July 2017 Newsletter

14 trading days ago the question to answer was

Did we see the top of the market for 2017 in June or is was this just another breather we can buy for higher highs into year end?

The answer today is the same its been since the end of the Great Recession: YES you should buy the fear based pull backs goddammit...have you not been listening? 

Nothing has changed really in our 9 year slogging 2% ish economic expansion, and that means our academically proven long/short investing formula aka NBT Macro Market Index says  "Buy stocks on pullbacks in expanding macro economic cycles and SELL them/Hedge them when the our Macro Market Index says the 60-day moving average of the expansion cycle run out of gas and shows recession coming in 4-6 months."

So first off we always check our trusty  NBTI Macro Market index to see where we are in odds of recession in the next 4-6 months

• NBTI Macro Market Index 17.2 — All Clear for stocks 
• Latest GDPNow Forecast: 2.4 percent — July 14, 2017

Key Point: As long time subs know, because we don't have more than 2% recession risk 4-6 months out we want to be a BUYER of great secular transformational growth stocks at their key key support after healthy corrections. We got that pull back in late June and early July on end of quarter rotation/profit taking.

Then guess what...our leading growth stocks rocketed right back to new highs. The AlgoBots took it to the 100-day line this time: Note to self: IN the ALGO market of the 21st century have pull back to 50-day, 65 day and 100-day lines!!!

SP Growth Stock Index looks even better...it never broke down

What sucks? VALUE...Why? Because in a 2% growth economy VALUE STOCKS grow much slower than Russell 1000 GROWTH and don't appreciate in value nearly as quickly. Value stocks do well leading up to and into recessions. 

My good pal Ed Yardeni shares his work here to say: Bull market intact and valuations still reasonable 

Avg. Hedge Fund: 3.2%

We will get our research out tomorrow on ASML and LITE...they are both buys here.

Look at the rotation BACK to secular growth tech stocks!

As Wall Street loves to say "without meaningful GDP growth or inflation and no exogenous event to negatively amplify either, the way to make money in stocks is to hold the best of breed high margin IP companies that enable relatively high rates of secular growth."

And so we do. We continue to ride and massively profit from the Super 7 once a generation  technology spending “Super-cycles” 2016-2020:

The Super 7 Technology Super Cycles 2017-2020

1. Artificial Intelligence (AI)-as-a-Service that a) fuels transition to GPUs vs CPUs and b) the transition to 100G intra data center fiber optic networking: Nvidia (NVDA), AMD Micro (AMD)  Micron (servers eat DRAM) and Applied Optoelectronics (AAOI) 
2. LED to OLED Conversion: billions of digital devices and TVs from LED screens to OLED AMAT LRCX
3. NAND memory transformation from 2D to 3D: MU LRCX AMAT ACLS ASM Limited ASML (transformation to .7m lithography)
4. The Internet of Things iOT 5G Roll-out  (based on new 5G wireless roll-out starting later this year): Cavium CAVM and Corning (GLW) for fiber network upgrades
5. Apple X Super Cycle: OLED MU Lumentum (LITE) 
6. Autonomous Driving Vehicles: MobileEye (being bought by Intel): New Picks coming
7. The HyperScale Mega Cloud : ALL of these secular super cycles driving $400 Billion a YEAR in Data Super Center development (aka the Mega Cloud.Applied Optoelectronics (AAOI) --will will add more pure plays like MTSI, Lumentum (LITE) and Fibernet (FN) and Corning (GLW)  on pullbacks

Last month we added:

Axcellis/ACLS--semiconductor equipment pure play on 3D NAND BUY <$25.50 with $40 target

Advanced Opto-Electronics/AAOI--laser fiber optic play on the conversion of data centers from 25 gigabit speed to 100 gigabit speeds. They are IP and low cost leader in the lasers Buy <$90 with $125  target. AAOI pre-announced another earnings beat and shot up to $85 from our $74 entry on June 8...classic short squeeze. 

Cavium CAVM: THE semi conductor play on 5G upgrade already underway. 124% y-o-y growth with 5G upgrade cycle JUST starting...and they are big in the data Super Center super cycle upgrade to 100 gigabit speed as well. Buy under $70 with $120 target 5G Supercycle with Cavium Networks (CAVM),

More On AAOI:  New $125 Target

We invest in the strongest transformational changes in the world and the high profit margin IP leaders that empower those waves. AAOI is perfect example: On Thursday, July 13th, Applied Optoelectronics (AAOI) delivered its fourth consecutive quarterly positive earnings surprise. The company now guides for C2Q2017 revenue of $117.3 million compared to previous guidance of $106 million to $112 million, while non-GAAP EPS is now expected to be $1.31-$1.36 versus prior guidance of $1.09-$1.19. Notably, gross margin is now expected to be 45.0%-45.4%, well above previous guidance of 41.0%-42.5%.

Strong demand and solid manufacturing drove the upside surprise. Relative to manufacturing, it looks like smooth capacity expansion, strong yields, and continuing efficiency improvements, possibly aided by increasing automation, all contributed nicely. Management should be commended for its fourth straight quarter of flawless execution.

Street consensus non-GAAP EPS estimates are now the following:

C2017 Rev $463 million (up 77% yoy), EPS $4.98 (up 258% yoy)

C2018 Rev $561 million (up 21% yoy), EPS $5.56 (up 12% yoy)

C2019 Rev $646 million (up 15% yoy), EPS $6.05 (up 9% yoy)

C2020 Rev $748 million (up 16% yoy), EPS $6.37 (up 5% yoy)

Yet  the street see growth rate deceleration reflected in the current consensus --WAY excessively conservative in my view. But as I have also said before, that is opportunity.

Why is consensus so conservative? Because the closest historical fundamental comparables to the “Gold Rush” happening now in hyperscale data center optical transceiver demand all happened before in the Telco data center world on early 2000's...and it ended very badly. Slowdowns in demand coupled with supply surges crashed the markets as pricing got crushed, margins contracted, and earnings vaporized (can you say JDS Uniphase?) 

With that said, we can confidently presume that the demand side of the current hyperscale data center driven demand surge is most likely to continue to be very strong for many years. That seems to be consensus for very good reasons. Data bandwidth expansion requirements are huge, lots of massive new data centers have been announced, and “rip and replace” of existing data centers is alive and well. It turns out its cheaper to rip out old 20-40 GIG optical fiber and replace it with 100G...who knew? 

Applied Opto is the highest quality and by far lowest cost producer for the opticial lasers that move terabytes of data from server to server in these huge hyper scale data centers. Because of explosion in video and cloud based apps...Facebook and Google and Microsoft and Amazon AWS literally can't build new capacity quick enough to stay ahead of demand. 

In addition, new EU rules demand that data  must be stored in data centers located in sovereign countries . . . this is driving a new additional race to comply. 

Key Point: in  the current hyperscale data center scenario, bandwidth technology is getting ripped out at 10G, 40G speeds and all converting to  100G transfer bandwidth...they have no choice. The hyper scale bandwidth arms race means robust growth from year to year with minimal cyclical pauses.

Our Opportunity: The problem is optical stock investors have never really seen this movie before. As such, forecasts are extremely conservative and stock multiples are low until a “day of reckoning” materializes, or not.

What we do know is that consensus is very likely wrong, which is more often the case than not in volatile sectors. So as investors we have to try to get in front of the revision direction . Right now the better position at this moment in time relative to AAOI shares is to be long.

The Short Term: Look with 42% profits in the first half vs. 7.8% for the S&P 500 I do not intend to be greedy or believe that trees always grow to the sky. Each tech stock has gotten a thorough review on fundamentals and technicals. As I explain later at the end of this newsletter: to a large extent we are riding the $trillion indexing fad, and when it ends will like any fad, markets are going to get crushed just like the commodity "as a new asset class" fad did in the great recession. 

Those us old enough to remember other Wall Street fads..."portfolio insurance", dot com stocks etc. 

But that day is not today. We ARE in a game of chicken between

1. The Fed and leading Central Bank's slow an d steady tightening monetary policy toward a new lower level of what we would call "normal central bank monetary policy" to reflect the dis-inflationary weight of low inflation/disinflation from low productivity and population growth + excess energy and commodity (including food!) supply + the disinflationary effect of  the "Amazon e-commerce effect" and 
2. 60,000 people turning 65 every day in the world, and
3. prices paid disinflation of technology and e-commerce removing friction and cost from the product and distribution supply chains. 

Whatever Janet Wants, Janet Gets

I'm NOT saying this bull market is peaked, but am saying we gotta be careful and take profits when we get fully valued like with did on Impinj a few weeks ago (we top ticked it!). The historic low volatility in the market comes from having 7000 indexes trading that are comprised of only 3600 stocks (I know it sounds insane...but those are the facts). Today we have twice and many stock indexes as stocks...amazing

Key Point: RSI aka relative strength on many tech stocks is NOT washed out...<30 is washed out...we are in the 40-42 RSI range. A wash out to <30 takes the stocks to their 200-day moving averages. I want to be a BUYER of great transformational growth stocks at 200-day MVA...that is a great way to make big money in stocks. BUT you have to have the firepower and guts to do it.    

Key Point: In a healthy bull market for stocks the 50-day moving average line has been the "buy the dip" algorithm for 9 months (and really 9 years). When a index or stock  submerges below its 50 day in a bull market it needs 5-7 trading days to get back above it. IF the 20-day line dives below to 50-day too AND the stock fails to reclaim its 50-day moving average, THAT is technical failure.

This pullback was a 100-day line in the sand:  

Where does that leave us with our tech stocks? Glad you asked...lets give'em a look. After the mass profit taking in early May (which we took advantage of with another winning position in AMD and January 2018 call options) AMD is fine.

Action to Take: Buy Under $13 with $18 target. 

Ambarella: BUY a<$50. With the next version of GoPro not using AMBA now priced in, the auto/drone/video alarm, law enforcement cams etc all continue to depend on AMBA video chips. But like I said in the June newsletter, if we don't get a good quarter and guidance we are out. If you want to take a small loss against some of your profits, by all means do it. 

Applied Materials: Buy under $48 Target $60 We got the update on the OLED manufacturing equipment cycle we have definitely more room to run on the peak spend for new OLED equipment. AMAT had  a "mini-death cross" where 20-day plunges below 50-day...but it shook it off and rises above its 50-day again soon. 

Why Secular Tech Investors SHOULD Care About Inflation and Interest Rate

BOND YIELDS DROP ON LACK OF INFLATION ... June's CPI report showed no change from the previous month, reflecting the absence of inflation. Its annual gain of 1.6% was the smallest since last October. Excluding food and energy, the core CPI saw a modest monthly bounce of 0.1% (for an annual rate of 1.7%). The main reason why the core CPI is slightly higher than the headline number is the exclusion of food and energy. While food prices were flat, energy saw a June drop of -1.6% (more on that later). Given the Fed's growing concern with low inflation, those numbers are lowering market expectations for further rate hikes. As a result, bond yields are falling as bond prices rise. Chart 1 shows the 10-Year Treasury Yield dropping in Friday trading. Stock prices are rising along with bonds. Utilities, which usually rise with bond prices, are the day's strongest sector. Bank stocks, which suffer from falling yields, are the weakest.

Chart 1: click chart to view a live version

FALLING RATES ARE BOOSTING TECHNOLOGY STOCKS ... One of the lesser known intermarket relationships is the inverse link between bond yields and technology stocks' relative performance. That make some sense. Growth stocks like technology don't need a stronger economy to thrive. In fact, they do better in a slower economy which is usually associated with low interest rates. Value stocks (like banks) do better in a stronger economy with rising bond yields.

Let's take a look. The black line in Chart 2 is a relative strength ratio which divides the Technology SPDR (XLK) by the S&P 500. The green line plots the 10-Year Treasury Note yield. The two lines have tended to travel in opposite directions over the last fifteen years. The upturns in bond yields in 2003 and 2013 resulted in tech underperformance (red arrows). [The Fed's taper tantrum during 2013 pushed bond yields sharply higher and hurt tech performance]. Downturns in yields during 2008 and again in 2014 boosted tech performance (black arrows), which continued into the second half of 2016.

Chart 2: click chart to view a live version

MORE RECENT HISTORY ... Chart 3 examines the same link between bond yields and tech performance over the past year. The jump in bond yields last November (following the presidential election) caused technology stocks to underperform the rest of the market (first red arrow). The tech/SPX ratio started rising again after rates peaked near the end of 2016, and especially after they started dropping between March and June. More recently, the drop in the tech ratio during the second half of June occurred while bond yields were climbing. [

The jump in bond yields that month caused a rotation out of tech dominated growth stocks into value stocks like financials]. Following today's drop in bond yields, techs are up nearly twice as much as the S&P 500 while financials are weakening. All of which suggests that technology traders are well advised to keep a close eye on the direction of bond yields. Despite low inflation readings, longer range trends continue to favor higher global bond yields. That's especially true if foreign central bankers follow through on their talk of tapering their bond holdings or hiking rates (as the Canadians did on Wednesday). Rising global bonds could make the going tougher for technology stocks. Which is why tech traders should also be keeping a close eye on inflation trends. Any serious uptick in inflation during the second half of the year could cause profit-taking in technology stocks.

The BottomLine: We continue to kick the indexes and hedge funds asses by 8X-13X!!!

We are still up 42.1 % for the year vs. 3% for hedge funds or almost 13 times better performance. WHY ANYONE has money in anything other than an all world long/short algorithmic hedge fund (and unfortunately in this category almost ALL are closed to outside money) I will NEVER EVER understand. I SWEAR when our economic indicators tell me recession is 4-6 months away I am going to reopen my hedge fund (that I closed in 2005) and take our amazing results back to rich retail investors who have been bamboozled into shitty performance hedge funds with HUGE fees.

Also I love articles like this saying "You don't have what it takes to beat the market!"

Really? From Marketwatch

Opinion: You probably don’t have what it takes to beat the market

Indexing is best for those without access and special information!

Awarding the 2013 Nobel Prize in economic sciences jointly to Eugene Fama and Robert Shiller puzzled many. “If you’ve been wondering whether it’s possible to regularly beat the stock market averages,” wrote Steven Rattner, a Wall Street financier and commentator at the time, “you didn’t get any guidance from the Nobel Prize committee this year.”

Rattner placed Shiller in one corner, claiming that the Yale University finance professor “argues that markets are often irrational and therefore beatable.” He placed Fama, of the University of Chicago, in the opposite corner, describing him as “the father of the view that markets are efficient,” whose “followers believe that investors who try to beat the averages will inevitably fail.”

BULLSHIT...see the scorecard above. We have beaten the S&P 500 index by 525% since our start in 2013 with a 50.3% ANNUAL return (see Junes Newsletter for details). What you need to SMASH the overall market returns is simply understand the Transformity Investing Principle and buy high secular growth stocks in the 2% ish slow 21st century mature US economy.

OK...I feel better now. Other than a shooting war with North Korea, my biggest fear and issue with market is we have never had $trillions and $trillions of money locked into black boxes that manage $trillions in index funds with the S&P 500 being the largest repository of this "passive" investing strategy in financial history

Key point: The history of "hot new investment strategies" is good, great and then eventually the cycle turns and money runs for the door out. Let's not kid ourselves; indexing is screwing up a lot of things. This is not news. Equity investors and value investors in particular who focus on bottom-up, fundamental analysis have been complaining for years about how hard it is to make money. They complain about valuations being too high and out of whack with reality. They complain about how the market goes up every day. They complain about how things don’t make any sense.

It is true: except for true secular transformational sectors and their leaders (which we own) the overall stock market has entered Bizarro World, and nobody really knows why, but they suspect that this is all somehow related to indexing, which, as a strategy, has attracted like I said trillions of dollars in assets under management.

That assessment to me is basically correct. And there is precedent for all of this. If you go back 10 years to the commodities bull market of the late 2000s, you may recall that people began to believe that raw materials were an "asset class" with "entirely different characteristics than equities and fixed income"  and one that is "less correlated, providing diversification benefits to any portfolio."

Blah blah...it was a fad. And so people began to invest in commodity index swaps, swap agreements that gave exposure to a broad basket of commodity prices. Since investors typically only bet the price would go up with these agreements, the proliferation of these index swaps put upward pressure on the price of commodities. 

Turns out was was correlated was the flow of $trillions into thinly traded  commodity derivatives made commodity prices began to levitate, all at the same time, and people who had worked in the commodity markets for years suddenly could not figure out what was going on.

I had conversations with those people back then and they assured me that corn was going back to $2 and wheat was going back to $6, which were the levels that would prevail under normal supply-and-demand fundamentals rather than $7 and $9, respectively, at the time. I said, "No, you don't understand," this is the new paradigm -- macro demand for commodities is here to stay.

As you can imagine, there was as much hate and discontent about commodity index swaps back then as there is about exchange-traded funds today. There were congressional hearings and people testified that commodity index swaps facilitated hoarding of commodities by those who were not end-users, raising prices for everyone else. Such speculation should not be allowed in commodities markets, they argued.

In the end, a bear market did what the government couldn't. Commodities topped out in March of 2008 and plunged almost 60 percent in a matter of a few months based on the Goldman Sachs Commodity Index as the inflows into commodity index swaps became outflows. Commodities prices never recovered, and remain at a fraction of their previous levels.

Many have questioned the wisdom of treating commodities as an asset class. After all, wheat is different from gold, which is different from oil. Well, what about equities? Are equities an asset class?

That may seem a silly question to ask. Equities have been considered an asset class for decades, and index funds have been around for a lot longer than commodity index swaps. But hear me out.

ExxonMobil Corp. is different from Google's parent, Alphabet Inc., which is different from Wal-Mart Stores Inc. These businesses have nothing to do with one another, except that they are all C corps, and that their shares are publicly traded on an exchange. But you can't find three more different businesses. So why buy them all at the same time, through an index?

The answer is that they are all U.S. companies and are all affected by the same macro factors, such as politics or the U.S. economy, but you could have made similar statements about the commodity markets. The idea of commodity indexing has been mostly discredited, but it's interesting that only commodity indexing was discredited, not all indexing.

A lot has been written about the distortions caused by purchasing a basket of stocks indiscriminately. In the old days, if you bought an S&P 500 Index fund you could say that you were diversified. But can the same be said now when so many people are buying the same fund? Active managers have been praying for an unwind of the index fund trade, but if what happened in commodities is any guide, it would probably mean a hurricane-force bear market.

All financial fads come and go. I started in bond based financial products in the early 80's and then real estate tax shelters and watched on Black Monday as all the "portfolio insurance" contracts sold tanked the NYSE 27% in a day. As we saw with commodity indexes, flows can go out as well as in. The idea of large-scale redemptions seems too terrible to contemplate, but it WILL happen to huge index funds when aging Baby Boomers see real volatility again and say "Fuck it--I'm taking my profits and going home." 

That day may be sooner than most think IF the Fed stops being so dovish (Janet Yellen replacement?) and raises short term interest rates while long term rates come down with low inflation, excess capacity, bubbles in residential real estate, cryptocurrencies, home flipping, modern art, and cult stocks like Tesla and others. 

There is a reason fads come and go in the capital markets. Someone devises a strategy, the strategy works, promoters promote the strategy, the strategy gets large enough to cause distortions -- then the strategy unwinds, and people spend the next few decades reflecting on how dumb it was while looking for the next fad. Is indexing simply a fad? I don’t know the answer, and time will tell. Certainly it is large enough to cause distortions now, and history shows that the exit is always much smaller than the entrance.

On that cheery note...

Have a great week!

- Toby

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