Which do you think has more likelihood of success, a pure start-up that has never sold a product, or one like K-Tel that has been in business for 35 years?”
Coffin Communications, 1998
I hope this finds you healthy in all respects, at peace with what you can’t change and with wisdom what you can.
I don’t need to identify for you the many difficult events than span almost a year now. Compounding the problem has been a deluge of opinions and rants in news and social media circles that elevates the recently suggested idea that a third political party for the sixty to seventy percent of us who are not on the fanatical fringes of either side begins to make sense. I might suggest considering the return of the Whig party, but alas, who remembers, history is no longer relevant. Pity, for Abraham Lincoln was a Whig before he was a Republican.
Over the years I have said that events in Washington are typically nothing more than noise that most of the time affects the market only mildly over the short-term. Despite being in such a tumultuous period, when the decibel level has produced a nasty headache for most of us, if not a migraine, Mr. Market has more that held its own. Of course, as with two branches of our government recently, Mr. Market is conveying it too can cross the line of appropriate behavior.
The rampant speculation in company shares from GameStop, AMC Entertainment (theatres, not the cable channel), Bed Bath & Beyond and others is beyond rational definition. From the quote above, K-Tel began in 1962 selling Teflon-coated frying pans at Eaton’s, Canada’s then largest, now defunct, department store chain. Over the years, the company went from advertising locally, to creating an effective infomercial business, especially in the United States, peddling Ronco products like the Dial-O-Matic and Veg-O-Matic food slicers. For those who remember decades back when Saturday Night Live was funny, I will add Dan Ackroyd’s Bass-O-Matic, but I digress. K-Tel also sold compilation records by the millions, such as the venerable Super Bad, Souled Out, 24 Great Truck Drivin’ Songs, Disco Fire and, of course, 25 Polka Greats, among many, many others.
In 1998, as the dotcom bubble was forming, K-Tel announced they were going to start selling compact discs on their corporate website. In mid-April that year, the thinly traded shares went from $3 to $7 the day of the announcement. In two weeks, the shares vaulted to over $40. Volume went from an average of about 2,000 shares per day to 14 million per day. By November that year, the stock had fallen back to $12 and was on its way to becoming a penny stock.
Having gone public in 2002, GameStop is a video game and associated merchandising retailer with over 5,000 stores in ten countries. The purchase, sale and rental of video games is their primary business. As a client recently shared, they are to gaming what Blockbuster was to movie rentals. As a reminder, at its peak, Blockbuster had over 9,000 locations, but the company ceased operations in 2010, leaving today one privately-owned franchised location in Bend, Oregon. The stock never completely delisted, now trading in the pink sheets for usually less than a penny per share. On January 27, it raced to $0.30 for no reason other than because it was mentioned on Reddit and Twitter. That may not sound like much, but buy 100,000 shares for $750 in the morning, talk it up on Reddit over lunch and sell your shares for $30,000 by the afternoon’s close. Not bad for a day’s manipulation, uh, I mean work.
GameStop hired a new CEO in 2019 and an activist investor bought in last year when the shares were a modest $12.70. Shares closed 2020 at $18.84 on the hope of a COVID-19 recovery and a CEO and investor who have had tangible success in the retail market. Of course, not everyone believes success is assured.
Enter hedge funds. Historically a club for the wealthy, hedge funds used to be investment partnerships that sought to balance risks, most often by “hedging” long positions in some stocks with the short sale of others. The idea was that one makes money regardless of market direction and the fund owner is handsomely, i.e., egregiously, paid for this. Today, these funds are only out for profit and most, no longer pretending to be investors, don’t care where or how they get it.
Hedge funds and others have been actively shorting GameStop, believing the stock would go lower and allow them to purchase the shares at a lower price to cover their short position. In the past few weeks, there have been significantly more shares shorted than GameStop has shares outstanding. Supposedly by law, one cannot sell short without borrowing an equal number of shares, but apparently “synthetic” shares were created to allow selling and delivery of a security not currently owned. I’ve heard of synthetic options and futures, but this was a first in my 38+ years in the business that someone could short shares in a company that weren’t issued by that company. If increased regulation occurs because of recent market behavior in certain stocks, this is a good place to start.
Now enter Robinhood. Robinhood is an online broker founded by two Stanford classmates and roommates named Baiju and Vlad. Since 2013, the firm has been a favorite of millennials and amassed over $20 billion in assets offering commission-free access to the securities markets, gold and bitcoin. Considering they have over 13 million accounts, the average account size is a modest $1,500, yet formidable when combined with other like-minded financial agitators. Comments began to travel on Reddit, Twitter and other similar means of online communication that hedge funds held massive short positions in GameStop. This disgruntled army of mostly young, in experienced and driven individuals began buying GameStop, urging others that their patriotic duty was to inflict financial pain on the rich and should do the same.
Recall GameStop stock closed December 31at $18.84. Since January 12, the shares have experienced extraordinary volatility. From the previous day’s close of $347.51, GameStop opened January 28 at $265 per share before vaulting to a new high of $483. The stock then abruptly fell to $112.25 before recovering to close at $193.60, all in the same trading day. (It closed today at $90.) One hedge fund, Melvin Capital, at one point had $12.5 billionin assets under management, but needed a $3 billion infusion from two other hedge funds to remain afloat after losing clients over 50 percent of their investment on a single trade. Talk of other billion-dollar funds losing 30 percent or more of their client’s assets has grown. One source said over $50 billionhas been lost by short sellers inrecent days.
For the amateur individual investor, their involvement became a political statement. The buyers of shares did not care about corporate fundamentals; they are angry and wanted to take down the rich. Most of their online chatter was vulgar and cannot be reproduced here, but statements were also made such as “We are better at being irrational than Melvin is of being solvent,” or especially something like, “This is class warfare.” AsIstated, most posts were profane, racist or homophobic and caused Reddit to close the main discussion board for GameStop and companies like it,not in fear of allowing market manipulation, but for violating their hate speech rules.
Brokerage firms are also taking steps to limit trading in these names. Even Robinhood announced last Friday morning they would restrict new GameStop purchases, which then brought harsh criticism from this reckless mob that they can’t trade while the rich continue to do so. Of course, these firms are taking such steps due to increased capital restrictions and/or the concern for their own solvency or what the government may do. We saw an opening salvo of the latter the afternoon of the 28th by the likes of
Massachusetts Senator Elizabeth Warren and New York House Representative AOC condemning the SEC for allowing such chaotic speculation and market manipulation and “lacking backbone” to enforce their rules. It’s more complicated than this because these speculators may merely be performing their first amendment rights, but that’s never stopped a politician from reaching for a microphone. After the political rhetoric, Robinhood reversed their position, but only after securing $1 billion in new capital.
This was followed two days later by an additional $2.4 billion in capital that in total eclipses all other capital Robinhood raised in the eight years the firm has been in existence.
There will be hearings over this and there should be. In not one, but several cases, we are not seeing orderly markets. The 50% to 100% daily rise and fall of GameStop and other company shares not only affects the brokers and clearing firms that are financially responsible to settle such trades, but also individual investors in the stock and even market indices, especially those associated with consumer discretionary companies and the retail industry. This distorts performance and volatility measures as well as fundamental metrics used for determining value. And speaking of value, since we all need good news, let’s move from this financial drama to what matters much more.
As you know, the stock market had much to decipher in 2020; the pandemic and the election certainly dominating this. Still, the Dow Jones Industrial Average (the “Dow”) closed above 30,000 for the first-time last November and generally hasn’t looked back. To justify why we are long-term investors, the Dow was created by Charles Dow in 1884, but the index we know today was initially traded on May 26, 1896. That day, it closed just shy of 41. To say more simply, that’s a move from 41 to 30,000, or an advance of 73,000 percent.
While generally good, market performance in 2020 was not evenly distributed as the table below demonstrates:
| Dow Jones Industrial Average | + 9.7% |
| S&P 500 | +18.4% |
| S&P 500 Growth | +33.5% |
| S&P 500 Value | + 1.4% |
| MSCI EAFE (international) | + 7.8% |
For Legacy clients, 2020 equity returns generally followed, if not surpassed, the S&P 500 because we were invested primarily in diversified portfolios of large cap companies, while mostly avoiding the underperforming deep value cyclicals. We were not invested internationally and don’t generally see us allocating your investment capital there except for special circumstances. Overall, I hope you share our view that given the political and economic backdrop from which it had to contend, 2020 was a good, if not exceptional, year for the market.
I apologize for running long, but want to touch on two additional topics. Regarding China, they also had a respectable 2020, with its older, larger and larger capitalized Shanghai exchange up 13.9 percent and the smaller, newer and more “entrepreneurial” Shenzhen index up 38.7 percent. The Chinese have been on a global goodwill campaign, marketing their Sinovac COVID-19 vaccine, CoronaVac, to the world before the US had approved its first vaccine from Pfizer and the German firm BioNTech.
Unfortunately, it was discovered in Brazil last week that Sinovac’s vaccine is not effective at China’s touted 78 percent, but is only 50.4 percent effective. To put this in perspective, the World Health Organization states a drug should have an efficacy rate of at least 50 percent to be used. Apparently, the Chinese, like the Russians, were not thorough enough in hacking various U.S. and Western computer networks while on their way onto the world stage with a less than promised deterrent.
Of course, the Chinese were hoping that while they extended a hand to some countries, they wouldn’t be seen clinching their fist elsewhere. I don’t trust the Chinese, but I do believe them when they say they seek to assimilate Taiwan one day, by force if necessary. It’s not only Taiwan, but their own people. This Communist country is increasingly returning to its authoritarian roots by inhibiting personal liberty through greater mass surveillance and censorship. A cornerstone of this is the Chinese General Secretary, Xi Jinping’s vision of a social credit system in 2014 whereby, for example, the more propaganda videos one downloads, the greater one’s ability to obtain perks, like a ticket for a train. Commit minor infractions, such as jaywalk, or say the wrong thing in public, and one may be blacklisted from public transportation of any kind. This was supposed to be nationally implemented last year as a way for the people to demonstrate their patriotism, but this dystopian future is only regionally active for now.
A few years ago, China was hailed in some circles as a nation that was better implementing capitalism than America was. As companies are increasingly being forced to accept directives and board members aligned with State edicts, this is no longer debated. For example, Ant Financial’s initial public offering (IPO), that was to raise $37 billioninnew capital and provide a market capitalization of over $300 billion, was terminated by the Chinese government days before the November 2020 IPO was to be launched on world markets. For smaller companies, failure to comply with the State’s increased demands may cause it to fail. Like Putin, Xi has effectively removed term limits on his own position, while assuming greater top-level roles in government. Unsurprisingly, Chinese economic productivity has fallen under the Xi regime and as his control continues to consolidate,Isuspect it will continue to do so.
At Legacy, we are not direct or indirect investors in China through individual stocks, mutual funds and/or exchange traded funds (ETFs), and we never will be as long as they are a Communist, State-controlled nation that suppresses its people, including the sterilization and genocide of China’s Uighur population that both the Trump and Biden administrations recognize.
As you know, Pfizer/BioNTech and Moderna have Covid-19 vaccines available that are 95 percent effective. Johnson and Johnson has completed its major trial and AstraZeneca, a major UK pharmaceutical company, is shipping. These latter vaccines have efficacy rates of about 70 percent each in part because their trials involved mutated strains, such as the South African mutation, older drug trials did not. Pfizer and Moderna have both admitted their own efficacy rates would likely not be as high had their trials involved these newer mutations. Fortunately, like with annual flu vaccines today, these mutations can be addressed in future Covid-19 vaccines.
Globally, there are 200 companies working on vaccines, with about 60 interventions in some sort of trial. One might not know this from the news, but before the Biden administration assumed power, the US ranked fifth in the world at vaccinating its population. Of developed countries, Israel has been first from day one and has vaccinated over 30 percent of its population. France is last. Back to the US, states with the best and worst job at vaccinating their population follow below. West Virginia leads the country in the ratio between the number of vaccines distributed in the state (278,400), versus how many have been administered (224,604):
| Best States | Vaccine Delivery vs Distribution Rate | Worst States | Vaccine Delivery vs Distribution Rate | ||
|---|---|---|---|---|---|
| 1 | North Dakota | 92.1% | 46 | Idaho | 56.1% |
| 2 | New Mexico | 86.6% | 47 | Missouri | 55.3% |
| 3 | West Virginia | 85.3% | 48 | Kansas | 54.9% |
| 4 | South Carolina | 82.6% | 49 | Rhode Island | 54.4% |
| 5 | South Dakota | 82.4% | 50 | Alabama | 54.3% |
Other notable state rankings: Colorado (12th – 72.5%), Louisiana (14th – 71.4%), Virginia (15th – 70.1%), Texas (21« – 68.2%), Florida (42^ – 59.1%) and Mississippi (45* – 56.2%).
Covid-19 will continue to be a major topic for many months and the science will go on for years, but Mr. Market has generally moved on. Were it not for the likes of GameStop and companies like it, the market might well be focused more on fiscal policy expectations of the Biden administration. While monetary policy is important, and Mr. Market is well pleased with the Federal Reserve’s massive accommodation, it should be concerned with regulations that are already beginning to be felt. For example, when President Biden penned an executive order banning drilling on federal lands and off coasts, New Mexico’s legislature immediately worried how schools, Medicaid and public safety will be covered, given the reduced rate of royalties and revenue for an industry that provides 30 percent of its budget. This from a state Mr. Biden won with 54 percent of the vote. Another major fiscal concern is tax policy. Because stock prices follow earnings, if earnings fall from increased taxation, then stock prices should commensurably adjust. All things being equal, this shouldn’t produce a major sell-off, but it will be a headwind for stocks, as shares are repriced to the new policy.
Countering the above is pent-up consumer demand. This will drive areas of the economy for several quarters and may well more than offset higher taxes. As a result, in a world defined in so many areas as being half empty versus half full, we continue to take the path of optimism. The market needs a breather, but the magnitude is not such that one needs their assets in a mattress. The market can produce an average return in 2021 and we continue to believe the greater risk lies in being in intermediate to long-term bonds and being too much in cash. Market corrections are healthy, keeping stock prices from overheating too much, while letting earnings catch up. Like all corrections before it, it will most likely turn out to be noise.
Thank you for your continued trust and your business. It is a privilege serving you.
Kindest regards,
