SPOTTING THE UNPOPPED BUBBLE PART 2

09-09-2019

My clients are more concerned than ever about where the market is and why it’s there. For years, we have searched for answers to such questions, and very scarcely do we find satisfactory reasons. From the research that I have done on the macro side, and following the completion of several tomes on the topic, I feel much better equipped to answer that question than 99% of other financial professionals. Nevertheless, I feel deeply indebted to both have the ability and resources to discover such answers. 
 
Ok, let’s not get too emotional. 
 
Determining a bubble and what the fallout might be and where the significant asset impairments will be is difficult work and certainly my conclusions may be flawed. Therefore, please do not consider any of the following investment advice. 
 
Three things worry me after conducting extensive research and application regarding what I’ll call “market inflation”. 
  1. Index Funds are in fact over bought.
  2. Tech is overbought and underwhelming
  3. Banks are approving extraordinarily risky loans.
Of course, please remember that I have already covered general global debt as the reason for the bubble, and while this is true, we need to understand that the administration of debt is what will pop the bubble. In China, as in most countries, determining trends based on public figures is mostly a wild goose chase. The reason? Non-GAAP, non-IFRS, and non-audited. 
 
As an aside, some countries’ citizen corporations have a lot going for them despite unfortunately being headquartered in controversial economies. Determining this from audited, GAAP statements is key. Therefore, I look through predominately domestic listings. Two such corporations are Petrochina and Central Puerto (both NYSE). Anyone who has done basic accounting can see these are unjustly depressed.
 
We may be getting closer each year to full economic transparency due to analytical technologies, but we aren’t there yet. We probably never will. Though I mentioned in the first part that Chinese mortgages have a relatively high chance of causing the next bubble pop, numbers are so inaccurate from PRC that the ‘p-value’ is simply too high to infer trends. All I would say is to not make naked macro bets on PRC or interest rates therein.
 
Seems like interest rates globally are only going to fall lower and lower; there is no rate hike catalyst that I see anywhere. The primary worries causing a rate hike are twofold. Inflation is getting out of control, which is currently unlikely as wages have been stagnant in relation to production. Second, making a currency more attractive to foreign investors, which would be likely if there wasn’t such tremendous debt levels globally. 
 
Back to the three worries from the outset.
 
Index funds are overbought, causing the largest common constituents to experience unparalleled growth. Take Home Depot, which has negative tangible book value, incredible amounts of debt (more with every passing quarter), a $250 Billion value and is the company I would bet will get hurt most by trade tariffs. HD is up over 30% YTD. How can this be? 
 
If a stock I am watching falls unexpectedly, I’m wondering who is selling. If a hedge fund is selling, there is probably a reason behind it and more research is warranted. If it’s a pension, the sale is probably agnostic and a liquidity trade. In the case of a pension sale, buying on the dip makes sense. For the first time in the history of the market, we are seeing the opposite.
 
If I see a company like HD rising 34% in the face of all this diversity, it’s not hedge funds buying; it’s index funds. While I am still researching this point, I feel as though the move to index funds with a limited number of stocks is growing the entire market in a way that isn’t backed by reason. Therefore, just as I would buy on the dip for liquidity trades, so to would I sell on the rise on these trades. Index funds allow more and more unsophisticated investors to enter markets, and holy moly, the inflows have been staggering. The pool is full and more people are jumping in all the time. Market caps cannot sustain at this level and if they fall, there will definitely be a domino effect. 
 
Even worse, these index funds are introducing unsophisticated investors to a new form of gambling. I had someone ask me to buy Lyft at its IPO. I almost fell out of my chair. $13.75 Billion IPO price on $2 Billion revenue and $4 Billion in expenses and negative  $4.5 Billion of tangible book value. This is giving a company money they don’t have to pay back.For most, buying $100 of tech today is like this: I have this great idea that has cloud, IOT, data analytics, Big Data, and Machine Learning features! BUT I don’t have any money, I have lost about $5 Billion on overpaying employees and throwing massive parties (i.e. WeWork), and I will probably lose another $2 Billion this year partying and buying houses for myself. But maybe in 20 or 30 years, you might get your $100 back! 
 
In my mind this is venture capital and should not let anyone invest in such offerings under $2 Million net worth. Interestingly, private equity groups can only invest for ‘sophisticated clients’ by law but public market regulators tend to look the other way. Anyone with $100 can lose it on a company like Lyft, Uber, or WeWork. Thus my second possible cause for the bubble bursting – tech companies fizzle out.
 
Problem today is that there is an agency risk with little regulation. Many new IPO’s have broken business models like Lyft, but also significant shareholders. Is it better to go bankrupt and have current investors lose everything or raise new money to stay alive? Hard question. Of course, for an investor, these investments are also a form of leverage – any of the money invested not represented by tangible book value is considered goodwill. This goodwill has a very high cost associated with it for an investor of a company that isn’t profitable. Traditionally, this is called a cost of equity capital, and this cost is very real. I’ll cover this in future memos.
 
Unfortunately, unsophisticated investors without advice make awful choices, inflate markets and run for the hills at the first sign of trouble. Even further, studies I’m reading show that while tech is booming, its results aren’t there: productivity is mostly the same. I hope you get the picture. 
 
Not to say that sophisticated investors are any better. In a predator/prey scenario, banks are lending money to unsophisticated borrowers at staggering rates. Corporations are being formed exclusively on the premise that borrowing money is cheap! Though rates are down and will stay down domestically, many loans are ‘asset backed’.
 
Banking 101 – the value of banks is similar to the value of an insurance company. While insurance company book values are primarily driven by the underwriting of loans (i.e. who is approved and at what rate – largely a gamble), bank values are driven by the ability to underwrite loans (i.e. who is approved and at what rate). The big difference is that bank loans are tied to assets, so if the borrower does or doesn’t pay, the bank wins either way. So what’s the problem? Dominoes. 
 
Banks have every reason to liquidate bad loans, because by doing so they can convert non-earning assets into earning assets and they may also be able to recapture some of the reserves they have been obliged to set up by regulators. The danger is that the liquidation of bad loans uncovers other bad loans. For instance, let’s say there were many farmers who could not service their debt but the value of their land was still high enough to provide adequate collateral: these farmers were given additional credit rather than being forced into bankruptcy. But the liquidation of bankrupt farmers depresses land prices, so that additional farmers are forced into bankruptcy… After all, it turns out that the income from already syndicated farm loans will be insufficient to cover the mortgages and the deficiency will be habitually made up from new syndications. This is also referred to as ‘Ponzi scheme’.
 
Most banks are too big to fail – that old elephant in the room. No matter how many non performing syndicated loans in the book value, the Federal Reserve and taxpayers will ultimately pay up for them. It’s in a large bank’s best interest to lend more in a downturn; it can be stimulative (at times).
 
So who will cause the bubble to burst? investors that both buy blindly and get taken advantage of. Buying index funds is a ‘gateway drug’ many times, and has also elevated markets incredibly due to staggering inflows. Corporate IPO’s, Banks, private equity firms, real estate groups, etc. will sell these unsophisticated investors investors more and more frequently, especially as interest rates come down and wealth rises. As billions of dollars come out of the economy when these inflated companies (both in private and public markets) finally start to come down to true valuations, we will know that the bubble has burst.
 
Know what you are buying and whom you are buying it from.

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