- We’ve seen a huge amount of new retail investors joining the financial markets, with the ambition of finding opportunities to “buy the dip”. Whilst they have benefitted from the rebound, we question how much longer can this last.
- Cash on the side-lines as a percentage of the overall market value is ultimately one of the biggest drivers of market performance. The dramatic increase in money-market funds should be interpreted as a word of caution.
- As a society, we’re not ready nor willing to face an extended period of time living “below our means”. We’ve started to study the potential solutions for the economic and financial distress we’re facing, which ends up driving political and social tensions across the globe.
A summary of where we came from:
As the virus hit, the S&P 500 dropped 34% from its all-time high in February 19, until it began a bear market rally on March 23.
Since then, the S&P 500 has rallied 37%, and only needs a further 10% increase to reach the February 19 all-time high.
The rebound has been driven by a cumulative effort from the U.S. government and the Federal Reserve to support the market and the economy, comprised of:
- $2 trillion dollar rescue package from the U.S. government that includes $1,200 one-time payments to most adults (those earning less than $100k a year) and $500 to children, as well as increased unemployment-insurance support to the states
- Federal Reserve added $3 trillion to its balance sheet in three months in an effort to limit the economic damage to the economy (for comparison, it added $1.4 trillion post-GFC over a two-year time span), as well as lowering the federal funds rate range by 1.5% since March 3 to 0-0.25%
- The willingness of the current administration to run an almost $4 trillion deficit in 2020, and of the Fed to step into a broader set of asset purchases, like corporate debt and business loans
The latest economic indicators seem to show a small sign of recovery: during the month of May, U.S. retail sales jumped 18% meaning that some level of consumption is coming back (especially from lower income levels boosted by the government stimulus) and 2.5 million jobs were added in the economy. Flash PMI releases, which look at how market conditions are evolving through the lenses of purchasing managers, show a slowing contraction overall. However, all of this may have been expected given the historic contractions through March and April, and the equally historic responses from the federal government and the federal reserve”:
- Since March, nearly 40% of low-wage income earners lost their job
- There are still almost 20 million people unemployed since the beginning of the virus
- The Congressional Budget Office estimates that U.S. GDP will be $2 trillion lower in 2020 and $1.9 trillion lower in 2021 than previously forecasted before COVID happened
- 42% of employees who have lost their jobs likely won’t return to their former employers
- Corporate indebtedness is taking its toll: companies defaulted on $14 billion junk bonds in April (three times the volume seen in April 2019), with J.P. Morgan estimating that junk defaults have already reached a 10-year high at 4.8%. Goldman Sachs expects that number to reach 13% by year-end and Bank of America 21% by 2021.
- The market is under-appreciating this risk. As reported by the WSJ, “the market is currently pricing in a 12-month default rate of 8.1%. A different model produced by research firm CreditSights put the market-implied default rate on Friday at 7.4% over the next nine months.”
No one really knows where we are headed, as there are as many moving parts here as characters in the Game of Thrones or “That’s what she said” jokes in the Office. But we’re committed to studying different schools of thought to learn where we might be headed next. Currently, we believe that the most important themes to be aware of in order to understand the markets are:
- The understanding of how the current structure of the financial markets affects price discovery
- The role of central banks within that structure, and the further steps that both governments and central banks can take to support (or manipulate) the markets
- The evolution of economic indicators as a true representation of the reality in which the overall population lives, and how the discrepancy between these indicators and the markets can continue to challenge the peaceful functioning of society
We’re studying those themes and will be covering them at length in the next publications.
Retail Mania Like the Ones in the History Books
The most important recent development in the market is that we’ve now entered a “mania” phase of the “Everything Bubble” which is likely to become a Michael Lewis or an Andrew Ross Sorkin book. As Roger touched upon in this month’s Macro print:
“The US equity market that was making all-time highs in February 2020 was devoid of the emotional buying of private investors. It was fueled by the dispassionate flows of corporates and pension funds. Today, however, is another story. We now have the emotional involvement of the retail investors to complement the re-leveraging of the shadow banks, systematic funds and hedge funds.”
Prior to COVID, the market was already making all-time highs, but that was mainly driven by institutional money and passive flows; in contrast, we now have an over-participation of retail investors who buy stocks without, on average, any fundamental knowledge of the market (a traditional KPI for stock market bubbles). What the COVID bear market rally has brought us is the massive adoption of “zero commissions” trading activity from non-professional retail investors, something that we’ve already touched upon last month. These retail-investors euphoria has been led by earners of income between $35,000 and $75,000 probably at the sound of Dave Portnoy’s tweets. Analogously, it would be like following Phil Jackson’s strategies on a NFL field – although we all respect the coach, we’re talking different sports.
Hertz has become the poster child of this new retail involvement. Stocks entering bankruptcy proceedings have seen their share prices soar. At one point, Hertz had gained 600% in a few trading sessions on an incredible surge in volumes.
They had approval from a bankruptcy judge to go ahead with an equity placement of up to $1 billion, before announcing that they planned to raise $500 million on the open market. The prospectus did at least warn potential investors that they would most likely get wiped out unless there was ‘a significant, rapid, and currently unanticipated improvement in business conditions.’
Eventually, the SEC intervened, and Hertz pulled the plug on the idea. But Hertz is not alone in this lunacy. Chesapeake Energy, flirting with bankruptcy for a few weeks, has also seen its prices surge and collapse on massive volumes. This is a market that, taking its lead from the Fed, doesn’t want to see bad companies die.
Despite how risky all of this seems, if we just focus on returns, buying the dip has worked well for retail investors. As Fortune wrote earlier this month, “Retail investors outperformed in part because they were quick to snap up value stocks as the rally gained traction. While high-quality growth stocks outperformed as the market tanked and in the first few weeks of the rebound—benefiting institutional investors who shifted to growth stocks amid the decline—since mid-May, the rally has shifted toward cyclicals, small-caps, and economically sensitive stocks, Goldman notes. “Stocks with these qualities…were quickly embraced by value-seeking retail investors, and now make up a large portion of our retail basket,” strategists at Goldman write. The firm notes that broker data reveals a tripling of retail trading activity as the market declined.”
Retail investors have apparently outperformed seasoned hedge fund managers. The Twilight Zone is real. But, as Tim and I have discussed over the last few weeks, to what extent isn’t this actually fair? To what extent isn’t this simply a way for the other 99% to participate in the upside of a roaring stock market? Asked differently, why should retail investors, even if they are less experienced, not be allowed to capture some of the free stimulus money that is driving markets ever higher?
Retail’s interest in slightly more complicated products, like derivatives, has also been peaking. The risk for many is the overuse of leverage, intentionally or not, which can have tragic consequences.
Also, it is important to keep in mind that companies like Robinhood, although they correctly advertise themselves as commission-free, really aren’t free. Robinhood sells its customer’s flow to high-frequency traders who in turn execute the trade in the market and profit from what is called a bid-ask spread. This means that if you are trading through the platform, you’re likely buying stocks at higher prices or selling them at lower prices, and Robinhood, as well as the high-frequency traders, profit from that difference. As the WSJ reported in 2018:
“If a customer buys 100 shares of Apple for $200 each—a $20,000 purchase—Robinhood could get up to $5.20 for routing that order to electronic-trading giant Citadel Securities LLC, according to calculations based on a recent Securities and Exchange Commission filing.
Schwab would be paid around 9 cents for sending the same order to Citadel, while TD Ameritrade would get 16 cents on average, according to these companies’ SEC filings.
That’s a nearly 60-to-1 difference between what Robinhood and Schwab are paid. The gap isn’t always so wide, because of differences in the formulas used to determine the size of the payments. Still, Robinhood often makes much more for the same orders, the filings suggest.
One executive with a high-speed trading firm that executes orders for Robinhood said its price improvement is much worse than that of competing brokers.”
There’s nothing wrong with Robinhood’s business model, but we wonder about how many retail investors are really aware of this? And how many of them, if they were aware of the difference in the quotes they are getting, would continue with the same broker?
Ultimately, the key question surrounding retail investor’s involvement in the markets is how long can this trend actually continue? How long can retail investors keep on bidding for bankrupt stocks like Hertz, GNC Holding or Valaris, and come out on the other side as (temporary?) winners in the craft of trading? And when the market turns south, if it ever does, could we have even further social unrest as the retail segment sees their profits evaporate? This is a really challenging market to invest in, as it makes large moves rather quickly:
- The February/March correction was the fastest one into bear market territory in history
- The subsequent market rebound from March 24 to 26 was the largest three days positive move in 80 years
These swings can easily put a dent in retail investors already fragile finances. Yes, the average Robinhood trading account size is $1,000-$5,000, which is a much smaller asset base than its competition (E-Trade, for example, is almost $70,000), but remember that prior to COVID, 40% of Americans did not have $500 to cover an emergency life event. The total asset base of Robinhood clients playing the markets is probably low, and as such, even losing a couple of thousands of dollars could be a detriment to their living standards.
More than a David and Goliath battle of egos between retail and professional investors, we’re just hopeful that this retail mania does not add on to the already damaged social infrastructure we currently live in. Personally, we believe that the entire movement towards enabling retail easy access to financial markets will need to be regulated or controlled in a stricter way. But only time will tell.
A Crisis for Some is a Blessing for Others
Whilst the current environment has been a crisis for some, it has also been a blessing for others. As the Financial Times reported, “In a dismal year for most companies, a minority have shone: pharmaceutical groups boosted by their hunt for a COVID vaccine; technology giants buoyed by the trend for working from home; and retailers offering lockdown necessities online”. Some stats:
- Amazon added more than $400 billion in market capitalization since the beginning of the year, despite Bezos warning that they will have $4bn of COVID-related expenses in Q2, which would eclipse the $4bn of operating profits one could expect for Q2 under normal circumstances.
- Tesla has become the most valuable automaker in the world, with a $180 billion market cap, despite Elon Musk saying on Twitter that Tesla’s stock price was too high. For perspective, they’ve sold 190,000 vehicles in the U.S. in 2019 compared to Toyota’s 2,300,000, which is currently worth a couple of billion less than Tesla.
- Netflix added $55 billion in market cap since the beginning of 2020, after having added two times the level of subscribers they had forecasted for Q1.
- Zoom Video added $48bn in market cap, despite all the awkward situations it has put us on in the last couple of months (the camera is ON, dude). The stock price is up 270% year-to-date.
What does it mean for capitalism, and competition, when big companies get bigger during times of crisis?
Cash Levels Rule the Market
“A bounce from the depressed levels of late March was warranted at some point, but it came surprisingly early and quickly went incredibly far. The S&P 500 closed last night at 3,113, down only 8% from an all-time high struck in trouble-free times. As such, it seems to me that the potential for further gains from things turning out better than expected or valuations continuing to expand doesn’t fully compensate for the risk of decline from events disappointing or multiples contracting.
In other words, the fundamental outlook may be positive on balance, but with listed security prices where they are, the odds aren’t in investors’ favor.”
Howard Marks, The Anatomy of a Rally (June 2020)
With the latest addition of retail investors, we feel that we’re in a “mania” inside a financial and economic recession, and although one would expect a return to the mean eventually, there’s no real reason for it to happen today or tomorrow. There is little difference between being “early” and “wrong” when you’re judged on your ability to generate returns, so we should always make an effort to avoid group-think and realistically assess the odds in front of us.
The extreme levels of dislocations have continued since we flagged them in May. With cross-assets correlations at two decades high, as pointed out by J.P. Morgan, currently it’s not easy to find ways to diversify risk exposure.
How do you generate any alpha if the market moves with the magnitude it currently does, and all in the same direction? It almost seems that, if you’re long the market, you’re likely to make money but not beat the market (bad for money managers, good for passive funds). If you’re short the market, then you’re likely losing money (pretty bad for everyone involved). And if you’re in the side-lines (i.e. you hold cash), you’re likely not getting any return (and in some places you’re paying negative interest rates on your cash accounts), which could be good or bad, depending on your risk tolerance.
The reality is that we’re currently in a market driven by liquidity and central banks stimulus, which leaves little space for market participants to use economic indicators or corporate fundamentals for price discovery. It is indeed very hard, and almost pointless at this point, to discuss “fair values” and valuation multiples given how distorted the market currently is.
You see, market participants tend to behave in a tribalistic way, where they build an opinion and constantly tweet or look for arguments to support their view (confirmation bias). Some are right, some are wrong, but that is not the point. At The Lykeion, we tend to avoid belonging to any tribe at all, as we want to maintain clarity of thought. Everywhere we look at, left and right, is a chart flagging how expensive the market is. Whilst we agree with that, could it be the case that the market continues to get even more expensive? Have we reached a point in which the market is not a forward-looking indicator of the economy, but rather a dynamic mechanism of high-frequency traders reacting to flows managed by algorithms? Do valuations matter in the way they used to? We’re studying this theme and will be writing on it in upcoming editions.
On that topic, we’ve had an exchange with Logica’s Mike Green on Twitter, where we asked him about this, and he highlighted how prices are a step-function of cash, and the more cash is invested in the market rather then held on the side-lines, the more valuations will mechanically need to go up. In his words:
“The challenge is the term “valuation”. Makes sense when money resides with discretionary investors where cash is base asset and securities are purchased based on forward expected return. Presumably, a scenario exists where a discretionary manager finds nothing priced for positive expected return and sits 100% in cash. Obviously, restrictions on portfolio construction reduce the proportion of cash allowed. This ability to “flex” cash levels is largely what determines valuations. Ultimately if I buy and you sell, “cash levels” don’t change. The urgency with which I get rid of my securities relative to your urgency to sell cash determines price, which changes cash as a percentage of the market. Note the inverse relationship between cash in money market funds (roughly approximates cash as a percentage of the market) and S&P price.
These prices are then compared to some denominator – Book Value, Sales, DCF, etc – to determine “valuation”. But unless market participants respond to the valuation signal [i.e. unless cash levels change], it has no impact on prices. The only thing that matters is cash levels. And this is where passive changes the game by agreeing in advance they will NEVER hold cash. As passive gains share [of total funds in the market], the proportion of cash falls mechanically driving “valuations” higher. As discretionary managers evolve to keep up, they in turn hold less cash as well, creating conditions where the only source of liquidity is cash external to the market. Needless to say, getting this cash into the market is challenging under most conditions. The easiest way the Fed can create buying power is by pumping up collateral, i.e. bonds. Systematic rebalancing means bonds must be sold and equities bought. This leads to the mistaken impression that cutting rates or buying bonds provides “stimulus” that then gets discounted into “valuations.” This is not the mechanism at work. It’s a collateral play.”
He makes it sound simple…
As the Fed lowers interest rates or buys bonds, it drives bond prices higher. When funds need rebalancing in order to maintain the same level of exposure they advertise in their prospectus to the different asset classes, and as bond prices increase driven by the Fed bids, the average fund ends up being a seller of bonds and a buyer of equities. It is through this mechanism that some of the Fed stimulus ends up being reflected in higher equity prices, and when you take into consideration the amount of stimulus received by the Fed since the pandemic broke out, it becomes a touch easier to understand the mechanics of why we’re witnessing higher prices.
That being said, if we follow Mike’s theory in which we assume that cash levels is the only thing that matters, what happens when cash on the side-lines start to swell to record highs? Assets in money-market funds have increased by $1 trillion since the beginning of the year, reaching a record high of $4.6 trillion. Companies are doing the same and are now actively hoarding cash. As reported by the WSJ, “for S&P 500 companies, the median increase in cash and short-term investments was 13.9% in the March quarter, compared with less than 4.1% in the prior three quarters, the analysis found. The degree to which firms spent or saved those funds will be evident when they report second-quarter results starting next month.” This is something that Roger mentioned in the May Macro print, and it might well be the first stage of the deflationary spiral we discussed.
These are all negative developments, in the mid-term, for the markets. Not only because a deflationary backdrop is negative for economic fundamentals, but because the market is now at risk of losing the boost mechanism of cash. Ultimately though, with the amount of money the Fed can inject into the markets, and with the continued rise of passive investments, it is always important to approach cash on the side-lines not as an absolute measure, but always in comparison to the overall size of the market. Yes, cash on the side-lines as a percentage of the total market size is increasing, but how will that change in the coming months? These are the questions we keep in front of us.
A Word on the Fed
The Fed can be compared to MJ on the Chicago Bulls during the 1980s (I’ve seen the Last Dance and now believe that I know all about the NBA, despite still not really knowing the job of a point-guard on a basketball court). In the 80s, Michael Jordan was the most important player in the sport, the one that ultimately decided the outcomes of the games. Everyone had an opinion on him, and the media spent an extraordinary amount of time covering every move MJ, or analogously the Fed today, did. For our European friends, the Fed now shapes the faith of the markets like Maradona did with the Serie A in 1986/87.
As we try to be as objective as possible in this publication, one could say that the Fed is battling a global pandemic, the highest unemployment rate since WWII, challenging demographics, the threats of deflation, an over-levered economy, a consumer base that barely has any savings, geopolitical tensions between the two largest economies in the world, de-globalization, kids addiction to TikTok and a society in which the Kardashians have more influence than Alain de Botton. With that backdrop, one would say that the level of stimulus The Fed has agreed to provide to support the economy is justified action. And in part, it is, but for one main reason: the only real battle the Fed is battling is a political one.
We’re starting to believe that the only way we can get out of this challenging backdrop without fully restructuring (or destroying) the entire system we currently operate under is through austerity, the increase of the net national savings rate, the promotion of competition and a prolonged period of living “below our means”. That is economics 101, ladies and gentlemen: we’ve spent the better part of the last three decades pulling consumption forward, and eventually, that will catch up with us (see this month’s Editorial for a discussion of the U.S sovereign debt crisis). But given that it is unclear of “when” it will catch up with us (if ever), no politician, central banker, or individual consumer wants to be the one paying the dues of decades of consumption beyond our means. We selfishly want to get the best out of our time on earth and pass on the problematic consequences onto other generations. I mean, why would this be the generation, or the administration, that purposefully puts a limit on what we can spend and produce because others have not been willing to do so?
But it takes more than a couple of people behind a brand-new financial publication to find a solution for this. That is why we’re studying the theme and speaking with subject matter experts, and will be continuing to cover these themes in the coming months.The Russell 2000 (IWM) is still down 18% since pre-COVID highs
Keeping track of the spread widening between the Russell 2000 and the S&P 500 matters for two main reasons.
First, it validates the importance of passive flows effects on investment returns. The mega-caps of the S&P 500, meaning the top five companies in it (MSFT, APPL, AMZN, FB, GOOGL) now represents 20% of the entire index. The last time this happened was in 1999 at the height of the tech bubble, right before it burst. The Russell 2000 does not have the liquidity flow monsters in it and that partially explains the performance differential.
Second, if we assume that the S&P performance is distorted by the size and performance of the mega-caps which realistically do not represent the overall market, then the Russell 2000 more closely reflects the actual conditions of investor sentiment towards most US equities, which are down over 13% as of June 23 close compared to down 3% for the S&P. That number is much more consistent with the rest of global markets like the Eurostoxx 50 in Europe, which is down 15% year-to-date. Takeaway: Look at the Russell 2000 for better indicator of appetite for U.S. equities.
Oil & Gas Exploration ETF still ahead of oil prices
We’ve seen WTI Crude Oil clinging to intermediate highs near $40/barrel, while XOP, the Oil and Gas exploration ETF, has faded from the mid-$60s back into the mid-$50s, a 15% move lower. That is somewhat justified as the oil exploration sector has moved ahead of WTI despite the fact that it needs oil closer to $50/barrel to justify any business operations for many of the companies it follows, especially those with U.S. shale exposure. If one needs to play a sustained rebound in oil, the lower risk way could potentially be via the oil large cap conglomerates such as BP, RDS, and XOM. With WTI crude oil still under $50/barrel, it is hard to see the light at the end of the tunnel for oil exploration companies.
Betting industry going online
Consider the Gaming sector, where a sustained revenue collapse has already hit. Las Vegas Sands (LVS) is one particularly vulnerable entity. LVS is the 800-pound gorilla in brick and mortar casinos, with a market cap of $35 billion compared to $9 billion for MGM, their closest competitor. LVS is looking at a 50% haircut on the top line in 2020 and the “hope” is that they can return to 2016 levels by 2021. They also have a significantly higher exposure to China, representing 80% of their revenues compared to 14% for MGM. DraftKings, on the other hand, is in a unique spot because they represent online sports gambling, and have one of two licenses to operate in New Jersey, which recently legalized sports betting.
If one assumes gambling will increasingly occur digitally and one also believes that the US will continue to open up sports gaming on a state by state basis (state finances could benefit from taxed gaming revenue in order to fill budget deficits), then the price action differential between LVS and DKNG starts to make sense. The question is, will this narrative continue to hold?
High Yield Corporate Bonds ETF sees record inflows despite massive defaults on the horizon
As the Fed announced an unprecedented purchase plan for HYG (ETF that tracks high yield corporate bonds market) earlier this year, the market reacted by expanding this ETF’s total shares outstanding by almost 100% in a few months. That’s over $10 billion in new money flow into the HYG in just a few months.
The increase in HYG share count shows another distortion in the capital markets, as the increased demand for the ETF has basically matched the supply of bad corporate debt (which shouldn’t have been touched) with demand of investors trying to buy the dip in the index. This is likely to create an environment of future defaults and financial distress in the corporate bond market.
If one recalls the 2006-2008 packaging of toxic mortgage products going too far, it created a real-world bubble where borrowers were able to borrow unreasonable amounts backed by overpriced assets with very low repayment odds. We believe even made a movie about it with Batman, Tyler Durden, and Michael Scott.