Paying The Piper

Good Morning,
 

Stocks slumped on Friday as increased tensions between Ukraine and Russia sent oil spiking and led investors to dump risky assets like equities. Shares were mostly flat on the day until Ukraine-related headlines in afternoon trading caused traders to dump stocks and buy Treasuries.

With about 2 hours left in the trading day, U.S. National Security Advisor Jake Sullivan said at a White House briefing that there were signs of Russian escalation at the Ukraine border and that it was possible that an invasion could take place during the Olympics, despite speculation to the contrary.

Both the U.S. and U.K. have called for their citizens to leave Ukraine as soon as possible. Sullivan noted that the U.S. is not certain that Russian President Vladimir Putin has made a final decision to invade Ukraine. But “it may well happen soon,” 

This week’s volatility in the bond market started after a hotter-than-expected inflation reading on Thursday, which prompted St. Louis Fed President James Bullard to call for accelerating rate hikes — a full percentage point increase by the start of July.

Goldman Sachs shifted its expectations for the Fed this year, calling for seven rate hikes in an effort to cool an economy that has generated inflation far more persistent than policymakers had anticipated.

Our Take 

What a difficult environment. It’s as if with every passing day the macro environment deteriorates and the outlook for 2022 grows more fragile. 

We believe that investors should avoid wasting time on things that are unknowable and unimportant and focus primarily on things that are knowable and important. Nevertheless, some unknowable questions such as the direction of interest rates, how high inflation will go and where the economy is headed are important.

Yet how do we confront their importance if they are unknowable? To study such questions, we practice looking at facts and deriving probabilistic statements. Not whether we will be right or wrong but rather: “What is the probability of this scenario versus another, and how does this information affect my assessment of value?”

When it comes to the unknowable yet important macro questions above, we believe as we stated back in November, that governments and central banks are caught between a rock and a hard place. They face persistent above trend inflation that is poorly understood while their economies’ fundamentals weaken, dependence on loose monetary policy becomes entrenched, debt burdens continue to rise, and politicians have gone all in on anti-growth/anti-business populism.

We still maintain this view, yet even after the historic selling which kicked off 2022, we see the potential for more downside as the piper collects his due. Both the Fed and Joe Biden’s credibility are now on the line as too many people are suffering from the effects of stubbornly “non-transitory” inflation. The issue is now political and with 40% of American voters holding no stake in asset markets, the Fed will find it very hard to pivot away from established tightening expectations.
 

The Fed will be tightening into fading cyclical growth momentum at peak valuations, significantly raising the probability of additional drawdowns. 

Core to the slowing growth view are peak/declining readings on various well-known inputs like ISM New Orders, US Consumer Confidence, trade weighted US$, US BBB credit spreads, and Global Manufacturing PMIs. Bond markets seem to agree as the gap between the 2-year and 10-year Treasury yields has sunk to its lowest since late 2020.

Unfortunately, the Fed looks poised to tighten for the wrong reasons (slowing runaway inflation in an economy with a backdrop of weak fundamentals) rather than for the right reasons (slowing runaway inflation in an economy with a backdrop of strong fundamentals). It should also be noted that investors underestimated how much the Fed would raise rates in the last three tightening cycles, so there is a risk that the Fed may tighten more than expected this time around.

Bottom line, the probability of profit growth momentum peaking and slowing through 2022 and even into 2023 is high. With 4Q earnings underway, the slowdown is already apparent. The pace of positive surprise has slowed meaningfully in 4Q21 with fewer positive revisions to subsequent quarter forecasts and corporate guidance has returned to its mildly negative average. The slowing rate of change is how weakness begins…

China is also an important leading indicator (typically as goes China, goes the West) and their central bank has already begun an easing blitz with fresh rate cuts. A serious Chinese economic downturn would endanger growth everywhere.

Despite the above, we must stress that this environment is fluid. As a result, we will remain defensive yet will not hesitate to shift to offense if the pendulum swings too far towards extreme fear.

This is a challenging environment with the worst start to the year since January 2009, but for the long-term investor, there is always opportunity amidst volatility. The long-term investor’s portfolio is not, nor should it be, immune to rough patches. After all, to enjoy the benefits of compounding, such patches must be endured.

The long-term investor should remain focused on allocating capital to assets based on well-reasoned estimates of their potential and remain confident that with patience, the storm will pass as it always does.

“To make money in stocks, you need to have vision to see them, courage to buy them and patience to hold them. Patience is the rarest of the three.” -Thomas Phelps

Musings

 

Looking back on 2021 at Logos LP with an eye to 2022 we’ve put most of our energy into honing the definition of our “circle of competence”.

“I’m no genius, but I’m smart in spots, and I stay around those spots.” -Tom Watson Sr.

As liquidity is drained and capital becomes more discerning, the ability to correctly evaluate “select” businesses is paramount. As opportunity sets improve, the importance of knowing our sweet spots increases.

At its core, our circle of competence includes durable, high-quality (growth security and deliverability) businesses that are trading at reasonable (or cheap) valuations relative to their long-term earnings power. If we are able to develop a deep understanding of these businesses and establish confidence in their long-term business results, we will build meaningful stakes.

No single strategy works in every kind of market yet we believe that long term, having a concentrated portfolio composed of such businesses will offer the best odds of outperformance.

As the Fed moves down a tightening path and elevated market volatility compresses multiples, dislocations are beginning to create attractive opportunity sets in our sphere of competence. One sector in which we are seeing the most attractive opportunity set of relative value per unit of fundamentals is healthcare/life sciences.

At present, the healthcare sector typifies the “quality value” factor trading at a roughly double discount relative to the broader market. This sector offers well above market FCF yield, double digit sales growth and low volatility of sales. Relative earnings for the sector (vs. other sectors) also appear to be poised for improvement which can support outperformance. This is before considering the secular forces of aging populations, growing demand for health and wellness as well as treatments for complex and chronic diseases. Such factors also underpin the secular trends currently fueling investment in healthcare sub-sectors including healthcare services, infrastructure, and research globally.

We believe these sub-sectors hold some of the most important innovations of our lifetime, in addition to possessing some of the most durable tailwinds we have seen in a post-Covid world. According to EvaluatePharma, by 2026, global pharmaceutical R&D spend is expected to reach $233 billion coinciding with US national healthcare expenditures increasing at a 5.5% CAGR between 2019 and 2028. These secular tailwinds should continue to drive greater demand for diagnostics and novel therapeutics, addressing the world's most complex and onerous disease threats, such as cancer, Alzheimer’s, and other life-altering diseases.

There are currently more compounds in Phases 1-3 of clinical trials than in any other period in history (Figure 1). Additionally, the number of biotech formations and catalysts (these are measured by FDA approvals, audits, readings, or patient output) has declined to 9-year lows due to: 1. Covid delays; 2. No FDA head for the 9 months prior to October 2021; 3. Fluctuating lockdowns impacting clinical trials (Figure 2). This has led to one of the lowest valuation troughs for the small-to-mid cap biotech sector over the past 20 years (Figure 3) and the longest (and largest) drawdowns for the XBI vs. the SPY in history (Figure 4).

Figure 1:

Source: Pharmaprojects 2020

Figure 2:

Source: Evaluate Pharma; Bloomberg; Wedbush Securities, Inc. Research

Figure 3:

Source: Wells Fargo Securities

Figure 4:

Source: Wells Fargo Securities

Additionally, the biotech sector is well capitalized with high quality assets during a period in which cash rich big pharma will likely look to M&A as they face imminent patent cliffs.

Within the complex described above, we believe the optimal approach is to look at the ‘compounder’ businesses that are less cyclical, possess oligopolistic characteristics, very strong pricing power and are comfortable with share buybacks. 

We are currently focusing on a few businesses that meet these criteria including:

1. Charles Rivers Laboratories (CRL) – Provides CRO services to roughly 80% of all FDA approved compounds.

2. West Pharmaceuticals (WST) – Holds 70% market share in drug packaging and has been involved in 90% of all biologics delivery since 2019.

3. Repligen (RGEN) – Has a virtual monopoly on ligand A proteins, a key ingredient for any FDA approved vaccine or therapeutic.

Given the make-up of the economy in a post-Covid world, we believe this rare breed of business is well positioned to take advantage of certain secular tailwinds that will likely be present over the next decade and will provide attractive long-term IRRs. Furthermore, this view is supported by peaking cyclical growth as well as a slowing pace of earnings growth as 2022 progresses (see above). Slowing growth elsewhere will favor the growth security and deliverability of such businesses in the healthcare/life sciences sector.

Charts of the Month

The gap between 5- and 30-year yields narrowed to less than 40 basis points, the smallest since the Fed was at the end of its last rate-hike campaign in 2018. That signals speculation that economic growth will slow as the Fed tightens monetary policy.

History doesn't repeat but it sure does rhyme. Tightening tantrum followed by growth correction…

Earnings revisions and outlook views tend to begin with a trickle and then the downward revisions lead to a change in the consensus outlook…

Historical look at core goods minus core services inflation with recessions … spread is more negative now than at any point going back to late-1950s.

The S&P 500’s real earnings yield continues to plunge; now at -3.2% (an all-time low). We are living in the upside down…

When if ever will China take the number one spot? Maybe never..

Mid term years can be ugly…

Logos LP December 2021 Performance

December 2021 Return: -9.46%

2021 YTD (December) Return: 4.82%

Trailing Twelve Month Return: 4.82%

Compound Annual Growth Rate (CAGR) since inception March 26, 2014: 22.58%

 

Thought of the Month


“People who arbitrage time will almost always outperform. The first order thought of instant gratification is a crowded path, ensuring mediocre results at best. Delayed gratification, which requires second order thinking, is less crowded and more likely to get results.” — Shane Parrish

Articles and Ideas of Interest

• Does the national debt matter? For decades now, there have been many over-simplistic views on government debt. Some people were acting as though it would be a near-term catastrophe thirty years ago, and it never was. On the other hand, there are people who say it barely matters at all, ironically when it’s probably starting to actually matter. As with most things in life, the truth is somewhat more nuanced. This article by Lyn Alden dives into some of the details as far as the available data are concerned.
  
   

• The great climate backslide: How governments are regressing worldwide. From the U.S. to China, harsh economic realities mean the political will for painful choices is evaporating fast. In 2022, a toxic combination of political intransigence, an energy crisis and pandemic-driven economic realities has cast doubt on the progress made. If 2021 was marked by optimism that the biggest polluters were finally willing to set ambitious net-zero targets, 2022 already threatens to be the year of global backsliding. 

• When will China be the world’s biggest economy? Maybe never. When will China outstrip the U.S. to claim the top spot in the world economic rankings? For Beijing, it would be convenient if everyone viewed that transition as inevitable and imminent. The reality is as Bloomberg outlines, it’s anything but. A debt crisis, demographic drag, and international isolation could all keep China stuck in perpetual second place.

• Are we cultivating a generation of failed startup founders? Are we driving innovation, or instilling false hope in wannabe entrepreneurs? Medium’s largest publication is The Startup, with more than 700,000 followers. Hundreds of thousands of people who are curious about startups, have created one themselves or plan to build one in the future. More and more people are joining the conversation. More and more people are starting their own side hustles or full-time ventures because they’re hoping that it will lead them to success. Can all these people make it? Can so many people change the world in a million different ways? Or might we be better off encouraging these people to search for secure jobs, so they contribute to the economy in a safe and predictable way? Very interesting article examining the implications of the cult of the “startup”.

• The big question: how long can private market multiples stay elevated while young public companies compress? The median ARKK holding traded for 33x sales in early ’21. Today it’s 9x and going lower by the day. There is almost certainly a tipping point, but Michael Batnick thinks this dichotomy can last longer than most people think. There’s too much money chasing too few deals in private markets, and an interest rate hike or two may not change that.
  
   

• The lockdown catastrophe. Where are the public health benefits to justify Covid-era shutdowns and spending? Government disease doctors and politicians around the world panicked in the face of Covid and began shutting down societies in early 2020. The accounting has hardly begun on the impact of isolating human beings, denying them opportunities, education and experiences—not to mention disrupting non-Covid medical treatments and myriad other valuable services—and then attempting to simulate the benefits of a functioning society by printing fiat money. It will take years to understand the full cost of this man-made catastrophe, But emerging research suggests that on the other side of the ledger, public health benefits were extremely small, if they can be verified at all. The WSJ digs into the results of a new study on the effects of lockdowns by Johns Hopkins economist Steve Hanke and colleagues from Denmark and Sweden.
  
   

• Some good observations from Michael Batnick about 2021. What makes this game fun and exciting is that there is no handbook where we can observe the rule changes. All we have are numbers on a screen. When something that worked for 30 years stops working, how long before we pick up on the shift? My favourite: avoid extremes.

• The capital sponge. Why have US stock outperformed for so long? Lyn Alden suggests that the US put in place a set of policies over the past four decades that pulled a lot of domestic and global capital into its stock market. This naturally had some pros and cons associated with it. Each country generally has a set of political priorities, and those priorities can change over time. Compared to other developed nations, the US has favored its corporate sector above most else since the early 1980s, which made the US stock market an attractive sponge to absorb capital from everywhere. As a result, the US stock market capitalization currently represents 61% of the global stock market capitalization, despite the fact that US GDP is only 23% of global GDP. Are the factors behind this trend running out of steam?
   

Our best wishes for a year filled with discovery and contentment,

Logos LP

When Winning Is Not Losing

Good Morning,
 

Stocks rallied Friday, but still posted their first losing week in six amid heightened inflation fears. The major averages closed the week lower after the hottest inflation report in 30 years. The Dow fell 0.6%, the S&P 500 dipped 0.3% and the Nasdaq Composite inched down about 0.7% on the week.

Consumer sentiment in early November dropped to its lowest level in a decade, the University of Michigan reported Friday. Plunging consumer sentiment prompted hope among traders that the Federal Reserve would delay any interest rate hikes. Many survey respondents cited inflation concerns, according to the report.

Meanwhile, workers left their jobs in record numbers in September with 4.43 million people quitting, the Labor Department reported Friday. The exodus occurred as the U.S. had 10.44 million employment openings that month, according to the report.


Our Take 

Inflation is looking a lot less "transitory" after CPI numbers for October showed that consumer prices jumped 6.2% from a year ago, while notching the fifth straight month of a figure higher than 5%. It's also the fastest rate since 1990, and while that might cause some worry in the general population, Wall Street appears to be discounting the effects. Many continue to argue that the Fed won't get too aggressive, inflation could moderate next year, while some think stocks could even benefit along with a rise in asset prices.

Politicians are certainly taking notice: "Inflation hurts Americans pocketbooks, and reversing this trend is a top priority for me. With the [infrastructure] bill we passed last week, and the steps we're taking to reduce bottlenecks at home and abroad, we're set to make significant progress," President Biden said in a statement. "Very soon we're gonna see the supply chain start catching up with demand, so not only will we see more record-breaking job growth, we'll see lower prices, faster deliveries as well. This work is going to be critical as we implement the infrastructure bill and as we continue to build the economy from the bottom up and the middle out by passing the Build Back Better plan."

On the other hand, in the face of persistent inflation, central bankers around the world are increasingly looking like they are caught between a rock and a hard place. The only way to keep the economy afloat and the expansion continuing was (and is) to keep rates near zero. 

Yet the medicine used to solve the problem of jumpstarting the economy created two new problems: asset bubbles in just about everything, spiralling cost living and an economy that has become addicted to the stimulus drug. 

As John De Goey has pointed out, stimulus can be conceptualized as a form of economic antibiotics: antibiotics stop infections caused by bacteria; stimulus stops economic illness caused by slow growth. No one would ever recommend staying on antibiotics indefinitely. Yet given that any change to the status quo risks triggering a financial meltdown, central banks are stuck. 

Thus, what appears most likely is that there will be no significant tapering or normalization of any kind until we are faced with the harsh no-win economic ultimatum to do something about inflation that is without a doubt non-transitory. 

We haven’t reached that moment yet and there is a compelling argument that we may never reach it as with each passing day the status quo (and associated addiction) becomes more entrenched.


 Musings

Observing most of the major indexes, asset classes, economic output and inflation hit record highs, while consumer sentiment hits ten year lows, has prompted us to shift focus away from the “build wealth” side of the coin to the “preserve wealth” side. 

Market participants appear to have discarded caution, worry and fear of loss and instead obsess about the risk of missing opportunity. Worry appears to be in short supply as most investors who have stayed the course over the last decade have done exceedingly well. Despite the fact that about half the U.S. population does not have a significant stake in the stock market, U.S. household net worth has hit record highs led by real estate values and stock prices.

Stocks have surged to record highs, and low borrowing costs have supported a flurry of home buying, and ultimately home price appreciation. Massive support provided by the government and the Fed has bolstered Americans’ wealth. 

Gains are so considerable that data suggests they may be fuelling the labor shortage (U.S. workers quitting their jobs just hit record highs) as people exit low-paying work to trade stocks and risky digital assets. Too much money is chasing the risky and the new, driving up asset prices and driving down prospective returns and safety. 

What should we make of all of this? In our view what is occurring today appears to be a modern permutation of a classic behaviour. As Mark Twain famously remarked: “History doesn't repeat itself, but it often rhymes.”

Economies, like life, are sine waves with attitudes and behaviour oscillating between peaks and troughs. When it comes to markets, declines can occur because many people’s goal is to become so successful (wealthy) that they can relax (think top of the sine wave), and relaxing leads to complacency (worry is in short supply) which sows the seeds of future decline (and back to the bottom of the sine wave we go).
 

I’ll always remember a conversation I had with a mentor of mine years ago when he noticed me “over celebrating” a win. He saw celebration as something sloppy, something dangerous, a self-indulgent act that could derail one's focus. He told me “if you have arrived, then what is there left to do?”

Most people’s career goal is to work hard so that one day they can stop working. Our economies are set up around this concept. If we can just get to retirement then we can relax.

The problem is that if enough people adopt this mentality simultaneously and feel that they can“relax”, relaxation is compounded into complacency. Think about the uncertainty and hardship brought on by COVID-19. Perhaps the incredible recent asset price gains and associated investor behaviour can be better understood through this lens. 

Becoming financially successful typically requires years of hard, stressful and unglamorous work. It’s understandable that once a certain level of financial success is achieved some feel justified to slow down, kick back, and let their guard down – especially when their assets are rising in value almost daily. 

People today understandably need a break from what has been an incredibly taxing and uncertain last two years. Desire for comfort and confidence is high. Bandwidth for skepticism, fear of loss and risk aversion is low. 
 

Investors long for the feeling that they are finally “getting ahead” despite the gravitational pull of inequality/class stagnation and spiralling costs of living. Yet as my mentor so aptly pointed out, there is usually a cost to such indulgence. A cost for casting skepticism aside and replacing reticence with eagerness. Success has an odd way of increasing confidence more than ability. The longer it lasts, and the more it was tied to some degree of luck, the truer that becomes. 

Recognizing this pattern and identifying it is key for investment survival as building wealth and preserving it are two different skills. 

On the one hand building wealth requires taking risks, being optimistic and swinging the bat. On the other, preserving wealth requires frugality, humility and a healthy dose of skepticism. It also requires an understanding that what you have can be taken away from you just as fast in addition to an acceptance that at least some of what you have can be attributable to luck. 

For us, the past two years and the current moment of rapid asset appreciation and high risk tolerance have made us think a lot about longevity and survival. Few gains are worth permanent capital loss and to experience the power of compounding in life and in markets, one must survive the unpredictable dips along the way. 

What does thinking about survival and longevity mean for us today in light of the above? 

For us it means increasing room for error by focusing on increasing our “margin of safety”. What measures can be taken to raise the odds of success at a given level of risk by increasing our chances of survival: 

-Reducing financial leverage 

-Flexibility of strategy and worldview

-Increasing willingness to commit capital to investments when risk is obviously being well priced, such as late 2008, 2009 or March 2020 and being less willing when risk is not being as well priced like 1999, 2007 and perhaps today

-Adopting an attitude of patience, humility and skeptical optimism about the future

-Having clarity on one’s investment time horizon

-Focusing on avoidance of accidents and permanent losses - recovering from disaster is difficult if one loses 50% on an ill-considered investment as a 100% gain is needed just to get back to where you started

-Respecting uncertainty by not assuming that the period ahead will resemble the period one most recently experienced 

-Avoiding faddish and vogue investments 

-Avoiding business models that are particularly vulnerable to technological change as well as those with opaque balance sheets or too much financial leverage

-Focusing on businesses that are less vulnerable to competitive forces - think DHR, WST, MSFT, CRL

With a focus on increasing our “margin of safety” we can increase our odds of hitting the ball out of the park without ever swinging for the fences. During “go go” times like these in which investor behaviour evidences a widespread belief that risk is low, winning becomes about not losing...

Charts of the Month


When looking at the sheer volume of money flowing into the market, it's easier to understand today's price action. Whether it's the record flow of speculative options volumes, or the torrential downpour of cash flooding into the broader equity markets, we've simply never seen anything like this:

Traders are nearing the all-time speculative blow-off peak from February, with the smallest of traders spending 53% of their volume on buying calls to open. That ranks as the 4th-most out of the 1,141 weeks since January 2000. It's even more extreme among large traders. 

Among all traders on all U.S. exchanges, net speculative volume is equal to the peak during the week ending February 12. There's no point showing the complete history because extremes over the past year are so far beyond anything seen in the prior 20 years that it completely distorts a chart.

Investing capital when prices are exceedingly above the underlying growth trend repeatedly had poor outcomes. Investing money at peak deviations led to very long periods of ZERO returns on capital.

The S&P 500 ended October with a return greater than 20%, and when that's the case the index has never been lower - neither in the month of November, nor in the months of November and December, combined.

Heading into November with the S&P 500 up 20%+ for the year means that the average returns investors may expect are 3.7% for November and 6.2% until year-end. That's significantly higher than the average year's returns of 1.7% and 3.2%, respectively.

Over the last month, investors pushed the stock market to extremely overbought, extended, and deviated levels. Currently, the deviation from the long-term bullish monthly moving average is at the most extreme since 1997. Furthermore, the stock market is now highly overbought, which has typically preceded more significant market corrections.

For nearly 5 decades, the NFIB Small Business Cost of Labor index has been a good barometer, especially for extended cycles. Based on this gauge, it took 19 months (on average) for the US economy to be in recession once the reading >=8. 

FYI: The most recent reading is 12... (needless to say this is an all-time high and this index has never failed).

The path out of the pandemic continues to defy straight-line forecasts. The hope was that getting the virus under control by vaccinating a large percentage of the population would turbocharge an economic recovery. Now we know it’s not that simple. As the chart below shows, countries with pre-pandemic challenges haven’t escaped them.

Focus on what you can control. There are always reasons to sell.

Time horizon is everything.

Logos LP October 2021 Performance

October 2021 Return: 5.14%

2021 YTD (October) Return: 17.97%

Trailing Twelve Month Return: 56.43%

Compound Annual Growth Rate (CAGR) since inception March 26, 2014: 25.04%

 

Thought of the Month

“The function of the margin of safety is, in essence, that of rendering unnecessary an accurate estimate of the future." -Benjamin Graham

Articles and Ideas of Interest

• The best market indicator over the last 34 years. Interesting article by Ralph Wakerly which looks at six major market indicators and their track record in navigating the last seven bull/bear market cycles. Investment advisor sentiment has the best track record. CAPE has little value as a short-term timing tool, but is powerful in forecasting future long-term market returns. CAPE is currently near historical highs, signaling weak returns over the next ten years. Technical analysis is controversial and murky. Contrary to many academic studies and proponents of efficient markets, some technical indicators have proven useful. But their effectiveness varies with time. And most technicians don’t rely on any single indicator.
  
   

• Generation lockdown: Where youth unemployment has surged. Young people around the world have found themselves shut out of the labor market—and the consequences could linger for years to come. Niall O’Higgins, one of the authors of the ILO report, warns of the consequences of being shut out of the labor market for an extended time. “Clearly there is a serious danger that young people being out of work for a long period is likely to damage both the individual’s earnings prospects and the society’s productivity and long-term earnings potential.” The damaging effects go beyond economics. In countries with relatively young populations, having a large number of out-of-work youth can contribute to criminality and political instability.

• There's a massive chasm between government policy and our energy reality. Eric Nuttall suggests that it is epically frustrating that in Canada, a country blessed with some of the most abundant energy resources in the world, the majority of the population suffers from profound energy ignorance: the lack of knowledge of how hydrocarbons are used, how critical they are to our daily lives, and the realistic timeline to replace them with a “renewable” alternative. Without oil and natural gas, we would literally be back in the Stone Age, experiencing a fraction of our current standard of living. So how did we get here, where the average Canadian thinks the end of oil is at hand, politicians contemplate the necessity of limiting production growth, and where we have lost sight of how blessed we are as a nation to be gifted with such valuable energy resources produced in one of the most ethically and cleanest manners anywhere in the world? Joe Oliver also ​​reminds us that although Canada represents only 1.6 per cent of total emissions and cannot make a difference to global climate, we have a moral obligation to do our part in a worldwide effort. A common-sense approach would be to optimize our contribution while limiting damage to the economy. Instead, we seem determined to minimize our effectiveness and maximize self-harm.
  
   

• America needs a new scientific revolution. A repurposed antidepressant might help treat COVID-19, a remarkable study found. The way this research was funded highlights a big problem-and bigger opportunity-in American science. The Atlantic diagnoses several paradoxes in the current U.S. system.
  
  

• The bio revolution: innovations transforming economies, societies, and our lives. Mckinsey suggests that a confluence of advances in biological science and accelerating development of computing, automation, and artificial intelligence fueling a new wave of innovation. This Bio Revolution could have significant impact on economies and our lives, from health and agriculture to consumer goods, and energy and materials. We believe this is one of the best investment themes for the next decade. We like IONQ, KZIA, WST, CRL, RGEN, BDSX.
  
   

• AI is no match for the quirks of human intelligence. We may sometimes behave like computers, but more often, we are creative, irrational, and not always too bright.
  
   

• I’m a life coach, you’re a life coach: the rise of an unregulated industry. Fascinating piece in the Guardian charting the rapid rise of an unregulated industry at a time when the demand for mental health services is outpacing supply. Operating in the murky realm of “empowerment”, where personal development and financial success blur together, Life coaching Schools are having their moment yet are they empowering their largely female client base with the tools and support they need? Or selling them an unattainable fantasy?

• No One Cares! Our fears about what other people think of us are overblown and rarely worth fretting over. Arthur C. Brooks for the Atlantic suggests that we are wired to care about what others think of us. As the Roman Stoic philosopher Marcus Aurelius observed almost 2,000 years ago, “We all love ourselves more than other people, but care more about their opinion than our own,” whether they are friends, strangers, or enemies. This tendency may be natural, but it can drive us around the bend if we let it. If we were perfectly logical beings, we would understand that our fears about what other people think are overblown and rarely worth fretting over. But many of us have been indulging this bad habit for as long as we can remember, so we need to take deliberate steps to change our minds.
  

• The metaverse will mostly be for work. Stanford professor Jeremy Bailenson has been thinking about virtual reality and the metaverse for decades. As of 2020, he even teaches in it (more on that in a moment). For all of the chatter from Facebook/Meta, Nvidia, and other companies about building the metaverse, though, he thinks the metaverse will be mostly empty. That is to say, there won’t necessarily be a lot of things to do in this immersive version of the internet.

• Unions are on the rise, but so are the robots. U.S. manufacturers hired 60,000 people in October, double economists’ estimates and the most since June of last year. It was a robust showing, led by automakers. But payrolls in the sector are still down by almost 300,000 since the end of 2019, even as many large industrial companies are reporting sales above pre-pandemic levels. Last month’s recruitment success will only make a modest dent in the nearly 900,000 open manufacturing positions as of the end of August. The tight labor market has created a moment for unions: Deere & Co. workers this week felt so confident in their value to the company that they voted down a revised contract proposal that included substantial wage increases and enhanced retirement benefits. It’s also creating a moment for robots.

Our best wishes for a month filled with joy and contentment,

Logos LP

Tilting the Odds in Our Favor

Good Morning,
 

Stocks gyrated between gains and losses Friday to end a volatile week on Wall Street, as investors appeared content to consolidate positions after worries over Evergrande and a slowing global economy prompted traders to pull $28.6 billion from U.S. equity funds over the first three days of the week, the most since February 2018. But stocks then staged a two-day rally after the Federal Reserve signaled no removal of its easy money policy, at least for now. 

Tech stocks trailed Friday after a crackdown on bitcoin by China overnight hurt sentiment in the sector, but financial stocks rose as the 10-year U.S. Treasury yield reached its highest since July. "What is clear is that inflation is likely to be the determining factor for liftoff and the pace of rate hikes," Deutsche Bank Chief U.S. Economist Matthew Luzzetti wrote in a note. "If inflation is at or below the Fed's current forecast next year of 2.3% core PCE, liftoff is likely to come in 2023, consistent with our view. However, if inflation proves to be higher with inflation expectations continuing to rise, the first rate increase could well migrate into 2022."

Meanwhile Nike confirmed investor concerns about the pandemic wreaking havoc with supply chains and raising costs for companies, especially multinationals. Nike shares fell 6.2% after the sneaker giant lowered its fiscal 2022 outlook because of a prolonged production shutdown in Vietnam, labor shortages and lengthy transit times.

Our Take 

Skepticism on Wall Street is widespread with most of the major investment firms calling for a 10-20% market correction. Furthermore, the popular narrative for the rest of the year appears to be falling Covid cases globally and economic acceleration favouring cyclical stocks in the energy, financial, industrial and travel sectors. For us the data is noisy. Economic acceleration could very well occur but we also believe as we have stated in the past, that there are equally compelling reasons to infer significant economic deceleration. 

At present we believe policy error in the form of excessive government intervention in the economy to be the largest risk to growth estimates. Several countries closely regulate industries, labor, and markets, set monetary policy, and provide subsidies to help boost their economies yet many countries are veering towards giving the government a level of control that would allow it to steer the economy and industry along a path of its exact choosing channeling additional private resources into strengthening state power.

The big risk for these countries is that the push winds up suppressing much of the entrepreneurial energy and incentives that have powered their boom, years of innovation and improving standards of living.

From a market standpoint, we continue to believe that as pandemic-era programs to bolster the economy are lifted there will be an easing of market conditions which favor the indexes and tech megacaps. The era of narrow stock leadership -- powered by the explosive growth in passive funds -- may be beginning to unwind. Less aggressive monetary easing ahead should expand the number of market winners favoring active management. PanAgora Asset Management’s research suggests that a cap-weighted strategy thrives as concentration rises, but delivers “significantly” lower returns when the macro climate shifts in favor of higher rates. 

The removal of policy supports could mean the fundamentals of individual companies come to the fore replacing what has been a wall of stimulus money hitting the indexes. We see much opportunity for outperformance ahead...


 Musings
 

Over the past month, as I’ve watched politicians worldwide flounder around on everything from public health, housing, the economy, taxation to capitalism itself I’ve found myself thinking more about my framework for viewing life and investing. The future is becoming more and more uncertain as the world is changing rapidly while those in power appear less and less capable of leading with grace and conviction. It is possible we are at the dawn of the period of greatest change for the past few centuries and the range of potential outcomes when pondering the coming decade or two spans from “dystopia to Renaissance”. 

In Canada and across the border in the USA, our democracies appear to be in the hands of statists who believe that government justifiably holds near-absolute power. During the recent Canadian election and the ongoing Democrat proposed 3.5T spending discussions there is little sense that there are or should be limits on the power of democratically elected governments. Such limits still exist in constitutional form, but they are being overwhelmed in spirit if not in law. A tax on wealth and capital? Previously unimaginable spending and deficits? Restrictions on the right to buy and sell property? Restrictions on speech, employment, movement and association based on “woke” ideological purity? Break up corporations? State led discriminatory attacks on certain corporations and individuals based on their ability to make profits? No worries. Big brother knows best and more government intervention and control is warranted. 

The overall ideological thread today has been that governments have the power and the right to do whatever they want — a trend that COVID-19 appears to have entrenched globally. 

Authoritarianism is on the rise around the world with governments becoming less transparent and losing the people's trust. The latest report 'Freedom in the World 2021' by Freedom House is sobering. The report, which is an annual country-by-country assessment of political rights and civil liberties, downgraded the freedom scores of 73 countries, representing 75 per cent of the global population. Democracy has eroded in the United States as well, the report noted.
 

While still considered 'free', the United States has experienced further democratic decline. The US score in 'Freedom in the World' has dropped by 11 points over the past decade, and fell by three points in 2020 alone. 

How much of the above is in our control? The rules of the game keep shifting as the state increasingly imposes its will on markets, society and culture. Watching this distressing reality unfold, largely out of my control, has prompted me to think more deeply about my framework for viewing life and investing. 

As a starting point, William Green in his fantastic new book suggests that it’s helpful to view investing and life as games in which we must consciously and consistently seek to maximize our odds of success. The rules are slippery and the outcomes unpredictable yet there are intelligent ways to play as well as stupid ones. 

How can we avoid swimming upstream and instead be carried with the current? How do we tilt the odds in our favor regardless of the environment or “playing field”? 

When it comes to investing, much ink has been spilt on this. Without diving too deeply we could distill the common “get an edge” formula into the following principles:

Be patient and selective exploiting neglected and misunderstood market niches. 

Say no to almost everything. 

Exploit the market’s bipolar mood swings. 

Buy companies at a discount to their intrinsic value. 

Stay within your circle of competence. 

Filter out the noise, keep things simple and avoid anything too complex. 

Make a small number of bets with minimal downside and high upside. 

Control your emotions and be patient. 

Simple but not always easy to follow. But my goal here isn’t to review the core principles that most investors likely already know, or should know. 

Instead, faced with the increasingly frustrating and downright depressing global macro political environment I tried to think about the times in my investing career I was best able to follow the above principles. 

What I found was that essentially all of the moments I had achieved some sort of “high performance” or “success” occurred in periods of time in my life in which I was joyous. Periods of time when I was particularly happy.  

Interestingly, perhaps the most consistent way we can maximize our odds of success is adopting an optimistic and positive attitude. Shawn Achor in his fascinating book “The Happiness Advantage” explains that “waiting to be happy limits our brain’s potential for success, whereas cultivating positive brains makes us more motivated, efficient, resilient, creative, and productive, which drives performance upward.”

New research in psychology and neuroscience demonstrates that we become more successful when we are happier and more positive. In his book, Achor outlines that: “doctors put in a positive mood before making a diagnosis show almost three times more intelligence and creativity than doctors in a neutral state, and they make accurate diagnoses 19 percent faster. Optimistic salespeople outsell their pessimistic counterparts by 56 percent. Students primed to feel happy before taking math achievement tests far outperform their neutral peers.” 

Unfortunately, for most of us, we are conditioned from birth to believe that once we become successful then we will be happy. Success is conceptualized as a necessary condition for happiness. If we get the promotion/raise/car/return [insert success/external validation], we will be happy. But with each victory the goals shift and the happiness gets pushed further out. 

Instead, in the face of an increasingly precarious future including its associated “FUD: Fear, Uncertainty and Doubt” I think that focusing on happiness as a precursor to success rather than simply its result is game changing. This kind of relationship with happiness is the ultimate way we can tilt the odds in our favor in investing and perhaps more importantly in life. 

Anytime you get a truth that much of humanity doesn’t understand, that’s a large competitive advantage. Intelligent people are easily seduced by complexity while underestimating the importance of simple ideas that carry enormous weight. When you consistently apply a powerful idea such as the happiness advantage with thoughtful diligence, the effects may astonish you...

Charts of the Month

According to the Fed's Z.1 report, U.S. Household net worth rose at a solid 18.4% rate in Q2 to $142 Trillion, after gains of 16.7% in Q1 and 28.5% in Q4 '20. The "Wealth Effect" is one of the most important statistics we can use to measure how American households are faring. This measurement leads to the "feel good" effect that adds to the confidence to go out and spend. It is comical that this report never makes a headline. Then again the popular rhetoric is still concentrating on how BAD things are out there. The data on consumers doesn’t seem to support that outlook...

Men are falling behind remarkably fast, abandoning higher education in such numbers that they now trail female college students by record numbers. No one is talking about it.

Logos LP August 2021 Performance

August 2021 Return: 10.23%

2021 YTD (August) Return: 18.26%

Trailing Twelve Month Return: 57.07%

Compound Annual Growth Rate (CAGR) since inception March 26, 2014: 25.71%

 
Thought of the Month

“The very purpose of religion is to control yourself, not to criticize others. Rather, we must criticize ourselves. How much am I doing about my anger? About my attachment, about my hatred, about my pride, my jealousy? These are the things that we must check in daily life.” -Dalai Lama.

Articles and Ideas of Interest

• ESG is inflationary. As the global economy rebounds, the likelihood of inflation has become the dominant economic story. You can’t watch the financial news for long without hearing about inflation. At the same time, environmental, social, and governance (ESG) initiatives continue on an inexorable march to greater public perception. However, despite both issues occupying ever more column inches, one consideration has been underexplored; ESG will add to inflationary pressures. TwentyFour Asset Management suggests that yes, ESG is a new source of inflation that was not so present in the previous cycle and cannot be overlooked when forming a view on this cycle’s inflation outlook. How willing will consumers be to shoulder such rapidly increasing costs? There's arguably a point at which a preponderance of inflationary pressures may backfire, with people suddenly demanding governments do something (anything!) to ensure access to cheaper energy (never mind whether it's dirty or not)...Britain looks set to bump up against this reality as some customers are facing a 50% increase in their energy bills…
   

• Replicating private equity with liquid public securities. According to a Harvard Business School study, it is possible to replicate private equity returns with liquid public securities. “A passive portfolio of small, low EBITDA (earnings before interest, taxes, depreciation, and amortization – a commonly used measure of cash flow) multiple stocks with modest amounts of leverage and hold-to-maturity accounting of net asset value produces an unconditional return distribution that is highly consistent with that of the pre-fee aggregate private equity index.” Accelerate in a fascinating report believes that Harvard has it right, despite claims from private equity executives insisting otherwise.

• Lie Flat’ if you want, but be ready to pay the price. ​​The new “lie flat” social protest movement seems to be catching on. It started among overworked Chinese factory workers burned out from grueling 12-hour, six-day work weeks, and the unrelenting pressure from the government and society to climb the economic ladder. So some Chinese millennials formed an underground movement to opt out of work and the pressures of society. Never ones to miss a chance to cry “hardship,” upper-middle-class, well-educated young Americans are also getting in on the action, claiming they, too, are burned out and quitting their jobs to do nothing. What this trend will mean for China is unclear, but Allison Schrager suggests that Americans who choose to lay down in lieu of work may end up worse off than they think.
  
   

• The ‘melancholic joy’ of living in our brutal, beautiful world. Brian Treanor writes that it’s a challenging time to be an optimist. Climate change is widespread, rapid and intensifying. The threat of nuclear war is more complex and unpredictable than ever. Authoritarianism is resurgent. And these dangers were present even before we were beset by a historic pandemic. The data clearly show that based on certain objective measures of wellbeing we are living in the best of times – yet many people feel dissatisfied. In some places, including the US, self-reported happiness has actually been on the decline. So how should we view the state of the world: with optimism or pessimism? In answering, Treanor suggests that we must contemplate the broad sweep of both the world’s goodness and its evils.
  
   

• The everything bubble and TINA 2.0. FTX research does an fantastic job of exploring that common statement that “We are in an everything bubble” reviewing the data and going asset by asset. Worth the read. Spoiler: There’s most certainly pockets of excess in nearly every corner of the financial markets, but there’s also ample opportunity.
   

• Why is gold not rising? Interesting take on the shiny metal (albeit from a gold bug) via GoldSwitzerland.
  
   

• Silicon Valley is searching for the fountain of youth in a bill. Human aging is the latest and greatest field being disrupted by technology. The big picture: Work on therapeutics that could slow or even prevent the aging process is moving out of the fringes and into the mainstream, fueled by funding from tech billionaires who have one thing left to conquer: death.

• What if people don’t want a career? Charlie Warzel, a reporter on the future of work has found an interesting and potentially profound trend: the growing skepticism around ‘careers.’ ‘Careerist’ has long been a dirty word in the working world — usually it’s meant to signify a cynical, ladder climbing mentality. A careerist isn’t a team player. They care more about the job title and advancement than the work. The current brand of career skepticism he is talking about is different, more absolute. It’s not a rejection of how somebody navigates the game, it’s a rejection of the game itself. The idea isn’t limited to a specific age group, but the best articulation of it comes from younger Millennials and working age Gen Zers. Many of them are fed up with their jobs and they’re quitting in droves. Even those with jobs are reevaluating their options. What comes next?
   

• You are living in the Golden Age of stupidity. The convergence of many seemingly unrelated elements has produced an explosion of brainlessness. Interesting take by Lance Morrow suggesting that stupidity dominates in our time because of a convergence of seemingly unrelated elements (the death of manners and privacy) that - mixed together at one moment, in our cultural beaker - have produced a fatal explosion.

• Why you need to protect your sense of wonder - especially now. As the pandemic era goes on, more than ever we need ways to refresh our energies, calm our anxieties, and nurse our well-being. The cultivation of experiences of awe can bring these benefits and has been attracting increased attention due to more rigorous research. At its core, awe has an element of vastness that makes us feel small; this tends to decrease our mental chatter and worries and helps us think about ideas, issues, and people outside of ourselves, improving creativity and collaboration as well as energy. David Fessell and Karen Reivich, a physician and a psychologist, have facilitated hundreds of resilience and well-being workshops; they suggest for HBR a number of awe interventions for individual professionals as well as groups. 

Our best wishes for a month filled with joy and contentment,

Logos LP

Older, Slower and Entitled

Good Morning,
 

Major U.S. stock averages rebounded Friday, but closed the week in the red amid fears of the Federal Reserve pulling back its stimulus as well as concern regarding the delta variant. 

Minutes from the Fed’s July meeting released this week showed the central bank is willing to start reducing its monthly asset purchases this year. Investors sold equities and commodities this week buying bonds on fears that a “backwards looking” move by the Fed could upend the global economy already under stress by the delta variant.


Our Take


With investors considering a Fed tapering while the delta variant keeps spreading, the transition away from liquidity/policy regime to more mid-cycle markets means volatility is likely set to continue.   

Policy error represents the most obvious risk for markets. For weeks, changes in the economic data suggest that economic growth is slowing, rates have been heading lower, the dollar has headed higher, and commodities have by and large corrected. According to the bears, this picture seems to suggest that any Fed tapering this fall - just as the global economy's growth is normalizing - could create a growth scare, and as a result, that theFed would have begun taperingat the wrong moment leading to further economic weakness and eventually a stock market rout.

This may or may not occur. Corrections are inevitable and although we do think that it would be unwise to chase many major index components as future returns from these levels appear unattractive, we do believe that the strength of this bull market is remarkable. 

This year alone the S&P has hit 48 new highs. Since we finally broke through the 2007 pre-GFC highs in the summer of 2013 we’re now looking at more than 320 new highs in this bull market. The gains are smaller, befitting a less extreme year as when the S&P 500 Index has risen in 2021, the daily increase has been half what it was in 2020. But in terms of persistent, day-after-day gains, these seven months in the U.S. stock market have few historical precedents.

Interestingly, as Nir Kaissar points out for Bloomberg, the past 30 years may not be an anomaly but a new normal. 

For about 120 years from the 1870s to the 1980s, the U.S. stock market reliably reverted to its long-term average valuation, and just as important, it spent roughly equal time above and below that average. Investors could therefore expect an expensive market to become cheaper and a cheap market to become more expensive, a useful assumption when estimating future stock returns. 

Since 1990, however, the market has rarely dipped below its long-term average valuation, the notable exception being the period around the 2008 financial crisis. Neither the dot-com bust in the early 2000s nor the Covid-induced sell-off last spring managed to subdue it.

Accordingly, with volatility moderate and the uptrend persisting, any trading tools that told investors to do anything but buy are failing. When applied to the S&P 500, half of the 22 charts-based indicators tracked by Bloomberg have lost money since the end of March, back-testing data show. All of them are doing worse than a simple buy-and-hold strategy, which is up 12%. 

Over the past 10 years, the S&P 500 is up almost 360% while gold is down 2%. That’s a lost decade for gold, even after it was up 25% in 2020 and 18% in 2019.

It has been incredibly profitable to adhere to the classic mantras of “don’t fight the fed” and “the trend is your friend”. Investors buying virtually every dip have been rewarded. 

Most non-recession 10%+ corrections over the past 25 years began with certain conditions. They all typically start with wildly overbought conditions and excessive optimism. We can’t predict when the party will end, but we do believe that “wildly overbought” and “excessive optimism” are not at present characteristic of the prevailing sentiment. Furthermore, for many high quality companies, multiples have been contracting and fundamentals have been improving. You just need to know where to look….

 Musings
 

Humans are creatures of habit and easily susceptible to conditioning. From childhood we learn (the hard way) to avoid touching a hot stove and alternatively, we learn that certain behaviours such as doing our chores will earn us rewards from our parents. We learn (or are supposed to learn) that by working hard and developing the right skills and habits we will get ahead and unlock a more “pleasant” life. 

Our environment influences us. We react to the incentives and disincentives we are presented with attempting to reduce pain and maximize pleasure and this process of conditioning shapes our behaviours and attitudes. 

The economy and markets work similarly because after all, they are composed of humans. Given the incredible shock Covid-19 represented (which we are still dealing with), we’ve been thinking a lot about the conditioning it has precipitated or perhaps accelerated. How have our brains/habits and thereby societies and economies been re-wired? 

Aware of the seemingly endless amount of time one could spend on this topic, one thing in particular has caught our attention. 

The fact that the labor force in the US has shrunk (this is a phenomenon that is also  affecting most developed economies). The US economy has been creating jobs at a rapid clip. Employment has risen by an average of about 617,000 people per month so far this year.

While the total number of Americans who are working is still more than 5 million short of 2019 levels, there is work available. The number of open positions surged to a record 10 million-plus in June.

Nevertheless, many employers say they’re having trouble filling those jobs, even with the unemployment rate still relatively high.

That points to one big question-mark around the recovery. Americans have dropped out of the labor force.

More than half of the unemployed have been out of work for 15 weeks or longer and, on average, it’s taking people 29.5 weeks to find a job -- even with all those openings.

Why? Common explanations fall into three categories. 

1. Disruption owning to the spread of Covid-19

2. The Impact of welfare policy

3. Changes to attitudes wrought by the pandemic 

When it comes to the first bucket it is believed that school closures have made it impossible for parents, particularly mothers to take a job. The evidence of this is more mixed and less compelling. Furthermore as restrictions ease, Covid-19 recedes and children head back to school, such issues should correct. 

The second bucket is of particular interest as welfare policy (ie. entitlements) is something policy makers can control. Where do we stand on this front? There was an interesting article in the WSJ recently entitled “Hooked on Federal Checks”. The author Nick Stehle wrote: 

“My family is receiving the new Advance Child Tax Credit Payments, passed by Congress and signed into law by President Biden in March. Under this policy, I’m going to make more than $11,000 by the time I file my 2021 taxes. I “earned” this extra cash by having four children between 5 and 13.

The policy—which pays $300 a month for each child under 6 and $250 a month for each child between 6 and 17—is set to expire at year’s end, yet the Biden administration and congressional Democrats are pushing to make it permanent. If that happens, I’m looking at more than $10,000 a year for the next four years, then thousands more annually for nearly a decade after that.

Do I need this money? Thankfully, no. I have a good job that puts my family solidly in the middle class. Should I be getting this money? Absolutely not. But will I use the money? Yes. That is why this new entitlement is so dangerous.

The federal government is conditioning families like mine to expect “free” money. When you see that cash in your account, the first thought is how to use it. It becomes a habit to see and spend extra money each month. Like many habits, it is liable to worsen.”

The political discourse in Canada is no different with each challenger party putting forth colossal spending platforms designed to one up the current incumbent Liberal spending bonanza. 

Politicians of all stripes continue to clamour for more spending as they decry that life is getting more expensive. All of this while nearly 61% of U.S. households paid no federal income taxes in 2020 and central banks have spent $834 million an hour for 18 months buying bonds to force down borrowing costs since the pandemic hit (the US Fed alone has put in roughly $4 trillion). 

The question is how much longer can central banks and governments keep the cash spigots flowing at full force? Politicians appear to be openly uninterested in such trivial details.  

Many of the entitlements such as the Advance Child Tax Credit Payments discussed above or the Old Age Security benefits in Canada (only two small examples) are not primarily directed to families in poverty. 

Instead, such entitlements are better understood as an attempt to buy votes from various voting blocks. Once you come to expect an entitlement you are much less inclined to vote for someone who wants to cut off the cash. A similar understanding can be applied to the Canada Emergency Wage Subsidy, CRB, CRCB and the CRSB in Canada. The conditioning has become powerful. 

Nick Stehle points out that the price tag of such measures in terms of expanding the national debt is high yet the human cost of these policies is perhaps even higher. Since many of these benefits are not tied to work/output, people have less reason to try and climb the ladder of opportunity. 

Is this how a social safety net should work? Will such political discourse erode cultural attitudes surrounding “work ethic”? Has irreversible damage already been done? 

This idea dovetails on the third category of common explanations: changes to attitudes wrought by the pandemic. One intriguing possibility is that the pandemic has made people value work less. The pandemic forced us all to take a hard look in the mirror and many surveys suggest that people now treasure time with family more than they once did. A shift in attitudes towards work is hard to pin down yet a recent study from Britain suggests that people want to work fewer hours even if their pay falls.  

By making unemployment insurance schemes (entitlements) competitive with market wage rates in a pandemic, it would come as no surprise if attitudes surrounding work ethic have suffered. Rewards and incentives change habits and behaviour. The longer this dynamic persists, the longer and more difficult it will be to reshape such habits and adjust behaviours. 

It is still too early to tell how much work ethic has suffered yet this potential conditioning accelerated by COVID-19 is not a positive development. 

The economic carnage brought on by Covid-19 induced lockdowns necessitated extraordinary monetary and fiscal intervention. Politicians and Central bankers had to act. The problem we see today is that a potential pandora’s box of entitlement and complacency has been opened. 

When leaders have simply to open the spigot to earn votes, there is little incentive to improve the quality of leadership. Hence, in our opinion, the disastrous state of leadership today. 

Thomas Jefferson and Alexander Hamilton agreed on little publicly, but they did agree that when the public treasury becomes a public trough and voters take notice, they will send to government only those who promise them a bigger piece of the government pie.

There’s an old theory that wealthy democracies follow a socio-economic cycle from slavery to spiritual faith, to great courage, to liberty, to abundance and wealth, to complacency, to apathy, to dependence and back to slavery. Judging from the post Covid-19 socio-economic climate we appear to be on a problematic path to complacency and apathy. 

When entitlement is not linked to output and contribution there is little willingness to accept responsibility for one’s own life - which is the source from which self-respect and thus character, springs. Instead, one develops the perception that the outcomes of one’s life are entirely out of one’s hands. 

And to be without character is perhaps the worst fate of all. 

Charts of the Month

Valuations are certainly in the upper band even when measured against the past 25 years, which has been a time filled with higher-than-average historical valuations. Here’s one that may surprise you though — this year we’ve actually seen multiples on the S&P 500 contract:

JP Morgan also broke out valuations and earnings by the top 10 stocks in the S&P (which also includes Berkshire Hathaway, Tesla, Nvidia, JP Morgan and Johnson & Johnson) and everything else:

The top 10 stocks are now close to 30% of the market. This sounds concerning until you see they contributed 34% of the earnings over the past year. These companies are large for a reason.

They’re also expensive for a reason. You can see once you take away the top 10 holdings, the valuation of the other 490 or so stocks doesn’t look all that bad.

Logos LP July 2021 Performance

July 2021 Return: -1.18%

2021 YTD (July) Return: 7.28%

Trailing Twelve Month Return: 41.47%

Compound Annual Growth Rate (CAGR) since inception March 26, 2014: 24.39%
 

Thought of the Month

“Enough of this miserable, whining life. Stop monkeying around! Why are you troubled? What’s new here? What’s so confounding? The one responsible? Take a good look. Or just the matter itself? Then look at that. There’s nothing else to look at. And as far as the gods go, by now you could try being more straightforward and kind. It’s the same, whether you’ve examined these things for a hundred years or three.” - Marcus Aurelius


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Articles and Ideas of Interest

• Florida is America's Future: Old, Southern and Retired. Why we should be concerned that the fastest-growing cities in the U.S. are retirement villages in the South. One of the most important trends to emerge from the 2020 Census didn't get much attention last week, but it reveals more about how both the U.S. economy and its politics will look in the coming years than most other details focused on by the news media. Americans' vision of their city of the future typically involves skyscrapers populated by large new technology companies. Yet the 2020 Census didn't point to San Francisco or New York as the fastest-growing city, or even one of the dozens of smaller metros that emulate them. The fastest growing metro area in the U.S. is the Villages, a retirement community in central Florida. And that's indicative of an economy that's older, less dynamic and more reliant on government benefits. It also points to a growing concentration of political and economic power in the south. Why is no one talking about this?  
  
   

• The Opposite of Toxic Positivity. Countless books have been written on the “power of gratitude” and the importance of counting your blessings, but that sentiment may feel like cold comfort during the coronavirus pandemic, when blessings have often seemed scant. Refusing to look at life’s darkness and avoiding uncomfortable experiences can be detrimental to mental health. This “toxic positivity” is ultimately a denial of reality. Telling someone to “stay positive” in the middle of a global crisis is missing out on an opportunity for growth, not to mention likely to backfire and only make them feel worse. As the gratitude researcher Robert Emmons of UC Davis writes, “To deny that life has its share of disappointments, frustrations, losses, hurts, setbacks, and sadness would be unrealistic and untenable. Life is suffering. Scott Barry Kaufman for The Atlantic suggests that no amount of positive thinking exercises will change this truth.

• The Coronavirus Is Here Forever. This Is How We Live With It. Sarah Zhang for the Atlantic suggests that we can’t avoid the virus for the rest of our lives but we can minimize its impact. The current spikes in cases and deaths are the result of a novel coronavirus meeting naive immune systems. When enough people have gained some immunity through either vaccination or infection—preferably vaccination—the coronavirus will transition to what epidemiologists call “endemic.” It won’t be eliminated, but it won’t upend our lives anymore. Politicians crafting policy based on “Covid zero” are going down a dangerous path…

• Warren Buffett’s Cash Trap Can Snare Big Tech, Too. The Berkshire Hathaway CEO has more cash than he knows what to do with. But Apple, Amazon and other tech giants face a similar dilemma. It may remain one of Buffett’s most memorable lessons. Even as tech company after tech company has joined the $1 trillion and then $2 trillion market-cap club during the pandemic, they all have something in common with Buffett: more cash than they know what to do with. It’s a good problem to have until it isn’t.
  
   

• Companies and Families Are Loading Up on Debt. It Could Be a Dangerous Trend. For folks with finances stretched by inflation, using “buy now, pay later” (BNPL) to help pay for luxuries or even necessities, such as an updated wardrobe to return to work, might be the clincher in the purchasing decision. Square’s ability to provide ready funding to merchants and consumers apparently justifies the $29 billion price tag for Afterpay—equal to an enterprise value of 35 times gross profit for the next 12 months, according to MoffettNathanson analyst Lisa Ellis. But it belies the notion of flush consumers. Or does it?
  
   

• Why Managers Fear a Remote-Work Future. Interesting take on remote work by Ed Zitron in the Atlantic suggesting that like it or not, the way we work has already evolved. Remote work lays bare many brutal inefficiencies and problems that executives don’t want to deal with because they reflect poorly on leaders and those they’ve hired. Remote work empowers those who produce and disempowers those who have succeeded by being excellent diplomats and poor workers, along with those who have succeeded by always finding someone to blame for their failures. It removes the ability to seem productive (by sitting at your desk looking stressed or always being on the phone), and also, crucially, may reveal how many bosses and managers simply don’t contribute to the bottom line.
  
   

• Why is China smashing its tech industry? Noah Smith suggests that it has something to do with what countries consider to be the “Tech Industry”. China may simply see things differently. It’s possible that the Chinese government has decided that the profits of companies like Alibaba and Tencent come more from rents than from actual value added — that they’re simply squatting on unproductive digital land, by exploiting first-mover advantage to capture strong network effects, or that the IP system is biased to favor these companies, or something like that. There are certainly those in America who believe that Facebook and Google produce little of value relative to the profit they rake in; maybe China’s leaders, for reasons that will remain forever opaque to us, have simply reached the same conclusion.

• What’s Holding Back China’s Recovery? The Kids Aren’t Alright. There are many answers, but one important piece of the puzzle is starting to become clear: Young workers and job seekers, who often spend more of their income since they are just starting out, are struggling. Until that is rectified, regaining China’s pre-pandemic consumption-growth trend could be challenging. Online movements springing from youth discontent such as “tang ping” or “lying flat,” which was started by a disenchanted former factory employee and rejects overwork, may be difficult to fully suppress. This problem is affecting most nations globally as policy makers ignore the plight of the next generation…
  
   

• America’s Investing Boom Goes Far Beyond Reddit Bros. Robinhood traders have earned the most attention, but they’re only part of a larger story about class stagnation and distrust. Fascinating account by Talmon Joseph Smith in the Atlantic of the investing craze that has characterized the post pandemic world. In a series of interviews conducted with economic analysts, amateur and professional investors, cryptocurrency lovers, and former hedge-fund managers, several people expressed the view that the subcultures born out of America’s untamed investing boom are many and varied. They’re diverse, if not integrated; some silly, some assiduous—yet all infused with a quiet desperation to reach escape velocity and defeat the gravitational pull of class stagnation that’s lasted decades...

Our best wishes for a month filled with joy and contentment,

Logos LP

That "Peak Everything" Feeling

Good Morning,
 

Stocks fell on Friday, with the Dow Jones Industrial Average posting its worst weekly loss since October, as investors began to question the reflation trade narrative of above trend growth and higher inflation. 

Pockets of the market most sensitive to the economic rebound led the sell-off this week. The S&P 500 energy sector and industrials dropped 5.2% and 3.8%, respectively, for the week. Financials and materials meanwhile, lost more than 6% each. These groups had been market leaders this year on the back of the economic reopening.

Volatility broke out in equities following Wednesday’s Fed decision, where policy makers projected raising interest rates twice by the end of 2023. The tech rally was accompanied by a violent flattening of the 5-year to 30-year Treasury yield curve, which narrowed by the most since 2011 on a weekly basis.

Our Take

We have been largely uninspired by the endless popular coverage of the following three themes: meme stocks, cryptocurrency (scamcoins) and inflation. Without repeating the tired warnings about the risk surrounding investment in such above mentioned speculative assets, (Michael Burry has done an excellent albeit dramatic job of this) we do believe that the topic of inflation warrants a few thoughts as a follow on to our assertion back in March of this year that the rise in inflation and interest rates would be a temporary diversion from a clear downward trend.

The robust economic recovery we have witnessed has understandably come with some inflation as the pent-up demand has simply overwhelmed supply. Yet we remain of the opinion that there is enough evidence mounting to suggest the Federal Reserve is correct in its prediction that the inflation scare will be transitory. In fact, the reflation trade may have peaked around June 10. The CPI reading came in at 5% year-over-year, ahead of estimates for 4.7%. But despite the hotter than expected reading, bond yields continued to slide. Despite months of hotter than expected inflationary data points, bond yields have been moving lower, and breakeven inflation expectations are now sliding as well.

It seems likely that inflation rates have now peaked, and we should begin to see easing inflation levels in the coming months as commodity prices such as copper, soybeans, lumber, and gasoline have either flattened or have started to decline. 

It's clear now that the yields are looking into the future, not the past. The Federal Reserve appears to have recognized that it might have to raise rates - earlier than expected - to deal with a possible inflationary threat. Market participants could be realizing that tightening from the Fed could temper GDP growth (China’s growth is already moderating and the ECB sees lower inflation forecasts starting in 2022). This concern was recently expressed by Goldman Sachs: "Investors may be interpreting the Fed's hawkish tilt Wednesday as a sign that an extended U.S. post-pandemic economic expansion may be a bit harder to achieve in a potentially emerging environment of less accommodative monetary policy.” Interestingly, since Wednesday’s Federal Reserve meeting, there has been a drastic flattening of the so-called Treasury yield curve. This means the yields of shorter-duration Treasurys — like the 2-year note — rose while longer-duration yields like the benchmark 10-year declined. The retreat in long-dated bond yields reflects less optimism toward economic growth, while the jump in short-end yields shows the expectations of the Fed raising rates. Yields on junk bonds also fell below inflation (see chart below). 

But the most significant issue isn't interest rates, it is inflation expectations, and they have been falling sharply (The Cleveland Fed says five-year inflation expectations are still just 1.5% a year and how hawkish can the Federal Reserve’s recent commentary really be if, all told, the most skeptical members are thinking about raising rates by 0.5% in 2023?). This is sending a negative signal to the reflationary parts of the equity market, the parts of the market that were riding the wave of prospective yield and inflation increases. Lock in step, the rate of change for commodities is stalling out, and if so, the Federal Reserve's call for transitory inflation will likely be correct. That could mean we have witnessed peak inflation for this cycle and that the probability of inflation surprising to the upside is on the decline. 

And this all makes sense. Financial markets’ sensitivity to monetary policy has NEVER been higher. The Federal Reserve’s balance sheet has doubled since the end of the 2008 financial crisis, now 40% of gross domestic product. By buying massive amounts of bonds, the Fed has lowered rates and used asset prices—especially stocks and real estate—as a primary tool for monetary policy. That’s through the wealth effect, or the tendency for consumers (which make up two-thirds of gross domestic product) to spend more as their assets grow. Any meaningful correction in stock or real estate prices would hamper economic growth and thus limit the Fed’s ability to tighten.  

Furthermore, when one considers the debt side of the economy, Lisa Beilfuss for Barron's reminds us that if the Federal Reserve was unable to lift rates above 2.5% during the last tightening cycle, and had to cut rates in SEVERAL meetings BEFORE its unprecedented actions during the pandemic, why would it be able to raise now? 

Since the pandemic began, U.S. households, businesses, and the federal government have grown only more indebted (which is the case all over the West including Canada). When most of the developed world is running on debt-driven growth it’s very hard to raise rates. Furthermore, it requires increasing levels of debt to generate lower rates of economic growth. At present in America, the economy requires roughly $5.01 of debt to create $1 of growth. While already a poor return on investment, it will worsen as debt continues to retard economic growth.

Since 1980, the overall increase in debt has surged to levels that currently undermine almost the entirety of economic growth. With economic growth rates now at the lowest levels on record, the change in debt continues to divert more tax dollars away from productive investments into the service of debt and social welfare.

As the market begins to price in the above, the problem for its indexes such as the Dow, S&P and Russel, is that if inflation expectations continue to fall, the reflation trade which has been driving their outperformance, will likely fall with them as cyclicality is repriced. 

On our end, we have remained on the sidelines when it comes to the reflation trade and are instead positioned primarily in sustainable growth at reasonable valuations. Looking forward, we believe the path of least resistance is a return to the pre-Covid investment environment characterized by structural deflation, below trend growth and perhaps even stagnation as policymakers in the West shift their focus from growing the pie to splitting the pie. 

Musings

Of late we have been focusing our attention on the evaluation of under followed smaller capitalization stocks set to benefit from certain structural changes in their respective industries. 

We believe Biodesix (BDSX) offers an interesting risk/reward.

Biodesix is a data-driven diagnostics company that has developed a proprietary AI platform called the Diagnostic Cortex to discover innovative diagnostic tests for clinical use, with particular focus on the lung. The particular problem that their platform solves is what researchers call ‘overfitting’: this is when machine learning-based biological discoveries cannot be repeated or assessed in additional specimen cohorts (ie. the machine can identify something in a genomic dataset but not in a proteomics dataset). 

We recently had a call with management and believe the company is hitting an interesting inflection point over the medium term as the company is facing a few key catalysts into 2022:

1. Re-ignited volumes: As pulmonologists and clinics open up, this will reignite lung based diagnostic testing volumes away from Covid tests. 

2. Salesforce expansion: The company raised $64 million in its IPO on Oct. 2020 which will be used to double the salesforce by the end of the year. Travel restrictions and delayed ramp up were all headwinds in the beginning of the year but that should subside in the back half.

3. Biopharm services: The reopening of clinics and non-Covid testing means the reopening of clinical trials at biopharmaceutical companies. The biopharm segment is a higher margin segment than their diagnostic business.

4. New innovative tests: The more data collected from patients and biopharm companies means more data into their AI platform which means more tests. The company has launched multiple new tests since the beginning of the year and launched a Covid test in record time late last year. This also means they will be able to collect new data and create partnerships with other providers (ie. Datavant).

5. Competition: Most of their tests have no real competition from other diagnostic companies.

On the back of a near 60% drawdown a few weeks ago, the company traded at a little under 7.9x next year's revenues (Guardant Health, which is somewhat of a comparable, trades at a much higher valuation) and should see meaningful revenue growth in the coming years. Their unique platform flywheel coupled with their agility when launching new tests and upcoming catalysts should lead to a much higher valuation as the company progresses up its S-curve growth runway. 

Charts of the Month

Money just keeps getting cheaper…

The Citi Economic Surprise Index—which measures how economic data is coming in relative to expectations—has come significantly off the boil relative to its peak last July. The accompanying table shows that as the index descended historically, so did annualized returns for the S&P 500.

Ned Davis Research has looked at those points in time when margin debt hit a peak and then began descending—considering them “sell signals.” Following those signals, the average subsequent returns for the S&P 500 for time periods ranging from three-to-18 months since 1970 were all in negative territory—although not to a significant degree.

As measured by The Conference Board, CEO confidence is at a record high as you can see in the chart above. Historically, this has worked as a contrary indicator as it possibly signals the environment is “as good as it gets,” which you can see in the accompanying table.

Logos LP May 2021 Performance

May 2021 Return: -6.28%

2021 YTD (May) Return: -3.46%

Trailing Twelve Month Return: 49.09%

Compound Annual Growth Rate (CAGR) since inception March 26, 2014: 23.21%

 

Thought of the Month

“Just imagine traveling 10 years back in time and trying to explain this to someone; just imagine what an idiot you’d feel like. “There’s going to be this online currency that people think is a form of digital gold, and then there’s going to be a different online currency that is a parody of the first one based on a meme about a talking Shiba Inu, and that one will have a market capitalization bigger than 80% of the companies in the S&P 500, and its value will fluctuate based on things like who is hosting ‘Saturday Night Live’ and whether people tweet a hashtag about it on the pot-joke holiday, and Bloomberg will write articles and banks will write research notes about those sorts of catalysts, and it will remain a perfectly ridiculous content-free parody even as people properly take it completely seriously because there are billions of dollars at stake.” - Matt Levine

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Articles and Ideas of Interest

• Boredom: An Investor’s last remaining edge? The entire investment world thrives on activity and commotion. Zero-commission trading turns investing into a sport. Ill-chosen LPs want decisions to justify management fees. Brandon Beylo for Macro-Ops suggests that the best investors are the ones that have an unnatural ability to choose inactivity. As crazy as it sounds, boredom is an investor’s last remaining competitive advantage.

• Millennials are running out of time to build wealth. The oldest members of the generation turn 40 this year. They’re only 80% as wealthy as their parents were at this age. Should we be surprised that 51% of young Americans say they feel down, depressed or hopeless?

• What a work-from-home revolution means for commercial property. As offices remain empty, does a financial reckoning loom? The Economist suggests that the fate of office property could well rest on vacancy rates. If they stay high, then things could start to get hairy. In April the imf reckoned that a lasting increase in the vacancy rate of five percentage points would dent commercial-property valuations by 15% over five years. Fitch, another rating agency, estimates that the value of offices in America could fall by more than half if workers continue to work from home for three days a week. The long-term nature of property leases and the continued availability of debt mean that losses from the pandemic may not materialise for several years. But if the reckoning comes, it will be painful.

• Has there ever been a worse time to be a homebuyer? Yes, rates remain low and houses are bigger and better than ever but this is likely the worst buyer’s market in modern economic history. Ben Carlson digs in and suggests that on a relative basis, it’s probably never been cheaper to rent in most areas.
  
   

• Scamcoins and other hyped stocks on social media are still all the rage. Is this time different? Jamie Catherwood puts together a fantastic historical overview of times of fraud, mania and chicanery suggesting that the reckless speculator is alive and healthy. Of particular note is his inclusion of the story of Gregor MacGregor who pulled of the greatest confidence trick of all time. MacGregor found an uninhabited piece of land on the coast of Honduras, created a fictitious country called Poyais, and sold over a billion dollars worth of ‘Poyais bonds’ in London by misleading investors into thinking the uninhabited jungle he had found in Honduras was actually a legitimate country boasting beautiful architecture, an opera house, parliamentary building, cathedral, and more. Eventually, seven ships in total came to Poyais with passengers looking to settle in MacGregor’s fairy tale paradise. Of the 240 settlers that arrived, only 60 survived. How many investors will survive today’s manias? 
  
   

• When companies replace people with machines, the government loses the ability to tax workers resulting in millions of dollars worth of lost tax revenues a year. McDonalds,  Dominoes and other quick service restaurants are actively replacing human workers with robots. Can taxing robots as if they are human employees be the solution? What are the pros and cons of a robot tax?
  
   

• Cal Newport on why we'll look back at our smartphones like cigarettes. Cal for GQ suggests how we're always ceding our autonomy to these devices as well as some of the long-term ramifications of always craving that constant hit of stimuli and distraction. No wonder studies have shown that social media makes us feel terrible about who we really are. Neuroscience explains why – and empowers us to fight back. No wonder quitting has become the ultimate form of self-care. 

• A (small) pre-emptive strike against the doomsday asteroid. In March 1989, an asteroid measuring half a mile wide careened past Earth at 46,000 miles per hour. When it crossed Earth’s orbit, it was only 425,000 miles away—about twice the distance between Earth and the moon and an uncomfortably close shave for an object the size of a football field. If the asteroid had slammed into the planet, it would have punched a hole in Earth’s crust with the force of 20,000 hydrogen bombs, excavating a crater between five miles and 10 miles wide and a mile deep. Anything within a 40-mile radius would have been obliterated, and dust flowing into Earth’s atmosphere would have cooled regional temperatures enough to affect crop growth, causing localized food shortages. If it had slammed into the ocean instead, millions of people worldwide could have been killed by the ensuing tsunamis. With the DART mission, scientists have attempted to prepare for Earth’s worst catastrophe. The thought of such an asteroid is fascinating. Most of us spend our lives avoiding the thought of death yet its inevitability should be continually on our minds. Understanding the shortness of life and its precarity should fill us with a sense of purpose and urgency to realize our goals. 
  
   

• Scientists have determined the oldest age humans can live to and it depends on our relationship to stress. Researchers studying the relationship between aging and the ability to cope with stress found that the limits of a human lifespan lie anywhere from 120 to 150. Based on data collected from an iPhone app and medical records from volunteers in both the United States and United Kingdom, the study’s authors measured subjects’ resilience to stressors. With age, the researchers found a decline in the subjects ability to recover. “As we age, more and more time is required to recover after a perturbation, and on average we spend less and less time close to the optimal physiological state,” study author Timothy V. Pyrkov said in a press release.

• Canada is on the wrong path when it comes to residential real estate and long-term prosperity. The country is now 50% more dependent on housing than the US bubble in 2006. Furthermore, Canadians are spending so much on housing that they have limited ability to spend elsewhere. According to a recent report from National Bank of Canada, the typical homebuyer in Toronto spends 56 per cent of their income on mortgage payments. In Vancouver, it’s 64 per cent; in Hamilton, it’s 34 per cent; and in Victoria, it’s 58 per cent. During the pandemic, real estate prices increased rapidly in small towns and rural communities, meaning even more Canadians are struggling with housing affordability. Many Canadians are aware of how our sky-high real estate prices negatively affect young people and exacerbate income inequality. Less frequently discussed, however, is that larger mortgage debts result in fewer people pursuing entrepreneurship. A study from the Bank of England found that “mortgage debt diminishes the likelihood of entrepreneurship by amplifying risk aversion,” and that this “may hinder economic activities and adversely affect the general economy.” Also, according to the Brookfield Institute for Innovation + Entrepreneurship, 42 per cent of the Canadian labour force is at high risk of having their jobs automated over the next 10 to 20 years. In light of these trends, Scott Stirrett suggests that it is increasingly essential to foster entrepreneurship to build high-growth firms that create new jobs so that all Canadians have the opportunity to find meaningful employment and meet their basic needs.

Our best wishes for a month filled with joy and contentment,

Logos LP