Q2 Update for Cactus Capital

After a 6.5% gain in Q1, my account had a time-weighted rate of return of negative 21.2% in Q2, leaving it down 16.1% on the year at quarter’s end. That compares with a 31.6% gain for the Nasdaq and a 16.9% gain for the S&P 500.

My cumulative rate of return since the start of 2021 (when I began trading stocks, after previously having been unable to due to job-related restrictions) stood at 239.2% as of the end of Q2. That compares with a 7.1% gain for the Nasdaq and a 23.2% gain for the S&P 500.

What Went Wrong in May and June

Success is a menace. It fools smart people into thinking they can’t lose.

That line was uttered by Bill Gates’ character in a made-for-TV movie about the PC industry’s early days called Pirates of Silicon Valley, after he was asked by Steve Ballmer why IBM (then near the apex of its IT dominance) was about to let a then-small company like Microsoft control the OS its soon-to-launch PCs would run on. IBM had a playbook that worked very, very well for decades, and since selling operating systems a la carte wasn’t part of it, they couldn’t see what harm would come from letting Microsoft do it, as long as IBM was selling much of the hardware that the OS ran on.

Gates’ comment has popped up in my head a bit recently as — following a monster 2022 in which my returns were far beyond anything I expected at the start of the year — what had been a choppy first half for my account turned into a downright ugly one towards the end of Q2.

Since the fall of 2021, I had a playbook — underpinned by beliefs that inflation (labor/services inflation especially) would remain elevated relative to the Fed’s 2% target, that the economy wouldn’t easily roll over into a large/deflationary recession, and that we’d seen a speculative mania in select risk assets that would eventually lead to a washout similar to what happened from 2000–2002 — that had worked very well heading into 2023. Generally, this playbook involved:

1. Aggressively shorting high-multiple growth stocks that had been madly bid higher in 2020/2021, as well as speculative/highly unprofitable firms that weren’t certain to ever make money.
2. Going long moderately-priced growth stocks (often chip and Internet stocks, but occasionally others) that had sold off on recession fears, along with cheap/overlooked small-caps that had lagged as money flows heavily tilted towards larger companies.
3. Increasing net long exposure following selloffs that had meaningfully lowered valuations and led sentiment to become pretty bearish, and vice versa.

I felt that unless inflation looked poised to fall to near 2% and stay there, we got a big deflationary recession, and/or the froth was truly washed out of financial markets the way it was by mid-2002, there was no need to change up that playbook. And since none of those things have happened — one can perhaps make a case that much of the froth was gone from the tech sector by the end of 2022, but that didn’t last long — I felt comfortable staying the course as 2023 began to unfold.

In spite of violent short-squeezes in late-January/early-February and late-March, I was doing alright by late April, and there were a couple of days in early May when I was outperforming the Nasdaq for the year. But things went downhill after that. And as they did, I was too quick to add short exposure and trim long exposure amid a spike in bullish sentiment and equity call-buying, thinking it wouldn’t be long before frothy assets sold off hard again. Instead, they kept ballooning higher, with 2021-like speculative euphoria making a comeback and (with an assist from both retail call-buyers and institutional traders that smelled blood) short-squeezes in some names begetting additional short-squeezes.

When I look back at what market variables I overlooked or underestimated, a few things stand out:

1. As many others have pointed out, tech positioning among institutional investors was pretty bearish going into the year. This clearly led a lot of these investors to chase popular tech stocks higher as they became more optimistic about various things, and it also helped drive the aforementioned short-squeezes.
2. While I was bearish on high-multiple/long-duration stocks on a “higher for longer” thesis, many others were bearish on these names (and often, many other stocks as well) on a doomer/recession thesis. Thus when the latter thesis failed to play out, a lot of bears became more bullish.
3. Many growth-stock investors (weaned on decades of low inflation and a mostly-friendly Fed) badly want to believe inflation is no longer a problem, just as they badly wanted to believe inflation was transitory in 2021. And since inflation has been cooling on an annual basis thanks to lower energy/commodity prices and supply-chain improvements, they’re convinced for now that inflation is finished (never mind all the wage, services and consumer goods inflation data suggesting otherwise).
4. In spite of rate hikes/QT, there’s still a lot of liquidity sloshing around, and the Fed’s response to the March bank “crisis” added a little more to the pool.
5. With much of the job market still healthy and consumer savings/asset levels still elevated, it didn’t take long for many retail investors to shake off last year’s losses and regain their animal spirits.
6. ChatGPT’s arrival unleashed a tsunami of speculative euphoria around AI. Though I was far from oblivious about what’s now called generative AI — as early as mid-2022, I noticed services such as Dall-E and Github Copilot were handling more complex/creative human activities than what older AI/ML-powered services typically handled — I didn’t think we’d see investors lose their minds over a tech trend so soon after many of them had been burned doing so over things like electric cars, fuel cells, cryptos and “the metaverse.” Social media has clearly been a factor here.

Also, my focus on the froth that remained in markets (and the selloff that I expected it to drive) kept me from betting as much on legit and moderately-priced beneficiaries of AI-related spending (e.g. chip and hardware suppliers, public cloud providers) as I should have, though I did have a few winners here. In addition, this focus kept me from investing as much as I should have in large-caps that had been pressured by recession fears (and sometimes other things) and which had levers to pull to drive margin/EPS expansion.

Hindsight is 20/20, but I think (after a year in which betting on frothy assets coming back to earth paid off very well) my frustration over how parts of the tech sector hadn’t stopped acting irrationally kept me from being sufficiently bullish about those parts of the sector where there were reasons for rational optimism.

Search activity for “AI stocks” soared this year, while searches for “recession” and “inflation” have fallen.

Positions as of the End of Q2

Longs: Activision Blizzard (ATVI), Cellebrite (CLBT), Alphabet (GOOGL), Interactive Brokers (IBKR), Intellicheck (IDN), Indie Semiconductor (INDI), inTest (INTT), Iteris (ITI), Microchip (MCHP), MercadoLibre (MELI), Perion (PERI), STMicroelectronics (STM), Direxion Daily 20+ Year Treasury Bear 3X Shares ETF (TMV), United States Natural Gas Fund (UNG), United States Oil ETF (USO), Valens Semiconductor (VLN)

Shorts: Archer Aviation (ACHR), Affirm (AFRM), C3.ai (AI), Aurora Innovation (AUR), Ballard Power (BLDP), Confluent (CFLT), Coinbase (COIN), Carvana (CVNA), Envoix (ENVX), FuelCell Energy (FCEL), FuboTV (FUBO), Gitlab (GTLB), HubSpot (HUBS), IONQ (IONQ), Samsara (IOT), Joby Aviation (JOBY), Lucid (LCID), Lightwave Logic (LWLG), MongoDB (MDB), MicroStrategy (MSTR), Cloudflare (NET), Sunnova (NOVA), Palantir (PLTR), Plug Power (PLUG), Quantumscape (QS), Riot Platforms (RIOT), Rivian (RIVN), SES AI (SES), Shopify (SHOP), Snowflake (SNOW), Virgin Galactic (SPCE), Sprout Social (SPT), ProShares UltraPro QQQ (TQQQ), Tesla (TSLA), Trade Desk (TTD), Vuzix (VUZI)

I was about 20/80 long/short as of the end of Q2, with gross exposure around 155%. Both short and gross exposure are higher than what I’d normally like, in no small part due to squeezes in some short positions. That said, I think we’ve reached an extreme moment both for investor sentiment and many growth-stock valuations, particularly given the inflation/Fed/yield backdrop, and I don’t want to meaningfully reduce short exposure until things look less extreme.

Thoughts on Portfolio Positions

1. I firmly think most of the speculative, cash-burning names that have squeezed higher (think companies such as Carvana, Lightwave Logic, Aurora Innovation, Lucid, Wayfair or the crypto, flying taxi and development-stage battery tech plays) will be more than 50% below current levels 12 months from now, and that some of them will be out of business within a couple of years. Shorting such names has been painful in recent months, but spreading out my bets and taking some other measures to manage risk has prevented a total blow-up.
2. Strictly from a business standpoint, Palantir and to a lesser extent C3.ai don’t deserve to be in the prior category. But given that both companies have been madly chased higher thanks to how they’ve pandered to AI hype among retail investors even as consensus sales estimates for their current fiscal years have fallen over the last six months, on another level I think they do.
3. For shorts in non-speculative growth companies (e.g. various SaaS companies, Tesla, The Trade Desk), my thesis has been that valuations are much too high given both mixed near-term business trends and the impact of higher rates on the discounted value of expected FCF/share several years or more into the future (when the lion’s share of the cash flows that investors are paying for are expected to arrive). This impact, it’s worth noting, is especially large for SaaS companies that are diluting their shareholders by 4%-6% annually via stock comp. With the 10-year yield now around 4%, valuations really look stretched for many long-duration growth-investor favorites. That said, if we get a major pullback, I’ll likely trim/exit some positions, given that demand in various markets is now looking a little better than it was expected to be a few months ago, while leaving the door open to re-upping them if these stocks rally strongly again.
4. Among chip stocks, I still like inexpensive analog suppliers with good exposure to auto/industrial secular growth trends, such as STMicro and Microchip, though (with some of these stocks up a lot this year and auto supply and demand now coming into balance) I’m a little worried about the near-term impact of auto semi inventory corrections. I also think TSMC (trades for 16x a 2024 EPS consensus that looks beatable given the AI-related demand boost it’s beginning to see) is still reasonably valued. And there are some other chip and hardware names with meaningful exposure to AI capex that I could enter or re-enter if markets pull back (among them: Broadcom, Fabrinet, Super Micro, AMD, Wiwynn, Alphawave).
5. Other tech stocks I like right now include large-cap Internet stocks with moderate valuations, strong moats and good margin/FCF growth stories (e.g. Alphabet, MercadoLibre, to some extent Booking) and assorted small-caps that trade at major sales and/or EPS discounts to larger peers with comparable margin/growth profiles (e.g. Cellebrite, Indie Semiconductor, Iteris, Perion).
6. Though I don’t dabble in M&A arbitrage plays very often, I took a position in Activision Blizzard. Based on what I’ve read about U.S. and U.K. antitrust proceedings, I think there’s a meaningful chance the Microsoft deal closes. And if it doesn’t, I think Activision’s current valuation and a $3 billion breakup fee limits its downside, particularly with the gaming market strengthening recently and Diablo IV off to a good start.
7. I thought it was worth adding a bit of exposure to energy/commodities and financials. Institutional positioning in these areas looks as bearish as it did for tech at the start of the year, even though energy/commodity prices have already fallen sharply, the economy has held up much better than what many feared, and valuations are often pretty low. All of that arguably spells a decent risk/reward. That said, since these aren’t sectors that I’m deeply familiar with, I plan to have just a moderate amount of exposure to them.

How I’m Looking at Things as Q3 Kicks Off

I think the odds of a sharp pullback that hits the frothiest and most aggressively chased/squeezed risk assets especially hard are high over the next few weeks, given how stretched sentiment and valuations have often become and how recent gains have come amid a spike in Treasury yields that has led the equity risk premium for U.S. stocks at-large to hit a 16-year low (and for high-multiple growth stocks, it appears to be at the lowest level since the Dot-com bubble). There have been some signs of momentum stalling over the last week, and if/when momentum firmly breaks to the downside, a lot of recent chasers and speculators could rush for the exits.

Provided we do get that kind of pullback, however, I think there could be cross-currents for a while. Though it’s easy to see a lot of long-duration and debt-laden tech companies lagging, the second-half outlook could be better for some cheaper parts of the tech sector and the market at-large.

On one hand, I think (on a month-to-month basis) inflation is poised to tick higher again in the back half of the year, given factors such as tight labor markets that are driving strong wage growth; wealth effects and easing financial conditions; greater consumer and corporate optimism; a ton of AI, manufacturing and infrastructure spending; a resilient single-family housing market; stabilizing energy/commodity prices (with risks arguably skewed to the upside); and — after so much fiscal and monetary stimulus — the way many consumers and businesses have become conditioned to accepting price hikes. The only major counterweights I see to all of this are lower car prices and, in some regions, apartment rents.

As Paul Tudor Jones said, inflation is like toothpaste: Once it’s out, it’s hard to get it back in. At least not without a recession that takes a serious toll on employment and consumer spending, which doesn’t seem to be on the horizon for now.

Sustained inflation of course likely spells more rate hikes. And perhaps more importantly, it likely spells even higher yields for longer-dated Treasuries, given that the yield curve (though steepening at bit lately) is still pretty inverted and has been pricing in a quick return to pre-COVID inflation levels. The way things are trending, it really wouldn’t surprise me if the 10-year yield crossed 4.5%, and that would almost certainly weigh on equity valuations — particularly for firms with high valuations, a lack of significant near-term profits (at least after backing out stock comp) and/or high debt loads.

On the other hand, there are still parts of the tech sector where moderate valuations can be found (for example, select chip and Internet stocks, as well as various small-caps), and I think earnings season is poised to be reasonably good for the sector.

While there’s lingering weakness in areas such as PCs, smartphones and on-prem IT hardware, companies both inside and outside of tech are tripping over each other to spend on AI-related R&D, capex and cloud service (though for now, the list of firms getting a major top-line boost from this is probably narrower than what many recent chasers believe). Also, a lot of chip inventory corrections are now winding down, and with macro optimism acting as a tailwind, recent data points to better demand in areas such as autos, e-commerce and digital ads, all of which present secular growth stories for various tech companies.

What’s more, while some tech stocks have seen a lot of chasing, positioning for equities at-large still isn’t that stretched, and valuations remain subdued for stocks in many recession-sensitive cyclical sectors (energy/commodities, financials, consumer discretionary, etc.). Those kinds of stocks could easily get a boost from rotational flows if the economy stays resilient in the face of higher rates.

Looking farther out, it’s possible higher rates really start causing a lot of stress for parts of the economy (real estate, debt markets, etc.) and weighing heavily on consumer and corporate spending, which would pave the way for a full-blown recession. And it’s also possible Jerome Powell eventually responds to sticky inflation by channeling his inner Paul Volcker, in which case the smart move might be to fade risk assets in general until it looks like inflation is truly crushed and the Fed is poised to cut rates. But for now, I think it’s too early to make either of those calls, let alone trade on them.

None of this should be taken as investment advice (it’s simply meant to be a recounting of how I’ve been trading and am looking at things). And please do your own research before taking a position in any company or asset I discuss. Thanks for reading.