So… Tech stocks are dropping.
The former poster boy of the tech rally Tesla, is now down 30% from its Feb highs.
I saw a question in the Facebook Group:
And again from a FH Reader:
Curious. These few days. Tech sell offs. What’s your plan vis a vis tech stocks, buying more or wait and see?
So I wanted to share my views with all of you. Hopefully, it would help with your investment thinking.
All this is in line with the framework in my article 2 weeks ago. So if you want the background, do check it out.
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Why are interest rates going up – Doesn’t the Fed peg it at zero?
Short answer – The Feds control the Federal Funds Rate, which is:
Federal funds rate is the target interest rate set by the Federal Open Market Committee (FOMC) at which commercial banks borrow and lend their excess reserves to each other overnight.
So Feds only control short term interest rates that banks use to borrow overnight.
Longer term interest rates are set by US Treasuries.
US Treasuries are traded on the open market, so their prices (and yield) are determined by supply demand.
The Feds can influence it by buying Treasuries, and they have been buying at $120 billion a month (Quantitative Easing).
But in recent months, supply is greater than demand.
Supply goes up because the US government has to issue more treasuries to fund all the stimulus.
Demand from the Feds is constant at $120 billion a month – they didn’t increase the pace of buying.
Which means the buyer at the margin is the private sector. But private sector sees all that stimulus coming and bonds at 1.0% don’t look super attractive. So demand from private sector drops as well.
Bond yields are inverse to prices.
So when price of Treasuries fall, the yields (interest rates) go up.
What is going on with yields?
There are 3 things you need to look at with yields:
- Absolute level
- Nature of move
- Speed of move
The US 10-year Treasury is at 1.57% now.
That may not seem like a lot, but don’t forget we were at 0.5% in Aug last year. So that’s a TRIPLING in the most important interest rate in the whole world, in 6 months.
And don’t forget that the yield on the S&P500 is 1.5%, so at current levels the 10-year treasury yields more than the S&P500, completely risk free.
Things like that may not matter to you, but they matter to guys like GIC and Pension Funds who are throwing around hundreds of billions.
Nature of move
This part’s a bit technical. But it’s really important to understand, so bear with me.
Nominal interest rates are broken up into 2 components:
- Interest Rates (expected investor return)
- Expected inflation
Think about it this way – imagine you’re GIC and you need to achieve a 3% inflation adjusted return.
So if inflation is at 1.5%, you need to get 4.5% nominal return on your bonds to achieve this goal.
So when interest rates go up, we need to know whether it is due to (1) rise in the expected return that investors are asking for, or (2) rise in expected inflation.
This is where breakevens come in.
There are inflation indexed Treasuries – Treasury Inflation-Protected Securities (TIPS). By looking at the price of TIPS, we can work backwards to figure out what level of inflation the market is pricing in.
From Jan 2021 to today, inflation expectations have barely gone up, only about 0.2%
But interest rates have gone up 0.5%.
What does this mean?
What this means, is:
Interest rates are going up because investors demand a higher return, not because they expect more inflation.
Or more simply – Real rates (inflation adjusted) are going up.
This is super important, and will affect the rest of this entire discussion.
A lot of people confuse a rise in nominal rates with a rise in real rates. Don’t make the same mistake – each has a very different implication on markets.
In Aug 2020, just 7 months ago, the US 10 year was at 0.5%.
In Jan 2021, 2 months ago, the US 10 year was at 1.0%.
So we’ve tripled the US 10 year in 7 months, and a 50% increase in 2 months.
In the most important interest rate in the whole world.
This has created a lot of unwinding in other asset classes.
So far it’s been quite orderly, but that may change in time.
Why are stocks going down?
For those familiar with discounted cash flow (DCF) – what is the risk-free rate that you use in a DCF calculation?
The US 10-year Treasury.
So what happens when the 10 year yield triples in the span of 7 months?
Answer – valuations that look good 7 months ago, suddenly look very pricey.
This is particularly pronounced in long duration assets – things with cash flow that are very far away in the future.
Time Value of Money
For the old school folks, think of this as the time value of money.
With interest rate at 0%, a dollar 10 years from now is worth the same as a dollar today.
When interest rates go up to 1.5%, a dollar today is worth much more than a dollar 10 years from now. Because of the time value of money.
So when interest rates go up, companies with a lot of future earnings do poorly. And companies with a lot of earnings today do better.
So which is the industry with most of its earnings that are very far away?
Absolutely right – tech stonks.
So Tech stocks are taking an absolute beating right now. The more hypey the stock, and the further out the earnings, the bigger the hit.
The other asset class super sensitive to real rates is gold – which is why we see gold taking a huge tumble.
Fixed income proxies like utilities and REITs as well. Which is why we’re seeing underperformance there.
Why are the Feds not stepping in?
I find it crazy that people think the Feds will step in now.
Cmon guys, the S&P500 is down what, 100 points from all time highs?
I said this last week, and I will say it again.
Feds will not come in so quick.
Don’t count on the Feds saving the day so soon.
The Feds will only come in if there is Systemic Risk.
If March 2020 happens and credit spreads blow out, the Feds will step in.
But if Tech stonks are down 20-30%, and the move is limited to momentum names without broader contagion, no way in hell.
Removing the froth in the market is exactly what the Feds want, and so far they’re achieving it without having to touch interest rates – which is just an amazing job from Powell.
When will the Feds step in?
The million dollar question then – When do the Feds come in.
In my article 2 weeks back, I split this up into 2 phases:
- Phase 1 – Yields go up
- Phase 2 – Yield Curve Control
In Phase 1, yields continue to go up, together with expectations for economic growth. This is actually good for stocks, leaving out the frothy momentum names.
Cyclicals like banks and energy will do well.
But at some point in time, the rising yields will affect stocks because the market just cannot take higher interest rates anymore.
My reasoning is set out in the original article, but broadly:
- Stock valuations are very high for the start of a new cycle
- The stock market is very tilted towards growth stocks
- Global debt levels are crazy high (and long duration)
And I think eventually, Powell will be forced to implement yield curve control by bringing the long end rates down.
And once that happens, we transition to Phase 2.
When do I see this happening?
Gun to my head, I think a 3 to 6 months timeframe. Probably before the year is over.
But things need to really blow up before the Feds step in. Think systemic risk, with bonds, gold, stocks, FX selling off all at the same time.
A sell-off in some meme stocks is not going to cut it.
What to buy in each Phase?
I wrote a detailed article for Patrons this week on what does well in each phase, so do check that out if you’re keen.
Phase 1 – What does well is cyclicals like banks, energy, commodities. Tech should do ok too if you leave out the frothy momentum names. But anything that is sensitive to real rates will suffer – gold, fixed income, bond proxies (eg. utilities), REITs.
Phase 2 – What does well is risk assets generally, commodities, tech, REITs, Gold, BTC, silver etc. Fixed income does well during the transition phase, but after that probably not. Cash definitely suffers. Banks are tricky – because it depends on how economic growth does (do we see stagflation?).
Is this a buying opportunity?
I think the 2021 market is going to be incredibly hard to play.
Much harder than the 2020 one – which was really just waiting for the Feds to step in and buying the dip.
I think in Phase 1, we’re going to see vicious rallies and drops, that will trap bulls and bears alike. It’s just going to be very choppy.
And then we have some kind of massive event in markets.
And then Powell finally steps in to save the day.
So how to invest in this market, really depends on your risk appetite.
Do you want to buy now and average in all the way? Do you want to try your hand at timing the collapse? Do you want to hedge via options?
Many ways to make money.
But what I will say is that I think passive investing is dead. Don’t approach investing the same way it was done the past 40 years.
The 1980s to today was a 40 year bull market in bonds.
Just look at the chart below. Sure, there are rate hikes during this 40 year period, but the broader trend is down.
So in the past 40 years, you just buy stocks and you buy bonds, and you passive index, and you retire.
But going forward – all that changes.
We’re going to be in an environment where interest rates are going up and inflation expectations are going up.
Very few people today have experience investing in such a market.
The closest period historically was the post-WWII period.
But this isn’t exactly the same, because we now have the internet, and we have technology, and we have rampant option trading.
Start thinking from first principles, and don’t get carried away by mainstream media narratives.
Am I buying tech?
As shared 2 weeks ago – I’ve been doing a lot of rebalancing recently.
I sold some gold, I sold my US banks, I sold deadweights like Comfort and Singtel, I sold bond proxies like Netlink Trust. I also sold REITs that I didn’t want to hold long term.
I didn’t want to go to cash entirely, so I rotated into long term positions I wanted to hold in tech, real estate and commodities. You can check out my portfolio moves and names I’m keen to buy on Patreon.
But again, I just think 2021 is going to be a very tricky market.
I would say understand your risk-reward, and control your risk.
Don’t FOMO either way in this market. And don’t leverage.
If there is big weakness like yesterday, I may add to positions. But if we see big strength in the coming weeks, I may look to close some positions.
I think the real mega event for markets will only come later in the year, and until then it’s just about playing it out.
As the saying goes – Bears make money. Bulls make money. Pigs get slaughtered.
Don’t be a pig. Don’t get carried away in this market.
Closing Thoughts: ARK is becoming a problem
It’s been a monster of an article, and I know it’s a lot to digest.
I’m still working through all this information myself, so I would love to hear from you guys.
Whether you agree or disagree – share views below, and we can have a constructive discussion on how to make money in this market.
But one point I wanted to leave you with, is that Cathie Wood’s ARK is becoming a real problem.
The liquidity issue is covered by some other commentators, but basically ARK’s trades are copied by Nikko and Sumitomo. And because of how big ARK grew the past 12 months, it’s getting to a point where ARK now holds significant stakes in very illiquid stocks.
You can see in the chart above – combined positions exceed 25% for some of these names.
And these are small caps with $2-3 billion market cap. Very little liquidity – more than 20 days to sell in some of them.
Don’t forget ARK is an ETF not a hedge fund, they cannot hold cash positions. So if investors sell out of the ETF, Cathie Wood needs to sell the underlying stocks to raise funds.
And as an ETF – Cathie needs to disclose these positions publicly.
If things go bad, other hedge funds are going to front run Cathie Wood by shorting these names, and with the kind of liquidity in play Cathie Wood is going to be in a world of pain.
And the icing on the cake – Tesla is the single largest holding for ARK. Who now has taken a big position in Bitcoin.
This works very well on the upside, but if things start to go the other way, it could blow up very fast.
Love to hear from you below!
As always, this article is written on 6 March 2021 and will not be updated going forward. Latest thoughts (and my stock watch and personal portfolio) are available on Patron.
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