Mad Hedge Technology Letter
August 23, 2018
Fiat Lux
Featured Trade:
(THE RACE TO ZERO FOR BROKERAGE COMMISSIONS)
(JPM), (WFC), (ETFC), (SCHW), (AMTD)
Posts
The other shoe has dropped.
No more waiting for it as it was only a matter of time, but it was going to happen soon enough.
The acceleration of the race down to zero for brokerage commissions has moved into full throttle.
In a bid to engage new customers, especially millennials, J.P. Morgan (JPM) will offer its customers 100 free stock or ETF trades for one year.
The new service will be available on Chase’s mobile banking app called “You Invest” and also does not require a minimum balance as do so many of the competitors.
Last year, J.P. Morgan was still charging customers a horrific $24.95 per trade, a ridiculous sum in an age of brokerages slashing fees left and right.
Recently, I chronicled the start-up fin-tech brokerage Robinhood, which rolled out the zero-commission model to the chagrin of the traditional brokerages on the verge of major disruption.
Well, Wall Street has stood up and taken notice. There is no way back from this new normal.
The catalyst for J.P. Morgan to change direction was its lack of competitiveness in the digital brokerage space and a free model of luring in business is seen as a quick recipe to correct its ills.
J.P. Morgan has pumped in $300 million in the past two years into digital initiatives but still lacks the volume it was hoping for. This could help capture fresh accounts that could eventually turn into a meaningful business.
Freemium models made popular in Silicon Valley are catching fire in other parts of the economy as potential customers can dabble with the service first before committing their hard-earned money.
This is dreadful news for the fin-tech brokerage industry as it indicates a whole new level of acute pressure on margins and revenue.
The brokerage business has been under fire the past few years after regulators discovered Wells Fargo (WFC) was cunningly ushering clients into higher fee trading vehicles, taking a larger cut of commissions.
Wells Fargo did everything it could to rack up costs for high net worth clients. The atrocious behavior was a huge black eye for the entire industry.
Technology has forced down the cost of executing a trade and each additional trade is almost nil after fixed costs because of software and hardware carrying out these functions.
E-brokerages are set for a rude awakening and their cash cows are about to be disrupted big time.
Charles Schwab (SCHW) has 11.2 million brokerage accounts, and no doubt clients will get on the ringer and ask why Schwab charges an arm and a leg to execute trades.
Schwab might as well start charging clients for emails, too.
The cut in commissions has already started to affect margins with Schwab revenue per trade sliding from $7.96 in 2017 to $7.30 in the most recent quarter.
TD Ameritrade (AMTD) is experiencing the same issues with revenue per trade of $7.83 last year dropping to $7.30 last quarter.
The beginning of the year provided e-brokers with respite after euphoric trading sentiment pushed many first-time equity buyers into the markets, making up for the deceleration in revenue per trade.
However, that one-off spike in volume will vanish and margins are about to get punctured by fin-tech start-ups such as Robinhood.
J.P. Morgan’s move to initiate free trades is a huge vote of confidence for upstart Robinhood, which charges zero commission for ETFs, option trades, and equities.
I recently wrote a story on the phenomenon of Robinhood, and the new developments mean the shakeout will happen a lot faster than first anticipated.
TD Ameritrade, E-Trade (ETFC), Fidelity, and Charles Schwab could face a deeply disturbing future if Silicon Valley penetrates under the skin of this industry and flushes it out just like Uber did to the global taxi business.
E-Trade shares have experienced a healthy uptrend and it is now time to pull the rip cord with the rest of these brokerages.
It will only get worse from here.
Investors should be spooked and avoiding this industry would be the right move at least for the short term.
The golden age of trading commissions is officially over.
Turning this industry into a dollar store variety is not what investors want to hear or hope for.
The decimation of commission fees has coincided with the rise of passive investing.
Only 10% of trades now are performed by active traders.
Brokerages earn demonstrably less with passive investing as the volume of trading commission dries up with this buy-and-hold-forever strategy.
Index funds have been all the rage and quite successful as the market has returned 400% during the nine-year bull market.
When the market stops going up, the situation could get dicey.
The real litmus test is when a sustained bear market vies to implode these ETFs and what will happen with a massive unwinding of these positions.
A prolonged bear market would also scare off retail investors from executing trades on these e-brokerages.
Many will take profits at the speed of light not to be seen or heard again until the next sustained bull market.
Moreover, it is certain the global trade war is scaring off retail investors from their trading platforms as the uncertainty weighing on the markets has thrown a spanner into the works.
Tech has been the savior to the overall market with the top dogs dragging up the rest, but for how long can this continue?
Other industries are experiencing minimal earnings growth and tech cannot go up forever.
Regulations are starting to bite back at the once infallible tech narrative.
Chinese tech is also having its own headaches where Tencent has been perpetually stymied by local regulators blocking access to gaming licenses needed to monetize blockbuster video games.
Tencent missed badly on its earnings report and there is no end in sight to the delay.
Social media has been torn apart as of late and the weaponization of its platforms is accelerating with government operations moving onto them to fight against each other.
Interest rate revenues are the saving grace for these brokerages that account for 50% or more of revenue.
As interest rates rise, there will be a bump in interest rate revenues. However, as competition heats up and commission falls to zero, will these clients stick around for the e-brokers to reap the interest rate revenues or not?
Millennials are hard-charging into Silicon Valley start-ups such as Robinhood, and the traditional brokers’ clientele are mainly directed on the lucrative middle-age cohort.
The next development for e-brokers is who can best harness artificial intelligence to best enhance their customer experience and products.
If the Charles Schwab’s of the world must compete with nimble Silicon Valley start-ups in technology, then they will find a hard slog of it.
One of these big e-brokers is likely to implode setting off another round of consolidation.
The race down to zero is fierce, and I would avoid this whole industry for now.
There are better secular stories in technology such as the e-gaming phenomenon capturing the hearts and minds of global youth.
________________________________________________________________________________________________
Quote of the Day
“Expect the unexpected. And whenever possible, be the unexpected,” – said Twitter and Square cofounder and CEO Jack Dorsey.
Global Market Comments
August 14, 2018
Fiat Lux
Featured Trade:
(WHY BANKS HAVE PERFORMED SO BADLY THIS YEAR),
(JPM), (C), (GS), (SCHW), (WFC),
(HOW FREE ENERGY WILL POWER THE COMING ROARING TWENTIES),
(SPWR), (TSLA)
I went to the local branch of Wells Fargo Bank (WFC) yesterday, and I was appalled. The bank occupied the most expensive corner in town. It was staffed by a dozen people, all of whom spoke English as a second language.
Ask even the simplest question and they had to call a support center and wait 10 minutes on hold for the answer. It took an hour for me to open a checking account for one of my kids. The branch was in effect a glorified call center.
I thought, "This can't last." And it won't.
Banks were supposed to be the sector to own this year. They had everything going for them. The economy was booming, interest rates were rising, and regulations were falling like leaves in the fall.
Despite all these gale force fundamental tailwinds the banks have utterly failed to deliver. The gold standard J.P. Morgan is up only 8.46% on the year, while bad boy Citibank (C) is down 5.47%, and the vampire squid Goldman Sachs (GS) is off a gut-punching 10.27%. Where did the bull market go? Why have bank shares performed so miserably?
The obvious reason could be that the improved 2018 business environment was entirely discounted by the big moves we saw in 2017. Last year, banks were the shares to own with (JPM) shares up a robust 24.5%, while (C) catapulted by 29.3%.
It is possible that bank shares are acting like a very early canary in the coal mine, tweeting about an approaching recession. Loan growth has been near zero this year. That is not typical for a booming economy. It IS typical going into a recession.
When the fundamentals arrive as predicted but the stock fails to perform it can only mean one thing. The industry is undergoing a long-term structural change from which it may not recover. Yes, the bank industry may be the modern-day equivalent of the proverbial buggy whip maker just before Detroit took over the transportation business.
Managing a research service such as the Mad Hedge Technology Letter, it is easy to see how this is happening. Financial services are being disrupted on a hundred fronts, and the cumulative effect may be that it will no long exist.
This explains why this is the first bull market in history where there has been no new hiring by Wall Street. What happens when we go into a bear market? Employment will drop by half and those expensive national branch networks will disappear.
Financial services are still rife with endless fees, poor service, and uncompetitive returns. Online brokers such as Robin Hood (click here) will execute stock and option transactions for free. Now that overnight deposits actually pay a return they make their money on margin loans. They have no branch network but are still SIPC insured.
Legacy brokers such as Fidelity and Charles Schwab (SCHW) used to charge $25 a share to execute and are still charging $7.00 for full-service clients. And it's not as if their research has been so great to justify these high prices either. In a world that is getting Amazoned by the day, these high prices can't stand.
Regular online banking service also pay interest and are about to eat the big banks' lunch. Many now pay 1.75% overnight interest rates and offer free debit and credit cards, and checking accounts. Of course, none of these are household names yet, but they will be.
To win the long-term investment game you have to identify the industries of the future and run from the industries of the past. The legacy financial industry is increasingly looking like a story from the past.
Are Big Banks Ready for the Future?
Sometime in the early 1970?s, a friend of mine said I should take a look at a stock named Berkshire Hathaway (BRKA) run by a young stud named Warren Buffett.
I thought, ?Why the hell should I invest in a company that makes sheets??
After all, the American textile industry was in the middle of a long trek toward extinction that began in the 1920?s, and was only briefly interrupted by the hyper prosperity of WWII. The industry?s travails were simply an outcome of ever rising US standards of living, which pushed wages, and therefore costs, up.
It turns out that Warren Buffett made a lot more than sheets. However, he is not a young stud anymore, just an old one, like me.
Since then, Warren?s annual letter to investors has been an absolute ?must read? for me when it is published every spring.
It has been edited for the past half century by my friend, Carol Loomis, who just retired after a 60-year career with Fortune magazine. (I never wrote for them because their freelance rates were lousy).
Witty, insightful, and downright funny, I view it as a cross between a Harvard Business School seminar and a Berkeley anti establishment demonstration. You will find me lifting from it my ?Quotes of the Day? for the daily newsletter over the next several issues. There are some real zingers.
And what a year it has been!
Berkshire?s gain in net worth was $18.3 billion, which increased the share value by 8.3%, and today, the market capitalization stands at an impressive $343.4 billion. (Sorry Warren, but I clocked 30% last year, eat your heart out).
The shares are not for small timers, as one now costs $214,801, and no, they don?t sell half shares. This compares to a 1965 per share market value of $23.80, and is why the media are always going gaga over Warren Buffett.
If you?re lazy and don?t want to do the math, that works out to a compound annualized return of an eye popping 21.6%. This is why guessing what Warren is going to do next has become a major cottage industry (Progressive Insurance anyone?).
Warren brought in these numbers despite the fact that its largest non-insurance subsidiary, the old Burlington Northern Santa Fe Railroad (BNSF) suffered an awful year.
Extensive upgrades under construction and terrible winter weather disrupted service, causing the railroad to lose market share to rival Union Pacific (UNP).
I was kind of pissed when Warren bought BNSF in 2009 for a blockbuster $44 billion, as it was long my favorite trading vehicles for the sector. Since then, its book value has doubled. Typical Warren.
Buffett plans to fix the railroad?s current problems with $6 billion in new capital investment this year, one of the largest single capital investments in American history. Warren isn?t doing anything small these days.
Buffett also got a hickey from his investment in UK supermarket chain Tesco, which ran up a $444 million loss for Berkshire in 2014. Warren admits he was too slow in getting out of the shares, a rare move for the Oracle of Omaha, who rarely sells anything (which avoids capital gains taxes).
Warren increased his investment in all of his ?Big Four? holdings, American Express (AXP), Coca-Cola (KO), IBM (IBM), and Wells Fargo (WFC).
In addition, Berkshire owns options on Bank of America (BAC) stock, which have a current exercise value of $12.5 billion (purchased the day after the Mad Hedge Fund Trader issued a Trade Alert on said stock for an instant 300% gain on the options).
The secret to understanding Buffett picks over the years is that cash flow is king.
This means that he has never participated in the many technology booms over the decades, or fads of any other description, for that matter.
He says this is because he will never buy a business he doesn?t intrinsically understand, and they didn?t offer computer programming as an elective in high school during the Great Depression.
No doubt this has lowered his potential returns, but with the benefit of much lower volatility.
That makes his position in (IBM) a bit of a mystery, the worst performing Dow stock of the past two years. I would much rather own Apple (AAPL) myself, which also boasts great cash flow, and even a dividend these days (with a 1.50% yield).
Warren will be the first to admit that even he makes mistakes, sometimes, disastrous ones. He cites his worst one ever as a perfect example, his purchase of Dexter Shoes for $433 million in 1993. This was right before China entered the shoe business as a major competitor.
Not only did the company quickly go under, he exponentially compounded the error through buying the firm with an exchange of Berkshire Hathaway stock, which is now worth a staggering $5.7 billion.
Ouch, and ouch again!
Warren has also been mostly missing in action on the international front, believing that the mother load of investment opportunities runs through the US, and that its best days lie ahead. I believe the same.
Still, he has dipped his toe in foreign waters from time to time, and I was sometimes quick to jump on his coattails. A favorite of mine was his purchase of 10% of Chinese electric car factory BYD (BYDDF) in 2009, where I have captured a few doubles over the years.
Buffett expounds at great length the attractions of the insurance industry, which today remains the core of his business. For payment of a premium up front, the buyers of insurance policies receive a mere promise to perform in the future, sometimes as much as a half century off.
In the meantime, Warren can invest the money any way he wants. The model has been a real printing press for Buffett since he took over his first insurer in 1951, GEICO.
Much of the letter promotes the upcoming shareholders annual meeting, known as the ?Woodstock of Capitalism?.
There, the conglomerate?s many products will be for sale, including, Justin Boots (I have a pair), the gecko from GEICO (which insures my Tesla S-1), and See?s Candies (a Christmas addiction, love the peanut brittle!).
There, visitors can try their hand at Ping-Pong against Ariel Hsing, a 2012 American Olympic Team member, after Bill Gates and Buffett wear her down first.
They can try their hand against a national bridge champion (don?t play for money). And then there is the newspaper-throwing contest (Buffett?s first gainful employment).
Some 40,000 descend on remote Omaha for the firm?s annual event. All flights to the city are booked well in advance, with fares up to triple normal rates.
Hotels sell out too, and many now charge three-day minimums (after Warren, what is there to do in Omaha for two more days other than to visit PayPal?s technical support?). Buffett recommends Airbnb as a low budget option (for the single shareholders?).
I was amazed to learn that Berkshire files a wrist breaking 24,100-page Federal tax return (and I thought mine was bad!). Add to this a mind numbing 3,400 separate state tax returns.
Overall, Berkshire holdings account for more than 3% of the total US gross domestic product, but a far lesser share of the government?s total tax revenues, thanks to careful planning.
Buffett ends his letter by advertising for new acquisitions and listing his criteria. They include:
(1) ?Large purchases (at least $75 million of pre-tax earnings unless the business will fit into one of our existing units),
(2) ?Demonstrated consistent earning power (future projections are of no interest to us, nor are ?turnaround? situations),
(3) ?Businesses earning good returns on equity while employing little or no debt,
(4) Managemen
t in place (we can?t supply it),
(5) Simple businesses (if there?s lots of technology, we won?t understand it),
(6) An offering price (we don?t want to waste our time or that of the seller by talking, even preliminarily, about a transaction when price is unknown).
Let me know if you have any offers.
To read the entire history of Warren Buffett?s prescient letters, please click here: http://www.berkshirehathaway.com/letters/letters.htm.
While driving back from Lake Tahoe last weekend, I received a call from a dear friend who was in a very foul mood. He had bailed on all his equity holdings at the end of last year, fully expecting a market crash in the New Year.
Despite market volatility doubling, multinationals getting crushed by the weak euro and the Federal Reserve now signaling its first interest rate rise in a decade, here we are with the major stock indexes sitting at all time highs.
Why the hell are stocks still going up?
I paused for a moment as a kid driving a souped up Honda weaved into my lane of Interstate 80, cutting me off. Then I gave him my response, which I summarize below:
1) There is nothing else to buy. Complain all you want, but US equities are now one of the world?s highest yielding securities, with a lofty 2% dividend. That compares to one third of European debt offering negative rates and US Treasuries at 1.90%.
2) Oil prices have yet to bottom and the windfall cost savings are only just being felt around the world.
3) While the weak euro is definitely eating into large multinational earnings, we are probably approaching the end of the move. The cure for a weak euro is a weak euro. The worst may be behind for US exporters.
4) What follows a collapse in European economic growth? A European recovery, powered by a weak currency. This is why China has been on fire, which exports more to Europe than anywhere else.
5) What follows a Japanese economic collapse? A recovery there too, as hyper accelerating QE feeds into the main economy. Japanese stocks are now among the worlds cheapest. This is why the Nikkei Average hit a new 15-year high over the weekend, giving me yet another winning Trade Alert.
6) While the next move in interest rates will certainly be up, it is not going to move the needle on corporate P&L?s for a long time. We might see a ?% hike and then done, and that probably won?t happen until 2016. In a deflationary world, there is no room for more. At least, that?s what Janet tells me.
This will make absolutely no difference to the large number of corporates, like Apple (AAPL), that don?t borrow at all.
7) Technology everywhere is accelerating at an immeasurable pace, causing profits to do likewise. You see this in biotech, where blockbuster new drugs are being announced almost weekly.
See the new Alzheimer?s cure announced last week? It involves extracting the cells from the brains of alert 95 year olds, cloning them and then injecting them into early stage Alzheimer?s patients. The success rate has been 70%. That one alone could be worth $5 billion.
8) US companies are still massive buyers of their own stock, over $170 billion worth in 2014. This has created a free put option for investors for the most aggressive companies, like Apple (AAPL), IBM (IBM), Exxon (XOM), Wells Fargo (WFC), and Intel (INTC), the top five repurchasers. They have nothing else to buy either.
They are jacking up dividend payouts at a frenetic pace as well and are expected to return more than $430 billion in payouts this year (see chart below).
9) Oil will bottom in the coming quarter, if it hasn?t done so already. This will make the entire energy sector the ?BUY? of the century, dragging the indexes up as well. Have you noticed that Conoco Phillips (COP), Warren Buffets favorite oil company, now sports a stunning 4.70% dividend?
10) Ditto for the banks, which were dragged down by falling interest for most of 2015. Reverse that trade this year, and you have another major impetus to drive stock indexes higher.
My friend was somewhat set back, dazzled, and non-plussed by my long-term overt bullishness. He asked me if I could think on anything that might trigger a new bear market, or at least a major correction.
I told him to forget anything international. There is no foreign development that could damage the US economy in any meaningful way. No one cares.
On he other hand, I could think of a lot of possible scenarios that could be hugely beneficial for US stocks, like a peace deal with Iran, which would chop oil prices by another half.
The traditional causes of recessions, oil price and interest rate spikes, are nowhere on the horizon. In fact, the prices for these two commodities, energy and money, are headed lower and not higher, another deflationary symptom.
Then something occurred to me. Share prices have been going up for too long and need some kind of rest, weeks or possibly months. At a 17 multiple American stocks are not the bargain they were 6 years ago when they sold for 10X earnings. Those were the only thing I could think of.
But then those are the arguments for shifting money out of the US and into Europe, Japan, and China, which is what the entire world seems to be doing right now.
I have joined them as well, which is why my Trade Alert followers are long the Wisdom Tree Japan Hedged Equity ETF (DXJ) (click here for ?The Bull Case for Japanese Stocks?).
With that, I told my friend I had to hang up, as another kid driving a souped up Shelby Cobra GT 500, obviously stolen, was weaving back an forth in front of me requiring my attention.
Whatever happened to driver?s ed?
I have discovered a correlation in the market that you can use for the rest of this year, for all of 2014, and probably for the next 20 years. Whenever the Treasury bond market (TLT) takes a dive, bank shares rocket. This is a particularly happy discovery, as my model-trading portfolio is long bank shares and short the Treasury bond market.
By buying bank shares here you are playing the second derivative of the short bond trade. Banks are about to go from being less profitable to more profitable during a falling bond, rising interest rate environment. Every trader on the street knows this, hence the sudden renaissance of the financials.
Take a look at the charts below prepared by my friends at Stockcharts.com. They show that after tracking nicely with the S&P 500 for most of the year, Financials suddenly started to drastically lag the market in October. That was on the heels of the bond market rally triggered by the Federal Reserve?s failure to taper in September.
Fast forward to two weeks ago, when I correctly called the top of the bond market and started slamming out the Trade Alerts to buy puts as fast as I could write them. Since November 1, financials have become the top performing sector of the market, and it is dragging the (SPY) upward kicking and screaming all the way.
I?ll tell you what is happening here. Traders are dumping story driven momentum stocks like Tesla (TSLA), and piling into the biggest lagging sectors for fresh meat. The dive in Treasuries gave them all the excuse they needed. That?s why the Financial Select Sector SPDR ETF (XLF) has bolted out of nowhere to a new five year high. The same is also true for Wells Fargo (WFC) and our favored Citigroup (C).
The financials rally could continue until the sector becomes overbought relative to the rest of the market, which could be well into next year. And yes, before you ask, that includes Morgan Stanley (MS) and Goldman Sachs (GS), which are really more structured like banks now in the wake of the Dodd Frank bill.
So I am going to take profits here on my existing long position in the Citigroup (C) December $45-$47 bull call spread. With the shares now trading just short of $52, we are now too far in-the-money to get much further benefit from a continued appreciation. Better to go into cash now, so I can reload on the next dip, which could happen next week.
We grabbed 80% of the potential profit holding the position a mere seven trading days. This is my 15th consecutive closing Trade Alert, and the 20th including my remaining open profitable positions. I have only six more to go until a break my previous record of 25. It doesn?t get any better than this.
Time to enter more bids on eBay for Christmas presents. That black Chanel Classic handbag with gold trim is looking pretty good. Do you think a new Brioni suit will fit into Dad?s stocking over the fireplace? Santa?.hint, hint!
