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    Monday
    Mar262018

    The Greatest Trade Ever and the Money Bubble

    Two trends compete today: a bubble of money powering everything and the overvaluation of nearly everything.

    Consider this: after World War II, the U.S. invested – in today’s dollars – about $100 billion to re-build Europe. After 2008, the U.S. “invested” – as a start – $700 billion to save our own country. For several years, we added another $100 billion each month. We held interest rates to near zero. We cut taxes and the cost of repatriating foreign earnings. We have pumped so many trillions into the economy that I can find no reliable number for it, though you can see its effect in the accelerating growth of the national debt and the price of financial assets.

    Enjoy the ride, but prepare for a torpedo.

    While happy with the performance, I have been searching for insurance. Oddly, it is hard to discover a true hedging strategy that could offset a large portfolio loss. In the last year, I have asked hedge fund managers and wealth managers about their hedging strategies. Most of them say, “We think buying good companies and diversifying is the best protection.” If you remember 2008-9, virtually every asset class got destroyed. When the torpedo hits, all boats sink. I did, however, come across one story, which I have come to think of as …

    The Greatest Trade Ever

    Over breakfast, a friend described his best trade ever. Here, at last, was a hedge I could love.

    My friend felt that the market would drop in 1987, so he bought short-term puts on the S&P 500. Whenever I have bought options, I have trusted my reasoning, but thought that I could not predict the date at which the market would come to agree with me. My predictions are usually early, so I have purchased options a year out, which have sometimes provided excellent returns, but not enough to offset the loss incurred on an entire long portfolio. My friend, though, bought two-month puts while the market was going up.

    If you watched the movie, The Big Short, you remember the bankers selling short positions to the fools asking to buy them. When the market is accelerating upward, betting against it is cheap, and betting against it short term is even cheaper. That cheapness created the Greatest Trade Ever.

    In August, 1987 my friend bought $1500 in two-month S&P 500 Puts, and they expired worthless. In September, he bought another $1000. He believed the market would drop in October, but, knowing the perversity of the market, it would drop in the second half of the month – after his puts expired, so he bought the November puts. Having studied the intra-day drop of historically bad days, he expected a 42% swing when the bottom dropped out. When a knife falls, no one wants to catch it.

    I remember October 19, 1987. My company, Clancy-Paul Computers, was prepared to go public. It was my first wedding anniversary, and we were at the Victoria Jungfrau in Switzerland as guests of NEC, the monitor maker. I was literally and figuratively on a mountain top when the news arrived that the market had dropped 500 points from 2500. The public offering would be off the table.

    Meanwhile, the Greatest Trade Ever unfolded as planned. That day, my friend watched for the point of maximum distress and closed out his puts with an 800x return. That is, his $1000 investment had yielded $800,000.

    The Greatest Trade 2018 and my hedge today

    I applied my friend’s idea recently by buying February 2018 puts in December. When the S&P sank on Monday, February 5, that position was up 3715% for the day. To be fair, the puts had already declined because the expiration date was nearing and the S&P had continued to increase. Still, the position was up 700% over the purchase price. While that portfolio took hits like NVDA dropping $20 a share, the overall portfolio was up for the day. It was a gratifying.

    Mainly, the hedge kept me from selling long positions. One friend asked if I was going to sell the puts. No, because I could not tell what would happen the next day. If the market continued to melt down, the puts would have protected me. The market came back, and those puts expired worthless. When the market powered up, I bought more puts because the only time to buy is when everyone else thinks you’re crazy. You would like to buy puts when the market is crashing, but, by then, it’s too late: in a panic, put prices rocket.

    The ability to keep the long positions without fear is not incidental. I know people who locked in their losses that day by selling into the panic.

    I had resolved to cover the year with six two-month puts, but I now intend to hold overlapping positions. If I had had overlapped puts in February, I would have sold the older one and pocketed enough to pay for the puts for the entire year. This hedge allows me to sleep. Given the uncertainty, I am happy to lose a little every month with the knowledge that, if there is a panic, I will not be a part of it.

    Are companies really over-valued? Splunk revisited

    At the beginning of 2018, there was much talk about the fear of missing out on the market “melt up” – that buying panic that pushes up every price. This is particularly true of tech companies with growing sales and big ideas. Though the companies may lose money hand over fist, investors seem to think that they will all become the next Amazon or Facebook: that is, tech companies will grow fast and profitlessly for many years until they dominate their space and become wildly profitable. Not every tech company will work out this way.

    My favorite example of this trend is Splunk, which I included in the Puts of Death column last year. Splunk is my favorite because, instead of buying puts, I mistakenly bought calls and made 250%, while my other Puts of Death expired worthless. As I said, my predictions are often early. (Also, I am often wrong; fortunately, the ten-baggers more than make up for the losses.)

    Last year, Splunk, saw its sales expand from $668 million to $950 million and its loss expand from $288 million to a loss of $344 million. This is not an aberration: Splunk has lost money for the last five years. The trend is in the right direction, though. Investors were overjoyed that Splunk only lost $50 million last quarter, and only $200 million in the last four quarters.

    How much would you pay for the privilege of owning a company with a billion dollars in sales and a loss of $200 million? $1 billion? $5 billion? If you said, “$14 billion,” – the enterprise value today – you would be right. That seems extreme to me, but let’s consider the opportunity.

    Splunk promotes Big Data technology – as in, “Organizations with big data are over 70 percent more likely than other organizations to have BI projects that are driven primarily by the business community.” BI is Business Intelligence, which is good, right?

    I have asked programmers about Splunk, and some have said, “I don’t know why anybody would pay for that.” Here is a positive Infoworld article that explains that “Splunk's continued relevance may come down to both product completeness and industry inertia,” which is thin support for a valuation of 14 times sales in a loss-making company.

    Splunk may have a future, but it’s no Amazon, and it’s expensive even as an acquisition candidate. Compared to a Perfect Company liked Nvidia, Splunk is a dog. When we bought Nvidia, it was profitable, paid a dividend, was being bought by insiders, and had an interesting opportunity in artificial intelligence. NVDA was a good value; Splunk is pure speculation, and there are many companies that have been bid up on hope and a mountain of cash.

    Here are some questions people ask lately:

    Should I buy Facebook?

    Disasters often go from bad to worse, and I think the abuse of personal data could be a real problem for Facebook and others. If it were public, I would invest in DuckDuckGo, a search engine that protects user data, and from where we have seen increased traffic at dotphoto. Besides, FB has 2 billion users and is unlikely to change your life by becoming a ten-bagger. If FB merely doubled, it would become the most valuable company in history.

    Should I sell Nvidia?

    I have consistently said that NVDA is one of the few companies that really is changing the world. NVDA announces a new technology or relationship virtually every quarter. Quarterly profits have move than doubled in the last year. I sold IBM to buy NVDA; at the time, NVDA had a fraction of IBM’s market cap. Today, NVDA is worth slightly more than IBM. Still, the great theme of our lifetime may well be machine intelligence, and NVDA is a very real presence in that effort.

    Should I buy Bitcoin?

    Bitcoin is pure speculation. Countries will shut it down when it threatens their currencies, and we have seen some of that. Banks will fabricate their own currencies when they are threatened, and we are seeing that, too. The value of Bitcoin and perhaps the whole cryptocurrency market is as a measure of the money bubble. When the cryptocurrency market declines, it will be one indication that the money bubble is deflating.

    The time to sell is when people are buying.

    We are beginning to see a wave of public offerings: DropBox, ConvergeOne, Aramco, and others. If you own a company, now is the time to sell it or accept investment. There is a dearth of investable companies: as of December 31, the Wilshire 5000 had only 3,492 companies. There are more funds than actual companies – how weird is that? Do we really need so many funds to buy so few companies?

    This will create some interesting opportunities and some dogs. Aramco will be the biggest offering in history – just in time for oil to become even less important. I don’t think Aramco will make anyone but the Saudis rich.

    On the other hand, I would love to buy into Afiniti, an AI-company launched by the founder of Align Technologies that has the most awesome roster of board members and employees I’ve ever seen. I’m told they will go public this year. Check this out:  https://www.afiniti.com/meet-the-team/

    What can go wrong?

    Goldman Sachs warns of inflation. Interest rates will go up. China, China, China. The president’s next Tweet. I’m glad to have protection on the downside.

    On the other hand, there is a giant money bubble chasing interesting new ideas. Some of them could be a good value. I’ll be looking for them.

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