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A little more long

Last week I wrote about how my portfolio was positioned “nominally net long” but “in terms of my portfolio’s response to market moves, a little net short”. I also wrote that I thought “that a change was coming” where the bear market would end soon.

Since that time the market has gone down (it was about 3,800 then, is a little over 3,600 now) and my portfolio has not done much of anything. But my thinking has changed a little. I’m not so sure about the change, ie. not so sure that this bear market is going to end soon. But I’m not sure we have to go straight down just yet. And in the mean time, I think some stocks could go up while others go down.

This week, with a few fits and starts (I never seem to know what it is I want to do until I do a few things and realize that those are not it) I cautiously moved my positioning to being a little more net long, which I think should mean that I am actually net-net long in terms of my portfolios response to market moves. I did this even as I feel like the medium term picture is probably more bearish for the economy.

The moves I made were to take off about 20% of my index short on the S&P (the HIU), close my short on the Nasdaq, add to my position in Google, add back my position in Bank of America, add a new position in Constellation Software, add a new but so far small position in TLT, and go back to a gold names with Newmont and Barrick Gold. I also added a position in VIXY.

None of this is going to cause wild gyrations in my portfolio. If the market goes up 5%, I expect my portfolio will go up 1-2%. And (hopefully at worst) vice-versa. But I think I am more likely to participate in upside now, whereas a few weeks ago I dreaded the big up days as much (or more) than the big down days.

Ok, so why did I do what I do?

Well, I have read and listened to a lot of bearish stuff the last couple days. There are a lot of bears out there and they make a lot of good points. There is a lot to be bearish about.

If you want to hear a really bearish take, listen to this spaces, with Michael Taylor. I like listening to Michael Taylor. He is a very smart guy and well connected to the hedge fund business. As he says himself, Taylor talks primarily with 50 major hedge fund managers.

Taylor is extremely bearish, especially on the British Pound (which he says is going to blow up) but also on the stock market. Stocks aren’t seeing what bonds are seeing, he says, and if they were they would go down. I imagine most of the fund managers he talks to think the same thing.

Taylor thinks that we are going to see big redemptions from hedge funds (other hedge funds), especially around year end. He thinks the economy is going to crash (he says there is a 100% chance of this) and it is going to happen now. He thinks high yields are going to blow out, while US Treasuries are going to reverse and fly higher. It is quite dire.

Most importantly, he outlined how the carry trade is blowing up many funds. And how that has become a big headwind for the market.

As Taylor explains, it is the unwind of carry that led to the collapse of the British Pound and the eventual rescue of the UK bond market by their central bank. Taylor linked this FT article that describes the bets that went sideways for pension funds and appear to have nearly led to a collapse of these funds. This FT article, written in July, describes how pension funds have been forced to put on large carry trade bets to match their liabilities, which get larger as rates fall.

I’ve written about the carry-trade a couple of times before but not for a couple of years because when things are going well it doesn’t really matter. Knowing that it is being unwound makes me pause. Because something could blow up and this week it sounds like it almost did.

For this reason alone (and its not the only reason) I would not want to get too long of stocks right now. Taylor believes that some sort of big whooshy crash is inevitable. I’m not nearly so sure. But if there is a small probability of a whooshy crash, I want to be prepared.

For me, that is where the VIXY comes in. If something systemic is truly about to happen, the VIXY should go up a lot. Consider that it usually comes close to a double when something fairly bad happens. When something really bad happens (like COVID), it can go much higher. The trick is to buy it close to when you think a risk is there for something very bad but not so close that the bad is already priced in. When I bought it (on Monday), it wasn’t really pricing in very much risk being just a couple of points off the lows. It still isn’t.

I know any VIX ETF is a terrible instrument to hold for any length of time (see the awful chart below). But that is because it is the inverse of a carry trade, its purpose is to have sudden bursts of out-performance during times of volatility while carry-trades implode. Carry trades are essentially “short vol” trades. If they are being unwound, then the VIXY seems worth it to me as a part of my hedging routine right now. It won’t collapse overnight but it may spike overnight and if it does my hope is, in addition to my other hedges, it will put me well positioned to deal with ensuing chaos.

So that is the VIXY. What about the longs? Well Taylor’s very bearish conclusion is that the market (I’m can’t be sure if he means the GBP, the stock market or both but I think he means both) is going to go down hard. Though he had covered his entire short position after the BOE pivot, after listening to his own talk, Taylor went max short again and made big money again today (though fortunately not the GBP, which was up big today).

I am not so nimble, so I will not being going max short or long of anything at any point. Instead I will just try to eek out a few gains in both up and down markets.

This is clearly been a down market. Yet (apart from my VIXY crash protection) I’m moving my position to being more bullish. Why?

Funnily enough, it is because of what Taylor says.

Taylor is very long US Treasuries. He says on a few occasions he is long $100 million of 10-year treasuries! I am not long $100 million of 10 year treasuries. But I took a small position in TLT.

I have been scratching my head the last couple weeks about why the bond market keeps falling, ie. rates keep going up. How can this be happening when just about anyone can see that things are slowing, maybe dramatically.

Taylor explained this conundrum. Its the carry-trade! The unwind of the carry-trades in the UK has been causing funds to liquidate UK bonds. I can only presume that the same thing is happening in North America and elsewhere. Bonds that were either on the other side of the trade or being used as collateral for the other side are being sold, and it has nothing to do with rate expectations.

If this is why bonds are falling, it will end. So I followed Taylor, who has been long treasuries for at least a little while, and took my own position in the TLT, which has done very badly this year.

Taylor thinks that the market is going to tank and that government bonds are going to become the “only-one-to-own risk-free asset” again. On this point, I am kind of in agreement, but only up to a point with that point being treasuries and not tank. The market has gone down quite far, quite fast over the last month, sentiment is very bad, and it doesn’t seem to me or the transcripts I read that the US economy is doing all that badly just yet. So I’m not sure I’m onboard with the whole tank side, at least for now.

Absent a systemic catalyst that is. Which could happen. And I can’t predict it. So I’ll keep tight with the hedges and VIXY for the moment.

In my post last week I basically said I was out of the small-cap stuff and in with boring larger cap names like Verizon, Vertex, Google and Pfizer. But I wasn’t entirely sure why.

I think I know now. I think that if Taylor is right and longer term interest rates are going to peak and begin to fall, big cap names are going to outperform.

Rates will be falling because the economy is weakening. But there won’t be an expectation that the Fed will come to the rescue and save everyone. All those crappy, money losing stocks that, as Taylor says, “need the HYG” (the one’s I tend to be short) are going to have trouble. But falling rates are going will provide some positives for more established stocks, both because they mean we aren’t going into an inflationary spiral, that there will be a chance of a soft(er) landing, that bonds aren’t in competition to dividends (ala Verizon or Pfizer) and that lower discount rates translate into higher multiples.

Meanwhile a stock like Bank of America has a PE of 9.5x. Pfizer has a PE of 6.8x. Google has a PE of 17x. Constellation is more expensive, at 23x next years earnings, but it has a 5% FCF yield and grows at ~20%.

I understand that if things deteriorate enough, all of these P’s and E’s can go down more. But if rates are coming down, it will be a signal that an end of tightening is in sight (it worked!), and so just how far should the PEs of the best companies be compressed?

That same argument is why I decided to take down my S&P index short (which is weighted towards the big cap names) and not my Russell or single name shorts. Again, “short the companies that need the HYG”.

I want to keep my exposure to being short crappy stuff but get a little long the not-so-crappy stuff.

Meanwhile, there is SO MUCH negativity out there. While I am not the sort to take sentiment indicators all that seriously, sentiment certainly seems overtly bad right now. It makes me more nervous about my shorts being too large than my longs. I can imagine a scenario where something, anything, good happens, the Canadian dollar rips off of extremely oversold lows, the market rips off of its extremely oversold low, and I am left getting smacked by a big up day.

My feeling is that a big up day is the bigger risk right now than a big down day. And with a big down day I always have that VIXY backstop. Besides we’ve had a month of big down days. The Nasdaq is down ~20% from where it was mid-August. Bonds have been in a straight line down. Non-USD currencies have been in a straight-line down. After such extreme moves it is usually not prudent to press while it is usually prudent to rebalance. So that’s what I am doing.

Dear Diary

I came up with this title because my daughter is sick and I’ve spent the morning reading her a Dear Canada book about the Second World War. Reminds you things could be much worse!

Right now, things could be much worse. In fact, my problem is that things are not quite bad enough but they aren’t near good enough either.

I’m really torn about what I should be doing right now. While I can see that things are bad I can also see how they are not so bad, or that they could quite easily get better. But before they do they might get suddenly worse.

I went into the weekend a little more long than I usually am. This was mostly because I had taken a few positions in the large money center banks, Bank of America and Citigroup.

Why did I buy these banks? Well it was partly what I wrote about last week, about how they should have some good earnings with increased net interest margin and maybe even be able to take share from the regional banks struggling with their security portfolios.

But it was also partly because I had spent a bunch of time reading through transcripts of bank executives at the recent Barclays and Bank of America banking conferences.

I read through what the big banks said, so BAC, C, JPM, etc. And I read through what a number of regional banks like Regions, First Third, Comerica, MTB and a few others had to say. Most of these banks, in fact almost all, were really quite positive. They aren’t seeing the slowdown yet. They aren’t seeing consumers pull back much. They aren’t seeing reduced loan demand (other than in obvious places like finance) and aren’t seeing increased distressed credits.

This put the idea in my head that maybe the slowdown in Europe and China might be enough to slow inflation and put the Fed at ease, without having to slow the economy too much in the US.

So it made sense to take a position in a few banks.

That still makes sense to me. But over a longer time horizon, one measured in months.

For today, I sold the bank stocks I bought a few days ago. It was very frustrating because A. I had to take a small loss and B. I really feel like the market should be close to a bottom soon.

But I still did it. What spooked me are the moves in a number of currencies that happened Sunday night and Monday morning. The pound. The yen. The Canadian dollar.

It is not that these moves give me something specific to worry about. I am not really sure what I should be worrying about. And that is kind of the point. I don’t know what is going on that would cause such huge moves in big currencies that typically don’t move much at all.

All I know is that when the moves are big in big, liquid markets I have to wait it out just in case. This is especially the case with banks, where risk-off situations can manifest themselves pretty fast.

I am aware I might regret it. The other side of it is that big moves like we are seeing usually mean a turn is near.

But usually those turns come because of a pivot or perceived pivot by central banks. And this time, I’m not so sure how that will manifest.

For 14 years it has been a fools game to assume that each panic does not mark a bottom for the next move up. Today was the first day it felt a little panicky. Every other time it started to feel like this, the bottom was close at hand and so today not a time to sell.

But without the Fed or ECB or whatever other central bank ready to backtrack, could this be the time that doesn’t happen?

I just don’t know. Like I said I’m torn. Because part of me thinks we are really, really close to a bottom and there are big bargains out there in stocks. And the other part of me thinks this time conditions are such that it could actually be different.

That puts me square in no mans land. One where I can’t own the banks I really want to own. And also one where I probably miss the turn and kick myself a month or two from now because the market moved and my portfolio did not.

Small Cap Hiatus

I haven’t written for a while. Summer is a hard time to find time.

This summer, that was compounded by a lack of things to write about. We rallied, the rally failed, we rallied, the rally failed again. I bought a couple stocks. I sold a couple stocks. I held nothing with a particular conviction that would compel me to write about it. My portfolio did nothing, which means, as it importantly implies, it did not go down.

The last time I wrote (mid-July) I was talking about going back to my default position. Putting back on hedges, putting back on shorts and trying to squeak out a few gains while not taking any big chances. That is pretty much what I did and pretty much where I am now.

While I remain nominally net long I am, in terms of my portfolio’s response to market moves, a little net short. Witness that on big up days during the summer I lost money (this is also due to my “natural short” of being long US stocks with a Canadian dollar account, otherwise known as my “edge”). On down days, I made a bit. Overall I am very slightly better off than where I started the summer.

The reason my portfolio acts as if it is net short is because I don’t own much in the way of small cap stocks. Yet the stocks I am short are the somewhat shitty one’s that tend to go down a lot when the market goes down (though vice versa as well).

The moves in the portfolio overall are small and the exposures are as well. That’s okay. The time will come again to take a large line. That time does not feel quite here. While many portfolios are down big double digit percentages from highs set in 2021, I am not and that is good enough for me.

I do feel like change is coming. This bear market is getting long in the tooth. Yes, there are plenty of things to worry about, but there are always plenty of things to worry about.

My approach this time around may be different. I am not looking to place bets on small-cap shooting stars.

Quite the opposite. My portfolio today (which I know I haven’t updated in a while, I will do that in the next couple days) is full of very large businesses and, for the most part, somewhat boring businesses.

My largest positions today are in stocks like Vertex Pharmaceuticals, Dole Foods, Hewlett Packard Enterprise, Verizon Communications, Meta Platforms and Alphabet.

Why the shift? Right now many very large companies trade at valuations that seem pretty reasonable to me.

In addition to these large cap names, I’ve bought some bank stocks. This is maybe crazy if we are indeed on the cusp of a recession. But I’m also short the Canadian banks, and short some other parts of the market that I believe will go down more, so I’m trying to cover my downside here.

My reasoning on a bank stock long is that if this recession is not deep, the banks have a lot going for them. What I heard on the Q2 earnings calls were banks talking excitedly (for a bank that is) about their net interest margin expansion. They were passing the floors on their variable rate loans, meaning they could hike rates on loans in concert with Fed hikes, and yet the deposit betas (meaning how much they had to raise deposit rates for their customers) was coming in muted.

Banks remain very cheap on trailing earnings that don’t reflect this expanding margin. The banks I am buying are generally below 10x PE.

But you have to be careful about what you buy right now. While the rise in interest rates has been good for income, there are some banks that have seen their book value slashed by paper losses on the securities they hold.

I am seeing some banks taking huge mark-to-market losses on treasuries and mortgage backed securities. These securities are going down as rates go up.

I’m not really sure what to make of these losses, because they are just paper losses, but they are also real in so far as they impact the banks tangible book calculation and therefore the capital ratios. Which means they will also impact the banks ability to grow.

These losses, which are called “other comprehensive income” (OCI) losses, don’t show up on the income statement. They feed through on that next page, called “Comprehensive Income”. I have noticed that most of the banks with the biggest OCI hits have kind of glossed over it like it doesn’t exist.

But they do exist and OCI losses are very big for some banks. Take Keycorp for example. I bought them and owned them for a few days until I figured out what was going on with their comprehensive income. Once I did I sold. Because Keycorp took an OCI hit of 37% of their tangible book in the first half of the year. That’s huge! They aren’t the only one – Fifth Third Bancorp, another bank I was looking seriously at until I ran into this OCI issue with them, took a hit of 31% of TBV.

Again, I don’t know what to make of these OCI hits. Do they matter? I’m not sure. They certainly make the bank look more expensive on a book value basis. Post the OCI hit, the bank is closer to running into regulatory trouble if something goes wrong with its loan book. OCI hits don’t impact earnings, though as I said they might impact the ability to grow earnings in the future.

Just to be safe, I’ve stayed away from banks with big securities portfolios that are taking big OCI hits. Funnily, its either the very small banks or very large banks that aren’t having to do that. The small banks don’t own a lot of securities. the largest one’s (like C, BAC or JPM) seem to be better at hedging their exposure.

The other big question is whether the banks will get creamed on loan losses brought on by a recession. A lot of that will depend on how bad the recession is. It will also depend on the nuances of each bank – where they made the loans, who they made them to, and what are the loan-to-values. So again, you just have to be careful.

The thing is, banks went through a pretty strict rationalization of their loan book with Covid. We are barely two years past that. It is not like there are years of excess baked in.

While I could get smacked on real credit driven downturn (I mean if credit goes south no bank is immune), if this is a mild-ish recession, I think bank stocks are going to do okay and maybe even well.

I have also done something that I never thought possible. I made the move into a few SaaS and tech names. I own Datadog, and Zoom. Pigs fly.

These stocks aren’t really “cheap”. But they are a lot cheaper than they have ever been since I’ve followed them. Take Datadog. I have followed it for a few years now. I make this little discounted cash flow model for it that I update every quarter or two. The details of that model aren’t super important, but what is important is that I always use the same assumptions.

Using the same assumptions means that I can track how Datadog is valued against my own crude valuation over time and get a sense of when it seems quite reasonable.

At $90 Datadog trades at a 20% discount to this fair value. It hasn’t traded at that level before (other than in June when it was $90). I read through the Q2 call, I read through their talk at the Goldman conference. The business still is what it is.

The thing about Datadog is that yes, its growing very fast, but it is also a free cash generating business. Their FCF margin was 18% in 2021. It probably goes about 20% this year. They are doing this while growing 60-70%. Yeah it looks expensive on a PE. But on a DCF basis with even conservative assumptions, it doesn’t.

So that’s Datadog. You can kind of make similar comments about, though they are maybe 2 years earlier on in the process and the free cash flow barrier hasn’t been cracked just yet.

Zoom is a different beast. They aren’t growing right now. They grew too much during Covid and now they have stopped. The stock is being whacked because they aren’t growing and because Teams is free.

That’s fine and it seems well-founded. My thoughts with Zoom are that A. It is hated and yet seems to be bottoming, B. It is not all that expensive at 11x EBITDA and a 5% FCF yield, C. It may start growing again some day and most importantly D. Zoom is on everybody’s desktop, everyone’s smartphone and I don’t think the value of that is priced into the stock.

But Zoom gives me the most pause. They could pull out an awful Q3 and I get stopped out of the stock.

You have to remember that my style is not to do a conviction-building deep dive into Zoom (or any other name) that most likely turns out to be wrong anyway and just keeps me from selling the stock when I should be. It works better for me to come up with a cautious, heavily caveat-ed, thesis, that has some merit and if the stock acts right I’ll assume I might be onto something.

I sold my oil stocks. I sold a lot of the gold stocks. I only own a small position in Newmont and Alamos Gold. I have been buying a couple copper stocks – Hudbay Mining and Taseko. These miners have been whacked pretty bad, they discount $3.50 copper at the current price and the longer term outlook for copper looks quite good to me. I’ve read a number of analyst reports that make the case that we don’t have enough copper for the renewables transition and that we will (eventually) need higher copper prices to get those projects built.

I also have sold almost all my biotechs. I moved up the food chain with the purchase of Vertex. Though I still own Eiger. I did sell a some of my Eiger in my less risk tolerant accounts (RRSPs) but I kept it in my own account, where I was okay having a bit more risk and also able to have more hedges via shorts (like an XBI short for example).

Eiger as a Covid play seems less likely to pan out than a few months ago. But Eiger’s stock has been surprisingly strong. The HDV results will be coming up in a month or two, which will make or break the stock. CEO David Cory also hinted at the Baird conference that they might have other countries interested.

So that is the kind of catch-up, catch-all summary. I’ll try to write something more specific about a name or two in the next few weeks.