Weekly Reflection for May 7, 2021

Market Update

The Federal Reserve was generally positive about the state of our financial system in a report out this week. It pointed out that asset prices “may be vulnerable” especially in “episodes of high trading volumes and price volatility for so-called meme stocks”. It also noted concerns about the high debt taken on by hedge funds and other investors who are leveraging their market positions (see more on that below).

Earnings reports over the last several weeks have highlighted how well companies have done in managing the fallout from the pandemic restrictions. This week the markets have taken it all in stride, measuring the strong results alongside worries about interest rates, inflation and now potential higher taxes which still have to be legislated.

Headlines are trotting out the “sell in May and go away” mantra. The phrase is believed to originate from an old English adage, “sell in May and go away, come on back on St. Leger’s Day.” It refers to 19th century England when the wealthy would go on holiday during the hot months of the summer. They would return in time for September’s St. Legers, a horse race still held in England each year. (Mark your calendar for September 12th if you want to see what all the fuss is about! )

The phrase has taken on a new definition in more recent times. It now commonly refers to an investment theory that would involve selling your stocks to avoid market losses in the month of May. Does the theory payoff? According to Yardeni Research Inc. there have been 54 positive May markets and 39 negative in the S&P 500 Index returns from 1928-2020. In the last five years the S&P 500 has been up an average of 2.8% for May and up in 4 of 5 years.

Margin Debt

Margin debt, the type of loan used by investors to buy securities, is growing. Currently there is $820 billion in margin debt.

Low rates and a still soaring stock market make borrowers feel more confident in taking on debt. And taking on debt fuels the market; more money pushing into stocks perpetuates higher and higher prices. It works the other way too. A market pullback usually leads to forced selling by borrowers, adding fuel to the downside. One only has to think back to late March when the hedge firm Archegos was forced to sell heavily margined positions in Discovery and ViacomCBS exacerbating losses in those stocks. Discovery lost 27% in a day of selling by Archegos and its stock price has still not recovered.

As a quick reminder, investors use margin to purchase more shares than they could with their own funds. Assume you have an account with $13,000. If you buy 100 shares of Apple (AAPL) stock at $130 and the stock goes up 50% to $195, you have a $6,500 profit.

If you use margin you can borrow $13,000 from your broker, the amount equal to the cash already in the account. Now you have $26,000 available to purchase 200 shares of Apple. If Apple goes to $195, you make $13,000 or twice as much before paying the interest on the loan. On the other hand, if Apple drops by 50% now you have only $13,000 (200 shares x $65). Since you owe $13,000 to your broker, not including the borrowing fee, you have lost all of your money and then some.

Even though general borrowing rates are low, margin debt rates are not really cheap, relatively speaking. They reflect the commiserate risk. For example, borrowing less than $10,000 at TD Ameritrade will cost you 9.5% annually. Borrowing $50,0000-100,000 costs 8%.

Where Are the Chips?

The chip shortage has become a big mess for just about every modern manufacturer but is perhaps it is worst for the car makers. Why can’t we just make more chips? It is not that hard people say. To paraphrase the industry joke, “Chip making is not rocket science. It’s much more complex.”

Of course the pandemic work disruption last year was just the beginning of the problem. Along with sudden demands for more of everything – work-from-home gadgets, workout-from-home equipment, and improve-the-home upgrades – factories were quickly overwhelmed.

This is the “bullwhip” effect of small changes in behavior that have large effects across a supply chain. When a cowboy with a whip, or Indiana Jones for example, flicks his wrist only a few inches, the long end of the whip moves several feet through the air with force. The receiving end of the whip gets a massive hit compared to the small flick of the wrist.

So with demand up and factories trying to catch up work stoppage, we have a mess. There is not much more a chip maker can do to rush things. It takes years to build a single factory, which are massive structures complete with the only the most current robotic technology and absolutely dust free, meaning cleaner than an operating room. A new Intel factory today costs $20 billion.

Once up and running, production is happening 24 hours a day. Even at that pace, it may take up to three months to make a single chip, which has as many as 100 layers of components and materials. It is also a race to recoup costs as quickly as possible. Due to the speed of innovation, a facility’s technology can become obsolete in just five years.

Most of the semiconductors are manufactured in China with the U.S. having the second most production. Given the economics, it is not easy for a new producer to pick up the slack. Thus, it may take up to two years for supply and demand to come back into balance.

Any company that requires chips for its products are needing to make adjustments. Samsung said that it might skip the next launch of its Galaxy Note smart phone. No word yet on whether Apple may do the same. The situation seems the hardest for the car industry, which is struggling to adapt. Some are shuttering factories and 1 million less cars will be built this quarter alone. Nissan is leaving out the navigation system in some models. Ram Trucks will forgo rearview guidance to help drivers avoid blind spots. Let's hope this chip shortage is not as long as some say it may be!

Quotes from The Oracle

Both Warren Buffett (“the Oracle from Omaha”) and Charlie Munger are in their 90s, nonagenarians with little signs of taking holiday from their day jobs. Last Saturday they spent three hours on stage in Los Angeles during their investor day to sound off on economics, markets and their ages.

They like big technology and high cash flow businesses like Microsoft and Alphabet, with Buffett arguing that they are not too expensive, all things considered. "We don't think they're crazy. If interest rates are appropriate and 10-year Treasury bonds are priced correctly, those companies are a bargain. The stocks are very, very cheap."

On the other hand, the potential economic outcomes of the massive government stimulus coupled with ultra-low interest rates are alarming. "Charlie and I consider it the most interesting movie by far we've ever seen in terms of economics."

Neither has anything encouraging to say about SPACs (special purpose acquisition companies) but in part because their popularity has made business more difficult for Berkshire Hathaway, a company known for scooping up diamonds in the rough. Said Buffett, "It's a killer. You stick a famous name on it and you can sell almost anything." Munger highlighted some of the darker aspects of the SPACs, which by definition involve a manager selling investors shares of a shell company and taking those proceeds on a shopping spree. Managers have two years to make an acquisition or they must give the money back to investors. "I call it fee-driven buying. In other words, they're not buying because it's a good investment, they're buying because the advisor gets a fee.

On the Robinhood phenomena and options trading by retail investors, the two were more understanding. Said Buffett, "There's nothing illegal about it, there's nothing immoral. But I don't think you build a society around people doing it. I hope we don't have more of it."

And finally, on age. "People talk about the aging management at Berkshire. I would like to point out that, in three more years, Charlie will be aging at 1% a year. No one is aging less than Charlie. Some of these new companies with 25-year-olds, they're aging at 4% a year. We will have the slowest aging management percentage-wise by far that any American company has."