Reflation vs. Stay At Home, a Large Rotation

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The Once Certain has become FAR Less Certain

The Cobra Effect is all about the certainty of unintended consequences. That means the ten-year valuation of future cash flows coming out of Big Tech companies is now worth far less as the certainty of deflation is FAR less certain. Let’s explore.

Month over Month

Our “Re-Flation – Re-Open” Basket

Mosaic $MOS +50%
Alcoa $AA: +37%
Metals ETF $XME: +19%
Berkshire $BRK: +17%
General Motors $GM: +15%

The “Stay – At – Home” Basket

Microsoft $MSFT: -3%
Cloud Software ETF: -5%
Netflix $NFLX: -11%

Bloomberg data

The Purchasing Power Problem, 2020 Style

Let’s say you’re a newly minted billionaire in Saudi Arabia. You just spent the last 20 years taking care of the family, especially Dad. Unfortunately, he passes on leaves you $1B in US 10 year Treasuries. After running around San Tropez for a couple of months, you sit down with your financial advisors and they give you the blood-curdling news. Real bond yields are -1.10%, so you’re burning through $11m year in negative carry. That’s right, inflation expectations > income. After lightening up on all the extra help around the Bayt al-Razzaz, you turn on the 108-inch flat screen and the first thing you see is a large collection of junkies in Washington running up a $5T bill, a 24-7 pork-athon with no end in sight. Next, your advisors point to gold’s 36% year over year return, but you become distracted by the insanity going on in silver, up nearly 90% over the last 3 months. Frustrated that you missed those boats – you’re instructed to turn around, “focus on agricultural commodity plays Sir.” You turn on CNBC and Mosaic MOS is on the screen – up 50% month over month, “‘uwh la!” Then comes the worst news of all. Someone whispers, “the US dollar is off 7% over the last three months.” So, your $1B has lost another $60m of global purchasing power. “Sell the yikht!”

Asset Flows out of Tech
Cloud and SaaS (software as a service) equities widely underperformed value equities such as Berkshire Hathaway this week. In our view, investors continue to realize they are not positioned correctly being overweight technology with rising inflation expectations. From the Tea “Austerity” Party in 2010 to an MMT fueled, junkie-juiced fiscal spending overdose in 2020? We’ve come a long way baby. Hard to process a $4 to $5 trillion Federal deficit under a Republican Administration without concluding that either inflation is around the corner or the dollar is going to substantially weaken or most likely both. The current inflation picture (August 2020) is meaningless. Markets are starting to price in the 5-10 year forward path. You DO NOT need current inflation today to change the models and valuations, you simply need to dramatically alter the certainty of deflation.

What is “Terminal” Value? Think Stay at Home vs. Re-Open
The GM vs. Netflix debate is the ULTIMATE “Stay at Home” vs. “Re-Open” conversation. Think of Netflix, no free cash flow, or real earnings. The company simply takes all incoming cash and builds a Capex funded content war chest. It’s a cash-burning inferno. Terminal Value (TV) is the present value of all future cash flows, with the assumption of perpetual stable growth in some cases. Terminal value is used in various financial tools such as the Gordon Growth Model, the discounted cash flow, and residual earnings computation. However, it is mostly used in discounted cash flow analyses. Any hint of inflation can DRAMATICALLY alter the company’s valuation built on a high terminal value element. If all the company’s value is found in the projected, long-term (5-10 year) future cash flows, and the probability of inflation rises 3-5 years out, those FUTURE cash flows are WORTH far LESS! To us, this is what’s shaking tech at its core, large tremors (capital outflows into stagflation resilient sectors) are forming. Some LARGE, clever investors are leaving the party early – while the “high-kites” want to rock-on, hang around for the sunrise.

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