2013 was a tough year to be a short seller of equities, as Dialectic Capital Management returns indicate. With the hedge fund’s 2013 annual performance reported in a 4th quarter investor letter down -6.24%, and the S&P 500 near record highs driven by nearly a +30% 2013 rise, could a break in equity returns in 2014 lead to the year the fund’s defensive strategy pays off?
In its recent investor letter Dialectic observes that equity markets are in “some form of a tech bubble,” and many professional investors agree as nearly 82% of Bloomberg respondents are claiming the markets are in a bubble.
Dialectic’s investor letter
Looking back on 2013, the investor letter said “We have been too defensively positioned for a 25% year-to-date rally in the S&P where constituent revenues have grown only 2% and estimates have come down all year. Even we are surprised at the number of topping indicators that we are now seeing: peak margin debt, trough bearishness, short funds shutting down, record credit creation in new and covenant-lite loans, multi-year high in hedge fund net exposures, IPO’s doubling on the opening print in numbers not seen since 2000, and extreme valuations appearing in multiple sectors.”
As the investor intelligence percentage of bears falls near all time lows, typically a contrarian indicator, Dialectic notes a 2014 that might look very different. “We think the market shows a combination of attributes of the last three bubbles, only in a much more dangerous form,” the investor letter says. “We have the 1998 emerging markets bubble, this time driven by Chinese construction and the hunger for yield. We have the Internet bubble repeat, notwithstanding the hard lessons learned the last time and the missing greenfield story that drove the excitement during the episode that peaked in 2000. To top it off, we have signs of excessive speculation in credit, with many market metrics reaching or exceeding their 2007 peaks.”
Shorting 3D Printing, Solar, SAAS and China
Looking into sectors that are showing attributes of bubble behavior, or as the letter says “pockets of bubble,” Dialectic points to 3D printing, Software as a Service, Solar and China. The firm seeks to short specifically vulnerable stocks in these sectors.
Dialectic notes the 3D printing stocks are “in the middle of a clear valuation bubble,” noting public hype for the industry has moved valuation past any reasonable expectation that earnings will catch up with the stock price. In particular it notes market leader 3D Systems Corporation (NYSE:DDD), which lowered guidance during the 4th quarter, and where margins have failed to expand and organic growth rates have stagnated.
Looking into the history of the 3D Printing market, Dialectic looks to the past to guide the future: “This bubble has happened before. It may not pop tomorrow, but if we keep seeing disappointing quarters and an inability to generate profits these stocks will decline. If they trade back to their multiples of a few years ago where they belong, they will decline a lot.”
3D Printing isn’t the only bubble the fund sees.
Solar market looks primed to burst
Dialectic notes the dramatic run up in the Guggenheim Solar ETF (NYSEARCA:TAN) of almost 230% since 2009 and notes the very different profit environment they face in 2014 when compared to the run-up years from 2009 to 2012 where demand for solar energy and government subsidies were both plentiful. With demand soft and government cash drying up, Dialectic expects the solar market to be among the first to burst.
In the Software as a Service industry, the letter is equally pessimistic. Noting the craze to add the term “As A Service” to a software company’s corporate moniker, the letter says this reminds them “of the late ‘90’s dot-com era, where every company real or fake simply added a dot-com to their name to drive their stock price, today’s ‘.com’ is ‘As A Service.’”
In China, Dialectic’s view is somewhat opposite the mainstream. “We are seeing a real change in China and believe that now more than ever is a time to pay attention,” the letter noted. “Over the course of the summer the new administration consolidated power, arresting thousands of people who spoke out against them on the internet. Now with power consolidated, they are trying to regain control of the economy.” Dialectic recommends shorting both Chinese stocks traded in the US and exiting stocks traded exclusively in China.
On the bright side, Dialectic noted the US energy sector and the containerboard markets may offer long opportunity. Dialectic is utilizing an option strategy in the energy markets and in containerboard is investing in stocks that might benefit from industry consolidation and enhanced pricing power.