Absolute Return Podcast #43: A Tale of Two Jobs Reports: US vs Canada

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December 9, 2019—U.S. Reports Blow-out Jobs Numbers. Is a 2020 Recession Off the Table?

Canada Records the Worst Jobs Figures in 10 Years. What’s the Story Behind the Numbers?

The World’s Largest Company Goes Public. Why Did the Shares Price so High?

A Discussion on Short Selling: For Intelligent Investors or Deranged Masochists?

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Welcome investors to the Absolute Return Podcast. Your source for stock market analysis, global macro musings and hedge fund investment strategies. Your hosts Julian Klymochko and Michael Kesslering aim to bring you the knowledge and analysis you need to become a more intelligent and wealthier investor. This episode is brought to you by accelerate financial technologies. Accelerate because performance matters. Find out more at www.Accelerateshares.Com.

Julian Klymochko: Welcome investors and podcast listeners to episode 43 of The Absolute Return podcast. I am your host Julian Klymochko.

Michael Kesslering: And I am Michael Kesslering.

Julian Klymochko: Today is December 6, 2019. A lovely Friday, not a ton going on in the market this week, but we’re here, we are working harder than ever to bring you the impactful market moving events of the week.

    • We wanted to chat about the jobs reports both in the U.S., which reported just blow out jobs numbers for November.
    • And we’re going to talk about what this means for a potential recession in 2020. Compare that to Canadian jobs reports, which were just horrific. In fact, the worst in 10 years. What is the story behind these numbers? We believe there is something potentially nefarious going on there.
    • Then on the IPO front, the world’s largest company went public. Why did the shares price so high?
    • Lastly, we are going to chat about a blog post we put out this week called. A discussion on short selling for intelligent investors or derange masochists.

Job Reports

Julian Klymochko: All right. We will get into it with the most important market event of the week with U.S., reporting just blow out jobs numbers for the month of November. The Labour Department reported that non-farm payrolls surged by two hundred and sixty six thousand. This absolutely crushed the consensus estimate expectation of one hundred and eighty seven thousand jobs.

This massive report, jobs gain reduced the unemployment rate from 3.6 percent to 3.5 percent, which represents a 50-year low. Makes you ask, can it get any better than this?

Wanted to note some of the details. Some of the jobs gained was attributed to GM workers returning from lengthy strike. This boosted employment in the motor vehicles and parts by over 41000, which represented part of an overall 54000 gain in manufacturing. Contrast that to October’s jobs report, where you saw that figure fall by nearly 43000. You did have a bit of reversal effect. However, that would have been reflected within the consensus estimate, and that does not account for the massive beat on this number. Some other positives, average hourly earnings up three point one percent, beating expectations of, three point zero percent. You had some past revisions to the upside, which is positive. In September, non-farm payrolls revised upwards by 13000 and in October revised upwards by 28000. Clearly, investors loving it. Markets loving it. S&P 500 up 1 percent today on the news. And in my opinion, these jobs numbers and employment, they’re good coincident or perhaps even a forward looking indicator that to me implies no U.S. recession in sight, specifically for 2020. What are your thoughts on this positive economic data we are getting?

Michael Kesslering: Yeah, so kind of the theme of today’s podcast with jobs in U.S. and Canada. The interesting looking granularity in the granular sense is there is a two hundred and six thousand gain in the private sector. So this is really driven by the private sector as opposed to the public sector, which is a positive as well as it is spread throughout multiple different sectors amongst manufacturing, health care and resources and other such sectors.

Julian Klymochko: Which is really broad-based.

Michael Kesslering: Absolutely, Just because you know it is not one single sector driving it as well. I would point out that the one negative is that the participation rate dropped from sixty three point three percent to sixty three point two percent. However, that was from a six year high at that sixty three point three percent. So it is one negative aspect, but in the context of the entire jobs report, not really that big of a deal. The interesting aspect as well is that this is really, as you had mentioned, despite know views of the trade war and companies just keep hiring. So in some of the surveys, companies are talking about how they are worried about the trade war, but they’re acting in terms of hiring people and that’s what matters most.

Julian Klymochko: Right, and so that positive economic data, perhaps people are not necessarily feeling it through what they say. But what’s more important is what they do and they are hiring. The economy is growing exceptionally well here. The longest economic expansion of all time. I would like to note. If you look at the historical unemployment rate plotted over a graph of the S&P, they’re basically perfectly inversely correlated, i.e. when unemployment reaches its maximum, you typically have a trough in, say, a market cycle. And when unemployment reaches its lowest, I guess where it is, you could perhaps say is 3.5 percent going to be the lowest? Who knows? It is a 50 year low. They say full employment is, what, north of 4 percent? So certainly, the Federal Reserve deems this very, very low unemployment rate number, but historically, if you look at the past market peaks, that lines up incredibly well with the bottoming of the employment rate, which is just something for investors to keep in mind. You know, valuations are at the high end of historical. So something to keep in mind where we are, in fact, with this market cycle and the implications for future market returns.

In contrast to those beautiful U.S. jobs numbers, Canada reported a stunning loss of over 71000 jobs in November. This compares to the average forecast for a 10,000 job gains. A massive mishear here, unemployment rate just skyrocketing from 5.5 percent to 5.9 percent, which represents the largest jump in unemployment since 2009. So in 10 years, Canada just reporting horrific numbers while the US is reporting, best ever. Now, these job losses were broad based, recorded in all major provinces and then after a large expected job gains prior to the election.

Something about the last few jobs reports, it seems kind of fishy. So I am calling stats Canada out for this one. I suspect there might be some election trickery because we just had a federal election in October. Now, if you go back and we previously discuss these jobs reports say in August and September, they were abnormally high, abnormally bullish, such that the Liberal government could go in to the election basically saying, oh, the economy’s so great to try to attempt to get re-elected, which many expected that to happen then. So we were sceptical about the previous jobs numbers being too high. Then what happened post-election? Well, October jobs numbers were bad. Now November comes out and it is pretty much the biggest mess ever. The worst number in 10 years. And makes you think, hmm. Are these jobs numbers realistic? For the past four months or was it front loaded to before the election? So it’s really something that we have been telling listeners for ever, it seems. On these Canadian jobs reports, you can never take any one month into account. You definitely want to look at some sort of trailing average, whether it be three or six months, a quarterly average, just because they are all over the place. Interesting to note, the market action. The Loonie was down nearly 1 percent on this news. So definitely not bullish for the Canadian dollar and perhaps goes against what the Bank of Canada was saying in their most recent meeting. I mean, they are one of the few developed markets, central banks holding rates steady and not cutting rates this cycle.  What are your thoughts on the Canadian jobs numbers here?

Michael Kesslering: Yes, with a little more detail. The job losses similar to the U.S., I guess on the inverse is that the losses in Canada were broad based as well, both among goods producing and service sectors. Ontario and PEI were actually the only provinces to actually see job growth and leading the pack in terms of the job declines, was Quebec losing forty five thousand one hundred jobs mainly due to a decline in manufacturing. While Alberta and BC, both lost over 18000 jobs each.

Lastly, this weak report really contrasts with the Bank of Canada’s view. Their view has been that a healthy labour market will drive consumption and provide resilience despite the trade tensions. But that hasn’t been the case over the last couple of months. Now on the year, there has been job growth. But over the last couple of months, and maybe not some good sentiment moving into the New Year.

Julian Klymochko: It is important that investors be very sceptical of these numbers.

And just keep in mind that this is still the strongest year for job growth in Canada in 17 years. The economy’s still ticking along, not doing nearly as well as the U.S. economy is. However, one area of strength was in compensation. You had average weekly wages increasing by four and a half percent year over year, which certainly is pretty much the only positive aspect of the report, otherwise complete disaster. But in my opinion, perhaps some manipulation behind the numbers. So not to be trusted.


Julian Klymochko: On to some IPO news, we had Saudi Arabia’s state owned oil business, Saudi Aramco. They price their initial public offering this week, raising nearly 26 billion dollars and valuing Aramco at 1.7 trillion dollars, which makes this the biggest IPO of all time and makes Aramco the largest company in the world by market capitalization. Now, this share sale is at the heart of Crown Prince Mohammed Bin Salman plans to modernize the Saudi economy and wean it off its dependence on oil. The country urgently needs tens of billions of dollars to fund mega projects and develop new industries. The previous largest IPO of all time was Alibaba’s. Now, this Aramco IPO beat it by about 600 million, and they did that by selling only a 1.5 percent stake, they initially plan on selling a lot more. But this was a four year process and it was not easy.

They ran into a number of difficulties, including choosing really not to sell it to many international investors. It was actually 90 percent subscribed to by Saudi Arabian investors, which is really, strange in a global market like we have. And it will only trade locally, it’s not trading on London or New York or anything like that. Stock is set to trade next week, and interestingly enough, they will institute a daily 10 percent plus or minus fluctuation limit. It cannot go up or down more than 10 percent in any one day. As I indicated, oversubscribed. So this attracted bids worth north of 44 billion, which represents an over subscription of one point seven times and 10 percent went to non-Saudi, which is very abnormal. It just goes to show you, this was partly priced for political reasons. You saw MBS, the leader of Saudi Arabia, really gunning for that 2 trillion dollar valuation. And international investors has balked and they wouldn’t even buy at its 1.7 trillion valuations that the Saudi investors were able to invest at. Interestingly enough, I read a poll today that indicated international investors had an average valuation for Aramco 1.26 trillion, which indicates that at the current 1.7 trillion valuation that the stock is overvalued by 40 percent and it is overvalued for political reasons. So what does that really tell you? What does that tell investors when they think it is worth 1.26 trillion and it’s trading at one point seven trillion?

Michael Kesslering: Absolutely, and so in terms of the domestic demand, so, I mean, Saudi banks were offering very favourable credit terms for their populace to buy shares. I guess the question would be is it really diversifying your economy if most of the investment is domestic? It is really just shifting that ownership from the actual public fund to the actual populace themselves. So kind of moving from one hand to the other, but economically, somewhat the same as well. Aramco has said that it will pay an annual dividend of 75 billion dollars to shareholders, which works out to be about a 4.4 percent dividend yield. Now, it has been rumoured that they’re just going to have an artificially high dividend yield for the first number of years to entice investors and that dividend yield may be scaled back a bit in future.

Julian Klymochko: And speaking about artificial nature. It is just what happened with the oil market this week. Is that Saudi Arabia wanted higher cuts from OPEC to buoy the share price, and make this IPO successful. However, how sustainable is that? It seems like a lot of these actions are completely unsustainable. They are trying to put lipstick on a pig. You know, prior to putting it out there.

Michael Kesslering: Absolutely. Really not sustainable, and the intelligent investor institutional investors see through that. Right? They are not as concerned about daily commodity prices or even weekly or anything like that. They are looking at a longer-term trend. We were discussing this as well, is that this does have a lot of implications for start-up funding with the Saudis being the cornerstone investor behind Softbank’s vision fund.

Julian Klymochko: Right. They put in, what, north of $40 billion, which gets funnelled from Saudi Arabia to Softbank’s vision fund to typically Silicon Valley start-ups.

Michael Kesslering: Absolutely, and even outside of the vision fund. The Saudis are talking about putting up an office in Silicon Valley and doing some of their own direct investing as well, which they already do a little bit, but really ramping up some of those efforts as opposed to just focusing on Softbank’s vision fund and having that external manager for that mandate.

Short Selling: For Intelligent Investors or Deranged Masochists?

Julian Klymochko: Wanted to touch on a blog post we put out this week entitled short selling for intelligent investors or Deranged Masochists. And this is really the sentiment with respect to short-sellers this year. Just because it’s been such a tough go of it, you’ve had all markets going up over 20 percent, low quality stocks, what we call junk stocks, having pretty tremendous rallies, which happened in September, happened again last month. When we talk about junk stocks, I wanted to talk about and really discuss how we define junk stocks. We basically rank all equities on Main 5 Factors. The 5 factors are quality, value, price momentum, operating momentum and trend. Where the junk stocks come into play is we are looking for low quality, highly valued stocks with negative price momentum, poor operating momentum and an unfavourable share price trend.

So if we evaluate all 4000 liquid North American securities and run a simulation over the past 20 years on these stocks with those five factor models and separate them into deciles as ranked by the five-factor model. If we look at the junk stocks, which are the bottom ranked stocks, they actually lost 10 percent per year over the past 20 years, which would make your investment go down 90 percent over those 20 years. And if we look at the top decile ie, the stocks that are of high quality with low valuations, positive price momentum, great operating momentum and a favourable share price trend, those stocks rallied 17 percent annually over 20 years on average, leading to twenty three x return if you’re invested in that portfolio. So junk stocks are really the stocks we think are circling the drain. They are low quality, they have really bad momentum. They are overvalued, and if you look at a portfolio that is losing 10 percent per year, you may think perhaps that could make a good short portfolio. However, the short selling it is a strange thing because it requires a weird, you know, weird sort of mind-set, different sort of skill, because it does not necessarily give you the exact opposite returns if you went long those securities. For example, in that scenario, say you go long and portfolio drops 50 percent and then rally is 100 percent, you get back to square one, the same amount of capital that you had. But due to the rebalancing and the compounding nature of short selling, you have this inverse like trade on. If you are short a portfolio, it drops 50 percent and then you rebalance and then it rallies 100 percent in your investment goes to zero. You are pretty much insolvent there in spite of the exact same price action if you’re long your flat. But if you’re sure you’ve gone down to zero. So it’s really important to keep that in mind, but what I talk about in this blogpost is short selling as a form of insurance or selling lottery tickets. If you look at an insurance provider, they are constantly issuing policies. And from a policyholder’s perspective, it’s basically a negative expected value investment when they buy home insurance. You are not expecting to recoup that, right.

So it tends to be profitable for the insurance company. Occasionally you get a big payoff should something bad happen, just like a lottery ticket owner. Occasionally it makes a big win, but over time and on average, it pays off to sell insurance. It pays off to sell lottery tickets, and the same perspective can be seen from short selling. What we are doing in short selling junk stocks is basically underwriting insurance where we expect to have positive expected value over time. But occasionally, you know, things go poorly and you have one that hits and it hurts, but it does not necessarily undermine the long term benefits of having shorts within your portfolio. Now, I am in no way advocating for a short only portfolio. I think the best way to utilize short selling is to have it as a partial hedge against a long portfolio, say, you know, 50 percent short against, say, 100 percent, 110 percent. Even if slightly levered long portfolio nonetheless, even if it does not generate positive returns over the long term. There are two main purposes of short selling within an investor’s portfolio. Number one, it reduces portfolio volatility. But by providing a hedge or a portion of a portfolio that will outperform when the market’s declining, which we would have seen last year. This leads to lower volatility and mitigated downside risk for investor’s portfolio.

Now, number two, it allows hedge funds such as ours to leverage their longs, which are their best ideas, the securities that you have the highest return expectations of with the goal of adding outperformance through increased exposure to these best ideas with a commensurate increase in market exposures.

Then you really get a little bit of a bonus from short selling and that when you sell a stock short, you get paid cash.  Then you have this cash, and in an era of reasonable interest rates, you have that positive carry such that the interest you can earn on that cash from the short position, it outweighs the cost of borrowing that securities. So it’s a bit of a tailwind and an even better tailwind when rates go up and serve long term rates ever, ever normalize. If treasuries ever go up to a reasonable yield, then you could have a tailwind of roughly 5 percent just from those short portfolios.

We are big advocates of short selling not going to work out every month. Certainly not every year. Twenty nineteen has been a tough one for short sellers, but it really does not eliminate the need for those hedges. In my opinion, they are superior to basically buying puts because buying puts, you are basically throwing that money away. You are paying for that insurance and by short selling; you are hoping to get paid for giving that insurance. You want it to be profitable, but I think best expectations are to break even on your shorts, but provide that risk mitigation and also the ability to lever your long portfolios with the goal of generating that outperformance over the long term.

Michael Kesslering: And one thing to really highlight with regards to the junk stocks that you had mentioned is that on the weight that you’d mentioned, circling the drain is kind of the analogy. But while they are circling the drain and on their way to zero, there still will be known face roping rallies that they have the potential to go up 100 percent over the course of a day or two as they’re then going back down. It is a negative trend, but still having some of those intraday and daily volatility.

Julian Klymochko: Yes, certainly. That is a great point. You need to have strict risk controls. You need to know what you are doing. You need to have a diversified short portfolio. So none of them can inflict too much damage on those dead cat bounces, which every great short has on its way to zero. You know, you have these face tripping rallies as big dead cat bounces, but they’re never sustainable and they’re just kind of keep going lower and lower and lower as they ultimately turn out to be great short sale candidates.

That is all we got for you guys this week, and the Absolute Return Podcast over the next week, I hope you have a great week of trading, investing. And until next week, we will chat with you soon.

Thanks for tuning in to the Absolute Return Podcast. This episode was brought to you by Accelerate Financial Technologies. Accelerate, because performance matters. Find out more at www.AccelerateShares.com. The views expressed in this podcast to the personal views of the participants and do not reflect the views of Accelerate. No aspect of this podcast constitutes investment legal or tax advice. Opinions expressed in this podcast should not be viewed as a recommendation or solicitation of an offer to buy or sell any securities or investment strategies. The information and opinions in this podcast are based on current market conditions and may fluctuate and change in the future. No representation or warranty expressed or implied is made on behalf of Accelerate as to the accuracy or completeness of the information contained in this podcast. Accelerate does not accept any liability for any direct indirect or consequential loss or damage suffered by any person as a result relying on all or any part of this podcast and any liability is expressly disclaimed.