Playing for a Tech Wreck
Featuring Larry McDonald
Published on: July 24th, 2019 • Duration: 16 minutesLarry McDonald, founder of the Bear Traps Report, takes a deep dive into tech and determines that many of the “FAANG” stocks face significant downside risk over the next few years. He highlights the growing threat of populism and the political backlash against big tech, notes the companies’ valuations from a fundamental perspective, and considers a pairs trade to play the situation, in this interview with Justine Underhill. Filmed on July 23, 2019.
JUSTINE UNDERHILL: Welcome to Real Vision's Trade Ideas. Today, we're sitting down with Larry McDonald of the Bear Traps Report. It is great to have you here.
LARRY MCDONALD: Thanks, Justine.
JUSTINE UNDERHILL: So, the Fang stocks and specifically, a lot of the tech giants have been fueling the market rally that we've seen this year, whether it's Microsoft, Apple, Amazon, Facebook, they've accounted for about 20% of the S&P 500 rally. And that's about the same that we saw in 2017 and for a lot of 2018. So do you see this trend continuing, that Fang stocks, that tech giants will power the rally?
LARRY MCDONALD: Absolutely not. But there has to be a reason in the catalyst. Perma bears are not popular people, and I don't want to be perceived as a perma bear. But there is a political firestorm coming at us that is unprecedented. Inequality has exploded over the last decade, not just Mr. Trump's fault. President Obama and Mr. Trump, more central bankers have created a vicious cycle of inequality. And you have left leaning politicians on the Democratic Party side that are going to do a number of debates this year. And you have a President in the White House that is captured the populist vote of America. And there's really a competing mechanism between the White House and Democrats.
The Democrats lost these middle class voters to Trump. And in the 2016 election, the Democratic Party wants those people back. And what you'll see is tremendous noise and pressure from the Democrats, Bernie on all the Fangs through the- not just the primaries, but the debates, very public. And President Trump will see this and we've already seen this in the last month, will start to really fight back and make more noise on his populist agenda against the Fangs. So the backdrop on that alone is going to be extremely difficult for the Fangs to make new highs from here.
JUSTINE UNDERHILL: So do you think it's going to just be noise? Or is it going to be actual action?
LARRY MCDONALD: That's the thing. President Trump, one, he'll have two punches. The first punch is noise. And that's what he's been doing the last month, like two weeks ago, he hosted a social media summit, where he really came after Google and Facebook. But the next step is just looking at inequality, looking at the percentage of- let me give you a stat, in say the 1950s, 1960s, the percentage of profits that were coming out of the top hundred companies was like 45%, 50%. Now, we're up to 86%.
So within Google and Facebook, in particular, those are the two primary bad actors, you have just a real problem coming at them from the DOJ, FTC. And you're going to see real action, because that's President Trump's antidote to Democrats. It's not just talk but following up with action, because the Democratic Party, obviously, is not in control of the White House, so he'll counter their noise with action, his administration, very aggressive action as you head toward the election against we think Facebook and Google.
JUSTINE UNDERHILL: Okay, so would it be specifically regulation? Or do you think you would be breaking them up? Where do you see this potentially going for Facebook and for Google?
LARRY MCDONALD: Well, as you remember, with Microsoft, there's multiple parts to this trade, Microsoft in the '90s. I lived through that. And the perception, the entire, like, first three, four years was break-up. And in the end, there was a regulatory solution that Microsoft dealt with pretty well. But the original, like one thing I've learned in spending a lot of time in Washington, our partner, ACG Analytics has done a great job. We take the clients around the hill, our institutional clients. And there's noise that comes out of the initial Washington reaction. That is, the bark is a lot worse than the bite. So in the end, they won't be broken up most likely. But the perception of a breakup will go from like a 10% probability to maybe an 80% probability in the market size, then back to zero over the course of five years.
JUSTINE UNDERHILL: Now, just to play devil's advocate here. A lot of these tech companies are competing against other tech giants in Asia, in China specifically, do you see the government wanting to prop up these tech giants for national security issues?
LARRY MCDONALD: Well, the big thing that they're going to focus on is Huawei and China, and so the government, the US government's going to make a lot of noise in this bipartisan support. So although there's incredible differences between the White House and Congress in so many ways, there's one area of the most bipartisan support is an intellectual property in Huawei. So I think that's where you're going to see- if the president doesn't do enough in this China trade deal, to really pound home and penalize Huawei for their intellectual property violations, you're going to see real action out of Congress. So it's much more going to be focused on intellectual property, and not so much defending US companies.
JUSTINE UNDERHILL: Okay. Now, in terms of Facebook and Google, specifically, beyond the threat of regulation, do you see them as overbought anyway? What metrics are you looking at there?
LARRY MCDONALD: Price and sales, you want to buy Fangs when they're three, four or five times sales and sell them when they're 10 times sales. If you look back over the last 10 years, right now, they're at the high watermark, they're right around 10 times sales again. And the other great lesson for young people watching us right now, the one thing I've learned over my career is when you have a sector that's close to 30% of the S&P 500's market capitalization, that's just a natural risk reward sell signal.
10 years ago, when I wrote my book, Colossal Failure of Common Sense, but one of the things that we talked about in that book is the financials 11 years ago were close to 30% of the S&P market capitalization, and the financials, and then the tech stocks, by the way, were less than 9%. So 11 years ago, the most popular sector for investors watching us right now 10, 11, 12 years ago, was the financials and we know what happened there.
And the least popular sector a decade ago was tech. And now, it's completely reversed. The financials are a joke. Staples are joke, energy is a joke, energy's gone from 20% of the S&P to less than 8% of the S&P market capitalization. So the bottom line is, you just have a very crowded trade, too many people globally are hiding out in Fangs. Too many people coming to the US. Fangs are being treated almost like a money market fund where you can just- they're so liquid and there's just so much capital there. And it's the most crowded trade we've seen this year.
JUSTINE UNDERHILL: So then how would you go about trading your thesis here?
LARRY MCDONALD: Well, at the Bear Traps Report, we have institutional clients for the most part. About 85%, 90% institutional, hedge funds, asset managers. There, we do a long short combination. And for our financial advisors, we just recommend underweight tech and overweight Telecom. But I would structure the trade simply either long the QID ETF, which is short the Fang stocks, the QQQs, which is that's that index of large cap tech stocks, is almost 50% Fangs. So literally, you have an index, which is QQQs, which is like 50% eight stocks, which is insane, and by itself. But the hedge funds that our clients were recommending short your Google, your Facebook versus long Telecom.
JUSTINE UNDERHILL: And why, specifically, are you looking at Telecom to go long?
LARRY MCDONALD: Well, two things. Number one, 5G. Literally, this is you're talking about the most exciting technological advance since the internet. You're talking about speeds on your phone 100 to 1000 times faster for the next five years, all that infrastructure, all that's going to be built out and the Telecom space is in a prime position to benefit. But most of all, is just the underperformance of Telecom. Telecom has been such a poor performer over the last five years, they've been practically kicked out of the S&P like you talked about energy going from 20% of the S&P 500 market capitalization to 8%, Telecom is gone. So it's so bad for Telecom that a good chunk of Telecom stocks have been kicked out of the S&P. So it's a very small component.
You're talking about underperformance versus big tech of 200% underperformance over the last five years. So your big tech stocks are up 190% and Telecom is essentially flat. So that's the type of risk reward that we like looking at over the next five years, we have a major technology advance catalyst, you've got electric vehicles, you've got so many things are going to be powered by 5G in this country so much. So much excitement will come in and innovation will come into this 5G space. And the Telecom stocks are really in a prime position to be to capture a massive amount of profitability relative to where they've been the last five years.
JUSTINE UNDERHILL: Are there specific levels that you're looking at for this trade, especially for going short the Fang stocks, which seems like it's a somewhat risky trade, especially if looking back for the past two years?
LARRY MCDONALD: Well, in the last week, we've had a big Fang miss. So one them, Netflix, had a colossal miss that we put the report out about two weeks ago. So we've got one Fang down, we got several more to go. But net, net, if say you got a China trade deal and you just have things come together this summer with the market and the market goes on to new highs. The Fang index, which we track on Bloomberg, is substantially underperforming the S&P by the way, so it's technical, but if that index were to make new highs, we'll take the trade off. But right now, you've got lower lows. And you've got a real ugly technical backdrop for the Fang stocks as that large basket as a whole.
JUSTINE UNDERHILL: Interesting. So what would your timing be on this trade? Do you see this playing out in the next few months? Or is this more a yearly, five-year trade?
LARRY MCDONALD: I think in the next six months, you definitely going to have some downward action. But it's a five-year trade for sure. But it's really an election trade, between now and the 2020 election, you're going to have to see- you're going to see action out of the Trump White House, all the warning signs are there. The tweets, we track President Trump's tweets relative to some of these stocks. And you can see that they make new highs and then he comes up with the tweet, Don Jr.'s tweeting about this, Trump's entire close-knit group of loyalists are all talking about inequality in the Fang stocks. And so you're going to see a lot of action out of the White House. But net, net, I think you've got 10%. If you're short the Fangs here versus long Telecom, you've got 10% to 12% downside and 50% upside over the next two years.
JUSTINE UNDERHILL: So these are two totally different kinds of stocks. IYZ has a much higher yield than the Fang stocks do. How do you see the Fed decision that's coming up at the end of this month potentially impacting that?
LARRY MCDONALD: The Fed has a very high, high bar, because in recent weeks, you've got different Fed governors, Governor Williams, John Williams and alike that's just different. Mr. Clarida have hinted around this 50 basis point cut and the Fed- it's really playing catch-up with the world. In other words, most of the global central banks have acted, and the Fed's going to have to play catch-up. So number one, if the Fed goes aggressive, which we think they will, that's going to really help the Telecom space. Because once again, a more accommodative Fed, lowering rates that the juices dividend plays, and that's where Telecom has a major advantage over Fang stocks.
JUSTINE UNDERHILL: So what do you see as the potential biggest risk to this trade?
LARRY MCDONALD: Biggest risk is just more crowd in passive asset management. So it's really- I don't want to call it an ignorant, crowded trade, but you had $1 trillion in passive asset management, say, six, seven years ago, now, you have $7, $8 trillion. It's a freight train where- and then let's describe what passive asset management is. It's just index funds. So when I was growing up, people would put their money in the fail at any Magellan fund. And that's an actively managed fund where a human being decides what to buy and sell.
Now, you have index funds, like the QQQ, like the SPY, that have literally over the last decade, they've gone from practically no assets, less than a trillion to $7, $8 trillion dollars. And as the money flows in from investors all around the US, as that money flows in, there's no human being there making a decision. There's no thought to it. It's really quite scary. And it's gotten to the point now where if money just keeps flowing in, those Fang stocks have to be bought. So definitely, there's always a chance that this freight train runs for the only thing.
JUSTINE UNDERHILL: All right, can you break down your trade idea in 30 seconds?
LARRY MCDONALD: The most crowded trade in the world right now is long Fang stocks. There's a political backdrop, historic populist backdrop, fueled by the ugly stains of inequality, which will lay a sword through this group of Fang stocks in the next six to nine months.
JUSTINE UNDERHILL: Great. Larry, thank you so much for breaking this down for us.
LARRY MCDONALD: Thank you.
JUSTINE UNDERHILL: So Larry is bearish on big tech. Specifically, he likes shorting the Fang stocks and thinks that QQQ ETF has significant downside risk over the next few years. In addition, Larry's bullish on the Telecom sector. He believes the Telecommunications ETF, IYZ, will begin to outperform as we approach the 2020 elections. As a pairs trade, he likes shorting the QQQ versus IYZ.
Just remember, this is a trade idea and not investment advice. You should do your own research, consider your risk tolerance and invest accordingly. For Real Vision, I'm Justine Underhill.