Valuentum Exclusive Analysis for the Discerning Investor

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Let’s get the Valuentum team’s thoughts on recent developments.

No changes to newsletter portfolios.

Last Friday, August 16, Bank of America (BAC) CEO Brian Moynihan said in a Bloomberg interview, “We have nothing to fear about a recession right now except for fear of recession.” We sat down with the Valuentum team to get their thoughts. Let’s go around the horn.

Callum Turcan: Interesting take, and I get why he thinks that way. The feedback loop of recession fears prompting businesses to invest less which in turn hurts consumer spending by weakening wage growth/employment growth rates thus leading to additional reductions in business investment. However, I think we are past the point of fear being the main enemy. Poor industrial data is backward looking and already weak in many parts of the world, which is why China (FXI, MCHI) is launching stimulus efforts and why the UK (EWU) is prepared to spend plenty on the national level to head off a steep recession and so forth.

We’re witnessing weakening data in China, Germany (EWG), the UK, the EU at-large, and now the US. Consumer spending is holding up well in America, but industrial production is coming under a lot of fire and forward-looking indicators are flashing signs of pain ahead. All of this shows that the global slowdown is here. The question is: will a lower interest rate environment combined with additional spending/stimulus at the national level--a possibility in Germany as its federal elections draw nearer, along with other parts of Europe pursuing additional spending and/or tax cuts, like in Italy (EWI)--be enough to manage that decline so we don't tip into a global recession (with weakness widespread, from Europe to Asia to everywhere else)?

Given the ability of the US Fed to cut interest rates by a significant amount and considering the dynamic nature of the US economy in general (the US economy rebounded from the Great Financial Crisis on much stronger footing than its European peers), I think the US is without a doubt the best-prepared of the wealthy, developed nations to avoid a deep recession. For one, the EU is already posting non-existent growth with negative interest rates, and Japan's (EWJ) upcoming VAT increase might push the country into recession regardless of what happens on the global stage. However, I don't know if the US economy can avoid a recession outright within the next two years if global growth slows down substantially given expansive fiscal policy late in the business cycle and that US interest rates are still historically quite low, offering less firepower on the monetary easing front (even though they are higher than in the EU or Japan).

Brian Nelson: Very interesting Callum.

It’s hard not to take the behavioral dynamics (“fear”) seriously given some of the wild swings in the market. Many are pointing to the “algos” for the huge intra-week up and downs coupled with large 800-point down days. It could have been program selling on the 2-10 inversion recently, but nonetheless, I don’t think a lot of investors are thinking about individual securities, but rather playing theme-based indexes and ETFs, and economic indicators could influence broad based selling irrespective of micro considerations. Markets are starting to trade more and more as one as ETFs and indexes proliferate.

I think the currency war with China, if that can be called as such, might be the unexpected catalyst for the global slowdown, but I do think that psychology and behavioral considerations play an important role behind what causes recessions. One dynamic that may mitigate the pain of the next recession, however, is that most companies today are very asset-light relative to those of decades-past. Where recessions may have been driven by overbuilding and then excess capacity followed by a drying-up of demand, the global economy today seems much nimbler in fitting costs to changing revenue. We see this perhaps best reflective in the failures of the traditional value factor, which is based on price-to-book, where book equity has become largely irrelevant to assessing operating and intrinsic value.

I feel like the global economy is walking on thin ice. We are definitely in unchartered waters given the massive amount of negative yielding debt and that we’re even considering NIRP in the US. Many are even saying we could see a 75-basis point cut the next time the Fed meets to surprise the market and indicate that the Fed is serious about attacking deflation. I think the idea of the US entering recession at some point is a given. The answer is always when and how deep the recession will be. On the other hand, there are others that are suggesting the business cycle is antiquated and that US Fed, Treasury have tools to make the idea of a recession a part of the past.

The markets have been a tremendous source of wealth during the past decade or so, and I believe that for the global economy to really turn sour, the markets would have to lead the drop. We saw a steep fall in December 2018, but investors were so anxious to jump in at those levels (perhaps aided by advisories’ view that “markets have always gone up”) that the weakness wasn’t long-lived for structural re-allocations. Same might be the case for the inverted yield curve. For these items to truly influence buying and selling behavior to cause the recession that many are anticipating, they have to be more prolonged in nature.

On Monday of this week, President Trump called for a full point cut and quantitative easing.

Callum: Maybe one day soon there will be something known as the Trump put, where the market starts pricing in expectations that the Trump Administration will do whatever it can do to keep equity markets up (keeping the unconventional nature of this mercurial presidency in mind). Whether that involves firing Fed Chairman Powell to ensure a very accommodative US Fed, possibly rolling back certain tariffs in a bid to make it look like trade talks are improving, or something else, Trump has his eyes firmly set on S&P 500 (SPY) reaching and staying at the 3,000 level.

Matthew Warren: I guess it shouldn’t be surprising that there is a circular logic to the economy and the markets. After all, it was quantitative easing that pulled us out of the last recession. Higher stock, bond, and home prices were huge drivers of the global recovery. So, every time the market goes down 5% from an all-time high, people get spooked about deflation and an 2007-2008 type event. Because we stimulated our way out of it, we never took all the pain. Just look at the European banks (XLF). We still have overcapacity and “zombie” banks. In the US, we have unaffordable housing (XHB) in so many markets the younger generations are becoming perma-renters even though we have way more buildable land than Europe. 

The tail now wags the dog, and I very much agree with Brian that the price-agnostic quant trading is creating air pockets left and right. I would bet dollars to donuts that if the market went down 25% and stayed there, we would have a recession. The economy is simply too dependent on inflated markets just to get by.

Brian: I’ve been really thinking about what Matt said regarding a deflationary bust and how that might topple the banks in our latest discussion. It’s one of the situations where if the US does win the trade/currency war, driving China into a tailspin, everyone loses. I guess perhaps nobody really wins a trade war. Interesting that some of the gold bugs out there are talking about the risks of global inflation, even talking about the need for a return to the gold standard.

In the age of cryptocurrency (BTC, GBTC), it seems that the potential for dislocations to occur in the currency markets could complicate matters. Crude oil (OIL, USO) prices have been falling. Norway’s krone hit the lowest level since the 2008 financial crisis. Some are talking about perhaps a structural reason for bank and energy (XLE) weakness, too, that we are entering a new phase of digital currency and the rise of clean fuel. I’ve traditionally shared the same views as Buffett on gold (GLD), but I wonder if I should change my thinking. In the age of cryptocurrency, by comparison, gold even seems like a safe(r) haven.

Gold is at half-decade highs, and I wonder if it may be the “play” for both inflation and deflation?

Matt: I am sympathetic to the money printing and debasing of currency arguments, but I pretty much follow Buffett’s lead on gold. 

In a wildly inflationary environment, economic moats matter a lot, so high quality companies beat low quality. In a deflationary environment, one may want to consider long-duration treasuries, high quality companies, and one absolutely wants to avoid financial leverage.

Banks would struggle in deflation, just as their borrowers would and there would be no yield pickup in safe assets in the balance sheet (treasuries and mortgage-backed securities).

Brian: Although we’ve witnessed some very strong second-quarter results from consumer bellwethers, including Walmart (WMT), Target (TGT), and Lowe’s (LOW), there are also pockets of significant weakness, particularly in the department store and mall-based space. On the other hand, there are also areas such as prestige beauty that sell into these channels that are doing extremely well.

We continue to focus on some of the strongest names out there, particularly those with solid balance sheets (net cash positions) and those that we expect to generate substantial free cash flows. We still like big tech with Facebook (FB), Alphabet (GOOG, GOOGL) in the Best Ideas Newsletter portfolio and Microsoft (MSFT) in the Dividend Growth Newsletter portfolio, as a few of our favorites. We maintain our view that antitrust scrutiny on big tech will force the market to evaluate assets on discounted cash-flow basis for potential divestitures, a counter-intuitive net positive for shares.

Visa (V) and PayPal (PYPL) continue to be at the forefront of the financial tech revolution, and we like this exposure. A large part of the world has yet to make the transition to digital payments, so we view Visa and PayPal as having long secular-growth runways. Interesting, too, we view Visa and PayPal (and Facebook) as indirect ways to play the trend in cryptocurrency given Libra. Cryptocurrency is not core to our thesis on these names, but rather icing on the cake. We don’t see cryptocurrency as a potential “diversifier” for any portfolio. Many of these digital assets could be worth nothing in coming years, so please be careful out there.

We view speculating in cryptocurrency somewhat in the same manner as we do with speculating with cannabis stocks (MJ, SOIL, ACT, YOLO). Where we like Visa, PayPal and Facebook, by themselves (without Libra), and only as indirect plays on cryptocurrency, if investors feel like they must be involved in cannabis stocks, diversified beer and wine producer Constellation Brands (STZ), given its exposure to Canopy Growth (CGC), would be our idea for consideration--but only if you’re interested in exposure to the cannabis space, which we are not. Cannabis pure plays are rather risky, and one doesn’t have to look much further than Tilray’s (TLRY) substantial decline to see why.

That’s it for now. Please join the conversation below.