July 27, 2016 - 3:01pm EST by
2016 2017
Price: 120.67 EPS 0 0
Shares Out. (in M): 10,000 P/E 0 0
Market Cap (in $M): 10,000 P/FCF 0 0
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT 0 0
Borrow Cost: General Collateral

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I suggest shorting IWM. The thesis is quite simple. The Russell 2000 (RTY) trades at 40 times earnings and 4.2 times tangible book value. Basically it is priced for perfection in a dangerous world.

First, you might see a PE of around 20 being advertised for the RTY. Well that is because they exclude the companies that lose money. I think that’s crazy, but it isn’t the first time I see crazy stuff being sold as common sense on Wall Street. The real PE ratio is around 40 if you include all companies that are a part of RTY.

So what does 40 times earnings mean? It means that if I want a 10% return going forward, I need the earnings of RTY to grow by about 7.5% a year to perpetuity. Or calculated differently for the same 10% return it requires the RTY earnings to compound at 10.25% for the next 25 years with a 2% perpetuity growth rate. That all might not sound like a lot, but it is … especially for a group of 2000 companies. Since profits are a part of GDP and since it is hard to see how US GDP will exceed a long-term 1.5% to 2.5% growth rate it is difficult to see how the RTY companies collectively will outpace the economy by more than 3 times over a long period of time. Also it is hard to see how corporate profit margins can become a much larger part of GDP as they are already maxed out too.

A similar exercise can be done for tangible book value. Despite our belief in great managements and honest accounting, it is especially in this segment that we find the crooks and a lot of that goodwill should be written off. I am not saying that one should never pay 4.2 times tangible book for something. There is a theoretical case to be made that some, very few, companies have such high ROIC and growth that they are worth that much. But it is hard to see how the group of companies assembled in the RTY will have those characteristics.

So we have an asset that is priced to perfection in a dangerous world. I have no clue what will happen next, but I do perceive a number of dangers out there:

-          A potential recession in the US. The chance of a recession goes up exponentially every year we get further away from the last recession. Well the last recession ended 7 years ago. Since the Great Depression we have only had three times where the period between recessions has been longer than 7 years. I know economists have predicted 7 out of the last 3 recession, but it is highly likely that we will hit a recession in the not too distant future. Btw. The longest period with no recession in the US was 10 years.

-          China clearly is a troubled spot. It just doesn’t have the necessary labor availability anymore to drive growth as it did in prior years and it needs to transition towards consumer demand which isn’t working. The Chinese government has avoided a recession by massive credit expansion on a historic scale. Also we have seen massive capital flight (over $1 trillion last year) and this situation just cannot last. In short the Chinese people themselves are telling us things are bad through their capital flight. The developed world is not very exposed to the Chinese credit bubble, but our economies are exposed to a large degree to a Chinese economic calamity.

-          Europe and the Eurozone are not out of the woods.

o    2015 was a tipping point year for the working age population of Europe. It is hard to grow GDP over time when you have a declining working age population. Mix that lack of working age population with high unemployment, generous welfare systems and high Debt to GDP ratios and you have a tough challenge. A new recession in Europe could create serious budgetary and political problems.

o    In addition Europe has to worry about migration in a huge way. On its southern border in North and Continental Africa we are moving towards a group of failed states. Another year of migrant flows and terrorism as we saw last year and we might see Marie Le Pen run France next year.

o    In short, it is not hard to see new political and economic crisis reappear around the Euro or the European Union.

I have just listed a number of potential sources of trouble, but it could easily be something else that comes out of nowhere and surprises us all. What I do know over the years is that the way to the top is not a straight line and that hiccups happen in our system. So personally in this pricey environment with all the macroeconomic imbalances I think it makes sense to have some form of hedge. I think the IWM is an excellent candidate for this.

If you want an example of how vulnerable the IWM is, just look back at the end of last year when the IWM took a 20% dive because of fears over China. Justified fears that only ended when Chinese authorities doubled down on credit expansion. Just image where the IWM would have traded if China would have hit a real recession. At this valuation IWM is very vulnerable.


Lastly you can short the IWM outright without much problem, but there are also plenty of put options available. The puts are not really cheap, but I wouldn’t consider them expensive either. Currently one can buy puts at an implied vol of around 20%. I’d think they become attractive in the mid-teens, but I can live with something in the 20% range.

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.


No direct catalyst, but being priced to perfection IWM is vulnerable to any form of trouble out there.

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