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Arete’s Observations 7/24/2020

By David Robertson | July 24, 2020

David Robertson, CFA serves as the CEO and lead Portfolio Manager for Arete Asset Management, LLC. Dave has analyzed stocks for thirty years across a wide variety of sizes and styles. Early in his career, he worked intimately with a sophisticated discounted cash flow valuation model which shaped his skill set and investment philosophy. He has worked at Allied Investment Advisers and Blackrock among other money management firms. He majored in math with extensive studies in economics and philosophy at Grinnell. At Kellogg, Dave majored in finance, marketing, and international business while completing the CFA program concurrently.


Market observations

I’ve made mentions several times over the last few weeks of the substantial outperformance of the big tech stocks relative to the rest of the market. More recently, that advantage seems to not only be dissipating, but reversing.

Major Market Buy Sell Review, Arete’s Observations 7/24/2020

Rise of the US mega-caps creates shaky ‘top-heavy’ market

 “More than 200 companies in the S&P 500 index advanced at least 1 per cent for the day and nearly three-quarters of the benchmark closed in positive territory. Despite those gains, the index rose just 0.2 per cent, dragged down by the handful of mega-cap stocks at the top of the market.”

In the stead of big tech stocks, gold and silver seem to be taking over on the momentum front. At the same time, the decline in volatility is setting records.

Economy

Lacy Hunt has a way of getting right to the point and then pounding that point home with data. At a time in which many different crosscurrents obscure the view of the economic environment, his high-level perspective is extremely helpful. He lists four key considerations …

Hoisington Quarterly Review and Outlook Second Quarter 2020

“First, with over 90% of the world’s economies contracting, the present global recession has no precedent in terms of synchronization … Second, a major slump in world trade volume is taking place … Third, additional debt incurred by all countries, and many private entities, to mitigate the worst consequences of the pandemic, while humane, politically popular and in many cases essential, has moved debt to GDP ratios to uncharted territory … Fourth, 2020 global per capita GDP is in the process of registering one of the largest yearly declines in the last century and a half …”

The consequences are meaningful and need to be considered seriously. Hunt notes, “an extended period of low inflation or deflation will be concurrent with high unemployment rates and sub-par economic performance”, “The lasting destruction of wealth and income will take time to repair”, and finally, he expects “years will pass before the economy returns to its prior cyclical 2019 peak performance.”

As serious as the consequences are from the top-down, they are also serious from the bottom-up. John Mauldin captures some of these and in a way that I can certainly relate to.

Small Business Blues

“I should mention, I’ve been one of those small business owners or managers my entire career. I know how it feels when employees are like family (or perhaps literally are), the desire to protect them as any parent or friend would, and the agony when you can’t. This situation hasn’t just cost jobs and income. It’s killed hopes and dreams.”

Major Market Buy Sell Review, Arete’s Observations 7/24/2020

These perspectives were both affirmed by the initial jobless claims report for the week ending July 18 which indicated that 1.4 million jobs were lost, up 109,000 from the week before. This is just one data point but it is discouraging to experience a noticeable bump in the road to recovery. It is even more discouraging that the initial claims remain so high this long after reopenings started. “Hopes and dreams” indeed.

Commercial real estate

Blackstone to shutter real estate income fund that held CMBS

“Blackstone Group Inc. is closing a real estate fund that used leverage to load up on commercial mortgage backed securities, investments that have slumped during the Covid-19 pandemic.”

Major Market Buy Sell Review, Arete’s Observations 7/24/2020

When I read this piece I couldn’t help but to think of Bear Stearns in 2007. At that time a couple of hedge funds that used leverage to invest in real estate securitizations blew up. It ended up being a canary in the coal mine for the financial crisis that followed. That certainly doesn’t mean the same thing will happen this time, but Blackstone is no neophyte to credit or real estate. If they got caught out, there is good chance there are more that we don’t know about yet.

Coronavirus

One of the factors that still seems to have the power to move markets is progress on vaccines. While I admit that I have not followed the scientific developments closely, I absolutely believe that there is a lot of great technology, that there are several different and interesting approaches, and that there are resources available to develop multiple solutions.

I am far less optimistic that vaccines will actually have a huge impact on controlling the coronavirus, however. The reason, for lack of better words, is poor governance. Having the technology (which I am assuming will be developed) is a necessary, but not sufficient, condition to stanch the pandemic. What is also required is a focused effort to distribute the vaccines and a prevailing desire to receive them. Although I would like to be wrong, I don’t think either is likely to happen.

On the first point, public policy in regard to the coronavirus (at least at the national level) has ranged from dismissive to episodic. At no point has it been uniform or coordinated. While treatments by medical professionals are improving and have been effective at reducing mortality rates, no such discernible progress can be found at the national policy level. This is painfully apparent with testing …

US coronavirus surge: ‘It’s a failure of national leadership’

“’No one expected that the lag time would go from a day or two to seven or, in some cases, 14 days,’ says Rajiv Shah, president of the Rockefeller Foundation, which this week published a plan calling for the country to spend $75bn on a mass testing programme.”

“’With the seven-day lead time you basically aren’t testing at all, it’s the structural equivalent of doing zero tests,’ says Dr Shah, explaining that people are at their most contagious during the earlier stages of the disease. If someone finds out they are positive a week or more after being tested, they might have already stopped shedding enough virus to infect someone else, he adds.”

So, we are something like five months into this and not only has testing not gotten better, it has gotten a lot worse. This is especially discouraging because testing isn’t all that complicated. Testing is the relatively cheap and easy and already existing way to prevent the spread of the virus, and we can’t even get that right. Why do we think anything would be different with vaccines?

On the second point, it is not at all clear to me that even if a perfect vaccine were created that it would be widely administered. By one report in the Washington Post 30% of Americans do not think vaccines should be mandatory and 9% go as far as to believe vaccines are harmful. These facts, combined with the widespread experiences of people adamantly refusing to wear masks, suggest that even if the perfect vaccine were made available to everyone for free, a significant percentage of the population would still opt to go without.

Politics

David Brooks has long been on the moderate side of political conservatism, but his recent piece in the New York Times almost makes him sound like a fanboy of Joe Biden. The more interesting takeaway, however, is the prospect that a Biden victory could fundamentally “realign American politics”.

President Biden’s First Day

“But I do know that if he can win a chunk of the white working class (44 percent of the electorate, according to Ruy Teixeira), he will realign American politics.”

“But he has found a way to craft an agenda that could reshape the American economy and the landscape of American politics in fundamental ways.”

In order for this to happen, Biden would both have to win the presidential election and successfully appeal to a large proportion of the white working class. If he is able to pull both of these things off, however, it could redefine what it means to be “Democrat” and “Republican” with a whole host of interesting possible consequences.

Interestingly, another take on the election from another smart observer provides a very different perspective …

The deceptive radicalism of Joe Biden

“What he [Biden] does have is their seeming innocuousness. Bold policies can be smuggled under its cover.”

“The more he is seen as a do-nothing grandpa, the more license Mr Biden has to advance ideas that would have done for another candidate. Americans, if he wins, should not count on a quiet life.”

Europe

Long negotiations, clique groups, broken deadlines, breathless speculation and … finally a Eurozone pandemic recovery package. What it means, however, is in the eyes of the beholder …   

Investors hail Brussels as a new force in bond markets

https://www.ft.com/content/da0f71e4-e629-404d-ba65-fe1dcf3d4a14

“’The symbolism here is very important,’ he [Paul O’Connor, Janus Henderson Investors]

said, describing the move as the eurozone’s ‘first real attempt at mutualising debt and its biggest step yet towards fiscal integration’.”

“’Everything about this is limited and conditional,’ said James Athey, a fund manager at Aberdeen Standard Investments. ‘Italy can’t just take this money and pay its civil servants. If . . . this crisis can’t get us to more meaningful fiscal transfers between members, it’s hard to see what can’.”

My take is that there is a heartening precedent being set with this agreement, but one that comes with a lot of caveats. If it is this hard for politicians in Europe to spend money they don’t have, I would hate to see what happens when they have difficult decisions to make. The bottom line here is reminiscent of the response to the GFC: This is just an aid package (as opposed to investment) and as such it doesn’t fix anything. Even at that it is probably too little and too late.

Cybersecurity

The Great Twitter Hack has exposed the precarity of our online existence

“In this environment, what havoc might a more canny and manipulative attacker cause by secretly taking over the accounts of the powerful? What extra doubts might that seed in the public mind about the trustworthiness of political leaders? And how long will it be before the tweeter-in-chief at the White House, after a particularly controversial tweet, claims his Twitter account has been hacked?”

One of the huge problems with cybersecurity is that most people’s eyes glaze over until some serious breach happens, and then it’s too late. Richard Waters does a nice job of conveying some of the possible consequences so we can keep them top of mind and thus remain vigilant.

I participated in a cybersecurity bootcamp hosted by leaders from the cybersecurity company ZeroFOX a few years ago when I was working out of Betamore co-working facility. One of the lessons I took away was that if someone really wants to hack you, they will. You will never be completely protected so you should plan accordingly. Some of the things I do are to build in redundancy and to fragment sensitive information so as to minimize impact if anything does happen.

Another takeaway is that phishing efforts occur all the time. It’s actually pretty hard to hack someone without any information so hackers look for clues. Some of these efforts are very sophisticated and are hard to identify even when you are alert and ready. Unfortunately, it only takes a moment of weakness, fatigue, or distraction to fall for one of these persistent efforts. Twitter is not unique in this respect.

What the Twitter hack does, however, is suggest some greater scrutiny on the governance of social media is warranted. Clearly, there is potential for mass dissemination of misleading and outright deceptive communications. Clearly, there are a lot of bad actors who face few (if any) repercussions from their bad behavior. And clearly, these things are far better for advertising-based revenue models than they are for healthy social discourse. It’s time to establish a better set of ground rules or we will have major problems.

Topics – inflation

One of the points that is often overlooked in discussions about inflation is that at any given time, there is a multitude of both inflationary and deflationary forces at work. The important thing is to consider all these forces and to avoid overly simplified arguments.

This article from the FT is interesting partly because it highlights just one of the many ways in which Covid lockdowns have affected the economy. It also reminds us that these things take time to resolve.

US liquidators give stores low-price shock

“America’s largest liquidation firms say retailers have been inundating them with calls to offload goods following weeks of lockdown, only to balk at the ultra-low prices they are offering to take inventory off their hands.”

“It’s a big sticker shock, going from full price inventory that you expected to make margin on, to now having to sell it for some fraction of cost. Usually it’s been through multiple mark downs before it gets to that point.”

Another bit of anecdotal evidence provides a peak into the pricing environment. Because GATX leases rail cars, it is deeply embedded in the economic fabric and therefore especially informative of current trends …

GATX Corporation Reports 2020 Second-Quarter Results, 7/21/20

“As customers right-size their fleets, railcar lessors are competing aggressively to place both new deliveries and their existing idle railcars, resulting in significant pressure on lease rates. In the second quarter, the renewal lease rate change of GATX’s Lease Price Index was negative 28% and the average renewal term was 31 months.”

One interesting takeaway from this report is that the renewal rate was down 28%. This is largely a function of price adjusting to balance lower demand with increasing supply. Cars are getting leased, but at much lower rates.

Another point is that with renewal terms of 31 months, the effects of these rate adjustments are just starting to be realized in aggregate revenues. It will take two and a half years for the adjustments to work all the way through and for revenues to bottom – and that is only if nothing changes. This highlights the same point I made two weeks ago in regard to commercial real estate: “a decline and fall takes time.”

Implications for investment strategy

One of the key tenets of finance is the time value of money. Uncertain future cash flows are discounted at a rate commensurate with the level of uncertainty. Higher uncertainty warrants higher discount rates which yield lower security values given the same level of cash flows. Keeping this in mind, at least in a qualitative sense, can help provide some directional guidance regarding valuations.

While uncertainty is often considered in the context of a particular business or an economic cycle, Martin Wolf highlights several sources of global uncertainty:

Covid exposes society’s dysfunctions

“We are living in an era of multiple crises: Covid-19; a crisis of economic disappointment; a crisis of democratic legitimacy; a crisis of the global commons; a crisis of international relations; and a crisis of global governance.”

“The Financial Times series on the new social contract brought out several dysfunctions: over-leveraging of corporations; the disappointments of western millennials; corporate tax evasion; and the low pay of many of the people on whom we have particularly depended in the Covid-19 crisis. In my own piece, I referred in addition to some of the longer-term dysfunctions, including the hollowing out of the middle class and the decline in trust in democracy, notably in the US and UK.”

A couple of things strike me about Wolf’s summary. One is that although none of these items is unfamiliar to me, when considered in aggregate they create quite an ominous environment for risk assets. This serves as a useful reminder of what long-term investors are up against and suggests incremental caution is warranted.

Another idea that occurs to me is that it is hard to escape the growing body of evidence pointing toward the gradually diminishing stature of the US as an excellent place to invest. Characteristics such as stable democracy, rule of law, and robust and diverse economic growth are less descriptive of the US than they used to be. This isn’t to say they have vanished or cannot revive. For now, however, it is most accurate to say they have eroded.

Points of Return email by John Authers, Bloomberg Opinion, 7/22/20

“On Wednesday, the real 10-year Treasury yield (the nominal yield minus the inflation breakeven) dropped below minus 0.9% and briefly dipped under the previous all-time low set in December 2012.”

“These developments are awful news for savers and anyone trying to run a pension fund.”

Authers is exactly right to home in on the real yield of the 10-year Treasury as an important metric and exactly right in recognizing the consequences for savers. Although it is easy to get distracted by any number of sensational headlines, investors should not lose sight of the fact that investment goals are becoming harder to reach. Low returns and increasing systemic risk mean that it will require an ongoing effort to preserve and (hopefully) grow wealth.

Feedback

This publication is an experiment intended to share some of the ideas I come across regularly that I think might be useful. As a result, I would really appreciate any comments about what works for you, what doesn’t work, and what you might like to see in the future. Please email comments to me at drobertson@areteam.com. Thanks!        – Dave

Principles for Areté’s Observations

  1. All of the research I reference is curated in the sense that it comes from what I consider to be reliable sources and to provide meaningful contributions to understanding what is going on. The goal here is to figure things out, not to advocate.
  2. One objective is to simply share some of the interesting tidbits of information that I come across every day from reading and doing research. Many of these do not make big headlines individually, but often shed light on something important.
  3. One of the big problems with investing is that most investment theses are one-sided. This creates a number of problems for investors trying to make good decisions. Whenever there are multiple sides to an issue, I try to present each side with its pros and cons.
  4. Because most investment theses tend to be one-sided, it can be very difficult to determine which is the better argument. Each may be plausible, and even entirely correct, but still have a fatal flaw or miss a higher point. For important debates that have more than one side, Areté’s Takes are designed to show both sides of an argument and to express my opinion as to which side has the stronger case, and why.
  5. With the high volume of investment-related information available, the bigger issue today is not acquiring information, but being able to make sense of all of it and keep it in perspective. As a result, I describe news stories in the context of bodies of financial knowledge, my studies of financial history, and over thirty years of investment experience.

Note on references

The links provided above refer to several sources that are free but also refer to sources that are behind paywalls. All of these are designed to help you corroborate and investigate on your own. For the paywall sites, it is fair to assume that I subscribe because I derive a great deal of value from the subscription.

Disclosures

This commentary is designed to provide information which may be useful to investors in general and should not be taken as investment advice. It has been prepared without regard to any individual’s or organization’s particular financial circumstances. As a result, any action you may take as a result of information contained on this commentary is ultimately your own responsibility. Areté will not accept liability for any loss or damage, including without limitation to any loss of profit, which may arise directly or indirectly from use of or reliance on such information. 

Some statements may be forward-looking. Forward-looking statements and other views expressed herein are as of the date such information was originally posted. Actual future results or occurrences may differ significantly from those anticipated in any forward-looking statements, and there is no guarantee that any predictions will come to pass. The views expressed herein are subject to change at any time, due to numerous market and other factors. Areté disclaims any obligation to update publicly or revise any forward-looking statements or views expressed herein.

This information is neither an offer to sell nor a solicitation of any offer to buy any securities. Past performance is not a guarantee of future results. Areté is not responsible for any third-party content that may be accessed through this commentary.

This material may not be reproduced in whole or in part without the express written permission of Areté Asset Management.


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David Robertson CFA is the CEO of Areté Asset Management and founded Areté with the mission of helping people to get the most out of their investing activities. Most of his career has focused on researching stocks and markets, valuing securities, and managing portfolios for mutual funds, institutional accounts, and individuals. He has a BA in math from Grinnell College and a Masters of Management from the Kellogg School of Management at Northwestern University. Follow Dave on LinkedIn and Twitter.

2020/07/24
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