Betting on Morality

I have recently taken an interest in the Hong Kong protests and what they stand for.

I am most amazed by how little support the protests get in the west. Most of my friends are telling me: it’s because no one wants to disturb China as they do business there or want business there. I’m not sure if there’s any credibility to that, but if there is, I suppose that also explains why so many American companies are working alongside the Chinese Communist Party. Apple has been banning apps that Hong Kong protesters used to mobilize and hide from police. Michael Bloomberg, yes the owner of Bloomberg terminals, recently gave the Communist Party glowing reviews.

As the saying goes, “The capitalists will sell us the rope with which we will hang them.”

So how did we get here? I think it begins with the auto-pilot nature of some emerging market fund managers and what seems to be a mindless allocation of American investment Dollars to Mainland Chinese VIEs like Alibaba because they’re listed as “emerging market stocks.” It’s one painful development that should strike anyone on a deeper level. It definitely hits me. Look at any emerging market ETF or emerging market mutual fund’s top holdings and… surprise! You’re buying Alibaba bro. It’s generally the most widely held stock sometimes up to 5% of the ENTIRE fund. There is no consideration for American accounting standards, communism, free speech, oligarchs, or anything else core to the inner workings of America’s success all these years.

In my early days as an investor, I was taught markets don’t care about politics. The markets, being made of up of millions of buyers and sellers, will do what they have to do. Lately, I’ve been reevaluating that belief. Especially as I found myself watching video clips from China’s massive military parade — giant red flags, guns firing, huge portraits of leaders, and phrases like “strive for the motherland’s complete reunification” and missiles that can reach as far as the United States. I wish I was making this up:

All of this has me rethinking the way I plan to mix markets and politics going forward. In the past, I would focus on my own career path and my own investment theories. But I can’t do that now because what I see is directly in conflict with my investment goals going forward. So here is what I know and then what I plan to do:

1. When China tried to pass a law saying any Hong Kong citizen could be detained and moved into Mainland China for any reason, the people of Hong Kong stood up. Today, what you’re seeing or reading, is their young people fighting China’s Communist Party who is focused on forcing Hong Kong into their control.

2. Over one million Uighur Muslims who live in China have been arrested and put into government internment camps meant to “re-educate” them. There is very little religious freedom in China, if at all. And headlines like this particularly concerning:

3. Taiwan, a country of 25 million people, is fighting an information war each day with China. Most people in Taiwan say they are an independent country. China, however, says they rule them. Some think China will take the country by force in the next year or two if the Taiwan population does not come to accept their reality. On Wikipedia, Chinese Communist Party employees monitor the site 24/7 to try to edit in things like, “Taiwan is a province of China” when it is actually not.

4. Tibet, for years, has been battling China over independence. I remember while living in Cambridge, Massachusetts walking through Harvard Square to see Tibet protesters playing music and holding signs. For the longest time, I overlooked them. I had thoughts like, “I need to get to work” and “Can’t you do something better with your time?” Several years later and I finally get it. They have been at this for more than 10 years pouring their energy into consistency of protest. Today, the Dali Lama is still forbidden from ever returning to Tibet because the CCP is worried he is too influential.

5. I remember a time when the militarization of the South China Sea was all over the news. That was several years ago. The thing is, these things happen gradually until, suddenly, they are. China still says they own the entire South China Sea while everyone else like Vietnam and Malaysia say that’s not fair. The sea is home to several countries who also happen to live on it or share borders on it. As of this writing, the Chinese Communist Party is weaponizing the sea at an alarming rate.

6. The censorship in China is mind-boggling. A post like this would probably have me jailed and it would entirely be removed from any Internet property in the country. There is no free speech.

As the protests in Hong Kong continue, I will be watching Chinese stocks closely as well as the Southeast Asian countries that surround China. Several months ago I wrote about my thoughts on the Trade War and how I think it’s actually healthy for the world. It’s good to redistribute trade away from China and to other developing countries that need it more, are free, and most importantly, are actual *democracies* like Mexico, Vietnam, and others.

I have been scanning for the biggest and largest Chinese companies listed in the US and adding some to my short book. And I will short them through puts with a long expiration date. This will be my first time mixing politics and markets. I think people in the west are smart enough to see the tyranny taking place and will act. My money is betting on morality and I can’t imagine thinking about this in any other way right now. Let’s see what happens.

Side note: read this if you missed my post on Chinese VIEs.

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Selling To Everyone When Everyone Is No One

Let me start by reminding you of an IPO I have been unable to forget. I will show it to you as a chart, a wonderful chart that goes straight down.

What you see is the great meal delivery company Blue Apron since it went public. The unicorn! The one that would change the way we eat!

I’m not totally sure how it happened, but at one point this idea to deliver meals in a cardboard box using the USPS was a billion dollar company. In 2017, during a strong bull market, Blue Apron went public. If you had bought $200 worth of this then lauded unicorn, you would have about $15 left today. Good enough for a few coffees and two bagels.

So what exactly happened here? How did it go from exciting startup to the depths of today’s Miami Dolphins? While some might say business decisions or leadership or competition, it seems more likely it was just valued really, really wrong in private markets. Oh, and a good PR firm can really make that valuation pop…
Screenshot 2019-04-15 at 6.30.56 AM

The other week, I read a fascinating stat. It went like this: in 1980 there were only 47 venture capitalist firms and combined they had about $3 billion in total capital. Today, there are 600+ venture capital firms and they have $515 billion in total capital.

Venture Capital is incredibly important to the economy. They fund start-up companies and take immense risk. But it’s important to remember the valuations they seek, or the valuations they decide on, are generally done in a fairly closed setting. Seven people sitting in a room can chose to invest in a company at a valuation of $80 billion and kachinga, this company is now worth $80 billion – call the newspapers and reporters.

In the words of South Park:

The fate of WeWork, to some degree, may be shedding some light on these valuations. Just because some private investor decided to give money to a company at one price does not mean that’s what it’s worth to everyone else with the same information. When WeWork was opened up to public markets for its potential IPO where thousands of people could scrutinize, discuss, and dive deep into it, it fell apart. It wasn’t really worth what private investors told everyone it was worth. There are now more VCs and venture money than ever. The hype and dreams of billions naturally only scales with that. I come back to that scene from the movie The Social Network and how that permeated the startup landscape.

Chamath Palihapitiya, a private investor who made his mark as an early employee at Facebook, but also one who is pretty outspoken, not long ago started talking about problems in the private investing world. He’s worried about the ponzi scheme nature of the existing cycle. I don’t agree or disagree, but I find it interesting and here’s what he writes:

“Over the past decade, a subtle and sophisticated game has emerged between VCs, LPs, founders, and employees. Someone has to pay for the outrageous costs of the growth described above. Will it be VCs? Likely not. They get paid to allocate other people’s (LPs) money, and they are smart enough to transfer the risk. For example, VCs habitually invest in one another’s companies during later rounds, bidding up rounds to valuations that allow for generous markups on their funds’ performance. These markups, and the paper returns that they suggest, allow VCs to raise subsequent, larger funds, and to enjoy the management fees that those funds generate.”

It’s almost as if we’ve taken the “rounds” and accepted them as truth without ever actually getting a clear picture ourselves. If a tree falls in the forest did anyone hear it? If a TechCrunch headline says a company is worth billions do we all believe it?

It’s important to remember that what we see today in private investing is fairly new. Public markets, on the other hand, have been around a long time going back to the Buttonwood Tree. But this cycle of private deals and private rounds of investing is entirely on its own. What I mean is I have yet to meet someone who could show me a historical example of anything like the size or scope of private investing and venture capital like we’re seeing today.

*person walks out of boardroom*

“Today we decided this company is worth $7 billion and we’ve invested $100 million. Tell everyone it’s worth $7 billion.”

*everyone proceeds to say company is worth $7 billion*

My friend always jokes that his life is a startup and it’s worth hundreds of millions if he could pitch it to the right people.

When Lyft IPO’d, I noticed a chart showing who invested in the company when and where. I was most surprised to see Fidelity and Carl Icahn on the list. These are companies and people known for their careers in public markets. You don’t see those names in venture capital often and when you do, you have to wonder: is it now so easy to make money in venture capital that Carl Icahn can just prance right in and then flip his money for a cool 10x return?

2019 has so far been the year of giant new IPOs being challenged. Uber, Smile Direct Club, Lyft, and more hit all-time lows shortly after their IPO. Lately, a group of VCs have been calling for direct listings. One of the core arguments is that investment bankers, day traders, and speculative investors are taking advantages of these companies on the long and short side when they go public. I can’t help but think this is a call for help. A call for help signaling the public markets aren’t buying their companies like they thought they would. I wonder how many private investors have been injecting money into these mega companies on the basis that, “public markets will take care of it, don’t worry.”

Public markets are ruthless. Any real investor or grizzled trader will show you that. I hang with them all the time and hear stories that no one should go through with their own money.

Going forward, the question will be if something like WeWork’s IPO collapse is an outlier or actually the norm for a wave of abysmally wrong private market valuations. I even wonder if a wave of write downs are coming. If anyone is safe. Especially those who have been marking up their stock behind closed doors on the idea that the arbitrary price they determined will easily be accepted by everyone else.

Not so fast.

I have long been a proponent of public equity markets. They are over 100 years old. The Government is heavily invested in regulating them and millions of people have access to them. Generations of people have passed through them and handed down their prized holdings. I am beginning to wonder if, perhaps, public markets are actually the smart money and private markets are the “not-so-smart” money. We will find out over the coming months and it’s possible that this wake up call won’t be friendly to the gurus of today’s private investing landscape.

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Cash Rich, Asset Rich, and Repo Markets

I’ve been having this thought lately, one that has been debated before, it’s that very few people are actually cash rich today. Most are asset rich.

Like no other point in time, even greater than the DotCom Bubble, investing has permeated every corner of culture. In hindsight, Bitcoin was a phenomenon that introduced millions to speculative markets practically overnight. There are more brokerage accounts open today than in the DotCom Bubble. And it’s growing. I think part of that is because of the ease of investing. The 20-year-old who just got into vaping can download a commission free brokerage app and buy two shares of Tilray in a few minutes. Even the rapper Waka Flacka, not long ago, was sharing an Instagram image of his stock portfolio.

While I think investing can be beneficial across all asset classes, I do wonder what it means to have a society that is entirely focused on being asset rich and not cash rich. Corporations especially. We read daily about how much cash companies like Apple have, but we rarely ever scruntize their liabilities, their debt, or the actual nature of this “cash.” I would wager most cash assets today are actually in short-term vehicles that are marketed as such, “just as good as cash” … *reads fine print at bottom of page* “but not really cash in its true definition.”

Today, the Fed is quietly injecting $30+ billion each night into repo markets. The main cause is because there isn’t enough cash in the short-term to fund the immediate overnight needs of banks and corporations. Even if it is just a one-time fluke, which many tell me it is and that it’s not that out of the ordinary, the fact remains that whatever just happened, beneath the surface, there was a squeeze for cash going on.

Just recently, on one of these cash-squeezed nights, the interest rate on an overnight loan in the repo market, that thing in the corners where very few ever look, went as high as 9%.

A family member of mine once warned me about the perils of being asset rich. How much do you think everything in your room, the one you grew up in, is worth today? I think a couple thousand dollars. I mean I have some great baseball cards in there, some video games that are still worth playing, some clothes, and a few other items. Now, imagine you took all of that stuff to a garage sale and spent a day or two trying to sell it. How much is it worth now? Probably a couple hundred dollars. Maybe less.

That’s the difference between being cash rich and asset rich. And when the signals start to show, heed them wisely on where you should be.

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Inflation-Adjusted Returns Always Suck

It isn’t much fun to talk about. It’s kind of a party killer. The music sounds good, the people are jiving, but then you remember you’re still in middle school, a censored Nelly album is playing, and your parents are outside waiting to pick you up.

Inflation is that. No one wants to talk about those moments. They’d rather tell you about the crazy times they had in college.

What can 1 US Dollar buy you today?

What could 1 US Dollar buy you 30 years ago?

The difference between those two questions, in its simplest form, is inflation. So let’s quickly go over some numbers to see how inflation is the worst party in town and awfully humbling. But first, let’s look at the numbers *before* inflation.

– On a nominal basis, the S&P 500 is up roughly 330% since the absolute depths of the Financial Crisis.

– It’s up about 105% since the highs right before the Financial Crisis in 2007.

– It’s up 110% since the highs of the Dotcom Bubble, before it crashed, back in 1999/2000.

These are the facts you see in headlines everywhere. That the S&P 500 is up 330% since the bottom of the Financial Crisis and it’s now up 105% for those who accidentally bought at the highest points before the Dotcom Crash or Financial Crisis.

Let’s chart it:

If you want to humble yourself, try adjusting all your returns and gains for inflation. I don’t know many people who do that and I think I know why. You are literally about to tell yourself you’re not as good as you thought you were.

So if you can stomach it, if you’re a real one confident in your abilities to fight the forces of inflation, keep reading. Because I will show you what Mordor really looks like.

Since the bottom of the Financial Crisis, inflation-adjusted S&P 500 returns are up about 150%. Not 330%. Had you bought at the peak of the Dotcom Crash, adjusted for inflation, you’re up about 40% right now. Had you bought at the peak of the Financial Crisis, you’re up about 50% right now. Basically each comparison had their returns cut in half.

Let’s chart the party no one wants to go to. Here’s the S&P 500 chart when it’s adjusted for inflation. The difference is startling in scope and pace compared to the chart we shared earlier:

Inflation-adjusted returns suck, I know. They are not as glamorous as nominal returns. But it’s a healthy reality check and a reminder of how important it is to keep up with the inflation rate. It’s also a reminder that you’re not as good as you think you are. Most of us, when we’re invested in risk assets, are just riding the waves of inflation.

If you have the guts to work on your own personal inflation-adjusted returns, please let me know. Hope you hang in there and just remember, the real ones know inflation well and want the challenge. The others will dance around their nominal gains and never speak a word about it.

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A Simple Thought on Optimism

As time progresses, people generally get smarter. And better.

I just finished a book on how the Internet came to be and I had no idea about the science behind it all until now. Especially the complexities behind the increasing speed that we are able to send data to one another.

A signal travels from phone to tower to tower and back to your phone in seconds. I don’t think I give that enough credit for the pure human ingenuity that went into such an accomplishment. And if we figured that out, what else can we do.

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My Thoughts on Passive Investing

On the fifth day, an Oracle from Omaha descended from thee heavens. “Today,” he said, “I bring you thy S&P 500.”

So it began.

From all across the lands, people began pouring their earned coin into this magical transcendent creature.

“Here ye, here ye! Take all your monies! We can deposit it monthly or quarterly or weekly. We shall call this act, passive investing!”

And that my friends, is the start of passive investing. The story of how it all came to be…

Act 1

Did you know the S&P 500 Index is actually owned and operated by a company. That company is the S&P Dow Jones Indices. Did you also know this company has over 10,000 employees. Some of those employees, well actually a lot of them, work daily to manage all of the indexes they sell, market, and create.

They add stocks, they remove stocks, they debate new and old methods, and they probably get into some nasty board room fights here and there about what stocks should go where. They have entire committees dedicated to these processes.

I can read it to you if you want, straight from them:

“All committee members are full-time professional members of S&P Dow Jones Indices’ staff. The committee meets monthly. At each meeting, the Index Committee reviews pending corporate actions that may affect index constituents, statistics comparing the composition of the indices to the market, companies that are being considered as candidates for addition to an index, and any significant market events. In addition, the Index Committee may revise index policy covering rules for selecting companies, treatment of dividends, share counts or other matters.”

I’m not sure I see the “passiveness” of a monthly meeting to decide what stocks should go into a basket of equities. I guess what I’m saying is that the indexes people passively invest in, are, quite frankly, actively managed. But perhaps there’s more to this story. Let’s keep going.

Act 2

The other day I was being shown some interesting new software for passive investors. Here’s what I was told:

“You ready!? Our website is going to make life easier for passive investors. Before you do automatic deposits into different asset classes, you need to take a risk assessment test. Depending on your risk level, the website automatically tells you what assets are good for you. It’s that easy!”

I’ve found myself pressing buttons and moving sliders on this website. I want to take massive risk. Nah, I want to take no risk. The website spits out new assets and allocations just for me depending on where I moved these sliders and how I press certain buttons. I can invest in an aggressive basket of assets or a conservative basket of assets.

But wait one second. What exactly are these assets I’m being recommended?

It turns out, most of the “assets” these machines recommend are really just ETFs. I could end up in the TLT ETF, sometimes known as the biggest Longterm Treasury Bond ETF. Or I could find myself in the popular Nasdaq-100 ETF called QQQ.

Lucky me.

It’s at this point, in my journey to understand passive investing, that I think I’ve cracked the code. Passive investing is just buying ETFs on a set schedule whether it’s each paycheck or each quarter. The machine has told me I need exposure to classic US Treasuries. So I find myself searching the official TLT ETF website for more information. I think I’m ready to jump in!

Act 3

“Well that’s weird.”

I’ve just learned the Treasury Bond ETF, the one I was looking at called TLT, is managed by two people. As of this writing, this ETF has $17 billion in assets under management and yes two people are responsible for steering the ship. Not my words, their words:

“Portfolio Managers James Mauro and Scott Radell are primarily responsible for the day-to-day management of the Fund. Each Portfolio Manager is responsible for various functions related to portfolio management, including, but not limited to, investing cash inflows, coordinating with members of his portfolio management team to focus on certain asset classes, implementing investment strategy, researching and reviewing investment strategy and overseeing members of his portfolio management team that have more limited responsibilities.”

There’s nothing wrong with this. It’s kind of nice to meet our portfolio managers James and Scott. I wonder if they like avocados… But what you’re also telling me is that by taking the machines recommendation to diversify into a low cost ETF managed by a couple of guys walking around an office yelling about inverted yield curves is passive investing. Okay then.

Act 4

The name “passive investing” is good.

It’s friendly. It’s easy.

What’s really happening, however, is a little marketing department has done something clever – that somehow this passive investing thing is better, different, and safer. But in reality, passive investing is the same thing people have done in financial markets since the dawn of the Buttonwood Tree: we trade our hard-earned money to buy a paper asset like a stock because we estimate it will create bigger future returns than if we just held our cash money and did nothing with it.

There’s no secret sauce here.

The funds you buy can screw up just like anyone else can. So yes, you might be a passive investor, but you surely aren’t investing in anything even close to what the word passive actually implies.

What I’m saying is someone behind the scenes of all those ETFs or whatever fund you think qualifies as passive investing is actively moving money and assets around. When I say actively, by the way, I mean like sometimes daily. ETFs rebalance and move things around all. the. time.

Curtain Begins to Close, @Scheplick Walks Unto the Stage

Passive investing was built by those who need your money to continue conducting the alchemy of finance. You see, if it’s too easy, the people will just do it themselves. If it’s too scary, no one will ever want to do it. You need the perfect mixture of too scary and not easy enough and voila – money deposited, business earned.

Just as fast as passive investing became a wonderful buzz word in a massive bull market, it can also become a shunned marketing phrase in a devastating bear market. Because at the end of the day, that’s all it is… a marketing word.

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Beasts of Record

Bill James, the now near 70-year-old who spent his career changing the way people think about statistics in baseball, has a few things to teach.

No one working in Major League Baseball today thinks like they did 30 years ago. Bill James changed everyone’s mind.

That’s how important he is. I think, at the end of the day, we’d all like to do that in the fields we care about most.

In his early days, when maybe 10 people were actually reading his self-published work, he was working to change the perception of common stats that measured a player’s performance. Like batting average.

When you hear, “that player is a .300 hitter” what comes to mind? All-star? Top player in the league?

When you hear, “he’s a .275 hitter” what do you think? Mediocre player? Pretty good?

I’ll let Bill James explain:

“One absolutely cannot tell, by watching, the difference between a .300 hitter and a .275 hitter. The difference is one hit every two weeks. It might be that a reporter, seeing every game that the team plays, could sense that difference over the course of the year if no records were kept, but I doubt it. Certainly, the average fan, seeing perhaps a tenth of the team’s games, could never gauge two performances that accurately — in fact if you see both 15 games a year, there is a 40% chance that the .275 hitter will have more hits than the .300 hitter in the games that you see. The difference between a good hitter and an average hitter is simply not visible — it is a matter of record.”

While everyone can tell you the difference, no one can actually see the difference. You can think it, you can read it, but you will never actually be there for it.

I imagine all the millions of fans who talk about .300 hitters in a completely different light. The brand and image a .300 hitter has compared to a .275 hitter is drastic. For those who know baseball, you know. They practically live on two different planets. One is an all-star, the other is not.

In reality, the difference is barely even noticed.

Investors love to compare baseball to the markets. The statistical observations, streaks of success, and long enduring season all have their commonalities with markets. You will often see traders and investors quoting the great baseball players or comparing their craft.

Warren Buffett is probably the greatest investor ever. But, what if we could see all the other professionals out there and compare their returns to his. I’m sure the second best or third best, the ones without the same marketing or publicity machines, are probably pretty close. So close, most of us probably could not tell the difference between them, especially without Warren’s brand or digging deep into their actual account statements.

Yes, the record says one thing, in this instance, that Buffett is best, or that one batter is better or worse, but they fail to explain just how much worse or how much better they are. Or just how hard it is to actually see the difference. That is rarely discussed.

We are beasts of record without much regard for perception.

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