The Week That Matters (22-26 Jan, 2024)
"Turbulence is life force. It is opportunity" Ramsey Clark
According to aviation science, there is no such thing as an air pocket. Aircraft drop suddenly mid-flight due to turbulence. That’s it.
The air pocket metaphor does work well in financial markets, though. Your portfolio can be traveling perfectly, and then, out of no-where, the market drops 500 points, and your portfolio doesn’t look so good. Invariably, people sell at the lows, and convince themselves it makes more sense to stick with private credit going forward. It is almost always a mistake.
Back in September, this newsletter argued that inflation expectations would drop dramatically, and real interest rates would peak. That’s what happened and the market began its rally. It is the author’s opinion now that in the short term, the market will panic about rising inflation expectations and real interest rates. January and February tend to be seasonally strong for inflation prints. Real interest rates just need to be flat for a while for them to spook market participants. The volatility won’t last long but it will be a scary ride. The trick will be to appreciate it for what it is: an opportunity to pick up stocks at better prices.
A Melt Up is Possible (after the sell off)
Edward Yardeni is right. The market might experience a melt-up at some point in the 1H. We have mirrored the moves seen in 1998-1999. At any moment, the market might get carried away. And why not? There is a lot to smile about.
For the author, it’s increasingly clear this is 2010, not 2007, and it might even be a lot better than that! You have to go back to the 1990s to see an economy like this. The pundits spent far too much time worrying about a repeat of the 1970s. Instead, they should have realized that the 18 months leading up to last September was merely a long-drawn-out version of the market tantrum we saw in the autumn of 2018. That was the last time Powell took liquidity out of the market.
More than 85% of companies who have reported have beaten estimates. Even a basket case like United Airlines topped its numbers. Of course, companies might have been conservative with their forecasts originally, but it has not been a bad reporting season by any stretch of the imagination.
We are also conveniently seeing bottoms, as discussed last week, emerging in key industry cycles such as semiconductors. ASML’s numbers this week blew the doors off, which followed a very optimistic TSMC print the week before. Despite this, most analysts are still asleep at the wheel. What is going to happen to demand for advanced chips going forward? The author thinks it’s probably going to be a big deal. Isn’t that why SMCI is having its own Nvidia moment?
Scale Matters
It is the author’s firm belief that we live in a Victorian Age of technology, where the largest tech companies will become even more important in our daily lives. The banking sector was roughly 25% of the equity indices in the US in 2008. Today, the Magnificent 7 is 30% of the S&P 500. Why can’t it be 40%? Banks back then were in a much worse shape than they are today (hence the GFC!). And their leaders were nowhere near the same caliber as Tim Cook and Satya Nadella.
Winner-take-all-strategies do very well in a lower interest rate environment. To win, you need huge barriers to entry. You need to have scale. That’s why those pushing Russel 2000 names are being naive. Small caps have no barriers to entry, tend to operate in industries with a lot of competition, and most have been battered by the recent increase in the cost of capital. The author is constantly surprised that pundits spend so much time on the index. It’s tiny!
We are about to hear from the Magnificent 7. The author isn’t that concerned about their earnings this quarter. What is more important is whether they have picked growth strategies that will work over the long run and where their scale matters. For the author, that’s the AI focus from Google and that’s the chip strategy from Apple. Yes, they might disappoint short term. But how much would Apple drop, if they had a shocker? It produces $25billion of free cash flow a quarter and has a very high ROIC. How does the market value those cash flows when Powell cuts in March?
Uber and Shopify
It’s not just the Magnificent 7 that should be a focus when it comes to scale. Smaller companies are also starting to become category killers. Uber, for the author, is one of the few companies that has run the gauntlet of VC funding and got to the other side. It is arguably THE success story of the post-cloud VC software factory era. Very few, if any, fintech companies, have got even close (wait for the IPO of Chime to see how excessive optimism in 2021 wrecked a fintech name). With Uber’s impressive CEO, Dara Khosrowshahi (ex-Expedia), the author believes Uber might have already won.
Increasingly, the author believes Shopify is on course to take the undisputed category killer in its field. The author was looking at Bill.com again. He had success owning it when everyone loved “vertical SaaS.” It was an expensive name, but people were willing to drink the Silicon Valley cool-aid back then.
If a software company could show signs that it could aggressively gain market share in a vertical like expense management or billing, then the company deserved to be valued highly. The thesis also argued that such companies would be tough to displace as they integrated further into the tech stack of their customers.
Unfortunately, it didn’t exactly play out that way. If a business was doing well, it attracted a lot of copycat companies, making pricing hard for everyone. Customers were also more willing to switch to other providers much more than originally thought and they also tended to renegotiate lower after the initial contract rolled over. There are few friends in the software game.
Bill.com suffered from competition and a slowing economy but the killer blow, based on the author’s own research (his research might be flawed), was the introduction of Shopify Bill Pay in April 2023. It would seem Shopify could do so much more given its existing scale!
It is clear to the author that a lot of things will grind towards a stock like Apple now that it has the scale to dominate what it focuses on. But isn’t the real alpha going to be finding the next category killers? Hubspot also has to be on the list, no?
Davos: A Pointless Echo Chamber for the Uber Wealthy
We live in an age of rapid wealth creation. John Maynard Keynes predicted this period would happen when he wrote his essay, “Economic Possibilities for our Grandchildren,” way back in 1930! Rising house and share prices over the last 40 years have created a mass affluence that we have never seen before.
Getting the consumer right in 2023 was key to beating the market. The biggest mistake was not understanding how consumer balance sheets had changed since the GFC. It is this newsletter’s opinion that this wealth effect is one of the most important dynamics in understanding what might play out in markets over the next three to five years.
Those fund managers, like Jeremy Grantham, who bleat about government debt levels all the time, will continue to underperform. Those fund managers, who understand that private sector debt ratios are back to where they were twenty years ago, will tend to do better. It’s going to be that simple.
Such wealth creation naturally comes with downsides. Capital tends to have a better return than labor, which means early advantages compound, leading to the dramatic wealth poor divides we see today though out the Western world.
But it also can lead to intellectual stagnation. When you have nothing, you are a happy risk taker. When you have a lot, it’s natural to become conservative. Unfortunately, this is not the time for conservatism. We have been growing below trend growth since 2008 and we desperately need fresh ideas to come to the surface.
We kid ourselves that we live in a particularly innovative age. We don’t. Compare the steam engine, the heat transfer pump or the contraceptive pill with 5G or an app to order a coffee. The last 10 years or so are marked by declining productivity and innovation. It quickly becomes clear that Silicon Valley, for the most part, hasn’t delivered what we need it to.
The issue with Davos is it ends up being an echo chamber. Who really wants to challenge ideas in the forum? Who wants to try to add value for the world? There is only downside in being bold. You might lose out on a business contract. Worse still, you might have to stay in a villa that’s at the bottom of the hill.
George Soros once remarked that the only reason people listened to him was because he had made a lot of money. If he had remained a university professor, no one would have given him the time of day. And that’s the problem. The plutocracy of Greece produced Aristotle and Socrates, but it also slowly died because it lost its dynamism.
Traditionally, contrary to what is commonly discussed, it has been government that has led the real innovations in the economy. There would be no Google, no Apple, no Tesla and no Qualcomm without government funding and support. Venture capital funds, especially since the cloud, cannot deal with the highly uncertain and lengthy innovation process.
For the government to work, however, you need capable people in bureaucracy. Unfortunately, as the FT pointed out this week, the UK government has been infantilized by the consulting industry, to use a line from Mariana Mazzucato. And that is a very serious problem. Until that situation changes, we will be forced into silly policy driven by wealthy people with no qualifications in the field but plenty of self- interest.
As always, thanks for reading. I wish you the very best this week with business, family and trading. None of the above is financial advice. Please do your own research. It’s just the meanderings of a man who likes markets too much.
Best regards
Mateen
DISCLAIMER: None of this is financial advice. The opinions expressed are purely my own opinions and it is imperative for you to do your own research. They do not represent the views of any company I am associated with