Weekly Market Commentary | 09/01/2024 | JD., CMCX | How the yield curve got it wrong

Bruce looks at why the inverted yield curve seems to have sent a false signal about a recession.  Companies covered: JD. and CMCX.  

The FTSE 100 fell -0.9% to 7,658 last week. The Nasdaq100 was down -3.5% and the S&P500 was down -1.8%. The FTSE China 50 was the worst performing index, down -4.7% over the last 5 days. The US 10Y bond yield briefly touched 4% before rising to 4.0361%, that’s down c. 90 basis points from its peak in October last year.

The yield curve has been inverted 18 months, but this once reliable indicator has failed to predict a recession. Let’s use Sharepad to look at what I think is happening. In “normal times” the yield curve will be upward sloping, meaning bond holders earn a higher fixed rate of return for longer periods of time. Shorter-term interest rates represent what investors believe will happen to central bank policies in the near future. Longer-dated maturities – like the 10 year bond yield – represent investors’ expectations of inflation and economic growth. An inverted yield curve has in the past signalled that investors believe Central Banks will need to cut interest rates in the medium term as the economy stagnates.

Sharepad has this excellent chart showing how the current yield curve (green) has changed versus 3 months ago (blue), 6 months ago (orange), 1 year ago (pink). Across all those time periods, the curve has been inverted (left side of the chart higher than the right side).

The chart below also shows the 10 year spread less the 2 year. The dates are a little hard to read but the spread has been negative (i.e. fell below zero) in July 2022.

The yield curve flashed a warning signal ahead of both the 2007-9 GFC and late 1990s TMT stock market bust. So, the question is why has this normally reliable indicator, which has been flashing a warning sign for 18 months, been wrong? Crossborder Capital’s Mike Howell has an interesting theory, which I think is probably correct. He highlights that Central Banks have maintained very benign financial conditions even as they have raised short term interest rates.

Howell suggests that liquidity bottomed during the Truss/Kwarteng gilts crisis. This, and the SVB / regional bank blow up sent a warning signal to Central Banks, ever since then CBs have made sure to provide enough liquidity to forestall the risk of systemic blow ups. That means rather than the inverted yield curve reflecting bond investors’ view of inflation, interest rates and economic growth, Central Banks have suppressed yields at the long end of the curve. In other words, the yield curve as a recession signal no longer works. One example of Central Bank action is the Bank Term Funding Program (BTFP) introduced last year to prevent US regional banks having to be forced sellers of their long term “Hold to Maturity” bond portfolios. If you have forced sellers of any asset the price falls and yields rise – but yields haven’t risen because regional banks are not forced sellers.

I mentioned last week how during the financial crisis regulators allowed banks to shift assets from the mark-to-market Available For Sale (AFS) accounting bucket to Hold To Maturity (HTM), so that they didn’t need to recognise losses on their trading assets. This time regulators have focused on making sure that banks are not forced sellers of their HTM bond portfolios.

Howell’s conclusion is that with Central Banks providing ample liquidity, the US stock market is likely to continue to enjoy favourable conditions for the next two years. He’s suggested that the way to play this theme is to buy gold, not because it protects against high street inflation, but as a hedge against monetary (ie Central Banks’) inflation. He also points out that one unintended consequence of sanctions and talk of confiscating Russia’s Central Bank foreign currency reserves, is that emerging market Central Banks (ie non G7 countries) are likely to hold more physical commodities, particularly gold.

A gold mining companies like Centamin (mkt cap £1.1bn) which I don’t own, trades on a PER of 10x Dec 2024F and 2025F.

I do own Capital Drilling, which rents out gold mining rigs, as it trades on a PER of only 6x Dec 2024F, despite a 3 year average RoCE of 18%. In any case, Howell continues to track global liquidity; you can follow CrossBorder Capital on Twitter here, and his most recent YouTube interview is here.

Someone on Twitter, called The Quality Small Cap Investor, has been complaining that investment writers should not be allowed to write about stocks they own. He is happy for me to write about stocks that he owns though: his top picks are NextFifteen or Polar Capital. I intend to write up those two companies when their results come out; alternatively he has a substack, where he posts about his portfolio but also how it’s surprisingly difficult to publish a weekly blog and keep the quality high. Commendably TQSCI has posted his performance since inception (end of December 2020) and he is down -17% in absolute terms. I occasionally recommend books, and in this case Simple, but not Easy by Richard Oldfield might apply.

The whole point of a tool like SharePad is that it allows you to think for yourself and research companies. I’m sharing my process and write about how I use the system, the ratios and graphs I find interesting (see above) and this naturally leads to how I select stocks.

This week I look at JD Sports profit warning and CMC’s more positive RNS. CMC’s update does seem encouraging in the broader context of markets, that we may see “animal spirits” return in 2024.

JD Sports profit warning

This sports fashion retailer announced a disappointing update for 22 weeks to 30 December, with organic revenue growth +6%, but like-for-like sales (which adjusts for store openings) up less than +2%. Management blame mild weather in September. I wanted to compare this performance with Next’s trading update, however they only report 9 weeks to 30th December and Full Priced sales +6%. The market interpreted Next trading update more positively though (share price +4% last week), versus JD Sports share price down -28% last week.

JD. management now anticipate PBT to FY ending 3rd Feb as between £915m and £935m, compared to previous forecast on Sharepad of £996m. Assuming bottom of the range is achieved, that implies an -8% downward revision.

History: JD Sports was founded in 1981 and sells premium brands such as Nike, Adidas and The North Face. Last year they opened over 200 new stores and currently have 3,377 stores in 38 countries. The long term track record of sales and profits is impressive. Sales have grown from £1.2bn a decade ago to around £10.6bn forecast FY Feb 2024F.

I’ve always been surprised by their long term performance, the JD. share price is up a whopping 250x since the late 1990s, despite the business not having any obvious “moat”. JD. was profitable through the 2007-9 financial crisis, suggesting that it is not particularly exposed to consumer discretionary spending.

One investment strategy I quite like is looking at multi-baggers which have performed well over 10 – 20 years, but have hit short term problems. This looks like a good example. The JD. balance sheet doesn’t look distressed: as of July 2023 inventories stock were £1.6bn (+14% on the previous July) versus over £10bn of annualised sales. Intangible assets were £1.3bn, which seems healthy in the context of £2.5bn net assets too.

I might be missing something as SharePad’s financial health indicators are suggesting caution though, so that would be one area of further investigation.

Around a third of sales come from the USA, where previous Chief Executive Peter Cowgill expanded via two major acquisitions, Finish Line in Indiana and DTLR in Baltimore. It could be that customers are reluctant to spend money on premium sportswear brands, as Nike has also signalled a slowdown. John Hempton, the well known Australian hedge fund manager, has written up branded sports wear sector here. I learnt a lot from his post, including why wearing trainers without shoe laces is cool, but also that Nike was trying to sell directly to consumers, cutting out the likes of Foot Locker and presumably JD Sports. I also like his caveat, because I think it applies to everyone who writes about stocks that they own:

“One reason fund managers do not write up stocks in detail often is that reality has a habit of making people with strong opinions look like idiots. I may look like an idiot here too one day.”

Valuation: The JD. shares are trading on a PER of around 9x 2025F (year end beginning of Feb). It’s possible that some of the downward revisions have yet to feed into the Sharepad estimates data provider, so the PER migh in reality be 10x. That still seems very good value though, assuming no further disappointment. There isn’t much support from the dividend yield (less than 1%), but the company has historically reported a 3 year RoCE and CashRoCI of just under 20%.

Opinion: Not a company that I’ve looked at closely before. I’m not particularly a fan of retailers, as things can go wrong quickly and be hard to fix (Superdry!) – Worthy of further investigation, and you can’t argue with the long term track record. It does look to me that financial markets related businesses have enjoyed a stronger end to 2023 compared to ‘real economy’ businesses like shops. Markets have reacted much more quickly to the change in interest rate expectations than consumer facing businesses have.

CMC FY March trading update

This CFD trading company released a profit warning last August, when the shares fell -15%. On Monday they said that market conditions have improved, particularly institutional rather than retail investors. They raised their Net Operating Income range from £250m-£280m previously to £290m-£310m. Assuming that they achieve the top end of the new range, then that implies H2F NOI of £187m, a +39% increase versus H2 last year.

The RNS doesn’t give profit guidance, but H1 CMCX recorded a £2m loss before tax. The business is very operationally geared: fixed costs and variable revenue. In H2 2022 when CMCX recorded NOI of £155m, they achieved H2 2022 PBT of £56m at a margin of 36%. Understandable then that the shares responded by rising +20% on Monday’s announcement.

Net Operating Income includes not just revenue from clients trading CFDs and investing in cash equities and mutual funds, there’s also interest income from client balances. This was up 5.5x in H1 to £16m. I think investors had been assuming that as interest rates rose CMCX and other companies would not pass on the benefit to clients, but instead the upside would go to shareholders.

More recently the FCA has been writing to firms reminding them of their “Consumer Duty” that hypothesis has become less obvious. The other regulatory risk is that CMC Markets own website says that 69% of retail investor accounts lose money when spread betting and/or trading CFDs with them. One of my friends is a former hedge fund manager, and even he said that he found the position sizing and risk management too difficult. He didn’t lose a significant amount of money (he said), but he thought the leverage embedded into CFDs made them more trouble than they were worth.

Ownership: Peter Crudas, the founder, owns 62% of the shares. Given that he wasn’t a significant seller when the shares rose to over £5 during the pandemic, it’s interesting to speculate at what point he might sell. There are a couple of institutions that own 5% Aberforth and Schroders.

Valuation: As of September 2023 the business had £178m of net cash, around half the market cap of £385m. I haven’t seen any new EPS forecasts, and they’re hard to calculate due to operational gearing, but also variable remuneration linked to revenue. On a price to sales basis they’re trading on 1.2x, which seems good value for a company with such high EBIT margins and RoCE in good times. There’s a 4.3p dividend forecast for FY Mar 2025F, which implies a yield of 3%.

Opinion: I commented in August last year that the investment case for the whole sector looks very interesting when trading activity returns. If you can stomach the half on half volatility and also the regulatory risk, it does look like there could be significant upside here. I’ve used SharePad’s comparison tool below to compare CMCX with Plus500 and IG Group. Interestingly SharePad thinks that Plus500 has the better quality indicators in the sector. It’s worth noting though that Plus500 is based in Israel, and has had more than its fair share of governance concerns in the past.

Bruce Packard


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This article is for educational purposes only. It is not a recommendation to buy or sell shares or other investments. Do your own research before buying or selling any investment or seek professional financial advice.