May  7,  2015  

  Greetings,

The US government won’t have a debt problem unless growth drops below the cost of

financing said debt. Since 2007, the country’s debt burden has grown from 64% of GDP in 2007 to

104% currently. Reinhart and Rogoff’s seminal economic paper from 2010, “Growth in a Time of

Debt,” hypothesized that countries with ratios of public debt to GDP above 90% tend to see their

economies contract by about 0.1% annually. While graduate students have since challenged that

paper, it’s worrisome that growth expectations in the US are being cut once again in 2015.

On Wednesday, HSBC’s US economist cut 2015 growth estimates from 2.9% to 2.5%, citing

the accelerated decline in oil drilling activity. This marks the third consecutive year economists have

cut expectations in the second quarter and it comes on the heels of Jeremy Grantham’s latest letter,

which highlighted the downward pressures on long-term US growth prospects. Grantham believes the

country’s secular growth rate is around 1.5% Y/Y; below the 2.4% Y/Y growth from 2014. Assuming

his 1.5% estimate is correct, 10-year yields at 2.2% (-0.7% on the chart below) spells debt trouble

ahead for the US.

 

How does the government reverse this trend? Either growth needs to pick up or debt needs to

decline, although they’re not necessarily mutually exclusive. The Federal government has already cut

back significantly on debt issuance. The country’s budget deficit is down to -2.8% of GDP, compared

to -6.5% in 2013. In theory, interest rates at 0.25% should take care of the growth equation, but that’s

clearly not working.

Hypothetically, if Congress was serious about jumpstarting growth, it could do worse than

bolstering the country’s lousy infrastructure. The World Economic Forum calculates a long-term gain

of five to twenty-five cents on annual GDP for every dollar spent on public infrastructure. If Congress

doesn’t want to pony-up for better roads and airports, the private sector should get involved.

The demand is there. Goldman Sachs recently announced plans for a new $3 billion

infrastructure fund, and Norway’s sovereign wealth fund, the world’s largest, is increasingly interested

in the sector. These types of investments have a good track record. For private investors in Australia,

it's estimated that infrastructure investments in the mid-1990s yielded 7-8% annually, with favorable

risk exposure. Congress isn’t known for prudent decision-making, but if they want to avoid a debt

problem, infrastructure would be a good place to start. Investors looking to capitalize on this theme

should keep an eye on ETFs like IGF and GHII.

The Cup & Handle Fund is still roughly flat on the year, and +15% since August (inception).

I’m still increasing risk after a slow start to this year after some sloppy positioning. I added one new

theme this week, shorting a high-flying sector that I believe will come back to earth in short order. I’ve

decided on a pick for my May letter, and just have to write it. Hopefully it will be available within the

next week or so. If you’d like to start receiving these letters click here. Today’s letter will cover several topics, including:

• The Tesla Trap • Don’t Call It a Bounce-back • The Buffett Barometer • Chart of the Week

As always, if you have any questions or comments or just want to vent, please send me an

email at mike@cup-handle.com.

Until next time, tread lightly out there,

Michael Lingenheld Managing Editor – Cup & Handle Macro

 

The Tesla Trap Take a look at the chart below. Would you buy TSLA at these levels? Few stocks attract more

attention from retail investors than Tesla even though it has posted disappointing results for several

quarters. Deliveries in the first quarter came in at 10,030, up 55% Y/Y. However, sales will need to

explode in the second and third quarters to meet Elon Musk’s target of 55,000 deliveries in 2015. The

long-term target of 500,000 annually by 2020 seems even more ambitious. Musk has said he doesn’t

expect the company to be profitable until then.

These figures are a fraction of the sales

for most automakers, but Tesla’s stock is not

priced like an automaker. In fact, Tesla really

doesn’t have any true competitors. Nissan and

Chevy have both sold affordable electric cars,

but they suffered from poor range. Toyota

(among others) has done well with hybrid

vehicles, but Tesla owns the luxury market. This makes valuation tricky, but it’s reasonable to assume

that TSLA’s multiple will come back in-line with traditional automakers once they devote meaningful

cash and scale to the segment.

Musk made plenty of headlines last week announcing Tesla’s new stand-alone batteries.

They’re a game-changer, but not for Tesla. The battery packs will be installed in homes to store

renewable power when the sun isn’t shining – in the case of solar. Musk’s other big venture, Solar

City (SCTY), will surely benefit more than TSLA. Tesla is only offering this product because its new

Giga-factory gives it the scale to buy parts cheaper

than competitors.

The problem for Tesla is that the market is

extrapolating its current 15% margins on future sales

of 500,000 by 2020. However, with profit margins at

these levels, traditional automakers will throw huge

resources into the luxury electric sector to compete,

which will inevitably bring down margins across the

board. You can either have volumes or margins, but

not both. It’s conceivable that margins could stay

elevated if Tesla successfully taps into emerging markets, but given the company’s problems in China

and need for electric-charging infrastructure that seems unlikely. Currently, more than 80% of

deliveries are made in the US.

 

Make no mistake; Tesla is producing revolutionary technology that is worth a premium.

However, unless the company can sustain its margin-advantage through other products (like

batteries), the stock will eventually ascend back to earth. It may take time for the market to reach this

conclusion, but if you’re playing the long-game shorting TSLA is the right move.

Don’t Call It A Bounce-back The much-anticipated short squeeze finally arrived last week as EUR/USD jumped higher in

violent fashion. Weak first quarter GDP data hampered the USD leg of this position and rising

German yields fuelled the rally higher. Germany’s 1.6% growth forecast from the IMF looks like it

could be on the low side, as a cyclical rebound appears to be underway. For unbeknownst reasons,

the media is still explaining the shifts in EUR by developments in the Greece saga, but German yields

are far more important.

In fact, Bunds have been making lots of headlines as bond heavyweights Bill Gross and Jeff

Gundlach both recommended shorting German debt. Gross called it “the trade of a lifetime” in a

tweet. Norway’s $900 billion sovereign wealth fund, the world’s largest, is also piling into this position.

Shorting Bunds with negative yields is intriguing in the sense that it offers a positive carry, but there

are reasons to believe it won’t be the “home run” that Bill Gross makes it out to be.

 

A simple look at the supply / demand fundamentals shows this trade has limited downside.

Demand for high-grade collateral is projected to be $400 billion more than supply in 2015. Bunds are

especially valuable as collateral because they carry a higher rating than US Treasury’s. The ECB

alone has a mandate to hoover-up 11 billion EUR of Bunds every month until September 2016. A

huge increase in supply is also unlikely since the Germans pride themselves on austerity.

Even if the ECB is successful in reflating the European economy and the German yield curve

steepens, the real “home run” could be in EU banks. Higher yields would help improve margins for

banks across the continent, which continue to trade like distressed assets. Bill Gross and company

could easily be correct, but the real money to be made is on the derivatives of this theme.

The Buffett Barometer The so-called “Buffett Index,” a metric the world’s most famous investor follows closely,

measures the percentage of total market cap relative to the world’s GDP. The total market value of

stocks traded globally hit a record $74.7 trillion at the end of April, according to the IMF. When the

Buffett Index peaked in 2007, total market cap globally was a mere $64 trillion.

At these levels it’s hard to say that stocks are overvalued, which is probably why Mr. Buffett

sounded so optimistic at the annual Berkshire Hathaway shareholder meeting last week. Let’s

assume for a second that the Buffett Index at 90% represents fair value. The IMF predicts global GDP

will reach $98 trillion by 2020, meaning the global stock market’s value would be roughly $88 trillion.

That’s $14 trillion in upside potential, assuming global central banks don’t step in and ruin the party

with higher rates. Chart of the Week Two days after Twitter (TWTR) reported dismal first quarter earnings the stock had decline

23%. Ironically, the results were leaked before public release… on Twitter. Investors have given

 

Twitter a pass over the past two years because of the company’s reliable revenue growth, even

though user growth has never been a strength. Many assumed user growth would eventually follow

and Twitter would be able to monetize that activity into profits, justifying the company’s high multiple.

However, now that revenue growth is showing weakness, investors are bailing quickly.

Even though Twitter celebrated its one-year anniversary as a public company last week, it’s

considered mature within the Silicon Valley landscape where more than 80 private companies are

worth more than $1 billion. If a $27 billion company like Twitter can’t convince the market it has a

viable plan for profitability, what does that mean for other social media stocks? LinkedIn also

disappointed the market last week with a poor outlook, sending shares down 21% in after-hours

trading. Twitter might not be an attractive short because of its potential as an acquisition target, but

shorting the social media ETF (SOCL) would mitigate that risk. If the business models of these social

platforms continue to show their flaws, SOCL could be headed for a crash landing.

Reader Question: **Editor’s note: Every week we’ll try to answer at least one reader question. If you would like to submit a question, please send us an email at info@cup-handle.com. We’d love to hear from you! **

Q: Have you read Bridgewater’s views on pension funds (85% could fail within 30 years)? What’s

your take? – LD

A: I actually had not read Bridgewater’s hypothesis until LD brought it to my attention. First of all, a lot

can happen in thirty years. Thirty years ago, 2-year Treasury’s were yielding 10%, the Cold War was

in progress, and the Internet had barely been invented. However, this is a serious problem. In the US,

pension funds are forecasting returns of 7% with the 10-year yielding 2%. Common sense would lead

you to believe either, A) pensions will buy risky assets and blow up or B) play it safe and miss their

 

benchmark. There are markets where a 5+% yield is attainable, mostly EM debt (Argentina, Brazil,

Russia), but they’re not nearly liquid enough to handle pension inflows.

The 25 largest pensions in the US face $2 trillion in unfunded liabilities. It’s the same story in

Great Britain where 6 FTSE 100 companies have pension liabilities greater than their equity market

value. Paul Volcker once said the Federal Reserve was envious of Bridgewater’s research

capabilities, so it’s hard to believe they’re missing something. As I said, thirty years is a long time but

there’s no denying the outlook for pensions is awful.

That’s all, see you next week!

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