End of Week Update (Oct 2nd wk '22)
Dear Birkoa LPs:
This past week, the inflation numbers came out a little hotter than expected, and therefore like the reaction to stronger than expected jobs numbers last Friday, the markets reacted negatively expecting that the Fed will stop its hiking cycle later rather than sooner. That has hurt our portfolio as well, and I think there might be a little more to go until the end of this year before things stabilize. The current short-term lending rate set by the Fed is 3-3.25%, and it is widely expected to get to 4.25-4.5% by the end of the year. The terminal rate is expected to be 4.6%, which means early next year the Fed will stop hiking. If inflation numbers cool down in the coming months then they might settle for a lower terminal rate. These are all short-term market worries but they have hurt all asset categories.
As of this moment, we’re down a total of 41.5% (including the accumulated margin loans), giving back the gains from last week and then some. While very annoying, once again, I’m not worried about the portfolio results long-term since our time horizon is ~3 years (commodities ~1 year). The point of the strategy is to position ourselves for the next ~3 years in anticipation of changes to the current environment, so that by the time the rest of the world catches up, we’ll have liquidated with high returns on each position and then move on to the next set of positions for the following 3 years (it takes roughly 3 years to go from one stage of the long term debt cycle to the next). The problem is, sometimes during the course of getting there, there are short-term market events events, including the one ongoing right now which is a once in a 20 year event in terms of cross-asset correlation when Dollar becomes artificially strong when the world goes into a synchronized recession. Birkoa strategy is not short-term, so these types of movements are unfortunately impossible to capture for a longer-range strategy like ours. So long as we can maintain our positions, for the long-run we will be fine, and I can virtually be certain we’ll have made more returns long term than if we traded for the short-term fluctuations (including the average annualized rate of return which is my ultimate metric that I care most about - if we hit our price our price targets within more 2.5 years we’ll have a rate of 45%). Plus you as LPs will also be paying more taxes every year for any unrealized gains whereas with my strategy largely your annual taxes and capital gains on your any returns will be zero.
At the very least, we are seeing the macro environment move according to what the strategy dictates - supply-chain breakdowns, bipolar world, global recession, Chinese monetary authorities pledging continued liquidity and support, banning on Russian metals, energy crisis in Europe. Events are a forward indicator and price action typically follows later, which I’m confident will be the case with our positions as well. Recession is most likely to have begun in the U.S., which means that the bond markets will cease to invert (inversion of the yield curve is a forward indicator of a recession, so once the recession starts the inversion ceases and the shorter-term bonds yield much lower than the longer-dated bonds; in the U.S. the bond markets have been inverted for about 4-5 months now) and the 2-year rate, which is extremely high right now (4.5%), might lower its yield by early next year. The markets will like that, and then there’ll be a massive rally of all the beaten down risk assets since so many people are moving to cash (there is a major cash buildup this year by major institutional investors and a pile of money is just waiting to go back into risk assets like stocks and crypto - higher cash buildup is also why longer-term treasuries are yielding lower than the short-term rate and inflation rate). This is why, it’s essential to be patient right now and not get too worked out re: the paper losses since the recovery should be quick once the uncertainty about rates hikes recedes and/or inflation cools (unemployment is at 3.6% which is as tight as it can get, and the Fed's goal is to get it up to 4.5%, so once unemployment rises core inflation will peak out too - there are glimmers of that happening in the jobs market but not quite there yet).
Here in this newsletter, I wanted to briefly go over some statistics per asset category of our portfolio, how much each is contributing to the total losses thus far, and I’ll try to explore some reasons why including the reason to not change anything now that we are midstream. I’ll keep it brief and to the point. The accentuated nature of losses is due to the usage of margin. If I hadn’t used margins, the losses would’ve been contained, plus any upcoming prospective losses as the market undergoes further liquidity events would’ve been minimal as well. So why on earth did I use margin?
The answer is because this is the buying opportunity of a lifetime, plain and simple. Taking uncomfortable positions and making most use of a bear market, like the one we’re in now, is the single biggest determinant between building large wealth and not, and although I would’ve liked it had I not been thrown to the deep end of the pool immediately after the fund launched, I believe it’s moments like these that’ll make the portfolio swell up larger once these positions hit their price targets in 2.5-3 years. Thus, although very uncomfortable, I couldn’t be gun shy and I needed to identify this once in a generation moment to buy. Under most normal circumstances, margin usage will have been much lower than this current time because the opportunities just wouldn’t have been there. Thus far, it is yet to work out but I know it will work out eventually since the macro forces are coming along the right way.
1. Commodities : -2.1%
Commodities are a bit choppy although they are largely but slowly moving along in the direction expected. Oil markets gave back 7% this week following the mammoth 22% rally the week prior, and although demand concerns consistently pull the price of oil down, over time oil will hit $125 as this winter plays itself out. Furthermore, Putin has been actively threatening to dismantle the world’s energy supply and given this proposed oil price cap by the G7, the risk of asymmetric upside to oil prices outside of the core fundamentals (north of $200/barrel) is rising by the day.
Palladium pulled back this week after going positive last week on our position. Possibly on the Dollar surge. Obviously, Chinese demand picture hasn’t yet improved given the strict adherence to Covid zero.
2. Crypto : - -12.8%
Liquidity-led anemic behavior over the past month. My guess is we’ll simply have to wait a few more months to see surge in crypto prices. 2 months ago after Ethereum hit $2k and Bitcoin $25K, it has remained stagnant around the $1500 ($22k) range first and then now at the $1300 ($20K) range. There’s been little activity on this front, except for glitters here and there and it’s quite obvious traders are awaiting the Fed pivot (or at least Fed curbing its rate hikes) prior to going all in.
The crypto ETF is now -ve (after being up 45% less than 2 months ago). Needless to say, it’s solely a liquidity issue since the stocks that form the ETF are all reacting to the Fed’s larger-than-anticipated rate hikes, on the back of hotter-than-expected inflation and a more resilient U.S. economy. This will change possibly by the end of the year when inflation finally starts cooling a little bit. Then, names like Coinbase will skyrocket, and we’ll quickly recover all of crypto losses even though the tokens themselves may take longer to break even. Over the longer-term however, I am comfortable about both the tokens and the ETF. The correlation with equities for the crypto tokens at least also is beginning to show signs of breaking, as evidenced in this Bloomberg article from last week.
3. Chinese Equities : -23.3%
Chinese ADRs: -14%
Hong Kong stocks: - 9.2%
Very irritating. A lot of factors, ranging from continued and nonsensical COVID-zero to Biden administration’s semiconductor export ban to China, are hitting this sector continually, especially the last week. All of our Chinese holdings both ADRs and Hong Kong are in e-commerce and media/technology stocks, so quite literally a chip ban to China would have zero impact on these platforms that’re cloud-based and software-centric. My read on semiconductor battle between the U.S. and China was correct, which is why I could foresee something like the CHIPS Act in the U.S., hence my bullishness on the U.S. semis sector. However, this export ban and the resulting selloff in Chinese tech stocks both in the U.S. and Hong Kong are an overreaction.
The CCP Congress meeting is this weekend. It is widely believed that we’re towards the last days of COVID zero - an idiotic, ineffective and unscalable policy that’s wrecked havoc across vast swaths of the Chinese economy. Needless to say, that’s going to change someday. I’m hopeful that day will arrive quickly, but until that happens, it’s like having a dampener on our Chinese positions, due to which we’re incurring such steep paper losses.
The chart below shows the Hang Seng Index, which is at its lowest in 11 years and recently crossed its 2020 lows. We brought its stocks in June, so as far as local peaks go, it was bad timing. However, once the Chinese economy is allowed to reopen again and the Chinese monetary stimuli is allowed to take effect, that’s when we’ll see our positions finally take off. Until then, we will simply have to hold tight.
Until now at least in the Chinese equities markets it’s been like catching a falling knife, and while you do it, you might get hurt a bit, but the knife will fall at some point. Therefore, I remain confident of the bottom being near, as evidenced by this opinion by a Chinese hedge fund manager last week.
4. European Equities : -1%
Recently brought a position in a holding company that had one of the most widely awaited IPOs in European history (Porsche) with both green energy as well as economic implications as a recession-hedge. The stock went down about 7% on the day of the IPO, so it was a decent entry point. Thus far, it hasn’t yielded anything but I’ve seen a lot of analyst ratings on the stock suggesting a Buy rating with a +40-50% price target range. I’m excited about this position for the next 2-3 years.
5. Tech Stocks (Semis, Snowflake) : -1.1%
Semis: -0.6%
Already illuminated several times earlier my bullishness on U.S. semis, which is a macro play. In today’s world, semiconductor names, since chips are in every consumer item, typically are the first casualties of an impending recession (similar to cars and hotels earlier). When I initially brought them, some names like Intel, Nvidia, AMD were already off 40-70% YTD. And last Friday, after Biden made the announcement of stopping exporting of chips to China, there was a steep selloff, at which time I bought 10% more. Semiconductors will benefit greatly from U.S. federal subsidies, and will soon behave like a commodity (greater than oil acc. to Secretary of Commerce Gina Raimondo in a recent talk). I’m incredibly bullish on this position for the next few years as we eventually come out of the recession, because I think we got something at an incredible discount. Sure, there could be further selling, but 40-70% dip is good enough for me.
Snowflake: -0.5%
I bought Snowflake because I think tech names within the cloud services sector, which have almost recession-proof business models as they’re in the enterprise services sector, were selling steeply in line with the NASDAQ big tech names. I generally like business models like these and the valuations were cheap enough, so I bought a little bit of it. It’s supposed to be yet another longer-term position so we’ll let it play out.
Thus, as you can see, while mostly correct on the macro side, the price movements are being caused by factors that are shorter-term and idiosyncratic. It is essential to remember the virtues of sticking to your strategy and not be too affected by what the market is doing, and let the market come to you. In the meantime, I continually kept building my positions in the same assets that I’ve been holding all along to take advantage of irrationalities whenever possible, which for the time being has accentuated the paper losses. I am careful and very attentive to the technicalities of margin maintenance and outside of that (as explained in my newsletters from the previous week) there is simply nothing that threatens our portfolio for the time horizon it is designed for. While it would’ve been nice to have the skills to time the bottom of a market, I believe we caught most things closer to the bottom than top for our time horizon, so our long-term returns expectations continue to stay strong.
As always, available for an in-person Zoom call if you have any questions any time to discuss these.
Sincerely,
Pranjit Kalita
Chief Investment Officer