Copper Canyon LLCInvestment Outlook May 2020, By Dylan Quintilone
Investment Outlook May 2020
By Dylan Quintilone
There Is A Divergence FormingBig Technology stocks are holding the NASDAQ index up and they are a contributing factor to the index being near all time highs. The divergence of the (NASDAQ: QQQ) NASDAQ 100 ETF and (NYSEARCA: SPY) S&P 500 ETF illustrate that there is a disconnect between Large Market Capitalization Technology and the rest of the market. As of 05/04/2020, the NASDAQ 100 ETF was positive by nearly half a percent, while the S&P 500 and Dow Jones ETFs were down 12.19% and 17.82% respectively. The top three holdings in the QQQ were Amazon, Microsoft and Apple, which have returned 25.44%, 12.67% and -0.95% year to date. Between the three stocks, they account for nearly 33.24% of the QQQ NASDAQ 100 index. The heavy weighting gives these three stocks significant influence over the daily return in the index. In my opinion, it is creating concentration risk in the indices and indicating investors should choose individual stocks, rather than an index.
The NASDAQ Isn’t The Best Place To Be Invested At The Moment
The reason the stock market rallied just below all-time highs is the performance of large market capitalization technology stocks. Amazon, Apple and Microsoft are outperforming the market by a wide margin and investors are clamoring for these so called “quality” names. Investors believe these business models are coronavirus proof and won’t be materially impacted as other industries are. It’s understandable why investors are clamoring for Amazon and Microsoft, they are experiencing record data center growth and are at the forefront of internet of things/automation.
The coronavirus has illustrated how important a mobile network infrastructure is for the “work from home” employee model. Things have changed. The work from home model may be here to stay and companies are rethinking renting of commercial office space when their employees can produce the same product without the fixed cost of rent. Video conferencing, VPN remote access and other methods to allow employees to seamlessly work from home while remaining fully capable to complete their tasks are the most important aspect to a Fortune 500 company surviving the current business environment. It is why increased focus and reliance is put on data center and building the back-end infrastructure to serve enterprise needs. Amazon and Microsoft remain at the leading edge of datacenter construction and cloud deployment.
Everyone thinks of packages and ordering with Prime, but in reality the most profitable portion of their business is Amazon Web Services “AWS”. AWS is the data center and cloud operations segment of their business, they provide enterprise solutions for web hosting and building a company digital infrastructure. The financials explain the performance behind Amazon shares because AWS accounted for 12.5% of Amazon’s 2019 sales, but the growth rate was 37%, which is near double their Fulfillment/Website operations in the North American segment growth figure of 21% (Amazon 2019 10K, Page 24). AWS also accounted for 63% of the company’s operating income, which explains the datacenter segment is the most profitable in the company. The company had a 26% operating margin on AWS, compared to 4.11% operating margin on the Fulfillment/Website operations North American Segment. Customers are deploying web based infrastructure through AWS because their service is industry leading and offered at a competitive cost.
In our business, we use AWS to deploy our website and host an “instance” which is a our website hosted on a virtual computer in the data center. This along with Amazon’s content delivery center “CDN” allows our website to be served faster. The suite of tools on the AWS control center are expansive and the reason why enterprises deploy their network infrastructure with Amazon.
Amazon isn’t just a package company and investors know AWS will continue to be the profit center of Amazon for the foreseeable future. With continued reliance on automation and digitalization, the company will rely on this segment to drive future growth and stock performance.
Microsoft Changed From Old Technology, To Mobility/New Technology Company
The turnaround story of Microsoft from earlier this decade is truly remarkable. In the 2000’s, the stock was believed by investors to be an old technology company lacking growth, similar to IBM. Yet in the early 2010’s, new management came in and the company reduced their reliance on hardware/software sales by transitioning their entire business model to subscription and service based. Instead of delivering their software via licensing agreements and physical disk, the company revolutionized the deployment of their operating system/Microsoft 365 by serving it on the cloud. This mobility strategy along with Windows server and SQL servers are driving growth and the share price.
Microsoft Is Using Datacenter As A Growth Driver Too
Similar to Amazon’s foresight, the same data center and cloud growth trend was evident in Microsoft. Microsoft’s counter to AWS is Azure. This is creating the next leg of growth for enterprise and Microsoft’s internal growth aspirations. With Azure being a big driver of growth in their intelligent cloud segment, it drove sales to $38.98 billion during their most recent fiscal year and server products and cloud services coming in at $10.49 billion in the quarter ending March 2020, a growth of 30% compared to the same quarter a year ago. They are capitalizing on the big move to mobility and deployment of enterprise architecture from the cloud. Microsoft is performing brilliantly and their business model has adapted, yet investors must realize a portion of growth is being driven by datacenter.
Apple, Still Hardware Dependent
Apple is a different story; they are reliant on hardware sales and it’s hard to see iPhone performing in an environment where consumers have less available dollars, while their supply chain was constrained earlier this year. IPhone accounted for 54% of sales coming in at $142.3 billion in their 10K filed 10/31/2019, this was a 14% decline YoY. Services accounted for 17.79% of total sales coming in at $46.29 billion and this segment continues growing revenues in the high teens (Source: Apple 10K Page 19).
The company’s shift to a recurring service-based model has helped Apple, as hardware sales continue their decline and the smart phone market becomes saturated. In Q1 2020, the company had a 7.1%, or $2.08 billion decline in iPhone sales to $28.96 billion compared to the same period a year ago; whereas, services increased 16.5%, an increase of $1.89 billion coming in at $13.34 billion. The company cited supply chain shortages in February due to Covid19 and it is expected to push the release of the updated IPhone SE beyond the normal upgrade cycle (Source Apple 10K Page 25).
The company reported their cash hoard at $192 billion and this should provide ample liquidity to weather the coronavirus slowdown. Apple is a little bit different than Microsoft and Amazon in that they are reliant on hardware sales to maintain their current valuation. Apple is trying to adapt like Microsoft and Amazon to capture a business model that is serviced based and recurring in nature.
Apple’s stock performance isn’t approaching Amazon and Microsoft’s because they are still in a transition to reduce their hardware sales, while capitalizing on services. I think Apple is nearing break even on the year because their strong balance sheet and financial situation, investors believe the company won’t have liquidity problems with their fortress balance sheet. Yet, investors don’t feel confident to bid the stock higher until more clarity emerges on supply chain slow downs and Apple’s long term plan to decrease their reliance on iPhone sales.
The NASDAQ’s Reliance On Datacenter, Whether People Know It Or Not
Datacenter hypergrowth and deployment is a contributing factor to the market approaching all time highs. Think about this, if there is a slowdown in capital expenditures in data center construction, the growth in Amazon and Microsoft’s business segments could pause or slowdown for a period of time. These three stocks pose concentration risk to being invested directly into the indices. The purpose of passive index investing is to “diversify” company specific risks from a portfolio and create a broad basket of companies that are representative of the underlying index and market in general. And since the NASDAQ provides larger weighting to large market capitalization stocks, it puts undue influence on the “Big 3” technology names and company specific risks.
Data center has been growing and will continue to grow, but one thing I know when there is a liquidity crunch in the credit markets, CFO’s delay capital expenditure decisions and budget planning. It’s hard to invest for growth when you need to shore up liquidity. The large companies have liquidity and will continue to do so, but their suppliers may not. I’m talking about the Lumentum’s, Applied Optoelectronics, Neophotonics, IIVI and Infinera. The companies that are critical suppliers for the deployment of datacenters are reporting their customers (the Amazon’s and Microsoft’s) are pushing capital expenditures out to the end of the year. Not to mention, a majority of optical suppliers have manufacturing in China and Taiwan, which was shutdown much longer than normal for Chinese New Year. Supply chains are being tested and the datacenter providers are spreading their capital expenditures into 2021 and beyond.
Putting It All Together
Datacenter will continue to be a growth driver as companies bolster their enterprise infrastructure to help a transition to a permanent work from home model. I believe growth could accelerate into 2021 and beyond; yet, there is uncertainty if the big 3 companies will deploy capital expenditures in an uncertain economic environment.
Apple will continue to see slow downs in their handset business. The smart phone market is overly saturated and the company’s only hope is the growth of their service segment. They haven’t created a revolutionary product since Steve Job’s tenure and are reliant on their strong balance sheet to acquire companies to spur creativity.
This means if the indices are being propelled higher because of the increasing earnings growth expectations of Amazon, Microsoft and Apple, investors could be disappointed if growth doesn’t accelerate into the second half of the year. The risk is the NASDAQ won’t be held up by large market capitalization technology companies and it will correct to reflect a more reasonable valuation representative of the broader stock market. The concentration risk is too great.
Options Pricing Remains Elevated
Options pricing remain elevated and the VIX is sustaining the $30 to $40 pricing level. This implies options are 1.7 to 2.3 times more expensive than historical levels; yet, less than the $80 level it touched in mid March. Something I saw in March was Implied Volatility spike anywhere from 3 to 10 times historical volatility on many normally liquid stocks. It was a great environment to sell options and collect premium on short contracts. Now things are beginning to settle and the black swan is over.
What Strategies To Use?
So with options prices still elevated, you have to focus on strategies to can capture directional moves in the underlying stock. Things are too uncertain to initiate positions in iron condors and benefit from a lack of movement in the underlying. Yet, I believe you can sell put options that are greater than 1 standard deviation out of the money and even sell covered calls on quality stocks. The purpose of selling put options cash secured is to acquire a quality stock at a cheaper price than it is currently trading and to be paid premium to do so.
I also like bull and bear vertical spreads. This strategy is directional and isn’t as expensive as a naked call or put. The long position premium is contracted with a short option contract. Initiating a bear vertical spread on the SPY when it is trading near $290 is an idea to keep in mind and a potential hedge is you make the lower priced contract farther out of the money on the put side.
Treasuries Have Been A Winner, Especially Long Duration
Treasuries rallied hard when the Federal Reserve cut rates to 0% , especially longer duration bonds. It’s simple, when yields fall, the price of previously issued bonds appreciates. The 20 year plus Treasury Bond ETF “TLT” is up 23% year to date and up over 37% over the last year. It’s hard to believe, but at the end of 2018 the 10 year treasury rate was greater than 3% and today is hovering near 0.60%. Even with a collapse in the yield curve, there is positive news of spreads widening and the yield curve resuming contango. Spreads have widened as the Federal Reserve injected liquidity into the overnight markets and increased open market operations of buying corporate debt. I don’t think the yield curve inversion we experienced last year foreshadowed the recession we are in. Yet, it was a warning sign. In summary, long duration has performed well and it remains a speculative play that interest rates could fall further (dare I say go negative). It’s hard seeing inflation anytime soon and it will allow the FED to keep easing the economy into an overheat cycle as we enter 2021-2022.
Don’t Fight The FED
Economists are predicting a Q2 slow down in GDP of 15% to 50%. These estimates illustrate that even the most seasoned professionals are guessing. What we can do is define the trend… And it is significantly down. Trying to pin a quarterly GDP estimate is all guess work because when you input data into an economic forecasting model, it will spit out a result that is only as good as the data put in “Garbage in, Garbage out”. All the data we are receiving is new and it has never happened before, the US economy has never ground to a halt. What economists should be focusing on is the Federal Reserve and US Consumer.The US consumer is fighting for their survival and 1/4 of American’s have been affected by a furlough or layoff. Jobless claims have spiked above 30 million and we have given up all job gains since the Great Recession. It is not all doom and gloom because a contingency included in the Payroll Protection Program “PPP,” is businesses must bring back employees by the end of June for the loan to be considered forgivable. Yet, some lower paid employees are receiving more income in unemployment benefits than their low salary jobs. The Federal government gave unemployed individuals an additional $600 weekly benefit on top of the $300 or so they would normally receive. Think, this Federal benefit lasts until July… What incentive do you have to report to work if you are making more income sitting at home? The answer is you have no incentive, and thus, unemployment could remain higher than anticipated through the middle of 2020.
The Federal Reserve continues to deliver money to main street and ease liquidity concerns across credit markets. Without these lending programs and direct stimulus, we would be in far worst shape. The remaining tools the FED has at their disposal are injecting money into illiquid markets and outright purchasing of stocks, bonds and other asset classes. The one tool they don’t have available is lowering the overnight lending rates below 0%.
According to the statements released on 04/29/2020, it doesn’t appear as if the Fed will lessen any of their open market operations: “The Federal Reserve is committed to using its full range of tools to support the U.S. economy in this challenging time, thereby promoting its maximum employment and price stability goals.” The Fed wants inflation to pick back up and they will continue deficit spending to get the economy out of this rut. It doesn’t help that QE1 and stimulus didn’t spur inflation because it is making the Fed more bold. Who knows, maybe this time will be different as the scale of this 2020 QE dwarfs the original program by an exponential value.
The Federal Reserve lessened the impacts of coronavirus and they were spot on with their monetary bazooka to pump trillions of dollars into main street lending programs and stimulus. It provided a soft landing for an overall volatile situation and they truly saved the day.
The Market Is Complacent Yet Again
If I told you the S&P 500’s earnings multiple is above 20 times in the middle of a recession, would you believe me? During the Great Recession, the S&P 500 forward price to earnings multiple hit below 10 times, yet the trailing P/E spiked well above 45 times. Anytime the US economy experiences an economic shock, the trailing earnings multiple spikes and then collapses because earnings fell during a period of economic contraction, while share prices were forward looking not expecting it. Not that this matters because the market is forward looking and the forward price to earnings multiple is more important.
Speaking of the forward multiple, how can an investor pay greater than 20 times to own the market at current levels? The only way I can answer this question is investors aren’t looking 12 months out, but greater than 24 months out. The market is pricing earnings expectations 2 years out and it is reasonable to expect the US economy to recover by then. All the capital the FED is injecting into the economy will spur inflation and it will create a growth hyper cycle. I’m not buying the market just yet because I think it will take out the March lows. Many companies will experience an earnings deterioration. Q2 will be a total dumpster fire and it’s hard to see a V shaped recovery in earnings by year end. We have already established the US consumer is in rough shape and this is not an environment where you go purchase new cars and other questionable debt financed assets.
How Am I Investing Based On My Views?I am positioning client portfolios to raise cash, purchase speculative longer duration treasury ETFs, build a 10% to 20% short position in the S&P 500 and own specific equities. Over the next 3 to 6 months, I believe the market has 10% upside potential and 35% downside potential based on the S&P 500 trading at 2900. Near term headwinds with the US economy reopening and the potential for a second outbreak of Covid 19 have skewed the risk to the downside. The only thing not accounted for in my estimates is if the Fed continues to inject capital into main street lending programs and begins purchasing equity securities. I like the TLT, IEF and SHY Treasury Bond ETFs as a speculative play that investors will go back to safe haven assets in a market sell off. These ETFs are around all time highs and they need to be traded with stop limit orders to limit any potential counter trend movement. A safer play is to buy the BIL and SHY ETFs to keep the duration of the investments below 3 years, it will preserve the capital but not yield very much in the current rate environment. To short the S&P 500 you can outright short sell the ETF “SPY,” or go long the “SH” Inverse S&P 500 ETF. The expense ratio is near 1% on the inverse ETF, but if you are trying to execute this strategy in an IRA or 401k SDBA, it generally is allowed. Something to consider about the inverse ETF is you shouldn’t hold it forever. It experiences time decay and is worth less everyday because of the futures used to create the inverse ETF, so don’t hold it over a long period of time. Without getting deep into the woods, the S&P 500 could retest the March lows near 2150. If this breaks the index will trend to a longer term support around the 1800 range. Based on both of these support levels, the potential downside could be 24% to 37%.
Some Other Thoughts
- US energy companies are near impossible to invest in and bankruptcies will rock the corporate debt markets moving forward.
- Aerospace, Retail, Restaurants and Hospitality experienced material changes and may not recover to pre-crash highs anytime soon.
- Macys, GAP and JC Penny’s are circling the toilet as they seek emergency financing and restructuring to survive.
- Amazon continues dominating all aspects of e-commerce and accounts for 40% of the consumer discretionary sector in the S&P 500. Just looking at XLY the S&P 500 consumer discretionary ETF, the top holding as of 05/04/2020 is Amazon at 25.22% of the total weight of the index.