Look around the poker table. If you can’t see the sucker, you’re it.
I actually don’t know if Warren Buffett was the first to say that and I’m not sure that’s exactly the right phrasing. When I sat down to to write this I thought it was from Amarillo Slim, a professional gambler from Arkansas. Or maybe that other Arkansas gambler named Titanic Thompson who was allegedly the one who fixed the poker game that got Arnold Rothstein killed. Rothstein was, of course, the guy who famously fixed the 1919 World Series. I’ve also seen the quote attributed to Paul Newman but I think that is just because he was in The Sting. I’ve also seen it as “If you’ve been playing poker for half an hour and you still don’t know who the patsy it, it’s you.” But whatever the source or the exact phrasing or the reputation of the guy who coined it, it’s a great line.
Of course, none of that is important in the least in the context of a weekly commentary about financial markets. That first paragraph is a distraction. I’d bet that there are more than a few of you who have already googled Titanic Thompson (who was indeed a notorious gambler from Arkansas) because you’ve never heard of him. A few of you have googled Amarillo Slim but as our demographic runs older, many of you have at least heard of him. And a few of you have gotten so distracted that you have just come back to read the rest of this after a half hour detour into the Black Sox scandal (Shoeless Joe was the patsy). The internet may be a lot of things but a boon to productivity probably isn’t one of them.
One of the main themes of this weekly letter is to block out the noise of the financial press (professional and amateur). Most of what passes for economic or market news is just noise, distractions that take your focus off what is really important. The noise can be deafening and can prevent you from taking necessary actions or convince you to take unnecessary ones. And you certainly don’t need to waste any time listening to or taking seriously those market commentators who claim some clairvoyant ability. The future, today as always, remains unknowable and a large number of Twitter followers or podcast viewers doesn’t change that.
I have said repeatedly in these weekly missives that it is not our job as investors to predict the future and we don’t have to. It is our job to interpret the present and most of that boils down to observing what people are doing rather than what they are saying. And what they are almost always doing is acting very human, making the same mistakes their forebears did, being greedy when they should be fearful and being fearful when they should be greedy. And reacting – over reacting – to the news of the day; listening to the noise and missing the market signals. Today is certainly no exception and in fact may well be the most vivid demonstration of greed winning out over prudence in modern history. Or maybe just history.
I saw an article recently about how fund managers who are avoiding Tesla stock are being punished through withdrawals. They can’t keep up with the S&P 500 without owning Tesla but they don’t feel they can justify owning the stock from a fundamental standpoint and investors are cashing out. My first thought was that I would probably eliminate from consideration any actively managed fund that owned Tesla. Why? Because what Tesla would have to accomplish over the next decade to justify today’s stock price borders on the ludicrous. Tesla would have to dominate the global automobile industry to such a degree that most, if not all, of the rest of the industry would be bankrupt. No fund manager should own this stock voluntarily. To quote GHW Bush (and Dana Carvey and my wife), it wouldn’t be prudent.
Tesla is but one example of the degree of speculation in today’s markets. How about Rivian that recently went public and now has a market capitalization of $115 billion despite not having sold a single car? Or Lucid with a market cap of $90 billion and the same sales record as Rivian. Or QuantumScape, a research stage battery company with a $15 billion market cap and no revenue while Panasonic* has sales of $67 billion (including the batteries that move most of Tesla’s cars) and a market cap of less than $30 billion? NFTs? What about this “art” that recently sold for $3.4 million? Cryptocurrencies? Doge coin, meant as a joke, has a market cap of $40 billion. Or Shiba Inu, a spinoff of the joke, has a market cap of $29 billion. No one is buying these things because they have some intrinsic value. They are only buying them because they think someone will come along and pay them more than they paid. The supply of greater fools is finite or at least I think so, but we obviously haven’t found the limit yet.
The problem with all this speculation is that it starts to tempt the prudent investor into reckless behavior. A recent tweet from David Andolfatto, an economist at the St. Louis Fed, helps explain how we got here. Calpers, the big California pension plan, recently voted on a plan to add leverage to its portfolio to meet its already reduced return target:
The board of the nation’s largest pension fund voted Monday to use borrowed money and alternative assets to meet its investment-return target, even after lowering that target just a few months ago.
Mr. Andolfatto responded with this tweet:
…this is a consequence of irresponsible behavior on the part of fund managers. Will they be held responsible should their levered bets fail to pay off?
No, it can’t be the fault of the Fed or other economic policy makers for pushing interest rates down to zero. It is the fault of investors, fund managers and investment advisers who have to try and produce a reasonable return taking reasonable risks in this ZIRP environment. What exactly are investors supposed to do? If they avoid risk, they will get negative real returns, their purchasing power eroding by the day. What if a portfolio that produces an expected real return is beyond their risk tolerance or capacity? Does Mr. Andolfatto really think they’re going to just go broke slowly so the Fed can continue to execute a failed policy?
What about the fund managers and investment advisers? What are they to do? If they act prudently for their clients, the clients (some of them) will leave for an adviser willing to take more risk, chase more return. If they make “irresponsible” investments, which will likely be anything that went down in hindsight, they’ll get sued out of business. With all due respect Mr. Andolfatto, it is the Fed that has led us to this place, not “irresponsible” investors. They are merely responding to the incentives placed before them. When will the Fed be held responsible for its irresponsible monetary policies?
And that is why I’m on a bit of rant today about speculation and what is prudent. I said above that I wouldn’t own an actively managed fund that owns Tesla because it shows a disregard for the well being of its shareholders. But what about an index fund that owns Tesla? What has always been prudent – owning a low cost index fund – has now become a more speculative investment because of the degree of speculation in the market. How speculative? Well I’m glad you asked.
The S&P 500 has become the default stock market investment for an entire generation of investors. It has become so embedded in our investment culture that few even bother to find out what they own; they just want to own “the market”. But is that what you get when you buy SPY? Consider these stats:
- The top 10 stocks in the S&P 500 make up 30.1% of the fund. Is this the diversification you expected when you bought an index with 500 stocks (actually 507)?
- These top 10 stocks have an average P/E of 43.7. Yes, that includes Tesla at 137 times earnings (based on data from Morningstar) so if we take that out the average drops to..33.3.
- The top 20 stocks in the index make up 38.9% of the fund with an average P/E of 38.3
- The top 25 stocks make up 42.2% of the fund with a P/E of 34.6
- Two of the stocks in the top 10 are different share classes of Alphabet (Google). So you really have 30% of the fund is just 9 stocks. Furthermore, if you exclude JP Morgan and Berkshire Hathaway, you have 27.6% of the fund invested in 7 companies: Microsoft, Apple, Amazon, Tesla, Alphabet, Meta Platforms (Facebook), Nvidia (chip maker for crypto mining). Do you think those companies will be in the top 10 a decade from now? Only 4 of the top 10 from 2011 are still in there. Only one stock from the 2000 top 10 remains (Microsoft).
The current concentration of the fund is unprecedented. Its long term average is about 18% in the top 10. It reached 26 during the dot com mania. Is it still prudent to use this fund as your main equity exposure?
My job is not to just buy stuff that I hope will go up. It is not to buy stuff that has gone up already in the hopes that it will continue to do so. It is not to buy the stuff that is most popular on Twitter. My job is to act as your agent, as your fiduciary and follow the prudent (wo)man rule that requires us to “to observe how men of prudence, discretion and intelligence manage their own affairs, not in regard to speculation, but in regard to the permanent disposition of their funds, considering the probable income, as well as the probable safety of the capital to be invested.” A lot has changed since the prudent man rule was first introduced in 1830. We can buy risky or speculative investments in the context of a diversified portfolio as long as the portfolio as a whole conforms to our understanding of the risk tolerance and capacity of the client. But what must a fiduciary do if an investment previously identified as prudent no longer fits the bill? The answer to that question is not simple but the short one is that that investment can no longer occupy the same percentage of the portfolio as previously. If the client’s risk tolerance hasn’t changed the investment must. And by the way, that has nothing to do with whether it rises another 10, 20 or 100% from here.
There are ways to invest these days while sticking to a prudent person mandate. But it is a dwindling list of investment that fit that bill and we are at such extremes now that I think a cash reserve (or very low duration bond portfolio) is a requirement. Yes, there is the risk that you may lose some purchasing power but that risk pales in comparison to the risks of owning the most popular stocks. Doing what is prudent is not easy and it is harder when meme stocks, ridiculous NFTs and joke cryptocurrencies are making some people rich or richer. It isn’t easy being the party pooper. But someone has to do it. The Fed sure isn’t interested in the job.
*Alhambra clients and employees own Panasonic stock.
The economic news last week was pretty uniformly good with retail sales, industrial production and the housing market index all better than expected. The Empire state and Philly Fed surveys were also quite a bit better than expected. Housing is still a weak link but the rising HMI and permits allows some optimism.
It’s Thanksgiving week so there are no economic releases on Thursday or Friday. All markets are closed Thursday and stocks trade a half day on Friday. The important reports next week are probably durable goods, non-defense capital goods, PCE and personal income and PCE inflation.
Stocks were generally lower last week and bonds were up a bit. Commodities took an even bigger hit as crude finally started coming back to earth. Foreign stocks did worse than US with the exception of Japan which was up 2/3 of a percent. Growth generally won on the week but only large growth finished the week in the green.
Energy got whacked with crude and financials are starting to feel the flattening of the yield curve. Technology, shocker, was up on the week.
There are a lot of market players out there today wondering who the sucker is, who’s gonna play the patsy. There are plenty who say it is those of us trying do the right thing, trying to actually analyze investments before we invest our hard earned dollars. I saw a tweet from some twit this week that said:
Fun Fact: Did you know there’s still some people that don’t know the entire market is driven by options and liquidity, and they still think fundamentals matter? Crazy, right?
The person who wrote that has no idea why we look at fundamentals. He thinks we look at fundamentals to judge whether an investment will rise or fall. That isn’t it at all. Fundamentals cannot tell us whether an investment will rise or fall because it isn’t fundamentals that move stocks or markets. It is perception, what people believe about a company or a stock that moves the price. Fundamentals can’t move markets because most people in the market – like this twit – don’t know what the fundamentals are. ROE? What’s that? But fundamentals do tell us about risk. Think of fundamentals as the odds posted on a football game or horse race or a game of chance. Now ask yourself, would you ever make a bet without knowing the odds? So who’s the sucker?
P.S. I started trading options in 1987. I know a thing or two.
Why You Should Give an Extra Big Holiday Tip to Your Dog Walker and Babysitter This Year
The service workers who make your life easier deserve a bigger tip this year.
It’s December, and that means it’s time to work through your holiday gift list. In addition to presents for family and friends, it’s time to show appreciation for everyone who helped you get through the year. We’re talking about holiday tips and gifts for babysitters, dog walkers, in-home caregivers, house cleaners, and perhaps even your hair stylist and manicurist, not to mention the mail carriers and sanitation workers that visit your neighborhood every day.
Between ongoing challenges caused by the pandemic and shortages and price hikes caused by a global supply chain crisis, 2021 has been an unusual year. Service employees worked on the front lines of the pandemic, often for lower pay than white-collar workers who had the ability to work remotely. That’s one argument for making room in your budget for an extra big tip this year.
And then there’s inflation. If workers didn’t get a raise of at least 5% this year, they’re probably falling behind because of how quickly prices are rising. That’s another good reason to give a generous tip this holiday season.
Here are some more specifics, if you still need convincing about why it’s important to be more generous this year — and some advice on how much to give.
Inflation is making everything more expensive
In other words, your money doesn’t stretch as far as it used to. So that $100 tip you gave your dog walker in 2020? At today’s rate of inflation, it’s only worth about $94 this year.
Rising prices, especially for gasoline, have hit the workers in the service industry harder than most. “As costs continue to rise, it’s definitely affecting childcare providers,” says Morgan Clark, founder of STL Sitter, which employs 425 babysitters in the St. Louis area. “Many of our sitters will work three or four different jobs per day.”
That’s a lot of driving between jobs, and with gas prices more than a dollar higher than they were this time last year, the costs can add up quickly.
Not to mention the fact that low-paid childcare workers are quitting their jobs in droves this year. “If you combine the issue of inflation with a staffing shortage, and then you add in a high demand for service,” Clark says, “you have a recipe for chaos.”
Service workers took on extra risks in 2021
As in 2020, workers in the service industry faced additional risks — and sometimes, additional hurdles — related to the coronavirus pandemic. UrbanSitter co-founder and CEO Lynn Perkins noted that many families asked their caregivers to avoid public transportation and carpooling during the pandemic. Not to mention the inherent risks involved with a public-facing job that doesn’t allow a worker to limit their interactions to a small circle of people.
“If they’re being asked to jump through additional hoops due to Covid, I think that’s another reason to give a little more this year,” Perkins says.
Jessica Abernathy, president of the National Association of Professional Pet Sitters and owner of two petsitting businesses in the Chicago area, pointed out that many pet caregivers looked after animals when their owners were hospitalized with COVID-19 this year. “We’re there for you, no matter what the circumstances are,” she says of petsitters.
Tips are going up, but rates are too
In a survey conducted by UrbanSitter, 42% of 500 parents polled said they are planning on tipping their babysitters more than $25 this year. That’s up from 25% of parents who said the same in 2018. Another survey conducted by CreditCards.com found that 45% of people plan to give bigger tips than usual this holiday season.
UrbanSitter also found that childcare rates on its platform have risen 10.5% over the last year. That means that for families that tip their nannies and babysitters based on an extra week or two’s worth of pay rather than a set amount, an inflation-adjusted tip is already baked in.
But that’s not the case for everyone. Real hourly wages in October were 1.2% lower than the year before, according to data from the Bureau of Labor Statistics. For most Americans, wage gains haven’t been enough to keep up with rising inflation. So if you haven’t begun paying your babysitter more already, now is a good time to start.
Cash isn’t the only way to say thank you
If you don’t have the extra room in your finances for a holiday tip, there are still ways to show your appreciation for the people who helped you get through 2021 through thoughtful words or personal tokens of your thanks.
“Homemade gifts from the kids can go a long way in showing appreciation,” says Sheri Reed, Managing Editor for Care.com. “Things like a scrapbook of quotes from the kids or a heartfelt drawing are always a great idea.”
There’s also the gift of time: UrbanSitter’s Perkins recalls one family that gave their nanny an afternoon off and the use of their car when she was scheduled to work, as a holiday surprise.
Or if your dog walker has a pet of their own, Wag! CEO Garrett Smallwood recommends making a homemade puzzle toy or another DIY pet gift.
Service workers can find other jobs
Regardless of how much you tip, or whether you can afford to tip at all, a tightening labor market means that showing you value the service providers in your life is extra important in 2021. Caretakers and service workers are in especially high demand, and record levels of Americans quitting their jobs translates to more openings and tight competition for workers.
STL Sitter’s Clark says that on her platform, some families are even offering bonuses above and beyond a sitter’s rates to secure services. “Retention should be something that’s in the back of your mind when you’re thinking about tipping,” Clark says.
“If you really like your care provider, this is not a bad year to give a little bit more just because people are starting to look around [for other jobs],” says UrbanSitter’s Perkins. “If this is someone who’s really meaningful to your family…show them a little additional love this year.”
More from Money:
Here We Go: Market Begins Pricing In Rate Cuts As Yield Curve Inverts
Here We Go: Market Begins Pricing In Rate Cuts As Yield Curve Inverts
With Powell effectively confirming an earlier end to the Fed’s taper…
Here We Go: Market Begins Pricing In Rate Cuts As Yield Curve Inverts
With Powell effectively confirming an earlier end to the Fed’s taper program this week, parts of the US yield curve inverted, and as the chart below shows, forwards traders are starting to price in rate cuts in a few years suggesting the Fed will not only end its tightening campaign prematurely, but will be forced to cut relatively soon.
And, we would add, the more stocks drop, the greater the priced in future rate cut will be. In fact, with the forward swaps curve now pricing in more than 10bps of cuts, we are now where we were in late 2018, just weeks before stocks tumbled 20% and Powell capitulated, sparking a massive rally as the Fed’s last brief tightening cycle came to an abrupt close.
In inverting, the US curve joined the UK, Europe and especially many Emerging Markets where yield curves have already inverted aggressively.
Commenting on this inversion, DB’s chief FX strategist George Saravelos argues that the omicron variant – irrespective of the precise immunological properties – would just help reinforce existing trends, not change them. It is a fallacy that the market has been “looking through” COVID.
What does he mean by this? In his own words: “weak US labor supply, strong inflationary pressure in the goods sector, high excess saving, very low terminal rate pricing, a stronger dollar and very negative real rates are all because of persistent COVID forces this year not despite of them. It’s the new “COVID normal”, very different from the “old”. Is the market right to price such late-cycle dynamics?”
His conclusion: “If the whole point of the Fed turning hawkish is to slow the economy down and take the unemployment rate back above the “new” NAIRU, the answer is yes.”
The only problem: Powell is also taking down the entire market down with him, and today risk assets made it clear that they will not go down without a fight, and will push back until Powell capitulates on his rate hiking plans.
High flying growth companies will badly damage new shareholders
The problem with having a huge amount of anticipated growth baked into your stock price is that the expectations become incredibly difficult to achieve….
The problem with having a huge amount of anticipated growth baked into your stock price is that the expectations become incredibly difficult to achieve.
High expectations result in high stock prices.
I’ll post the charts of two of these companies which are household names – Zoom (Nasdaq: ZM) and Docusign (Nasdaq: DOCU):
We will look at Zoom first.
At its peak of $450/share, Zoom was valued at around $134 billion. Keeping the math incredibly simple, in order to flat-line at a terminal P/E of 15 (this appears to be the median P/E ratio of the S&P 500 at the moment), Zoom needs to make $9 billion a year in net income, or about $30/share.
After Covid-mania, Zoom’s income trajectory did very well:
However, the last quarter made it pretty evident that their growth trajectory has flat-lined. Annualized, they are at $3.55/share, quite a distance away from the $30/share required!
Even at a market price of $180/share today, they are sitting at an anticipated expectation of $12/share at sometime in the future.
Despite the fact that Zoom offers a quality software product (any subscribers to “Late Night Finance” will have Zoom to thank for this), there are natural competitive limitations (such as the fact that Microsoft, Google and the others are going to slowly suck away any notion of margins out of their software product) which will prevent them from getting there.
The point here – even though the stock has gone down 60% from peak-to-trough, there’s still plenty to go, at least on my books. They are still expensive and bake in a lot of anticipated growth which they will be lucky to achieve – let alone eclipse.
The second example was Docusign. Their great feature was to enable digital signing of documents for real estate agents, lawyers, etc., and fared very well during Covid-19. It’s an excellent product and intuitive.
They peaked out at $315/share recently, or a US$62 billion valuation. Using the P/E 15 metric, the anticipated terminal earnings is about $21/share.
The issue here is two-fold.
One is that there is a natural ceiling to how much you can charge for this service. Competing software solutions (e.g. “Just sign this Adobe secure PDF and email it back”) and old fashioned solutions (come to my office to scribble some ink on a piece of paper) are natural barriers to significant price increases.
Two is that the existing company doesn’t make that much money:
Now that they are reporting some earnings, investors at this moment suddenly realized “Hey! It’s a long way to get to $21!” and are bailing out.
Now they are trading down to US$27 billion, but this is still very high.
There are all sorts of $10 billion+ market capitalization companies which have featured in this manner (e.g. Peleton, Zillow, Panantir, etc.) which the new investors (virtually anybody buying stock in 2021) are getting taken out and shot.
This is not to say the underlying companies are not any good – indeed, for example, Zoom offers a great product. There are many other instances of this, and I just look at other corporations that I give money to. Costco, for example – they trade at 2023 anticipated earnings of 40 times. Massively expensive, I would never buy their stock, but they have proven to be the most reliable retailer especially during these crazy Covid-19 times.
As the US Fed and the Bank of Canada try to pull back on what is obviously having huge negative economic consequences (QE has finally reached some sort of ceiling before really bad stuff happens), growth anticipation is going to get further scaled back.
As long as the monetary policy winds are turning into headwinds (instead of the huge tailwinds we have been receiving since March 2020), going forward, positive returns are going to be generated by the companies that can actually generate them, as opposed to those that give promises of them. The party times of speculative excess, while they will continue to exist in pockets here and there, are slowly coming to a close.
The super premium companies (e.g. Apple and Microsoft) will continue to give bond-like returns, simply because they are franchise companies that are entrenched and continue to remain dominant and no reason exists why they will not continue to be that way in the immediate future. Apple equity trades at a FY 2023 (09/2023) estimate of 3.8% earnings yield, and Microsoft is slightly richer at 3.2%. Just like how the capital value of long-term bonds trade wildly with changes of yield, if Apple and Microsoft investors suddenly decide that 4.8% and 4.2% are more appropriate risk premiums (an entirely plausible scenario for a whole variety of foreseeable reasons), your investment will be taking a 20% and 25% hit, respectively (rounding to the nearest 5% here).
That’s not a margin of error that I would want to take, but consider for a moment that there are hundreds of billions of dollars of passive capital that are tracking these very expensive equities. You are likely to receive better returns elsewhere.
Take a careful look at your portfolios – if you see anything trading at a very high anticipated price to cash flow expectation, you may wish to consider your overall risk and position accordingly. Companies warranting premium valuations not only need to justify it, but they need to be delivering on the growth trajectory baked into their valuations – just to retain the existing equity value.
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