Friday Haymaker Edition
In The Ring - July 28th, 2023
Slowly Then Quickly
“In economics, things take longer to happen than you think they will, and then they happen faster than you thought they could.” -The late famed economist Rudi Dornbusch
Let’s give this market its due. Perhaps I’ve been wrong and a new bull market started last October, not just an unusually muscular bear market rally. Per both Bloomberg and Jim Grant, the S&P has reclaimed over 76% of the ground it lost during the worst of last year’s decline. That was unquestionably a true ursine event, but the good news is that in all of those years since 1929, the S&P has never retested its lows once that degree of recovery has occurred. (Jim attributed this factoid to Gina Martin Adams, Bloomberg’s Chief Equity Strategist.)
Frankly, I’m pleased with recent market action because the latest phase of the rally has lifted many of my favorite boats. The most cherished of those is, unsurprisingly to my regular readers, energy shares. Since I stuck my neck out on those in our June 23rd Haymaker edition, the energy ETF, XLE, is now up 10.5%*. Meanwhile, the tech ETF, XLK, has continued to rise, but at about half that clip, 5.5%*. For the year, though, tech has crushed energy.
*Revised from original posting to reflect current figures.
On the other hand, from 12/31/20, XLE has erupted by 150.5%, with the tech ETF up a respectable, but much less stirring, 40.5%. December of 2020 is when I wrote one of my most passionate endorsements of oil and gas stocks. It’s titled Totally Toxic and a link to that is included at the end of this Haymaker edition. (Needless to say, not all of my “anticipations” worked out this well, but that was definitely one of my highest-conviction positions.)
To learn more about Evergreen Gavekal, where the Haymaker himself serves as Co-CIO, click below.
Another non-shocker is that I am always uncomfortable being overexposed to highly popular asset classes. Clearly, nothing snaps the sox of Mr. and Mrs. Retail Investor as much as tech does right now. This is despite incipient signs their affections are broadening out, at least somewhat. Yet, to be true to my methodology, I also need to concede that the tech ETF has achieved a breakout to a new all-time high. As many of you know, I’ve learned the hard way to treat those with the utmost respect.
My main problem with going all-in on this development – which hedge fund legend Paul Tudor Jones refers to as “range expansions” – is valuations. This is, of course, in addition to the aforementioned overly zealous love affair between the majority of market participants and all-things tech-related. Well, let’s make that almost all things.
On the unloved-tech theme, there is a name I’ve been tracking in this picked-over sector that I find intriguing. One attraction is that it is in what is arguably the hottest IT space other than AI. That would be cyber-security software.
It’s not my contention that there is only one company that sports a modest valuation among this group. Actually, a quick perusal of Value Line’s July 14th edition covering the cyber security industry reveals one company trading at a single-digit P/E. However, before you go searching for it, please be aware that earnings have been essentially flat over the last decade. (On the positive side, it looks like perhaps a turnaround has been underway since 2019 and, if Value Line is right, it will generate a gusher of free cash flow — definition pending — next year.)
A potentially more compelling play sells at an upper-teens multiple, still a steal in this high-expectation sub-sector. Profits are projected to be at an all-time high this year, roughly double their 10-year earlier level. The decided drawback, though, is that its earnings history has been uncomfortably erratic.
Because I am not suggesting it, I’ll mention by name the superstar of this cohort, Palo Alto Networks (PANW). (Crowdstrike is another, and its revenue growth has been ever more meteoric.) PANW has quintupled in price over the last five years. Sales have more than doubled, but, oddly for a company with a nearly $80 billion market cap, it has been a stranger to profitability, at least on a GAAP basis, throughout its history, until this year. It is also trading at over 10 times sales. Unquestionably, however, it is a very exciting growth stock. Yet, like most of that ilk these days, you are paying a hefty price for that potential… and if there’s ever a hiccup, the downside can be absolutely brutal.
A far less pulse-quickening entity is the one I find most deserving of my investment capital. It’s trading for around 16 times earnings, a multiple more akin to a utility stock. Sales have certainly not doubled since 2019. In reality, they are up only about 20%. Earnings per share are up a bit more, around 30%, but that’s almost totally due to share buybacks. Actual profits have been largely stagnant.
On the sunny side, it generates about $1 billion of free, or excess, cash flow on a $15 billion market cap. (Free cash flow is gross cash flow minus capital spending, which for this industry is next to nothing.) It has no debt, but it also pays nary a scintilla of a dividend. Not paying a dividend combined with its lush cash flow has allowed it to shrink its shares outstanding by almost 40% over the past decade. It also carries an Earnings Predictability Index rating of 100, by Value Line, the only one in this group that is so endowed.
On the downside, profit margins have been sliding and it has been losing market share to Palo Alto Networks, among others. The reason margins have been under pressure is that it is investing heavily in an attempt to reinvigorate growth via a new suite of products.
On that latter point, it just announced a positive earnings surprise about 5% over consensus estimates. On a year-over-year basis, profits are up a hefty 22%. Revenue growth, though, was a mere 3%. Also on the plus side, its main growth driver, its new cyber security platform, hit 10% of sales, up 140% versus the second quarter of 2022.
A possible under-the-radar attribute is that a friend of Evergreen Gavekal’s — where I’m Co-chief Investment Officer — is a big fan of the CEO. This individual has been extremely successful in the cyber security field, to say the least.
There are those who believe WWIII is already being fought between the West and the usual suspects. The battlefield is cyberspace and there is no question in my mind this will continue to be a high-growth area. There is another company, based in Israel, that has caught my eye, but that one will have to await further investigation. Regardless, I’d only buy partial positions in this technology niche for now. Moreover, the encouraging second quarter report for the company in question popped the stock yesterday. Thus, waiting for a retracement might be advisable.
Part of my caution stems from my skepticism that the bear market really is in the rear-view mirror. That benign outcome is highly contingent on validation of the soft-/no-landing thesis. Just this week, the most comprehensive tracker of the U.S. economy — the Chicago Fed National Activity Index — was released. It had the thumbprints of recession all over it, as it has for most of this year.
On another one of my favorite investment themes, there was big news yesterday that is causing me to reiterate my fondness for the Japanese yen. For those of you who listened to my David Cubed podcast, with the esteemed David Rosenberg and host David Lin, you heard the former’s lack of enthusiasm for buying the yen. This is despite his affinity for the Japanese stock market, a fondness I’ve long shared.
However, I continue to believe the yen is grossly undervalued; and far more important than my lowly — and lonely — opinion is that the Bank of Japan just announced it will no longer seek to hold interest rates at the silly-low level of ½% on its 10-year government bonds — 1% is the new ceiling, one that is unlikely to hold longer-term. Sub-atomic interest rates have been the prime reason the yen has been pounded down to ultra-depressed levels. The vast amount of money printing that has accompanied that suppression effort was another primary cause. An upside breakout in bond yields over there should trigger one of the more powerful currency rallies in recent times.
Thus far, though, I’d admit the reaction is underwhelming. Regardless, this is an important first step in restoring the yen closer to parity with its peers like the U.S. dollar and the euro. (Note: In the chart below showing the yen vs the dollar, up is actually down. When it takes 140 yen to buy one dollar versus, say, 100, that means it has lost 40% of its value.)
(Click chart to expand)
Select cyber security software stocks
Japanese yen
Copper-producing stocks
Industrial sector ETFs
Uranium
Defense industry (particularly those contracted to manufacture in-demand weapons systems)
Gold & gold mining stocks
Farm machinery stocks
Select financial stocks
S. Korean stock market
For income:
BB-rated bonds from dominant media companies and healthy automakers with upgrade potential
BB-rated intermediate term bonds from companies on positive credit watch
Certain fixed-to-floating rate preferred stocks
Emerging Market debt closed-end funds
Mortgage REITs
ETFs of government guaranteed mortgage-backed securities
BB-rated energy producer bonds due in five to ten years
Select energy mineral rights trusts
Contenders
For those of you who took advantage of the dip by the Master Limited Partnership (MLP) in America’s leading LNG (liquefied natural gas) shipping company last spring, congrats! You’ve enjoyed both about a 15% price move and a lush yield. Doing some profit-taking is reasonable now, especially if you acquired these units in a tax-deferred account, like an IRA Rollover. (The K1 this entity generates can also be problematic in IRAs. If you do own units in such an account, you might want to check with your tax advisor about incurring any Unrelated Business Tax income due to taking gains.)
As a bit of self-promotion, a number of our yield highlights have produced strong total returns (cash-flow yields plus price gains). This includes BB bonds with the characteristics I’ve cited. It’s not an exaggeration to say, in my admittedly biased view, that just a few of these ideas more than cover the expense of any affordable newsletter subscription cost.
Contender List
Select LNG shipping companies
U.S. oil field services companies
Oil and gas producer equities (both domestic and international, with a particular focus on those well exposed to the Permian Basin)
Top-tier midstream companies (energy infrastructure, such as pipelines)
Singaporean stock market
Top-tier midstream companies (energy infrastructure such as pipelines)
Short-intermediate Treasurys (i.e., three-to-five year maturities)
Japanese stock market
European banks
U.S. GARP (Growth At A Reasonable Price) stocks
Telecommunications equipment stocks
Swiss francs
Singaporean stock market
Intermediate Treasury bonds
Small cap value
Mid cap value
Select large gap growth stocks
Utility stocks
Down For The Count
This is unquestionably one of the most controversial negative calls in Haymaker history… and that’s really saying something! There may not be more popular stock indexes known to woman and man than those that are heavily weighted toward tech. (Wouldn’t that be pretty much all of them?)
But that’s straight down the middle of my contrarian strike zone! When just seven magnificent companies comprise 50% of a major index, that should be setting off ear-splitting alarm bells. Another strident warning is this July 11th commentary from CNBC’s preeminent trend-follower (hey, that was pretty polite, wasn’t it?), Jim Cramer:
It's just so darned easy to bet on the 'Magnificent Seven,' because everything always seems to go right with them," Cramer said. "While the group might get hit because of the Nasdaq 100 rebalancing or a bizarre move in the bond market or even some terrible inflation number tomorrow morning, you know the analysts will come out of the woodwork and they have no shortage of reasons to recommend them.
One thing I’ve learned the hard way over my 44-year career is that there’s nothing easy in the stock market. It may feel that way for a while, but that’s invariably when the clock is about ready to strike midnight for the hot asset class in question. Investment pros call this “chasing the hot dot” and it is one of the sure-fire ways to earn sub-par returns.
For those who are heavy on the Magnificent Seven (Apple, Alphabet/Google, Microsoft, Amazon, Tesla, Meta, and Nvidia), doing some serious profit realization is appropriate, if not overdue. (If you hold them both in taxable and IRA-type accounts, the no-brainer from a tax-efficiency standpoint is to sell them down in the latter.) For more aggressive types who are looking to hedge their long positions, buying puts on a highly tech-concentrated index might prove highly lucrative. (Be aware that you could lose whatever option premium you pay for puts; it’s safer to do this as a hedge against long holdings that have become uncomfortably large.) Once again piggybacking on the work of Jim Grant, rarely has there been a time when taking out downside insurance has been as cheap as it is presently. Also quoting Jim Grant’s Almost Daily Grant’s from this Tuesday:
With past form pointing to more calm seas on the horizon, investors have opted to plow full steam ahead. Bank of America strategists find that, going back to 2008, it has never cost less to protect against an S&P 500 drawdown of 5% or more over the next 12 months, as higher rates and low implied volatility and correlations have presented “a historic entry point for hedges.” The BofA team likewise emphasizes that such insurance comes cheaper than in 2017, when “several records for complacency, including the lowest VIX in history,” were established.
One other point is that, unlike the overall tech ETF, XLK, the high-octane version of the NASDAQ has not made a new high. You may also notice the great signal in the above charts on the yen showing its massive breakdown (again, higher means it costs more yen to receive dollars) it suffered in early 2022, right before it was seriously crushed.
DFTC List
Index funds that are highly concentrated in a handful of mega-cap tech names
The current shooting stars of the latest meme mania (remember, those celestial phenomena last only a few weeks — at the most)
Long-term Treasury bonds yielding sub-4%
Homebuilder stocks
Electric Vehicle (EV) stocks
Meme stocks (especially those that have soared lately on debatably bullish news)
The semiconductor ETF
Junk bonds (of the lower-rated variety)
Financial companies that have escalating bank run risks
The semiconductor ETF
Bonds where the relevant common stock has broken multi-year support.
Profitless tech companies (especially if they have risen significantly recently)
Small cap growth
Mid cap growth
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After quite a bit of research, my personal opinion is that Checkpoint fulfills a number of the criteria. .
Also don’t forget that extreme negative carry (~550 bps/year vs the usd) and very low realized vol make it tough to be long yen - even at these absurdly low levels. On a long-term basis, USDJPY is most strongly correlated with US yields (not equities as so many like to claim). It simply appears like it’s correlated with equities because over the last 40 years, more often than not falling equities are accompanied by much lower Us yields - not the case the last 18 months. Long yen right now is kind of like being long US treasuries except that you get charged the coupon instead of paid it like with UST.