It's Better to Shut Up...

Daniel Shainberg
November 23, 2018

Where have I been these past few weeks? There is a famous quote "It's better to shut up and give the impression that you're stupid than to say something and erase all doubt." Over the past few weeks we have seen many of our bearish calls prove accurate dating to the beginning of this newsletter just a few months ago. 

At the time, the markets were hot, Trump was taking credit for the stock market's performance, indexes were inching higher daily, equities were trading devoid of valuation and bitcoin bros were a thing. Now that seems to have all reversed. Stock market investors are nervously asking "what's next?" The bitcoin bulls have gone into hibernation. Real estate brokers, builder and bankers are wondering why their businesses have slowed. The spot price of oil has finally caught up with its depressed futures curve. Boeing's shares have plummeted, as we have predicted, and overvalued tech companies have seen their valuations come crashing back to earth. Credit spreads and rates are blowing out. 

When volatility spikes you simply cannot predict the daily moves. On Thanksgiving eve the equity markets rallied after its bearish performance over the prior week only to give back all its gains into the close. As we have said numerous times before, you cannot predict the short term movement of the stock market accurately. But you can certainly safeguard your assets from significant downturns by taking a longer term view and focusing on valuation metrics. 

I recently read a bullish posting on Boeing (BA), a company we have been bearishly inclined over the past few months, even before its stock price downturn. The bullish article pointed to their 8% Free Cash Flow yield and duopoly status in the aerospace sector. What the article failed to mention is that there free cash flow is not a rock solid figure. It can change. It is fluid. Their valuation implies an 8% yield on their current free cash flow. But their business is a mix of commercial Aerospace and Defense contracts. On the Aerospace side of the business they have experienced a temporary boom from cheap global credit and inflationary domestic spending in China (and India). That growth bulge in middle income consumers in the emerging markets led to a temporary boom in orders. But the aerospace sector, like the emerging markets sector, is very cyclical. Once that downturn occurs, the supply and demand balance for these aircraft could plummet, sending Boeing's Aerospace segment cash flow cratering down along with it. And their Defense business is ~1/3 of their total EBITDA. This is a business essentially with 1 key customer - the U.S. Government. And the outlook for that business over the next few years is even uglier. Sure the government has been spending without a care in the world, running over a trillion dollars deficits annually. But we now have well over $20 trillion in federal debt and our national credit metrics are approaching junk status. Defense spending is the largest expenditure of the U.S. government by an overwhelming degree. It is also the easiest to cut in a downturn. And given the national security implications involved, the U.S. government can also restrict Boeing from selling their products internationally. This is a business and sector that used to trade at 10x earnings, and is now trading at or above 20x earnings. And the earnings are inflate. When their earnings start crashing, their over-inflated multiple will as well. All their investors who have been attracted to their dividend yield will ask why they overpaid for the yield when competing rates offer larger returns with lower risk.  

Investors in Boeing, like their risk friendly equity investors in momentum driven tech stocks and other inflated asset classes will start blaming everyone but themselves. Even President Trump stopped taking credit for the stock market performance and started pointing fingers, most recently at Steve Mnuchin. "Trump is blaming Mnuchin for picking Jerome Powell to lead the Federal Reserve. Powell isn't very popular in the West Wing right now, as Trump has made abundantly clear with his repeated attacks on the Fed. Trump has blamed Powell for insisting on raising interest rates, and even hinted at times that he could be open to making a change at the central bank, something that has evoked nothing short of abject horror on Wall Street."

Dan Shainberg

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Will Further Rate Hikes Crush the Economy?

Dan Shainberg
November 2, 2018

Rising rates can be a sign of a strong economy if they are rising due to inflationary pressures, or a weak economy if they are rising because of a change to the supply and demand of credit. When the economy is flush with cash, lending activity increases, and investors scramble into deals where traditional credit risk metrics may be ignored. When the economic outlook sours, the relative demand for capital increases while the supply demands higher risk premiums, the combined effect of which is an increase in overall rates and/or spreads. 

There is almost universal agreement today, with unemployment at record lows and wage inflation soaring, that the rising rate environment is due to a strong economy. The Fed is increasing rates and credit spreads remain extremely tight. But if the Fed artificially raises rates, will the collapse the economy? Or is it simply going to serve as a GDP headwind, allowing for continued softer growth rates while reigning in the associated undesirable inflationary impacts?

“Further rate hikes will spark next stock market crash”, Peter Schiff warns, but without much substance. The perma-bear is probably right, but why? Why is he so convinced that rising rates will turn the economy into the Great Depression instead of triggering a soft landing where inflation and growth rates rest in a healthy balance?

The key culprits for financial crises is leverage. The last crisis in 2008 was primarily ignited in the banking sector, although the government certainly held a heap of blame. Today, the banking sector is much more regulated and healthy, although the shadow-banking sector is always a risk given more limited oversight. But the central banking and corporate sector debt is inflated. There is no doubt that should a similar ignition be lit in either of these sectors, the contagion could very well grow to be materially worse to the economy than that of the recession from a decade ago. In the next crises, there won’t be a central bank band-aid like we saw in the aftermath of the Great Recession.

We don’t know what will cause the ignition for the next financial crises, but a betting person would have to seriously consider that the next big one could be started by the likelihood for runaway inflation over the next 1-2 fiscal quarters. We are already seeing signs from Q3 2018 that the Fed’s 2% target for the CPI materially discounts true inflation which can be 3x greater when you actually read the statements from corporate America. As inflation whips up, interest rates will have to rise, and if they risk into a spike, which is likely, the “soft-landing” will not happen.

Dan Shainberg

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#RecessionResister
@DanShainberg

Boeing Boeing Gone

Just a few newsletters ago we warned of the risk inherent in Boeing’s market capitalization.

The Aerospace & Defense sector has seen valuations for the sector rise without a corresponding growth in cash flows over the past decade. Lockheed Martin (LMT) traded at 10x FCF with a 5% dividend yield, and today it trades for roughly twice the valuation despite minimal growth in annual profitability over the past 10 years. Boeing (BA) has seen more growth given its higher relative exposure to true aerospace customers; however, they are still trading at eye-popping valuations on current cash flows, and an insanely expensive valuation when factoring in its historical cyclicality.

Given its exposure to the commercial aerospace sector, Boeing has rode the emerging markets wave up, but they will eventually ride it down too. We noted the elevated valuations and how investors were stretching for yield in what has always been a defensive, dividend paying, liquid sector.

We also noted that the inflationary trends from the Defense sector from the past 5-10 decades are unlikely to persist given the obvious mathematical dilemmas that occur when the government reduces tax receipts and increases its debts and deficit at the peak of the economic cycle while interest rates skyrocket higher. At some point the math just doesn’t work. Now, the news of today that sent Boeing (BA) down >8% wiping 150bps off the Dow along with it is entirely unrelated to our bearish long-term thesis. They spent a ton of capital to develop a new plane. The plane crashed. It was a brand new Boeing 737 MAX 8 jet operated by Lion Air. Now the market is baking in a slight possibility that there are serious costs to retool and fix manufacturing problems and/or 1-time litigation payments.

The market is also incorporating the risks that tariffs could threaten their growth rates given they export 80% of what they build and 90% is built domestically.

This could easily be a pre-cursor for a long term Boeing bear market. Ultimately investors in Boeing need to incorporating the risk of a dividend cut. When you have 1 major customer (the U.S. government), and that customer cannot pay you and also can legally restrict you from selling your products to others, that becomes a major problem. When you combine that with a cyclical decline in the emerging markets, which historically have been the most volatile geographic sector of the macro-economy, that becomes the recipe for GE style dividend cuts. Savers who bid up BA shares over the past decade assuming they are a bellwether, nifty-fifty name will be shocked just like GE shareholders were in 2018.





Dan Shainberg

BLOODBATH!

Daniel Shainberg
10/26/18

BLOOODBATH! 

Not from the bomber, but in the market.

Our timing of this bearish newsletter warning of impending recession and subsequent market meltdown was completely random in terms of its inauspicious timing. Global capital markets are down now for 5 weeks in a row with a total loss of nearly $9 trillion of investor’s equity from its peak. This was the most brutal and steepest drop since Lehman.

And as we warned previously, the credit markets will not be a safe haven as they have been during volatility induced equity selloffs over the past decade. Risk parity funds will not work, we warned.

Gundlach similarly warned last week, and today again,  that yields are headed much higher. Such a move would have the effect of crushing the price of bonds as they move inversely to yields. He warned of two key concerns: “First is interest rate risk, which clearly has not been a positive now for a couple of years. You've not made money by price gains, you've actually had price declines. So you want to position yourself so that you're not so exposed to these price declines… Then the other thing you have to worry about is how much credit risk do you want. And I would argue that this is not a time to have a much of that either. So you need to be defensive against credit as well. So you're doubly defensive right now in the bond market.”

When looking at the equity markets, the pain in the indexes is most troublesome when you consider the extremely lofty valuations of the Tech sector and it’s recent pull-down effect on overall valuations. Given the low-rate environment of the past decade, investors have piled into anything that was “moving in the right direction,” namely art, bitcoin, bonds, startup app developers, cannabis and overvalued tech stocks. Now that investors can see the light at the end of the tunnel promising a reasonable yield on their savings, those funds are being rerouted from “hype” to “yield” or sitting on the sidelines until yields rise enough. 

Even Tesla is starting to finally come under scrutiny for their accounting and Twitter shenanigans as the FBI capitulated and decided it’s well overdue for an investigation. Don’t be surprised if they find Enron-esque, WorldCom-esque and Tyco-esque restatements.

There won’t be anywhere to hide this time. Unlike the past cycle that saw financial executives heading to B-schools to ride out the recession, this one could take years to unwind and may feel more like paint slowly cracking. The student loan bubble will pop as interest rates head higher. 

Howard Marks of Oaktree Capital has been famously warning about the bubblish environment for years, along with many other “experts.” Today he warned investors about being too risk averse. Interesting change on just a blip in the markets. Things can get a lot worse. But then again, not all of us have $9 billion of committed capital waiting on the sidelines to buy up distressed assets!

Dan Shainberg

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#RecessionResister
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Was that the Pinprick?

Daniel Shainberg
October 12, 2018

The art investor and collector community was stunned last week when immediately after Sotheby’s completed the auction of Banksy’s Balloon Girl the piece started self-destructing. Of course the notoriety of the surprise is believed to have actually increased the value of the piece! One might call it “art in motion.” 

Unlike Balloon Girl, the economic bubble will eventually pop, and it won’t increase the equity value of its stakeholders. 

  

The big debate currently roiling the financial news is whether or not the spike in volatility this week was the pinprick that will bust this cycle’s bubble or just standard volatility that re-entered the markets after a dull “low-vol” start to 2018.

• Peter Schiff: “The Recession is Coming”

• Howard Marks: “No Signs of an Imminent Correction or Crises”

• Ray Dalio: “War With China is Coming”

• Jeffrey Gundlach: “Something Bad Must be Happening”

• Larry Kudlow: “Normal Correction in a Bull Market”

• Scott Minderd: “More Inflation in the Pipeline”

• Mnuchin: “Yield Curve is Normalizing”

Everyone wants to predict where the market is going. It makes us sound smart. Of course nobody knows…. At least in the short term. 

The technical crash through the moving averages is not a good indicator for those bullishly exposed. The fact that the global markets have been rocked year-to-date while the U.S. was an outlier until this week likely as a hangover from the Trump tax cuts is not a good sign. The elevated level of volatility as measured by the VIX index is not a good sign. The likelihood that the move down is correlated to rising rates is not a good sign either.

As we noted in yesterday’s podcast, if the market is starting to reflect the anticipation of higher rates, then equities will demand a spread commensurate for its higher risk. And with the 10 year on a straight trajectory to 4% within the next 12-18 months, equities simply cannot trade at 20x earnings unless justified by material economic growth. And that just becomes a harder and harder sell when the economic growth we have been experiencing was largely due to one-time tax cuts, one-time global-trade wins upon the threat of tariffs and an end to the interest rate cycle. Nobody can predict daily moves or accurately predict where the market’s are heading next week. It’s just too tough. But when you consider all of the noted artificial stimulus that buoyed the market up, and the fact that they are all turning now, it just gets harder and harder to believe this bull cycle is just witnessing a bump in the road. And we haven’t even discussed margin debt!

Dallas Fed Chief Robert Kaplan recently addressed NYSE margin debt as it hit another record high. The reason this matters so much is that when markets tank, investors with margin exposure become forced-sellers. The lenders require them to liquidate their equity positions to repay their loans as their assets drop below minimum coverage ratios relative to their liabilities accounts. This has the effect of magnifying market selloffs. It becomes an excellent and ripe ground for value oriented investors, but only once the full brunt of the forced-selling waves is complete.

While we have listed true market indicators in this newsletter previously, NYSE margin debt reversals are excellent warning signs to the next bear market. Even FINRA warned in January that investors may be underestimating the risks. The chart below shows how the current market cycle could see a record forced-selling blowout as NYSE margin debt is ~50% greater than the peak of the 2008 market precipice. 

Dan Shainberg

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#RecessionResister
@DanShainberg

You Can’t Handle the Truth

Daniel Shainberg
October 11, 2018

• President Trump blames the Fed for the market drop 
• Economists largely agree the Fed is making the right moves
• Some economists argue the Fed is actually too late in raising rates

With the recent growth spurt in the economy, combined with tight employment, the Fed is predicting the recent wave of labor related inflation to increase. That is it. It’s not about politics. They have a dual mandate to keep employment and inflation in-check. If employment is tight and inflation starts taking off too much, they aren’t doing they’re jobs properly.

The truth is that Fed is not acting “reckless” as President Trump stated. He just needs an outlet to blame the sudden shock of equity losses onto someone else prior to the important mid-term elections. 

Guggenheim’s CIO Scott Minder likened the current economy to the Titanic, “full steam ahead with an iceberg.” It’s tough to disagree. While we have been forecasting this volatility and market selloff since the newsletter began last month we were focused on a few very simple concepts. There are a ton of speculators commenting on fancy charts and research. But it’s quite simple. 

What is the truth?

The truth is that for the past decade post-crises the Fed has been in an accommodating stance, and the phrase “don’t fight the Fed” worked for bulls. But as balance sheets expanded and the flood of liquidity made its way into market caps and the general economy, employment tightened and inflation began ticking up. The genie is always harder to put back in the bottle, so in anticipation of a major liquidity crises, which may happen anyway, the Fed is starting to be responsible. There are some like Peter Schiff who think that the level of monetary stimulus has totally corrupted the economy to the point where there is no turning back, and the U.S. dollar is doomed. 

If we take the Fed at its word, for those of us without such a hyperbolic stance, the story is quite simple: The truth is that it all boils down to math. When the risk-free 10-year yields 1-2%, holding such paper won’t beat inflation. So you as an investor throw your capital into art, stock in Tesla, bitcoin, cyclical equities, real estate, iPhone apps and cannabis frauds. You may even pay 20x EPS through your Betterment account to own the S&P 500 because why wouldn’t you earn a 5% yield. 

But once rates start rising all of those hyped up nonsense “investments” get scrutinized more. Do you really want to risk your capital in these bubbles and unproven momentum stories when you can actually earn a risk free return on your capital? 

Even if you answer yes, the required return still rises because of the alternative return offered to you. When the S&P 500 trades at 20x earnings which is where it was for the past few years, you are essentially earning a 5% yield excluding growth. That represents a decent spread to compensate for elevated risks relative to risk-free government bonds. 

Gundlach expects the 30-year to rise to over a 4% yield. Why would anyone buy the S&P 500 at or near cyclically peak earnings for only a 100bps spread? They won’t. And that repricing of risk is what the market is digesting currently. 

While there are always buyers to step in short term, I’d expect this regurgitation to continue in the coming quarters until the equity spread increases sending the S&P 500 multiple towards a more reasonable 15x earnings level. That would call for another 20-30% correction in the markets.

Dan Shainberg

#DanShainberg

#RecessionResister
@DanShainberg

Bloodbath Continues After Hours

With the ugliest day on Wall Street in a long time, the “bounce-back” may elude us tomorrow as the Dow is down another 1,000 points after hours. 

What’s going on? 

Well if you have been reading this newsletter then you would have already been informed of the macro themes that continue to present compelling and material downside risks to this market. The interesting thing about today’s selloff, and the continuation in the after-market, is that there was no significant single news event, no change in rates, no spike in oil, no new tariff news. 

It seems to simply be an unexpected pocket of air that hit the markets without any warning. The reassurances from the White House about the “strength of the economy” will prove meaningless to investors who have their own cash on the line. What equity investors finally picked up on was that the economic readings suggesting strong growth are driven by the low rate environment. And since rates have been spiking up quickly, the stock market as a forward indicator is incorporating its expectations for the future impact of these rate hikes. 

The market is not liking what it’s seeing! 

Nedbank's strategists Neels Heyneke and Mehul Daya explain why "we are approaching historical thresholds", where Fed tightening traditionally becomes the "straw that breaks the camel's back" for the equity markets and why "this time should be no different." 

According to Dennis Gartman, “the U.S. economy has close to a 100% change of entering a recession.” Gartman noted that the catalyst will almost certainly be the Fed.

As of now, he seems to be right. 

Dan Shainberg

#DanShainberg

#RecessionResister
@DanShainberg