During a Gold Rush, Sell Shovels…

The people who made the most money during the Gold Rush of 1858 were not the thousands of prospectors hoping to strike it rich, but the merchants who supplied them with everything from pic-axes to wagon wheels. While gold was discovered, the basic laws of supply and demand (too little gold, too many people searching for it) produced predictable and often disappointing results.

The hemp market today is the latest example of a speculative rush. As the chart below shows, U.S. acreage devoted to hemp production has increased more than three-fold over the last year. While three states (Colorado, Oregon and Kentucky) produce almost 80% of the current total, 24 states are now actively growing the crop.

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Several factors have contributed to the recent rush into hemp production. The first and most significant has been a change in the regulatory landscape. While individual states began approving industrial hemp production as early as 2009, federal approval was not achieved until the Farm Bill was passed in 2018. Many farmers across the nation, facing weak commodity prices caused by tariffs and over-production, have been more than happy to add a crop with promising prospects to their planting lineup.

The exploding demand for cannabidoil or CBD products has also helped. First, a primer. Hemp and marijuana are different varieties of the same Cannabis species. Importantly, while hemp contains no more than 0.3% of the psychoactive substance THC found in marijuana, marijuana contains anywhere between 5% and 20%. Because of its strong fibers, industrial hemp has long been used to make rope, fabric and paper. But increasingly, the processed flowers are being used to produce CBD. While the research is not definitive, many people believe that CBD produces calming and anti-inflammatory benefits without the “high” associated with marijuana.

The growing demand for CBD products is hard to ignore. CBD oils, tinctures, and edibles are now popping up at gas stations, farmers markets and even hardware stores. Research firm BDS Analytics expects the U.S. CBD market to be valued at $20 billion by 2024 up from $1.9 billion in 2018. Interestingly, the products today are only loosely regulated and only one drug, the anti-seizure remedy Epidiolex, has been approved by the FDA.

Unfortunately, growing hemp may not prove as profitable as many growers had hoped. Prices for a range of hemp products are falling across the board today. More easily produced biomass and crude hemp oil have seen declines of approximately 25% over the last three months. Meanwhile, an under supply of processing capacity has helped temper the declines for more refined products.

For investors, the hemp market presents some interesting lessons. Identifying solid investment prospects in emerging industries plagued by regulatory uncertainty and low barriers to entry can be difficult. In these cases, rather than try to identify the winners it is often easier (and more profitable) to focus on companies that provide supplies and services to all industry participants. Consider turbine blade manufacturer Vestas. This company has profitably supplied the volatile wind power market for years. Similarly Taiwan Semiconductor has made a very good business manufacturing chips for companies across the very competitive smart phone industry.

Picking winning suppliers in the hemp industry today is tough. Until this Fall, federal regulations prohibited banks from lending to most hemp related businesses. This lack of capital has meant that most equipment suppliers today are either foreign or privately held. A fresh influx of capital should be good news for firms trying to solve the industry’s current production challenges with new technology and equipment.




“In Investing, What is Comfortable is Rarely Profitable.” Robert Arnott

The outlook for global economic growth is plagued by uncertainty today. Just how far will the U.S. and China go in their efforts to win the current trade war? Will the U.K. arrive at a solution to the ongoing Brexit impasse? Will central banks around the globe continue their easy money policies?

At the industry level, it seems hard to pinpoint another time in history too when so many were witnessing deep, fundamental change. In payment systems, upstarts like Apple Pay are threatening to unseat well entrenched competitors like Visa and Mastercard (also see page 2). In healthcare, public policy initiatives aimed at controlling costs may undermine the basic business models of hospitals, drug distributors and pharmaceutical companies. In the media sector, the war to capture consumer “eyeballs” is forcing unprecedented consolidation and change.

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In periods of perceived heightened risk, it is helpful to take a step back and consider the long view of history. Take a look at the chart below of the VIX. This investment index, a popular measure of expected stock market volatility, tends to rise when stocks are falling and shows when heightened jitters are creeping into the market. Over the past 20 years there have been at least 10 periods when the VIX spiked above 30. While most of us remember the 2008-2009 recession, many have forgotten the anxiety produced during the summer of 2011 (European Sovereign defaults and the downgrading of U.S. debt) or fall of 2015 (fears of slowing economic growth and falling oil prices). In behavioral finance, the tendency to place more emphasis on recent rather than old information is referred to as Recency Bias. As investors, this trait gets us into trouble when we assume that current conditions (bad or otherwise) will continue into the future. This, of course, may be true but it is not necessarily true.

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Investors should also keep in mind the idea that they receive a return precisely because they are taking on risk and, all else being equal, the more risk you assume, the greater the potential return. Over short periods of time, the stock market’s gyrations are driven by the very human emotions of fear and greed. The result? If you are investing correctly, you are likely living in a constant state of dissatisfaction. If the market is up, you wish you had invested more in the market and if it is down, you will always think you have too much invested.

So, what is an investor to do in the face of such uncertainty? Investing is as much about understanding yourself as it is understanding the markets. Conduct an honest assessment of your own ability to tolerate risk by which I mean either temporary or permanent loss of capital. If principal preservation is more important to you than capital appreciation, your portfolio should hold a good slice of more stable things like bonds and cash. And don’t forget diversification within each asset class. At its heart, the concept of diversification is really an admission that we don’t know what the future holds. An adequately diversified portfolio will never keep pace with the market’s highest-flying sector like tech today, but it will never behave like the worst either.




The Yield Curve as Recession Predictor…

Economists and policy makers are spending a lot of time talking about the yield curve these days. This bond market metric plots the yields investors receive for different maturity bonds. Because they demand more compensation for holding longer-term debt, the yield curve typically slopes upward to the right (see chart below ). On rare occasions, however, the curve inverts and longer-term maturities offer lower yields than shorter-term maturities.

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So why should we care about a bunch of lines on a graph? The yield curve recently inverted, a development that occurred just prior to 9 of the past 10 economic downturns. The lag time between the yield curve inversion and the actual onset of recession ranged from 8-20 months with an average time of one year. To understand why the yield curve might have predictive powers consider that prevailing interest rates are actually a reflection of millions of investors’ views. When these investors expect the Federal Reserve to lower rates in reaction to a slowing economy, they flood into higher yielding long-term debt. This increased demand drives down long-term yields relative to short-term yields.

Several economists, however, are now suggesting that the outlook may not be as bad as it seems. More specifically, they claim that the increased demand for long-term Treasury debt comes not from investors’ fears of recession but from other recent developments in the bond market. To meet post-crisis regulatory requirements, banks have had to boost their reserves of ultra safe assets like Treasuries. Meanwhile, insurance companies and pension plans looking to reduce funding risk have also soaked up long dated bonds. Finally, the U.S. government may be playing a role. The U.S. Treasury finances most of its growing budget deficit by issuing short-term debt. This increased supply is likely driving up short-term relative to long-term rates.

Before you breathe a sigh of relief, consider the possibility that the yield curve may be less a predictor of recessions than a cause of them. The reasoning here is pretty straightforward. Banks fund their lending activity with short-term borrowings. When these funding costs go above what they can earn on long-term loans, lending dries up and with it general economic activity. Further, businesses may react to yield curve inversions by cutting back capital spending and other investment plans.

While the yield curve’s inversion can’t be viewed as a positive, investors should take a deep breath before running for the exits. First, measures of the “real” economy like unemployment and consumer confidence are holding up pretty nicely and research has shown that when the yield curve is flashing red and the real economy is doing well, it’s best to pay attention to the real economy. Second, economic predictions are notoriously bad (consider that most economists failed to see the global financial crisis coming).

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Unfortunately, we cannot know with any accuracy when the next recession will hit. But if history holds, when it arrives it will be neither fatal nor permanent. How to prepare? Make sure your current mix of bonds, stocks and cash is in line with your overall tolerance for risk. And don’t forget to hold sufficient cash to cover short-term (3-12 months) spending needs. In a down market, nothing soothes the nerves like cold, hard cash.

5G, Not Just Another Phone Upgrade…

Industry experts expect great things from 5G, the latest generation of wireless technology. To understand why, it helps to know a bit about how cell phones function. Cell phones convert voice and data into electrical signals and then transmit those signals over radio waves to the nearest cell tower. The cell tower then passes the signal along either through physical phone lines or by radio waves to the end destination.

The infrastructure used to transmit and receive signals today, everything from chip sets to antennae, has been designed for lower radio frequencies. Thanks to the explosion of mobile usage, these frequencies are getting saturated. Dino Flore, a Technology VP at Qualcomm, estimates that there are over 8 billion cellular connections today. Without change, the strain on the existing network will cause transmission failures and delays.

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Fortunately, engineers from around the globe have been working together to develop new cellular architecture standards capable of handling the growing network demands. 5G, which transmits data at higher frequencies, is the result of these efforts. In addition to increasing network capacity, 5G also reduces “latency” or the time it takes for devices to respond to each other. When fully deployed a 5G network, for example, will be able to connect 1 million devices per square kilometer, or transfer a full length, high-resolution film in 2 seconds. Industry experts believe this reduced latency will spur significant innovation. In medicine, for example, 5G could improve doctor/patient relations through higher quality video-conferencing and allow remote surgical procedures. Though less revolutionary, gamers could enjoy a more seamless streaming experience.

While promising, a full rollout of 5G will take time. The new network’s technical requirements make widespread adoption particularly expensive and challenging. High frequency signals are more fragile and, as such, require a vast number of close range micro cells and antennae. Technology consulting firm Greensill estimates that 5G related spending could hit $2.7 trillion by 2020. These investments will be challenging for network carriers like Verizon who must figure out how to get consumers to pay for their enhanced service.

China is furthest along in the race to build out a 5G network where firms like Huawei hold a significant share of 5G patents. On the infrastructure side, Deloitte estimates that since 2015, industry leaders Huawei and ZTE have deployed 10 times as many cell sites as we have here in the U.S.

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The recent move by the U.S. to prevent domestic tech firms from exporting network infrastructure to China on national security grounds highlights how high the stakes are in the race to gain technological advantage. While these trade spats may slow down the pace of 5G adoption, they are unlikely to stop it. Handset manufacturers in both the U.S. and China are already releasing 5G phones albeit with limited range. Denying Huawei chips and other technologies may actually backfire and cause them to speed up efforts to develop homegrown technology solutions.

If history is any guide, I would not dismiss 5G’s potential impact. Ten years ago, 4G’s rollout lead to the rise of whole new businesses like Uber and Airbnb. I would expect this time to be no different.