Fred Hickey: The Current Situation is much more dangerous than during the Dotcom Bubble

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via themarket:

Wall Street darlings like Apple, Google and Amazon have dominated this bull market. But today, the so-called FAANG stocks have lost some of their attraction and are lagging the overall market since last year.

«Without participation from the FAANGs it will be difficult for the stock market to rip to new highs», says Fred Hickey. According to the renowned contrarian investor, each of the tech behemoths is struggling with its own fundamental problems, with Apple being the weakest of the group.

Hickey also sees a huge gap between fundamentals and valuations in the semiconductor sector since the SOX Index is up more than 30 per cent year-to-date despite the worst downturn in the industry since the global recession of 2008/09.

Yet, in contrast to previous cycles, the editor of the «The High-Tech Strategist» hasn’t placed large bets on a crash. That’s because he fears that central banks could step in once again and bloat the stock market with new rounds of quantitative easing.

On the long side, Hickey spots the best opportunities in precious metals. In an in-depth interview with The Market, he hints which gold and silver stocks he thinks have the best chances to outperform the sector.

Mr. Hickey, despite growing worries about the global economy the US stock market is up almost 18 per cent since the start of 2019. What’s your outlook for the rest of the year?
We’re near a recession if not already in one. Many parts of the world are in trouble. China’s growth is at a multi-decade low and its economy might be in a recession. As a result, we see terrible export numbers coming out of Korea and Taiwan. Around the globe, trade, manufacturing and capital spending are contracting. In the tech world, all the end markets are very poor: auto and smartphone sales are declining, PC sales are weak, and semiconductors are in the worst downturn in a decade.

How bad is the situation?
All of this is indicating tremendous weakness. Yet, central banks are reacting with more of the same: They are slashing rates again because their policies have failed utterly and completely. They never admit any of their mistakes and are going to take us further down this problematic path which doesn’t work for many parts of the economy. The ECB is hinting at more quantitative easing and deeper negative rates, and the Fed clearly is going to be cutting rates again. As the rest of the world is trying to get ahead of them, many central banks are cutting rates. The only place with any interest rates to speak of are the United States. It’s a gigantic mess.

What does this mean for tech stocks?
We have all these companies building inventories because they’ve seen a slowdown. They haven’t cut back production much because they are hopeful that the economy will stage a comeback. They can’t do that forever. At some point, companies have to cut back production and that will cause lay-offs and a decline in margins. Their earnings and cash-flows will evaporate, which means their buybacks will evaporate as well.

How is this going to impact the stock market?
The propping up of the stock market through buybacks will go away. We started to see that possibly in the latest numbers: In the second quarter, buybacks in the tech sector are down 23 per cent from the first quarter. Companies like Apple, Oracle and many others have been spending a lot more money on buybacks than they generated with their cash flow. They have been adding debt and eventually they have to reduce buybacks. We’ve already seen that with Micron Technology: A couple of years back, the company had announced a huge billion dollar plus buyback program. Now they are buying back hardly anything because their cash flow has imploded.

We’re seeing softness in FAANG stocks like Facebook, Apple or Netflix. What’s your take on that?
Without participation from the FAANGs it will be difficult for the stock market to rip to new highs. This year, we’ve had some brief new highs in the S&P 500, but it’s not very broad. The FAANGs are noticeably lagging, and none of these companies is really healthy in terms of their fundamentals: Netflix had a big problem with subscriber growth last quarter. They have enormous cash needs since they burn so much of it. They can get away with it by saying they’re a big growth company. But when growth evaporates – which will happen – then that makes the N in the FAANGs a problem. Meanwhile, Google and Facebook are under fire around the world from governments questioning privacy rules and monopolistic tendencies.

Which one of the FAANG stocks is most at risk?
Apple is the weakest for sure. Apple’s smartphone sales are down dramatically, and their market share has halved from over 20 per cent down to 11 per cent. Huawei overtook them recently in global market share and Samsung is obviously much larger. So Apple is number three and at risk of falling to number four. Even so, the share price is still up in the stratosphere with the company valued close to a trillion dollars in market cap. Like the other FAANG stocks, Apple isn’t going anywhere because it’s hard to make new highs when you’re losing market share, earnings are falling, and buybacks are declining because the cash flow is weakening. All these things are happening at Apple.

Next week, Apple will introduce its new iPhone models. What are you expecting?
Numbers out of Taiwan show that they’re building only 70 million of the new generation iPhones versus 90 million a year ago. The new phones are boring with some slight camera improvements. Many analysts are talking about waiting to 2020 when 5G comes around and Apple is supposed to have a 5G phone. But I think that 5G is overhyped. It’s interesting: Qualcomm, a major player in 5G, was downplaying 5G pretty severely during their earnings call a few weeks ago. I just don’t think the technology is ready for prime time. So it’s not going to be that much of a driver for Apple. The company hasn’t come up with any new major products to speak of since Steve Jobs died in 2011. What’s more, they’re having a lot of trouble in China and it will get worse as the trade wars escalate.

Amid slowing iPhone sales, Apple touts its services business as the next growth driver. Will this strategy work?
Apple is a smaller player in the PC market, and they do fairly well in the relatively small market for wearables. They talk about services as their big growth area. But in the recent quarter the growth of Apple’s services business slowed down, too. That makes sense because if you lose a lot of share in the smartphone market, you’re not going to be able to grow in services since they depend on people owning the phones. What holds the stock up are the big buybacks and dividends as is the case with a lot of tech companies. Apple pays a 1.5 per cent dividend yield. Relative to the yields you get in the bond world that can be attractive to some investors. That said, Apple has been spending much more money on buying back shares than they are generating in cash flow, and last quarter we saw a slippage in their buybacks.

Which one is the strongest big tech company in terms of fundamentals?
Microsoft is the strongest. Its customer base is going to hold up better than others. There is growth in their cloud business because slowly but surely enterprises move to the cloud. Already back in 2008, I was saying that Microsoft was a cloud leader. So if you want a solid company that’s the most solid I can give you. The only problem is the valuation: Microsoft is not a high growth company and yet it has a very high multiple. You’re talking about a P/E ratio of 30 and over $1 trillion in market cap. That’s overpriced but the stock is up there because Microsoft’s CEO has decided to buy back a lot of shares and leveraging the balance sheet.

With WeWork we’re likely going to see another big unicorn going public in the next few weeks. What goes through your mind when you see all these «hot» new IPOs?
There are all sorts of signs of craziness. People are willing to buy anything with growth and anything with a dividend just out of desperation. We have cloud companies selling at 20 to 30 times sales and in many cases, they don’t have earnings at all. We also have all these unicorns going public. In some cases, their losses are as big as their revenues and that’s pretty hard to do. These are ticking time bombs. WeWork – which I call WeSpend because all they do is spend money – has no prospects of ever making money with their business model of borrowing long term and having customers leasing their offices for short terms. Many of these customers are small companies which will likely go away in a recession.

You’ve been investing in tech stocks for four decades and have seen a thing or two. How does today’s IPO surge compare to the excesses during the dotcom bubble in the late nineties?
I hoped I would never see that again in my lifetime. But here we are and it’s the same cause: central bank largesse. It’s also different in a way. Back then, some of the excesses may have been even more extreme than today’s because the bubble was so concentrated within tech. We had an economy that was overcooked in technology only. That’s where all the malinvestment took place. This time, the excesses are much broader, and the economy is much weaker globally. We surely didn’t have the debt levels we have now – not even close. This makes the current situation much more dangerous than it was two decades ago.

Where are the weakest parts in the tech sector right now?
Clearly the semiconductor industry. Globally semiconductor sales are going to be down 10 per cent this year according to Gartner. That’s the biggest downturn since the 2009 global recession. So one would have expected semiconductor stocks to get crushed. Yet, they’re one of the best performing sectors this year. They’re up more than 30 per cent. It’s unbelievable: In 2009, at this point in the cycle with revenues down 10 per cent, semiconductor stocks were down 60 to 70 per cent. We see a massive disconnect today.

Why do you think that is?
There was hope of a second half rebound but we’re pretty deep into the second half and it has not happened. So now they are holding up hope for 2020. But every semiconductor company I follow has seen rising inventories, falling sales and lower earnings. It’s terrible out there, yet the stocks hold up. This has everything to do with this wrapped world that we’re living in. Just like we would never have expected to see $17 trillion of negative yielding debt, we would not have expected semiconductor stocks to be up 30 per cent when their business is imploding. Investors are still euphoric and believe in the central banks.

How will this story end?
Against this economic backdrop, typically you would see a more than 60 per cent decline in the semiconductor world. And, if you look at the valuations in the stock market as a whole, you could see a 40 to 50 per cent decline there. But if central banks are determined to step in, print money, possibly buy stocks and propping up the market like they do in Japan and maybe soon in Europe, then you have a different world. When you have negative interest rates and investors are desperate, semiconductor companies with 2 per cent dividend yields are perceived as more attractive.

What’s your investment strategy in this market environment?
I was short in 1999/2000 and again in 2007/08 via put options. When I see that the market is potentially very vulnerable – as I did in the fall of last year and in May – I’m adding up to my put positions. But the put positions I had during this cycle have been tiny relative to those in the past because of quantitative easing. It’s always risky to be short, but it’s particularly risky when you have central banks printing money and possibly buying stocks. In nominal terms, the best stock markets in the world have been Argentina, Venezuela, Zimbabwe and places like that. Of course, their currencies collapsed but if you’re a short seller that doesn’t matter, you get killed. So it has to be the right moment for me to increase my position in put options. Right now, I have almost nothing on it, because I would have to see something breaking down and I’m not seeing that.

Are there any particular names you focus on?
My biggest position in puts is Micron. But that’s my only put position in the semiconductor sector right now. It’s my favorite for a collapse because their business is truly imploding, and the stock price is very high. Their earnings have already collapsed, and the buybacks have essentially stopped but the stock is still levitating on hopes. There are many other stocks in the chip sector that are very high priced like Nvidia, AMD and some of the analog companies like Analog Devices and Texas Instruments. They’re all at risk of declines. Obviously, the semiconductor equipment companies are trading at record highs too. At least, they are profiting from the Chinese build-up, since China is trying to create its own semiconductor industry. But there aren’t many semiconductor companies that are rightly valued and they’re all at risk of major tumbles.

Where else are you betting on a collapse?
I have put options on a handful of these cloud stocks. Here we’re talking about 20 to 30 times sales valuations with no earnings. I have never seen valuations like that sustained. They will fall apart at some point. But for now, they continue to levitate even though they don’t pay any dividends. It’s just hope, valuation and momentum. I could name thirty of them like Workday, Twilio, Service Now, MongoDB, Atlassian and Salesforce. Salesforce is not as highly priced but it’s just a big rollup where they keep buying companies to keep their growth rate up. I have these put options only in case the market falls apart and I wasn’t ready for it. On the total size of my portfolio it’s almost nothing.

So what are you doing with your money?
I have quite a bit of cash, more than I had in a long while. I also have short-term US government bonds. But my biggest position is in precious metals. I have been in there heavily ever since the Fed had started going crazy in early 2000. I pulled my position back in the last two months because of the breakout we had in gold. I still have large positions but they’re not as large as they were a couple of months ago.

Why are you getting cautious?
My accounts were up 50 to 60 per cent for this year and with those kinds of gains I thought it would behoove me to not be so heavily invested. Also, the sentiment changed. When I had my biggest positions in precious metals around August last year, the sentiment was as dark as it could be. Now, Commitment of Traders (COT) reports show the biggest long positions among speculators since 2011 and 2016. Both times, we had significant selloffs. I don’t know if we’re going to have a sell-off this time because there is a lot of gold buying going on and we never had negative interest rates like that before. But there’s risk with the sentiment as high as it is. So I pulled back a little bit.

Where do you see the gold price heading in the medium and longer term?
I still think that gold is the place to be and I’m not alone anymore. Some of the finest minds in the investing world have all come to the same conclusion: Ray Dalio, Jeff Gundlach, Stanley Druckenmiller, Mark Moebius and Sam Zell: They all say that this is the place to be. Also, people are very underinvested in gold and silver. In the past, when people were heavily invested in gold, they had 5 to 8 per cent of their portfolio in gold. Today, we’re at a fraction of one per cent. Most institutions have hardly anything. So the smart money has jumped in, the masses of institutions have not yet. We’re still in the early stages of this bull market.

Which mining stocks do you like?
A lot of the miners are in bad locations. I don’t want to be in Russia, South Africa and a number of other places where there is geopolitical risk. That’s why my favorite is still Agnico Eagle. The company has been going through a transition where they were building some major mines that are going to account for about 20 per cent of their production going forward. Now, they are going to see some big results, particularly with respect to cash-flow and that’s going to lead to higher dividends. So with any pull backs I will be adding to that position for sure. I also like Alamos Gold and Pretium Resources.

What about the big guys like Newmont and Barrick?
I like them and I own both of them, but they are different: They are not going to be production growth stories, but earnings growth stories. They are going to be selling the assets which are less profitable and keeping the best. That gives them a lot of flexibility to focus on the bottom line and shareholder returns. Barrick’s new CEO comes from Randgold. He had a great run there. He was very shareholder friendly and is talking about increasing the dividend at Barrick as well. Newmont has always been a dividend payer and a well-managed company.

And what about silver?
I like sliver calls that go way out in time. There is less risk in silver because COT reports show that there is less speculation than in gold. Also, silver and silver miners typically lag gold. So at this point, I would be more likely to buy silver. The other thing is that the silver to gold ratio is out of whack. Typically, it’s around 65:1. Right now it’s 88:1 and that’s very high. With respect to miners, the one I like most is Pan American Silver. The company is well run and well positioned. It has a mine called La Colorada where it made some significant discoveries which can double the size of that mine.




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