2018 Meltdown and What to Think of 2019?

Good Morning,
 

Santa Claus rally? No Santa Claus rally? Naughty or nice? One thing is for sure the last two weeks on Wall Street have been gut wrenching. Not for the faint of heart. During that time, the major U.S. stock indexes have suffered losses that put them on track for their worst December performance since the Great Depression. Investors have also been gripped by volatile swings in the market as they grapple with a host of issues.
 

The S&P 500 has logged six moves of more than 1 percent over the period, three of which were of more than 2 percent. For context, the broad index posted just eight 1 percent moves in all of 2017.
 

The Dow Jones Industrial Average, meanwhile, has seen seven days of moves greater than 1 percent. Its intraday points ranges also widely expanded. The 30-stock index has swung at least 548 points in eight of its past nine sessions, and also posted its first single-day 1,000-point gain ever on Wednesday. The index ended down 76 points Friday after vacillating throughout the session.
 

These moves are remarkable and what has been equally remarkable has been the fact that many pundits and astute market veterans haven’t had much of a satisfying explanation; fears of the Fed after Chairman Jerome Powell said he did not anticipate the central bank changing its strategy for trimming its massive balance sheet, a U.S. federal government shutdown, disfunction in Washington (almost every part of Trump's life is now under investigation), slowing global growth, weaker data coming out of the U.S., “end of cycle”, and thus fears of a recession. All of which seem convincing as a root cause of this vicious selling. Watching CNBC has been almost comical with pundits like Jim Cramer recommending gold one day only to recommend nibbling on stock as markets move higher the next.
 

2018 was the year nothing worked: In fact, in 2018, just about every single asset class one can invest in — from stocks around the globe to government debt to corporate bonds to commodities — have posted negative returns or unchanged performance year to date.
 

Even during the financial crisis in 2008, government bonds and gold worked...
 

What gives?

Our Take

While any 20 percent sell-off hurts (both the Russell 2000 and Nasdaq led the way into bear market territory. The S&P 500 (-19.8%) and the Dow 30 (-18.8%) did manage to fall just short of the 20% threshold yet the average stock is down far more than that) the one happening now is far from unheard of in terms of depth or velocity. Over the past 100 years, there are almost too many examples to count of stocks tumbling with comparable force.
 

THIS IS INEVITABLE AND NORMAL. WELCOME TO THE STOCK MARKET.

Investors over the Holidays have time to reflect on history, now that stocks have avoided a fourth straight down week via the biggest one-day rally since 2009. After coming within a few points of a bear market on Wednesday, the damage in the S&P 500 stands at 15 percent since Sept. 20.
 

This is normal but seems abnormal because we are all talking about it from morning to night.
 

As we are reminded by a recent article in Bloomberg: “A fair amount of complaining has gone on in recent months about the role of high-frequency traders and quantitative funds in the drubbing that reached its peak around Christmas. Perhaps. Those groups are big, and in the search for villains, they make easy targets. Treasury Secretary Steven Mnuchin is among the people who have made the connection.
 

One thing that makes it tough to lay blame for the meltdown on machine-based traders is the many past instances when markets fell just as hard without their help. The Crash of 1929 is one big example. However bad this market is, it’s a walk in the park compared with then.”
 

This pattern holds for the Dot-com Bust (S&P 500 lost 35 percent over the course of two months), Black Monday of 1987 (S&P 500 rose 36 percent between January and August 1987 in what was set to be the best year in almost three decades. Then the October sell-off pushed the S&P into a 31 percent correction over just 15 days), 1974 Sell-Off (the S&P 500 saw the index fall 33 percent in 115 days as a weakening economy, rising unemployment and spiking inflation pushed investors to head for the exits. Stocks subsequently rebounded, surging more than 50 percent between October 1974 and July 1975), 1962 Rout (S&P 500 Index lost a quarter of its value between March and June 1962), Not so Fat ‘57 (20 percent correction over 99 days in 1957).
 

Last I checked there were no high frequency traders then BUT there were equally dysfunctional administrations and equally irrational humans…
 

The selling is likely overdone. When the SP 500 peaked in late September '18, the forward 4 quarter estimate was $168.72; today, that same estimate is $169.58. The point is with the S&P 500 index falling some 15%, the forward estimate on which it's valued is actually slightly higher. The question is will these estimates hold. Clearly the stock market is not so sure despite the fact that the U.S. economy is in a good position to sustain a 2.5-3 percent growth rate in 2019.
 

With the selling frenzy pushing stock prices lower, investors are now pricing in zero growth in earnings for 2019. Is this reasonable? 2018 earnings will come in at around $162 for the year. Clearly, the market has lost a lot of confidence in the staying power of earnings and the health of the economy. If we apply a conservative 14-15 multiple to that, it yields a range for the S&P at 2,268-2,430. So with the index closing at 2,488 Friday, we are just above that range. The issue is that the stock market generally overshoots in either direction when it sees change. Emotion takes over and causes the rapid move.
 

Despite existing negativity, the market’s valuation has changed for the better. The S&P 500 is actually heading into 2019 with a P/E ratio right in line with its historical average going back to 1929. And if you look just at the last 30 years going back to 1990, it is actually undervalued.
 

Unless one sees another financial crisis upon us (which at this time we do not), the probability is high that this could also mark a near term low.
 

As for investor sentiment, bearishness sits at record highs. In fact, half of individual investors now describe themselves as “bearish” for the first time since 2013. The latest AAII Sentiment Survey shows greater polarization, with neutral sentiment falling to an eight-year low.
 

On December 24 73% of financial stocks hit 52-week lows. That exceeds all days from the worldwide financial crisis…
 

In the past 28 years, there have been 2 times when every stock in the 2&P 500 Energy sector was below their 10-, 50-, and 200 day average and more than half were trading at 52 week lows.
1) During the depths of the 2008 financial crisis
2) Now

The pendulum of the market may be set for a swing in the other direction.


A Few Things We Like for 2019 That We Have Been Nibbling On During The 2018 Rout

Cerner Corp. (CERN:NASDAQ): major player in the healthcare IT industry as its software is highly integrated into the operations of several large provider networks. The firm has internally developed much of its software, which makes its product lineup close to seamless and effective within the healthcare IT sector. The secular demand tailwinds for Cerner’s products are robust given ACA mandates that require providers to upgrade their health records management systems. This highly positive trend will be enhanced over the next several years by changing payer reimbursement structures. Trading at a roughly 30% discount to intrinsic value (earnings based DCF), 10 year low P/E, P/S and P/FCF.

CGI Group Inc. (GIB.A:TSX): deeply embedded in government agencies across North America and Europe. Gained greater scale with its acquisition of Logica in 2012. This scale will allow the firm to better meet the needs of global clients. The firm has a backlog of signed contracts of more than CAD 21 billion, with an average duration of approximately five to seven years. Growing IT complexity is expected to support long-term demand for IT services as companies look to simplify and streamline their IT landscape. Trading at a roughly 20% discount to intrinsic value (earnings based DCF), attractive 10 year low P/E, PEG ratio and EV/EBIT.


Chart(s) of the Month 


“Equity prices are said to have far outpaced earnings during this bull market. In fact, better profits accounts for about 70% of the appreciation in the S&P over the past 8 years. Of course valuations have also risen, that is a feature of every bull market, as investors transition from pessimism to optimism. But this has been a much smaller contributor. In comparison, 75% of the gain in the S&P between 1982-2000 was derived from a valuation increase (that data from Barry Ritholtz).”
 

Musings

I began reading a fantastic book over the break which I highly recommend entitled “The Laws of Human Nature” by Robert Greene. The book takes as its fundamental premise that we humans tend to think of our behaviour as largely conscious and willed. To imagine that we are not always in control of what we do is a frightening thought, but in fact is the reality. We live on the surface, reacting emotionally to what people say and do. We settle for the easiest and most convenient story to tell ourselves.
 

Greene writes: “Human nature is stronger than any individual, than any institution or technological invention. It ends up shaping what we create to reflect itself and its primitive roots. It moves us like pawns. Ignore the laws at your own peril. Refusing to come to terms with human nature means that you are dooming yourself to patterns beyond your control and to feelings of confusion and helplessness.”
 

These principles are all the more relevant in light of 2018’s market action. What is interesting is that like this sell off (including the cryptocurrencies sell off), when we look back at other selloffs like that of 2008, most explanations emphasize our helplessness. We were tricked by greedy banking insiders, mortgage lenders, poor government oversight, computer models and algorithmic traders etc.
 

What is often not acknowledged is the basic irrationality that drove these millions of buyers and sellers up and down the line.
 

They became infected with the lure of easy money. The taste of wealth and the envy of their fellow market participants appearing to make effortless gains.
 

This made even the most rational, experienced and educated investor emotional. Hungry for his own slice of the action. Ideas were rounded up to fortify such behaviour such as “this is game changing technology, this time it is different and housing prices never go down”. A wave of unbridled optimism takes hold of the mind and panic sets in as reality clashes with the story most people have accepted.
 

Once “smart people” start looking like idiots, fingers begin to get pointed at outside forces to deflect the real sources of the madness. THIS IS NOTHING NEW. IT IS AS OLD AS THE HUMAN RACE.
 

Understand: Bubbles/corrections/bear markets “occur because of the intense emotional pull they have on people, which overwhelm any reasoning powers an individual mind might possess. They stimulate our natural tendencies toward greed, easy money, quick results and loss aversion."
 

It is hard to see other people making money and not want to join in. It is also equally hard to watch one’s assets drop in value day after day. THERE IS NO REGULATORY FORCE ON THE PLANET THAT CAN CONTROL HUMAN NATURE.
 

As demonstrated above, the occurrence of these selloffs will continue as they have until our fundamental human nature is altered or managed.
 

As such, it is important during these periods that we look inward to acknowledge and understand the true causes of these phenomenon and even take advantage of them as they occur. The most common emotion of all being the desire for pleasure and the avoidance of pain. The most meaningful experiences of pleasure typically follow the most most meaningful experiences of pain…

Logos LP November 2018 Performance

November 2018 Return: 0.15%

2018 YTD (November) Return: -11.06%

Trailing Twelve Month Return: -7.60%

CAGR since inception March 26, 2014: +14.06%

Thought of the Month

"If you have trouble imagining a 20% loss in the stock market, you shouldn't be in stocks."

-- John Bogle

Articles and Ideas of Interest

• 2018: The Year of the Woeful World Leader. Trump, May, Macron, Merkel. Italy, Spain, Sweden, Latvia. Even the dictators stumbled. So much bad governing, so little time.   

• What the Fall of the Roman Republic can teach us about America. The bad news is that the coming decades are unlikely to afford us many moments of calm and tranquillity. For though four generations stand between Tiberius Gracchus’ violent death and Augustus’ rapid ascent to plenipotentiary power, the intervening century was one of virtually incessant fear and chaos. If the central analogy that animates “Mortal Republic” is correct, the current challenge to America’s political system is likely to persist long after its present occupant has left the White House. 

• Low fertility rates aren’t a cause for worry. AI, migration, and being healthier in old age mean that countries don’t need to rely on new births to keep growing economically.  

• Start-Ups aren’t cool anymore. A lack of personal savings, competition from abroad, and the threat of another economic downturn make it harder for Millennials to thrive as entrepreneurs.

• This McKinsey study of 300 companies reveals what every business needs to know about design for 2019. In a sweeping study of 2 million pieces of financial data and 100,000 design actions over five years, McKinsey finds that design-led companies had 32% more revenue and 56% higher total returns to shareholders compared with other companies.
   

• What do we actually know about the risks of screen time and digital social media? Some tentative links are in place, but many crucial details are fuzzy.

• Start-up economy is a 'Ponzi scheme,' says Chamath Palihapitiya. Tech investor Chamath Palihapitiya addressed concerns about his investment firm, Social Capital, while also calling the start-up economy "a multivariate kind of Ponzi scheme.”

Our best wishes for a fulfilling 2019, 

Logos LP

Market Cycles

Good Morning,
 

Bit behind on this July update but better late than never!
 

Stocks fell on Friday for the fourth straight day, capping off a volatile week for investors as rising trade fears and a tech sell-off led to broad weekly losses. The Nasdaq Composite fell 0.3 percent to 7,902.54, led by declines in Apple, Amazon and Alphabet. The tech-heavy index posted its fourth straight loss — its first since April — and is worst start to September since 2008.

The S&P 500 pulled back 0.2 percent to close at 2,871.68 as utilities and real estate both dropped more than 1 percent.

President Donald Trump, speaking from Air Force One, said Friday the U.S. is ready to slap tariffs on an additional $267 billion worth in Chinese goods. His remarks come after a deadline for comments regarding tariffs on another $200 billion in Chinese goods had passed last night.

"The $200 billion we're talking about could take place very soon, depending on what happens with them," Trump said. "I hate to say this, but behind that, there's another $267 billion ready to go on short notice if I want." (targeting a sum of goods equal to virtually all imports from China)
 

The selloff pummeling emerging market currencies shifted to stocks as contagion concerns weighed on risk assets. MSCI Inc.’s EM equities gauge entered a bear market on Sept. 6 and had its worst week since mid-August.

The fear also comes after the Wall Street Journal reported, citing U.S. officials, that the possibility of the U.S. and China reaching a trade deal are fading as the Trump administration tries to revamp the North America Free Trade Agreement (NAFTA). Meanwhile, Bloomberg News reports that the U.S. and Canada will likely end the week with no trade deal in place.

Wall Street was also under pressure after strong wage data stoked fears of tighter monetary policy in the U.S. Average hourly earnings rose 2.9 percent for the month on an annualized basis, marking the largest jump since 2009. The U.S. economy added 201,000 jobs in August, more than the expected increase of 191,000.

Treasury yields jumped to their highs of the session following the jobs report release, while the dollar also rose. The Fed has already raised rates twice this year and is largely expected to hike two more times before year-end.

Our Take
 

There is little doubt that the U.S. economy is in a boom. The Conference Board is reporting the highest levels of job satisfaction in more than a decade given a tight labor market — the ratio between the unemployment level and the number of job vacancies is at its lowest level in a half-century. A broader measure, the prime-age employment-to-population ratio, is back to 2006 levels. Meanwhile, real gross domestic product growth for the second quarter was just revised up to 4.2 percent. Corporate profits are rising strongly. And investment as a percentage of the economy is at about the level of the mid-2000s boom.

Wages are still lagging. But all other indicators show the U.S. economy performing as strongly as at any time since the mid-2000s — and possibly even since the late 1990s.

Why? A few reasons present themselves as outlined recently by Noah Smith:

1. Demand Side Explanations:

   1. Low interest rates: lowered borrowing rates for corporations and mortgage borrowers, which tends to juice investment. Fiscal deficits provide an added boost to demand, and deficits have been rising as a result of President Donald Trump’s tax cuts. Typically pumping demand will eventually lead to rising inflation but this hasn’t happened yet.

   2. “Animal spirits” or “sentiment” as small business confidence is at record highs, and consumer/investor confidence also is very strong.

   3. Tail end of the long recovery from the Great Recession — consumers and businesses might finally be purchasing the houses and cars that they waited to buy when the recovery was still in doubt. Housing, traditionally the most important piece of business-cycle investment and consumption, is still looking weak, with housing starts below their 50-year average. But business investment might be experiencing the positive effects of stored-up demand.

2. Supply Side Explanations:

   1. The Trump tax cuts removed distortions that held back business investment, and that fast growth — and the attendant low unemployment — is the result of the economy’s rapid shift to a higher level of efficiency.

   2. Technology: Information technology advances such as machine learning and cloud computing might be driving the investment boom — perhaps also spurring companies to invest in intangible assets such as brands and workers’ skills.

Which one is responsible? It is difficult to say but determining which are responsible matters as it can give insight into how the boom will end and how it can be prolonged. In our view all these factors have played a role, albeit certain ones have played a more crucial role during different stages in the bull market.  

At the current stage of the bull market we see evidence that the demand-side “animal spirits” or “sentiment” factor is doing a lot of the heavy lifting.

It should be remembered that although of late there has been a minor repricing of high multiple/risk assets, the trend is still firmly in place: investors are not put off by unprofitable companies. In fact, the proportion of companies reporting losses before going public in the United States is at its highest since the dotcom boom in 2000.

Last year, 76 percent of the companies that listed were unprofitable in the year before their initial public offerings, according to data compiled by Jay Ritter, a professor at the University of Florida's Warrington College of Business.

That's lower than the 81 percent recorded in 2000, but still far higher than the four-decade average of 38 percent.

Investors are currently keen on “new business models” and are willing to overlook losses. In fact, many are questioning whether “value investing” and classic investing principles even makes sense anymore. The market's euphoria for so-called "growth companies" has even made billionaire hedge fund manager David Einhorn question if classic investing principles that worked for him still make sense today.

As Howard Marks reminds us, in investing as in life, there are very few sure things. Very few things move in a straight line. There’s prograss and then there’s deterioration. We must remain attentive to cycles.

The process/cycle is typically the same: 1) the economy moves into a period of prosperity 2) providers of capital thrive, increasing their capital base 3) because bad news is scarce, the risks entailed in lending and investing seem to have shrunk 4) risk aversion disappears 5) financial institutions and investors move to expand their businesses - that is, to provide more capital 6) they compete for market share by lowering demanded returns (e.g. cutting interest rates), lowering credit standards, lowering prudence, disregarding the linkage between price and value, paying less attention to profits or disregarding them all together and providing more capital for a given transaction.

At the extreme, providers of capital finance borrowers and businesses (investments) that aren’t worthy of being financed. This leads to capital destruction -that is, to investment of capital in projects where the cost of capital exceeds the return on capital, and eventually to cases where there is no return of capital.

Is this time any different?

Chart(s) of the Month

JP Morgan shows us that holding cash for too long can be a dangerous proposition. 

Are overall tech valuations overstretched or only certain segments?  Notice the absence of earnings in the dot com bubble years. Valuations do not appear stretched when put into perspective, prices appear to be in line with the underlying earnings picture. The NASDAQ-100’s price to forward earnings ratio is still a little below its longer run average of about 23x. 
 

Musings
 

What of valuation? What of the relationship between price and value? For an investor (whether a “value” investor or not) price has to be the starting point regardless of where we are in the cycle and especially in the last innings. No asset is so good that it can’t become a bad investment if bought at too high a price.

As an example of the current “animal spirits” climate we should consider the following:

Cannabis : the thesis or “story” here is that cannabis, like alcohol, tobacco and other hedonistic instruments, has now achieved positive momentum with policymakers across the world. As such the fragmented industry will consolidate and a few early movers will reap the profits of this new multi-billion dollar industry. But just like investing in the nascent stages of many industries that in essence were revolutions from a status quo, speculation will initially replace prudent financial analysis of price relative to value.

As Easterly points out in a recent article Cronos' (CRON) current valuation is an outright manifestation of "extraordinary delusions" stemming from the madness of crowds.

Cronos trades at about 17.25 forward price to sales (TTM price to sales of 332.97 and TTM price to earnings of 874.69) compared to its peers. For some further clarity, highly valued SaaS stocks prized for their recurrent revenue stream and high gross margins seldom trade at 17.25 forward P/S ratio. The average P/S ratio for stocks in the software application industry is around 6.8, compared to 2.16 for the S&P 500.

Hence, why does an agricultural commodity producer trade at a higher valuation than Shopify and other?

In Deloitte's "A society in transition, an industry ready to bloom" 2018 cannabis report, they expect legal cannabis sales during 2019, the first full year post-legalization to be [CAD]$4.34 billion. This figure is likely inflated when compared against the results of other markets. Further, the study only surveyed a sample size of 1,500 adult Canadians, which is not significant enough to estimate the Cannabis purchase habit of millions of Canadians.

For some perspective, California, which is regarded as the most important Cannabis market on Earth realized sales of [USD]$339 million or [CAD]$444 million (at current spot USD/CAD) during the first two months post-legalization. Extrapolating this across a full year would infer total sales of [USD]$2.01 billion or [CAD]$2.7 billion. Sure there are other factors to consider like a larger Californian black market and a different set of regulations and taxes. However, the Californian market has also not been as stringent on marketing as Canada will be.

Assuming the Canadian market is at least on par with California, the author models the potential market using an optimistic CAGR of 23.54% from 2019 - 2023 which is more optimistic than some market reports. The author also models Cronos' revenue for the years from 2018 - 2022.

Cronos' current market valuation of [USD]$1.75 billion or [CAD]$2.29 billion is around 84.81% of the total Canadian legal cannabis market in FY2019. (And this does not take into account the fact that the total estimated legal cannabis sales [CAD] $4.34 billion number mentioned above represents a total retail sales projection and that will likely be shared between grower, distributor, retailer, and the government through taxes. Taxes will be large, perhaps even 30%. Retail will be handled by government in a few big provinces like BC -- yet the government will still take a retail margin cut. What will be left for growers could be as low as sub $4 CAD / gram.. half or less of that total [CAD] $4.34 billion number…

At a current market valuation of [CAD]$2.29 billion ($2.79 billion at time of writing) which is around 84.81% of the total estimated Canadian legal cannabis market in FY2019, has the fairness of Cronos’ price been considered? Or have people without disciplined consideration of valuation simply decided that they want to own something because the story is good, risk aversion is low and the future looks bright?

Overall, we see current valuation trends in certain growth stocks (cannabis, select tech.) (not to mention that the ratio of bearish option bets to bullish ones is waning as the S&P 500 keeps churning out records. That implies investors may be loading up on derivatives as way to make up for lost ground should 2018 deliver a year-end rally similar to last year’s, when stocks closed with a 6.1 percent fourth-quarter surge) to be evidence that the demand-side “animal spirits”/“sentiment” factor is doing a large portion of the heavy lifting to prolong the current bull market.

As such, we would advise caution before increasing exposure to these “loved” and therefore richly valued businesses. Investing is a popularity contest, and the most dangerous thing is to buy something at the peak of its popularity. For our portfolio, given where we are in the present cycle and overall market conditions we are abiding by the following maxim:
 

“The safest and most potentially profitable thing is to buy something when no one likes it. Given time, its popularity, and thus its price can only go one way: up.” -Howard Marks

Logos LP July 2018 Performance

 

July 2018 Return: -0.34%

2018 YTD (July) Return: 0.00%

Trailing Twelve Month Return: +12.79%

CAGR since inception March 26, 2014: +18.29%

Thought of the Month

 

"The polar opposite of conscientious value investing is mindlessly chasing bubbles, in which the relationship between price and value is totally ignored. All bubbles start with some nugget of truth: 1) Tulips are beautiful and rare 2) The internet is going to change the world 3) Real estate can keep up with inflation, and you can always live in a house.” -Howard Marks

Articles and Ideas of Interest

 

• After Coltrane, there is nothing left to say. The saxophone virtuoso pushed jazz as far as it could go, and it’s been downhill ever since.            

• These Fake Islands Could Spell Real Economic Trouble. Glitzy property projects and financial crises tend to go hand-in-hand.

• U.S. Household wealth is experiencing an unsustainable bubble. Jesse Colombo suggests that Since the dark days of the Great Recession in 2009, America has experienced one of the most powerful household wealth booms in its history. Household wealth has ballooned by approximately $46 trillion or 83% to an all-time high of $100.8 trillion. While most people welcome and applaud a wealth boom like this, research suggests that it is actually another dangerous bubble that is similar to the U.S. housing bubble of the mid-2000s. In this piece, he explains why America's wealth boom is artificial and heading for a devastating bust.

• Who needs democracy when you have data? Here’s how China rules using data, AI and internet surveillance.

• How tourists are destroying the places they love. Travel is no longer a luxury good. Airlines like Ryanair and EasyJet have contributed to a form of mass tourism that has made local residents feel like foreigners in cities like Barcelona and Rome. The infrastructure is buckling under the pressure. Great 2 part expose suggesting that travel has almost become a human right yet it has become predatory - devouring all the beautiful places which drive it. Has nature itself come to be viewed as merely one more good to be consumed? ; Have we developed a shallow, modern need to present a life free from the tyranny of a nine-to-five office job in the tight frame of Instagram? No wonder you are not original or creative on instagram. Everyone on Instagram is living the same life.  
  
   

• Peak Valley. The Bay Area’s primacy as a technology hub is on the wane. Don’t celebrate. Although capital is becoming more widely available to bright sparks everywhere yet unfortunately the Valley’s peak looks more like a warning that innovation everywhere is becoming harder.  

• Americans live in the ruins of the 2008 financial crisis. Prosperity is undercut by broken institutions, from health care to law enforcement. NYT presents some astonishing facts. Is the American dream dead?

Our best wishes for a fulfilling month, 

Logos LP

The Art of The Deal

Good Morning,
 

Stocks closed little changed on Friday as solid quarterly results from some of the largest U.S. companies, including Microsoft, Capital One and Honeywell, counterbalanced threats made by President Donald Trump stating that he is willing to up the ante in the trade war with Beijing and could slap tariffs on every Chinese good imported to the U.S. "I'm ready to go to 500," he told CNBC, referencing the $505.5B of American imports from China in 2017, compared to the $129.9B the U.S. exported to the country last year. (an interesting blow by blow look at global trade here)

In other news, President Trump sat down with Russian counterpart Vladimir Putin in Helsinki. Crimea, Syria and election meddling were likely on the summit's agenda, but no aide or official from the U.S. delegation were present during the meeting's initial stages. A controversial press conference ensued (in which Trump seemed to prefer Putin’s story suggesting Russia’s non-involvement in the US election rather than the opinion of U.S. intelligence), coming on the tails of a tense NATO summit during which Trump lambasted allies for not meeting their defense spending commitments.

The 10-year yield ended the week at 2.90% and the two-year yield finished up at 2.60%. Some analysts saw the increased 2-10 spread as a sign that investors believe President Trump's criticism of the Fed could slow down the pace of rate hikes.

Finally, Amazon reached a $900B market value for the first time, nipping at Apple's) heels as Wall Street's most valuable. The news comes after the company announced it sold more than $100M in products during its annual Prime Day sale. Shares are up over 57% so far this year, bringing Amazon's increase to over 123,000% since it listed on the Nasdaq in 1997.

Our Take
 

As perplexing as Trump’s actions can be, instead of spilling more ink on his diversions from “accepted” presidential behavior, it may be best to try and understand his approach by attempting to apply a different mental model. The seeds of Trump’s mental model can be found in his book “The Art of the Deal”. (His approval ratings also hold other clues)

Jim Rickards points out that the book is a window on Trump’s approach to every challenge he confronts, including economic and geopolitical challenges as president.

What is Trump’s process as described in the book?

1. Identify a big goal (tax cuts, balanced trade, the wall, etc.).

2. Identify your leverage points versus anyone who stands in your way (elections, tariffs, jobs, etc.).

3. Announce some extreme threat against your opponent that uses your leverage.

4. If the opponent backs down, mitigate the threat, declare victory and go home with a win.

5. If the opponent fires back, double down. If Trump declares tariffs on $50 billion of good from China,and China shoots back with tariffs on $50 billion of goods from the U.S., Trump doubles down with tariffs on $100 billion of goods or perhaps even $505.5 billion etc. Trump may keep escalating until he wins. (or loses)

6. Eventually, the escalation process can lead to negotiations with at least the perception of a victory for Trump (North Korea) — even if the victory is more visual than real.

This approach is abnormal from a historical perspective but to the astute observer this far into his Presidency should be looking more predictable.

What should we expect moving forward in light of this mental model? Likely more dramatic policy shifts and extreme threats. The key is not to overreact and hope that all escalations lead to fruitful negotiations in step 6….

Chart(s) of the Month
 

The S&P 500 PE ratio is right in line with historical norms.

J.P. Morgan: “High yields spreads and defaults are low and not rising. Mr. Bond is not yet sniffing a potential economic problem.”
 

The Big 5 tech companies together are worth more than the bottom 282 companies in the S&P 500 yet this level of concentration is not unprecedented. In 1965 AT&T and GM represented 14.5% of the S&P 500. What is wild is that these 5 companies are all in the same industry.

Courtesy of Michael Batnick.
 

Musings

This month we released our 2nd quarter letter to our investors. Included is a discussion of portfolio changes as well as a more detailed description of a new position we’ve initiated in Industrial Alliance and Financial Services (TSX: IAG). Please contact us if you would like to see a copy of this letter.

Logos LP May 2018 Performance

 

June 2018 Return: 4.29%

2018 YTD (June) Return: 0.34%

Trailing Twelve Month Return: +11.86%

CAGR since inception March 26, 2014: +18.77%

Thought of the Month


 

"Do you have the patience to wait till your mud settles and the water is clear? Can you remain unmoving till the right action arises by itself?”– Lao-Tzu, Tao-te-Ching

Articles and Ideas of Interest

 

• These 10 stocks account for all the S&P 500’s first half gains.David Kostin, chief U.S. equity strategist at Goldman Sachs, highlighted that more than 100 percent of the S&P 500’s total return of nearly 3 percent in the first half is attributable to just 10 equities. Amazon.com Inc. alone accounts for roughly two-fifths of the benchmark gauge’s advance. Find out which they are here.

• The average age of a successful startup founder is 45. HBR explores why and also why vc investors often bet on young founders.

• YOLO. A Boston College study has found that half of companies raising through ICOs die within four months after finalizing token sales. Is Blockchain even a revolution?

• Longer lives mean a single marriage may not be enough. More couples are wondering if the relationship they had in their first phase of adulthood is worth continuing.

• We have reached peak screen. Now revolution is in the air. Screens are insatiable. At a cognitive level, they are voracious vampires for your attention, and as soon as you look at one, you are basically toast. There are studies that bear this out. One, by a team led by Adrian Ward, a marketing professor at the University of Texas’ business school, found that the mere presence of a smartphone within glancing distance can significantly reduce your cognitive capacity. Your phone is so irresistible that when you can see it, you cannot help but spend a lot of otherwise valuable mental energy trying to not look at it.

• Can the cult of Berkshire Hathaway outlive Warren Buffett? Centuries from now, historians piecing together the narrative of this stretch of America’s existence will have to explain the curious four-decade (and counting) run in which an arena in an otherwise modest midwestern US city filled to capacity once a year for two aging billionaires talking about the stock market, life, and whatever else tickled their fancy. The annual meeting of the Omaha, Nebraska-based holding company Berkshire Hathaway has no analog in US business or culture. Buffett is 87. Munger is 94. And Berkshire Hathaway’s returns over the S&P 500 are slowing, as Buffett has warned for decades they would. Interesting article in Quartz exploring his legacy as well as his adage that America will always remain a safe bet...

• Google is building a city of the future in Toronto. Would anyone want to live there? It could be the coolest new neighborhood on the planet—or a peek into the Orwellian metropolis that knows everything you did last night. Politico magazine explores the tradeoffs and debates involved.

• In praise of being washed. Has a life of ambition and striving gotten the best of you? Do you sometimes wish you could give up a little—stop chasing so many pointless goals you probably won’t hit anyway? It’s time you got washed. A refreshing summer read in GQ.

• Scientists at a company part-owned by Bill Gates have found a cheap way to convert CO2 into gasoline. A team of scientists has discovered a cheap, new way to extract carbon dioxide from the atmosphere — which could arm humanity with a new tool in the fight against climate change.

• The friend effect: why the secret of health and happiness is surprisingly simple. Our face-to-face relationships are, quite literally, a matter of life or death. “One of the biggest predictors of physical and mental health problems is loneliness,” says Dr Nick Lake, joint director for psychology and psychological therapy at Sussex Partnership NHS Foundation Trust. “That makes sense to people when they think of mental health. But the evidence is also clear that if you are someone who is lonely and isolated, your chance of suffering a major long-term condition such as coronary heart disease or cancer is also significantly increased, to the extent that it is almost as big a risk factor as smoking.”

Our best wishes for a fulfilling month, 

Logos LP

Mistakes Happen

Good Morning,
 

Stocks fell on the final day of a busy week that included the U.S.-North Korea summit, major central bank meetings and escalating trade tensions between Washington and Beijing.
 

The S&P 500 Index declined in heavy trading on a quadruple-witching last Friday, a quarterly event when futures and options contracts on indexes and individual stocks expire. The U.S. and China spent the day exchanging tariff threats, which drove down tech and industrial stocks, while a drop in the price of oil hit energy shares. Consumer staples and telecoms advanced, offsetting some of the drop, and the index finished with a weekly gain, if only barely.

Our Take
 

Value strategies continue to underperform while momentum strategies lead the market. In fact, while broad benchmarks sit relatively still, speculative shares are soaring, among them companies that recently went public, stocks favored by short sellers, and firms with weaker balance sheets. A seven-week rally was preserved in the Russell 2000, which was joined in record territory by an index of microcaps.

Gains in the third category, companies with shakier finances, breathed new life into a trade that had prevailed for most of the bull market before deterioratingas investors sought safety. Known as the low-quality rally, its revival may signal indiscriminate buying pressure is building again for equities.

Fundamentals look to be less important right now as high flying IPO’s have been surging. Technology companies that went public recently soared. Dropbox Inc., which began trading on March 23, climbed 32 percent. Cloud-based software company Zuora Inc. surged 18 percent, topping off gains of more than 50 percent since the start of the month. An exchange-traded fund that tracks newly public companies, the Renaissance IPO ETF, posted its second-best weekly gain this year. Avalara Inc., a Seattle-based company that provides sales tax-management solutions, started trading on the NYSE Friday and nearly doubled. There have been 22 technology companies to go public so far this year in the U.S., and they’ve gained an average of 70 percent, weighted by offer size, according to data compiled by Bloomberg.

Investors are no doubt chasing returns and to juice performance but this recent “risk-on” trend may also evidence investor belief that the future looks bright. A recent comment sums up the climate: “Why would you invest in a company where the balance sheet is stressed? You would do it if you felt that either the company or because of the economic situation that they’re going to grow into a more satisfactory fundamental balance sheet.”

Chart of the Month


An inverted yield curve as measured by the 10-year yield less than the two-year yield has occurred ahead of every recession in the past 40 years. The time interval between inversion and recession averages 10 months.

The chart above, courtesy of Urban Carmel, suggests we aren’t there yet.

Musings

Great article by Barry Ritholtz exploring the topic of failure and why we all as investors should learn to fail better. We should all cultivate the ability to be self-critical and implement a “standardized review process” when things go wrong.

As Ritholtz reminds us in contrast to equity investors: “Silicon Valley, technology and the venture-capital business model do a better job. Entrepreneurs and venture funders alike wear their failures like a badge of honor. Many venture capitalists even post their biggest misses on their websites. They recognize their model is to make a lot of losing bets in pursuit of finding the next big winner. Equity investors don’t have quite the same model, but they would benefit from a similar approach to recognizing their own limitations.”

The stigma that surrounds failure in asset management needs to be revisited as even juggernauts such a Buffett and Druckenmiller make big mistakes. As always, the way to avoid future failure is to embrace and learn from past failures. This piece hit home as during the month of May we exited our position in Luxoft and realized we had made a mistake. We were reminded of a few things: 1) turnarounds can take much longer than anticipated no matter how bullish one can be about the business’s prospects 2) more time means a larger opportunity cost 3) sometimes being too early is the equivalent to being wrong.

What investment mistakes have you made lately?

Logos LP May 2018 Performance
 

May 2018 Return: 0%

2018 YTD (May) Return: -3.79%

Trailing Twelve Month Return: +4.38%

CAGR since inception March 26, 2014: +17.99%

Thought of the Month


 

"You know what Kipling said? Treat those two impostors just the same — success and failure. Of course, there’s going to be some failure in making the correct decisions. Nobody bats a thousand. I think it’s important to review your past stupidities so you are less likely to repeat them, but I’m not gnashing my teeth over it or suffering or enduring it. I regard it as perfectly normal to fail and make bad decisions. I think the tragedy in life is to be so timid that you don’t play hard enough so you have some reverses.” -Charlie Munger
 

Articles and Ideas of Interest

 

• World Cup players to watch (not named Messi or Ronaldo). The diminutive Argentine and the preening Portuguese are the most recognizable players in the global tournament now under way in Russia. Oliver Staley details why eight other all-stars also deserve your attention over the next month. Apparently machine learning has come to a conclusion about which team will win. Place your bets. Mine is one France.

• We are worrying about the wrong kind of AI. There’s a bigger AI threat than computers achieving consciousness. Rapid progress in lab-grown “mini brains” from human cells brings up huge ethical challenges. Consider that biologists have been learning to grow functioning “mini brains” or “brain organoids” from real human cells, and progress has been so fast that researchers are actually worrying about what to do if a piece of tissue in a lab dish suddenly shows signs of having conscious states or reasoning abilities. While we are busy focusing on computer intelligence, AI may arrive in living form first, and bring with it a host of unprecedented ethical challenges.

• Tudor Jones says his social impact ETF has potential to rival the S&P 500. Paul Tudor Jones said Tuesday that a new exchange-traded fund about investing based on social impact could one day rival the benchmark U.S. stock index. Social impact investing is making a real impact in private markets. Look for it to grow in popularity in public markets.

• Why China 'holds all the aces' in a full-blown US-China trade war. U.S. tariffs on $50 billion of China goods were imposed Friday to protect U.S. intellectual property and technology. It prompted China to retaliate. But before evaluating the policy prescriptions for this problem, we must first consider the starting point, which is flawed. The current $370 billion deficit estimate does not account for value-added. When looking at the value-added content of Chinese exports, the U.S. deficit with China is actually only half of what it seems. And if we then add back the U.S. surplus in "invisibles" and how much money the United States brings back from investments in China, the U.S.–China deficit shrinks from 2 percent of U.S. GDP to 0.8 percent, a report from Oxford Economics revealed. Furthermore, the reality is that many of the Trump administration's articulated demands are things that China is already doing, albeit at a somewhat slower pace. The United States wants China to buy more American goods and services — and so does China. Trump wants to impose stiff tariffs to prevent China from flooding the American market with increasingly less expensive technological products, like smartphones, computers and related accessories, which collectively comprise China's biggest exports to the United States. And China agrees — they want to export higher value-added goods, especially those with a high innovation content. Interests are much more aligned than either country wants to admit.

• You should be sleeping more than eight hours a night. Here’s why. To set the record straight about being horizontal, Quartz spoke to one of the world’s most-talked-about sleep scientists. Daniel Gartenberg is currently working on research funded by the National Science Foundation and the National Institute of Aging and is also a TED resident. (Watch his talk on deep sleep here.) He’s also an entrepreneur who has launched several cognitive-behavioral-therapy apps, including the Sonic Sleep Coach alarm clock. All that with 8.5 hours’ of sleep a night. Some topics covered: why 8.5 hours of sleep is the new eight hours, the genes that dictate if you’re a morning person or a night owl, why you should take a nap instead of meditating, how sleep deprivation can be a tool to fight depression, why sleep should be the new worker’s rights and tips on how to get a better night’s rest (hint: it’s not your Fitbit).  

• Here’s Mary Meeker’s essential 2018 Internet Trends report. A few highlights: Ecommerce vs Brick & Mortar: Ecommerce growth quickens as now 13% of all retail purchases happen online and parcel shipments are rising swiftly, signaling big opportunities for new shopping apps.Amazon: More people start product searches on Amazon than search engines now, but Jeff Bezos still relies on other surfaces like Facebook and YouTube to inspire people to want things. Subscription services: They’re seeing massive adoption, with Netflix up 25%, The New York Times up 43%, and Spotify up 48% year-over-year in 2017. A free tier accelerates conversion rates. Privacy: China has a big opportunity as users there are much more willing to trade their personal data for product benefits than U.S. users, and China is claiming more spots on the top 20 internet company list while making big investments in AI.

Our best wishes for a fulfilling month, 

Logos LP

Do Bull Markets Die Of Old Age?

Good Morning,
 

The S&P 500 and Nasdaq composite closed lower on Friday as tensions between the U.S. and China weighed on investor sentiment while both countries continued negotiations on trade.

On Thursday, the two largest economies in the world began the second round of trade talks. But President Donald Trump told reporters he doubted the negotiations would be successful.

Later, reports emerged saying China would offer the U.S. a $200 billion trade surplus cut. Those reports, however, were quickly denied by a Chinese ministry spokesman on Friday.

Investors are closely watching progress on the latest China-U.S. trade talks for signs of a breakthrough that could reignite a recent rally in global equities, while factoring in oil prices at a four-year high and a 10-year Treasury yield now firmly above 3 percent. Politics in peripheral Europe are also back in the spotlight after Italy’s populist leaders sealed a coalition agreement and a plan for reforms seen as a challenge to the European Union establishment.
 

Our Take

In a bull market pushing through its 10th year, market timing has again become a preoccupation. One week stocks are climbing to reflect fundamentals ie. stellar earnings growth. The next they’re dropping as yields jump, trade talks with China stall and an executive suggests “peak earnings” on a call. The cost is less to the wallet than the psyche, given that we are coming off two years of relatively straight line low volatility gains.

Furthermore, both stock market bulls and bears can marshal data in their favor. Considering the S&P 500’s current forward P/E which runs above its 5 and 10 year averages, as well as its elevated CAPE ratio, the market looks rich. On the other hand, looking at the market’s PEG ratio or a P/E that accounts for earnings growth, stocks appear to be trading at their cheapest level since 2012...

Best to focus on particular businesses rather than on market prices. How could the business create value in the years ahead? As Thomas Phelps reminds us: “When experienced investors frown on gambling with price fluctuations in the stock market, it is not because they don’t like money, but because both experience and history have convinced them that enduring fortunes are not built that way.”


Chart of the Month

Source: More Than Never. Less Than Always


Musings
 

This month, the current U.S. expansion reaches the 107-month mark, making it the second longest business cycle expansion in the post-war period. It’s looking increasingly likely that this expansion will continue for more than a year and will become the longest since World War II. Most economists will tell you that expansions don’t die of old age, but the odds of fatal mistakes and excesses increase the older they get.

The age of this bull market is the elephant in the room for investors who each year get less enthusiastic about increasing long exposure. How worried should we be? What should we make of comments suggesting that things have “peaked”?

What should be remembered is that output growth during this expansion has severely lagged other expansions. There has been no robust recovery. The slow start in this expansion in the wake of the Great Recession was counterintuitive to the thinking of most analysts, who expected a robust recovery following the worst recession in a generation. However, there is evidence indicating that recessions caused by financial crises tend to be deeper and have longer recovery times than normal recessions.

In addition, this expansion has seen comparatively low rates of personal consumption. Personal consumption which comprises nearly 70% of GDP, has been a major contributor to the overall slow economic performance in the current expansion. Real consumption has grown by 23% since the summer of 2009, compared to growth rates of 41% and 50% at the same point in the expansions of 1991-2001 and 1961-1969, respectively.
 

Consumers are not the only group that has shown uncharacteristic restraint during this expansion; investment by the private (non-government) sector has also lagged since the last recession. Real private fixed investment has grown by 50% in this expansion, compared to growth rates of 89% and 76% at comparable points in the 1991-2001 and 1961-1969 expansions, respectively.

Perhaps one of the most interesting aspects of this U.S. expansion is its global ubiquity. The subpar economic growth seen in the U.S. following the global financial crisis has been simultaneously experienced by many other countries. Whatever the causes of mediocre economic growth in the U.S., the same factors have been at work around the world due to the increasing level of global economic interdependence.

So what?

All we can say at this point is that the mediocre growth of the U.S. economy since the Great Recession is likely a contributing factor in this expansion’s length. As such, although there appears to be pockets of excess across the market (see below), there doesn’t seem to be the kind of widespread excess and economic robustness which is typically characteristic of an expansion’s “final inning”. This time may be “different”, yet the faster and higher you climb, the further and faster you fall. Have we climbed high? Have we climbed fast?

Long-term investors should be wary of remaining “underinvested” on the sidelines waiting for the cycle to turn, as the wait may be longer than planned.

Logos LP April 2018 Performance



April 2018 Return: -3.84%

2018 YTD (April) Return: -3.79%


Trailing Twelve Month Return: +8.22%


CAGR since inception March 26, 2014: +18.39%

Thought of the Month


 

“Over all, 76 percent of the companies that went public last year were unprofitable on a per-share basis in the year leading up to their initial offerings, according to data compiled by Jay Ritter, a professor at the University of Florida’s Warrington College of Business. That was the largest number since the peak of the dot-com boom in 2000, when 81 percent of newly public companies were unprofitable. Of the 15 technology companies that have gone public so far in 2018, only three had positive earnings per share in the preceding year, according to Mr. Ritter.” -Kevin Roose

Articles and Ideas of Interest

 

• Hooray for unprofitable companies!  Interesting article in the NYT that discusses an omnipresent characteristic of this cycle: the proliferation of unprofitable companies. The start-up pitch is basically this: “It’s called the 75 Cent Dollar Store. We’re going to sell dollar bills for 75 cents — no service charges, no hidden fees, just crisp $1 bills for the price of three quarters. It’ll be huge. You’re probably thinking: Wait, won’t your store go out of business? Nope. I’ve got that part figured out, too. The plan is to get tons of people addicted to buying 75-cent dollars so that, in a year or two, we can jack up the price to $1.50 or $2 without losing any customers. Or maybe we’ll get so big that the Treasury Department will start selling us dollar bills at a discount. We could also collect data about our customers and sell it to the highest bidder. Honestly, we’ve got plenty of options. If you’re still skeptical, I don’t blame you. It used to be that in order to survive, businesses had to sell goods or services above cost. But that model is so 20th century. The new way to make it in business is to spend big, grow fast and use Kilimanjaro-size piles of investor cash to subsidize your losses, with a plan to become profitable somewhere down the road.” Instead of pointing the finger at Musk and his unprofitable counterparts the author makes an interesting suggestion: For consumers who are willing to do their research, though, this can be a golden age of deals. May you reap the benefits of artificially cheap goods and services while investors soak up the losses. What could go wrong?

• Who’s winning the self-driving car race? A scorecard breaking down everyone from Alphabet’s Waymo to Zoox. Spoiler alert: Tesla isn’t even top contender.

• Could Argentina’s woes be the tip of the iceberg of an even bigger crisis for the world economy? Tightening U.S. monetary policy could threaten a broad range of emerging markets. Tighter monetary policy will drain liquidity and lift borrowing costs for much of the world economy. Debtors beware.

• You’re not just imagining it. Your job is absolute BS. Anthropologist David Graeber’s new book accuses the global economy of churning out meaningless jobs that are killing the human spirit. There is no doubt that many jobs could be erased from the Earth and no one would be worse off, but this is a tough argument to make as personal fulfillment is relative. Furthermore, in his comfortable seat as a professor at an esteemed institution, musing amusedly about the mind-numbing hours most working people have to put in and put up with—even at jobs that have lively, meaningful moments—appears to fit neatly in his own category of a BS job…

• Bitcoin fans troll Warren Buffett with ‘Rat Posion Squared’ clothing line. Oh it's on! A 10 year wager perhaps between the CCI30(A Crypto Currencies Index) against the SPY (a low cost S&P 500 ETF)? Any takers?  

• Why winners keep winning and why accepting luck as a primary determinant in your life is a freeing worldview. Cumulative advantage goes a long way to explain a moat.  The Matthew effect, and explains how those who start with an advantage relative to others can retain that advantage over long periods of time. This effect has also been shown to describe how music gets popular, but applies to any domain that can result in fame or social status.  As for luck, when you realize the magnitude of happenstance and serendipity in your life, you can stop judging yourself on your outcomes and start focusing on your efforts. It’s the only thing you can control. 

• The epic mistake about manufacturing that’s cost Americans millions of jobs. Quartz suggests that it turns out that Trump’s story of US manufacturing decline was much closer to being right than the story of technological progress being spun in Washington, New York, and Cambridge. Thanks to a painstaking analysis by a handful of economists, it’s become clear that the data that underpin the dominant narrative—or more precisely, the way most economists interpreted the data—were way off-base. Foreign competition, not automation, was behind the stunning loss in factory jobs. And that means America’s manufacturing sector is in far worse shape than the media, politicians, and even most academics realize.

• The burbs are back. Americans are once more fleeing the cities to the suburbs. According to the National Association of Realtors, a trade association for estate agents, more than half of Americans under the age of 37—the majority of home-buyers—are settling in suburban places. In 2017, the Census Bureau released data suggesting that 25- to 29-year-olds are a quarter more likely to move from the city to the suburbs than to go in the opposite direction; older millennials are more than twice as likely. Economic recovery and easier mortgages have helped them on their way. Watch this trend continue as interest rates rise and large mortgages become even more difficult to obtain.

• Biology will be the next great computing platform. Just as the exponential miniaturization of silicon wafers propelled the computing industry forward, so too will the massive parallelization of gene editing push the boundaries of biology into the future.

Our best wishes for a fulfilling month, 

Logos LP