Pull it Forward

Earlier this month I was asked a very interesting question; “what’s the point of credit?”  Seems innocent enough, but so does explaining to children where it is babies come from.  As I set out to explain my take on what the point of credit is, I decided instead of boring her with the intricacies of what and why credit is what it is, I would try to keep it simple.  So I told her credit exists so people can purchase things they can’t afford at the moment.  She responded with something along the lines of, “that seems kinda dumb,” in reference to purchasing things you can’t afford.  God bless her heart, she must not be from around here!  Actually she’s Canadian, which may explain something.

I would certainly have to agree that buying things you can’t afford is kinda dumb.  That is unless those purchases will allow you to improve your productive capacity and therefore income by a large enough amount to offset the interest incurred with the debt.  So really there’s “dumb” debt and “smart” debt.  Dumb debt would be about anything that doesn’t improve your ability to earn an income going forward.  The dumbest debt is the kind that depreciates to nothing and provides no income, like a new flat screen TV bought on a credit card.  With that said, regardless of whether it’s the “smart” or “dumb” variety, debt is simply borrowing from your future self to purchase something now.  Said another way, when you take on debt you are pulling forward future earnings to own something in the present.  Pulling forward future earnings, where have we seen that before? 

Well if you look around it’s all the rage!  What’s your flavor?  In the consumer sector the largest segment of new auto loans have terms between 73-84 months.  Some folks are even going as far out as 97 months according to the Wall Street Journal.  I can’t begin to address the litany of problems associated with paying 8+ years of interest on a depreciating asset.  Where in fact do the manufacturers think the new buyers are going to come from when nearly 20% of the current buyers will have car loans for the next 7 years?  Trade-In’s perhaps? Not likely since I’d bet the majority of these folks will be underwater on their loans for at least the first 5 years.  Perhaps it’s the financing arms from which these manufacturers are hoping to bridge the gap of lost sales?  All things considered, I probably wouldn’t invest long-term in any auto company.

Speaking of investing and autos the trajectory of Tesla’s stock is something to behold.  I do think they’re a great company led by a brilliant innovator, but I still wouldn’t touch their stock at this level even though they make a wonderful product.  Which leads me to another point, making a wonderful product seems to be a novel idea of late, not that investors seem to mind.   By product I mean something tangible that you can actually touch and feel.

A friend of mine asked whether the best we can do as a country is come up with new and improved packages for advertising; i.e. mobile.  I truly don’t think that’s all the US has to offer, but don’t tell the investing world that.  Facebook just spent a mind-boggling $19,000,000,000 to acquire glorified text messaging service WhatsApp.  Courtesy of the reformed broker1 that’s equivalent to:

  • 1/3 Ford’s Market Cap
  • Greater than Sony’s Market Cap
  • 1/3 of HP’s Market Cap
  • And 76,000 Trips to space on Virgin Galactic

 

All of that for a company with 55 employees, that produces and makes NOTHING.  That comes to well over $350,000,000 per employee.  Instead of advertising they charge a small fee of $1 after one year of service.  Here’s a quote directly from their blog, I apologize for the language:

“Why we don’t sell ads

Advertising has us chasing cars and clothes, working jobs we hate so we can buy shit we don’t need.
– Tyler Durden, Fight Club

Brian and I spent a combined 20 years at Yahoo!, working hard to keep the site working. And yes, working hard to sell ads, because that’s what Yahoo! did. It gathered data and it served pages and it sold ads.”

Source:  http://blog.whatsapp.com/index.php/2012/06/why-we-dont-sell-ads/

Again, great ideals and I can’t argue with a company that stands for something.  However, here’s the problem; how does Facebook justify purchasing a company for $19,000,000,000 that charges $1 per user and promises they will not advertise?  Obviously they can’t, because they’re not worth nor will they ever be worth that much, unless they compromise their values.  Ostensibly, Facebook just paid $19,000,000,000 for 450,000,000 users.  Which leads me to my next point; in the current investing environment it seems users are more valuable than factories, employee’s, ideas, you name it.

 

I remember about 15 years ago when page views were more valuable than companies that made real things too, we all know how that ended.  What’s more striking about this acquisition is that it’s likely these are not even UNIQUE users.  I haven’t seen any data, but I would be highly surprised if more than 5% of these users are not already Facebook users and I would say there’s an almost zero percent chance of more than 25% being unique.  Even if the users were unique, anyone with common sense realizes that users are not really more valuable than factories, skilled employees, raw materials, etc.  That’s why I find this value to be phony to anyone who holds on long enough.

 

As most of you know, DCM does not invest in individual stocks at this point, so it may seem odd to spend so much of this commentary on individual names.  Indeed it is a bit out of character.  However, I chose this acquisition to demonstrate a real-time example of what I believe is the Market transcending from a place where it borrows from its very distant future earnings, to a place where it’s simply reaching for imaginary future earnings.

 

In poker they call patterns or repeatable behavior that may give a glimpse into another player’s hand, a Tell.  I think the dislocations we’re seeing between real tangible value and hopeful value may just be the Market’s Tell. The good news is that nobody has to invest in Facebook or the Stock Market for that matter.  Also on a positive note, Private Equity is on fire, along with real estate and there’s been advances in Biotechnology that have been nothing short of remarkable.  Indeed much good has come of the easy money provided by the Fed.  I must reiterate however, that the key with these and all investments is that at some point you must cash out.

 

I suppose the question is whether or not now’s the time to cash out?  As most of you know I’m a believer in Positively Reinforced Cycles.  Meaning that rewarding behavior, be it good or bad tends to reinforce that behavior until some sort of outside force corrects it.  Consider that in the first week of March, there were 741 US stocks at 52 week highs compared to 35 at 52 week lows2.  Combine that with the fact that the Dow and S&P are bumping up against All-Time highs and it’s a recipe for more buying.

 

Compounding my belief that higher prices beget higher prices is something profound that was brought up to me recently; at all-time highs, nobody is losing money, nobody!  Except perhaps the foolish or hopeful shorts.  Based on this concept, I implore someone to explain to my why the investing world would cash out now?  I don’t think they will, until one or a combination of things occurs.  First, we need to see more WhatsApp type purchases for insane prices accompanied with general euphoria.  You can typically spot euphoria without following acquisition stories or IPO’s, by simply identifying when broad index charts begin to look parabolic.

Second relates to corporate profits.  For this discussion I will defer to “How to Invest When Both Stocks and Bonds Are Overpriced” featured in Casey Research by Mark Whitmore, of Whitmore Capital Management.  I had the pleasure of attending a presentation in which he was the featured speaker.  Mark runs a currency fund with a refreshing, long-term outlook.  I find his views insightful and although our methods are quite different, we share sympathetic views on many fundamental issues.

“Presently, corporate profits after tax (CPATAX) as a percentage of GDP are just over 10%. The previous post-WWII high in CPATAX? Just 8.5%, which interestingly occurred in 2007, right before the last bubble burst. The historic norm for CPATAX is only 6%.

This is a huge issue, as Jeremy Grantham of GMO notes:

“Profit margins are probably the most mean-reverting series in finance, and if profit margins do not mean-revert, then something has gone badly wrong with capitalism. If high profits do not attract competition, there is something wrong with the system and it is not functioning properly.”

 

If you look at a chart of subsequent four-year annual profit growth following peaks in CPATAX, you’ll find that in every instance, it declined between 10% and 20%. If you adjust expected corporate earnings downward to reflect this likely reversion to the mean, the “forward” P/E will be 25 to 30. Which would be a very expensive market indeed, and would suggest subpar returns for the S&P 500 for the next many years, through at least 2020.”

 

This is a topic almost nobody is talking about.  Turn on the business channel and any number of so-called experts will tell you that although some pockets of the Market are overvalued, the Market as whole is attractively priced.  For Mark’s full commentary you can access the story directly at http://www.whitmorecapitalmanagement.com/LettersAndArticles.aspx .  

 

I think it’s possible a sharp break in corporate profits could cause the market to put in a high.  However, I’d bet more likely, that the Market will break out to new irrational levels first.  Such unsustainable prices should induce some profit taking.  Which naturally will invite buyers back into the Market.  After all, every dip has been a buying opportunity for the past five plus years.  Perhaps not long after, we will see the CPATAX, begin to revert back to the mean.  If this occurs, I suspect it will be a bit of a Wiley Coyote moment for the Markets.  With Equities at record highs, based on unsustainable record earnings and investors using record leverage and phony pipe dreams, I do believe risk has begun to outweigh reward.  As I’ve mentioned many times before, leverage incites panic when the music stops playing.

 

So how to invest?  Obviously, our outlook is much more cautious on equity exposure going forward.  If you recall from recent commentaries, we suggested tapering down and then reloading on the retracement which was provided in Jan/Feb.  Now, the Market once again looks poised to burst to new all-time highs.  We suggest you become extremely nimble and strongly consider reducing exposure or hedging in some fashion.  Short Calls well above recent highs and/or ultra-cheap bear put spreads have been our hedge of choice.

Our fixed-income holdings include short to medium-term Cash US Treasuries overlaid with short futures contracts for price discovery.  In essence we are trying to exploit price inefficiencies from the short-side while simultaneously collecting our coupon interest.  This method has worked well for us with the weakness in US Treasuries.

Exposure to physical assets is warranted as well, particularly if they produce an income, like rental property.  Do not forget about the Fed.  Bent on keeping interest rates low, they have all but dropped the employment portion of their mandate in order to focus on reflation.  To be honest, playing this situation seems like a coin-flip.  If global deleveraging grabs hold amidst a rise in PCE and CPI, what will the Fed then do?  Or perhaps the questionable quantitative measures of inflation continue to keep the Fed quite dovish and ostensibly rates quite low.  Only time will tell.

  • Hedge or reduce equity exposure on any sort of burst higher
  • Fixed income in the duration of 3-5 years appears to be the sweet spot for yield, particularly if you can hedge yourself in the futures or other derivative.  Avoid anything longer than 5 years
  • Although the Fed is pulling back they are still present, keep that in mind
  • Have exposure to physical assets (particularly those with deep-retracements or that produce income)

 

One pesky little detail about pulling forward earnings from the future; it means you will actually have to decrease spending in the future to pay for those things you bought in the past.  Clearly there is much more to the credit story than what we have covered here, but that will have to wait for our next commentary.  For now I will leave you with something I haven’t quite wrapped my head around:

 

On some level WhatsApp’s founders clearly look up to Tyler Durden, the iconic protagonist character of one the most revered anti-consumerist films of our time.  I wonder if this company even wants to be worth $19,000,000,000?  How can they? For those not familiar with the film, I have included the full Fight Club quote that was clipped and featured on WhatsApp’s blog at the bottom of the page.

 

Best Regards,

 

 

Duane Cronin

President

 

 

“Man, I see in Fight Club the strongest and smartest men who’ve ever lived. I see all this potential, and I see it squandered. God damn it, an entire generation pumping gas, waiting tables – slaves with white collars. Advertising has us chasing cars and clothes, working jobs we hate so we can buy shit we don’t need. We’re the middle children of history, man. No purpose or place. We have no Great War. No Great Depression. Our great war is a spiritual war. Our great depression is our lives. We’ve all been raised on television to believe that one day we’d all be millionaires, and movie gods, and rock stars, but we won’t. And we’re slowly learning that fact. And we’re very, very pissed off.”