Stray Reflections March 2014
Jawad S. Mian, CFA, CMT Managing Editor jawad@stray-reflections.com
Our macro views getting down and semi-dirty in global markets
Jawad S. Mian
March 2014
Quintus Horatius Flaccus Horace was the leading Roman poet during the time of Augustus and is widely considered to be the the world’s first autobiographer. Dryden notes that “in his writings, he tells us far more about himself, his character, his development, and his way of life than any other great poet in antiquity.” He was most famous for Odes, a collection of lyric poems that he wrote over a span of ten years. I confess to not having read any of them but most of us are probably aware of at least one phrase from his entire body of work: “Carpe diem!” Horace used to think in terms of themes and he developed a number of them throughout his poetic career, including politics, love, philosophy and ethics, as well as his own social role. According to him, the aim of the poet is to inform or delight, or to combine together, in what he says, both pleasure and applicability to life. In instructing, he believes one should be brief in what he says in order that the readers may grasp it quickly and retain it faithfully. That’s our credo. Not carpe diem. The stuff below that. At Stray Reflections, we also want to inform and delight. In trying to reach that objective we take an approach similar to the one defined by Horace. We value your time and don’t feel like we can fairly command the reader’s attention for more than thirty minutes or beyond a dozen or so pages. If we’re unable to combine both pleasure and applicability to life and markets in that infinite space afforded to us then it would be unfair to ask for more. As we survey the macro environment, we also think in terms of themes and look to develop a number of them through these pages. We are constantly searching for a new paradigm. Fundamental to our approach to investing is a core understanding of history, politics, economics and psychology. We are always seeking more knowledge. We believe an eclectic approach that is based on common sense, strong logic, and objective data, balanced by rightbrain intuition and lots of curiosity is what works best.
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The English poet Alfred Lord Tennyson declared that Odes provided "jewels five-words long, that on the stretched forefinger of all Time, sparkle forever." It is our goal to provide ideas that turn out to be jewels as well.
Investment Observations In trading markets this year, our strategy is guided by the words of Horace: “Many shall be restored that are now fallen and many shall fall that are now in honor.� Among the fallen assets, commodities have been the most disgraced. As a group, they have been the worst performing asset class over a three-year period and the worst on a ten-year cumulative basis. The Dow Jones-UBS Commodity index has steadily eroded 30% of its value since the April 2011 peak. Last year alone, gold lost 28%, silver 36%, corn crashed 32%, uranium another 18%, copper 11%, and gold miners declined over 50% for a third consecutive yearly decline which is a pretty rare occurrence.
Source: US Global Investors We pay particular attention to the embedded beliefs in financial markets and assess valuations and trends in this context. In carrying out our
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research, we turned over every stone and we have yet to find a commodity bull anywhere aside from Jim Rogers. The BofA Merrill Lynch Fund Manager Survey for February found that only 2% think that inflation is the major up-and-coming risk, while an overwhelming majority think that a Chinese hard landing and commodity collapse is the biggest tail-risk to the global economy. The proportion of investors worrying about this deflationary outcome has risen from 26% in December to 37% in January and 46% in February.
Source: Tiho Brkan, Short Side of Long Given the lopsided consensus, we felt that it was time for the fallen commodities to be restored. Last month, we initiated a number of absolute long positions and relative value trades in the commodity complex and related assets. We currently own precious metals, natural gas, corn and gold miners. We also see value in resource-sensitive equities and intend to augment our positions in the energy sector in the coming weeks and months. Among our favorite positions, oil services stocks and natural gas producers stand out.
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It has been encouraging to witness commodities outperform every other asset from the start of this year. One by one, we have seen inflation sensitive markets rally hard and even make key technical breakouts in some cases. Coffee has risen 62%, natural gas 15%, gold 12%, silver 11%, corn is up 10% and oil increased 5%; meanwhile world equity indices are generally flat on aggregate. Horace would be proud. But only time will tell if the strength shown so far will outlast adverse weather conditions, and whether cyclical forces provide sufficient support to portend a defining change in trend. In a world of excess savings and inadequate demand, we can understand why deflation scares the wits out of central bankers. However, in our view, the prevailing deflation consensus is being severely challenged. The gold price breakout seems to signal that we should be watching out for G10 inflation to bottom later this year with inflation expectations also possibly surprising to the upside. Let’s discuss. A week before my birthday (on January 3rd) gold traded below $1200 and silver was stuck at $19, down more than 60% from its high of $49 recorded in April of 2011. According to the Daily Sentiment Index, the percentage of gold and silver bulls had fallen to just 5% for gold and 6% for silver. Needless to say, the sentiment picture had utterly reversed the unchecked optimism which coincided with the metals’ all-time highs three years ago. What’s somehow forgotten is that the record high in gold of $1921 in September of 2011 also coincided with a cyclical peak in developed world inflation. Since then, headline CPI inflation has been falling consistently and significantly alongside the price of gold. In England, the inflation rate fell below the 2% target last month for the first time in more than four years. The measure has now dropped below 1% in both US and Euro area and consensus forecasts are still headed downwards. Economists are kept busy highlighting downside risks to the inflation outlook.
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Source: Haver Analytics, Fulcrum Asset Management, Gavyn Davies FT Blog It is well known that gold and inflation are joined at the hip. In 2008, gold bottomed in November as inflation was still falling sharply. Six months later inflation turned up following gold’s lead. We expect the cycle to repeat. Gold has turned up this year despite very weak global CPI prints and lacklustre broad money growth. Fundamentals for the advance appear to be solid. Central banks added 369 tonnes to reserves in 2013, which is the fourth consecutive year of net purchases. Liquidation of gold ETF holdings has run its course and we may have seen the first month of inflows in February since 2012. Bar and coin demand rose to a record last year while demand for gold jewellery increased 17%, returning to its pre-crisis levels. Silver too has completed a major pivot last year and the upturn so far seems to have shaken it out of its funk. The speculative net short position in silver (as a percent of open interest) still represents a significant 1.1 standard deviation away from the 20-year average so the rally is by no means extended.
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After nearly three years of declining prices, however, one cannot be blamed for worrying about the sustainability of the current rebound. Based on the available evidence so far, we’re of the opinion that both gold and silver have most likely established meaningful long-term double bottoms on the charts. In the case of silver specifically, it also seems to have matched the peak-totrough analog from the Nasdaq top in 2000.
Source: Market Anthropology A key question arises: If the gold top coincided with an inflation top in 2011, shouldn’t the gold bottom in 2014 lead to an inflation bottom later this year? It remains to be seen but we certainly expect that to be the case. Inflation is a lagging indicator and according to Diapson Commodities, “the reason inflation has not yet accelerated is because inflation lags behind the changes in money velocity by two to three years. The recent change in money velocity is hence hinting that the period of low inflation is almost over.” Based on their modelling work, US core CPI growth is probably close to its trough and the subsequent acceleration of the core CPI is likely to add upside pressure on inflation expectations.
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Source: Diapson Commodities Looking ahead, economic trends also suggest disinflationary forces should begin to abate. David Rosenberg argues that wages and rents will head higher as the job and housing markets rebound and as faster credit creation and record stimulus by the Fed stoke price pressures. Meanwhile, electricity cost inflation and rising food costs will further complicate the price equation. In addition, the global credit impulse is beginning to show early signs of improvement which should be monitored closely. It is entirely conceivable that G10 inflation will make an important low in 2014 and enter a long-term bull-market. We have put in place an inflation hedge as a result. One thing is clear, with the developed world obsessed with deflation again, an easy monetary policy course will not be hindered. We therefore feel comfortable dabbling in commodities at the moment. I’m left wondering whether commodities are in the process of marking a major double-bottom in relative performance versus the US equity market. See top chart on next page.
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Source: Market Anthropology I was re-reading Jack Schwager’s Market Wizards over the weekend and one line caught my eye. It was a quote from Paul Tudor Jones, “even though markets look their very best when they are setting new highs, that is often the best time to sell.” I don’t know if he still feels that way since the book was written a very long time ago but it is interesting that I read that now, the week S&P closed at a new all-time high. That’s an omen.
Source: Greg Schnell, Stockcharts.com
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Along with stocks, US margin debt is also making new all-time highs which suggests that we are in the most speculative phase of the advance. The current rally is the best since 1998 with US stocks flying above the 200 day moving average for 331 consecutive days. Even money in retail money market funds as a percentage of total US equity market capitalization has fallen to 2.8%, which is a new all-time low. The chart above shows longterm cycle analysis by Richard Rhodes which fits well with the major stock market highs in the last 35 years. There is one expected in 2014. In following the “sign”, and to heed Horace’s advice, we started looking for assets that were held in honor that may suddenly fall from grace. Social media stocks. Biotech. Last year, social media stocks were up 63% on average while the biotech industry was the top-performing sector with a 66% gain in the Nasdaq biotech index. Since the 2009 low, biotech has caught fire and the group has put in an impressive return of 346%, clearly outperforming the S&P 500 which has risen a meagre 182% in comparison. Before we move on, I must confess that both sectors are not my strong suit. I’m technologically challenged. I don’t tweet. I don’t share pictures on Instagram. I’m not on Pinterest and you can’t add me as your friend on Facebook. I’m cool enough to carry an iPhone but not savvy enough to have more than five apps on it. It has been more than a decade since I last downloaded a song or a movie online. No, I’m not kidding. It has been twelve years to be exact. See, I told you, I’m technologically challenged. I’m not proud of it. I just can’t help it. I like keeping things simple and this new wave of technology just seems to add clutter in my life. Now, when I hear about WhatsApp being sold to mighty Facebook for $19 billion that piques my interest. I force myself to overcome my shortcomings, even if just for a little while. Of course, I don’t get the deal. I
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mean I get the deal, I don’t get the price. If I was the kid from Instagram I’d be pretty angry at myself for selling out so cheaply. All of a sudden that deal looks like a steal. Mark Zuckerburg is growing up to be a true value investor. According to a recent Forbes article, WhatsApps’ 470 million users have already erased $33 billion in SMS revenue from wireless carriers. That’s not chump change and a great example of creative destruction. The company makes $20 million in revenue but the founders believe they can get to $1 billion by 2017 as the service grows and billing falls into place. They charge nothing for the first year and then ask the user to pay $1 a year thereafter. It costs WhatsApp only five cents to support each user, and it’s charging customers in only a handful of countries at the moment, like the US and England, where mobile payments are relatively mature. Even if the financial goals are unmet, however, which is highly likely in my view, well that’s okay. Apparently Mark Z has promised the WhatsApp founders “zero pressure” to make money, saying, “I would love for you guys to connect 4 to 5 billion people in the next five years.” I don’t read Forbes. But I came across another interesting article yesterday thanks to Barry Ritholtz of The Big Picture blog. It was a great interview with Bill Janeway of Warburg-Pincus on tech valuations and the innovation economy. This is what we had to say: “Obviously, the valuations are huge relative to any set of metrics. It is new ground. Each one of these companies represents a new foray into what appears to be a limitless market space with evidence from Google and Facebook and potentially Twitter, that it can be monetized and generate positive cash flow over time. Think about what happened in the 1880s, as Railway Express provided the layer of “infrastructure software” on top of the railroad network in North America, which in turn enabled Montgomery Ward and Sears Roebuck to deliver the “killer app” for the railroad age known as mail order retail, which completely transformed the economy, created national brands like Procter & Gamble and re-architected the physical and economic architecture of North America. That is the kind of phenomenon that Google, Facebook, Amazon, EBay, Twitter represent. Trying to value them on a net present value of expected cash flows is just not relevant yet. Sooner or later, it will become so. The value now is driven by supply and demand amongst
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speculators who have liquidity and will not have to stick around to find out what the fundamental value turns out to be over time. Having said all that, I actually think the value of social media companies have relatively trivial significance to the overall health and prospects of the innovation economy.” I find it interesting that Bill Janeway compares today’s social network stocks to railroads. In many ways, social network stocks are the new railroads. After all, they’re building and connecting the information highways for the future. I get it, it’s revolutionary. I wanted to get a historical perspective on railroads so I turned to Edward Chancellor (the authority on manias) and pulled up an article he wrote in the FT back in 2010. As with all bubbles, it appears that railroads too entered a self-promoting cycle based on extreme over-estimation of the potential market size (think of Bill’s “limitless market space”). Railroad entrepreneurs found a ready market for their stocks and bonds to fund their massive expansion plans. Investors accepted uncritically their magical vision and chose to favor over-optimistic speculation. Of course, this ended badly. Shares collapsed once valuations reached bubble territory and investors realized that railroads were not as lucrative as they were led to believe. Could we be making the same mistake again? I was still a tad bit confused so I reached out to Amad, my younger brother who is also a much better looking version of me and a rising star in Dubai’s social media and tech scene, to help me understand what’s actually going on here. He got super excited since he’s obsessed with technology. He stopped playing with his porn star moustache and started talking, “Don’t you see it, the desktop age is over. The world is moving to mobile now and we are still early in this major transition. Never before has there been a device that can give you the power of your desktop computer yet sit in your pocket and give you direct contact with businesses and even government services now. The newness and exponential growth of smartphone platforms has left room for innovation in all business categories. I think Facebook gets this better than most and they want to be the leader in mobile. Mark and Sheryl realize how big of a market it will be, and that’s why they have adapted their strategy to develop and buy-out multiple apps for mobile. Google owns desktop. They want to own mobile.”
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I was losing interest but he continued anyway, “Currently on my phone I have 4 apps that are somehow linked to Facebook. When I download other apps on my phone I don’t put my email, I choose to connect with Facebook instead, it is easier and faster and at the end of it Facebook already has my data so why not just simplify the use of mobile apps given my short attention span.” I agreed with his short attention span. I would also like to tell people that Amad has a crush on Sheryl Sandberg. “We are going to see a mobile war in the next ten years,” by now he was becoming even more animated in his discussion and I was only wondering how long it must have taken him to grow that sexy moustache. “People are still underestimating the power mobile holds in our daily lives. The very first and last thing we do is check our phones, and we tend to check our phones over 100 times a day, even at 15 second spurts when we are out and about, looking to buy, to research and to visit. We have gone one step ahead with our customer purchase cycle on mobile, now its just finding a way to capitalize on the users journey and give them the right information at the right time in the right manner.” I don’t usually listen to my younger brother but he makes some valid points in this case. He’s making a secular change argument and I understand that now. However, the way I see it, we are in the first innings of the new social media revolution. In this phase, social mood is most elevated and valuations reach bubble territory fairly quickly and before the underlying story is even given the chance to be fully validated. This mix subsequently leads to a bust and then a far more gradual grind higher as reality and perception merge over the long-term. We saw a similar dynamic play out in the solar industry and it is probably occuring in the 3-D printing stocks as well. Social network stock prices have seen a more than three-fold surge since mid-2012. These basket of stocks are trading at 12 to 13 times sales (almost equivalent to valuation levels at the peak of the tech bubble) and their average P/E ratio is meaningless as a majority of them are yet to report any earnings. As Seth Klarman notes in a recent letter to his investors, “In
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Silicon Valley, it seems that business plans - a narrative of how one intends to make money - are once again far more valuable than many actual businesses engaged in real world commerce and whose revenues exceed expenses.�
Source: BCA Research I have not built-up a multi-tab financial model for these stocks and I admit to having no insight into their prospects for future profit growth. Like I said, I’m no tech expert. I was simply following the words of Horace when on February 20th (the day Facebook created even more billionaires) we opened a trifling short position in the Global X Social Media Index ETF (SOCL) which has Facebook, Twitter, Yelp and Google among some of its major holdings. I feel the WhatsApp purchase may mark a peak of some significance for this exuberant sector over an intermediate horizon. And
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just in case we’re wrong, we have a tight stop in place. We believe in being open-minded and flexible when challenged by the market. Moving onto the biotech industry quickly, it is easy to see the sector has become massively overheated. According to The Economist, the current biotech boom has seen more firms go public and more money being raised than at any time since 2000, which was known as the golden year. I totally get that big pharma companies are suffering from weak product lines and patent expirations and that smaller biotech firms have now become research engines for the larger firms and are at last starting to reap the rewards of studying the human genome. Naturally, there is an avid interest from the larger players to support and acquire cutting-edge biotech companies. With cheap availability of credit, the M&A boom is unlikely to run out of steam anytime soon. However, hot money flows into the biotech group have driven up valuations to nosebleed levels. For instance, the iShares Nasdaq Biotechnology ETF (IBB) is currently valued at 9 times average book value. According to Abdulaziz Shikh Al Sagha - a young analyst based in Dubai who knows more about this space than any other person I know - the biotech sector is collectively worth more than $500 billion now which is more than the aerospace and defence industry and the automotive industry combined. Does that make it a bubble? No. However, Boston Consulting Group reckons that 90% of the money spent researching new treatments goes on drugs that ultimately fail. Does that make me worried? Yes. After a near vertical ascent, technicals are also begninning to appear way too stretched for the parabolic advance to continue at this pace. IBB is trading at a very strong Fibonacci and upward-sloping channel resistance which I don’t expect to be cleared right away. A sizeable price decline is probably around the corner and we have initiated a short position in IBB as part of a tactical pair trade to take full advantage of the overextension. One of the first basic rules of trading is to buy low and sell higher. With that in mind, don’t these charts on the following page look interesting?
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Source: Kimble Charting Solutions Chris Kimble produces some of the most fascinating charts on the planet. The one cited above is a classic example. It is amazing how a simple inversion of the price chart provides a very different and strangely unique perspective. All of a sudden, doesn’t it feel absurd to chase these high-flying stocks even higher? I’d have better luck chasing Jennifer Lawrence. But since I’m happily married, it definitely makes more sense to buy the pattern displayed, which actually means that we would have to carefully sell short the stock in question. Well, that’s precisely what we have done. I’m still thinking about Jennifer Lawrence.
Kashmir Back in 2011, I went on a one-week trek to Kashmir in the northern part of Pakistan with a group of friends. We had spent months planning a fixed itinerary of how we would spend our days but we grossly underestimated the power of nature. The terrain in the north is hard to navigate and the best laid plans are often put to waste within the first few hours of getting there. Boosted by our inflated ego, we resisted nature trying to make us follow its own course but then submitted to its divine essence. As Horace
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advised centuries ago, we ceased to inquire what the future has in store, and learnt to take as a gift whatever the day brings forth. We traveled along Neelum Valley (neelum means blue gem in urdu) and were just amazed at the incredible views that greeted and surrounded us everywhere we went. I have been to a number of mountain ranges around the world but nothing compared to this. The beauty was raw and unkept. Every time our foot touched the ground, we felt we belonged to the earth and will one day return there. With each drink from the river, we felt as though the same water rushed through our body. With our every breath of air it cleansed our soul. Our journey was mystical. The waters refused to settle, but we could still see the moon and the stars mirrored in our own being as Rumi wrote in one of his poems. Something changed in me that week and I have not been the same ever since. I was recently reminded of my Kashmir trip after watching the new Indian film Highway which is hopefully still playing in cinemas right now. If you have ever wondered about the beauty of the northern parts of India and Pakistan it will be revealed to you in this film. The visuals are stunning and the music and acting is spot-on. It even has a powerful Sufi undercurrent for those that have the eye. The subtitles are excellent so understanding the language is no problem. The story is about a rich, dreamy 20-year old girl who is taken hostage and kidnapped in the first 10 minutes of the film. For the next two hours, we follow her incredible journey as she discovers her true self. In my view, Highway is nothing short of a Paulo Coelho novel. I would just recommend that you watch the film with your inner eye. “The place where you got me from, I don’t want to go back there. The place where we’re going, I don’t want to reach there. This road… It’s very good. I want this road to never end. I just want to keep travelling on this road.” - Veera from Highway In the end we all belong to God, and to Him we shall return. Jawad
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Source: M.H.Malik (Neelum Valley)
Source: M.H.Malik (Pir Chanasi)
Next publication date: 11th April 2014
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Positions The purpose of this section is to list our investment recommendations and real-time trade alerts which will only be shared with subscribers. We currently have 20 open trades across 9 investment themes. We also have 28 additional ideas on our watchlist.
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