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Market Update: Expanding Cone of Uncertainty

(Note: This is an excerpt from a note sent to Collective Members earlier today.)

I want to share some quick notes on this selloff, the trade war and potential risks, some portfolio updates, along with an earnings update from our value guy, Mr. Bean, on Construction Partners (ROAD) latest quarter.

Let’s start with the trade war.

We often write about how the market reflects the aggregate range of reasonable opinions about what the future will look like (here’s a link to one of our writeups on the topic). In visual form, the concept looks something like this.

What happens when things like a trade war intensify is that the range of plausible outcomes expands. Uncertainty goes from looking like this.

To looking more like this.

Uncertainty and volatility drive each other in a feedback loop as the market adjusts to new competing narratives as it seeks out a price that more properly reflects the new range of reasonable opinions. This is why analyst estimate dispersion tracks volatility. Both react to increased uncertainty over plausible and possible future outcomes.

The breakdown in trade talks and the tit-for-tat that is now taking place with Beijing recently stating they will raise tariffs on roughly $60bn worth of US imports after June 1st, is widening that cone of uncertainty and will continue to drive volatility higher until (a) the US and China make convincing progress on a deal or (b) the market reaches a price level, that along with sentiment and positioning, better reflect the expanded range of probable outcomes.

We talked in this week’s Brief how this ‘readjustment’ also happens to coincide with our indicators clearly showing stretched levels of bullish sentiment and complacent market positioning —  as these events often tend to do. This will make the readjustment particularly volatile.

We should see the market bounce over the next week or so, seeing as how oversold it is on a short-term basis. But I want to reiterate that this rally should be sold into, not bought.

It’s likely we see this down-leg continue until the percent of stocks trading above their 50-day moving average moves near the 20% level (green area below).

The major risk here is that the ensuing bout of market volatility feeds into the real economy and dampens consumer behavior enough that it tips us into recession. This is the whole “financialization of the economy” risks we’ve talked a lot about. The market “tail” now wags the economy “dog” which is why we saw such crappy data in January/February with retail sales falling through the floor. Consumers got spooked by the Nov/Dec market selloff and pulled back in their spending.

Considering the inflated GDP print last quarter that was due to a buildup in inventories and where growth in the US is headed now, the economy is skating on increasingly thin ice. A market shock could be the thing that plunges it through. Not saying that’s going to happen. But it’s certainly worth keeping in mind.

Moving on to our portfolio.

We’re taking profits and closing out the rest of our long Facebook (FB) position. Growth stocks should continue to get needled in this new regime, as I talked about in our most recent MIR. On that same note, our value plays are holding up much better than the broader market which is a good sign we’re seeing a rotation out of growth and into value happening.

We also got stopped out on our Gaia Inc (GAIA) trade yesterday. The bullish thesis is unchanged but that thesis is kaput until the market starts agreeing with it. In hindsight, I mismanaged the trade by sizing too large at 1% risk with too tight of a stop. My conviction behind the trade skewed my better judgment and as a result, our portfolio is the poorer for it. I plan on putting out a more extensive review of the trade soon.

Construction Partners (ROAD) came out with earnings recently and crushed it. Here’s Mr. Bean’s comments on the report (link here). ROAD is roughly 10% of our portfolio. I want to eventually build it into a 15-20% position.

Precious metals have been getting a bit of a bid the last few days. From a technical standpoint, they aren’t completely out of the woods yet. We need to see a higher swing low before I feel comfortable adding to our silver and AngloGold (AU) positions. There’s risk we see the dollar pop here which would likely stop us out of our starter positions.

Also, keep watching oil. It’s bouncing around its 200 and 50-day moving averages but, as we talked about in the Brief, positioning is stretched and due for a reset. 

That’s all I’ve got for now.

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Something That Everyone Knows Isn’t Worth Anything…

The pendulum of the mind alternates between sense and nonsense. ~ Carl Jung

Politics is a pendulum whose swings between anarchy and tyranny are fueled by perennially rejuvenated illusions. ~ Einstein

Stephen Buhner wrote in his book “The Secret Teachings of Plants” the following:

The physical Universe is an aggregate of frequencies. – Buckminster Fuller

All living organisms receive electromagnetic signals all the time. And like the signals received by our radios, many of them contain extremely large amounts of information, which can be used for a great many things. These range from regulating the opening of little doors in cells to let food in and waste out, to healing, to the beating of the heart, to birds orienting themselves to the magnetic lines of the Earth when migrating, to the communication between pollinators and their flowers, to the communications between members of the same family who have bonded with each other — and, of course, a great deal more.

Electromagnetic spectrum signals, like those we know as a particular radio station, can and do contain very large amounts of information… Every time life flows through a frequency in the electromagnetic spectrum, it fractalizes that wave differently, because the flow of life is always nonlinear. What is interesting is that unique information is always embedded or encoded within the way the oscillating sine wave is fractalized.

Fractalized sine waves seem to be encoded into the very fabric of our reality; like the Golden Ratio and the second law of thermodynamics. They appear throughout the universe on nearly every level of scale and function. It’s no surprise then that they underlie the very structure of our market, which is just fractalized sine waves overlaid on fractalized sine waves of various temporal scales.

This makes intuitive sense because a sine wave is just a continuous pendulum swing. And crowd dynamics naturally follow the path of a pendulum, swinging from one local extreme to another.

The market is in effect a large complex information transmission system. All acting participants make bets using their particular knowledge set which then in aggregate moves the market, providing new information for the actors to incorporate into their decision-making process where they then make new bets. Creating a neverending information feedback loop.

The infinite feedback loops in the structure of the market, not to mention the way group psychology evolves, necessitate this constant back and forth, like that found in every natural system.

Every rally sows the seeds for a reversal and every reversal sows the seeds for a rally. Ad infinitum.

Michael Mauboussin discussed a critical driver behind why this process plays out in his recent paper titled “Who is on the other Side?”. In it, he shares work done by economist Blake LeBaron which animates this concept using an agent-based model (here’s a link to the original paper).

The model is computer generated and the “agents” are imbued with decision-making rules and objectives similar to those that drive market participants (i.e., make money, try not to lose money, don’t underperform the average for long periods, etc…)

Here’s a section from the paper (emphasis by me):

LeBaron’s model replicates many of the empirical features of markets, including clustered volatility, variable trading volumes, and fat tails. For the purpose of this discussion, the crucial observation is that sharp rises in the asset price are preceded by a reduction in the number of rules the traders used (see exhibit 5). LeBaron describes it this way:

During the run-up to a crash, population diversity falls. Agents begin to use very similar trading strategies as their common good performance begins to self-reinforce. This makes the population very brittle, in that a small reduction in the demand for shares could have a strong destabilizing impact on the market. The economic mechanism here is clear. Traders have a hard time finding anyone to sell to in a falling market since everyone else is following very similar strategies. In the Walrasian setup used here, this forces the price to drop by a large magnitude to clear the market. The population homogeneity translates into a reduction in market liquidity.

Because the traders were using the same rules, diversity dropped and they pushed the asset price into bubble territory. At the same time, the market’s fragility rose.

Mauboussin goes on to note the important lessons this model underscores about our market structure, which can be broken down into three primary points.

  1. Falling agent diversity initially leads to agents making more money which creates a feedback loop of higher prices -> agents in the ‘herd’ make more money -> less agent diversity -> higher prices… This is why fighting trends, even ones based on faulty prepositions, can be so dangerous over a short timescale.
  2. A reduction in agent diversity is non-linear. Meaning, as diversity falls, market fragility rises exponentially. This is more often than not initially obscured by rising market prices. But, as Mauboussin points out “crowded trades work until they don’t” and eventually an incremental change in diversity will lead to an outsized drop in market price. This is the age-old liquidity problem. When a large portion of the market is using the same buy and sell rules there conversely becomes a disproportionately small population to sell into and the market needs to drop significantly for prices to clear.
  3. Lastly, the model highlights the importance of understanding how beliefs propagate across a network. Like a disease, a belief’s level of virality is based on its contagiousness (how compelling it is), its degree of interaction (how many high-density nodes in a network adopt it), and the degree of recovery (how supported is the belief by the unfolding reality).

The Palindrome George Soros was perhaps one of the best at playing the player and identifying these belief-diversity cascades when in his prime. He applied an entirely new vocabulary to financial markets with terms like reflexivity, feedback loops, false trends and so on.

Soros would break down reality into three sub-categories:

  1. Things that are true
  2. Things that are untrue
  3. And things that are reflexive

He said that “Economic history is a never-ending series of episodes based on falsehoods and lies, not truths. It represents the path to big money. The object is to recognize the trend whose premise is false, ride that trend and step off before it is discredited.”

Soros was exceptional at reading where the market was in its pendulum swing (i.e., gauging the level of extremity of  consensus narratives and their subsequent positioning) relative to the quality of assumptions in which they are based on (true, untrue, reflexive).

An example of the type of pendulum swing Soros would try to exploit is the clear narrative shift in bonds last year.

Remember back in the middle of 18’ how the popular belief had become that “we’re in a new secular bear market in bonds”.

Both “Bond Kings” we’re shouting about the “game changer” in rates….

Here’s a few excerpts from a Bloomberg article in October of last year when the bearish bond narrative reached its pitch — which also happened to be right when yields peaked. The article is aptly named “Bond Bears Popping Champagne Say U.S. Yields Have Room to Rise”.

Thirty-year Treasury yields pushed above the 3.25 percent level that fixed-income veteran Jeffrey Gundlach identified as a “game changer.”

“Solid data releases, higher oil prices and a technical backdrop that suggests there are not a lot of obstacles for yields to continue to push higher will have many wondering how far this new push higher can go,” said Rodrigo Catril, a Sydney-based strategist at National Australia Bank Ltd.

Short sellers were already positioned for more pain in the Treasury market. Speculative net short positions on 10-year notes climbed to a record, the most recent Commodity Futures Trading Commission data showed. An update to those figures comes Friday.

“In hindsight, we wish we were even shorter on U.S. rates,” said Raymond Lee, a fund manager at Kapstream Capital Pty in Sydney.

“That gradual withdrawal of liquidity is causing yields to rise,” Bob Baur, chief global economist at Principal Global Investors, said in an interview with Bloomberg Television in Tokyo Thursday. “We look for 10-year Treasury yields to hit 3.5 percent at some point — later this year, early next year — and I think that’s going to be a real problem for stock markets.”

The famous speculator of the early 20th century, Bernard Baruch, used to say “Something that everyone knows isn’t worth anything.”

The “Bond Bear” narrative was predicated on a false trend. It wasn’t a sustainable move. Our leveraged balance sheets combined with a decelerating China and a responsive Fed ensured it. Crowding in both positioning and narrative combined with a textbook technical breakout in late October made for a perfect buying opportunity — something we pitched in our November MIR at the time.

Not only was the move in bonds not much of a “Game Changer…” but it was also clearly a local extreme on the swing of the pendulum. The narrative was on the front pages of ALL the financial newspapers and shared by nearly ALL the talking heads on CNBC.

And how quickly that narrative pendulum has swung back. It’s now accepted wisdom that yields won’t and can’t rise. The global economy is simply too weak and the Fed too dovish… Subsequently, investors have been stampeding in droves into bonds since the beginning of the year. More on this in a minute. 

Something that everyone knows isn’t worth anything…

 Equity markets too, have seen a full swing of the pendulum over the last six months. Back at the end of December when we put out a number of reports explaining why it was an excellent time to buy, the dominant belief was that a vicious bear market had started and a recession was around the corner.

I mean, the Yield Curve had inverted!!!! Everybody was fretting about the yield curve and a recent drop in retail sales…

Five months and a vertical runup in stocks later and there’s hardly a whisper of either. Now, the talk is of a Fed Put, a low growth low inflation Goldilocks economy, and a Melt-Up in equities.

One more time: Something that everyone knows isn’t worth anything…

Viewing markets — also history, politics, culture, and on and on — through the lens of a swinging pendulum is a useful heuristic. Look for local extremes and compare it to alternative possible outcomes, ones that aren’t being discounted by the market. Then wait for a break in the technicals and you have yourself a trade.

Doing this, you’ll find that the market, especially when at pendular extremes, is more often than not suffering from acute myopia. It tends to overly discount what’s happening now while not accounting for a future that could look any different than today.

Stanley Druckenmiller (aka The GOAT) put it like this:

[My] job for 30 years was to anticipate changes in the economic trends that were not expected by others, and, therefore not yet reflected in security prices.

Too many investors look at the present; the present is already in the price. You’ve got to think out of the box and visualize 18 to 24 months from now what the world is going to be and what (level) securities might trade at… what a company has been earning doesn’t mean anything, what you’ve got to look at is what people think a company’s going to earn and if you can see something in 2 years that’s going to be entirely different than the conventional wisdom, that’s how you make money.

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Disney, Memetics, and Markets

Here’s a clip from a MO Collective trade alert I wrote back in May of last year on Disney (DIS).

 

Today we’re putting on a large position in Disney (DIS). This is a trade I’ve been thinking about for a while. The chart is what first caught my eye. Here it is on a monthly basis, below.

That’s a beautiful looking 3-year coiling wedge. Long technical setups like these are some of my favorites to play as they usually precede explosive trends. They also offer us great inflection points with clear go/no-go price points in which to enter and place stops.

In addition to the great looking tape, Disney also has a very attractive developing fundamental story. The stock is trading at just 13x next year’s earnings and the company has been aggressively buying back shares. And after 3-years of little to no revenue growth, top-line numbers have begun accelerating higher again.

Disney is a classic case of the market latching onto a stale narrative and failing to see the changing fundamentals. The stale narrative in this case is the focus on a declining subscriber base in Disney’s media business (think ABC/ESPN), which the market is now valuing at just 2x EBITDA — which is kinda crazy…

This stale narrative was pervasive and common accepted knowledge amongst the financial media and Wall St. analysts.

Despite a clear positive inflection in the fundamentals — both income and revenues pivoted higher in the middle of last year — along with extremely positive catalysts in the company’s DTC SVOD plans, this narrative persisted and Disney’s stock price continued to languish.

That is of course until last week when the stock finally gapped up and out of its 4-year trading range. This move has been accompanied by a complete and total shift in the popular narrative from “Disney as an out of touch legacy media business with a gangrenous ESPN division” to “Disney is a Netflix killer and the new hot growth stock”.

The only notable cause of this shift was Disney’s Investor’s Day the day prior to the breakout (here’s the link to the presentation and slidedeck). But hardly anything new was announced at the event other than frivolous details. Pretty much all of it was a rehash of what the company’s been communicating for the last 18-months and yet here we are, not only has the narrative changed but so has the trend in price.

What’s going on?!? Why do markets do this time and time again where they ignore the obvious shifting landscape and instead willingly latch onto bygone narratives that no longer reflect reality?

Let’s discuss…

In our December 2017 MIR I included the following section from Yuval Harari’s book, Sapiens (emphasis mine):

Sapiens rule the world, because we are the only animal that can cooperate flexibly in large numbers. We can create mass cooperation networks, in which thousands and millions of complete strangers work together towards common goals. One-on-one, even ten-on-ten, we humans are embarrassingly similar to chimpanzees. Any attempt to understand our unique role in the world by studying our brains, our bodies, or our family relations, is doomed to failure. The real difference between us and chimpanzees is the mysterious glue that enables millions of humans to cooperate effectively.

This mysterious glue is made of stories, not genes. We cooperate effectively with strangers because we believe in things like gods, nations, money and human rights. Yet none of these things exists outside the stories that people invent and tell one another. There are no gods in the universe, no nations, no money and no human rights—except in the common imagination of human beings. You can never convince a chimpanzee to give you a banana by promising him that after he dies, he will get limitless bananas in chimpanzee Heaven. Only Sapiens can believe such stories. This is why we rule the world, and chimpanzees are locked up in zoos and research laboratories.

We are genetically programmed to buy into the popular narratives that are shared by the crowd.

The German Physicist Max Planck quipped that “A new scientific truth does not triumph by convincing its opponents and making them see the light, but rather because its opponents eventually die, and a new generation grows up that is familiar with it”. This is where the saying “science advances one funeral at a time” comes from.

I think a similar dynamic plays out in major trend changes and popular market narrative shifts. And no, I’m not implying that new trends are caused by investors dying off. Rather, it’s that narratives eventually exhaust themselves by driving every seller who is going to sell, to sell, or vice-versa for buyers in a bullish narrative.

Price and narratives work in a reflexive relationship where both drive each other in a continuous and cyclical boom/bust process throughout multi-fractal timescales. The diagram below shows what this process looks like.

Since the two are self-reinforcing and all market participants suffer from cognitive shortcomings such as anchoring and confirmation bias, the availability heuristic, and so forth. It’s only natural that narrative and price trends would continue on well in advance of their past-due date — Tesla being an obvious current example of this.

There’s a research paper titled “Memetics Does Provide a Useful Way of Understanding Cultural Evolution” (h/t Jim O’Shaughnessy) which dives deeper into how narratives (aka, memes) spread. It’s a super interesting paper and I suggest you read it in full (here’s the link).

The paper discusses the origins of the term ‘memetics’. A word coined by Dawkins in his landmark book The Selfish Gene. Dawkins argued that “Darwinism is too big a theory to be confined to the narrow context of the gene.” He believed in Universal Darwinism as a general principle where whenever information, in any form, is “copied with variation and selection, then you must get evolution.”

The paper goes on to posit that memes, a word that stems from the Greek root mimēma which means “that which is imitated”, and can be thought of as the cultural transmission of packets of information, are not only the evolutionary force behind human culture (i.e., language, art, music etc…) but might have been a fundamental driving force behind human physical evolution, as well.

Essentially, what this means, is that we humans physically evolved to be optimized for imitating one another and transmitting memes. The paper notes that in line with this “prediction is that the parts of the human brain that maximally increased in size should also be those involved in imitation, and this has been confirmed by brain scanning studies (Iacoboni et al 1999).

Here’s a section from the paper which lays out exactly what all this might signify (emphasis by me).

A common objection to memetics is that it undermines human autonomy and the creative power of consciousness, and treats the human self as a complex of memes without free will. These ideas follow naturally from the universal Darwinism on which memetics is based. That is, the idea that all design in the universe comes about through the evolutionary algorithm and is driven by replicator power. This means that human creativity emerges from the human capacity to store, vary and select memes, rather than from some special creative spark, or power of consciousness (Blackmore 2007). The human self may also be a construct of memetic competition, surviving because it protects and propagates memes, including the many memes that make up a person (Dennett 1995). In this view the self is not a continuously existing entity with consciousness and free will but is a persistent illusion. This memetic view of human beings as the evolved creation of two replicators may be unsettling but it has the advantage of uniting biological and human creativity into one, and providing new ways of understanding human nature, self and consciousness.

This is kind of heady stuff and I’m not sure I fully believe in it but the concept is an interesting one and certainly has descriptive power for how we act in the aggregate.

Moving back to how we can think about this on a more practical note. Jim O’Shaughnessy I thought did a good job of summing up the intersection of memetics and markets in a recent tweet. He said “In non-academic speak: Many times, markets move from heterogeneous to homogeneous caused by consistent information cascades that compel people to copy other’s behavior. For example, after writing a scathing paper on the prospect of internet stocks, I founded an internet Co.”

Essentially, few things are more compelling than a popular narrative. It’s tough, if not outright impossible to completely remove ourselves from the ‘Herd’. We’re all a part of this Grand Collective Intelligence and are literally wired at the genetic level to be so.

This is why popular market narratives can persist — and often do — well past the point of no longer describing reality. Memes have a momentum all their own. And it often takes repeated bludgeoning from reality for them to die off and be replaced with a new one.

As participants in this game who are all equally susceptible to the same pull and sway of memes, all we can do is remind ourselves of our cognitive foibles, try to stand back and observe the observer, and continuously stress-test our opinions against the data and the market.

Studying the trading greats, you find that nearly all of them had an uncanny ability to get outside themselves and more objectively view their thinking. George Soros put it like this.

I am outside. I am a thinking participant and thinking means putting yourself outside the subject you think about. Perhaps it comes easier to me than to many others because I have a very abstract mind and I actually enjoy looking at things, including myself, from the Outside.

And in order to help combat the pull of popular market memes, he would begin his research from the starting point that the market was wrong. Soros said:

The prevailing wisdom is that markets are always right. I take the opposite position. I assume that markets are always wrong. Even if my assumption is occasionally wrong, I use it as a working hypothesis.

So that’s that.

For those of you wishing to dig more into memetics after reading the above paper, I’d recommend picking up The Diffusion of Innovation by Everett Rogers. It’s essentially a textbook on how ideas spread and there’s an extremely useful concept in it called The Adoption Curve (here’s a short Youtube video overview) with obvious applications to markets (I plan to write more on this soon).

Lastly, if you’d like to dig more into Disney and the new direction the company is headed in, then check out Ben Thompson’s latest Stratechery write-up (link here) and, of course, Matthew Ball’s recent work (link here).

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Target Hospitality (TH): A Former SPAC IPO with Multiple Ways to Win

Target Hospitality (TH): Leader in Vertically Integrated Specialty Accommodations


Target Hospitality is the largest vertically integrated specialty rental and hospitality services company in the United States. The company owns an extensive network of geographically relocatable rental accommodation units comprised of ~13,000 beds across 22 sites serving the country’s highest producing oil and gas basins.

Most of the company’s revenues are generated under multi-year “take-or-pay” contracts, providing Target high visibility into future earnings and cash flows. The company went public via SPAC merger with Platinum Eagle Corp and Signor Holdings and is trading for an incredible discount to just a middle-of-the-road valuation.

We believe one can purchase shares of a business generating over 50% EBITDA margins, 90%+ FCF conversion and a 26% 3-year EBITDA CAGR for 60% off — getting all future growth for free.


Is This a Good Business?

The modular accommodations business is a great business with enviable unit economics. There are predictable up-front fixed costs (like the initial build out of the site and beds) with very minimal ongoing maintenance expenditures. This trend translates into high margins with incrementally higher return on invested capital over the course of a project’s lifetime.

Let’s look at Target’s lodging business performance from 2018 to paint a clearer picture.  In 2018, the company generated a little over $186M in accommodation revenues on $93M of operating expense, giving us $93M in gross profit (over 50% margin). Backing out the depreciation of the accommodation assets gives us around $134M in EBITDA.

Most of these margin advantages are exclusive to the modular style of construction. Horizon North (HNL), a Canadian builder of modular homes and accommodations, did a fantastic job of outlining the benefits of switching to a modular construction style in their latest investors’ presentation. According to HNL, there are four main advantages to switching to modular: Time Savings, Cost Certainty, Sustainability and Quality Control. The biggest (and most important) advantage to modular homes is the extreme savings on project development.

How can a company achieve such high savings on time? The typical construction site build schedule goes as follows:

Design & engineering –> permits & approvals –> site developments & foundations –> building construction –> site restoration.

Modular combines of both the Site Development & Foundations and the Building Construction. Modular buildings are built off the job site and usually indoors, enabling the construction to both develop the buildings while making the build site ready to receive the buildings. Further, since the buildings are constructed indoors, build development isn’t stunted from adverse weather conditions. Reducing construction build time by 30 – 50% translates into faster return on investment, which creates a positive feedback loop where that returned capital can be deployed into new modular projects at those same high rates of return.

Another benefit of modular construction is lower waste levels per project (read: less money spent on unnecessary items). A company using modular construction processes knows exactly how much of each component is being built and can scale seamlessly.

For example, a company might need to order 15,000 lbs. of lumber for 400 modular buildings (completely arbitrary figures — I apologize to my former construction workers in advance). If they then go on to receive an 800-building contract, they know exactly how much material they will need to complete the job. WRAP, a UK company specializing in waste efficiency research, reported that an up to 90% reduction in materials can be achieved through modular construction. That 90% reduction in material costs drops straight down to bottom-line earnings.


Signor Holdings: Incremental Cash Flow at Low Cost

The merger of Signor Holdings (the hospitality segment) adds significant incremental earnings and cash flow for very little capital expenditures to an already high margin, high earning lodging business.

Operating independently, Signor’s financials were rock solid.  For the period Jan 2018 – Sept. 2018, Signor generated $61.2M in revenues, $30.5M in gross profit (50% margins) and $32.8M in EBITDA with over 90% FCF conversion. Signor (on its own) generated roughly $0.52/share in operating earnings. The company is a high margin value-add that costs Target (the parent) almost nothing in additional expense.

By combining the two businesses, Target Hospitality owns the entire process from manufacturing / supply of accommodations to catering, amenities and hospitality services within its owned and operated communities. The combination reduces expenses (removing the need to outsource various services) and removes the guesswork for its customers on how they’ll be able to fill all the aspects of rental / accommodation services for their workers.

What happens when you combine a high margin, high cash generative lodging business serving blue-chip customers with another high margin, high cash generative hospitality business providing turnkey catering, security, recreational and other amenities?

You get a robust business providing clients with 100% of their needs while achieving substantially higher margins than competitors.


Impressive Growth & Break-even Reduction

Between 2014 – 2016, Target was a small, albeit growing company with a network of just 5,500 beds. These beds were distributed 56% in Bakken Basin and 44% in the Permian Basin serving (for the most part) upstream oilfield services and midstream companies. Utilization rates were at a decent 65%, and the company’s average daily rate came in at $86. Cost of production wasn’t great by any stretch of the imagination, with break-even rates between $70 – $90 oil prices. This was great, of course, until oil peaked in June of 2014 — falling from $106bbl to the February 2016 low of $30bbl

The company has undergone drastic changes since to drive production costs lower, increase utilization rates while adding more beds in higher growth areas thus lowering their overall break even rates.

Seeing the growth prospects in the Permian Basin region (something we’ll touch on in a little bit), Target altered its concentration, putting 81% of its buildings in the area to create the largest and closest accommodation site in the entire Basin. Target’s main customers remain Upstream Producers, Oilfield Services, Midstream Owners and Government entities. Break-even rates are around $44/barrel in the Willston Basin and an impressive $32/barrel in the Permian Basin — representing a 60% cut in production costs over the last two years.


Industry Leading, Enviable Unit Economics

A leading driver of our bullish thesis is the incredible unit economics of Target’s vertically integrated business.

In February of 2018, Target won a contract to build 400 beds in the Carlsbad region in Mexico — located within the Delaware Basin — one of the hottest basins in the Permian landscape. The company’s average project is around 500 beds with $50K/room in CapEx. Average daily revenues are between $86 – 95 per bed, and COGS per bed is $35. Capping it all off, the company spends $3M total in maintenance capital expenditures during a given year. All capital expenditures are underwritten by Target’s contracts, so the risk for speculative building is (for the most part) nullified.

In Target’s latest contract, 400 beds at $50K per room gives us total upfront investment of $20M. Assuming the company’s historical EBITDA margins (and reaffirming that percentage with our median ADR/COGS figures), the $20M investment will generate roughly $7.2M in EBITDA per year. $7.2M EBITDA/year translates into an IRR of 36% annualized.

Due to the extremely low maintenance annual capex spending, over 90% of that EBITDA will drop down to free cash flow to the firm (read: over 12% FCF yield). Target should expect to receive $144M in EBITDA over the course of their latest contract (assuming a typical project lasts 20 years). This means that for every dollar the company spends on investment, they receive over $7 in unlevered cash returns.

To quote Charlie Munger, Over the long term, it’s hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for that 40 years, you’re not going to make much different than a 6% return — even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with a fine result.”

We believe Target offers the best of both worlds in Munger’s scenario: a business compounding capital at high rates of return while at the same time trading for a huge discount.


Contracted Revenues & Future Growth Prospects

The company’s already raised guidance higher for 2019 revenues and EBITDA, $340-$350M and $175-$180M respectively.

The increased guidance comes off the heels of renewed contracts with four of Target’s largest customers, representing nearly $45M in incrementally higher earnings. According to management’s press release, the contracts will add over $200M in cumulative value with all renewals signed on a multi-year agreement. The contracts extend the existing contracts by a minimum of two years and include the full-scale accommodation services from Signor Holdings (read: incrementally higher revenues per contract extension).

The upward guidance introduces our second largest driver of value: long-term contracted revenues. When looking back on the last few write-ups we discovered we really like long-term, contracted revenues. That long-term revenues provide high visibility into future earnings and cash flow makes these types of businesses some of our favorite to invest in.

Increased visibility offers us a better chance at achieving a more accurate fair value range over the next 3 – 5 years. The latest extended contracts lock up 90% of Target’s revenues for 2019. We’re highly confident these revenue sources will continue to expand as growth in the Permian Basin region picks up, with much of the growth coming from its two largest players: Chevron & Exxon Mobil.


Will Growth in The Permian Hold?

There’s arguably no area in the United States that’s reaped the benefits of a US Energy Exporter in Office than the Permian Basin. According to a Forbes article (dated 02/09/19), the Permian Basin is now the world’s second most productive oil and gas resource. We are confident that growth in the Permian Basin will continue its historic pace. But don’t take our word! Here’s what the US Energy Information Administration (EIA) had to say on the matter:

Growth in the Lower 48 onshore crude oil production occurs mainly in the Permian Basin in the Southwest region. This basin includes many prolific tight oil plays with multiple layers … making it one of the lower-cost areas to develop.

The EIA projects that domestic crude oil production will surpass 15 million barrels per day by 2022 (which would be years before their earlier projected figures) and will remain producing over 14 million barrels per day through 2040. Target’s latest investors presentation paints the TAM for the Permian Basin at $1B and has grown their share from 2% in 2015 to 20% today.

Touching on the two largest players in the Permian; Chevron supported their increased exposure to the Basin due to their past success. Over the last two years there, Chevron added almost 7 billion barrels of oil and doubled its portfolio value. ExxonMobil revised its Permian growth plans to produce more than 1 million barrels per day by as early as 2024 — which reflects an increase of nearly 80%.


Multiple Ways to Win (Organic Growth, Pipeline Catalysts
and M&A)

There are multiple ways for Target to win over the next five years.

We’ve touched on the Permian Basin and the renewed multi-year contracts, but there’s more room to grow. As a near term catalyst, the company’s identified close to 5,000 beds that will come online during 2019 — all through organic growth. Target’s spent $213M in CapEx on these beds and will generate a minimum contracted EBITDA of close to $260M — a 30% return on their investment within 2.8 years.  

The companies also engaged in three major projects (each coming online in 2019): US Government contract, Services Contract and LOI Awarded. The government contract is for multiple, large scale communities supporting a host of US federal agencies. Target estimates contract value for this project to be between $85M – $100M.

The services contract was awarded for work in the Keystone Pipeline, where Target will provide catering and facilities services. Work started on the project in 2018 and is awaiting full release. The company estimates around 5 million meals will be served over the duration of the contract (read: high margin, low capex revenues).

Target was also awarded a Letter of Intent to support the construction of a brand-new oil refinery in the North Dakota Bakken region. Total contract value is estimated between $35M – $45M with minimal capital expenditures (highly accretive free cash flow).

Finally, the company’s targeted (no pun intended) four regional accommodations providers for acquisition. Should Target go out and acquire all four of these local players it would add over 6,000 beds to the company’s network. At Target’s historical rate of $18K in EBITDA per bed in their network, those acquisitions translate to roughly $108M in potential EBITDA expansion.


Valuation

When estimating our conservative fair value for Target, we decided to exclude the multiple avenues of growth (i.e., M&A, organic bed growth and pipeline contracts) in order to give ourselves a clearer base rate range of valuation. The company’s been able to grow EBITDA over 20% annually over the last three years, but will this truly be the company’s growth prospects going forward? In valuing Target Hospitality we’ve projected three different futures: pessimist, neutral and optimist trajectories.


Pessimist Valuation

For our pessimistic view of Target’s future, we’ve assumed the following outcomes:

  • Top-line revenue growth: -10% annually after 2019
  • EBITDA margins: 35% after 2019 (this represents a 15% margin compression from current levels
  • Capital Expenditures: 2% of revenues (slightly above historical figures)
  • Tax rate of 25%
  • Discount rate of 10%
  • Net debt: $340M and EV/EBITDA
  • Multiple: 10.2x (comparable average).

Using the above assumptions, we arrive at 2023 FCF of around $65M, $391M sum of present values, and $972M Enterprise Value. Dividing by the total number of shares puts us at ~$6/share. Shares are trading for around $9.80 (as of 04/05), which represents a 40% downside in this given scenario.


Neutral Valuation

Assuming that Target doesn’t do anything over the next five years. They don’t grow, they don’t shrink, they remain in this static environment of top-line stagnation. For our neutral valuation we’re assuming 0% top-line growth, 40% EBITDA margins (10% lower than historical averages) and an EV/EBITDA multiple in line with industry averages — 10.2x.

Using the above assumptions, we arrive at 2023 FCF of $122M, $525M sum of present values and $1.6B in Enterprise Value. Taking the mean figure between our EBITDA approach and DCF gives us fair value of ~$11/share, or 20% higher than current prices.


Optimistic Valuation

We would argue that this isn’t an optimistic valuation in the sense that we don’t think it will happen — in fact — if each scenario could be put into probability buckets of potential outcomes, we would put this scenario into the bucket of “most likely to happen”.

We’re assuming top-line revenue growth of 15% (given the 3 year 28% EBITDA CAGR, it seems reasonable), EBITDA margins at historical 50% and an EV/EBITDA multiple of 12x. In this example, we’re projecting the market will realize the value of the company not only through share appreciation but multiple expansion.

The above assumptions spit out around $236M in 2023 FCF (8% FCF yield), $673M sum of present value and a near $3B Enterprise Value. At $3B EV, the company would have an exit EBITDA multiple of sub 10x, which we think is too cheap. Attaching a multiple that’s geared towards industry leading gives us a price of over $20/share, in line with our DCF estimation. At around $20/share you have a chance to 2x your initial investment.


Risks

Anytime you have a company that is tied to a commodity (i.e., oil) there is the chance of commodity price risk. Target’s been able to reduce this risk dramatically as the company’s been able to cut their breakeven prices from $76 in 2014 to $32 today.

Declining oil prices lead to capital and labor leaving the industry. This cycle ends up costing Target Hospitality the chance at filling their beds and generating revenues / cash flow. Target can mitigate this risk due to their long-term take-or-pay contracts. TH solidifies their contracts with their customers at certain oil prices — which are fixed in the contract. This means that for the life of the contract, it doesn’t really matter what oil prices do because Target locked in its contract at that fixed oil price during the time of signing.


Growing Pains in Basin

While all this growth is extremely bullish for Target, the major problem the Basin faces is in Takeaway Capacity. The basin saw early signs of this towards the end of 2018 with Midland – Cushing spreads hitting as low as $20bbl as every pipeline was full. If production continues its expansion as planned, there will once again be a need for increased takeaway capacity — or suffer backups.


SPAC Stigma & Liquidity

Another risk to share price appreciation is the fact that Target went public via SPAC IPO. SPACs have a sketchy history (at best) of post-IPO performance, which can dissuade many investors from becoming part owners. In other words, yes, over time the market is a weighing machine. However, if there isn’t a market of willing and able buyers, share prices might never truly reflect the underlying value of Target’s business.

Liquidity is also a risk when dealing with newly IPO’d SPACs, and TH is no exception. The company averages 30k – 70k shares in daily volume. At current shares prices its between $300K – $700K of daily volume. Again, not bad for the smaller investor — but for an institution or larger fund, it will take some time to build into a full position.


Buying Value, Get Growth for Free

To conclude, here’s a business that’s trading around 8x 2019 EBITDA with a current enterprise value that implies the company won’t be able to achieve any top-line growth in EBITDA over the next 5 years. Mr. Market is giving the investor an opportunity to own a high margin, high FCF conversion business with long-term take-or-pay contracts business for less than 8x next year’s EBITDA.

Target has many levers to pull to expand earnings, cash flows and multiples over the next five years. Over time, we believe the market will value this business closer towards (and even potentially higher than) its intrinsic business value. The company is an industry leader in vertically integrated specialty accommodations serving some of the hottest end markets in the United States — and current prices on both the warrants (which are 3-for-1) and the common stock offer a chance to buy the business while getting all its future growth for free.

If you want to know my process for finding these hidden market gems click here to receive my value investors checklist!

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Minsky and the Levy/Kalecki Profit Equation

I want to talk Minsky and the Levy/Kalecki Profit Equation

This may sound a bit heady, but don’t worry. We’re going to break it all down Barney style and then walk you through how you can use the frameworks for understanding the current environment in order to better assess the probabilities of potential outcomes (ie, gauge the general conditions).

I still had much to learn but I knew what to do. No more floundering, no more half-right methods. Tape reading was an important part of the game; so was beginning at the right time; so was sticking to your position. But my greatest discovery was that a man must study general conditions, to size them so as to be able to anticipate probabilities.  ~ Jesse Livermore

Let’s kick things off with the Levy/Kalecki Profit Equation.

The Profit Equation is just a macroeconomic accounting identity for how the global economy actually operates. Specifically, it answers the question as to where “Profits” come from and thus, growth.

If you’ve ever heard of The Jerome Levy Forecasting Center where a number of talented economists work. Well, that’s the same Levy. The center performs analysis using the Profits Equation framework developed by Jerome Levy in 1908 (side note: Kalecki was a renowned economist who developed the same framework as Levy years later and received credit initially for it because Levy was a relatively unknown name).

Now, you can read the full white paper on the equation here, which I highly suggest you do so. We’re just going to cover the gist of it today, because it’s relevant to potential macro risks and constraints we’ll be facing in the coming year(s).

The actual accounting identity looks like this:

Profits before tax = + Investment – Nonbusiness saving + Dividends + Corporate profits taxes

This accounting identity, which like any identity holds true under any circumstance, is just saying that corporate profits are the direct result of net investment minus nonbusiness (Households + Government + rest of world) saving before dividends and corporate taxes are paid out.

Confused? Don’t worry. I’ll break it down even more.

We all know where profits come from at the individual level, right? A company earns more in revenue than its costs and the excess is profit.

Well, if you pull back and look at the global economy as a whole, it’s a closed system. Its closed in the sense that profits aren’t magically appearing from anywhere outside of the global economy. But profits obviously aren’t a zero sum game. If one company earns profits it doesn’t necessarily mean that another company somewhere has to be operating at a loss. There wouldn’t be any growth if that was the case. So, where do profits come from then?

The answer is in net investment, which is a positive sum game. If we divide the economy into our four aggregate entities (1) US Corporations (2) Households (3) All levels of US Government and (4) the Rest of the World (RoW) and look at them as a whole, there needs to be net positive investment as a whole for their to be profits.

This means that an economy’s ability to produce profits comes down to the net expansion of the aggregate balance sheet in the macro accounting identity. For instance, if the US Government is running a budget surplus (shrinking its balance sheet), like it did in the late 90’s. Then either the Household, Corporate, or the RoW needs to take up the slack and expand their balance sheets to make up for the fall in demand. Or else demand will fall and profits will contract.

In the late 90’s, US Corporates made up for the government’s demand deficit by expanding their balance sheet. In the 2000s it was Households and the RoW (led by China) who borrowed money and invested — US Households in homes and China in building entire cities.

Understanding that profits are essentially the residual of the net balance sheet expansion/contraction of the entire global economy is helpful because (1) we can look at the trends in the balance sheets of our four macro aggregates to see if net demand (profit) is being created and (2) we know that their are natural limits to how much balance sheets can expand and therefore whether the global economy may be headed for a contraction in profits.

This is essentially a more nuanced framework for understanding how the debt cycle (as put forth by Bridgewater) works. Profits are essentially the result of expanding balance sheets (increases in debt). The more balance sheets expand the lower interest rates need to drop in order to decrease debt servicing costs and keep the cost of capital down for marginally profitable firms — essentially keep the economy from going into free fall.

Enough with the theory… How does this apply to the present day?

Well, think about what’s been the source of profits in the US economy the last couple of years.

The Household sector has been deleveraging since the Great Financial Crisis (GFC). They’ve been contracting their balance sheets and thus have been a negative source of profits/demand in the economy. The demand then has come from both the Federal Government and the Private Sector, both of which have been rapidly expanding their debt.

The RoW, primarily the Eurozone and China being the two economies large enough to matter, have been either a wash or net drag on global demand over the last few years.

China has pretty much maxed out its balance sheet limits where it now takes extraordinary injections of credit from the government to produce a relatively modest and short-lived economic impulse — the whole “pushing on a string” thing. And European consumers and corporates are fairly weighed down by debt and haven’t been helped much at all by their governments, who unlike the US decided to go with German imposed austerity following the GFC (though this may be starting to change, which we’ll discuss soon).

And this brings us to a growing concern of mine. Where is net demand going to come from in the future?

The fiscal impulse from the US tax cuts and increased budget deficit is starting to wear off. And on the corporate side, with corporate debt to GDP at all-time highs, how much more credit driven demand can we expect?

Things actually look worse when you disaggregate the corporate data. Taking a look under the hood we find that debt is actually much higher and there are a number of “zombie” firms that aren’t profitable even in such a low cost financing environment which means its going to take just a small tightening of financial conditions to cause these firms to go belly up, potentially kick starting a chain reaction of defaults.

Check out the following notes from Financial & Insurance Firm, Euler Hermes (emphasis by me):

  • Between 2009 and Q3 18 the US total debt has declined from a peak representing 350% of GDP in Q1 09 to 311.5% in Q3 18. While the US as a whole has been deleveraging, the business sector (corporate and non-corporate) has re-leveraged, standing at 72.6% of GDP or USD 15tn today. This represents a 2pp deviation to trend. Past recessions in the US have coincided with positive deviations ranging from 2-8pp of GDP.
  • According to our calculations, the true level of non financial corporate debt in the US may be 30% or USD 3.9tn higher than officially reported, primarily because of leveraged loans bought by non-banks. We estimate that the debt-to-EBITDA ratio would thus be close to 4.6 instead of 3.9. As a consequence, the BAA-Treasuries’ spread (to AAA) should be about 120bps higher than currently observed (~ 230bps today) if hidden debt were factored in.
  • The Trump Administration’s fiscal stimulus has boosted demand in the US over the past couple of years. According to our model, a correction of this excess demand, back to potential output growth, could trigger an increase of the corporate delinquency rate from 1% in Q3 18 to 2.32% (highest level since Q2 11). This adjustment could follow strong disagreement about fiscal policy as we enter 2019-20 budget discussions. Corporate spreads will thus continue to hover around 230-250bps as seen today, still underestimating hidden debt, but aware of looming risks in the corporate sector. In a stress scenario (likelihood to switch estimated at 35%), which could correspond to a series of defaults for instance, the delinquency rate would jump to 3% and credit spreads would very quickly increase by 70bps higher than today.
  • The bottom line is that be it from scoping (hidden debt) or for cyclical reasons, we believe that corporate spreads are underestimated today, and that unfortunate events (rapid downturn, market defaults) could end up pushing up spread by 70-190bps, by sheer realization by market actors of intrinsic risks in that segment.

The Bank for International Settlements (BIS) put out a research paper last Fall, titled “The rise of zombie firms: causes and consequences”, where they discuss the pervasive rot in the developed market corporate sector, especially here in the US.

Here’s a few of the notable highlights from the paper.

  • 12% of all companies globally are now “zombie firms,” meaning that they can barely pay the interest on their debts. The number is 16% in the US, which is an eight-fold increase since the 90s.
  • These zombie firms have been kept alive by low interest rates along with investor demand for “leveraged loans”.
  • The leveraged loan market is now in the trillions (the exact number is unknown) and consists of low-quality corporate debt that’s at risk of being downgraded — which would cause forced liquidation — should interest rates rise too much.

It seems we’re on a clear course of transition from what Minsky would call the “speculative financing” stage to the “Ponzi Financing” stage of the financial cycle.

For those of you not familiar with Hyman Minsky, here’s a brief summary of one of his more popular theories, which applies to our discussion today.

Minsky came up with the “financial-instability hypothesis” which stated that long stretches of prosperity sow the seeds for an eventual crisis. Economic stability breeds instability.

Minsky understood that recency bias drives myopia in the human decision making process. Economic actors end up extrapolating low volatility into the future which leads to more risk taking in the present through the use of leverage (credit).

The theory was established by defining what investment is, and its role in an economy. Which, put simply, investment is the exchange of money today for money in the future. That money (investment) can come from one of two sources: the economic actors’ (consumer, company, government) own cash flows, or from the cash flows of others (lenders). And it’s the balance between these two sources of investment that comprises the stability of the financial system.

According to Minsky, the financial cycle typically follows three stages of financing; these are:

  1. Hedge financing
  2. Speculative financing
  3. Ponzi financing

Hedge financing is the most stable of the three. It’s when the economic actor relies on its own stable cash flows to repay any borrowings. It’s when the actor’s earnings far outweigh its limited borrowings.

Speculative financing is when the actor uses its own cash flow to pay the interest on its debt, but must assume more debt to repay the principal; thus rolling its debt over. This stage of financing is less stable than hedge financing.

And lastly, there’s Ponzi financing, which is the most unstable of the three stages of financing. Ponzi financing is where the actor’s cash flows do not cover either the principal or interest payments on its debts. The actor is completely reliant on the appreciation of the underlying asset in the hopes that it’ll be enough to cover its liabilities.

Minsky argued that financial cycles naturally progress from each stage of financing to the latter; driven by human greed and carelessness. When economies enter the Ponzi stage, they become increasingly unstable and eventually experience a “Minsky Moment” which is a sudden collapse in asset values, leaving both lenders and borrowers exposed. This is the deleveraging phase of the debt cycle as put forth by Bridgewater.

So we have a diminishing US fiscal impulse, a nearly tapped out corporate sector riddled with zombie firms in an economy transitioning from speculative to ponzi finance, all which sits atop a leveraged loan market that measures in the trillions. Great…

The Game Masters (Policy Makers) are well aware of this threat. Former Fed chair Janet Yellen remarked in an interview with the FT last Fall that “I am worried about the systemic risks associated with these loans. There has been a huge deterioration in standards; covenants have been loosened in leveraged lending… There are a lot of holds. We should not feel the financial stability glass is full.”

I believe it was the market’s concern (rightfully so) that drove the large selloff at the end of last year. With the Fed acting as if they were on rate hiking autopilot, a painful recession and zombie killing field was all but assured if they had not changed course. But, they did, and here we are. The game is still going and may very likely go on for a while longer.

This is all rather big picture stuff. It may or may not be actionable in the near future. But it’s certainly something we need to be aware of because it will eventually matter and be actionable.

I’m still bullish the market but I do think the longer-term risk/reward is less positively skewed than it was just a few months ago.

There’s some deteriorating data that’s linked to the leveraged loan market as well as our zombie firms that will eventually cause a domino effect of economic pain should the data not reverse following the Fed’s easier stance. The two charts below are evidence front and center for this. We have the Fed Senior Lending Officer (SLO) survey showing banks are increasing the spreads on loan rates to large and medium firms (a reading above zero means lending conditions are tightening).

And the BAA/AA corporate bond spread has failed to reverse with our other indicators of financial/liquidity conditions. This tells me the market is finally starting to sniff out the brewing trouble we just discussed.

Thanks for reading! I’ll have additional updates as the data unfolds.

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A Tactical Short in Bonds

I was going to send out a note today where I dissect one of my favorite Bruce Kovner quotes and then get into how we can use Brier scores to make better probabilistically weighted market bets and combat two of our worst enemies, overconfidence and confirmation bias — the recent Invest Like The Best podcast with Michael Mauboussin dives into this (I highly recommend you give it a listen).

But, there’s a highly actionable setup triggering in the market so I figured I’ll put that note out to the Collective later this week and talk bonds and utes today.

The setup is for a swing trade. Specifically, for going short bonds (long bonds) and short utes (XLU). I’m neutral on US rates longer term. Actually, that’s not true. I think they’re probably headed lower (bonds higher) in the quarters ahead. Regardless, they’ve set up for a decent tactical short opportunity.

Starting with the 10-year. We can see that it’s pierced its upper weekly Bollinger Band near its 200-weekly moving average and then reversed. The highlighted bars show each time this has occurred over the last 3 ½ years.

 

Here’s a look at the same chart but on a daily. It’s also pierced its upper Bollinger Band on the daily timeframe and has completed a Demark 8-count.

Not only are bonds extended here but the copper/gold ratio is failing to confirm the recent trend. And as I wrote in Emergent Properties of the Market Collective the metals market tends to be the smarter of the two…

The technical setup looks even better on utes (XLU) — utilities tend to track bonds as the sector is extremely sensitive to interest rates. Check out the following weekly chart of XLU. It pierced its upper Bollinger Band then reversed and completed a weekly Demark 9 count last week.

The setup on the daily timeframe is similar.

 

A recent report by Sentiment Trader shows that just recently, more than 80% of utility stocks hit new 52-week highs. This is one of the sector’s most extreme momentum readings in three decades and tied for its second highest since 1990.

The following table from that same report shows just how hard it is for a defensive sector like utes to maintain this kind of momentum.

Here’s the following summary via Sentiment Trader (emphasis by me):

Across all time frames, utilities struggled to gain any amount, much less hold onto any gains that might pop up. Over the next 2-3 months, only two of the dates managed to show a positive return, and those gains were brief and ultimately erased.

The risk/reward ratio for the sector is one the worst for any study we’ve seen in 20 years. In a generally rising asset like stocks, it’s awfully rare to see a negative risk/reward ratio over a multi-month period, much less one shows as limited upside as this one, and such severe downside.

Bonds compete with stocks for capital flows. When stocks selloff, capital diverts to bonds in search of safety and vice-versa. The fundamental and technical picture still favors higher US equities, imo. A move up here in stocks should drive a reversal of some of the recent move in rates. This makes short utes/bonds a pretty good tactical short opportunity.

On an unrelated note, I’m currently working on the MIR (our monthly Market Intelligence Report). We’ll be focusing on two areas of the market that I’m most excited about; Ag and energy. There’s a number of trades to be made off these two macro themes. But there’s one that is actually a unique play on both. It’s an equity trading at low multiples of cash flow with a rock solid balance sheet and massive upside potential. I’m looking forward to sharing it with you and hearing your thoughts.

Only Macro Ops Collective members will receive access to my ag and energy trades. If you’re interested in checking them out be sure to sign up for the Macro Ops Collective by this Friday at midnight!

Click here to enroll in the Macro Ops Collective!

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Anchors Away: My Three Favorite Shipping Ideas

Deep value is found at the corner of “yucky” and “no way in hell” and over the last twenty years, shipping stocks have exhibited those two characteristics a hundred times over.

Alex did a great job summarizing the macro view of the shipping market in his latest article, which you can read here. To brush up, there are three main drivers of this deep value situation: 1) maximum pessimism in the industry, 2) regulatory requirements from IMO 2020 acting as near-term catalysts and 3) the need for countries to import cleaner fuel (mainly India and China).

With these factors in mind, I’ll offer three companies that are well positioned to capture the uptrend in the industry. Two of the companies mentioned have short-term catalysts that should help bolster share price acceleration while the industry heats up to capital inflows. The final idea is a micro-cap shipbuilder from Philadelphia which could provide handsome returns to those willing to stomach the illiquidity.

Diana Shipping, Inc. (DSX)

Diana Shipping, Inc. (DSX) is a sub $300M shipping logistics company that transports dry bulk cargoes and commodities (such as coal, iron ore, and grain). The company operates 46 dry bulk vessels for a combined carrying capacity of over 5M dwt (dead-weight tons) with an average age per vessel of 9 years.

The thesis for DSX is simple (and like that of almost all shipping companies): increasing charter rates resulting in higher revenue growth, most of which will drop straight to the bottom line. These higher revenues helped drive the rebound back to profitability last year. Along with the turnaround, management believes their shares are undervalued and initiated a Self-Tender offer to purchase 4M shares at $3.66 (current share prices are $2.65) while simplifying their capital structure by purchasing all Class-B shares. Finally, margin of safety can be found in its 40% discount to tangible book value.

Nowhere are the turning industry trends more apparent than in DSX’s income statement. The company reported net losses in 2017 upwards of $500M. Just 365 days removed from that time, the company boasted $16M in EBIT. DSX appears to be making all the right decisions. With this newfound cash, the company is aggressively reducing leverage (net debt trimmed from $560M in 2017 to $404 in 2018), selling off their oldest ships, and repurchasing shares at discounted prices.

Future growth will come from increased charter rates due to IMO 2020 as well as increased demand for the types of items DSX ships. For example, grain imports are projected to grow 4%, thermal & coaking coal to increase by 2 & 3% respectively and total bulk trade expected to grow near 3% (all according to Clarkson’s Research). The company is projecting revenues for 2019 – 2020 to hit between $224M – $255M respectively. If we use historical EBITDA margins of 50%, we arrive at 2020 EBITDA of $127M, which translates to 5x EV/EBITDA. Even at $4+/share the company would be trading less than 7x EBITDA. In other words, it’s cheap.

Risks for DSX mainly involve the commodity products it ships. Although the shipping industry could heat up and charter rates increase, if demand for any of the above-mentioned commodities drops, DSX ships will remain in their docks.

Although not my favorite of the three mentioned, I like what I’m seeing from management and their efforts to reinvest back into the business through the tender offer. Usually, when companies say they’re going to tender, it’s because they truly believe their shares are priced ridiculously low.

If DSX continues to grow top-line charter revenues, pay down its debt and reinvest its capital to shareholders, we could end up seeing that $3.66/share management talked about. Also, the company is paying a robust 12% dividend, which makes waiting for share appreciation easier.

Capital Product Partners, Inc. (CPLP)

Capital Product Partners (CPLP) is another micro-cap shipper that transports cargoes, crude oil, gasoline, diesel, jet fuel and containerized goods. Its 25 vessels include the suezmax crude oil tankers, medium range (MR) product tankers, neo-panamax container carriers and bulk carriers. What’s interesting about CPLP is its decision to spin-off its tanker fleet, which will then be merged with DSS Holdings’ business. This transaction is expected to close by 03/27/2019.

We’ll touch on the spin-off company in a little bit, but for CPLP’s purposes, what does their new business look like? The “new” CPLP will consist of 10 containerships and 1 drybulk vessel (average age of vessels is 6.5 years).

Each vessel is under charter with an average duration of 5.3 years providing high visibility into future revenues — 95% charter coverage for 2019 & 75% charter coverage for 2020 — and will be outfitted with the latest scrubbers (per IMO 2020 regulations). The company operates mostly in the spot rate market, and their longer-term contracts (ones that stretch out to Nov. 2024) are locked in for average day rates of $29,350.

The strategy for the new CPLP is in securing medium to long-term charter rates with their existing assets, while at the same time looking for accretive acquisitions through their dropdown sponsors (Capital Maritime & Trading Corp.) as well as secondhand market opportunities.

CPLP has current right or first offer for 4 ECO Chem/Product tanker vessels (both built-in 2016-17) with three ships having debt facilities in place. Along with the first offer right, the company has visibility to 4 LNG vessels (delivery in 2020 – 21), 4 10,000 TEU container vessels with 3-5-year charters, 4 ECO VLCC vessels with 5-7-year bareboat charters, 2 VLCC vessels on 5-7 charters and 1 Eco Aftramax tanker on a 5-year charter.

The new company will have a stronger balance sheet through reduced leverage and cleaner capital structure from the purchase of all outstanding Class B shares. CPLP’s 3.1x Net Debt/EBITDA compares favorably with the industry peer average of close to 6x.

Capital Partners currently trades for a roughly 70% discount to tangible book value, less than 6x unlevered free cash flow and just 7x EBITDA. Here’s where it gets interesting, since CPLP shareholders retain 33% of the spin-off company, it presents the investor with the opportunity of owning an extremely cheap medium/long-term tanker while at the same time owning a stake in (what will be) the third largest publicly traded shipping company (by NAV) in the world.

Diamond S Shipping — Vessels Galore

There’s an argument to be made that the CPLP spin-off is more attractive than the parent.

After spinning off its product and crude tankers, the new company will then merge with DSS Holdings, Inc. One of the largest owner/operators of modern crude and tanker fleets, to form Diamond S Shipping (ticker DSSI).

The newly merged company will have a large modern fleet of 68 tanker vessels with a combined NAV of close to $700M. The 68 vessels will be split between 52 product tankers and 16 crude tankers with an average vessel age of 7.8 years.

This spin-off seems well-timed by CPLP management — picking the bottom of the industry cycle. There’re significant short-term catalysts in place for DSSI when it comes to their crude fleet. Since DSSI deals primarily in the spot-focused crude market — in fact, 100% of their crude vessels are on spot contracts — upward momentum in spot market prices directly drop to the bottom-line for pure incremental profit.  Those crude spot market prices are on a meteoric tear over the last year, going from $16,171 to $40,497 — that’s an increase of 250%.

On the product tankers side, DSSI expects to benefit from the following three catalysts:

  1. Strong near-term growth in oil consumption
  2. The order book is less than 9% of the total fleet while the scrap rate has picked up
  3. IMO 2020 regulations could drive up product tanker demand by ~10%.

Within the product tanker business, medium-range (MR) ships are ideally positioned to sustain this supply/demand balance due to enough 20-25+ year ships expected to be scrapped with regularity over the next 3-5 years, thus offsetting order book deliveries. This idea is backed by Clarksons Research Services (the go-to source for all things shipping), who wrote in September 2018, that:

Fundamentally, we believe the market remains primed for a rebound through 2019 – 2020, with the orderbook remaining limited in the product tanker space, particularly for the MR fleet, while IMO 2020 regulations could support utilization trends.

Operating Leverage & Low Breakevens

DSSI is unlike some spin-offs in that it will end up having greater operational leverage and less debt. In the spin-off world, you routinely see the parent company throwing gobs of debt onto the newly public entity — but not in this case.

The company sports 60% net debt/fleet value, making it the fourth lowest of its peers. For comparison, Scorpio Tankers (STNG) sports a 67% net debt/fleet value. Diamond S will have a little over $90M in liquidity available — $50M in cash and $35M in a revolving line of credit. The debt they’re obligated to pay (close to $900M) is spread out over the next 5 years with $548M due in 2021, $63M in 2023 and $300M due in 2024.

On top of the favorable liquidity and net leverage aspects of the balance sheet, both of DSSI’s segments (crude & product) have low breakeven rates, making it easier to generate profits even in times of spot rate compression.

DSSI estimates their breakeven rates (based on daily operating expenses, G&A spend, and debt service) for 2019 to fall around $17,900 for their crude business and $12,800 for their product business. As a comparison, Frontline, Ltd. (FRO) breakevens are north of $20,000, Scorpio Tankers (STNG) are just under $19,000 and Tsakos Energy Navigation (TNP) fall between $19,000 – $20,000. All of this means that each incremental increase in spot rates drops straight down to bottom-line cash flows.

Management & Top Holders of DSSI

The newly spun-off company will be run by Craig Stevenson, Jr. Craig has over 40 years of experience in the shipping industry and previously served as CEO and chairman of OMI from 1998 – 2007 before selling the company to Teekay Shipping, Co and Denmark’s D/S Torm A/S for $2.2B. During his time at OMI, Stevenson grew the company into one of the largest project carriers in the world.

When it comes to major shareholders, you can’t do an analysis of DSSI without bringing up the fact that Wilbur Ross — yes that Wilbur Ross — will own roughly 25% of the company. First Reserve will own 20%, CarVal Investors will hold 6.5% and Chengdong Investment Corp (controlled by state-owned China Investments Corp) will hold 6%.

Valuation

Luckily for us, CPLP gives us financial projections for its spun-off entity as well as the Diamond S business that will merge with CPLP’s tankers. You can see the financial projections below:

We know that there will be roughly 1 share of DSSI for every 10.20 shares of CPLP, which equates to close to 38.5M in shares outstanding. Taking the sum of the present values after discounting the unlevered FCF we arrive at $739M.

CPLP’s SEC filing makes it easy for us to find the average EV/EBITDA multiple for comparable, which ends up being 8.3x for 2019 and 5.3x for 2020. Assuming an average EV/EBITDA multiple of 7x we arrive at a terminal value of $1.26B, which then gets us a PV of $782. Combining both figures puts Enterprise Value at roughly $1.5B. Dividing by our 38.5M shares outstanding we arrive at a fair value range around $16/share.

If we took a NAV approach, we can assume a P/NAV range of 0.91x to 1.01x (average of the industry competitors that we used for our DCF) and arrive at a valuation range of $600M – $66M for the net assets alone.

So, here’s a business that’s growing net asset value, being spun-off to take advantage of the spot rates in crude and product tankers / medium range contracts that we’ll likely be able to pick up for pennies on the dollars…

Risks

The risks — with all spin-offs — is the initial forced selling. The company will be leveraged, although not to the extent of its competitors, but debt always worries me in these commodity plays. Drastic reduction in spot rate prices below breakevens would result in significant operating losses — so if spot rates stay above breakeven, we won’t have to worry about that risk. Finally, failure to comply with IMO 2020 would keep ships at the docks unable to transport goods.

Philly Shipyard ASA (AKRRF)

I originally found this company after going through the OTC List of 10,000+ companies (it was easy because I started with the A’s) but never gave it the time of day due to its high operating losses in 2018.

However, Dave Waters from Alluvial Capital did an intro write-up to the company on his blog OTCAdventures.com. After reading Dave’s pitch, I decided a deeper look was warranted. The thesis is as simple as it is hard to stomach: AKRRF has no more ships to build, they’re laying off workers by the hundreds and hoping their strong balance sheet rides them through the trough of the shipbuilding cycle.

The company is taking steps to fill their short-term orderbook through government contracts while waiting for (hopefully) more ship contracts to satisfy the longer-term backlog. If the company can withstand this season of sit-and-wait, shareholders should be handsomely rewarded for their patience.

Philly Shipyard is a shipbuilder in, you guessed it, Philadelphia. The company builds ships for the US Jones Act market, which requires all commercial vessels transporting goods between ports in the United States to be built in the US, owned and operated by US citizens and registered in the United States (I can hear the patriotic fifer drums in the background playing as I write this).

This act covers all waterborne transportation between US ports — including mainland US, areas of Alaska, Hawaii and Puerto Rico as well as tankers in the Gulf of Mexico. The company owns the Jones Act shipbuilding space having built close to 50% of all ocean-going vessels for the Act since 2000.

What to Do When the Gold Dries Up

But that was then, and this is now — and times are tough. After the company delivers its 030 Hull vessel by Q1 2019 they’ll be left with no more ships to build. Delivering the largest container vessel ever built on US soil is a great way to end 2018, but what will Philly do now?

Management’s already begun the process of laying off workers — going from 1,200 at the beginning of the year down to >400 — and is cutting costs where they see fit. From here, there’s really two things they can do: 1) Rely on their balance sheet and melt the ice cube as slowly as possible until a new order comes in, or 2) go out and try to get shorter-term contracts. Luckily, they can do both.

The company has a strong balance sheet, low net debt and around $3.30/share in net-current-assets with $10/share in tangible book value. Cash burn isn’t great, however, as Philly burned through more than half of their 2017 cash in 2018, going from $110M to $49M. Once again — how fast will the ice cube melt before the next contract comes in?

In his letter to shareholders, CEO Steinar Nerbovik acknowledges that “… the market opportunities in the next 5-10 years will be cyclical and will not produce a steady and predictable stream of income.” Since its inception as a public company, AKRRF dealt exclusively with commercial contracts. Seeing that those have dried up, the company is now pushing efforts towards securing shorter-term government contracts.

Kickstarting this initiative, the company participated in a government-funded industry study and submitted a bid to be a major subcontractor for the US Coast Guard’s Heavy Polar Icebreaker. Although they failed to win the bid, it’s reinforced the necessity to keep bidding and bidding and bidding.

Along with the increased bidding for projects, Philly Shipyard is in the midst of having their facilities inspected for U.S. Government certification — which would qualify them to accept U.S. Navy vessels for repair work and dry-docking services.

Realistic Outcomes for Philly Shipyard

Shares are down over 50% from a year ago — which makes sense given the lack of contracts, laying off workers at the lowest trough in the shipbuilding cycle — but will it stay that way for long? If things do turn around, shareholders of AKRRF should be taking profits in truck-loads. As an example, Dave points out in his article that between 2014 – 2017, Philly Shipyard paid out nearly 3x their market cap in special dividends.

How are they able to do this? When times are good, they’re incredibly good. In 2017 the company generated close to $100M in free cash flow with a market cap of $100M — that means an FCF yield of 100%. Not bad! Even in 2016, the company generated an okay free cash flow yield of near 50% with $40M in FCF generated on $86.7M in market cap.

All the above scenarios assume that the company will once again win contracts and build new ships. That’s not a guarantee — so position sizing must be important if one wants to take a stab at the Philly shipbuilder.

How to Invest in These Shipping Companies

We know what the future could look like for AKRRF, but at this point, we have no idea which road they’ll end up taking. Because of this, the best way to invest with AKRRF would be to take a very small percentage of your overall capital (no more than 1% – 2.5%), buy your allotment and then don’t even look at it. Please note that I’m not saying you should explicitly buy these securities but give you a framework for how you should go about allocating capital to the shipping industry.

I’ll be releasing a more detailed, deep-dive piece into this world of “basket” picking stocks — so keep an eye out on your inbox.

-Mr. Bean

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A Golden Macro Opportunity

Yesterday, I talked about the massive vol compression I’m seeing across a number of major macro instruments —  most notably FX dollar pairs and gold — along with how these compression regimes set the stage for expansionary ones (i.e., Giant Macro Trends).

Here’s the chart of gold again which shows its volatility (as measured by the width of its monthly Bollinger Bands) recently hit ALL-TIME lows. The last time gold vol was anywhere close to being this contracted was in 2002, right before the yellow metal busted out the gates and ran for a decades-long bull market.

Now, compressed vol isn’t a bullish or bearish signal. It just means a big move is coming.

But one of the great things about compression regimes is that we can be directionally agnostic. A tight coiling market is the epitome of an inflection point. This means that we don’t have to discern any big macro narrative to try and guess where things are headed. We can just wait for the market to tip its hand and then play the cards…

With that said, let’s take a look at the gold market anyways and see what our data and indicators are telling us to see if we can get a jump on the trend.

We’ll start with another excerpt from Bigg’s Hedghogging. This time from his chapter on “Peter”. An investor that Bigg’s refers to as “the most knowledgeable gold analyst in the world”. Bigg’s writes (emphasis by me).

As he studied the literature, Peter focused on a long scholarly piece written in 1988 by Lawrence Summers (later secretary of the treasury and now president of Harvard) and Robert Barsky entitled “Gibson’s Paradox and the Gold Standard.” Summars and Barsky argued that the relative price of gold is driven by (and is the reciprocal of) the real rate of return from capital markets and that this relationship has strengthened since the price of gold was floated.

“Gold is a highly durable asset, and thus, as stressed by levhari and Pindyck (1981), it is the demand for the existing stock, as opposed to the new flow, that must be modeled. The willingness to hold the stock of gold depends on the rate of return of available assets. We assume the alternative assets are physical capital and bonds.” ~ “The Pricing of Durable Exhaustible Resources” The Quarterly Journal of Economics

Since 1988 the price of gold has had a negative 0.85 coefficient of correlation with the S&P 500 and an R2 of 72%. As things got crazier since 1994, the negative correlation rose to 0.94, with an R2 of 88%. In other words, the stock market explains 88% of the weekly price fluctuations of gold over the past eight years. The long-term correlation with Treasury bonds is not as high but still very significant.

As Peter explains it, the so-called problem with gold, which causes its erratic price behavior, is that “the elasticity of a positively sloped investment demand function overwhelms the inelasticity of supply.” I didn’t understand it either until he explained. You see, only 18% of the gold mined throughout history is held in investment form, or slightly more than $200 billion. The investable capital markets of the world are estimated to be about $60 trillion.

In a low return cycle for stocks and bonds, monetary and investment demand for gold turns positive, and there is a dramatic shortage of available metal. This large differential can only be solved by much higher prices. The point is that it is not inflation or deflation that is the principal driver of gold, but the return from other long-term financial assets, particularly equities. Peter’s model of this relationship is shown in Figure 19.1. As you can see, in times of bleak returns, gold beats everything else.

There are two key points to take from Peter (1) is that over the long run (and this is one of Dalio’s “principles” regarding gold, as well) the price of gold will approximate the total amount of money in circulation divided by the size of the gold stock and (2) it’s not “inflation or deflation that is the principal driver of gold, but the return from other long-term financial assets, particular equities.”

With that in mind let’s think about the world we’re in.

Is the total amount of money in circulation set to expand or contract in the coming years?

Well, the major central banks appear to be cornered into continuing easy monetary policy. The ECB effectively can’t reverse course and the Fed just announced they’re ending QT prematurely, are ready to cut rates soon if needed, and are willing to let inflation materially overshoot their target of 2%.

Then we have China who has the centenary anniversary for their glorious communist party coming up in 2021. This raises the odds that we’ll see them ease significantly in the second half of this year in order to pull their economy out of the doldrums and get things running hot in time for the celebrations.

Oh… Then we have the US running its largest non-recessionary fiscal deficit in peacetime plus Europe who’s about to see their biggest fiscal impulse in a decade. I, of course, could also mention the popular rise in MMT amongst Western policymakers, which essentially gives politicians the license to print. But I’ll save that discussion for another day.

Markets and their respective Game Masters (Central Banks and Governments) are still very much being influenced by the Event Echo of the GFC. An event echo is a:

Powerful psychological event (think crypto boom/bust or the GFC) that echos through time and affects the thinking and actions of the market for years. The 08’ financial crisis created a collective disaster myopia that is still prevalent today, 10-years on. This is not only noticeable in the psychology of market participants but also in the policymakers who pull the levers on the economy (ie, central bankers).

There’s a deep-seated fear around experiencing another deflationary “liquidity crisis” like the GFC. This fear will continue to drive the impulsive reaction function of creating ever more liquidity. This is bullish for gold.

What about the expected returns from other asset classes?

Here’s the 7-year asset class real return forecasts from GMO. US large cap stocks, which comprise the vast majority of global equity total market cap, have a projected real return  of -3.7% over the next 7-years. That’s not good…

It seems we have the two necessary ingredients for a major bull market in gold. These are (1) low expected returns for long-term financial assets and (2) a global money stock that is likely to keep growing (potentially by A LOT).

When we combine this with the current low vol regime + the textbook long-term inverted H&S bottom pattern forming, we get a clear trading opportunity.

There’s also positioning which remains relatively neutral considering the recent run up in price.

And TIPs, which had bearishly diverged from gold last year, have now completely reversed course and are now confirming the trend upwards in gold.

And finally, the gold/silver ratio has risen to levels that have marked significant bottoms every time over the last 20-years.

Looking at the tapes of a number of gold miners I can’t help but salivate. There’s a few stocks here that look ready to explode (I’ll share my preferred ones in a Trade Alert going out to Collective Members tomorrow).

One of my favorite historical figures, Miyamoto Musashi (the deadliest Ronin Samurai to have ever lived), wrote this about the importance of timing:

There is timing in the whole life of the warrior, in his thriving and declining, in his harmony and discord. Similarly, there is timing in the Way of the merchant, in the rise and fall of capital. All things entail rising and falling timing. You must be able to discern this. In strategy, there are various timing considerations. From the outset, you must know the applicable timing and the inapplicable timing, and from among the large and small things and the fast and slow timings find the relevant timing, first seeing the distance timing and the background timing. This is the main thing in strategy. It is especially important to know the background timing, otherwise, your strategy will become uncertain.

The background timing of the current macro environment tells us something big is coming, something that’s not yet fully known or fully discounted by the market…

This means some major trends are on the horizon. And along with major trends come major opportunities to profit.

Gold is just one area I see that’s ripe for exploitation. There are others which I’ll cover later this week.

If you want to see the exact gold stocks my team and I are interested in buying then check out the Macro Ops Collective.

Click here to enroll in the Macro Ops Collective!

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There’s a BIG Macro Move Brewing in Markets

A favorite market-related book of mine is Hedgehogging by Barton Biggs. If you haven’t read it, I highly recommend you do so. It’s excellent. 

One of the many entertaining stories Biggs shares in the book is a conversation he has with a very successful Macro Fund Manager, named “Tim”.Tim shares with Biggs a key pillar of his approach to markets, which I’ve included below (emphasis by me).

Tim works out of a quiet, spacious office filled with antique furniture, exquisite oriental rugs, and porcelain in a leafy suburb of London with only a secretary. My guess is he runs more than $1 billion, probably half of which is his. On his beautiful Chippendale desk sits a small plaque, which says totis porcis—the whole hog. There is also a small porcelain pig, which reads, It takes Courage to be a Pig.” I think Stan Druckenmiller, who coined the phrase, gave him the pig.

To get really big long-term returns, you have to be a pig and ride your winners… When he lacks conviction, he reduces his leverage and takes off his bets. He describes this as “staying close to shore… When I asked him how he got his investment ideas, at first he was at a loss. Then, after thinking about it, he said that the trick was to accumulate over time a knowledge base. Then, out of the blue, some event or new piece of information triggers a thought process, and suddenly you have discovered an investment opportunity. You can’t force it. You have to be patient and wait for the light to go on. If it doesn’t go on, “Stay close to shore.”

The last few weeks I’ve been writing about the abnormally low volatility we’re seeing across a number of major macro instruments.

Implied volatility in the major FX pairs (ex. GBP) is near ALL-TIME lows.

Volatility in gold as measured by the width of its monthly Bollinger Band is at levels last seen over 17-years ago, in 02’ right before the barbarous relic began its decade-plus run.

Markets tend to work like rubber bands in a way. The tighter they’re wound up, the more explosive they unravel. In other words, compression regimes lead to ones of expansion. And the size and velocity of the move often mirror the preceeding level of contraction in vol. There are logical reasons for why this occurs (it has to do with positioning and narrative cascades).

The current level of compression suggests something big is coming around the corner. As macro traders, it’s regimes like these where we need to be at the ready. An explosive macro trend is about to be born. Quite likely, multiple ones…

It might soon be time to go Totis Porcis.

Tomorrow I’ll be sharing a write-up on one of these potential major macro trends I’m looking at.

If you want to trade right alongside me when I go whole hog later this year then check out the Macro Ops Collective. I’m extending the enrollment period until this Friday because a number of you missed the deadline and still wanted in. There’s a TON of opportunity on the horizon and I don’t want anyone to miss out.

Click here to enroll in the Macro Ops Collective!

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Yield Curve Inversion: Why This Time is Different

It’s happened…

The 10yr/3m yield curve has inverted. The party is over folks. Sell your stocks, horde your cash, pack your bags and go home. Recession is imminent…

The mainstream financial news and twitter “market experts” have nailed it. The top is in.

It’s nice knowing that calling a recession is this easy. There’s really nothing to this game. Buy the dip when the curve is positive and sell when it inverts, sidestepping a recession and bear market. It’s so easy your grandmother could do it.  

Alright, enough of the sarcasm.

You can probably tell that I don’t quite agree with the above sentiment. Last time I checked, investing and calling macro tops isn’t quite so simple.

Let me give you a different interpretation.

First, I’ll explain what an inverted yield curve actually means. Then I’ll lay out why there’s almost certainly more upside in stocks (much more). And then I’m going to use the four dirtiest words in finance to explain why context matters in this game, especially now.

So what does an inverting yield curve actually mean? And why is it an excellent predictor of recession (though not omnipotent)?

I’ll tell you.

The yield curve reflects the pricing of bonds (and inversely their yields) from the front end rate which is set by the Fed all the way out to the long end of the curve, which is set by the market. Obvious, I know.

The yield curve shows us how interest rates are being discounted through time; from the present to decades out into the future.

It’s important because all assets are priced off this curve.

When the front end interest rate, which is set by the Fed, rises faster than what the long end is pricing in (ie, it flattens and/or inverts), it impacts markets and the economy in two ways (1) it has a negative present value effect on asset prices and (2) the flatter/negative curve causes a constraint on lending as well as the broader economy.

The first one is simple. When front end rates become equal to or exceed those of longer end interest rates, moving out of duration assets and into cash/cash-like instruments makes sense (why take on duration risk when you don’t receive compensation for doing so). This applies to stocks as well, as stocks are essentially long-duration assets.

The second part refers to how the curve — the spread between front end and long end rates — sets the price of money, and therefore incentivizes or de-incentivizes lending in the real economy. Here’s the following from Hedge Fund manager Ray Dalio, writing in his book Big Debt Crisis on the subject:

Typically, in the early stages of the top, the rise in short rates narrows or eliminates the spread with long rates (i.e., the extra interest rate earned for lending long term rather than short term), lessening the incentive to lend relative to the incentive to hold cash. As a result of the yield curve being flat or inverted (i.e.. Long-term interest rates are at their lowest relative to short-term interest rates), people are incentivized to move to cash just before the bubble pops, slowing credit growth and causing the previously described dynamic.

Early on in the top, some parts of the credit system suffer, but others remain robust, so it isn’t clear that the economy is weakening. So while the central bank is still raising interest rates and tightening credit, the seeds of the recession are being sown.

The fastest rate of tightening typically comes about five months prior to the top of the stock market. The economy is then operating at a high rate, with demand pressing up against the capacity to produce. Unemployment is normally at cyclical lows and inflation rates are rising. The increase in short-term interest rates are rising. The increase in short-term interest rates makes holding cash more attractive, and it raises the interest rate used to discount the future cash flows of assets, weakening riskier asset prices and slowing lending. It also makes items bought on credit de facto more expensive, slowing demand. Short rates typically peak just a few months before the top in the stock market.

There’s also a market/Fed disagreement component to a flattening/inverting yield curve which is where the signaling comes from.

When front end interest rates (which are set by the Fed) rise above long end rates (which are set by the market) it essentially means that the market disagrees with the central bank. The market is saying that the Fed has gotten ahead of itself and will soon have to reverse course (cut interest rates) due to slower growth and inflation in the future. That’s why investors take on duration even when it’s offering an equal or lower yield than the front end; they expect yields to continue to trend downwards.

I’ll explain in a bit why the dynamics of this have changed and why the signaling quality of the curve has deteriorated due to some very explainable reasons.

Before we get to that though, I want to show you quickly why even if the recession signaling value of an inverted yield-curve hasn’t been distorted, it’s still no reason to panic over the short-to-intermediate term.

The reason being is that the curve tends to invert well before a recession and depending on which specific curve you’re using, long before a market top as well. See the 10yr/3m curve chart at the top. It inverted years before the last two market tops.

The graph below shows that the standard 10yr/2yr yield curve has inverted on average 19-months before a recession, going back to 1968, whereas a top in the SPX has preceded recession by only an average of 7-months.

The 10/2yr curve hasn’t even inverted yet.

This chart via Sentiment Trader shows that the return picture following curve inversions is on balance positive going out to two years.

Okay, so maybe take the rising calls for recessionary doom and gloom with a shaker of salt.

More importantly, let’s talk context, which is something that so many market commentators seem to not care about.

There have been two very important changes this cycle that make present-day conditions unique and the signaling value of the yield curve diminished. Yes… I’m saying This Time is Different.

I know, I know, you’re never supposed to utter those words in finance. But excuse me if I think that’s the most overused lazy and abused adage in this game. The truth is, it’s always different this time. No two cycles are exactly alike. So, yes, we still have to use our little monkey brains to try and understand what things like yield curve inversions mean in the context of present-day reality.

Let’s start with the first change: Banking and Financial Regulations.

Following the GFC new financial regulations (ie, Dodd-Frank & Basel III-IV) were enacted to ensure a more robust and resilient banking system during times of significant market stress. One of the many byproducts of this new regulation is the liquidity coverage requirement (LCR) which requires financial institutions to hold a certain amount of high-quality liquid assets (HQLA) that’s sufficient enough to withstand a significant stress scenario.

What this means in practice is that banks have to hold a higher level of HQLAs (ie, sovereign bonds) than before. When you couple this with the need for duration matched assets from pension funds and insurance companies in a world where there’s $10trn+ in negative yielding developed market debt, we get price blind buyers for bonds. And when you have price-insensitive buyers (institutions who buy because they have to) well, the impact on that market’s signaling value should be obvious.

This has never been the case before in past cycles. This is why the yield curve may not serve as much of a valuable recessionary signal as it used to in the past. This is why THIS TIME IS DIFFERENT.

Then there’s the second and more recent change, which is within the Fed itself.

Fed Watch Tim Duy wrote in Bloomberg about the Fed’s recent and total about-face, writing (emphasis by me):

It is hard to understate the importance of this shift. The Fed’s models haven’t worked this way in the past. In previous iterations of the forecasts, the expectation of unemployment remaining below its natural rate would trigger inflationary pressures. To stave off those pressures, the Fed perceived the need to raise rates above neutral to slow the economy enough to nudge unemployment upwards. Now the Fed believes it can let unemployment hold persistently below the natural rate without triggering inflation and without Fed policy becoming restrictive.

Duy goes on to note that, “The Fed apparently has finally realized that persistently low inflation remains a problem.” And “to avoid the problems of the zero lower bound for as long as possible, the Fed needs to ensure that inflation stays sufficiently high to hold expectations at its target and that they act to avoid a recession. The policy implication is that they need to err on the dovish side.”

In practical terms, this means that the Fed has essentially thrown out the models that it’s relied on in past to help make interest rate decisions. Jerome Powell and team are making it clear that they need to see an actual and sustained spike in inflation before raising interest rates. And they’re willing to cut rates and even resume QE to get there, even at near full employment and stable growth.

This is a BIG deal. The Fed has learned some lessons from past cycles and doesn’t want to kill the party. So why fight the Fed?

I sure don’t want to.

Okay, so far I’ve explained what an inverted yield curve typically means along with why things are different this time. I’ve also laid out why context always matters and why one should never just lock onto a single input and form a market view. We want to put as many pieces together in our market puzzle. And most importantly, we need to be weighing the data we see against what’s already being priced in.

We need to always be asking ourselves: What’s part of the common narrative and what is the market blind to?

So let’s play the common knowledge game.

Everybody knows that the yield curve is inverting. And everybody knows what this historically has meant (hint: the news headlines at the start of this piece).

Everybody also knows that global growth has been slowing, for a while now. NDR’s Global Recession Probability Model (via CMG Wealth) shows that much of the world has been in recession since the latter part of last year.

Most global markets are already reflecting this. Take Europe for example where German equities are trading at 50-year lows relative to the US. And emerging market stocks spent all of 18’ in a gut-wrenching bear market.

It seems to me that there remains a pretty low bar for the global economy to clear in order to cause a shift in the popular market expectations.

There are a number of catalysts which could this.

We have the coming 100-year anniversary of the Chinese Communist Party which we believe the CCP will want a strong economy for. In which case, they’d likely have to start easing significantly in the second half of this year.

There’s also a potential for the trade war to get settled. We are entering election season after all and the President has made it pretty clear how important the stock market’s performance is to him.

And then there’s also the little-noticed changes going on at the margins which I’ve been discussing recently.

There’s the possibility that the atrocious econ data in Europe bottoms soon. At least for a while. After all, we are about to see the biggest fiscal boost our of Europe in a decade (charts via MS).

And European dataflow is already beginning to slowly improve.

Turning to the US, we are seeing some slowing growth. But our confluence of recession indicators are not flashing red, as of yet.

The labor market is still strong and signs of financial stress remain mum. Our liquidity indicators are all miles away from indicating recession and in fact, are very supportive of risk-assets moving higher.

NDR’s Credit Conditions Index (via CMG Wealth) shows that credit conditions are near cycle highs and a loooong ways off from signaling recession.

I understand that this may not be a very popular take — which means it’s more likely to be true — but I think the current macro conditions continue to set up to be extremely bullish for stocks. Note that I say stocks and not the economy. Remember, the two are not the same.

Trading legend Bruce Kovner once remarked that “As an alternative approach, one of the traders I know does very well in the stock index markets by trying to figure out how the stock market can hurt the most traders.”

Fund manager cash holdings are the highest they’ve been since January 09’.

Their allocation to equities are at some of the lowest levels this cycle.

So, let me ask you… Where is the pain trade? Higher or lower?

I think it’s pretty clear where I think it is.

On December 18th of last year. When the market was in total panic. I wrote the following.

The following week, on December 24th. The day before the very low of the selloff was reached, I sent this out in a note.

I’m not trying to gloat here. I get things wrong ALL the time and don’t mind doing so. That’s not the game I’m playing. I’m playing the game of making money, not being right.

But I show this to prove a point. When I wrote the above I was ridiculed. I got emails and comments from readers saying what a “sheep” I am and how I was about to get steamrolled and yada yada yada…

I personally love this kind of feedback to my work. It means I’m onto something. I have a feeling this piece will invoke similar cries of hysteria. Especially when the market moves a little lower in the week(s) ahead.

The market will be talking about the yield curve inversion, collapsing growth, and a coming recession. But I’ll be focusing on flush liquidity, a solid Fed put, and a normal technical pullback that was easy to spot (see chart below showing semis on the weekly piercing their upper BB. A move back down to around the orange line is expected).

While most will be selling into the hole, we’ll be looking to add to our risk in a number of areas of the market where we see extraordinary asymmetric opportunities.

So, yeah… This time IS different and the world probably isn’t coming to an end. If you’ve been offsides on this year’s face-ripping rally then you may want to use the coming small pullback as a chance to get back in.

Everybody else will be shorting into the hole…

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