The bull in the mirror

A bear by any other name still predicts weaker GDP growth and stubbornly high inflation, prompting our market-neutral stance.

· 6 min read
The bull in the mirror
🎵 I'm starting with the bear in the mirror... I'm asking him to change his ways... a hee hee 🎵

There are plenty of famous bears but almost none who are famously successful. You can count them on one hand, Michael Burry and John Paulson with the subprime crisis, George Soros with the pound sterling, Jim Chanos with Enron, David Einhorn with Lehman.

The story of the stock market, and more generally western civilization, is a triumph of the optimists. At almost any point in the last 50 years, you could have simply levered up on S&P index futures and forgotten about them for a decade or more. When it comes to the US equity market, historically it has paid to be bullish.

The consensus street view is one of moderate GDP growth, cooling inflation, and looser central bank policy. Bullish, in a word, and it is a view has been looking increasingly correct, but our view has differed. We have consistently estimated GDP growth lower and inflation higher than consensus.

Accordingly, we established a market-neutral to slightly net short positioning in April since GDP growth showed signs of slowing. To that end we were able to avoid a -7%/-5% drawdown in the NDX/SPX in April and May.

In fairness, our bear instincts told us it was salmon season. First, our trusty leading indicators of GDP momentum burned down to coals, the rally was exhausted, it said. If we accept the thesis that the market prices the forward, and we do, then our bear senses were confirmed by a glance in the rear view mirror. What kind of bull market has a simultaneous rally in Gold and Utility stocks? The topping kind.

But it would not last, for not only has the market recovered, roared back to all time highs, and the market is always right, so they say. There was renewed strength in technology, semis, and cybersecurity stocks in May and June. Even the GameStop idiocy raged again at full force for a minute.

Image

Did we catch the huge move back up out of the trough? No, no we did not. We were caught with our paws in the honey jar, leaning short into a rally. We at least had the reactive sense the prune our short exposure into neutrality.

We stare at our reflection for a time. Are those... horns? We want to be bullish, of course we do. How can you possibly have a recession when Congress is spending the country to oblivion at a -5% to -7% deficit? You absolutely can't, you stupid bear.

You even wrote yourself weeks earlier the Fed has its foot on the breaks while Congress has its foot on the gas. We're running a fiscal stimulus, and the infrastructure spending hasn't even hit the economy yet, it's still tied up with the apparatchiks.

Image
G

GDPNow ripped higher and the PMIs came in hot. A befuddled Jerome Powell gets on TV, shrugs and says he's not sure what everyone is complaining about, the data looks good. Wait, are those... hooves?

"Calm down, you're tripping balls, Pooh", says Piglet. We wait for the chemistry in our skull.

The question is, do we really believe this June data, even with sagging consumer confidence? No, we do not. We wait, wait, and wait some more to see how the data shapes up in July.

Finally, we are in the beginning of July. Consumer confidence, business activity, all slide. The scenario is still unfolding as we predicted. Inflation remains high in part due to fiscal stimulus, we think interest rates will need to remain higher. We observe continued layoffs across tech, so we disbelieve official jobs data.

We were almost hibernating too soon before winter. We stare at our reflection until the horns and hooves begin to fade, until at last we are a bear again.

Our positioning: Reduced leverage, Market neutral. The plan is to maintain slightly net short exposure via negative surprise candidates.

Technology Sector Forecast and Dynamics

As we head into earnings season, here are some of the dynamics we are tracking across themes.

Hyperscale Cloud

  • Outlook: Bullish
  • Dynamics: Increased data growth and AI demand drive our positive outlook. While budget cuts and reduced headcount are trimming cloud budgets (impacting SaaS seats and overall cloud demand), this is offset by significant investments in AI. Hyperscale cloud providers are making massive capex investments in infrastructure. This benefits semiconductor manufacturers (essential for AI and data processing), electronics manufacturers (producing computing and networking equipment), data center equipment manufacturers (essential for infrastructure upgrades), and construction firms (building new data centers). We anticipate significant growth in these areas.
  • Our Positioning: Long positions in hyperscale cloud providers and their supply chain partners. Caveat: All hyperscalers are not the same and we do not necessarily like the pricing here.

SaaS (Software as a Service)

  • Outlook: Bearish
  • Dynamics: The current environment of budget constraints and layoffs in the tech sector is reducing the demand for SaaS seats. Furthermore, the trend towards flat-rate software pricing, where customers buy and own software, is disrupting traditional SaaS revenue models. AI advances are not expected to offset these losses in the near term. Hence, we see challenges ahead for SaaS companies heavily dependent on subscription revenues.
  • Our Positioning: Short positions in companies heavily reliant on SaaS revenue streams.

Cybersecurity

  • Outlook: Bullish
  • Dynamics: The increasing threat landscape and rapid AI advancements in cybersecurity drive our bullish stance. We favor newer players with cloud services over legacy firms selling hardware, which face retooling challenges and IT budget cuts. Newer players are leveraging AI more effectively, enhancing their security solutions and market positions.
  • Our Positioning: Long positions in innovative cybersecurity companies with strong AI integration, selectively shorting legacy players.

IT Infrastructure

  • Outlook: Bearish, but with exceptions
  • Dynamics: The general outlook for on-premise IT spend is bearish due to budget constraints. However, companies like Dell and Supermicro are seeing growth in AI cluster sales to smaller cloud providers. Emerging GPU clouds will initially benefit from venture capital but may struggle against hyperscale platforms in the long run. We see potential in companies catering to AI infrastructure needs.
  • Our Positioning: Long positions in companies selling AI clusters to smaller cloud providers while remaining cautious on broader on-premise IT spend.

Data Centers

  • Outlook: Bullish
  • Dynamics: The demand for data centers is increasing due to AI and data growth. Large players are securing critical equipment supply contracts, limiting access for smaller buyers and creating supply constraints. This dynamic supports growth in the supply chain for data centers, including electronics manufacturers.
  • Our Positioning: Long positions in the supply chain for data centers, such as electronics manufacturers, rather than in data center REITs due to real estate sector risks.

Semiconductors

  • Outlook: Bullish
  • Dynamics: Nvidia and related semiconductor companies are expected to execute their backlog and meet or slightly exceed expectations, although supply constraints remain. In the Nvidia case, significant upside potential exists if enterprise software sales accelerate, but not so likely.
  • Our Positioning: Long positions in leading semiconductor companies, closely monitoring supply chain dynamics.

Blockchain and Cryptocurrency

  • Outlook: Bearish
  • Dynamics: The lack of meaningful use cases beyond speculation leads us to a bearish outlook on blockchain and cryptocurrency. Many miners and infrastructure players are pivoting to AI, highlighting the industry's challenges. We see limited growth opportunities in this sector.
  • Our Positioning: No positioning due to cryptocurrency volatility and inferior risk-reward.

Software Development Tools

  • Outlook: Bearish
  • Dynamics: The declining software job market will increase competition among tools vendors, leading to potential oversupply. This increased competition is likely to pressure margins and growth for these vendors.
  • Our Positioning: Short positions in over-leveraged tools vendors.

IoT (Internet of Things)

  • Outlook: Bullish
  • Dynamics: The emergence of AI provides a compelling use case for the vast amounts of data collected by IoT devices, driving renewed investment in IoT solutions. Companies integrating AI with IoT stand to benefit significantly from this trend.
  • Our Positioning: Long positions in emerging IoT solution providers and companies effectively integrating AI with IoT.

Disclosure: Hey! As of the date of this article I currently own or actively trade some of the stocks mentioned in this article. Please be sure to read these important disclosures.