Cycles Matter: Shorting Semiconductors
Featuring David Levine
Published on: May 28th, 2019 • Duration: 22 minutesDavid Levine, founder of Odin River, returns to Real Vision to express his bearish view on semiconductors. In this interview with Justine Underhill, Levine discusses his broader outlook for the market, drills down on the group’s relationship with global growth, and notes how much downside he expects for one particular stock: Micron Technology. Filmed on May 23, 2019.
JUSTINE UNDERHILL: Welcome to Real Vision's Trade Ideas. Today we're sitting down with David Levine of Odin River. Great to have you here.
DAVID LEVINE: Thanks for having me.
JUSTINE UNDERHILL: So you're known a little bit as a paranoid bull. Given that we've had a recent pop in the markets, what do you see going on? Is that going to last?
DAVID LEVINE: Well, thanks for having me back. You know, the first time that I was on was actually about a year ago, and we talked a little bit about political risk in Italy. And then I made kind of not a great call on German bunds, although the fundamentals of the political risk environment that underscored both of those ideas is still very relevant today.
So I think that what we've seen is that 2018 was a fairly rational market. 90% of asset classes were down. Q4 2018 was the worst quarter since prior to the dot-com bust for the largest pension fund in the world, which is GPIF in Japan. US equities people probably know we're pretty bad in December.
But then from January through, kind of, let's call it just the last few weeks, we experienced what's called a bear market bounce, or a return of the bull market, and that's a debate. From my vantage point, I think that what we saw was really more of a bear market bounce, and that the reason for that is the central banks, between Powell, Draghi, in Japan the BoJ, in addition to the monetary authorities in China, acted pretty aggressively to hope, you know, and to succeed in getting markets to balance. That was also then kind of coupled with positioning where people had done very poorly in Q4. And so once they started having good performance in January, people are focused on monthly returns, they thought, oh, this is going very well, let's keep doing more of the same thing, and so momentum kicked in.
However, if you look back to where the markets are today, which is roughly where they were at the beginning of the year last year in January of 2018, and where they were in September of 2018, one thing that is clear is that the fundamentals are actually way worse. And the main risk, or a systemic risk in the system, which is political risk, is also way worse. As of a few weeks ago, people thought maybe that President Donald J. Trump would save the entire world with a trade deal with China. Clearly, probably not going to be the case in the immediate term, even though a few weeks ago somehow we all had belief that President Trump through tweeting would save the entire financial system, which is kind of an absurd idea if you think about it.
However, when you look at fundamentals in markets from automotive, which are down 10% year-over-year for the last few months in China, PCs have declined, smartphones have declined, and because of that, industries like semiconductors have declined massively in the first quarter of this year. Also, S&P 500 earnings were negative year-over-year in the first quarter of this year. So fundamentals, now, are worse than the last time markets were at these levels.
So my own view, yes, I am a paranoid bull. I've got a Twitter account called Paranoid Bull on Twitter. But I am a long term optimist, Odin River's about that. But in the near run, I'm very concerned about equity markets across the board. So I think the S&P 500, the NASDAQ, and the US equity markets have quite a bit of downside more today than they did in the fall. And within that, certain sectors where fundamentals have gotten extremely bad, like automotive and semiconductors, I think there's also more downside than there was last time markets were at these levels.
JUSTINE UNDERHILL: So do you see this as something that's simply short term, or do you see this as a long term, secular, bear market that we're going into?
DAVID LEVINE: So there's this phrase that I use on Twitter, which is, cycles matter. And the reason why I say that is, the philosophy of Odin River's really two things, progress is inevitable. So in a secular basis, I'm actually very optimistic. However, cycles matter. And what I mean by that is the credit cycle and the business cycle, and now, unfortunately, a systemic risk cycle, is more important in the short run for prices.
So the short answer is, a short run move, meaning a month, or a week, or a day, it's a very hard thing to predict. Although most of the investment business now has been transformed to focus on that, which is a little absurd. It also helps to explain why we get moves like we do lately. So I'd say that I believe that 2018 was the beginning of a normalization that will take time, resulting from 10 years of systemic risk mispricing and the biggest credit bubble that we've ever seen in history by almost any other, sorry, by almost any measure, whether it is total debt-to-GDP, whether it is total debt in the system. Yes, US households are in better shape. but the corporate sector, specifically, in addition to governments, which is the most important risk, in my opinion, in the system, have had more debt issued than ever before in history.
In addition, the prices of asset classes from equities on any kind of adjusted basis, whether Shiller PE, or when you look at revenue multiples which adjust for peak margins, have also become very high. And even if we look at and if we ignore that margins are at peak and we look at current earnings multiples, the multiples are still now back to higher than they were in September, which is one of the reasons why I think there's more downside today.
So the short answer is, I am a secular optimist, but I do think there's more downside, more than just a week or two. This isn't kind of a short term thing. This is a continuation of what began last year. It seems that we need to, in my opinion, have a proper bear market. We need to have credit default pickup, we need to have bankruptcies, and likely systemic risk could emerge potentially, most likely, in Europe. But it could emerge in other places.
Now, how will that materialize in prices? Unfortunately, it's hard to know exactly where things break. Again, I think Europe is most likely. I was clearly wrong about bunds. We'll see about over the long run whether that changes. Italy, again, I still think is the most likely country within Europe where systemic risk can emerge in prices.
However, it doesn't necessarily matter for markets, exactly, how it emerges. Meaning, fundamentals are already bad, and so company's earnings are declining. The fact that prices might fall in equity markets and credit markets might have defaults whether or not systemic risk pricing shows up in government debt has already become very clear.
So as we enter a more volatile period where equities are down, where credit markets are correcting, in that environment it seems more likely that systemic risk will emerge in things like government debt, where volatility will emerge in things like the treasury market. And if that starts to happen, the banking system is way more exposed to government debt today than they were exposed to the subprime mortgages through CDOs last crisis, because government debt, because of the myth of the infallible central bank, has actually held on every bank's balance sheet. In Europe, you don't even have to use risk weightings for government debt on your balance sheet.
And so I think that the short answer is, systemic risk has been mispriced for 10 years, political risk and government debt's the most obvious example of that, and we see systemic risk actually already evident in the fact that our society is being ripped apart, for instance, by populism. How it will materialize, we'll see. We'll see. But for our purposes, and fortunately today in the financial markets, fundamentals are bad, multiples are high, earnings are rolling over, and so therefore we can hedge against systemic risk just by shorting companies that are overvalued. Which is ultimately what investing is about, in my opinion, is value investing.
JUSTINE UNDERHILL: All right, so let's follow up on semiconductors, specifically. When we reached out to get you onto this program, you were looking to short semiconductors. And that, so far, has played out quite well. They're down since then. But given that drop off, would you still consider shorting them now?
DAVID LEVINE: Yes. And so the reason is, again, if we look at the broader market as an example, what happened was that, as of last September, semiconductors are roughly today where they were last September. Now, they had, when you contacted me a few weeks ago, had gone past the peak of where they were last September.
What's very interesting about semiconductors as opposed to the rest of the market is that earnings have actually gotten worse in semiconductors than many other sectors since then. Q1 in 2019 had one of the worst performances of semiconductor earnings in history. March, sequentially, from February to March, had the worst sequential performance of semiconductor sales in history. So we actually have, in the most recent data, some of the worst earnings performance that's ever happened in semiconductors, yet the stocks went way up. Why is that? Why is that?
Well, the reason, is there's a narrative. There's a couple of narratives. There always needs to be a myth or some kind of mistaken assumption for prices to go up. And semiconductors, it's kind of a combination of really two things. The first is, the back half magic. Don't worry, even though Q1 earnings are bad, Q2 earnings are actually forecasted to be worse. Gross margins are being compressed across almost every company in semiconductors at a point that's quite bad.
On earnings calls and also in kind of the market sentiment, there's been this hope, don't worry, the second half of the year is going to be OK. Now, at least as of a few weeks ago, some of that assumed that there'd be some trade deal with China or something. That don't worry about the second half of the year, everything will be OK. It's actually true for S&P 500 earnings too. If you look at Q4 earnings, there's forecasted resumption and growth.
But within semiconductors, there's been a hope that the second half will be better. I do not think that's true. And the reason is, that 2018 was a peak of semiconductor earnings that has been way higher than previous peaks. Margins have been higher than previous peaks. Part of that is because in 2015 and 2016, when the cycle tried to turn, central banks did not let it. And so we kind of got a very big up cycle in semiconductors. Therefore, I think it will take quite some time for earnings to recover.
So the short term run up was partially based on the overall market. Semiconductors have a high beta, so people were allocating to that partially because of a belief in the back half rally.
There's a third thing which is, what I'll call, overly optimistic short-term earnings. And what I mean is, I'm a big optimist about autonomy, and I'm a big optimist about many of the trends that semiconductors are ultimately exposed to. However, those are very small components of the market today. So if you look at semiconductor earnings, they're primarily based on things like PCs, cloud computing, smartphones, and cars that are sold today.
JUSTINE UNDERHILL: And Bitcoin.
DAVID LEVINE: We should talk a little bit about the Bitcoin exposure of some of the GPU manufacturers for sure. And that's a good point. And gaming, of course, is another example.
But most of the end markets, and bitcoin aside-- and some of the bounces in Bitcoin, we can talk about that if you're interested-- but I do think that the end markets for semiconductors have slowed down. That's what earnings are down, right? So we're not really hypothesizing about the future. We're talking about today, which is the end markets are weak across almost all end markets that semis are in.
And when people get overly optimistic about the future, in the near run what they're doing is they're using this idea called content growth, which is a very good thing. Meaning, if I sell semiconductors to car companies, in the long run, there's going to be more semiconductors in cars because of autonomous vehicles. And that's true, right? But in the immediate run, autonomous vehicles are about 0% of cars today. Electric vehicles, which are way faster, or kind of more near term than autonomous vehicles are 1% of electric cars today.
So if you take auto sales, which are down 10% year-over-year in China, that are declining around the world, if a market declines 10% or 20%, the units that you're selling into that market will decline 10% or 20%. In order for you to make up for that in content growth, it's actually almost impossible if you're selling into a small part of the market. So if you have 20-- say you're selling 100 units at $10, and that goes down 20%. If you then sell of the 80 remaining that you're selling, if you sell 20% more content for 10% of that, it doesn't make even begin to make up for the decline in units. And so what happens is, these very, kind of, compelling long term narratives about content growth become, I think, overly emphasized in the near run. Because we're all optimistic, and hopefully we're all optimistic in the long run.
So those two mistaken assumptions, one is a back-half recovery, and the two is, kind of, I call it overly optimistic short-term assumptions about content growth have caused people to be overly optimistic about semiconductor earnings. And so, therefore, we can be short these companies based on fundamentals, notwithstanding all the other issues including systemic risk, you know, the underlying cyclicality of the economy, and other things. And that's why it's particularly interesting.
JUSTINE UNDERHILL: And then on top of that, there is political risk, in a certain sense, with the whole Huawei thing that's going on, where it looks like the US might ban a lot of Huawei technology from the US, overall.
DAVID LEVINE: It's a very good point. And, of course, I think that's exactly right. And so whether we look at the specific ramifications of Huawei, whether we look at things like Qualcomm and other industries, whether we look at China looking for alternative sources, you know, to US companies for their semiconductor needs, that is another political risk.
Fortunately, given earnings outlooks, we don't even need to believe that. That's what's so great about-- you know, it's great to short something maybe isn't a good thing. I think it's important to preserve capital in this environment. That's why it's, you know, it's good to look for shorts.
JUSTINE UNDERHILL: So how would you go about shorting the semiconductors? Are there certain levels that you're looking at?
DAVID LEVINE: So, for me, I tend to focus on individual security names. But rather than picking on a particular company, I think it's OK to look at the SOX index, and then there's an ETF for folks called SMH, which is basically a derivative of the SOX index.
I think that if we look at, kind of, again, going back to January of last year, and then September of last year, and then today. What we see is that the index is relatively close to where it was at those previous peaks, local peaks, which are way higher than when we draw the graph back and look at history. We can see, then, that January, last September, and then May was way higher, you know, even higher. But even today, now that the stocks are down a bit, we're still at an elevated level.
In December, we kind of began to breakthrough long-term resistance. And so semiconductors had started to, as an index, the SOX index or the SMH, which are relatively high correlated, had started to break down and break through, kind of, historical resistance levels. But we didn't quite get through the resistance that I think is necessary.
So I think that, actually, the downside is lower than where we were in December. Meaning that once the SOX and as the SMH indices pass where we were in December, we can begin to kind of think that the indices have started to correct to a more normalized level.
For me, I tend to look at the individual company earnings. And so I'm expressing this similar thesis based on fundamentals or companies that are components of the index. But looking at the index as a whole, we can capture somewhat of the same thing, which is the cyclicality of where we are.
JUSTINE UNDERHILL: What individual stocks would you be looking at here?
DAVID LEVINE: So, I really don't like to pick on individual companies. What I would say, though, is that, I will pick on one, which is Micron. Even though I have friends who are long Micron, I think it's a very good company in the very long run. Unfortunately, if you look at Micron on a longer time scale, if you look at the earnings of the company, they've really been inflated quite significantly by some smart moves that they made.
So what happened, Micron bought a company called Elpida out of bankruptcy last cycle. Very interesting, very strategic on the long side. It was actually quite good to be long Micron for a long time. However, because of that, the industry structure got to the point where earnings were very high and they were inflated in a major way.
So a lot of people look at Micron and look at book value. And they're like, OK, well Micron can't really change, trade it much lower than book value. The problem is that Micron earned almost its entire book value in one year going through from 2016 through 2017 into 2018, they doubled their book value. And the reason is because margins were very elevated.
In my opinion, the right way to look at a company that cyclical like Micron is you need to adjust for that. So the book value that people use when they look at Micron, in my opinion, is overstated. Not to mention Micron's-- we have the political risk point you mentioned, exposure in China, which is quite elevated-- but also their exposure in some of the end markets that are really slowing down.
But, really, a lot of these companies are kind of exposed to some of the same factors. Micron's also one where people have quite elevated expectations for the second half of the year. And so it's one that is kind of a highlight of some of the things we've been talking about. But many of the semiconductor companies would kind of fit the same.
JUSTINE UNDERHILL: And you would look to short at current levels?
DAVID LEVINE: Yeah, I think current levels. And one way of thinking about it is if you look at the book value, which is in the low 30s, depending on how you look at it, a lot of people don't think it can trade below book value. I think that book value at multiples is actually quite wrong. So if you adjust the book value, let's say, in half, or however you want to adjust for on a cyclical basis, you can see even if we kind of look at it on some kind of intrinsic book value basis, there's quite a bit of downside.
Earnings today are declining. So looking at current earnings, they're going to continue to decline in my opinion. So the multiple will be quite elevated on current earnings, especially if they begin to burn cash again, which seems quite possible in the second half of the year if I'm right about fundamentals. So the earnings multiple becomes very high if that happens.
JUSTINE UNDERHILL: Over what time horizon do you see this playing out?
DAVID LEVINE: Again, I think that it's begun already. When you're shorting things, it's good to kind of wait for markets to begin moving in the right direction. And so in this case, it's begun. The timing is really now. I think that it seems quite likely that-- what's important again is whether or not we get it back half recovery.
So where could I be wrong? If we get a trade deal, if the economy reaccelerates, if end markets, from smartphones, to automotive, to PCs, and cloud computing, reaccelerate. If all those things happen, I could be wrong. And so what is very important is to pay attention to the fundamentals of semiconductors. Which by the way, in South Korea, we had 30% year-over-year decline in semiconductor shipments coming out of South Korea last month. So it's possible it's temporary, but--
If, for instance, some of these fundamentals change, then that's where the thesis could be wrong. So the timing is to be, to continue to focus on near-term earnings forecasts. Again, next quarter earnings we're going to get a lot of information. I would imagine that the next quarter earnings we're going to have to see full year numbers continue to come down. But, again, if the broader market has the type of environment that I