The financial markets have been very emotional this quarter. The stock market
had a 7% correction in May followed by a 7.5% rally in June. Ten-year U.S.
government bond rates are trying to go below 2%. The world has the lowest rates
we have seen since 2016. The 10-year German government bond rate is now a
negative 35 basis points. This means you PAY the German government every year
almost a half percentage point for the privilege of loaning money to the
government. U.S. and China are in a full-blown trade war with no end in sight.
What does it all mean?
We don’t see the U.S going into a recession this year. The economy is slowing but
we don’t see GDP going negative. The bond markets of the world disagree with us
and are pricing in a recession. The way the bond market prices in a recession is to
take long-term interest rates below short-term rates. Today the 10-year Treasury
in the U.S. is 2.03% and the three-month Treasury yield is at 2.20%. When you see
this happen, it’s called an inverted yield curve. The bond market is saying the
odds of a Fed rate cut are high on the short end of the curve. To trade on that
view bond investors will “lock” in their money at the 10-year rate even though its
lower than the three-month rate. The bond market is willing to accept lower
interest rates now because it is convinced the economy is going to be much
weaker next year.
We think the inverted yield curve in the U.S. is a mistake by our bond market. The
U.S. is at record low unemployment, credit is flowing freely, and we don’t have
any big inflationary bottle necks in the system. HOWEVER, the rest of the world is
struggling more than we are, which is putting pressure on our bond market. Our
interest rates are being pushed lower because of them. The trade war is
influencing the rest of the world far more than it is us. We think economic growth
in the U.S. will keep the rest of the world from going into a recession. We are also
taking note of the very recent desire of foreign central banks to increase their
monetary stimulus. This will help the world stave off a recession.
We started writing about a coming trade war with China over five years ago. It’s
here now and we don’t see it going away. The genie is out of the bottle and it’s
not going back in. Our blueprint for this trade war is what happened in the last
trade war in 1971. We thought U.S. economic growth would pick up (check), the stock market would rally (check), unemployment would go lower (check),
commodities and the dollar would go lower (big miss so far). We thought the rest
of the world would run simulative fiscal and monetary policies to replace the lost
sales in the U.S. So far that has been slow to occur. Why?
The Germans (who run the European Central Bank), China and Japan all want to
have trade surpluses with the United States. The political leadership of those
countries believe a trade surplus is the best way to insure a vibrant economy
long-term for their people. There are numerous ways to gain an advantage on
your competitors when trying to have a trade surplus, tariffs, value-added taxes,
foreign ownership rules, currency manipulation-to name just a few. One way that
isn’t talked about is suppressing what your people can consume.
The German’s started the process of suppressing the wages and benefits of their
citizens by passing the Hartz law in 2002. At that time the unemployment rate
was 13% in Germany. The Germans were worried about another great
depression. They wanted to improve the competitive position of their
corporations, so they passed the Hartz law to help. In the law, the unions and the
corporations of Germany agreed to pay their workers less than they should get in
return for the companies agreeing to keep most of their jobs in Germany. The
Hartz law also revamped the German welfare system so that you got less money if
you didn’t work. The net effect of this law was to take money away from their
citizens and give it to their corporations. By restricting the purchasing power of
its citizens to buy US products or anyone else’s products, Germany now runs the
world’s largest trade surplus as a percent of GDP in the world.
Ten years ago, in China, consumer consumption represented 50% of its GDP.
Today it is below 40%. As China’s trade surplus has grown, their citizens have
received less money than they should have. In Japan, they passed a consumption
tax on their citizens. When individuals buy something in Japan, they are taxed
more today on that product than you were 10 years ago. This tax was passed to
Contrast these moves with the changes in the U.S. tax laws in the last 15 years.
We are lowering personal tax rates, increasing depreciation for business,
increasing tax breaks for business at the state level while increasing deficit spending by our federal government. The U.S is trying to increase consumption
while our trading partners are trying to restrict it. As a citizen I am happy about
lower taxes, but that will come at a cost of a higher trade deficit. We continue to
think a higher trade deficit will result in the dollar going lower. The dollar going
lower should cause gold and commodities to go up. We can’t declare victory on
that thought process yet, but we aren’t backing away from it either. To finish this
subject, we would like to note that our only gold stock, Royal Gold, made new all-
time highs this month. Perhaps the gold market is starting to agree with us.
We want to write about some crazy things Wall Street has been doing lately that
it has stolen from our efficient-market professors in academia. As a refresher on
academic thought, the professors at our colleges have stated that the markets are
efficient, and you can’t beat the market. This theory got started over 30 years
ago. However, when academia did more testing on the efficient-market theory
(EMT), these professors found out that value stocks did beat the market over
time. They also found out that small caps beat the market. This was followed by
momentum stocks beating the market. Another favorite is low volatility stocks
beat the market. There are more anomalies that academia can’t explain but we
will stop there. So to sum it up, the markets are efficient until they aren’t. Most of
the time the reason they give for not being right on value, low volatility, small cap
and momentum stocks doing better than the index is that they are riskier. Hence,
they have a value premium attached to them. We find that logic lacking but we
will move on. Why does this matter to you?
There has been an explosion in money allocated to “factor” funds on Wall Street.
A factor fund is simply a fund that manages money based on one or more factors
that academics say will beat the market, like value, small cap etc. Factor funds
take the academic studies of the market and apply them to today’s stock market.
We will outline how these funds manage money for value investing, which is what
If a factor fund wants to “beat” the market using value as its criteria it will do a
search of all 12,000 stocks in the market (most searches excluded finance
companies). It will look for the cheapest stocks based on THEIR definition of value.
That definition could be low price to book, low price-earnings multiples, high cash flow etc. After they have ranked the stocks at 1 through 12,000, they might buy
the 100 cheapest stocks and move on. Or they might try to improve on this
system by introducing momentum into the equation. Since academia says
momentum beats the market, how can we sort these stocks based on that? What
The seminal study on momentum was written years ago in academia. The study
defined momentum as a stock that was up on a one-month, three-month and 12-
month basis. They would use that momentum criteria to buy the cheapest value
stocks that were also TRENDING UP over these time frames. They would then
rebalance the portfolio at the end of every month to keep the portfolio fresh. Not
only would they have value as a factor they would combine it with momentum to
“double” their chances of beating the market.
In the world of physics, they have a saying that when you observe an object, your
observation of the object changes the way the object will behave. If you want
proof of this phenomenon watch how fans at a football game act when a TV
camera is turned on them. They act differently than when they aren’t on camera.
We think the same phenomenon is occurring with momentum. If everyone is
using momentum as a tie breaker in whatever factor you choose to invest in, the
driving force of the market is momentum and not the value, small cap factors you
invest in. What this means to us is that cheap stocks will keep getting cheaper and
expensive stocks will keep getting more expensive until they reach extremes. The
momentum “tie breaker” will be the driving force in how the stock market trades
since almost every factor fund uses it as the tie breaker.
We offer up the FANGs (Facebook, Amazon, Netflix and Google) as proof to the
upside of how this works. We offer up Centurylink, BGC Partners and Berkshire as
to how this works on the downside. At the peak of the FANGs popularity in 2018
their collective P.E. was over 100, which is crazy. However, the FANGs stocks were
up on a one-month, three-month and one-year timeline, which means you hold
them or buy more. They have momentum. In May the average PE of CenturyLink,
BGC Partners and Berkshire was under 9. None of those stocks were up on a one-
month, three-month or one-year basis (Berkshire was on a yearly basis only).
These stocks are extremely cheap but if they don’t have momentum, a factor fund won’t buy them. They will wait until the stocks go up to buy them, which seems
crazy to us. Because we hold stocks on average for seven years, we bought more
of the above stocks this quarter even though they have negative momentum. We
are willing to accept short-term underperformance to buy stocks that are three or
four times cheaper that the market. Eventually these stocks will have price
momentum again and join the party.
Our guess is that individual stocks will reach extremes in both directions because
of momentum being used as the tiebreaker in almost all of the factor systems.
Once a trend is exploited on Wall Street, we call that a “crowded trade.” If
everyone is doing it, the valuations become distorted from reality, and it ends
when the companies can’t produce enough positive earnings or sales to support
the stocks lofty valuations. When that occurs, the declines are quick and vicious.
You then have momentum working against you during the decline. We have
written in previous letters how this market reminds us of the 1999-2000 dot-com
bubble. When it burst, the no-momentum stocks did great and the high-flying
ones did not. We expect a replay of that to occur again.
We want to highlight a crazy flaw in discounted cash-flow models that have
helped move stock prices. We have included a chart at the end of this report on
the stock performance of companies that lose money. On average these
companies lose 3% a year and rarely go up. However, there have been two years
where money-losing stocks have done very well compared to the markets, 1999
and 2018. In 1999 money-losing companies made 19% and last year (which was a
down year for the market) they made on average 7%. Why would investors bid
these stocks up in those two years? The answer is it involves how you use a
discounted cash-flow model to calculate what a stock will be worth in 10 or 20
If you do a discounted-cash-flow model, you put in an assumed PE multiple, an
estimate of how much the earnings will grow (and for how many years it will
grow) and what the risk-free rate you want to discount those earnings by. If you
have a sudden drop in interest rates, it benefits those years way out in the future
compared to the early years. This means the value of money-losing stocks goes up
more than companies that make money because of using a lower discount rate on the earnings of a company 10 and 20 years out. Though short rates went up in the
U.S. last year the rest of the worlds interest rates dropped particularly at the long
end. Today we have $12 trillion of bonds trading at negative interest rates, which
makes these money-losing companies more attractive. When interest rates go
back up again these stocks will have a rough time. We won’t elaborate any more
on this subject, but if you would like to read up on it, here is the link.
Finally, we want to write about Tesla. We exchanged our Maxwell stock for Tesla.
Why accept Tesla’s stock? We believe that the world is headed toward electronic
self-driving cars. Governments across the world are tackling fuel-emission
standards to lower the amount of carbon dioxide in the air. Technology has
allowed the range of electric vehicles to increase along with an increase in
electric-charging infrastructure. We see the growth of battery electric vehicles
(BEV) increasing. According to a report from JP Morgan, the average growth for all
autos in the U.S. over the next five years is flat to slightly negative; however, for
electrics the growth is north of 30%. For electric vehicles sold year to date, Tesla
currently holds a 55% market share for the U.S. and 7% for the world. We expect
Tesla’s world share to increase once it ramps up production in China this year.
We were surprised no other company offered to put in a bid for Maxwell’s
technology. However, the more we dug into it, it seems no other auto
manufacture or auto OEM was as far along as Tesla in manufacturing electric cars
and batteries. Tesla saw something in Maxwell’s technology that we think other
buyers missed. With less buyers to compete with, they took advantage of it. The
only other likely buyer would have been one from China, which due to U.S. trade
tension, never would have gotten regulatory approval. However, we think
Maxwell’s dry electrode processing, coupled with Tesla mass-market potential
and technology wizardry, has the potential to produce a battery that can increase
the driving range and lower cost, which will further increase Tesla’s lead in the
fastest segment of growth in the auto industry.
Tesla’s software also sets it apart from its competitors. The self-driving
technology as well as the ability to change the cars’ performance and specs with
an over-the-air software update are impressive. We understand the controversy this company runs into, and we will be watching with a careful eye its balance
sheet and cash flow. Tesla, had negative cash from operations in Q1 due to more
deliveries taking place in Europe, but expect to be cash-flow neutral/positive in
the second half of the year when their European expansion is over. Tesla also
announced sometime in Q3 they will be hosting an Investor Battery and
Drivetrain presentation, where they will give more details of what they have
planned with Maxwell’s technology. We will stay tuned to what they say.
This was a very long letter, but we had a lot to talk about. Feel free to call us at
417-882-5746 if you have any questions.
Mark Brueggemann IAR Kelly Smith IAR Brandon Robinson IAR