Why are Tech stocks dropping? And Lockdown 2.0?

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What a week!

It started with inflation expectations leading to a tech sell-off, and ended with a mad rush for toilet paper with “Phase 2 (Heightened Alert)”.

Feels like March 2020 yet?

I received this great question from a Patron reader that I really wanted to share views on:

Hi FH, could you share why the tech shares globally have been dropping significantly over the past weeks, reaching the new low each day? For investors who had the shares bought at higher entry points, what could be a better strategy? Thanks

And I’ll also share some thoughts on the COVID developments. 

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Basics: Tech Stonks Underperforming?

Year to date (YTD) factor performance for equities below.

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Source: Koyfin 

Basically, the opposite of 2020.

Growth and momentum are having bad year, dividend and value are having a good year.

So those guys who are all-in tech are underperforming the broader market this year.

ARK Innovation ETF

There’s no better flagship for the Tech Stonk rally than Cathie Wood’s ARK Innovation ETF.

In my article from March, I shared that ARK would become a big problem on the way down, because of their illiquidity and their high profile. A lot of you disagreed with me, which is good because that’s what makes a market right?

Anyway, ARK has now broken below its 200-day moving average.

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And if you look at the volume bar, you’ll notice that ARK’s trading volume only really exploded from Dec 2020 onwards. Almost 40% of investors who hold ARK today bought into ARK after Dec, and they’re now all underwater. 

So… really interesting to see how this one plays out.

3 reasons why Tech stocks are dropping

Now I do want to caveat that this is not a science.

With markets, nobody can PROVE causation.

I may think that gamma hedging drove tech stocks up, but I cannot go back in time and remove gamma hedging 6 months ago to prove causation.

This is not like Physics where I can conduct an experiment 100 times to prove my theory.

So these are just my views, and I welcome all criticism and comment. Let me know if you disagree, and we can discuss to find the objective truth.

1. Rising Inflation Expectations

The framework I’m using here is broadly consistent with what I wrote back in March (Phase 1 vs Phase 2 in rates), so if you want a refresher do go back and look at that post.

Basically: 

Phase 1: The 10-year treasury will continue to rise as 2021 plays out, and that will eventually impact stocks. The hardest hit will be long duration stocks, eg. small cap tech with a lot of speculative earnings. Beneficiaries are cyclicals like banks and commodities.

Phase 2: Feds eventually come in with a modified Operation Twist or Yield Curve Control. But this won’t be so soon, it requires real systemic risk and not just a momentum stock sell-off. My base case assumed the Feds stepping in only around 2H2021 (and more likely later rather than earlier).

So all that is broadly still in play. 

The biggest change to the framework, is the rise in inflation expectations.

I’ve extracted the 10 year breakeven inflation rate below, which is calculated by:

10 year TIPs (Treasury Inflation-Indexed Bond) – 10 year Treasury

This value broadly shows what markets expect inflation to be in the next 10 years, on average.

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The big difference between now and March, is that inflation expectations have gone up significantly. Around 30 bps in fact.

Whereas the 10 year Treasury has only gone up around 10 bps to 1.64.

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Or in simple English – Investors are pricing in higher inflation going forward.

Now whether we see inflation make a comeback for good or whether it is transitory is the million dollar question.

The argument for inflation is that fiscal policy will be the driving factor going forward. Throw in COVID driven supply chain breakdowns, and a surge in consumer spending from all that stimulus, and you have a recipe for inflation. Just look at house prices to understand the dynamic.

The argument against inflation is that we’ve been doing this (stimulus) for the past 40 years, and it has been a non-stop deflationary train. If you’re in this camp, you believe that tech and demographics are powerful deflationary forces, stronger than the fiscal stimulus that governments can throw at it.

Now this topic probably requires a full article on it’s own, and we’ll probably revisit this again in future. If you’re investing for 2021 and beyond, you’ll eventually need to take a position on whether you hedge for inflation or you don’t.

For now, what you need to know is that whether rightly or wrongly, the market is pricing in higher inflation going forward, and that’s driving part of the tech sell-off.

Why are speculative tech stocks so vulnerable to inflation? 

2 big reasons:

Discount Rate – When you do a discounted cash flow, the discount rate you use is tied to the 10 year interest rate. When inflation expectations / interest rates go up, the discount rate goes up, and all that future earnings becomes a lot less valuable today.

Lack of growth – In a low inflation environment, growth is scarce. So there is a premium on the growth that tech stocks deliver. In a high inflation environment, every company is growing earnings, even the guy that sells vegetables. So earnings growth is everywhere in a more inflationary environment.

2. Gamma Hedging… in reverse

Now not everybody agrees with gamma hedging being a cause of the rally, so I leave it to you to make your own conclusion.

I tried to find a simple definition for gamma hedging, and this was the best I found:

Gamma Hedging refers to the strategy that helps eliminate the risk created with the sudden and aggressive movements of the underlying security.

What is Gamma Hedging?

Imagine it like this. 

You’re a market maker, and you just sold a 1 June 2021 call option for Tesla at $5000 for $0.01.

This means that somebody paid you $0.01, for the right to buy Tesla at $5000 any time before 1 June 2021.

And you did this because you think the chance of Tesla hitting $5000 before then is almost zero.

Now imagine that in the next 5 days, Tesla’s share price goes parabolic because of an Elon tweet, and it’s now $4000. 

That call option you sold looks a lot more likely to be exercised.

Which makes you worried because you sold it for basically nothing.

Imagine this for the big market makers like JP Morgan, with their internal risk controls.

At some point in time, they are forced to buy the Tesla stock to hedge their position.

That’s what the “WSBers” discovered back in Jan, when they bough a whole bunch of out of the money (OTM) call options on GME to create a “gamma squeeze”. 

As it turns out, put a bunch of monkeys together on the internet and they start to break stuff. Who knew?

Effect of Gamma Hedging

Anyway, the net effect of gamma hedging, is that when prices go up a lot in a short span of time, the market makers are forced to buy the underlying stock, forcing price up, creating further interest in the stock, in a vicious cycle.

Kinda like what happened in late 2020 and 2021.

The problem though, is that gamma hedging works both ways.

It works on the way up forcing market makers to buy, and it works on the way down forcing market maker to sell. 

And right now when the market is going sideways, gamma hedging is out of the picture so it removes a powerful force fuelling the rally.

But that’s just my view, feel free to disagree.

3. Archegos related unwind

Talked about this in the Archegos article so I won’t belabour it.

Basically, after Archegos, all the prime brokers were forced to reevaluate risk with their existing clients. Things like asking for more margin, tightening credit lines etc. 

This is a manual process that has to be done client by client, and would take anywhere from 3 – 6 months to play out.

We may be seeing some of that effects play out now. 

What happens next for Tech?

So what happens going forward?

Short term, interest rates and inflation expectations will continue to trend upwards, as the world reopens from COVID (or at least the west). 

Gamma hedging is gone now, and may even kick in to the downside. Archegos related unwind would take around 3 to 6 months to play out.

So the gamma hedging removes a powerful tailwind, and interest rates + Archegos creates a short term headwind. 

Which doesn’t bode well for tech in the short term.

Of course, on an individual stock level, strong earnings will continue to power share price growth. This discussion is more on a macro level.

Long Term Outlook for Tech

That said –  I’m still very bullish on tech in the long term. I just think tech is poised to change the world, and this wave is only just beginning.

But again, I just have to respect the broader macro trend here.

Like I shared in March, I expect this Phase 1 to be volatile, with big moves up and down, but a broader downward trend for the speculative names.

Last week is a good example – where there were big declines throughout the week, then a vicious rally on Friday.

If you’re a short term trader, don’t get too greedy with your longs/shorts, and be careful with your stop losses.

What should investors do?

What investors should do really depends on (1) time horizon, and (2) ability to average in. 

Take me for example. 

My time horizon is long – 3 to 5 years easily, possibly even 10 or more if I like the stock.

And I can average into a declining stock because I draw an income, and I don’t need the money as I have separate cash reserves.

So for me I’m ok to buy stocks I like on the way down, and continue averaging into positions.

But the analysis will differ for each investor. 

Market timing?

Let’s say hypothetically, I wanted to time this market, and buy tech stocks at the bottom.

How would I go about doing it?

I think this one is really tough. This wouldn’t be like March 2020 where the Fed buying marked a clear bottom.

I think here it may be a process rather than a specific point, with different bottoms for each stocks.

If I absolutely had to do it, I would watch the 10 year treasury. 

I think a yield at 2.0% or thereabouts would start to spill over into financial assets, and eventually cause the Feds to step in. 

Watching that + Fed actions + Fiscal stimulus, would probably be how I would do it.

But I genuinely think this one is hard, and averaging in would be my best bet.

Lockdown 2.0?

A couple weeks ago, a Patron asked me if I saw a COVID related stock market sell-off like March 2020.

My answer then, was that no I don’t see it happening, unless we have a mutated variant of COVID.

Based on news reports, the Indian variant is worrying because it seems to be (1) more infectious, (2) more lethal, and (3) hits the young more. Whether the vaccine works against it is still a bit of a question mark. 

It’s funny because the west is full on reopening, while here in Asia we’re going into “lockdowns” again.

But for now, I still think the bigger factor driving asset prices is fiscal and monetary stimulus.

If there are COVID lockdowns, but this means the governments and central banks come up with more stimulus, then that’s ok. 

If there are lockdowns and the governments withhold stimulus, then yeah all hell breaks loose, but I find it hard to see why the government would do that.

So for now, I see any COVID sell-off as a buying opportunity, unless governments/central banks start changing their tune on stimulus.

For all Patron subscribers, I’ll be updating the FH Stock Watch and look to get it out by next week. For those who are new – you can check out how I am positioned and the names I like on Patron.

Closing Thoughts

It’s been a monster of a post, so I would absolutely love to hear what you think.

I don’t profess to know all the answers here, I’m just sharing my honest opinion based on what I see in the news.

If you disagree, just let me know and we can discuss to triangulate the truth.

Stuck at home in Phase 2? Why not learn to invest properly? 

Back by POPULAR DEMAND – We’re running a May promotion for both investing courses.  

2021 will be a volatile year – with lots of opportunities for investors. 

Learn to invest here!

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