The Knock-On Effects Of A Deleveraging China

Over the last two decades China has been following the Gerschenkron Growth Model to deliver high levels of extended economic growth.

The Gerschenkron model of growth goes like this:

  • Undeveloped countries are plagued by poor infrastructure and have low savings and investment rates.
  • To increase investment and boost development, they lower the household’s share of GDP thus increasing governments and producers share of GDP. This in effect raises the nation’s savings rate, providing more money to invest.
  • This investment is then directed by government into big infrastructure projects and export focused industries.
  • The country then grows by increasing its market share of global exports and investing in high return projects.
  • Eventually the country maxes out the amount of productive investment it can absorb. This results in each new unit of debt having less and less of a positive economic effect.
  • The vested interests who became rich and powerful on the back of the investment led economy aren’t incentivized to rebalance. So they keep adding unproductive debt until, eventually, debt servicing costs exceed the economy’s capacity to service it and the economy inevitably goes through a painful forced or managed rebalancing.

China is now at this last step.

China has to rebalance its economy. It needs to transition from an investment and export led economy to a consumption based one; retransfer wealth from the vested interests in local government and private businesses back to households. In addition, it needs to deleverage by paying down, writing off, or inflating away its debt stock.

The quickest way to resolve a debt problem like this and rebalance an economy is to go through a financial crisis where assets are sold and debt written down. This is what the US did in the 1930s. But China can’t go this route because this path involves high levels of unemployment that bear socio-political risks, which the CCP can’t afford.

A much more likely scenario (which I believe we’re beginning to see now) is one where the CCP takes a gradual and pragmatic approach.

They assign the debt servicing costs to local governments, who are then forced to sell assets in an orderly manner to pay down debt. And then the CCP goes after debt in the most vulnerable areas of the economy, primarily the off-balance sheet / shadow banking sector and P2P lending, while balancing this with leveraging in the visible areas parts of the economy (ie, local government issuing bonds to boost specific investment).

This approach means that we shouldn’t expect a hard landing or financial crisis. It’s likely to look much more like Japan’s lost decade, though China has made it very clear in recent months that they won’t make the same mistake the Japanese did and let their currency strengthen too much. So we should expect the yuan to continue slowly devalue against the dollar.

When I share this China bear thesis with people I almost invariably get the question “Why now? What’s keeping them from kicking the can down the road, again?”

That’s a fair question. Chinese leaders have publicly stated as long ago as 2006 that the country had a serious debt problem and that they’d work to deleverage. Only to obviously do the opposite.

But there’s been a very important change over the last year that makes this time different. And that’s the centralization of power.

Only two types of government have been able to handle and survive a difficult economic and debt rebalancing like this (1) robust democracies with strong institutions (like the US in the 30s) or (2) strong centralized authoritarian regimes (like China in the 80s).

This is what the whole anti-corruption campaign and last year’s 19th Party Congress where Xi became de facto emperor, are all about: Xi consolidating power.

Many people have the misconception that the Chinese government is a well oiled machine, where word is past from on top and carried out at the bottom. But in practice this isn’t the case at all.

The real power and control over debt fueled spending has rested with the vested interests at the local government level; from the provincial on down.

There are two Chinese idioms that relate how things actually work, one is ‘heaven is high and the emperor is far away’ and ‘from above there is policy, but from below there are countermeasures’. Meaning, local government officials are free to do as they please, even if it goes against Beijing’s wishes.

This is why over the last decade we’ve seen leaders in Beijing come out talking about the dire need to rein in the country’s debt but local leaders continuing to borrow, spend, and build.

The vested interests who have become rich and powerful are reluctant to stop the activities that made them so.

The anti-corruption campaign that has punished or jailed over 1.5 million party members since 2012 has been effective in clamping down on dissidence. Xi now has the control and authority to carry out Beijing’s wishes.

The SCMP reported last week that updated party rules “state that failing to implement policies from the top is now officially a breach of discipline that can see cadres lose their jobs or even be expelled from the party. Those who refuse to implement policy directives from the party’s Central Committee, who run their own agenda, or ‘are not resolute enough, cut corners or make accommodations’ in applying them, will be subject to punishment under the new rules, which took effect on August 18.”

That’s why this time IS different

President Xi clearly stated his intentions in 2016, saying “If we don’t structurally transform the economy and instead just stimulate it to generate short-term growth, then we’re taking our future… If we continue to hesitate and wait, we will not only lose this precious window of opportunity, but we will deplete the resources we’ve built up since the start of the reform era.” He finished by stating that the country had until the end of 2020 to make this transition.

Another common objection I hear is, “they’re not deleveraging, they’re easing!” But this isn’t so. This misunderstanding is partly due to a failure to view the data holistically as well as intentional misdirection by the Chinese in order to manage the market’s response.

A recent paper by the Paulson Institute (the Macro Polo blog) helps clarify the recent words and actions out of Beijing. Here’s some highlights from the report with emphasis by me.

Upon a cursory look, the message from the Politburo meeting seems contradictory, emphasizing both deleveraging and growth. But this can be reconciled by clarifying just exactly what Beijing means by “deleveraging” in the current context.

Top policymakers are well aware that they’ve gotten a lot of flak from businesses and investors, as well as local governments, for tightening policies that have dried up credit. The complaints have grown since the beginning of 2018, so the Politburo meeting’s emphasis on deleveraging is meant to signal that amid grumbling among the masses, the central government is holding the line. In other words, Beijing isn’t going to do what’s popular—opening up the credit spigot again—but rather doing what it deems necessary for China’s economic stability. Indeed, the July Politburo meeting readout notably included Beijing’s renewed vow to uphold deleveraging, which was not included in both the April Politburo meeting readout and the December 2017 Central Economic Work Conference.

Even though the emphasis on deleveraging remains fixed, the central government appears ready to tweak its approach around the edges. Based on the readout of the latest State Council Financial Stability Commission meeting, deleveraging in 2H2018 and beyond will be targeted rather than across the board. At least for the time being, deleveraging has been tweaked to mean “structural deleveraging.”

What this means in the second half is that deleveraging will mostly rely on administrative measures targeted at state-owned enterprises (SOEs) and local governments. Meanwhile, the existing financial measures will remain but will not be further tightened, and monetary policy will become more accommodative and be more in line with inflation trends. In other words, Beijing is simply moving from its triple threat on tightening to just a “double” threat.

A more accommodative monetary policy does not necessarily mean that credit growth will increase. In fact, credit growth will likely remain subdued because of the continued clampdown on shadow banking. Even in the absence of additional regulations, the shadow banking sector will continue to shrink in size under the existing policy environment. If Chinese banks remain reluctant to lend to high-risk borrowers, then the disappearance of shadow banking won’t be offset by increased lending through formal channels.

You can find the report here, it’s worth reading in its entirety.

China is deleveraging and we should expect this deleveraging campaign to gain momentum over the next two years. The current trade war with the US gives the CCP even greater political cover in carrying out painful reforms as it gives them an easy scapegoat to assign blame.

Why this matters

The knock-on effects of a deleveraging China will be numerous and far reaching. The increased market volatility, the bear market in EM, the collapse in gold, and the rise of the dollar are all just the start of things to come. There’s no doubt that it’s long and slow deleveraging will be felt everywhere.

And one thing I find interesting is that this is all starting just as the market’s become blind to the China slowdown threat after fretting about it for years. The chart below via BofAML shows that the China tail risk is hasn’t been front and center on investor’s minds in nearly 4 years.

Practically speaking, we should expect EM to continue a slow and grinding descent lower — again, we shouldn’t expect any quick crashes, as global liquidity remains relatively robust. It’s likely that the EEM breakout of last year was just a massive bull trap. Price should continue lower back into its consolidation zone from here.

China’s largest trading partners (shown on the chart below via Atradius) are some of the most exposed to a Chinese deleveraging.

 

 

Ray Dalio on Debt Cycles, A Long Tech Trade, And God Walking With The Devil

Alex here with this week’s Macro Musings.

As always, if you come across something cool during the week, shoot me an email at alex@macro-ops.com and I’ll share it with the group.

Recent Articles/Videos —

China VS Russia & Japan — Is China headed for the same disaster both Russia and Japan experienced? Make sure you subscribe to Fallible to follow our latest series on China’s downfall!

Why Emerging Markets Are A Dead Money Trade — Find out why Alex thinks it’s too early to buy the EM dip.

Articles I’m reading —

I’ve been digging into global housing markets lately. It’s a sub-thematic of the two most important macro drivers of the current market, which are (1) the market’s continual underpricing of the Fed’s rate path and (2) the slow and quiet Chinese deleveraging.

13-D Research recently shared some of their work on the subject where they discuss how whacky things have become in select metros around the world. Here’s a snippet (emphasis by me).

In Vancouver, home and condominium prices are up roughly 60% in just the past three years. In Sydney, house prices jumped over 80% between the end of 2009 and the peak last September. And in Toronto, Stockholm, Munich, London, and Hong Kong, housing rose by 50% on average since 2011. As the IMF writes: “In recent years, the simultaneous growth in house prices in many countries and cities located in advanced and emerging market economies parallels the coordinated run-up seen before the crisis.”

…In its annual housing report released last September, UBS concluded: The risk of a real estate bubble in top global cities has increased significantly in the past five years.The role foreign and institutional money has played in escalating home prices beyond the spending power of the local population was at the heart of the Swiss bank’s concern.

In Hong Kong, it now requires 19.4 times the average salary of a resident to buy a home, up from 4.6 times in 2002. In London, the equivalent price-to-income multiple today is at 16 times. Paris, Singapore, New York, and Tokyo all have multiples greater than 10. The IMF has charted the escalating divergence of real estate and income appreciation globally since 2010.

I’ve tried to not focus on real estate this cycle because it feels too much like ‘fighting the last war’. But nonetheless, I think there may finally be actionable trades to be made off this theme as global liquidity continues to tighten. Here’s the link to the 13-D piece.

Ray Dalio (warning: there’s lot’s of Dalio in this week’s Musings) shared a short writeup on Linkedin this week, where he updates his views on where we are in the current cycle. Ray makes an important point about how longer bull markets tend to follow deeper contractions, like the one we just experienced in the GFC. He thinks we have a “couple more years left” in the current one, which I agree with. Here’s an excerpt and the link.

To reiterate where we stand now, a) the short-term debt cycles (also called business cycles) of most developed countries are in the 6th or 7th innings so they are not near their contraction phases. These expansions typically go on about 7-8 years (plus or minus a few years) with the longer ones coming when there is a lot of slack due to the last contraction being a deep one and when growth has been slow. Since the last one was deep, growth has been relatively slow, and debt growth is not high relative to income growth, and since capacity constraints that now exist are not leading to dangerously high inflation and fast tightening, it looks to me that we have a couple more years left in this cycle’s expansion.

And lastly, Institutional Investor did a great profile on famed short seller, Jim Chanos, that’s worth a read. Apparently, his Kynikos Capital Partners fund, which runs a 190% long and 90% short strategy, has returned a net annualized gain of 28.6% since inception in 1985. Those are Soros/Druck type numbers. Here’s the link.

Chart I’m looking at —

I remain bullish on US stocks but the high positive rate of change in yields recently, makes me cautious over the short-term (next 1-4 weeks). Stocks and bonds compete for capital flows and fast rising bond yields pull demand from stocks and back into bonds. My BAA yield ROC chart below shows that yields have picked up quickly enough to warrant caution.

The S&P 500 is also now technically overextended. The weekly chart below shows it’s bumping up against the upper part of its bollinger band. I’m looking for a pullback down to the midrange of the band (red line) which also happens to be right at its trend line. This pullback should be viewed as a buying opportunity.

Video I’m watching —

Ray Dalio has been doing the rounds on the financial news networks the past few weeks promoting his new book (more on that next). Here’s a 15 minute clip of his interview with Bloomberg’s, Erik Schatzker, that’s worth a watch. In it, Ray discusses his debt cycle framework and applies it to emerging markets, and what’s going on in Turkey and Argentina, specifically. It’s worth a watch. Here’s the link.

Book I’m reading —

This week I’m reading Dalio’s new book, A Template for Understanding Big Debt Crises. I’m a little over half way through the it and I’m a little disappointed. That’s not to say the book isn’t good. It is. And at the price of FREE (for the PDF/ebook versions) it’s certainly worth picking up. But if, like myself, you’ve read his previous white paper on the subject — which I think has been taken down from BW’s site — and were hoping for some new major additions, then you’re in for a let down.

With that said, it’s an excellent primer on the subject and an easier read than the original paper. And maybe there’s some new stuff towards the end of the book, we’ll see. I’ll be sharing my book notes with the Collective next week. Here’s a cut on depressions from the book.  

Some people mistakenly think that depressions are psychological: that investors move their money from riskier investments to safer ones (e.g., from stocks and high-yield lending to government bonds and cash) because they’re scared, and that the economy will be restored if they can only be coaxed into moving their money back into riskier investments. This is wrong for two reasons: First, contrary to popular belief, the deleveraging dynamic is not primarily psychological. It is mostly driven by the supply and demand of, and the relationships between, credit, money, and goods and services—though psychology of course also does have an effect, especially in regard to the various players’ liquidity positions. Still, if everyone went to sleep and woke up with no memory of what had happened, we would be in the same position, because debtors’ obligations to deliver money would be too large relative to the money they are taking in. The government would still be faced with the same choices that would have the same consequences, and so on.

Trade I’m considering —

I’m considering putting on a big position in Facebook (FB) soon; preferably after we see a broader market correction in the next few weeks which will help reset rates and sentiment a bit. FB stock is currently trading at major support in its 100-week moving average (green line below).

Sentiment has notably shifted on the stock since management reset growth expectations in their last earnings call. I view management’s moves as being smart and strategic, and which should ultimately be beneficial to patient shareholders.

One of my favorite value investors, Jake Rosser of Coho Capital, put out a great write up on FB in his latest Investor Letter. The entire letter is worth a read (he also discusses Disney (DIS), which happens to be our largest stock holding at the moment). Here’s the link and his concluding remarks on FB.

Strong Downside Support with Homerun Potential. The best money to be made on a stock is when  there is a sizable gap between future cash flows and anticipation of those cash flows. In Facebook’s  case, we think the gap is sizable enough to result in multiples of value creation over the next five years. If we net out Facebook’s $42 billion in cash, as well as its stake in WhatsApp, (since it is not yet profitable –we assume WhatsApp is only worth its acquisition price of $19  billion) then we are recreating core Facebook and Instagram for 18x forward earnings, in-line with the forward earnings multiple for the S&P 500. Not bad for a 30% grower with 35% operating margins (future margin guidance on Q2 earnings call that caused the stock to collapse – still 10% better than Google). This  valuation is based upon current Wall Street estimates, which have given little credit to Facebook’s non-nameplate platforms.

You get the optionality of future monetization of Facebook’s messaging apps and home-run potential with Instagram for free. We like the set-up and believe our downside is well-protected.  As a result, we have made Facebook our largest position. The steady rise in equity markets has made it more difficult to source stock bargains, but as concentrated investors we only need one or two opportunities a year to  make a difference. As students of the world’s best companies we prepare our shopping list well in advance. When volatility strikes, we can act quickly having already spent years (in many cases) researching the companies we purchase.  As French Micro-biologist Louis Pasteur once said, “chance favors the prepared mind.”

Quote I’m pondering —

As the story goes, God and the Devil were debating about the goodness of man as they walked down a seldom-used road. While they were arguing about man’s inner nature, they noticed the lonely figure of a man approaching them. Suddenly, the man bent over and picked up a grain of “truth.” “You see,” God exclaimed, “man just discovered ‘truth’ and that proves that he is good.” The Devil replied, “Ah, so he did. But you don’t understand the nature of man. Soon he’ll try to organize it, and then he’ll be mine!” ~ Bennett W. Goodspeed, from his book “The Tao Jones Averages”

I love this little story…

That’s it for this week’s Macro Musings.

If you’re not already, be sure to follow us on Twitter: @MacroOps and on Stocktwits: @MacroOps. I post my mindless drivel there daily.

Here’s a link to our latest global macro research. And here’s another to our updated macro trading strategy and education.

 

 

Why Emerging Markets Are A Dead Money Trade

In our most recent MIR we talked briefly about the growth struggles of EM in the context of the Gerschenkron Growth model, using China as our example.

Our conclusion was that China, and EM in general, is set to be a dead money trade and massive value trap for the remainder of this cycle.

So let’s flesh out a little more why this is likely to be the case.

To start, what exactly separates an emerging market from a developed one? Here’s a good explanation from Eric Lonergan writing on his blog Philosophy of Money (emphasis by me).

Emerging markets are not poor countries, nor are they countries which are making economic progress. They are defined by a very specific set of macroeconomic properties, which financial markets are conscious of, but are rarely clearly articulated.

The overriding characteristic of an emerging market is that a currency devaluation is a tightening of policy. In the developed world, a devaluation is typically an economic stimulus, indeed it often coincides with an easing of monetary policy through lower interest rates or an increase in QE. The post-Brexit policy response of the Bank of England is a case in point – sterling fell sharply and the Bank cut interest rates and initiated more QE.

In emerging markets the opposite occurs. These economies usually have public and private sector liabilities denominated in a currency which they do not issue. So when the Turkish Lira falls against the dollar the burden of finance on many Turkish corporates increases. Due to their US dollar liabilities, the interest payments and capital repayments in Turkish Lira rise. That is the first way in which a devaluation is a tightening of monetary conditions.

The second mechanism is more instructive and carries important lessons for monetary reform in the developed world, and in particular how we should think about the challenges posed by the zero-bound.

Emerging markets suffer from widespread price indexation and significant inflation expectations. In other words, when the currency falls, inflation rises, and when inflation rises the economic system attempts to respond by raising wages, and then raising prices. The 1970s concept of a wage-price spiral has meaning.

Because emerging markets have widespread wage and price indexation and alert inflation expectations central banks cannot exploit ‘temporary’ increases in the inflation rate by reducing real interest rates and stimulating demand, as they do in the developed world. Central banks, as we have seen in Brazil, Turkey and South Africa, have to respond to devaluations by tightening policy in order to prevent an increase in the underlying inflation rate.

EMs have what are called soft currencies, which is one of the three subsets of currencies in the global core-periphery paradigm that we talked about in our Jan 17’ MIR Vicious or Benign? To recap, these are:

  1. The reserve currency which is currently the US dollar.
  2. Hard currencies, that come from countries that can lend to themselves at competitive rates. These tend to be net-importers of commodities. Hard currencies generally act as safe-havens during periods of risk-off.
  3. And soft currencies. Soft currencies tend to be commodity producers. They are countries that have to borrow in other currencies at higher rates. These currencies depreciate during periods of risk aversion.

So… EMs are countries with soft currencies whom have to borrow in foreign hard money (typically dollar or euros) and therefore run into debt repayment problems when their currencies fall AND… due to widespread price and wage indexation, suffer from higher inflation when their exchange rate drops forcing their central banks to carry out procyclical tightening (ie, raising interest rates into a crisis) which causes a spiraling negative economic shock.

These conditions are what lead to the standard balance of payment (BoP) crises that EMs go through seemingly every few years.

A typical BoP crisis looks like this:

  • Rapid economic growth attracts large capital inflows from foreign investors chasing higher returns.
  • This capital flows into equities and hard currency denominated debt.
  • The strong domestic growth leads to a rise in imports which creates a current account deficit (more imports than exports) which then needs to be financed by more foreign capital flows.
  • Eventually, growth slows and debt reaches levels that cause foreign investors to become concerned about the country’s ability to service it and pay it back.
  • This causes the hot money flows to reverse, which drive the currency down, making the hard currency debt more expensive to repay, which causes more hot money outflows, in a crushing positive feedback loop.
  • This goes on until the central bank raises interest rates enough to steady the currency and domestic demand collapses which brings imports back below exports, thus balancing the current account.

This is what we’re seeing variations of occuring in EM now, specifically in Turkey and Argentina.

But here’s why this time is going to be different.

You see, in the past, an EM BoP crisis led to a painful but typically very short, economic contraction where the economies and markets experienced v-shaped recoveries. The 97’ Asian crisis being a perfect example.

They were able to do this because they were rapidly expanding their share of global exports from a low base. A devalued currency meant more attractive exports which meant rising profits and a quickly balanced current account (exports greater than imports). This enabled EMs to deleverage and grow their way out of trouble.

Sri thiruvadanthai of the Jerome Levy Institute wrote about this in one of his recent papers (emphasis by me).

Given this background, it is clear why globalization, especially the period 2000-08, was so beneficial for EMs. Globalization allowed EM exports to DMs to grow exponentially, relaxing the BOP constraint. Moreover, increased capital flows allowed EMs to build their foreign currency reserves, further weakening the BOP constraint. The process of building reserves also fueled demand for safe assets, depressing yields in DMs and extending the unsustainable process of debt-fueled growth in the DMs. However, the EM boom of the 2000s was in part supported by an unsustainable debt driven growth in the DMs. Thus, when the financial crisis of 2008-09 forced DMs to deleverage, it undermined a key pillar of EM growth. The weakness of DM growth post 2008 and the plateauing of offshoring and outsourcing meant that EM export growth hit a wall. Initially, EMs were able to counteract these headwinds by running large fiscal deficits and by turning to domestic profit sources. As we have seen in a previous section, domestic profit source growth requires domestic credit creation. Unsurprisingly, EM credit growth exploded post-2008, and not just in China. The limits of EM domestic demand-driven strategy were reached sometime in 2012-14, and since then EM economies have been struggling.

EM’s structural growth limitations can be boiled down to the following:

  • EMs are BoP constrained. Since they have soft currencies — meaning, they can’t finance current account deficits in their own money — they can’t grow faster than their exports for an extended period of time. Because, a current account deficit leads to a build up of hard currency debt, hot money outflows, and a BoP crisis.
  • EMs have maxed out their market share of global exports. EMs now comprise over 50% of global non-commodity exports (see chart below) and further export share growth will likely be from one EM cannibalizing another. Globalization has peaked and with increasing trade tensions, we should even see a reversal of some of the outsourcing and offshoring that’s occurred over the past two decades.
  • EMs are facing a significant debt burden amid tightening global liquidity. EMs are weighed down by a large amount of debt which they’ve accumulated in financing their current account deficits over the last decade, and much of this debt is dollar denominated. Rising US interest rates and a strengthening dollar will continue to put pressure on EMs going forward.

(Image via Bridgewater)

Then of course there’s a deleveraging China, which has been a big source of demand growth for EMs over the last decade but won’t be any longer.

So EMs are in a tough spot going forward. They need to rebalance their economies and boost domestic demand since they can no longer rely on exports as a serious source of growth. But, until they can get other countries to accept their currencies as payment, they will remain BoP constrained by their soft currency which won’t allow them to grow faster than their export growth. Which, as we’ve discussed, is going to be low.

I see a lot of investors and financial journos talking about how now is a good time to buy EMs. They’re all playing off the old EM playbook and are expecting a v-shaped recovery which is not going to materialize. What will, is a slow moving economic contraction with occasional country specific crisis that will frustrate investors trying to bottom pick.

Select EMs will make for incredible asymmetric investments once the next cycle begins in a few years time. By then, I expect the narrative to have completely flipped from where it is today and EM in general will be a hated and completely discarded asset class. That’s when it’ll be a good time to buy.

Lastly, here’s some good charts that show some of the headwinds EM is up against in the coming years.

A large amount of EM corporate high yield USD debt is maturing in the coming years. As the dollar continues to strengthen, the global dollar shortage will become more apparent and EMs will suffer for it.

(Image via Bloomberg)

Global investors put money in EM stocks and bonds (which are generally seen as riskier) because they are chasing higher relative growth and thus, higher returns. When their growth is declining relative to that of DMs then there’s little reason for investors to invest in EM. This is part of the core-periphery paradigm (charts via MS).

Over the last few years, there’s been a huge amount of hot money flowing into EM equity and debt. There’s still plenty of capital that needs to be unwound.

There’s going to be a reflexive global growth feedback loop in all this. EMs today make up a much larger share of global growth than they did 20-years ago. A slowdown in EM will drive a slowdown in developed markets which will reduce EM export growth, further constraining their ability to grow and so on.

(Image via Bridgewater)

(Image via Bridgewater)

 

 

It’s Late Cycle!!! Is it? And Chicken Soup For Your Portfolio

Alex here with this week’s Macro Musings.

As always, if you come across something cool during the week, shoot me an email at alex@macro-ops.com and I’ll share it with the group.

Recent Articles/Videos —

The Gerschenkron Growth Model – Alex explains how China’s reckless growth strategy will end just like the busted up economies of the Soviet Union and Japan.

Bullish 3D Printing — The 3D printing space is an undervalued goldmine right now.

Simple Trading — Comb through your investing process and take out the steps that aren’t adding to your bottom line.

 

Articles I’m reading —

I came across some good articles/papers this week. It wasn’t easy picking just a few to share, but here’s my three favorite must-reads of the week.

First, Michael Mauboussin put out a great paper on the benefits and limitations of certain valuation multiples with the exciting title, What Does an EV/EBITDA Multiple Mean?

He touches on many important points in the piece, as well as dispel some all-too popular misconceptions on just what various valuation multiples say about a business exactly. Read the paper in full, it’s worth your time. Here’s the link and an extract (emphasis by me).

In their pathbreaking paper on valuation, Miller and Modigliani provide a formula that is core to understanding value. They say: The value of the firm = steady-state value + future value creation. Over the last 60 years, roughly two-thirds of the value of the S&P 500 price was attributable to steady-state value and the other one-third to future value creation. Both pieces are important. Here’s an intuitive way to think about it. Say you owned 10 mature and profitable restaurants. Assuming the current profits persist for the foreseeable future, those restaurants are the foundation for the steady-state value. Now consider the possibility of opening new restaurants that are worth more than they cost to build. That is future value creation.

The important point is that future value creation is based on three elements: finding projects that generate a positive spread between the return on invested capital (ROIC) and the weighted average cost of capital (WACC), how much you can invest in those projects, and how long you can find those projects in a competitive world. Note that the latter elements, how much and how long, only create value if there is a positive spread between ROIC and WACC. If the spread is zero, the second term on the right side of the equation collapses to zero. Indeed, the second term can be negative if the investments fail to earn the cost of capital. This illuminates the critical lesson that you have to start with the spread between ROIC and WACC. Calculating ROIC and WACC correctly is a prerequisite to doing this analysis appropriately. Growth creates a lot of value only when the spread is positive and large, has no effect when the spread is zero, and destroys value when the spread is negative. Too many executives and investors focus on growth without recognizing the need for a positive spread in order to create value.

Second, Srinivas Thiruvadanthai, who is one of my favorite follows on twitter at @teasri, authored a paper titled Current Account Balances, Debt Buildup, and Instability. If you’re not familiar with his work or the framework he and his team at the Jerome Levy Forecasting Center use to analyze the world, I suggest visiting this site and reading the Profits Perspective and then go through some of their research papers.

Anyways, this is a great paper on the role current account imbalances play in macro leveraging and ultimately, financial instability. The paper includes many important concepts for understanding the broader structural problems facing emerging markets, today. Here’s the link and an excerpt.

Yet, as I argue in this paper, the mainstream view of current account imbalances ignores, among other things, their critical role in increasing financial fragility, both on the external and the domestic fronts. While, in theory, current account deficits could be financed substantially through equity investments, in practice, they tend to be disproportionately financed by debt. Thus, growing current account deficits lead to rising external debt. An even lesser known fact is that widening current account deficits lead to rising domestic leverage, especially in the private sector, with serious consequences for financial stability and future economic growth. The free-market resolutions of these imbalances do not happen smoothly via exchange rates but by severe economic contraction and prolonged economic weakness, with depressive effects on the rest of the world.

And finally, Daniel Want and team over at Prerequisite Capital shared some of their research this week. Daniel is a super smart guy and I’m a big fan of the way he approaches markets. Give this report a read where he shares his framework for analyzing currencies — there’s also a ton of great quotes in the piece. Here’s a section and the link.

When it comes to analysing the complex environment, or more specifically the ‘underlying conditions’ of the market in question – it is essential that we focus on generating competitive insight (a variant perception that is anchored in a high degree of reality).

Another principle (that bears repeating again) when studying and analysing the world, is that it helps to be able to glimpse reality through many different, unrelated ‘lenses’ (or perspectives). If you can look at reality through a multitude of independent but robust perspectives and you find yourself glimpsing the same underlying reality, then your conviction is able to grow around what you are seeing and your confidence to act grows. Hence, we tend to want to apply a multitude of unrelated tools and frameworks to our object of analysis.

 

Chart I’m looking at —

There seems to be general consensus that we’re “late in the cycle”. Dalio came out this week saying we’re in the 7th inning and we’ll see recession in 1-2 years and then Tepper appeared on CNBC saying we’re in the 8th… and the “Late  cycle” story count via Bloomberg shows late cycle mentions spiking. Stating we’re “late cycle” just feels right, doesn’t it? It feels like the responsible and wise thing to say, which is why I guess everybody is saying it. But here’s the thing, markets just don’t work like that. I can’t remember any time in the history of markets where everybody agreed on something, it happened, and then we all made money.

I don’t know, I’m not as smart as Dalio or Tepper, and the argument for it being late cycle is persuasive, I guess. But I still haven’t seen any of the uber bullishness, wide scale risk taking, and most importantly, leveraging, that typifies most “late cycle” periods. So to abuse the baseball analogizing further, maybe this game is going to extra innings?

 

Podcast I’m listening to —

This week I listened to a great Tim Ferriss podcast with one of my favorite non-fiction writers, Doris Kearns Goodwin.

She’s the author of the Lincoln biography, Team of Rivals, as well as one of my favorite books, The Bully Pulpit.

They cover a wide range of topics in the interview: from lessons on leadership, to amazing stories about the many Presidents she’s written on and spent time with (she worked and became close friends with LBJ). Anyways, Doris has lived a fascinating life and is a talented storyteller. I highly recommend giving it a listen. Here’s the link.

 

Book I’m reading —

This week I’ve been reading Out of Control by Kevin Kelly (founding executive editor of Wired magazine). This is a beast of a book, nearly 500 pages with small print. I’m about halfway through it now and really enjoying it.

I don’t even know how to describe the book. The back cover says the book “chronicles the dawn of a new era in which the machines and systems that drive our economy are so complex and autonomous as to be indistinguishable from living things.” Which seems to partly describe it, but doesn’t really do it justice.

Kelly goes deep into the subject of complexity and emergent evolution; discussing everything from the communication techniques of bee swarms to metaphysics and the systemic vulnerabilities of various forms of human government.

It’s an older book (published in 94’) but not outdated. If you enjoy learning about complex systems then pick this up, you won’t be disappointed. Here’s a section.

Coevolution is a variety of learning. Stewart Brand wrote in CoEvolution Quarterly: “Ecology is a whole system, alright, but coevolution is a whole system in time. The health of it is forward — systemic self-education which feeds on constant imperfection. Ecology maintains. Coevolution learns.

Colearning might be a better term for what coevolving creatures do. Coteaching also works, for the participants in coevolution are both learning and teaching each other at the same time. (We don’t have a word for learning and teaching at the same time, but our schooling would improve if we did.)

The give and take of a coevolutionary relationship — teaching and learning at once — reminded many scientists of game playing. A simple child’s game such as “Which hand is the penny in?” takes on the recursive logic of a chameleon on a mirror as the hider goes through this open-ended routine: “I just hid the penny in my right hand, and now the guesser will think it’s in my left, so I’ll move it into my right. But she also knows that I know she knows that, so I’ll keep it in my left.”

Since the guesser goes through a similar process, the players form a system of mutual second-guessing. The riddle “What hand is the penny in?” is related to the riddle, “What color is the chameleon on a mirror?” The bottomless complexity which grows out of such simple rules intrigued John von Neumann, the mathematician who developed programmable logic for a computer in the early 1940s, and along with Wiener and Bateson launched the field of cybernetics.

Von Neumann invented a mathematical theory of games. He defined a game as a conflict of interests resolved by the accumulative choices players make while trying to anticipate each other. He called his 1944 book (coauthored by economist Oskar Morgenstern) “Theory of Games and Economic Behavior”  because he perceived that economies possessed a highly coevolutionary game-like character, which he hoped to illuminate with simple game dynamics. The price of eggs, say, is determined by mutual second-guessing between seller and buyer — how much will he accept, how much does he think I will offer, how much less than what I am willing to pay should I offer? The aspect von Neumann found amazing was that this infinite regress of mutual bluffing, codeception, imitation, reflection, and “game playing” would commonly settle down to a definite price, rather than spiral on forever. Even in a stock market made of thousands of mutual second-guessing agents, the group of conflicting interests would quickly settle on a price that was fairly stable.

 

Trade I’m considering —

My book is pretty full when it comes to long equity trades so I’m not really looking to add anything at the moment. And the following stock is much smaller and more illiquid than what we typically buy but I found the long thesis presented by Scott Miller so intriguing that I figured I’d share it with you guys and gals.

Anyways, the company is Chicken Soup for the Soul Entertainment Inc (CSSE). And yes, it’s that Chicken Soup for the soul… I could give you the skinny on the CSSE’s bull pitch but I don’t feel I’d do it justice so I’ll just give you the link to Scott’s latest letter and you can read it there (link here).

 

Quote I’m pondering —

There’s nothing wrong with pricing. But it’s not valuation. Valuation is about digging through a business, understanding the business, understanding its cash flows, growth, and risk, and then trying to attach a number to a business based on its value as a business. Most people don’t do that. It’s not their job. They price companies. So the biggest mistake in valuation is mistaking pricing for valuation. ~ Aswath Damodaran

That’s it for this week’s Macro Musings.

If you’re not already, be sure to follow us on Twitter: @MacroOps and on Stocktwits: @MacroOps. I post my mindless drivel there daily.

Here’s a link to our latest global macro research. And here’s another to our updated macro trading strategy and education.

 

The Gerschenkron Growth Model

The following is an excerpt from our Macro Intelligence Report (MIR). If you’d like to learn more about the MIR, click here.

On November 18, 1956, during a reception at the Polish embassy in Moscow. Soviet Premier Nikita Khrushchev declared to his audience of Western diplomats that “We [the Soviet Union] will bury you.” This was not a military threat but rather an economic boast. And it was a remark taken very seriously by the West.

The Soviet economy delivered exceptionally high growth rates in the decades following WWII, far outpacing developed Western nations. This growth mesmerized Western academics, policymakers, and intellectuals with its astonishing pace. The Soviet Union was hailed as an “economic miracle” and many became convinced that the Soviet’s Command and Control economy was far superior to the West’s capitalist system… and that it was only a matter of time before the Soviets became the largest economic power in the world.

This was not a fringe belief. In fact, it was the mainstream narrative and accepted as a matter of certainty. Acemoglu and Robinson relate in their book Why Nations Fail, that:

The most widely used university textbook in economics, written by Nobel-prize winner Paul Samuelson, repeatedly predicted the coming economic dominance of the Soviet Union. In the 1961 edition, Samuelson predicted that the Soviet national income would overtake that of the United States possibly by 1984, but probably by 1997. In the 1980 edition there was little change in the analysis, though the two dates were delayed to 2002 and 2012.

Unfortunately for Samuelson, his prediction somewhat missed the mark. Not only did the Soviet Union fail to surpass the US in economic supremacy, it actually went bankrupt (twice!) in the following decades before finally disintegrating as a geopolitical power.  

But in the 70s, while the Soviet economy was beginning its slow descent into irrelevance, another “high growth” country took center stage, quickly becoming Western economist’s new infatuation: Japan.

Japan’s period of high growth lasted nearly three decades. And because of this economic prowess, Japan was also called an “economic miracle”. Economist, politicians, and intellectuals wrote many a books and thought pieces on the superiority of the Japanese economy to that of the laissez faire capitalist system of the West. And once again it became accepted as a matter of fact that the Japanese economy would soon surpass the US in size.

Here’s some excerpts from a NYT article printed in 1991 titled Leaders Come and Go, But the Japanese Boom Seems to Last Forever, that gives you a good sense of what the common narrative of the time was.

At a time when the American economy is struggling with recession, the Japanese economy has just completed its 58th month of uninterrupted growth.

Setting the new record may not have been an occasion for parades or speeches, but economists are calling this one of the greatest booms in recent history, a period that has not only fundamentally altered the Japanese economy but sown the seeds of even greater friction with the United States. Some have taken to calling this period Japan’s second economic miracle, as important as the one that turned a war-devastated nation into an industrial powerhouse.

Japan is a different country today than it was five years ago,” said Kenneth Courtis, senior economist with Deutsche Bank in Tokyo. “It will become even more evident in the 1990’s. The Japanese economy has so much momentum that, competitively speaking, the 1990’s will be over in 1995. The West won’t be able to catch them after that.” As Mr. Courtis put it, Japan has grown economically by the equivalent of one France since 1985, or by one South Korea each year. Its manufacturers invest more every year in new plants, equipment and research than American companies, though the American economy is some 40 percent larger than Japan’s.

This is the change that is likely to make Japan an even more threatening competitor for American companies, many of which used the immense wealth created in the 1980’s to benefit their investment bankers rather than investing aggressively in the future. Japanese companies are expected to increase their capital investment budgets this year… Mr. Courtis estimated that Japanese companies spent about $625 billion on such investments over the last five years, a sum it will take American companies nearly 10 years to spend.

Of course, we know now that “competitively speaking, the 1990’s” didn’t end in 1995… as senior economist Kenneth Courtis so confidently predicted. Instead, 1991 (when this article was printed) marked the peak of the Japanese miracle economy. What followed was the popping of a gargantuan asset bubble followed by decades of painful deflationary economic contraction.

Richard Koo, wrote in his book, The Holy Grail of Macroeconomics: Lessons From Japan’s Great Recession, that falling land and stock prices alone, accounted for the destruction of 1,500 trillion yen in wealth; a figure equal to the entire nation’s stock of personal financial assets or 3-years of GDP. This makes it the greatest economic loss ever in history by a nation in peacetime.

So much for miracles…

Do the economic miracles turned nightmares of Russia and Japan remind you of any similar majority consensus today? Hmmm?

It should, and for good reason. China is following the exact growth model used by both 1960s Russia and 1980s Japan. It’s called the Gerschenkron growth model and China has implemented it to a T, differing only in its intensity and scale which is unprecedented.

And like Japan and Russia before it, China’s economic “miracle” is anything but.

The China deleveraging is going to be the most important macro driver of markets in the years ahead. Emerging markets, commodities, precious metals, the dollar… all be affected by it. Understanding this thematic will help you better understand market moves as a whole. This is what we’re focused on and will be covering extensively in the months ahead.

The above is an excerpt from our Macro Intelligence Report (MIR). If you’d like to learn more about the MIR, click here.

 

 

Youtube Boxing and Some Soros Wisdom

Tyler here with this week’s Macro Musings.

As always, if you come across something cool during the week, shoot me an email at tyler@macro-ops.com and I’ll share it with the group.

Quick announcement: If you’re wondering why emerging markets have been getting taken to the woodshed lately, then sign up for the Macro Intelligence Report this weekend. Our September issue will cover China’s economic (quasi)-deleveraging, including everything from its impact on commodities and precious metals, to currencies, and the housing bubbles in places like Canada and Australia. If you need some short ideas you’ll definitely want to take a look at this report.

We have a 60-day money-back guarantee, so there’s literally no risk for you to read our latest bearish China thesis and decide if the information will work for you. Sign up to the MIR by clicking here.


Recent Articles/Videos —

The ONE Thing…China’s slowdown and the rough road ahead for EM — Alex lays out the case for why this downtrend in emerging markets is only the beginning.

Howard Marks On Market Edges — Marks speaks all about the high yield “junk bond” market back in the 70’s.

Joel Greenblatt On Big Picture Thinking — As Greenblatt explains, he was only average at valuation work. His real edge came from putting information into context and pinpointing what matters.


Article I’m reading —

In last month’s MIR, Alex explained why traditional accounting metrics and old-school valuation techniques cannot properly value long-term compounders like Amazon and the other dominant tech companies of today.

Bloggers at the CFA Institute have a similar take:

One argument we’ve been making for a long time is that these companies have made substantial investments in valuable intangible assets, but accounting rules require that these investments be expensed rather than capitalized. This depresses current earnings and book value and thereby inflates P/E and P/B ratios.

If you want to understand why the tech giants have expensive stock prices relative to earnings this article will help — Franchise Quality Score: A Metric for Intangibles.


Video I’m watching —

Logan Paul vs KSI — Two huge youtube personalities set up a boxing event at the Manchester Arena last month. The event was sold as a pay-per-view on youtube for $10 and it ended up being the largest live event in internet history. At peak the youtube stream had over 800,000 paid viewers.

I bring this up because I think this is a trend worth paying attention to. The fact that two vloggers, neither of them actual boxers, can get this much watch time is incredible. Professional boxers who train their entire life dream for this kind of audience.

It’s a clear sign that media, sports, and entertainment as we know it is changing in a big way. I haven’t quite figured out what this means from an investment standpoint, but I’m starting to visualize an entertainment future dominated by youtube personalities and esports. I’m sure the conventional sports organizations are taking careful notes.


Chart I’m looking at —

The EURUSD has a mixed outlook. The divergences earlier in the year have more or less corrected and positioning is now a headwind for the greenback. In response to this we have reduced our long dollar holdings until greater clarity develops.


Podcast I’m listening to —

Bear Vs. Pig Hammer Trader — SEC Filings, Volume Forecasting and Due Diligence — Bear vs. Pig is a new podcast I stumbled upon last week. It primarily focuses on the micro cap penny stock space which isn’t really my niche, but I still found the content interesting. In this particular episode, “Hammer Trader” explains how he makes sense of this crazy rumor driven area of the market. I think a lot of his analytical techniques can be carried over to other areas of the market as well. His style combines quantitative and qualitative analysis so there’s something for everyone in this 50 minute show.


Book I’m reading —

The Leangains Method: The Art of Getting Ripped. Researched, Practiced, Perfected — This has nothing to do with finance but definitely check this out if you are into health and fitness. The Leangains Method started out as a collection of blog posts over 8 years ago. It has now been refined and distilled down into this book.  

Martin Berkhan, the author, has a no-nonsense approach to diet and exercise. He was one of the pioneers of intermittent fasting at a time when 6-meals a day was the conventional advice. The diet and training regimens are simple, minimalist in nature with no frills. I’ve gotten a lot of results out of little time investment with this approach.


Quote I’m pondering —

Economics tried to model itself on Newtonian physics. It sought to establish universally and timelessly valid laws that govern reality. But economics is a social science and there is a fundamental difference between the natural and social sciences. Social phenomena have thinking participants who base their decisions on imperfect knowledge. That is what economic theory has tried to ignore. ~ George Soros

That’s it for this week’s Macro Musings.

If you’re not already, be sure to follow us on Twitter: @MacroOps and on Stocktwits: @MacroOps. Alex posts his mindless drivel there daily.

Here’s a link to our latest global macro research. And here’s another to our updated macro trading strategy and education.

 

The ONE Thing…China’s slowdown and the rough road ahead for EM

I think this is one of the more interesting charts in markets right now. It’s a monthly of the MSCI Emerging Market Index (EEM). The chart shows EEM breaking out to the upside of a 10-year wedge last year before reversing back down and testing the upper line of support. It’s down approximately 12% on the year.

The big question is whether this retest offers an excellent risk-to-reward buying opportunity or if this is the start of a larger downward trend.

I believe it’s the latter. Here’s why…

The selloff has widened the US/EM valuation gap, making EM stocks very attractive on a purely relative valuation basis (chart via Topdown Charts).

This notable valuation gap has spawned the popular market narrative that buying the EM dip is the ‘prudent’ to thing to do. Here’s some financial headlines from over the last few months.

This narrative has led to a large amount of capital flowing back into EM following the 2015/16 China scare (chart via IIF).

And here’s the big tell… Capital flowed out of EM from 14’ to 16’ as China was trying to slow its debt growth. That capital then came rushing back into EM as China injected massive amounts of liquidity into its economy in early 2016.

Looking at China’s fixed asset investment (FAI) by state owned enterprises (SOEs) provides a good measure of their fiscal policy, as SOEs are their preferred channel for juicing economic growth by building more high speed rail, bridges, and even entire cities.

You can clearly see the instances where China opened the FAI spigots (orange line) in 09’, 13’, and 16’. Following each of these instances, investment flows came pouring back into emerging markets.

There are two reasons for this (1) China is a large economy and comprises roughly a third of the MSCI EM index and (2) China has become such a large source of global commodity demand that when it slows its leveraging (ie, reduces its frenetic pace of building) that drop off in demand reverberates throughout the rest of the world, hitting EM growth particularly hard.

The graph below via KoyFin shows how Asian, and in particular Chinese stocks, dominate the top 10 weighted holdings of the index.

Knowing how important China is to the wellbeing of EM, it should be concerning that its preferred method of adjusting demand has collapsed from 23.5% yoy growth last year to just 1.5% growth today — its lowest level in 15-years.

This slowdown in China’s leveraging — we can’t call it a deleveraging yet because it appears their rate of debt growth is just stalling and not reversing yet — is largely what’s behind the diverging economic growth projections for the US and EM.

While everybody is focused on the Fed raising interest rates and quantitative tightening— an important variable because of its effect on the USD exchange rate — hardly anyone is talking about the potential impact of a critical drop in Chinese growth and demand.

This is probably because (1) The China bear argument suffers from “Chicken Little” syndrome. People have been calling for China to implode for nearly two decades now and yet the country has managed to keep trucking along and (2) Everyone assumes that China will just keep mainlining credit at each hint of economic instability.

But there’s increasing evidence that things are different this time around. That, in fact, Xi and the CCP are committed to fixing the imbalances in their economy and stomaching the necessary pain that goes along with doing so.

If we’re correct, this will have critical second and third order impacts on the rest of the world.

Hedge fund manager, Dan Loeb, once said that “A key rule in investing is that you don’t necessarily need to understand a lot of different things at any given time, but you need to understand the one thing that really matters.”

China is that one thing that really matters now in global markets….

This month we’re kicking off what will be a three part Macro Intelligence Report (MIR) series where we’ll dive into the investing implications of a wide scale China slowdown, covering everything from its impact on commodities and precious metals, to currencies, and the housing bubbles in places like Canada and Australia.

In this month’s report we’re going to start off by discussing how China and emerging markets in general have exhausted their easy growth channel of expanding their share of global exports. And then we’re going to dissect how China’s economic “miracle” is no miracle at all but rather the result of a standard cycle in the typical “Gerschenkron model” of economic development; one which has occurred time and time again throughout history and which has always, in every instance, resulted in a large, painful, and prolonged economic crisis.

We’re then going to dive into Chinese policy and share with you the evidence from Xi, the CCP, and underlying data on why we think this time is different, and the signals we need to look for going forward.

Then of course, the trading and investing implications… We’ll layout the case why gold is going to $1,000, oil is going to sub $56bbl, and AUDUSD is going to 0.60.

We’re also going to talk about why we are still bullish US stocks and then pitch two beaten down misunderstood US tech companies that offer extremely attractive asymmetric opportunities to the long side. Finally, we’ll cover a highly contrarian short trade on a popular US listed Chinese tech stock.

If you want the scoop on China be sure to sign up for the MIR at the link below.

Click Here To Learn More About The MIR!

There’s no risk to check it out. We have a 60-day money-back guarantee. If you don’t like what you see, and aren’t able to find good trades from it, then just shoot us an email and we’ll return your money right away.

China’s the most important macro situation to understand right now. Getting it wrong can mean years of subpar returns and underperformance. Don’t get caught on the wrong side of the boat! By reading this month’s MIR, you will be prepared for the worst and positioned to profit off of a full out Chinese collapse.

Click Here To Learn More About The MIR!

 

 

Stolen Press Releases, Market Tops, and A Long In Gold

Tyler here with this week’s Macro Musings.

As always, if you come across something cool during the week, shoot me an email at tyler@macro-ops.com and I’ll share it with the group.


Recent Articles/Videos —

Peter Brandt On Drawdowns — PLB talks about how to manage those nasty market drawdowns.

Jack Schwager On Risk Management — Jack explains why it pays to focus on your exits over your entries.

Did Wall Street Kill Toys “R” Us? — Distressed debt funds are cold blooded…


Article I’m reading —

How an international hacker network turned stolen press releases into $100 million — This is the craziest insider trading story I have ever read. If you got 15 minutes to spare check this out. It’s a highly entertaining read about how a few Eastern European hackers were able to get away with seeing the news before everyone else for years on end. These guys made HFT news algos look late to the party!

 

Chart I’m looking at —

The US stock market is back at all-time highs. We’ve been making this call for months now based off of the US macro fundamental picture, relative strength in the USD, and favorable liquidity conditions. Now that we are here it’s time to ask what’s next. The quant metrics would tell us that more highs are ahead. You can see the table above from @oddstats that a breakout in the S&P 500 is usually followed by more all-time highs.

We’re positioned accordingly with almost all of our open risk allocated to US stocks.


Podcast I’m listening to —

Naval Ravikant: The Angel Philosopher on Investing, Making Decisions, Happiness and the Meaning of Life [The Knowledge Project Ep. #18] — This one has been recommended to me so many times by pretty much everyone on the internet. And after listening, I will join the chorus as well. Naval’s a beast of a thinker and has so much wisdom to share. I love his mental models for making critical decisions which he explains in great detail on this podcast.


Trade I’m considering —

Gold has accumulated an extremely short spec position over the last few months.

Even though we are long-term bearish on gold, a short-term long looks attractive here. Once the price action starts to reverse, all of the shorts will have to rush for the exits creating a sharp countertrend rally. It’s worth a punt.


Quote I’m pondering —

The main purpose of the stock market is to make fools of as many men as possible. ~ Bernard Baruch

This has certainly been the case this summer! So many top callers… and now none of them left standing.

That’s it for this week’s Macro Musings.

If you’re not already, be sure to follow us on Twitter: @MacroOps and on Stocktwits: @MacroOps. Alex posts his mindless drivel there daily.

Here’s a link to our latest global macro research. And here’s another to our updated macro trading strategy and education.

 

 

A Chinese Frankenstein, Fallen Angels, and a Pitch to Buy T-Notes

Alex here with this week’s Macro Musings.

As always, if you come across something cool during the week, shoot me an email at alex@macro-ops.com and I’ll share it with the group.


Recent Articles/Videos —

The Human Trader’s Secret Weapon – Alex explains the three different types of investment edges and how humans can use a few of them to identify and hold onto long-term compounders.


Articles I’m reading —

Hayden Capital’s latest investor letter is out and as always, it’s a great read. Fred Liu, Hayden’s managing partner, has quickly become one of my favorite investors to follow. Each of his letters offer a master class in fundamental value investing. In his latest, he talks about the global competitive landscape, investing in China, and then discusses two compelling long theses for both Amazon (AMZN) and iQiyi (IQ). Here’s the link and a cut from the letter.

Few investors have the opportunity to look across borders, and thus their knowledge base is extremely siloed (for example, “US Small Cap Consumer”). I firmly believe this creates an opportunity for longer-term investors who are willing to break this mold, and be open-minded enough to recognize that sometimes the US business models & practices aren’t always best.

In particular, I’ve spent a lot of time studying China. This isn’t just because of my family background there (although it helps) – but rather because I believe successful business models are a function of evolution & adaptation – aka [survival of the fittest] X [access to capital]. My theory is the business models that can scale globally, and create astronomical wealth in the process, are those that have been battle-tested thoroughly in their domestic markets first. Think of it as a Darwinist process, where out of 1,000 startups, the weakest business models will fail, and only the strong adapt, survive & get funding. By the time they arrive on the global stage, they’re already the best of the best in their home country, and thus have a strong chance of having evolved the best model for succeeding elsewhere too. It’s even better if that home country was populous, entrepreneurial, had demanding customers, and formidable competitors who put up a fight. For this reason, it’s also more likely that the best business models from a >1 Billion population market will be more durable than one from a 5 million population market.

Speaking of China… Here’s a very long, very detailed, and super intriguing analysis of Alibaba’s (BABA) most recent 20-F (link here). BABA’s financials are a riddle, wrapped in a mystery, inside a giant convoluted 920 entity globe spanning Chinese Communist Party entangled esoteric financially leveraged turducken ponzi-looking thingamajig….

Seriously, there’s some strange things going on over at Jack Ma’s chinese empire. The entire piece is worth a read if you’re into this sort of thing (I am). Here’s a section from the post.

We covered the incestuous relationship between Wazu Media, Jack and Simon Xie in last year’s Finding Inner Peace in Dharamasal  20-F post. I’d encourage you to re-read it…..it’s pretty entertaining even if I do say so myself.  

In a nutshell, Simon got Jack to spend US$ 1 Billion of US Shareholder’s money on “Wealth Management Products” to use as collateral so that an unnamed Chinese banker would make Simon a loan to buy a minority interest in “Wasu Media”.

There’s no change described in the structure of this absurd deal in this year’s 20-F. Simon still owes the US$1 Billion to the unnamed Chinese banker and he’s still paying the interest on the loan using the money from his other loan directly from Alibaba.  The money drawn on this RMB 2 Billion Line of Credit given to Simon Xie (to pay the interest on the Billion US dollar loan keep this thing afloat) has increased by another RMB 400 Million to RMB 1.137 Billion. So it continues to bleed.

So Alibaba is on the hook for both the principal and interest. Tell me again, one more time, why we need Simon Xie involved?

This example is not even close to being the biggest head scratcher. There are many many more… BABA is a hedge fund hotel, trades at 12x revenues, and is currently teetering on critical support. Puts maybe?



Chart I’m looking at —

I’m considering buying 5yr Treasuries here for a punt. Short positioning is stretched and from a technical standpoint, it looks like price really wants to rise (yields down).

This chart offers a good R/R for an entry with a tight stop. I think it runs to at least its 50ma (red line).


Podcast I’m listening to —

This week I listened to the Capital Allocators podcast with guest Ben Reiter. This interview was so so good. Ben Reiter is a writer for Sports Illustrated and the author of Astroball: The New Way to Win It All. He’s the guy behind the 2014 SI issue entitled YOUR 2017 WORLD SERIES CHAMPS; a crazy prediction (the Astros were one of the worst teams in baseball) that ended up becoming true.

They talk about how big data and statistical analysis are evolving the game of baseball. It’s like Moneyball but on steroids with teams now analyzing all types of esoteric data in order to try and gain an edge. And the secret sauce that made the Astros so successful was their use of qualitative data (input from seasoned baseball scouts) on the intangible things that separate good players from great ones.

The discussion might as well have been about markets and investing — there are tons of parallels. Definitely check it out, it’s worth a listen. Here’s the link.


Trade I’m considering —

I’m closely watching a list of “fallen angels” which are great companies / value stocks that have fallen 30+% over the last few months. All great stocks go through periods of large drawdowns like this and it’s healthy, just as long as the business fundamentals are still sound (which they are for each of the stocks below).

These large pullbacks are the result of profit taking which leads to momentum and trend followers exiting, which eventually drives the stock down to a point where value investors come back in and scoop it up. Then the process repeats.

A few of the stocks on my “fallen angels” list are Fiat (FCAU), Interactive Brokers (IBKR), and Gaia (GAIA). I’ve owned all three in the past and have been waiting for a sizable pullback to get back in. I only hope the selloff continues a bit more so we can get even better deals.


Quote I’m pondering —

Most people’s lives are virtual monuments to cowardly indecision. Ah, that we lack the courage of our romantic convictions; and thereby miss the wine of life, forgoing the very thing that makes living worthwhile. ~ Hunter S. Thompson

Don’t lead a life of quiet desperation. Go and get after it….

That’s it for this week’s Macro Musings.

If you’re not already, be sure to follow us on Twitter: @MacroOps and on Stocktwits: @MacroOps. I post my mindless drivel there daily.

Here’s a link to our latest global macro research. And here’s another to our updated macro trading strategy and education.

 

 

The Guy Who Manages Charlie Munger’s Money and Some China Stuff

Alex here with this week’s Macro Musings.

As always, if you come across something cool during the week, shoot me an email at alex@macro-ops.com and I’ll share it with the group.

The August Macro Intelligence Report: A Value Investing Manifesto was officially released last night! We’ve already gotten some amazing feedback from current subscribers. In the first 20 pages I dissect our exact framework for identifying and evaluating highly asymmetric stocks. Using this framework we have identified two value picks in the tech sector that I think will soar over the next 12-18 months. Finally, since the SPX is back up at highs, Tyler wrote an entire section on portfolio hedging to make sure you can lock in your gains for the year. So if you’re not on board already, sign up now by clicking here. We have a 60-day money-back guarantee, so there’s literally no risk for you to learn our stock selection process and take a look at our highest conviction trade ideas. Click here and scroll to the bottom of the page to sign up for the MIR.


Recent Articles/Videos —

Economists Suck — Robert Shiller speaks on why he’s not a fan of classical economics.

Best Buy Is Still Alive? — Yup. Not only are they surviving the Amazon threat, they’re actually thriving…

AMZN vs SFIX — Amazon won’t take over the entire economy. There will still be places for companies like Stitch Fix. 


Articles I’m reading —

I’ve been digging into value investing theory these last few weeks and came across this fantastic speech given by Li Lu (manager of value focused fund Himalaya Capital) at Peking University in 2015. If you don’t know who Li Lu is, you should. Despite keeping a relatively low profile, he manages the majority of Charlie Munger’s money and Buffet regards him as one of the three best investors alive today.

His talk is wide ranging and illuminating. Lu covers everything from the ethics and philosophy behind being a good money manager to his 3 era theory describing human progress and our current trajectory; he also of course covers value investing and investing in China specifically.

The piece is worth reading in its entirety, you won’t be disappointed. Here’s the link.

Also, here’s a great interview with both him and Munger published in a Chinese investing journal and republished by GuruFocus.


Video I’m watching —

In a similar vein, here’s a great “Talks as Google” with famed value investor Bill Nygren (link here). Bill has shown himself to be one of the few talented value investors that has been able to adapt and evolve in response to the changing market and economy without turning his back on his value investing principles. He still seeks out quality companies that are selling for less than their intrinsic values. But, he’s developed the nuance and framework for understanding and valuing tech companies that have scale and growth curves not seen in other eras and which other value investors instinctively turn their noses up at (he owns Google and Apple).

Anyways, he walks you through his approach to investing, giving a number of examples. It’s an hour well spent.


Chart I’m looking at —

I’ve been scouring data out of China to see if there’s any indications that the government is indeed trying to juice the economy again. But I’m not seeing any signs of material pickup in the numbers, yet. One important data point I like to pay attention to is China’s fixed asset investment, particularly from SOEs since they’re responsible for so much of the spending in the economy. And the trend in SOE fixed asset investment is not good… It recently hit year-over-year growth of just 3%, down from 23%+ in early 2016. It’s close to turning negative for the first time since 2002.

Doesn’t bode well for commodities and select EMs in the near term…


Podcast I’m listening to —

I just started listening to a new podcast this week that I really enjoy called Business Wars. It’s a series of short narrated stories about the greatest contests between rival businesses and their struggle for survival. The Netflix versus Blockbuster series is a good place to start. Here’s the link.


Trade I’m considering —

The trade weighted dollar (DXY) just closed above a significant level (its 200 and 100 week moving averages) that it’s been battling over the last two months. If price holds above these levels into the weekly close this would mark a significant technical breakout. It also offers a good R/R entry point for those of you not long the dollar yet. You can put a stop right below this week’s low.

We’ve been long the dollar since early April and have been adding on the way up. I’m a little suspicious that this may be a bull trap, seeing as how stretched the bearish positioning has become in precious metals. So I’m going to wait for another strong weekly close to give me confirmation before I add to the position again.


Quote I’m pondering —

In making investments, I have always believed that you must act with discipline whenever you see something you truly like. To explain this philosophy, Buffett/Munger likes to use a baseball analogy that I find particularly illuminating, though I myself am not at all a baseball expert. Ted Williams is the only baseball player who had a .400 single-season hitting record in the last seven decades. In the Science of Hitting, he explained his technique. He divided the strike zone into seventy-seven cells, each representing the size of a baseball. He would insist on swinging only at balls in his ‘best’ cells, even at the risk of striking out, because reaching for the ‘worst’ spots would seriously reduce his chances of success. As a securities investor, you can watch all sorts of business propositions in the form of security prices thrown at you all the time. For the most part, you don’t have to do a thing other than be amused. Once in a while, you will find a ‘fat pitch’ that is slow, straight, and right in the middle of your sweet spot. Then you swing hard. This way, no matter what natural ability you start with, you will substantially increase your hitting average. One common problem for investors is that they tend to swing too often. This is true for both individuals and for professional investors operating under institutional imperatives, one version of which drove me out of the conventional long/short hedge fund operation. However, the opposite problem is equally harmful to long-term results: You discover a ‘fat pitch’ but are unable to swing with the full weight of your capital. ~ Li Liu, Himalayan Capital

There’s a LOT of truth in this little paragraph…

That’s it for this week’s Macro Musings.

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