February 20, 2021

 

February's equity rally cooled off a bit with the S&P 500 shedding 0.7% this week. The index remains up 5.3% month-to-date though, and energy and bank shares extended their best monthly gains since November. Interest rates jumped as bonds sold off, which we discuss more below.  
 
The breakneck rally in copper shows no sign of abating. The precious metal climbed 4.2% in London on Friday to its highest level since 2011, as the world’s foremost consumer—China—returns from the Lunar New Year holiday. The Texas blackout also played a role, underscoring the fragility of power grids around the world, which are already facing more demand from the rise of electric vehicles. Copper is used in power plants and electric cars. 
 
Following a sluggish holiday shopping season, the U.S. consumer surged back to life in January. Consumer spending at stores, online, and at restaurants (food services) jumped 5.3% from December, which places overall spending back at pre-pandemic highs.
 
We’ve written in the past about the amount of cash consumers are sitting on, and the same goes for Corporate America. Led by Technology and Industrials, Bloomberg estimates S&P 500 companies ended 2020 with around $2.6 trillion in cash reserves, the highest since 2013. There’s good reason to believe some of this cash buildup will be returned to shareholders in the form of dividends, buybacks, or both.
 
The deep freeze in Texas exposed severe energy infrastructure issues, as the flow of natural gas was stifled by freezing pipelines. In my days as an equity analyst covering Utilities, I learned it’s impossible to store electric power, which is also problematic for energy sources like solar and wind. No matter what, more utility grid investment is absolutely necessary going forward. More investment should benefit a host of industrials doing construction and engineering work, several of which Silverlight owns and commented on last week (i.e., Hubbell and Emerson Electric).
 
Power has returned to most of Texas, but the situation remains dire for many. For those who want to help Texans in need, there are several ways to do so.

Ways to donate.

 

 

Bond Yields Are Breaking Out

 

 

The copper-gold ratio, which has an uncanny ability to predict 10-year Treasury yields, is on the longest run-up since 1989. The last time the ratio traded here, the 10-year yield was 2.6%. Thus, the bond selloff probably has room to run.

U.S. Treasury bond yields have been marching higher since last summer, generating lagging returns for fixed income investors. Unless there is some abrupt reversal in the coming days, February will mark the seventh month of flat-to-negative returns for long-dated Treasuries.

So, what’s driving U.S. Treasury bond yields higher? A strong economic growth outlook and less Fed buying are contributing factors. But in our view, the main driver is higher inflation expectations. If market participants expect higher inflation down the road, they will want to be compensated more today (in the form of higher yields) for long-dated fixed income holdings. In this way, higher inflation expectations push bond yields higher.
 
As Gavekal Research notes: “the debate is no longer whether we are stuck in a structurally deflationary environment. Instead, the question has shifted to how much will inflation surprise on the upside.”

 

 

How This Bull Market Will Probably End

 

 

Speaking of higher expected inflation…
 
While bull market gains are being accrued now, it's never too early to start thinking about how this bull market will eventually end. In our view, the canary in the coalmine will likely be when inflation runs hot enough to force the Fed to pivot to a more hawkish monetary policy.
 
Smart risk management means proactively discerning where risks are and identifying specific indicators to spot those risks. The market correction in Q4 2018, for example, was tightly correlated to Fed tightening, and it likely serves as a sneak preview for what’s to come down the road.
 
It is premature to expect the Fed to change course soon, and recent Fed minutes indicate no appetite for tightening in at least the next year. But it’s also important to remember that ‘tightening’ does not only happen when the Fed raises rates – there are plenty of ways the Fed can take their foot off the gas. Each time they do, the equity market is likely to respond with volatility (remember “taper tantrums?”).   

 

 

 

Options Market Sentiment Is Near Euphoria  

 

 

As I was reading earnings report highlights from one of Silverlight’s Core Equity holdings, Valmont Industries, I noticed the above ad for options trading. As you can see, it boasts of huge profit potential and implores readers to “STOP TRADING STOCKS NOW” in favor of trading options. If ads like this generate revenue, it probably means options market sentiment is nearing euphoria.
 
Data suggests this ad is more than an anecdote. 7.5 billion options contracts traded in 2020, shattering the previous record by 45%. The frenzy shows no signs of abating, yet. 

Gauging investor sentiment is a fairly subjective exercise, which makes it challenging to get perfect. But noticing trends like surging options trading, classic click-bait ads looking to prey on ‘heat-chasers,’ and get-rich-quick trading ideas are all telltale signs we’re approaching some level of euphoria. 

 

 

 

The Food Delivery Business Has A Flawed Business Model

 

 

In today’s fast-changing economy, critical thinking about how well a firm’s business model aligns with all of its stakeholders is a vital part of the qualitative analysis Silverlight does when making investment decisions on individual companies. We use a checklist of qualitative variables as a shortcut device to help ensure the core business value proposition makes sense.
 
Third party delivery platforms don’t pass the test.
 
The biggest reason: delivery operators’ business models do not align with restaurant’s business models. In fact, on average, delivery services may be hurting restaurants’ bottom lines while helping their own – obviously a bad tradeoff.
 
One of the value propositions sales reps from delivery services pitch restaurants is the ability to bring-in new customers. But here’s the catch – about 50% of orders on third party delivery platforms are from repeat customers, meaning that restaurants are getting hit with a 30% service fee on customers who would have eaten there anyway (and paid full price). This adverse outcome is offsetting the benefits of new customers, arguably damaging a restaurant’s bottom line.

 

 

The Birth Rate In China Is Plummeting

 

 

Many economists have been warning of a foregone conclusion: China will pass the US as the world’s largest economy soon. But there’s a ‘not-so-fast’ factor not being fully considered:
 China has a demographic problem.

Registered births in China tumbled 15% in 2020, adding another data point to a longer-term trend of slowing population growth. When population growth slows, so does economic growth. Remember, GDP boils down to a simple equation: number of workers * the productivity rate of those workers.

China was already seeing stalling birth rates so their leadership may start taking more active steps to encourage a higher birth rate. Ironically, we may see the opposite of China’s former “one-child policy.”
 
A recent study in The Lancet finds that sometime in the middle of this century, global population will start shrinking. This follows centuries of steady growth. The study projects that China’s population will fall by half, the United States’ population will hold steady, and Nigeria’s will quadruple—making it more populated than the US or China.

 

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"Courage is very important. Like a muscle, it is strengthened by use."
- Ruth Gordon

 

As a professional money manager, part of my job is to take risks that are worth taking. Sometimes that can be scary and requires courage.
 
Years ago, I read a book called Feel The Fear and Do It Anyway, by Susan Jeffers. It echoes the point Ruth Gordon makes in the quote above. When we feel fear and take action, we deliberately rewire the circuitry in our brain. Those moments change us forever. Piling up courageous acts over time can help us proactively reshape our sub-conscious and personal identity in a way that serves us.
 
For example, in my early 20s, I decided to try skydiving. It was scary at first, but I’m glad I did it.
 
This past weekend, on a short getaway with my family to Palm Springs, I flew in a bi-plane built in 1935. It was scary at first, but I’m glad I did that too.

What's an adventure you can pursue to build your courage muscle?

 

 

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This material is not intended to be relied upon as a forecast, research or investment advice. The opinions expressed are as of the date indicated and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by Silverlight Asset Management LLC to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by Silverlight Asset Management LLC, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any of these views will come to pass. Reliance upon information in this post is at the sole discretion of the reader.​​