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The Days Ahead:
China retail sales. German GDP Fed minutes.
Snap. It was always going to be the most over-hyped stock of the year and it lived up to its reputation. Before we pile in, this is a $16bn company that IPO’d at $17, went to $24 and traded at $11 late Friday. It’s essentially a venture stage company facing aggressive price competition from larger companies, high expenses and disenfranchised shareholders. In its first full quarter, it lost $192m. It’s lost $2.2bn this year. Cash is about 85% of its tangible assets. It will run out of cash some time later this year unless it can increase revenues by 100% every quarter. Which will be tough because they're also lowering ad prices. It spent about $3.60 per user to generate $1.05 per user (h/t Andy Swan). That's the sort of costs you’d expect for your first 100,000 users. But at 173m, it's ridiculous. Yeah, and I’m looking at you Blue Apron, as well. And Twitter. And GoPro.
Anyway, we’re old fashioned and like companies with real balance sheets, experienced management, cash generative operations, equity. Ya, know. Real business. So Snap’s not really our thing. We wouldn't really mind about this sort of company but here’s the problem. For many millennials, this type of IPO, valuation, business model and disdain for shareholders are devastating. If the Snaps of the world shape their investment experience, they may be put off investing and the markets. For good.
The gap between the political headlines and financial reactions continues. The casual talk about hurling missiles around of course brings to mind Cuba in 1962. Back then discussions were tightly controlled, measured…and information kept at the highest security levels. The market had no details of the brinkmanship. Still, stocks fell 5% but recovered very quickly. History suggests that’s very normal. Our 118-year history of the Dow Chart (do check it out) shows that political events tend to have very little effect on markets. It’s earnings and inflation that push stocks.
1. Running out at NASDAQ:
The largest components of the NASDAQ index are the big five tech companies, which are up between 15% and 30% this year. The entire market is around 3,100 companies and market capitalization ranges from Apple at $800bn to Top Ships at $0.6m. (You can check out Top Ships here where the price fell 99.9999%. No, it’s not worth a punt. But, you know, not investment advice.)
The NASDAQ trades at half the yield of the S&P 500 and is 50% more expensive. The ROE for the S&P 500 is 14% and has dropped below that number only once in the last 20 years. NASDAQ’s ROE is 12% and it's never been higher than 14% in the last 20 years. It has 23% in tech, about the same as the S&P 500. But many investors use the QQQ ETF to track the NASDAQ, which is a mash-up of tech, large companies and growth. It’s over 50% in tech and explains this:
NASDAQ has been on a vertical climb for the last 18 months. Normally those two “moving average” (MA) lines are well below the blue line. In this case, we changed the scale for the MAs because they're sitting right on top of the price line. We've had no meaningful correction since the 7% decline in June 2016. Last week, we saw a 3% correction despite North Korea (stop me if you heard it) and some high profile poor results.
We get it that investors like growth in a low growth economy. And that low rates mean we can value stocks at a higher multiple. And company profitability has moved inexorably towards capital and away from labor. And that VIX is almost meaningless below 15. But markets need corrections to flush out the quick money and we would like to see one.
2. Inflation and Bonds:
Inflation is a killer for bonds. That's when the value of your fixed coupon erodes and current rates cannot keep pace with price changes. That's not happening now. In fact, the Fed has warned repeatedly that inflation is running too low, and some 50bps below the target rate. On Friday, we had the CPI report, which along with the employment report, is important to both the Fed and markets. Here's the chart:
The core number is bumping along at 1.7%. It hasn’t decisively broken above 2% since 2008. The weak components are lodging (down 3.6%), airfares (-6.8%), used cars (-4.1%) and wireless costs (-13%, that black line in the lower chart). These alone count for around 10% of the index. The big one, housing, is up around 3.2%.
On the wages side, real average weekly wages are up only 0.8%. We think that employers are still very reluctant to increase wages. They may reduce hours for the same pay or increase benefits both of which will show up as wage increases. But that’s not the same as putting extra discretionary spending in employees’ hands. We're in the minority in this view. Many people, including the Fed, think wage inflation is just around the corner.
Put all these together and we see core inflation running low at least until the end of the year. In our view, it won't force the Fed’s hand and we expect no rate increase until December. Meanwhile, they will tighten moderately by working on the balance sheet.
U.S. Treasuries rallied and are now at the bottom of the 2.2% to 2.4% range that we've seen since March. We think the debt-ceiling problem is real. We've already seen T-Bills maturing just this side of the debt ceiling deadline of early October rally more than those maturing afterwards.
There is no conviction in equity or fixed income markets right now. Even the South Korean Kospi index was off around 6% and it's still up 15% this year. We'll recreate a chart put out by the folk at Informa Global market, which shows the ratio of the Dow Jones Transportation stocks (i.e. cyclical growth) and utilities (defensive) overlaid with 10-Year Treasuries. If the line slopes down, we’re in a more defensive market, which seems to be the case right now.
Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice. We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security. The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended. Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data. Past performance is no indication of future results.
All charts from Factset unless otherwise noted.