Areté’s Observations 8/21/20
The S&P 500 hit a record high this week which helped fuel positive sentiment. Less positive, however, was the fact that the new high was driven by a very small subset of stocks.
The graph at the right reveals how disparate performance has been by sector. With the exception of discretionary and information technology, no sector has demonstrated especially notable performance since the February high. On the other side of the equation, the performance of energy and financials has been terrible. Both sectors are important for a healthy economy.
Gary Shilling’s Insight letter, July 2020
“A Bloomberg survey of 22,000 adults, conducted before the resurgence of Covid-19, found waning interest by consumers in material things and public events, and they plan to delay major purchases.”
“Also, three-fourths expected to increase their saving rates after the economy reopens, especially younger people who have been hit hard by layoffs and the lack of financial reserves.”
Gary Shilling has been negative (and right!) on economic growth for a long time and remains so in light of the coronavirus pandemic and the record fiscal and monetary measures to combat it. One of the phenomena he has followed is the proclivity to spend. By his account, consumers are hunkering down and trying to save more.
People aren’t just cutting back to fix their household budgets, though. By Shilling’s account, “people are cutting their outlays to save more in order to keep their retirement and other assets from declining along with negative interest rates.” In other words, the “cost” of retirement has gone up and is eating into consumption budgets.
These accounts are very consistent with economic reports showing a much higher savings rate. The key question is how long will the inclination to save persist? The answer to that question will go along way to determine money velocity and therefore the direction of pricing pressures. For now, however, Shilling assesses, “there’s much more Fed-created liquidity out there than consumers and businesses want …”
Target popped on the report of an extremely strong second quarter which saw sales rise 24 per cent year over year. Featured in the report were investments Target has made over the last few years and some strategic decisions that have worked out well.
What I find more interesting is what was barely mentioned at all – the advantages that Target (and other big box retailers) had by being allowed to stay open during lockdowns while smaller competitors had to close.
“During lockdown, big-box chains had a huge advantage over clothing outlets, department stores and other more discretionary retailers that were forced to close.”
Of course, there were reasons for such policies. It wasn’t a bad idea to ensure access to necessities like groceries. However, there were also obvious consequences. Those policies put almost every small retailer at a huge disadvantage to the big boxes.
This context puts Target’s results in a different light. While the CEO’s boast that “Every one of our merchandising categories is gaining share …” is good for Target, it also points to competition that was eviscerated and jobs that were lost.
“The problem is that campuses make an excellent breeding ground for the virus, and students travelling across the world are a good way to spread it. A study by researchers at Cornell found that, although the average student at the university shares classes with just 4% of their peers, they share a class with someone who shares a class with 87%.”
The two graphs below come from The Daily Shot and coincidentally, pose an interesting social experiment. Specifically, a good deal of the southeastern US has relatively high risk that students could arrive at school with coronavirus. As it happens, the areas where FBS schools are planning on playing all of their games this fall significantly overlaps the high-risk part of the country. As it also happens, campuses “make an excellent breeding ground for the virus.”
Putting all the pieces together, it seems reasonable to expect infections will increase among college students in the southeast. Of course, there is no necessary reason for this to happen either. It may be that with proper safety protocols and vigilance, university attendance and NCAA football games can safely resume. Either way, we should be able to learn something from the experience.
Commercial real estate
One of the difficult aspects of gauging the economic impacts from lockdowns is that so many of the effects have been concealed. Moratoria on various payments and other public policy measures have forestalled the economic impact from being immediately visible.
The graph at the right beautifully captures the lag effect. It reveals many of the early delinquencies have evolved into much more severe delinquencies over time. Some portion of these represent imminent, though not yet realized, defaults. It clearly shows a worsening of conditions.
It will also be important to watch these numbers over the next several months for any increases in initial delinquencies. Since leases that received forbearance won’t show up as delinquent, there is a good chance some portion of those properties will become delinquent once forbearance periods expire.
“It is easy to imagine how GPT-3 could be used to empower digital assistants, making it almost impossible to know if you are dealing with a machine or a human. Deployed at scale in a whole range of activities, the software could significantly enhance human productivity and creativity.”
“But the dark uses of such technology are just as easy to imagine, empowering disinformation campaigns and doctored videos, or deepfakes.”
“But the thing that has excited the techies most has been its use of AI to serve up the videos that are most likely to keep its audience hooked. The results of its personalization technology have been addictive, yielding the heightened engagement that is gold dust to a social media company.”
These two stories from the FT go a long way in capturing the conundrum that is technology today. Do we have great technologies that have the potential to vastly improve our lives? Yes. Do we have incredibly powerful technologies that can hobble society if improperly used or actively abused? Yes.
Of course, the same has been true since the beginning of time. The same was true of fire and nuclear power as well. What strikes me now is the cavalier attitude toward the potential downside of technology. People were scared of nuclear weapons and as a result developed something of a governance system around them.
Things like disinformation campaigns, deepfakes, and addictive personalization technology don’t elicit the same kind of visceral reactions as nuclear explosions. As a result, there is far less concerted effort to oppose them.
I highlighted similar issues in a blog post over a year ago. In that post I recommended thinking of AI as “a long journey rather than a short-term destination.” That still holds and as I also mentioned at the time, “In order to make the most of the opportunity, an active effort focusing on education is a great place to start but it will also take a lot of effort to establish system infrastructures and to map complementary strengths.” If these efforts don’t pick up speed, we will experience a lot mor of the dark side of tech than the bright side.
“All too often investment in technology reflects the faddish wish list of the rich and powerful rather than the objective real-world needs of society. Hype often determines those fads, conceals complexity and reinforces existing power structures.”
I don’t have too much to say about this other than I think there is a fair amount of truth to the statement. In my opinion we would be far better off thinking deeply about technology and debating pros and cons for society. What we often get instead is powerful personalities promoting pet projects.
One of the more regularly recurring patterns across history is that of the long-term cyclical relationship of the broad stock market to commodities. Barry Bannister, the market strategist at Stifel Nicolaus, has highlighted this for years as a useful indicator for both stocks and commodities.
There are several reasons why the pattern occurs and one of them involves the investment cycle for commodities. Since the returns on investment are only attractive when commodity prices are relatively high, investments in capital and exploration cluster around those times. At other times, capital is allowed to depreciate and exploration for new sources of supply is deferred. An important part of the supply/demand equation for commodities, then, is the supply the industry can economically invest in.
This dynamic has a couple of implications for the economic landscape. One is that it may help explain part of the recent rise in commodities like oil, lumber, and gold. While it is easy to assume the appreciation is driven by returning demand, and some of it may be. It may also reflect the anticipation of a dearth of supply given the relatively low prices. Insofar as this is the case, it would indicate potential for future inflation – since higher prices will be needed to supply the demand.
Another implication is simply that the S&P 500 is extremely expensive relative to commodities. Given the longstanding record of this relationship, it certainly issues a warning for exposure to stocks.
“Points of Return” email by John Authers, 8/18/20
“What really drives the bond market at present, according to Englander, is progress in the fight against the pandemic. This following chart, also from Englander, shows how the stocks that are most vulnerable to Covid-19 performed relative to tech stocks, and compares this to 10-year Treasury yields. Clearly, yields tend to jump whenever there appears to be a let-up in the pandemic, as there was in early June, and again in the last two weeks.”
“the bond market doesn’t care about a shockingly high core inflation number, but does care about signs of over-supply of bonds”
This is another interesting and thoughtful take on what may be happening with inflation expectations. The conclusion is inflation concerns are a function of debasement potential and not expected economic growth. Further, it suggests coronavirus reports are being used as a proxy for that debasement potential.
Several interesting points are made in this article but the most relevant one to this discussion is that there is “a (growing) level of decoupling between breakevens and inflation fundamentals.” The problem is that with nominal yields increasingly being constrained by monetary policy, they don’t accurately reflect inflation fundamentals. One takeaway is that it just got a little bit harder to gauge inflation. Another is that these are the kinds of asymmetries that can end up causing big problems in the form of unintended consequences.
“In California, Uber and Lyft have been given just days to reclassify their drivers as employees, with minimum wage, sick pay and other rights, unless they win a last-minute delay.”
“Uber and Lyft have said the California ruling would force them to raise prices by 20 to 120 per cent — an indication of how much money they have been saving relative to their law-abiding competitors.”
“The existential question for gig companies is how much demand will remain for their services when they stop being unfeasibly cheap.”
It’s interesting amid all the hoopla about the potential for inflation to start increasing that exactly nobody is talking about the panoply of “tech” firms that have made a business of selling services below costs. It always seemed obvious these practices were unsustainable but there was never a catalyst. Now there is.
While this particular case is being led by the state of California, the issues at hand are much broader. In essence, the California ruling is doing what in my mind never should have happened to begin with: allowing some firms to arbitrage labor costs by playing by a different (and easier) set of rules than incumbent competitors.
Although this is starting with California, undoubtedly several other jurisdictions are watching and deciding if they want to follow. I think this will cause huge problems for a number of companies and I also strongly suspect the consequences will ripple through the pricing structures of a lot of businesses. Sarah O’Connor sums it up best:
“But there was always something unreal about an industry that charges less for its services than it costs to supply them, and ignores labour regulations to which everyone else must adhere. This is the year that reality finally creeps in.”
“Over the past 20 years a growing body of research has shown that a key consideration [in the relationship between minimum wage and unemployment] is the power enjoyed by employers.”
To professional and armchair economists who fervently believe in perfect competition this research will be a tough pill to swallow. After all, supply and demand dictate that raising the price of something will reduce the demand for it.
To everyone else in the world, notably most employees, the world is not a perfect place and the research falls into the “no sh*t Sherlock” bucket. How many people have tolerated a bully of a boss to ensure health insurance for their family? How many people have not even tried to negotiate higher wages for fear of losing what they had?
There is a lot of room for nuance in this argument, but the thing that is apparent to me is many companies have gained undue power over their employees. To the extent this gets corrected, it will lead to some labor inflation relative to where things are now. It is also fair to expect that it will improve living standards for a lot of laborers and therefore improve the robustness of the overall economy.
Implications for investment strategy
“But in many industries, he says, the sense that information matters and must be protected remains stunted. This is particularly true for energy and commodities businesses, where the prevailing view is that oil remains both the old and new oil.”
One of the many things I have learned as an analyst is that companies don’t always work according to the textbook examples from business school. Despite great tools and great management insights and great strategic lessons, businesses are often stunningly imperfect.
This is a special problem for “value” companies. While I absolutely believe in the concept of value investing, it is often true that companies are cheap for a reason. In fact, I highlighted this very issue in a blog post a year and a half ago.
So, when I read Leo Lewis reporting the belief that information doesn’t matter in some companies, I don’t need convincing. I have witnessed the phenomenon myself. This also lends to much of my skepticism about artificial intelligence. It’s not that it isn’t great technology. It’s that a lot of business leaders fail to understand it so completely.
One of the main implications will become increasingly relevant. Many of the types of real assets that can serve as good inflation hedges are also in old school industries like commodities and industrials. This will add a degree of difficulty in finding businesses that can both retain their value in an inflationary environment and not get eaten by competitors with a greater ability to exploit information.
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 firstname.lastname@example.org. Thanks! – Dave
Principles for Areté’s Observations
- 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.
- 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.
- 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.
- 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.
- 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.
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.
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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.