Novum Alpha – Daily Analysis 14 October 2020 (8-Minute Read)

Here’s wishing you a wonderful Wednesday! And what a difference a day makes!  

In brief (TL:DR)

  • U.S. stocks pulled back slightly yesterday with the S&P 500 (-0.63%), tech-heavy Nasdaq Composite (-0.10%) and blue-chip Dow Jones Industrial Average (-0.55%) all down, as better-than-expected earnings were discounted for the political gridlock in fresh stimulus. 
  • Asian stocks were mostly lower as the prospect of fresh stimulus out of the U.S. dims. 
  • U.S. 10-year Treasuries were unchanged and yield was steady at 0.732%, or the higher end of the trading band. 
  • The dollar was steady against major trading partners, as the pressure of fresh fiscal stimulus waned. 
  • Oil stayed flat, with November contracts for WTI Crude Oil (Nymex) (-0.02%) at US$40.09 from US$40.20 as the worse of Hurricane Delta looks unlikely to cause any major supply disruptions. 
  • Gold slid with December contracts for Gold (Comex) (-0.08%) at US$1,893.10 from US$1,894.60 in the previous session as pressure on the dollar eased. 
  • Bitcoin (-0.23%) pulled back slightly at US$11,474 (GMT 0200) on the back of dollar strength and with outflows slowing from exchanges (outflows suggest that traders are taking Bitcoin off the blocks in anticipation that price will rise). 

In today’s issue…

  1. A Democrat Victory at the U.S. Elections Could Cause Some Immediate Chaos
  2. The Chinese Yuan Is Not The Safe Haven You Were Looking For
  3. BitMEX Debacle Paves The Way for DeFi 

Market Overview

In what can only be described of as a pandemic set of circumstances, stocks pulled back yesterday despite U.S. banks reporting better-than-expected profits. 
JPMorgan Chase (-1.62%) reported that third quarter profits were up by 4% from a year ago (go figure) while Citigroup (-4.80%) delivered results that beat analyst estimates. 
Taken together, the two banking giants’ third quarter results seem to suggest that U.S. businesses and consumers held up surprisingly well in the months since the pandemic plunged the U.S. into recession.
So why the pullback in stocks? 
Well part of the reason of course is that much of the resilience demonstrated by businesses and consumers was a direct result of unprecedented levels of fiscal and monetary stimulus. 
There are increasing signs that politics has overtaken the pandemic and that no further rounds of stimulus are likely to be forthcoming in the run-up to elections in the U.S. and that’s the bigger problem.
Because stocks are representative of what is to come, as opposed to what has happened already, investors were understandably jittery and discounted the third quarter’s results on concerns of the fourth quarter’s lack of stimulus. 
Asian markets were unimpressed and were uniformly down across the board, with Tokyo’s Nikkei 225 (-0.15%), Seoul’s KOSPI (-0.61%), Sydney’s ASX 200 (-0.12%) and Hong Kong’s Hang Seng Index (-0.09%) all in the red in the morning trading session. 

1. Snowflake is Riding on Cloud 9 – Could this be Dotcom 2.0?

  • The stocks of cloud companies have soared despite the pandemic as investors have bet on working from home becoming a lasting shift in work practices 
  • High valuations and a lack of profitability in many cloud computing companies has not quelled investor appetite for their shares 
It takes some guts to launch an IPO in the midst of a global pandemic and what the World Bank has described as the “worst economic conditions since the Great Depression.”
Or it could just be that your company happens to be in one of the hottest sectors that appears to be recession proof and that if nothing else, the fact that everyone is working from home should see your business become even more successful.
And it’s against this backdrop that cloud computing company Snowflake (+2.31%) had one of Wall Street’s most winning IPOs.
Snowflake’s blockbuster US$3.4 billion IPO will surely one day become a Harvard Business case study of how some companies can thrive amidst adversity.
The cloud data company more than doubled its offering price at its debut last month, on the same day that JFrog (-4.05%), another cloud computing company, raised over US$500 million from public markets.
And these cloud companies aren’t the only ones on Cloud 9 – a global ETF of cloud computing companies has risen by a over 11 times faster than the broader stock market this year.
The narrative fueling these cloud computing companies’ meteoric rise is compelling, regardless of profits (there are none) – that a global pandemic has increased the importance of cloud companies in a work-from-home world.
And judging by IBM’s (-1.66%) announcement last week that it would be hiving off all it’s non-cloud businesses by 2021, there’s more than a few who are betting that the cloud is the way forward.
There are also several factors driving the adoption of cloud computing – high speed internet connectivity and a move away from on-premise data centers (something that IBM still specializes in for now).
But there are some who are wondering if the hype may have gotten ahead of reality.
With the software and services industry group of the S&P 500 trading at a whopping 38 times reported earnings (the same valuation as in late 1998 before the dotcom bubble burst) some more senior investors are wondering if history is repeating itself.
Cloud computing bulls argue that there is method to the madness – the world was already becoming more digitized well before the pandemic, which only sought to accelerate preexisting trends towards work-from-home.
Cloud service providers also benefit from the “stickiness” of clients, who may be loathe to shift providers once their internal processes have already been structured around a service provider.
And cloud computing companies are demonstrating real growth, both in terms of revenue and customer acquisition, as opposed to the dotcom bubble where just adding a “.com” to the back of your company’s name would have boosted valuation.
So while there may be some froth – perhaps more than just a little bit, for now at least cloud computing companies are seeing their stocks soar – it’ll be hard to tell when those clouds will turn to rain, if ever. 

2. Think Your Money Would be Safer in Gold? Think Again

  • Gold’s ability to hedge against stock volatility has not been proved this year 
  • As a replacement for U.S. Treasuries and portfolio diversification, gold has taken on the characteristics of a risk asset this year, as speculators use leverage to bet on the price of gold
The logic is alluring in its elegance and simplicity – used as a store of value since ancient Mesopotamia, gold is admired and prized for its aesthetic beauty and scarcity.
But the world has fallen out of love with gold ever since the abandonment of Bretton Woods and the United States moved away from having the dollar backed by its equivalent in gold – or the gold standard.
Yet concerns over runaway inflation in the years that followed, appear now, with the benefit of hindsight, to have been somewhat exaggerated. 
No asset evokes as strong emotions in a portfolio as perhaps gold (Bitcoin possibly, but the jury is still deliberating on that one) – probably because it’s the most easily identified asset class and one which most investors find identifiable.
But gold is hardly a replacement for U.S. Treasuries in a typical 60% stock and 40% bond portfolio.
The whole point of a hedge is that it should move in a direction opposite to where the rest of your portfolio is headed.
Yet on several occasions this year alone, gold bore an uncanny correlation with stocks, moving almost in lockstep with equities.
And while that doesn’t affect gold’s allure as an asset class, it does sort of diminish its value as a diversifier within a portfolio.
A major part of the problem with gold is that it likes inflation, but right now at least, so do stocks.
And the outlook for inflation is tied inextricably with the strength of the economy – a strong economy stokes greater inflation and that increases gold’s allure.
With the U.S. Federal Reserve pledging to keep interest rates low for the foreseeable future, higher inflation would mean lower real yields, which helps gold, but higher inflation also suggests that the economy is doing well, which helps stocks.
Ceteris paribus, gold would then move alongside stocks, diminishing its value as a portfolio diversifier.
And then there’s the speculative element to gold as well.
Because so much gold is held by speculators, and often bought using debt, the precious metal suffers when markets seize up and gold gets dumped.
Which is why when the finance industry is in trouble, gold makes a particularly bad hedge, at a time when many would expect it to shine.
So when, if ever, is gold a good safety net?
There isn’t a straightforward answer to that question because if there was, every portfolio would be strongly advised to hold on to some gold.
But when inflation is driven by supply side issues such as commodity and labor costs, while economic growth is slow – that might be a good time to hold on to some gold.
Otherwise stagflation could also see goldbugs celebrating – but that’s not the case now.
Inflation is being driven by underlying demand and the Fed is stoking it – unless that changes anytime soon, expect gold and stocks to move in tandem – which is perfectly fine, provided investors recognize that they’re buying both sides of the same coin (a gold coin). 

3. Could Bitcoin Hold the Secret Key to Portfolio Diversification? 

  • Bitcoin’s lack of correlation with any specific asset class raises its potential as a portfolio diversifier 
  • 60 / 40 stock and bond portfolio split provides limited diversification as bond prices have not moved opposite to stocks and negative real yields means that the bond portion of portfolios are creating substantial drag on overall portfolio returns
  • More institutional investors and high profile listed companies are moving into Bitcoin as part of their treasury management strategy  
Because bonds are providing negative real yields and because the Fed has pledged to keep interest rates low for the foreseeable future, typical 60/40 stock and bond investment portfolios are no longer as effective as they used to be in providing adequate protection for investors.
The rationale between a 60/40 split has been the long-held assumption that when stocks fall, rising bond prices ought to protect a typical portfolio.
But unprecedented amounts of fiscal and monetary stimulus and low interest rates in the decade after the 2008 financial crisis, have upended traditionally held portfolio management strategies.
And because so much liquidity is chasing so little yield, this past period has seen both stocks and bonds rise in tandem, while we’ve also witnessed them decline together on several occasions this past year.
Which means that a traditional 60/40 stock and bond portfolio split not only provides limited diversification, it could also be heart attack-inducing, as a portfolio fluctuates synchronously with the broader market.
Some suggest that the solution is to take on more risk, which could either be through doubling down on stocks, or moving from safe U.S. Treasuries, to riskier corporate and emerging market debt.
And then there are some who suggest Bitcoin instead.
To be sure, investors who are seriously considering a portion of their portfolio in Bitcoin would be in reasonably good company – just this past month, Microstrategy (-0.23%) and Square (+2.86%), which are listed on Nasdaq and the New York Stock Exchange respectively, both announced substantial allocations of their treasuries into Bitcoin.
And earlier this year, billionaire hedge fund investor Paul Tudor Jones revealed that he had up to 3% of assets in Bitcoin.
There may be method to the madness.
As anyone in the cryptocurrency industry will attest, volatility is a way of life – it’s become like white noise.
Yet this year has been one of Bitcoin’s most stable (in comparison to years past).
Earlier this month, Bitcoin’s 6-month volatility reached an almost 2-year low, this despite no shortage of bad news, including a substantial cryptocurrency exchange hack and the indictment of founders of BitMEX, one of the world’s top cryptocurrency derivatives exchanges.
And while Bitcoin has long been derided for providing no yield (thanks Warren Buffett), those in the cryptosphere responded with a “hodl my beer,” as decentralized finance or DeFi now makes it possible for Bitcoin holders to loan out their Bitcoin at substantially higher rates than for traditional assets.
As the best performing asset on the entire planet over the past decade, Bitcoin has also demonstrated various levels of inconsistent correlation with other assets including indices, gold and other safe havens, which bodes well for its diversification qualities.
Because Bitcoin is correlated with everything some of the times, it’s technically uncorrelated with anything all of the time, which bodes well for its ability to provide portfolio diversity, especially in uncertain times.
Just be careful with managing your keys.

Novum Digital Asset Alpha is a digital asset quantitative trading firm.

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The information and thoughts laid out in this analysis are strictly for information purposes only and should not be regarded as an offer to sell or a solicitation of an offer to buy any security in any jurisdiction where such an offer or solicitation would be in violation of any local laws.

It does not constitute a recommendation or take into account the particular allocation objectives, financial conditions, or needs of specific individuals.

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