Yield Curve Steepens… and My Latest Trade on CRM

• Yield curve hits its highest level in 2.5 years
• Reflation trade set to benefit most (e.g., cyclicals and banks); and
• My latest trade on Salesforce (CRM) for 15.4% annualized

Yesterday I talked about the exuberance we see with markets. 

2021 optimism is in the air.

Now I have specifically dropped the term ‘irrational’… as some might suggest. 

Why?

Look no further than rates and yields. 

This is a zero rate environment or negative in real terms.

As I explained yesterday – when it comes to stock valuations – with borrowing costs so low (bond yields at record lows) – future earnings should be discounted at a lower rate which implies corporate valuations should be higher.

The more difficult question is how much higher? 

For example, is a forward PE of 23x to 25x now the “new normal”?

Today’s focus is on bond yields (and rates).

In short, they are moving higher in the near-term. The question is whether that sticks? 

And that will be a function of whether the expected economic recovery in 2021 is real?

Or…

Whether a strong recovery is nothing more than a mirage…

For example, fueled mostly by optimistic hopes around big government deficit spending and COVID-19 mass inoculation. 

And I am sure you will have your own view… 

10-Year Yield Moving Higher

As part of yesterday’s missive – I shared this long-term trend for US 10-year bond yields

US 10-Year Bond Yields

This is a “text-book” technical trend of lower lows and lower highs over the past 40 years (i.e., in turn sending bond prices through the roof). Note – bond prices trade inversely to yields. 

Now every rally has been met with stiff resistance at the upper limit of the trend channel. 

And that may happen again at some point in 2021… don’t rule it out. 

But if we look up close (e.g. from August this year)…. yields have managed to tick slightly higher… 

US 10-Year Yield – August to December 2020

So why the rise? 

Perhaps three things from mine: 

• Reaction to the improved economic outlook (e.g. 2.5% to 3.0% GDP growth for 2021);
• The possible threat of higher inflation next year; and
• Increased likelihood of further fiscal stimulus coming down the pike. 

And as the “long-end” continues to rise – and with the short-end remaining low (thanks to the Fed) – this has dramatically increased the shape of the yield curve. 

Yield Curve Steepens

Below is the chart for the US 10-Year Treasury yield less the 2-year. 

US 10-Year less the 2-Year Treasury

As we can see – the delta between these two durations is close to what we saw in 2017/2018 

So what sectors does this benefit? 

With stocks and yields both rising together – it will be the ‘same old’ sectors which will most likely benefit (and where the money today is flowing) 

• Cyclicals
• Industrials;
• Materials; and 
• Banks

These are all basically reflationary trades. 

My Latest Trade… Salesforce (CRM)

Before I close… let’s switch gears… trading!

I’ve been watching the market like a hawk lately for any great risk/reward trades… and today I found one… Salesforce (CRM)

Over the couple of months or so I’ve had successful (option) trades against stocks such as Pfizer, Gilead, Alibaba, Cisco, Intel, Bank of America, Exxon and recently silver (selling Dec 18th $19 strikes)

In each case, I felt the selling set up an attractive risk/reward play.

Today I think we see that with Salesforce.

First the weekly chart (and then the logic behind my trade): 

Salesforce (CRM) – Dec 02 2020

It’s revenue rose 110% in fiscal 2018, 82% in 2019, and 57% in 2020. And it’s daily user base is said to be in excess of 12-13M. 

Critics of Slack will argue it doesn’t make money….

Sure. 

Neither Instagram or YouTube made any money when Facebook and Google acquired those platforms in the early stages. 

However, Slack’s non-GAAP gross margin expanded last year, which indicates it still has pricing power, and its free cash flow – while negative – is improving.

Slack’s GAAP losses will eventually narrow – as it builds from a base of zero debt

Now if we look at Salesforce… it’s also incredible business growing at 20%+ doing more than $20B per year in revenue (even without Slack)

In fact, it was one of my Top 10 growth companies I recommended buyers look at on a dip (Alibaba being another) 

Their service offerings include Sales Cloud, Service Cloud, Marketing and Commerce Cloud, and Salesforce Platform. Its primary competitors include SAP, Oracle, Microsoft and IBM.

Below is a quick summary of the revenue and growth rates vs its peers: 

Salesforce will overtake these companies in time… that much is certain. 

My Trade on CRM

First up, I am not convinced the selling in Salesforce is done here. 

For example, I think we could see the stock move anywhere between $200 and $220 over the coming few weeks as investors digest the acquisition. 

However, I think investors will start sniffing around the $190 to $200 zone. 

I say this because that was the previous zone of resistance. Typically what we find is previous resistance becomes new support. 

As a result, I am buyer of Salesforce at $195. 

So here’s my trade: 

Today I sold CRM $195 March 2021 Puts for a price of $8.80

Based on the time to expiry (107 days) – this premium represents an annualized return of 15.4% on my risk capital. 

Here’s the math to determine the annualized return:

(($8.80 / $195) x 365) / 107 = 15.4%

Now if Salesforce trades above $195 at the time of expiry (March 19th) then I will simply keep the option premium of $880 per contract sold (n.b., where 1 option contract controls 100 units of stock). 

And if Sales trades below $195 – I will happily take delivery at that price – whilst keeping the option premium (effectively lowering my entry price to $186.20)

I will let you know how it goes…

Hopefully I get to add this name to my portfolio at a good risk/reward level. 

The market was fractionally higher today… with the S&P 500 notching another record close.

December has made a solid start… given the stellar performance over November. 

As I say – I think we finish the full year with 8-11% gains. 

With respect to yields and long-term rates… 

One question mainstream will raise at some point (not anytime soon) is when the Fed may act on the long-end (i.e., to keep rates from rallying too far)?

My view – not anytime soon. 

We are still historically low with rates… i.e., less than 1%… and I think the market will not be too phased until these test levels closer to 2.0% (or more). 

But what’s perhaps more important is the speed of any rate rise.

For example, if the 10-year yield goes exponentially higher in a short space of time… then we might see the Fed intervene with more purchases of long-term bonds (i.e. QE). 

For now, higher longer-term rates is not yet a concern for the market. 

That’s not to say it won’t be in the months (and years) ahead (it could be)… however today bond yields and liquidity are not a concern (evidenced by what we see with credit spreads). 

Regards,
Adrian Tout