August 13— Worst Case Scenario

Soundtrack

Clarifications/corrections from last time.

1. I said credit event involves people who lent out debt calling it back early. This is an over simplification. The way it works is — As debt expires. debt rollovers, line-of-credit extensions, margin limits are reduced. Debt usually can’t be “called early”. Just a technicality, but trying to be accurate.
2. I was skeptical of the Japan carry trade argument. Looking at the increase in Yen since, it seems like a short squeeze event, which means that could’ve been the reason that caused it. However, I still think Japan was only the straw that broke the camels back, ie the trigger in a weakening environment.
3. When I said the inflation story is over — I meant the ‘story’ is over ie it’s not going to be the main concern going forward. This is because inflation is slowing. While Inflation has slowed down, it’s not over yet — CPI (3%) and PPE (3.1%) are still over 2%. Remember — inflation is rate of change of prices. Prices are still going up, albeit slower than before. If the fed eases, we could be in the worst environment of all — stagflation — where prices go up and there’s no growth (I actually think that is what this year was but that’s another story)
4. I said the fead will ease 3 times this year with 1 percetage points each time — this is specific to a ‘something breaks’ scenario. Past examples: 1) Archegos Capital/Bill Hwuang blowup. 2) Regional Banking Crisis of 2023

Why is the Japan carry trade debate important?

Why the crash happened, determines how long it’s going to be. I still believe it was a trifecta of higher rates, lower volumes in the summer, election and geopolitical uncertainty, pain in retail and commercial real estate, change in direction/trend of unemployment, foreclosures, delinquencues, for that caused this. Japan was just the cherry on top.

If this was indeed the Japan trade that caused this — a glitch, things would go back to normal and everything would bounce back immediately and we’ll never talk about it again. This happens in the market from time to time. (See Chinese 2015 Stock Market Instability).

If I’m right and this is the slowing economy, things would continue sliding down. We’ve talked about Nike, Lululemon, Starbucks, McDonalds slowing down before and now Airbnb has joined the fray.

The only growing companies in this economy are Mag 7. Out of which only 4 forecast earnings growth that we can be cautiously confident about— MSFT, NVDA, META and AMZN. The rest of S&P 493 has been lagging. These Mag 4 also have excellent balance sheets, with dollops of cash that they can use for anything — including stock buybacks or dividends to support the stock price.

When it comes to investing “downturns maketh the portfolio”. There are 2 reasons for this

1. Take any number X, subtract 50% and then add +50% and you’d get 75% of the original number. It’s takes a lot to grow a stock but it’s super easy to lose it.
2. Money’s value is relative. If you add a 0 ($100 -> $1000) to every USD note in the world, no one would actually be any richer. Dollar for dollar, staying stable when everything else is losing money (Financial speak: alpha) is a LOT better than gaining when everything else is also gaining (Financial speak: beta — correlation with the market).

Aug 05 VIX after effects

VIX is the measure of instability. The higher the VIX, the more unstable things are (mathematically it’s just standard deviation). On Monday VIX reached a peak last reached in 2020 and before then 2008.

In finance, volatility is the gold standard in measuring ‘risk’. High volality = higher risk. Most financial risk models just use this number. The problem with this is that it’s backward looking. When investing we need to look into the future.

Now, most pension funds, hedge funds etc have risk managers whose job is to keep risk low. Because of the way this is setup, they don’t have a choice to reduce holdings that have been volatile, making this a good opportunity if you want to buy a stock that you believe is high quality.

Predictions

What I was right about:

On July 24th I suggested buying bonds. They’ve gone up ~4% since — almost whole years return in half a month.

On July 24th I also said I was skeptical of the rotation story — which said money was moving from MAG7 to small caps (Russell 2000). It spiked up 10% at the time and gave up almost all of it’s gains.

On June 28th I said travel related stocks (Delta and Airbnb) will suffer. They’re both down double digit % since.

What I was wrong about:

I was upbeat on Argentina (ARGT) and Copper (SCCO). While they’re both still up for the year, they’ve been down more recently and I’ve taken the L on this. Copper demand slows in a recession and Argentina might take years to recover and isn’t guaranteed to given political uncertainty.

Looking ahead

Bankruptcies so far in 2024, seasonally adjusted is monotonically higher than the past 4 years. As of August, Chapter 7 (household) is 34% higher and Chapter 11 (business) 25%. The lower end of american economy is struggling — people and businesses. The personal savings rate is 3.4 — one of the lowest ever. The last time it was this low was in 2022 and before then 2007. The fed has it’s back against the wall with inflation fears on one hand and slowing economy on the other. This situation is ripe for political instability.

You can never tell how things play out for certain, but here are 3 scenarios:

Fed Ease (25% Chance): JPow panics and eases too much, too early causing inflation to rise again. This is like snorting coke after a breakup. Will only delay the inevitable pain.

Fed Stay Put (50% Chance): Slowly inflict short term damage to the economy, for long term gain. A bit like going to the gym. Froth and excess spending will be optimized. BS jobs will go away. Things will emerge stronger than before with low interest rates and high growth.

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Political Overcorrection (25% Chance): Excess regulations, price controls, import duties, immigration restrictions. This is like turning bitter, angry and resentful. It’ll only make everything worse.

Critical Data that I’m Watching

FRED Data

Metrics that need to start curving up (accelerate)

• Personal Savings Rate — https://fred.stlouisfed.org/series/PSAVERT
• Median Sales Price of Houses Sold for the United States — https://fred.stlouisfed.org/series/MSPUS —
• Inflation Adjusted Median Household Income — https://fred.stlouisfed.org/series/MEHOINUSA672N
• Financial Soundness Indicator; Regulatory Tier 1 Capital as a Percent of Risk-Weighted Assets — https://fred.stlouisfed.org/series/BOGZ1FL010000016Q
• Balance Sheet: Tier 1 Leverage Capital (PCA Definition) — https://fred.stlouisfed.org/series/QBPBSLEVK
• Motor Vehicle Retail Sales: Heavy Weight Trucks — https://fred.stlouisfed.org/series/HTRUCKSSAAR

Metrics that need to start curving down (decelerate)

• Unemployment Rate: https://fred.stlouisfed.org/series/UNRATE
• CPI for US Cities: https://fred.stlouisfed.org/series/CPIAUCSL
• Delinquency Rate on Consumer Loans, All Commercial Banks — https://fred.stlouisfed.org/series/DRCLACBS
• Large Bank Consumer Credit Card Balances: Total Balances — https://fred.stlouisfed.org/series/RCCCBBALTOT [This needs to be normalized relative to Personal Savings Rate]
• Large Bank Consumer Credit Card Balances: 30 or More Days Past Due Rates: Accounts Based https://fred.stlouisfed.org/series/RCCCBACTDPD30P
• Mortgage Delinquency Rates for United States https://fred.stlouisfed.org/series/Q09084USQ507NNBR

Earnings and Stock Price

Dr Horton — One of the largest home construction companies. Their earnings guide is a leading indicator to the optimism and affordability of the American populace

Caterpillar — One of the largest industrial/construction firms. Their earning guide is a leading indicator to the optimism of labor intensive American Infrastructure Firms

AirBnB— Likely the company with the most concentrated amount of discretionary spending of the largest and fastest growing consumer demographic. AirBnB also is a downstream, leading, fast-reacting indicator of real estate demand. Normally, real estate demand is slow and sticky. AirBnB on the other hand react faster. If a property isn’t cash flow positive, owners don’t have a lot of time before they have to list that property for sale.

Home Depot — In a slowdown, consumers are more liekly to delay remodelling projects and expensive upgrades. This will be reflected in Home Depot’s earnings.

USO — Oil futures (prices) go down in a downturn because of reduced energy demand and go up when the economy is alive and buzzing. Oil prices are sensitive to geopolitics, so that has to be kept in mind. This is also a 2-way correlation-causation, since an increase in oil prices is inflationary and vice versa.

Commodities (DBC, GSG) — Commodity prices have a similar relationship with the economy to USO/Oil. However, commodities can be slower to react compared to oil. Since commodities are fungable (1 unit of american grade X copper = 1 unit of australian grade x copper) it’s less sensitive to geopolitics than oil. (Except rare earth materials)

Shipping (AMKBY, GNK, ZIM) — Shipping and Logistics prices can be a leading indicator of inflation. If demand is strong shipping prices (and as a consequence, margins and earnings) will expand. If not, price cuts will entail and eat into margins.

Technological breakthroughs

A fundamental principle of my investing philosophy is that all growth comes from technology. Humans are addicted to growth. Today, ‘Tech’ = social media, cloud, streaming and EVs. To me, that’s just ‘new technology’. Everything humans have ever developed was ‘technology’ at some point. From fire, to clothing, money and even agriculture and horticulture, railways, cars etc. We just get used to it and stop calling it ‘technology’.

A second fundamental truth I believe that of anti-fragility (read Antifragile by Nicholas Taleb). Humans are anti-fragile. Stressors make us stronger. Every crash in our past has come with a series of technological innovations. Here are a couple:

The Great Depression (1929 — late 1930s): Television, Nylon, Jet Engine. Post-World War II Recession (1945–1949): Transistor, Nuclear Power. Early 1980s Recession (1980–1982): Personal Computers (PCs), Mobile Phones. Early 1990s Recession (1990–1991): Internet, Biotechnology. Dot-com Bubble Burst (2000–2001): Broadband Internet, Mobile Technology, E-commerce. Global Financial Crisis (2007–2009): Smartphones, Social Media, Cloud Computing. COVID-19 Recession (2020): Remote Work Technologies, mRNA, Telemedicine, E-commerce and Delivery Services, Biotechnology

This time too, we’re on the cusp of several breakthroughs and technological revolutions.

Artificial Intelligence: Self-driving cars (Waymo) are now on the streets on SF picking up riders every day. Hurricanes, weather and earthquake fault lines are being modelled by machine learning. Protein folding — a problem we struggled with for decades is a solved problem using machine learning. Of course personal assistant — a problem we spend billions and billions of dollars on for decades is a solved problem.

Nuclear energy: Small Modular Reactors (SMR) are gaining steam (no pun intended). Nuclear Fusion has acheived net energy gain in labs at Lawrence Livermore National Laboratory in California with private startups like Commonwealth Fusions from Massachusetts and Helion Inc. in Washington.

Healthcare: We have CRISPR revolutionizing gene editing with active research from public and private companies. mRNA was deployed for the first time with covid vaccines. GLP-1 drugs like Ozempic are revolutionizing healthcare with studies reporting lower risk of dementia and heart disease as side effects.

VR/AR: This technology is finally at a point where it’s becoming near mainstream with Apple Vision Pro and Meta Quest 2. If it takes off, the downstream app development and economy that comes out of this will be enormous. Minecraft and Roblox are already mainstream metaverses.

Super Sonic and Space Travel: The restart of supersonic travel will be be a step change for a more connected world. Boom Super Sonic and SpaceX are geared to expand the boundaries of human exploration.

Having said all that, good technology != good company != good investment returns (See: ARK Invest).

My Strategy

I’m still heavily invested in high earnings growth companies like NVIDIA, MSFT and Eli Lilly. I’m hedging my holdings by buying puts on consumer discretionary (Starbucks, McDonalds, Nike etc) and selling short dated calls with a current_price + 20% strike price. I buy back the calls once the current price approaches ~10% of the strike price.

I’m selling my low performers to release and build a cash balance.

NOT INVESTMENT ADVICE. Just Musings

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