Submitted by QTR’s Fringe Finance
Friend of Fringe Finance Mark B. Spiegel of Stanphyl Capital released his most recent investor letter last week, with his updated take on the market’s valuation and Tesla.
Mark is a recurring guest on my podcast (and will be coming back on again soon hopefully) and definitely one of Wall Street’s iconoclasts. I read every letter he publishes and only recently thought it would be a great idea to share them with my readers.
Like many of my friends/guests, he’s the type of voice that gets little coverage in the mainstream media, which, in my opinion, makes him someone worth listening to twice as closely.
Photo: Real Vision
Mark was kind enough to allow me to share his thoughts from his July 2022 investor letter, where he noted that his fund was down 10.6% for the month.
Mark’s Thoughts On The Market
Rallies such as this month’s notwithstanding, I believe stocks are only partway through a massive bear market, the inevitable hangover from the biggest asset bubble in U.S. history, and thus today, July 29th, I took advantage of this rally to reinstate our SPY short position.
For far too long, the Fed printed $120 billion a month and held short-term rates at zero while the government concurrently ran a record fiscal deficit. Now, thanks to the massive inflationary hangover from those idiotic policies, the Fed is reducing its balance sheet and raising interest rates, accompanied by no extra fiscal stimulus. (In fact if the new Manchin-Schumer plan is approved, on a net basis it will be somewhat of an anti-stimulus despite its “green energy” boondoggle subsidies.) Why do I believe that July brought us a bear market rally and not the beginning of a new bull market? Because the Fed is pulling too much money out of the system via quantitative tightening to re-inflate a stock bubble, rates are now high enough that there is “an alternative,” and corporate earnings are too lousy to push stocks up on their own. Bear market rallies such as the current one of 14% (from trough to peak) are not at all unusual; in fact as Keith McCullough points out, there was a 23% bounce in 2008 and a 21% bounce in 2000.
And courtesy of Bank of America we can see that despite bearish short-term investor sentiment polls being cited as “contrary indicators” to support bullishness, investors are still very overallocated to stocks vs. historical norms, and nowhere near as “under-allocated” as they were at the 2009 market bottom:
And regarding sentiment, we can see from Ed Yardeni that in the Investors Intelligence poll the highest the “bear percentage” got (so far) in the current market was only around 45% (it’s currently just 33%), yet there were multiple times during the 1980s, 1990s and 2008 that it climbed much higher:
Also, we can see from this old academic paper that during the grinding bear market of 1973 to 1975, when the S&P 500’s GAAP PE multiple dropped from 18x to 8x (it’s currently over 20x!), the bears in the Investors Intelligence poll climbed to around 75% and went over 80% during the bear markets of the 1960s.
So if you think that based on this bear market’s sentiment we’ve “seen the bottom,” I wish you luck!
Additionally, we can see from CurrentMarketValuation.com that the U.S. stock market’s valuation as a percentage of GDP (the so-called “Buffett Indicator”) is still astoundingly high, and thus valuations have a long way to go before reaching “normalcy” (which the market will almost certainly overshoot to the downside).
And finally, the last time the 10-year Treasury yield was where it is now (a bit over 2.6%) was March 2019 when the S&P 500 was around 2800 (over 30% lower than it is today), yet inflation was vastly lower (allowing much higher PE multiples) and growth prospects were far better.
And although corporate earnings are higher now than they were then, they’re at best “sluggish” relative to expectations and, as previously noted, inflation will substantially lower the PE multiples placed on them. (Perhaps a move to 14x from the current over 20x might be appropriate, although markets typically overshoot to the downside.)
When stocks get meaningfully cheaper I’ll get longer, but until then the fund’s bias is towards caution!
Meanwhile, even last year when short-term rates were set at just 0.125% and average rates were around 1.5%, the gross interest on the $30 trillion of federal debt cost $573 billion, and that cost is now on a path to nearly double.
Does anyone seriously think this Fed has the stomach to face the political firestorm of Congress having to slash Medicare, the defense budget, etc. in order to pay the even higher interest cost that would be created by upping those rates to a level commensurate with even 4% or 5% inflation (not to mention today’s over 9%)? Powell doesn’t have the guts for that, nor does anyone else in Washington; thus, this Fed will likely be behind the inflation curve for at least a decade. And that’s why we remain long gold (via the GLD ETF).
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Mark On Tesla
Late in July, Manchin announced he’d made a deal with Schumer to extend the $7500 EV tax credit which Tesla lost a couple of years ago. However, due to the new program’s price caps, only Tesla’s cheapest, short-range Model 3 qualifies, along with its Model Y which sneaks in as a “small SUV” (which have higher price caps), despite simply being a Model 3 with a bloated, guppy-like body stuck on it.
But there are new income cutoffs restricting who can use these credits: $150,000 for an individual and $300,000 for a married couple, which will eliminate a number of potential Tesla buyers. If we then add in the fact that a myriad of great and less expensive Model Y competition has now arrived, with much more coming in 2023 when the credits begin, I see this government spending boondoggle adding perhaps 100,000 deliveries a year for Tesla; i.e., a rounding error for its market cap and volume projections. And now for the rest of the news…
In July Tesla reported a terrible Q2, with deliveries down 26% from Q1 (which itself showed no growth over Q4). However, Q2’s sales decrease was primarily due to a monthlong COVID-related closing of Tesla’s Shanghai factory, and thus it might be a while before we can get a “clean” demand picture for the company.
Regardless, in Q2 Tesla generated only $621 million in stated free cash flow, yet that included a sequential increase in payables (and decrease in receivables) despite a $1.8 billion decrease in revenue! (In other words, Tesla isn’t paying some of its bills!)
Additionally, there was a $106M operating cash flow benefit from a Bitcoin sale, so adjusting for the working capital and Bitcoin benefits Tesla was barely free cash flow-positive. Meanwhile, earnings were just $1.95/share including roughly .30/share of emission credit sales which will disappear some time next year when competitors have enough EV capacity of their own.
If we add back in the one-time .09/share loss for the aforementioned Bitcoin sale and deduct the sunsetting credit sales, we get annualized adjusted run-rate earnings of just $6.96, giving Tesla an annualized run-rate PE ratio (as of July’s end) of 128 in an industry with an average current multiple of only around 5! And even to make that lousy earnings number Tesla (an alleged “technology growth company”) had to slash R&D spending sequentially by almost $200 million while simultaneously claiming a mysterious reduction in SG&A despite opening two brand new factories in the quarter that Musk called “gigantic money furnaces.”
Regardless of any Q2 sales shortfalls caused by the temporary factory closing, Tesla has objectively lost its “product edge,” with many competing cars now offering comparable or better real-world range, better interiors, similar or faster charging speeds and much better quality. (Tesla ranks second-to-last in Consumer Reports’ reliability survey while British consumer organization Which? found it to be one of the least reliable cars in existence.)
In fact, Tesla is likely now the second, third or fourth choice for many EV buyers, and only maintains its volume lead though a short-lived edge in production capacity that will disappear over the next 12 to 36 months as competitors rapidly increase the ability to produce their superior EVs. Tesla’s poorly-built Model Y faces current (or imminent) competition from the much better made (and often just better) electric Hyundai Ioniq 5, Kia EV6,Ford Mustang Mach E, Cadillac Lyriq, Nissan Ariya, Audi Q4 e-tron, BMW iX3, Mercedes EQB, Volvo XC40 Recharge, Chevrolet Blazer EVand Polestar 3.
And Tesla’s Model 3 now has terrific direct “sedan competition” from Volvo’s beautiful Polestar 2, the great new BMW i4, the upcoming Hyundai Ioniq 6and Volkswagen Aero, and multiple local competitors in China.
The worst thing that can possibly happen to “the Tesla story” will be when its German and Texas plants are fully operational and the subsequent excess capacity stares the world right in the face, thereby ending its myth of “unlimited demand” (especially at current, drastically-raised prices, where the cheapest Model 3 now starts at $47,000 and the cheapest Model Y begins at $66,000); in fact, look for margin-destroying price cuts by late this year or early 2023.
Indeed, for years I’ve said “Tesla is Blackberry”—the maker of a first-generation version of a product that—once the market was proven—would be supplanted into niche obscurity by newer, better versions; now I can provide a much more recent analogy: Tesla is Netflix. For years Netflix had an absurd valuation based on its pioneering position in streaming media, but once it proved that such a market existed myriad competitors swarmed all over it, and in April the stock collapsed when we learned that not only is Netflix no longer in “hypergrowth” mode but for the first time since 2011 (when it transitioned from physical DVDs) it actually lost subscribers. I believe Musk knows that Tesla is “the next Netflix” (hence his recent “Twitter buying distraction”), with VW, Hyundai/Kia, Ford, GM, BMW, Mercedes, BYD & other Chinese competitors and, in a few years, Toyota & Honda, being the Disney, HBO Max, Amazon Prime, Peacock, Hulu, Paramount +, etc., of the electric car market, stealing Tesla’s share and eventually pounding its stock price down 95% or so from today’s, into the valuation of “just another car company.”
Despite this obvious “writing on the wall,” many Tesla bulls sincerely believe that ten years from now the company will be twice the size of Volkswagen or Toyota, thereby selling around 20 million cars a year (up from the current run-rate of around 1.3 million); in fact in March Musk himself even raised this as a possibility. Setting aside the absurdity of selling that many cars at Tesla’s high price points, to illustrate the “logistical absurdity” of this, going from 1.3 million cars a year today to 20 million in ten years means that in addition to two million cars a year of sold-out existing claimed production capacity (once the German and Texas factories are fully operational), Tesla would have to add 36 more brand new 500,000 car/year factories with sold out production; i.e., a new factory almost every single quarter for the next ten years!
Meanwhile, in July the head of Tesla’s “self-driving” program quit, while in June the NHTSA announced that its investigation of Tesla’s deadly Autopilot has expanded into “an engineering analysis,” the last required step before (finally!) demanding a full recall. The refund liability potential for Tesla for this is in the billions of dollars, and possibly even the tens of billions if a class action lawsuit proves that the cars involved were purchased solely due to the (fallacious) promise of “full self-driving.” And, of course, there will be a massive “valuation reappraisal” for Tesla’s stock as the world wakes up to the fact that Tesla’s so-called “autonomy technology” is just trailing-edge garbage. As of July, the NHTA is investigating 48 crashes involving autonomous driving systems, 39 of which—and all the deaths but one—involve Tesla. (For all Tesla deaths cited in the media—which is likely only a small fraction of those that have occurred—see TeslaDeaths.com.)
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Disclaimer: This letter was not reproduced in full. I may own Tesla call and put options and am short TSLA. QTR is long various gold and silver miners and has both long and short exposure to the market through equities and derivatives. You should assume I have positions in any names I publish about. I have no position in Mark’s funds. Mark is a subscriber to Fringe Finance via a comped subscription I gave him and has been on my podcast. The excerpts from Mark’s letter, above, shall not be construed as an offer to sell, or the solicitation of an offer to sell, any securities or services. Any such offering may only be made at the time a qualified investor receives formal materials describing an offering plus related subscription documentation. There is no guarantee the Fund’s investment strategy will be successful. Investing involves risk, and an investment in the Fund could lose money.