
But wait, there’s more.
Here’s a statistic – 70% of the world’s transactions are in USD. And 100% of USD is created by the US government. For reference, let’s discuss oil.
Oil is having a rough year – many years ago, oil was the key to incredible wealth, and today, there’s too much supply and very little demand. The only path to survival for the entire industry is production cuts. Ironically, it was the US that innovated fracking and spoiled the game to a large degree. I have a feeling that the same thing that is happening to oil right now will happen to the USD soon.
Oil is similarly used by the majority of the world and is therefore in large demand. However overproduction has destroyed value, leaving the leaders to argue. This is important – oil has 3 main players – the US (15% of total market), Russia (11% of total market), and OPEC (35% of total market). All others are insignificant, though MANY of these countries DEPEND on oil being above certain prices. So, while oil is having trouble staying alive based on three parties agreeing with each other, the USD only has one party dictating 70% of global transactions and, to a greater extent, global wealth. The bailouts to US corporations/consumers in USD is flippant and destructive, as other nations rely on the USD to maintain strength, yet have no say. This will likely be met with trouble for the USD, and it seems, from my perspective, that there isn’t consensus about when to print money and in what amounts with all relevant parties.
If I bet on stocks today in light of all corporate challenges, it would be more of a short on USD than a long on corporations. Thus, we have zombie companies that have relatively no fundamental value propped up on an extraordinarily weakened dollar. This begs the unanswerable question – why do we not have advocates around the world fighting for a stronger dollar? This brings me full circle to my level of incompetence.
Of course, I spare scrutiny to other nations’ currencies due to the USD being so important and also the world’s current reserve currency. But, most other currencies will see the same weakening.
Analysts at Investment Banks cling to $800 valuations for Tesla, $30 valuations for Bank of America, $2200 valuations for Amazon. Why? The fundamentals just aren’t there and the only way to get there is to print more money. Do these analysts understand that they are encouraging higher asset prices while millions struggle to pay rent?
As a demonstrative experiment, measure the stock market based on the price of gold instead of the USD. Gold, in theory, should have the same value at all times, while other assets fluctuate around it, making its price change. This year, when Gold has jumped in value about 10% VERSUS the USD, giving us a benchmark for the counteractive drop of the USD.
Because the stock market is down about 10% this year (destructive), and the USD is also down about 10% (stimulative), we now have about a 20% drop in total for US stock markets. This is the theoretical level to which Howard Marks refers to when he discusses that ‘drops are priced in’.
A few questions I have for Marks – what good news hasn’t been priced in? Will everything fall in line in corporate America exactly as it was when the virus is resolved in two weeks (as people expect), or will unemployment/lost revenues permeate the globe for years?
I believe we are seeing the divide between social classes deepen with each passing bailout. Those unemployed people without REAL income-producing assets can’t survive, while those that do have such assets will continue to thrive.
Due to unemployment and our status as a rather large ‘debtor nation’, the risk of inflation is very high. The risk is also high that those income producing assets will not produce the same income, which is my greatest concern and probably the concern of 100% of people that are likewise sitting around in cash. Additionally, those zombie companies that are thriving on cheap money now are beginning to form the majority of the world, and will probably take out much of the rest when they eventually die. These things won’t happen for 3 to 9 months while the government continues printing infinite amounts of money to cover the wounds in the next few months.
Ok, take a breath…. This next part is hypothetical and well outside my circle of competence.
What happens if the US can’t pay back all the debts (ie new money) it has now taken claim to? We either default or print more money, which every other country probably does too, negating much of the effect. With all of the bailouts, I get the feeling that the government really doesn’t hold taxpayers (that are footing the bill) in too high regard. If this were happening at a corporate level – a corporation buying a loser of an investment for a very high price, shareholders would be up in arms!
I’m not immune to thinking that many of these bailouts needed to happen so the market doesn’t get obliterated – but I would be interested in knowing the benefits of that scenario – it may be a healthier alternative. After all, the worst case would be that these bailouts are all for nothing, and all of those market participants die anyway.
So is there a downside to constant money printing? I direct you to one of my favorites by Warren Buffett – Thriftville versus Squanderville
The deficit gets worse to other countries, our currency becomes worth much less and nobody wants to hold our treasury debt. Also, since real assets are rising in comparison to cash, everything should be more expensive for people that have cash currently. Is it a good thing to have a very expensive world (relative to the USD)? ‘Expensive’ really means ‘fair price’ if there is demand, and if there is not, those assets must drop in price until demand is met. So, is the market something that will cultivate demand now that will grow into the future?
So if people can’t afford businesses, inventories, real estate and food, prices of those things must come down until demand is met. At elevated prices and no demand for products and services at those prices, there is no demand, especially if people…
1) Have unemployment persist longer than 1 month.
2) Choose to save money rather than spend/ invest
3) Significantly change lifestyle to shut out systemically important industries (like cars/travel, oil, retail/hospitality, etc.)
4) USD will be used less prevalently, diminishing demand.
5) Decide to have a world war (US/China, Russia/OPEC) – very low likelihood.
At least these five items affect the global economy and drop all prices and are significant challenges that I believe haven’t been priced in yet. This thought challenges the current level of the market as elevated. Again, outside my circle of competence.
Finally, many folks in my industry aren’t doing this level of research, which probably worked out well for them so far. We are probably at Bitcoin levels for assets – I think you will not be paid a return on your assets unless you can find someone dumber than you to buy it. Which may well be the government.
There are folks that buy at any price because if prices drop, they can just buy more. My goal is to invest where I can obviously get a good return on invested capital. Therefore, because folks like Howard Marks that buy at all times, I don’t currently have any real edge with any amount of research I perform. Bailouts have forced me into cash and it’s going to take a heck of a lot next week and the following to get me to change my mind, I’m sad to say. I’m hoping that tomorrow’s headline reads – “All US Portfolio Managers To Receive Stimulus Checks to Make Up for Market Downturns” – that would be my best bet for a gain going into next week. I’m beginning to think this is a likely scenario.
Until then, best of luck.
Disclosure – I am short Redfin.