Research Notes: The Beatings Will Continue Until Morale Collapses
The intense focus on the Fed and inflation is missing the point. Plus, positioning for a rough 12-18 months
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In the wake of this week’s CPI print, broad market discussion has focused intently on the Federal Reserve. Will the Fed now go with a historic 100 basis point hike? Will that hike lead to a recession — or deepen the recession in which we already find ourselves?
But as far as the equity market goes, I’m not sure the macro picture really is the biggest problem. The simplistic narrative here is that higher interest rates plus recession risks led to the big sell-offs over the past 3-17 months (depending on which part of the market you’re looking at). That narrative ignores a key factor, and I’d argue the key factor: valuation.
At the beginning of the year, the ratio of US market cap to GDP was over 200% — which appears to be a record and was higher than that seen during the dot-com bubble. In the context of the post-crisis world, that ratio remains elevated:
We can talk all we want about GDP, but the problem with this ratio isn’t the denominator — it’s the numerator. And as we’ve written repeatedly, looking at equities right now, even ignoring recession risk, they’re not cheap. There are not seemingly obvious buys1 out there left and right, which is usually the case when a bottom is in sight.
Another well-known problem with the macro discussion is that it’s not like any of us have a real chance of predicting performance. Obviously, no one really knows for sure. Economists have a mediocre track record on this front, and generalist investors do just as poorly.
In recent history, the equity market’s macro expectations badly overshot to the downside in 2009 (things were bad, just not nearly as bad as many feared), 2011 (when many were convinced of a double-dip recession in the US and Europe), and 2020 (for obvious reasons). Conversely, in 2005-2007, and to a lesser extent 2019 and 2021, investors incorrectly believed that the party would continue despite rising evidence to the contrary.
But that’s precisely the point. From the perspective of equity investing, these macro discussions matter not in the context of what actual macro performance will be, but how our fellow investors will react to that performance. And hence, in recent weeks, we’ve had some express the tortured logic that a high CPI print is good because the economy will slow down faster, which means the Fed will cut faster, which means investors will get back to buying equities faster, and so it’s best to hop on board first.
There’s a way to cut out the middleman here. The first words I wrote on this site were:
I don't believe the market can be consistently timed. But the market can be occasionally timed.
Particularly at these inflection points, the sentiment of other investors can be enormously valuable in trying to time a bottom. Again, the point of these exercises, if they’re useful at all, in an environment like this is to understand when to press and when to pull back. And if those exercises are useful, and the analysis correct, the value is enormous.
Because the most important prerequisite for long-term capital appreciation is avoiding the big losses that destroy compounding. This isn’t just a matter of buying properly-timed call options.
There has been some discussion (including today on CNBC, apparently) that sentiment indeed is bearish enough. We disagree.
Broad market indices have fallen, yes — but, in reality, nothing really has changed. We still have a crypto venture capitalist investing $30 million in “Twitter (TWTR), but on the blockchain”. The excesses in private equity haven’t been cleared. We still have equity investors trying to find reasons to buy. Tourist retail investors remain (and, March 2020 aside, they’re always late to ride the bull and last to get off the bear). AMC Entertainment (AMC) is still at $15, and GameStop (GME) has nearly doubled since mid-May.
Other investors are welcome to do all the macro analysis they like. Having seen this story play out before, my analysis is simple. We need a reckoning. The silliness on the way up needs to be matched by the pain on the way down. The DeFi pumpers, the sh—coin buyers, the growth bros, the institutional investors who piled into PE and VC at the end of the run, the “traders” on Twitter doing technical analysis based on a three-month candlestick…they all need to be cleared out, to be chastened.
We expressed precisely that sentiment in our very first post. The reckoning hasn’t happened. This still looks like a market that is looking for reasons to buy, and clinging to hope that this is all going to work out somehow. We bottom when those hopes are gone, along with the investors and charlatans who fueled all of these bubbles. It’s hard, from here, to believe we’re anywhere close to that point.
Looking For Shorts
And so we’re looking for shorts.
In our short call on Carvana (CVNA), we detailed the argument that short-selling doesn’t require trying to time the top. It can be just as profitable — and certainly far less risky — to hop on once a stock like that starts to collapse.
With some of 2021’s hottest stocks down 80% or more, it may seem like it’s still too late. But whether an investor disagrees with our take on the market as a whole or not, it doesn’t take a long look to see that many of these stocks may well fall 80% — and then another 80%. Investors nervous about the market, looking to hedge, or simply comfortable with bearish bets2 shouldn’t necessarily believe that the “easy money” has been made. In these names, there’s probably some easy money left:
Yes, COIN stock is down 86% from its highs. But ignore that past and focus on the present: Coinbase incredibly still has a market capitalization over $11 billion.
Yet everything is going wrong. Everything. The issue here is not just the plunge in cryptocurrencies (though that, too, is obviously a huge threat). Coinbase operates in a competitive industry which — just as in the equity market — commissions will over time move to zero.
Meanwhile, its market share has plunged, with a recent Mizuho estimate now at 2.9% against 8-9% as recently as November.
Coinbase is going to be sharply unprofitable this year, at the same at least two of those three negative trends show no signs of abating. (Of course, in fact they’re connected; the fact that Coinbase’s fees are so high is a key part of the reason its market share is compressing so quickly.) It’s hard to think of a better example of just how far this portion of this market still has to fall.
We stand by our short call on TSLA from last month. If anything, the biggest risk seems to be that the stock continues to defy gravity. Competitors are taking share, the head of autonomous driving just left, and CEO Elon Musk managed in the Twitter saga to upset at least a chunk of left-leaning Americans who are probably in his target market.
But this still is a company with a $700 billion market capitalization. If an investor believes that the true market wipeout hasn’t yet arrived, this is one of the best plays on that thesis. There is absolutely a world where TSLA is worth $150 billion twelve months from now — no matter what happens with Twitter.
I wrote about Upstart for Investing.com this week, and to be completely honest I need to get deeper into the business model here to understand if there’s something I’m missing.
But I’m not sure there is, and in that context the fact that UPST has declined 94% from its highs and yet still has short interest over 30% makes some sense. (We haven’t updated our Sh—co Rule of 100 list, but UPST might now be at the top.)
The entire debate here comes down to whether Upstart has some secret sauce that makes its loans more profitable. Q2 earnings suggest it doesn’t. And as I wrote in that piece, long-running personal lender Enova International (ENVA) historically has been valued at 6-8x earnings at most (it’s at 5x+ right now). If that’s the long-term profile for Upstart, that company’s market cap is not going to stay at the current $2.65 billion.
Beyond Meat (BYND)
We’ve talked about Beyond Meat a few times here, in the context of its 0.2% gross margin in Q1 (9.8% if you exclude launch costs for Beyond Meat Jerky), and its role as one of a number of struggling early-stage, consumer-facing, stocks.
It’s worth mentioning BYND again, if briefly, because the stock has spiked back to near $30; it’s now up 45% off its lows, and the fully-diluted market cap clears $2 billion. The three-month equity chart now looks like this:
And the three-month chart for the company’s 0% (LOL) convertibles, due 2027, looks like this:
The bond market is telling us that Beyond Meat likely won’t make it to 2027 without filing for bankruptcy3. The stock market is telling us the company’s equity is worth $2 billion.
In theory, those two statements aren’t by definition contradictory: imagine a company with a 20% chance of survival and a terminal value of $10 billion in that upside case. In practice, however, the credit and equity markets are telling us two very different stories. In this case, betting on the credit market seems to make some sense.
To be clear, SHOP seems like the weakest short opportunity in this group, and the market seems to agree. Short interest is just 6.41% of the float at this point, per YCharts data, nearly double where it was at the beginning of the year but down from a May peak above 8%.
But there’s a bear thesis here that goes beyond the 150x forward P/E: that Shopify’s business is about to get wrecked, for two reasons.
First, an inflationary/recessionary/slower-growth (pick as many adjectives as you like) environment leads people to de-risk. One imagines many Shopify businesses being started in lieu of a second job, or with relatively modest but still material amounts of capital that were easier to expend during a boom.
Second, Shopify may be a victim of the privacy changes being enacted by Apple (AAPL) and, eventually Alphabet (GOOG) (GOOGL) unit Google. It’s precisely targeted advertising that has allowed the growth of many of these independent online businesses; their ROI seemingly is about to plunge.
To be sure, this doesn’t mean Shopify’s revenue has to fall 30% or 40% — but, remember, this is a platform business. Incremental margins are high, but so are decremental margins. A modest deceleration in revenue growth means a significant deceleration in profit growth. And, as with so many of these fallen angels, there’s still a lot of growth priced in.
As of this writing, Vince Martin is short TSLA. He may initiate a short position in BYND, COIN, or other stocks mentioned in the near future.
Tickers mentioned: COIN TSLA UPST BYND SHOP
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To be sure, some of these seemingly obvious buys are value traps, particularly ahead of a recession. But that’s the point — it’s difficult even to get into trouble right now!
One not-terrible idea for this group is at-the-money or even out-of-the-money bear spreads, which can provide impressive returns simply for betting that these stocks won’t rise. Obviously, a bear market rally is a huge risk, since it’s usually garbage stocks that bounce the biggest, but expirations and strike prices hopefully can mitigate some of that risk.
Recovery value here probably is pretty minimal: PP&E is carried at $241 million. The last trade of 37.75 probably puts the odds of bankruptcy in the high 60 percent range.