Monthly Archives: February 2017

Portfolio Trade Alert – 01-18-22

Trade Alert For Equity & ETF Models Only

This morning we trimmed exposure in energy and Ford (F) due to their more extreme overbought conditions. As shown in our MoneyFlow indicator (Under the Research tab) XLE is extremely stretched and will likely turn lower in the next few days. At the same time many of the technology names are in the exact opposite position, so be careful making wholesale portfolio changes.

Equity Model

  • Reduce XOM and MRO back to model weights of 2% of the portfolio each
  • Reduce F back to 3.5% of the portfolio.

ETF Model

  • Reduce XLE back to model weight of 3.5% of the portfolio.

No Vaccine Mandate Is Bad News For Vaccine Makers

Pfizer and Moderna shares struggled on Friday as the Supreme Court overturned a federal (OSHA) vaccine and testing mandate. States and individual employers can now decide if they want to have and enforce vaccine mandates. The OSHA mandate would have covered companies with 100 or more employees. The vaccine mandates would have impacted approximately 80 million workers and may have resulted in further labor shortages.

Despite the bit of bad news for Pfizer (PFE), SimpleVisor rates it a “strong buy” with very bullish medium and long-term technicals. Its shorter-term outlook is bearish.

pfe pfizer vaccine
Daily Market Commnetary

What To Watch Today

Economy

  • 8:30 a.m. ET: Empire Manufacturing, January (25 expected, 31.9 prior)
  • 10:00 a.m. ET: NAHB Housing Market Index, January (84 expected, 84 prior)
  • 4:00 p.m. ET: Net Long-Term TIC Flows, November ($7.1 billion prior)
  • 4:00 p.m. ET: Total Net TIC Flows, November ($143 billion prior)

Earnings

Pre-market

  • 5:45 a.m. ET: Truist Financial (TFC) to report adjusted earnings of $1.21 on revenue of $5.583 billion
  • 6:30 a.m. ET: Bank of New York Mellon (BK) to report adjusted earnings of $1.01 on revenue of $3.979 billion
  • 6:45 a.m. ET: PNC Bank (PNC) to report adjusted earnings of $3.50 on revenue of $5.151 billion
  • 7:30 a.m. ET: Goldman Sachs (GS) to report adjusted earnings of $11.65 on revenue of $12.010 billion

Post-market

  • J.B. Hunt Transport (JBHT) to report adjusted earnings of $2.02 on revenue of $3.289 billion
  • 4:00 p.m. ET: Interactive Brokers (IBKR) to report adjusted earnings of 83 cents on revenue of $669.8 million

Market Holds Important Support On Friday

With the market closed on Monday for MLK day, we pick up where we left off on Friday.

Notably, despite the market’s failure to hold previous gains, it successfully retested and held the lower trend line. However, sell signals remain in place and have not yet reached more oversold levels. It will be important for the market to muster a bit of a rally this week to defend that lower trend. Our concern comes on Friday with the expiration of options which could pressure markets.

Inflation Surge, Inflation Surge Pushes Fed To Hike Rates Faster
SimpleVisor.com

The Week Ahead

From an economic viewpoint, the holiday-shortened week will be quiet. The Fed now has up-to-date employment and inflation data for their coming January 27th policy meeting and will enter its self-imposed black-out period this week. As such, investors will get a brief reprieve from the barrage of hawkish commentary coming from many Fed members.

Earnings will likely guide the markets. Thus far, with limited data, earnings have resulted in large stock price swings. Thursday saw the airlines soar on better than expected earnings from Delta. JPM was down about 5% on Friday despite beating earnings estimates. Given valuations are so high and the macroeconomic and monetary environment riskier than prior quarters, we are likely to see heightened volatility surrounding earnings releases and management commentary.

It will also be interesting to see how companies like Apple and Google’s response to not comply with the “No Vaccine Mandate” ruling will be received by employees.

Sentiment Fading

The University of Michigan Consumer Sentiment Survey continues to decline faster than expected. On Friday, they reported sentiment at 68.8 versus 70.6 last month. The graph below shows that a recession has always occurred when the survey falls 25% from its peak. It is not there yet but getting close.

michigan consumer sentiment

A Policy Mistake In The Making

As noted, the Fed is in a tough spot. While they should be aggressively tightening policy, they are also aware of the ramifications of losing market stability. As shown, the massive spread between input and consumer prices suggests corporations cannot pass along inflation entirely. Such means we could see a contraction in profit margins in the quarters ahead.

Inflation Surge, Inflation Surge Pushes Fed To Hike Rates Faster

Furthermore, as noted, the surge in inflation erodes consumer confidence. As prices rise, so does the cost of living for the average American struggling to make ends meet.

Inflation Surge, Inflation Surge Pushes Fed To Hike Rates Faster

That loss of confidence quickly translates into lost sales (demand reduction). Consider that retail sales comprise roughly 40% of PCE, which is approximately 70% of GDP.

Inflation Surge, Inflation Surge Pushes Fed To Hike Rates Faster

The decline in retail sales suggests weaker economic growth ahead.

Weak Retail Sales

December Retail Sales were much weaker than expected, falling 1.9% versus expectations for a slight increase. More troubling, the control group, a subcomponent of the data, was down 3.1%. The control group directly feeds the GDP report. As we discussed in prior months, we offered caution at the strong retail sales data in the prior few months. We suggested that shopping behaviors were drastically altered due to the pandemic and the related shortages of goods. Retail sales are now back to the same levels as in March of 2021. The graph below shows that the aggregate’s October, November, and December retail sales are basically unchanged. It is also worth reminding you that retail sales include inflation. On a nominal basis, retail sales are down around 7% from the prior year. People aren’t buying more, they are paying more!

retail sales

Bearish Sentiment = Rally, or Is This Time Different?

The Bank of America graph below shows AAII Investor Sentiment has fallen to levels that suggest a rally may be in store. The last time the index fell below 25% was in late September 2021 after stocks fell for the better part of the month. In early October that year, the market troughed and headed higher. From that point, it was a one-way street upwards until early November, racking up a 10% gain. From October 13th until November 5th, there were only two down days in the S&P 500. In the fall of 2021, the market did not have to contend with a hawkish Fed. Today, the Fed seems to become more hawkish by the day.

investor sentiment aaii

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Market Selloff Into January

The market selloff into January rattled investors as concerns of So Goes January, So Goes The Year” began to dampen expectations. Combined with a more aggressive stance from the Federal Reserve, rising inflation, and a reduction in liquidity, investor concerns seem to be well-founded.

As discussed last week in Passive ETFs Are Hiding A Bear Market,” the “blood bath” in the high-beta stocks is particularly humbling for the retail crowd that piled into risk with reckless abandon last year.

“Probably one of the best representations of the disparity between what you see ‘above’ and ‘below’ the surface is the ARKK Innovation Fund (ARKK). While the S&P 500 index was up roughly 27% in 2021, ARKK is down more than 20%. That is quite a performance differential but shows the disparity between the mega-cap companies and everyone else.”

S&P vs ARKK

During the market selloff in the first two weeks of January, things did not improve for that group of stocks. However, retail traders have now set their sights on a new target: “value stocks.”

“Retail investors have been plowing a great deal of money into the markets in recent days. But remarkably, in addition to the broad index ETFs, they’ve been buying value sector ETFs (according to JP Morgan Research). So this rotation is not limited to institutions.”The Daily Shot

Retail etf flows

Despite the market selloff to start to the New Year, Wall Street continues to push overly optimistic projections of year-end returns. But, as noted, reality will likely be something entirely different.

So Goes January

For now, let’s set aside assumptions of year-end outcomes and focus on the statistical evidence. From this analysis, we can potentially respect the risks that might lay ahead.

According to StockTrader’s Almanac, the direction of January’s trading (gain/loss for the month) has predicted the course of the rest of the year 75% of the time. Starting from a broad historical perspective, the chart below shows the January performance from 1900.

January historical returns

Furthermore, thirteen of the last seventeen presidential election years followed January’s direction. Speaking of Presidential election years, the second year of the Presidential cycle statistically has the second-lowest average return rate with roughly a 63% chance of being a positive year.

Presidential election data

Of course, unlike most years since 1980, this year, stocks will be dealing with the highest inflation rate since the late 1970s, excessively high valuations, and an aggressive policy change by the Fed.

While that doesn’t necessarily mean poor outcomes for investors, it certainly increases the risk.

Digging In

The table and chart below show the statistics by month for the S&P 500. As you will notice, there are some significant outliers like August with a 50% one-month return. These anomalies occurred during the 1930s following the crash of 1929.

Monthly market statistics

The critical point is that January tends to be one of the best return months of the year. January also sees the most inflows into equities as asset managers put cash to work. Last week, Net flows into global equity funds remained strong (+$30bn vs +$26bn in the prior week).

Net fund flows

However, while fund inflows remain positive, January is significantly underperforming the long-term median and average, so far.

January average media returns.

While January also holds the title for the most favorable return months since 1900, followed only by December and April, negative returns occur about 33% of the time. Such is a high enough risk not to get ignored.

January positive negative months.

But January is not always a winner. While the statistical odds are high, it does not always end that way, even with a strong start. It is worth noting that while January’s maximum positive return is 9.2%, the maximum drawdown for the month was the lowest for all months at -6.79%.

January best worst returns months

However, that is history. Let’s talk about where we are now.

A Rough Start

As noted, it has been a rough start to the new year so far as the market selloff caught investors off-guard. As shown below, the market failed to hold December’s gains, negating most of the “Santa Claus” rally. However, on Friday. the market successfully tested and maintained the lower trend line from last October. 

Stock market technical view
SimpleVisor.com

Risk is still prevalent. With sell-signals still intact, and the market not back to short-term oversold levels, there is still downside pressure on stocks.

Stock market retracement levels.
SimpleVisor.com

As shown, the current correction has already retraced 38.2% of the rally following the October correction. A full correction would wipe out all of the gains since December by completing a 61.8% retracement. While not shown, the 200-dma currently resides around 4400 on the S&P index, which would encompass roughly a 10% correction from the peak.

With earnings season kicking into gear this week, it would not be surprising for the market to hold current support, given that earnings should be reasonably robust. In addition, given we are looking at earnings for the 4th quarter of 2021, where there was still substantial liquidity in the system and the Fed was still highly accommodative. However, as we get into the later quarters of 2022, the support for earnings will fade considerably.

As noted in this past weekend’s newsletter:

“As shown, the massive spread between input and consumer prices suggests corporations cannot pass along inflation entirely. Such means we could see a contraction in profit margins in the quarters ahead.”

Net profit margins PPI CPI

A Year Of Challenges

From the mainstream media’s view, expectations are high that 2022 will continue 2021. Maybe such will be the case. However, as we laid out just recently, many of the headwinds that supported the ramp in speculative behaviors have, or will, reverse in the months ahead. To wit:

  • Tighter monetary policy, and high valuations.
  • Less liquidity globally as Central Banks slow accommodation.
  • Less liquidity in the economy the previous monetary injections fade.
  • Higher inflation reduces consumption
  • Weaker economic growth
  • Weak consumer confidence due to inflation
  • Flattening yield curve
  • Weaker earnings growth
  • Profit margin compression
  • Weaker year-over-year comparisons of most economic data.

The media is correct that “Fed rate hikes” won’t cause a bear market.

As is always the case, the event that changes the “bullish psychology” is always unknown. However, the eventual market reversion is almost always a function of changes in liquidity and a contraction in earnings. Such was a point I made Friday on Twitter:

Twitter post Fed rate hikes crisis

The biggest problem for investors is the bull market itself.

When the “bull is running,” we believe we are more intelligent than we are. As a result, we take on substantially more risk than we realize as we continue to chase market returns allowing “greed” to displace logic. Like gambling, success breeds overconfidence as the rising tide disguises our investment mistakes. 

Unfortunately, our errors always return to haunt us. Always too painfully and tragically as the loss of capital exceeds our capability to “hold on for the long-term.” 

Conclusion

I have no idea what this year holds. Maybe it will be another wildly bullish year where throwing caution to the wind pays off once again.

Maybe, it won’t be.

The current market selloff, and rotation to value, may undoubtedly be essential clues. With market valuations elevated, leverage high, and economic growth and profit margins set to weaken, investors should be paying close attention.

Pay attention; things are beginning to get interesting.

Viking Analytics: Weekly Gamma Band Update 1/17/2022

We share the Weekly Gamma Bands Update by Viking Analytics. The report uses options gamma to help you better manage risk and your equity allocations.

The S&P 500 (SPX) could not overtake the gamma flip level last week and remains in an amplified volatility regime as we head towards the January monthly opex this Friday. Our gamma band model enters the short holiday week with a 30% allocation to SPX. The dashed black lines on the chart below show the dates of the recent monthly option expirations. Please note the sharp moves before and after the opex. The programmatic delta hedging programs tend to be long calls and short puts, which can result in supportive “charm” flows as the options decay (this is a complex issue which can be understood better by following and listening to Cem Karsan). 

The Gamma Band model[1] is a simplified trend following model that is designed to show the effectiveness of tracking various “gamma” levels. This can be viewed conceptually as a risk management tool. When the daily price closes below Gamma Flip level, the model will reduce exposure to avoid price volatility and sell-off risk. If the market closes below what we call the “lower gamma level” (currently near 4,570), the model will reduce the SPX allocation to zero.

The main premise of this model is to maintain high allocations to stocks when risk and corresponding volatility are expected to be low.  For investors who have been conditioned to “buy low and sell high,” it is counter-intuitive to increase allocations when the market rises, but this approach has shown to increase risk-adjusted returns in the back-test.  

The Gamma Band model is one of several indicators that we publish daily in our SPX Report (click here for a sample report).  

With stocks climbing to obscenely high relative valuations, risk management tools have become more important than ever to manage the next big drawdown. We incorporate many options-based signals into our daily stock market algorithms. Please visit our website to learn more about our trading and investing tools.

The Gamma Flip – Background

Many market analysts have noted that daily volatility in the S&P 500 will change when the value of the SPX moves from one gamma regime to another.   Some analysts call this level the “gamma flip.”  The scatterplot below shows how price volatility (on the y-axis) is increasingly lower as the value of SPX rises higher above the Gamma Neutral level (on the right side of the chart).  When the value of the S&P closes lower than Gamma Neutral (to the left of the chart), volatility increases. 

Gamma Band Model – Background

The purpose of the Gamma Band model is to show how tail risk can be reduced by following a few simple rules.  The daily Gamma Band model has improved risk-adjusted returns by over 60% since 2007.  The graph below demonstrates how this approach can limit drawdowns while maintaining good returns.  A quick video introduction of the Gamma Band model can be seen by following this link

Disclaimer

This is for informational purposes only and is not trading advice.  The information contained in this article is subject to our full disclaimer on our website.

[1] The Gamma Band model in our SPX Market Report adjusts position size DAILY based upon the daily closing levels of SPX value and calculated Gamma Neutral.  The Weekly Gamma Band model is shown for illustrative purposes only.

Authors

Erik Lytikainen, the founder of Viking Analytics, has over twenty-five years of experience as a financial analyst, entrepreneur, business developer, and commodity trader. Erik holds an MBA from the University of Maryland and a BS in Mechanical Engineering from Virginia Tech.

Rob McBride has 15+ years of experience in the systematic investment space and is a former Managing Director at a multi-billion dollar hedge fund. Rob has deep experience with market data, software and model building in financial markets.  Rob has a M.S. in Computer Science from the South Dakota School of Mines and Technology.

 


Technical Value Scorecard Report – Week Ending 1/14/2022

The scorecard report uses a series of technical studies to quantify how various sectors, factors, and indexes score on a technical basis versus the S&P 500 (relative value) or versus a more appropriate benchmark, as well as on an absolute stand alone basis (absolute value).

Relative Value Graphs

  • The energy sector is on fire. XLE picked up over 5.5% versus the S&P 500 last week and 20% over the previous 20 trading days. It is now grossly overbought relative to the market, with a sector score of 86%, and likely to give up some of its recent outperformance. The third chart shows the gross relative outperformance of energy over multiple time frames. We normalize the graph to show the average per day relative performance. As shown, over the last ten days, XLE has beaten the S&P 500 by 1.5% per day. A truly remarkable feat.
  • Most other sectors remain slightly over or undervalued but not to any extremes. There was a slight general weakening in scores this past week. Excluding energy, the more conservative, higher dividend sectors underperformed the market, following a robust relative performance over the last month. These sectors include real estate, utilities, healthcare, and financials.
  • Emerging markets and developed markets are both slightly overvalued now. This follows a long period where they were among the most oversold sectors. Some of the gains are attributable to an overweighting of commodity stocks in these indexes versus the S&P 500. Further, the dollar has been trading weaker, which benefits those indexes.
  • Technology and the QQQ’s are the weakest sectors and factors/indexes. Higher bond yields and rising implied inflation works against these high duration sectors.

Absolute Value Graphs

  • On the absolute sector scores, energy is also the most overbought sector but not quite as overbought as on a relative basis.
  • The S&P 500 remains near fair value and at the lower end of its range of the last year. While it has typically bounced from similar levels, caution is warranted as it is not oversold. Further, our proprietary models are not yet signaling an imminent bounce.
  • In general, most sectors and factor/indexes are moderating toward fair value.
  • Not surprisingly, energy is nearing three standard deviations above its 50 and 200 dma. This is yet another warning that consolidation or decline is likely in the days ahead.
  • Staples and value versus growth are also two and a half standard deviations above their respective 200 dmas
sectors S&P 500
s&P 500 absolute
excess returns

Users Guide

The technical value scorecard report is one of many tools we use to manage our portfolios. This report may send a strong buy or sell signal, but we may not take action if other research and models do not affirm it.

The score is a percentage of the maximum score based on a series of weighted technical indicators for the last 200 trading days. Assets with scores over or under +/-70% are likely to either consolidate or change the trend. When the scatter plot in the sector graphs has an R-squared greater than .60, the signals are more reliable.

The first set of four graphs below are relative value-based, meaning the technical analysis is based on the ratio of the asset to its benchmark. The second set of graphs is computed solely on the price of the asset. At times we present “Sector spaghetti graphs,” which compare momentum and our score over time to provide further current and historical indications of strength or weakness. The square at the end of each squiggle is the current reading. The top right corner is the most bullish, while the bottom left corner is the most bearish.

The ETFs used in the model are as follows:

  • Staples XLP
  • Utilities XLU
  • Health Care XLV
  • Real Estate XLRE
  • Materials XLB
  • Industrials XLI
  • Communications XLC
  • Banking XLF
  • Transportation XTN
  • Energy XLE
  • Discretionary XLY
  • S&P 500 SPY
  • Value IVE
  • Growth IVW
  • Small Cap SLY
  • Mid Cap MDY
  • Momentum MTUM
  • Equal Weighted S&P 500 RSP
  • NASDAQ QQQ
  • Dow Jones DIA
  • Emerg. Markets EEM
  • Foreign Markets EFA
  • IG Corp Bonds LQD
  • High Yield Bonds HYG
  • Long Tsy Bonds TLT
  • Med Term Tsy IEI
  • Mortgages MBB
  • Inflation TIP
  • Inflation Index- XLB, XLE, XLF, and Value (IVE)
  • Deflation Index- XLP, XLU, XLK, and Growth (IWE)

David Robertson: Market Review And Update Q4-2021

Market review Q4-2021: The low-rate conundrum

Back in the mid-2000s, then-Fed chair Alan Greenspan remarked on the curious phenomenon of long rates staying low even though there was healthy underlying growth. He called it a “conundrum”. A decade and a half later, long rates are much lower than they were then, even as inflation has started rearing its ugly head. The consumer price index, for example, hit a 6.8% annual rate in November.

What gives? As rising prices are killing a lot of household budgets, long rates have bounced around but are still incredibly low. Are rates wrong or is inflation wrong? Regardless, this is a monumentally important puzzle for long-term investors to solve. Different answers imply dramatically different portfolios.

Rates and inflation

Historically, inflation has figured prominently in long-term interest rates. Gary Shilling highlights in the January 2022 edition of his Insight letter what many market followers have also observed, “Treasury bond yields reflect inflation, with a 60% correlation between those yields and CPI inflation over the entire post-World War II era.”

Based upon the premise that inflation expectations are largely embedded in rates, and inflation is currently high, the question must be asked, “Why are rates so low?” Shilling’s answer, essentially, is that rates are so low because economic growth prospects are poor and current inflationary impulses will not persist.  

He goes on to list ten major factors that are likely to dampen growth and ease inflation. Among them are an inventory cycle that has created excess supply, continued supply chain disruptions that will inhibit growth, a softening economy, and softening growth in China. In short, his read is that the recent spurt in inflation will pass and ultimately reveal weak economic growth.

Shilling reinforces his thesis by contrasting current conditions with the environment of structurally excess demand of the late 1960s and early 1970s. As he notes, it was the forces of “military outlays for Vietnam and spending on Great Society programs, on top of a fully employed economy,” that drove prices up at the time. Fair enough.

Bad signals

An important assumption made in such a thesis, however, regards the validity of rates as good signals. Indeed, this is exactly the issue Grant Williams posed to Greg Jensen of Bridgewater Associates: “[D]o you believe that the bond market still sends [sic] uncorrupted signal?” Jensen answers with a very thoughtful analysis:

“But you move to this world, wherein a sense, the Central Bank is controlling the short rate. They’re also in a soft sense with QE controlling the bond yield and in a soft sense, controlling the aggregate corporate spread and mortgage rates. I mean, you went from one level of control to multi-layered control of the economy. That’s a big difference. And so, when you look at market prices today, what do you see? It’s much more like what you’re seeing is what the market thinks the policymakers will do to achieve the outcomes that they want rather than reflecting what economic conditions it will be.

“That’s why, why is it that the bond yield is where it is? Well, people think that’s where the Fed wants it, and that the Fed can get what they want. And so that’s the thing. Now, I think, even on that basis, the markets are going to prove to be wrong because I think the Fed is going to be forced to change their policy, and they’re going to allow a higher bond yield because they’ll be overwhelmed by the evidence.”

Packing a punch

Wow, that packs a punch. Let’s break out a couple of points. When Jensen calls the migration from “one level of control” to “multi-layered control of the economy”, he’s right; it is a big difference. Because the magnitude of monetary intervention has changed, it is fair to entertain the notion that the relationship between rates and inflation has changed.

When Jensen hypothesizes that long rates are low because that’s where the Fed wants them, he makes another good point. The Fed might be misguided, obtuse, sophomoric, or ham-fisted, but it will also always have a bigger balance sheet than other traders. If the Fed wants something, it has been safe to assume the Fed can get it, and therefore risky to bet against it.

That bet is made riskier yet by persistent flows into passive funds that have zero interest in fundamentals. As the Fed leads, passive flows follow. As a result, betting on what you believe could happen, or should happen, is an expensive bet if Fed policy indicates otherwise. Just stroll through the hedge fund graveyard from the last thirteen years and you can see the evidence. 

Louis Gave chimed in with his own similar interpretation of rates in an interview on MacroVoices:

“[I]nflation was a massive surprise but it had no impact on the markets. Or, the bond market, currency or the stock market. And I think the reason for that is pretty simple is that the markets fundamentally don’t really care about macro. They care about the policy environment. So they care about how perhaps the macro might impact the policies.”

In short, Gave describes in even more explicit terms that market metrics are not providing good signals on inflation. In this regard, it is probably more appropriate to consider metrics such as long rates to be more an indication of investor obedience to central bank policy goals than a revelation of information content about macro conditions.

The power of narrative

Yet another piece of the low-rate puzzle can be explained by the phenomenon of narrative. Ben Hunt of Epsilon Theory has produced some of the most prescient analyses on inflation and the recent piece, “Inflation and the Common Knowledge Game,” is an excellent refresher.

Hunt describes the powerful role “Missionaries” play in establishing common knowledge. For example, when Fed chair Powell characterizes issues like inflation as “transitory”, it sends a strong message to the entire market that not only is inflation not a serious problem, but everybody knows that everybody knows inflation is not a serious problem. This helps explain why the market’s reaction to rising inflation through 2021 was so muted. The reason is the Fed told everyone inflation wasn’t a problem. This explanation dovetails nicely with comments by Jensen and Gave that markets care more about the policy environment than about macro conditions per se.

The narrative explanation also describes why long rates have recently been surging upward. When Powell made remarks at a Congressional hearing in late November and explained that inflation should no longer be considered transitory, he changed the narrative. Those comments were reinforced by hawkish comments in the Fed’s minutes which came out in the first week of January.

Now, “everyone knows that everyone knows that inflation is here to stay.” Worse, this common knowledge becomes self-reinforcing. As Hunt describes, “And when everyone knows that everyone knows that inflation is here to stay, ALL businesses can raise prices to maintain margins without fear of competitive pressure or customer pushback.”

Money

The power of narrative helps better understand changing views on inflation, so too does a fresh economic theory shed additional light on the inflationary process. As economist John Cochrane elaborates, it is not so much money printing, per se, that creates inflation, but rather the amount of money printing that funds deficit spending.

His theory, outlined nicely in the Economist, uses the analogy of equity dilution to describe the concept. Just as the value of stock gets diluted by the issuance of additional shares, the value of money gets diluted by the amount of deficit spending a central bank monetizes.

“The logical extreme of this argument is known as the ‘fiscal theory of the price level’, created in the early 1990s (and in the process of being refreshed: John Cochrane of Stanford University has written a 637-page book on the subject). This says that the outstanding stock of government money and debt is a bit like the shares of a company. Its value—ie, how much it can buy—adjusts to reflect future fiscal policy. Should the government be insufficiently committed to running surpluses to repay its debts, the public will be like shareholders expecting a dilution. The result is inflation.”

One key point is that fiscal spending is an important element of the inflation equation; it is not just a monetary phenomenon. To this point, additional comments by Greg Jensen are instructive:

“And today, we’ve moved from, the period from let’s say, the 1950s through 2008, and a period of interest rate, what we call MP1 [monetary policy phase 1] into MP2 being quantitative easing, and now this phase that’s been accelerated with the pandemic, has been this movement in the monetary, what we call Monetary Policy 3, but it’s the merger of fiscal and monetary policy.”

More money

In other words, by Jensen’s analysis, monetary policy has evolved over time to the point where the inflationary process, at least according to the fiscal theory, has been institutionalized. As a result, the process of monetary “dilution” can be dialed up at any time. This doesn’t require the government to significantly outspend tax revenues, but it does leave the door wide open for it to do so.

This leads to another point: The quantity and duration of monetized deficit spending are also important factors to the inflation equation. As such, it is easy to see how the pandemic stimulus packages could produce a noticeable, but ultimately temporary, inflationary impact. Although the programs were quite large, they were also mostly one-off programs of limited duration.

What happens when the economy slows down the next time around though? When that happens, the signs are pretty good fiscal spending will crank up again and the Fed will monetize deficits again. Except for next time, there is a good chance spending program will also be more recurring in nature. In an environment of excessive debt and chronically weak growth, the temptation for politicians to “help” struggling citizens with substantive programs will be enormous.

Indeed, this now sounds a lot like Shilling’s characterization of structural inflation. Vietnam war spending was huge, but one-off in nature. However, on top of that came large, recurring programs like Medicare and Medicaid. Perhaps the two episodes are not so different after all.

Implications

Bringing these ideas together, we see the low-rate conundrum can be explained largely as a function of two different factors. On one hand, since central banks have pursued an increasingly extraordinary monetary policy, the information content of interest rates has migrated more to policy objectives than to inflation expectations. At the same time, those inflation expectations have largely been kept in check even despite some extremely high readings over the last year.

All that said, a really important takeaway, especially for long-term investors, is the seeds of significant inflation have been planted. The presence of low rates should not be used as an excuse to ignore the potential for inflation, to forestall acting on inflation for too long, or to act in too small a size to matter.

Also, however, the trajectory of inflation is rarely a straight one and never a completely predictable one. Even though inflation is likely to persist on a higher trajectory than it has been, that path depends on many unknowable factors. Nobody knows what situations might arise or how the Fed might respond to them at any point in time. The path is inherently uncertain.

The last few weeks are certainly indicative of that uncertainty. While rates did rise a couple of times last year in response to higher inflation expectations, rate levels remained extremely low. It was only after Powell agreed inflation was not transitory and his comments were backed up by hawkish minutes from other Fed members that the market really seemed to react. Herein lies another lesson: Narratives can flip quickly.

Finally, systemic inflationary conditions and big market moves in both directions are not conditions that are conducive to passive management. Rather, these are the types of conditions that enable astute investors to dynamically manage risk and identify opportunities as they arise.

Conclusion

Inflation is one of those really big things in investing that if you get it mostly right, most other things take care of themselves. Conversely, if you get inflation wrong, your nest egg can erode away. As a result, resolving the low-rate conundrum is an especially important one for long-term investors to resolve.

Five High Dividend Low Beta Stocks

This week’s scan comes courtesy of a subscriber’s request. She asked us to scan for stocks with “lower betas and strong dividends.” Perhaps she is basing the request on the fact that value and higher dividend stocks have been trading well the last few weeks. Our scan may provide a few ideas for her and others with a similar mindset.

We added a few factors to her scan, including fair valuations, current and future profitability, and low debt levels. Ultimately, the scan seeks reduced volatility in stocks that pay higher dividend yields.

The five favorites of the scan are all small-cap companies with market caps ranging from 1.8 billion to 270 million. Also, note that three of the companies are foreign. We excluded MLPs and REITs from the scan. While they tend to have high dividend yields, their fundamentals are not easily comparable to other companies. For our recent scan of MLPs, please see Five MLP Stocks to Stuff the Stockings.

Screening Criteria

This week’s scan resulted in five smaller companies, all of which underperformed the market this past year. Such is not surprising given that growth tended to lead value and lower beta for large parts of the year. The companies in this scan should perform better if recent trends in value and low beta persist.

five for friday

Company Summaries (all descriptions courtesy Zacks)

Ennis, Inc (EBF)

Ennis, Inc. is one of the largest private-label printed business product suppliers in the United States. They offer an extensive product line from simple to complex forms, laser cut-sheets, negotiable documents, internal bank forms, tags, labels, presentation folders, commercial printing, advertising specialties, screen-printed products, and point-of-purchase display advertising that can be custom designed to customer needs.

EBF offers investors a respectable dividend yield (5.2%) and carries no debt. Without debt on its balance sheet, the stock is well suited to withstand potential rate hikes by the Fed. In addition, EBF is likely to benefit as in-person business activities inch back towards pre-pandemic levels.

ennis ebf

GreenTree Hospitality Group (GHG)

GreenTree Hospitality Group Ltd. operates as a franchised hotel operator. It operates business chain hotels, serviced apartments, shell inns, and hostels. The company’s properties include GreenTree Eastern Hotel, GreenTree Inn, GreenTree Alliance Hotel, and Vatica Hotel. GreenTree Hospitality Group Ltd. is based in Shanghai, China.

GreenTree experienced a sharp sell-off last summer along with other US-listed Chinese stocks. As a result, GHG is down nearly 45% since it peaked at the end of May and is back to trading in a range. Although the company’s ties to China pose a risk, the stock could also benefit from a potential rally in beaten-down Chinese stocks. In addition, the Chinese hospitality sector should see a boost as Covid related pressures ease, which is reflected in EPS forward growth expectations (29.8%).

ghg

Gilat Satellite Networks (GILT)

Gilat Satellite Networks Ltd. is a global leader in Very Small Aperture Terminal satellite communications technology, manufacturing, and service. The company provides end-to-end telecommunications and data networking solutions to customers across six continents.

GILT offers the highest dividend yield (12.2%) and the lowest beta (0.21) on the list. In addition, it trades at a low P/E (7.88) with no debt and EPS forward growth expectations of 10%. Overall, the valuation looks cheap, and the company is poised to perform well.

gilt gilat

Northwest Bancorp, Inc (NWBI)

NWBI is a bank holding company whose sole activity is the ownership of all of the issued and outstanding common stock of Northwest Savings Bank and the majority ownership of Jamestown Savings Bank. Northwest Savings Bank is a stock savings bank. The bank is a community-oriented institution offering traditional deposit and loan products, and through its subsidiaries, consumer finance services.

NWBI is the largest company on the list, with a market cap of ~$1.9B. Given that it’s a regional bank, it makes sense that it also carries the highest debt-to-equity ratio (0.24). The stock trades at a low P/E ratio (11.7) and has a solid dividend yield (5.4%). In addition, expectations for rising yields due to Fed policy could boost the stock if the yield curve steepens. 

nwbi

G. Willi-Food International (WILC)

G. Willi-Food International Ltd. is one of Israel’s largest food importers and a single-source supplier of one of the world’s most extensive ranges of quality Kosher food products.

WILC trades at a market cap of $270M, making it the smallest company on the list. With a debt-to-equity ratio of 0.01, the stock would hardly see an impact from a rise in yields. In addition, WILC’s margins will likely benefit when inflation eventually fades. Expectations for EPS forward growth (15%) may reflect this.

wilc

Five for Friday

Five for Friday uses stock screens to produce five stocks that we expect will outperform if a particular investment theme plays out in the future. Investment themes may be relevant to the current or expected market, industry and/or economic trends. Investment themes may not always represent our current forecast. 

Disclosure

This report is not a recommendation to buy or sell the named securities. We intend to elicit ideas about stocks meeting specific criteria and investment themes. Please read our disclosures carefully and do your own research before investing.

Airline Stocks Soar Despite Market Turbulence

Airline stocks took off on Thursday on the back of better than expected earnings from Delta Airlines. American Airlines led the way, increasing by 4.5%. United, Delta, and Southwest flew up 3.50%, 2.10%, and 1.28%, respectively. As a result of airline strength, JETS, an ETF heavily focused on the airline industry, was up 2.25%. Its top four holdings, accounting for 40% of its total assets, are the four airline stocks mentioned above. Conversely, stocks had a rough day. While there was little news, it appears hawkish tones from Fed speakers are to blame.

jets airlines

**Markets will be closed on Monday for the Martin Luther King Holiday. We will rejoin you with our next Commentary on Tuesday.

Daily Market Commnetary

What To Watch Today

Economy

  • 8:30 a.m. ET: Retail sales advance, month-over-month, December (-0.1% expected, 0.3% in November)
  • 8:30 a.m. ET: Retail sales excluding autos and gas, month-over-month, December (-0.2% expected, 0.2% in November)
  • 8:30 a.m. ET: Import price index, month-over-month, December (0.2%. expected, 0.7% in November)
  • 8:30 a.m. ET: Capacity utilization, December (77.0% expected)
  • 8:30 a.m. ET: Industrial production, month-over-month, December (0.2% expected, 0.5% in November)
  • 10:00 a.m. ET: University of Michigan sentiment, January preliminary (70.0 expected, 70.6 in December)

Earnings

  • 6:15 a.m. ET: BlackRock (BLKto report adjusted earnings of $10.15 on revenue of $5.16 billion
  • 7:00 a.m. ET: JPMorgan Chase (JPM) to report adjusted earnings of $2.99 on revenue of $30.01 billion
  • 7:00 a.m. ET: Wells Fargo (WFCto report adjusted earnings of $1.02 on revenue of $18.85 billion
  • 8:00 a.m. ET: Citigroup (Cto report adjusted earnings of $1.62 on revenue of $16.80 billion

Market Fails To Hold Rally

We noted in yesterday’s commentary that:

“Despite a much more hawkish Fed in recent testimony, 7-percent inflation, and a lot of hand-wringing over the recent decline, the market has done ‘nothing’ wrong. The uptrend channel that began in early December remains intact, the current ‘sell-signals’ are starting to turn towards ‘buys,’ and the market pushed above resistance with yesterday’s rally.”

While airline stocks rallied, the broader market did not. The rally attempt failed miserably with both the 20- and 50-dma moving averages broken again. The only good news is the bottom of the current uptrend channel is holding. However, if that fails today, we will need to rethink positioning more quickly. The market is oversold, so we want to be careful not to make a kneejerk reaction, but there are increasing signs that downward momentum is building. Caution remains advised.

Looking For Value?

As we have noted in previous commentaries and articles, value stocks have grossly underperformed growth stocks over the last ten years. In recent weeks value has made a comeback of sorts. If the rotation from growth to value is real and lasting, it is important to have a few value candidates in mind for possible purchases. Finviz can help with this task. The heat map below shows each constituent of the S&P 500. The color-coding, as detailed at the bottom right, coincides with each stock’s forward price to earnings ratio. The site allows you to zoom in and see the companies with smaller market caps.

heat map S&P 500 forward p/e

It is clear from the heat map that many S&P 500 constituents have high valuations. However, you can also easily spot companies, sectors, and subsectors in green that are more fairly valued.

Its All About Apple

Apple stock (AAPL) now constitutes 6.9% of the S&P 500 as @charliebiello shows below. Such is the largest weighting in the S&P 500 by one company since at least 1980. In 2008 the price of crude oil was approaching $150 a barrel and Exxon (XOM) was soaring along its side. At the time it rose to become the largest company in the index with a 5% holding. Now, it only contributes 0.66% to the index. Exxon is just one of many companies that were the largest for a period but have since given up their lofty status. Apple will follow; it’s just a question of when.

aapl apple stock

Food Shortages Are Real

While Covid has impeded travel, as shown above by the decline in airline stocks, the supply disruptions are impacting the supply of food. According to Google data, searches associated with food shortages and empty shelves have posted triple and quadruple-digit percentage spikes in the last week.

Food Shortages

“On Thursday, Yahoo Finance’s Dani Romero wrote how port bottlenecks are one element being monitored by the Federal Reserve as it inches closer to hiking rates. The Fed is making increasingly hawkish noises about inflation, which is being exacerbated by high demand underlying supply shortages. However, if prices cool down in the near term, the central bank may be persuaded to be less aggressive on tightening.

Unfortunately, all available evidence suggests that’s unlikely to happen, and the central bank is much more likely to hike by more than Wall Street anticipates. Meanwhile, companies and consumers alike have grown accustomed to paying more for goods that take longer to reach them — worsening the inflationary pressures eating away at purchasing power and higher wages.

According to a C-suite survey from The Conference Board released on Thursday, CEOs rank supply chain disruptions as their third biggest external concern, and many feel unprepared for more disruptions.” – Yahoo Finance

Think Real Estate Prices are High Near You, Check out the Metaverse?

According to CNBC Investors Are Paying Millions For Virtual Land In The Metaverse. Plots of land are in hot demand in the Metaverse. Such land is similar to NFT’s, where buyers are purchasing a unique “asset.” Investors of virtual land are hoping the Metaverse becomes the new social media and the plots rise in price. Some view it as getting in on the ground floor of a new crypto-like currency. Bubble or reality, the profits are real and investors are chasing yet another highly speculative asset.

“Rather, the land is located online, in a set of virtual worlds that tech insiders have dubbed the metaverse. Prices for plots have soared as much as 500% in the last few months ever since Facebook announced it was going all-in on virtual reality, even changing its corporate name to Meta Platforms.”


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“Don’t Fight The Fed”

“Don’t Fight The Fed.” But, unfortunately, that mantra has remained a “call to arms” of the financial markets and media “bullish tribes” over the last decade.

Armed with zero interest rate policy and the most aggressive monetary campaign in history, investors elevated the financial markets to heights only rarely seen in human history. Yet, despite record valuations, pandemics, warnings, and inflationary pressures, the “animal spirit” fostered by an undeniable “faith in the Federal Reserve” remain alive and well.

Of course, the rise in “animal spirits” is simply the reflection of the rising delusion of investors who frantically cling to data points that somehow support the notion “this time is different.” As David Einhorn once stated:

“The bulls explain that traditional valuation metrics no longer apply to certain stocks. The longs are confident that everyone else who holds these stocks understands the dynamic and won’t sell either. With holders reluctant to sell, the stocks can only go up – seemingly to infinity and beyond. We have seen this before.

There was no catalyst that we know of that burst the dot-com bubble in March 2000, and we don’t have a particular catalyst in mind here. That said, the top will be the top, and it’s hard to predict when it will happen.”

Is this time different? Most likely not. Such was a point James Montier noted recently,

Current arguments as to why this time is different are cloaked in the economics of secular stagnation and standard finance workhorses like the equity risk premium model. Whilst these may lend a veneer of respectability to those dangerous words, taking arguments at face value without considering the evidence seems to me, at least, to be a common link with previous bubbles.

stock market uncertainty, schedule an appointment

Mental Gymnastics

While the “bulls” are adamant, you shouldn’t “fight the Fed” when monetary policy is loose, they say the same when it reverses. Such got evidenced by Fisher Investments arguing rate hikes are NOT bad for stocks.

“Many pundits blaming 2018’s stock market decline on that year’s Fed hikes. While we can’t predict Fed policy from here, we can correct the record on 2018, which we think had very little to do with the Fed.

Fed funds and S&P 500 index

Fisher does “mental gymnastics” to suggest the sell-off in 2018 was due to forces other than the Fed. However, what reversed the “bullish psychology” was evident.

“The really extremely accommodative low-interest rates that we needed when the economy was quite weak, we don’t need those anymore. They’re not appropriate anymore. Interest rates are still accommodative, but we’re gradually moving to a place where they will be neutral. We may go past neutral, but we’re a long way from neutral at this point, probably.” – Jerome Powell, Oct 3rd, 2018

That sharp sell-off in the chart above started following that statement from Jerome Powell. Why? Because even though the Fed had already started hiking rates previously, the comment suggested much tighter policy to come.

What reversed that “bear market psychology” just two months later? The Fed’s reversal on their “neutral stance.”

“Where we are right now is the lower end of neutral. There are implications for that. Monetary policymaking is a forward-looking exercise, and I’m just going to stick with that. There’s real uncertainty about the pace and the destination of further rate increases, and we’re going to be letting incoming data inform our thinking about the appropriate path.” – Jerome Powell, Dec 18th, 2019

By the summer of 2019, the Fed’s interest rates returned to ZERO.

Why did the market rally?

“Don’t fight the Fed.”

Never Fight The Fed

“Rate hikes aren’t inherently bearish, in our view. Like every monetary policy decision, whether they are a net benefit or detriment depends on market and economic conditions at the time, including how they affect the risk of a deep, prolonged, global yield curve inversion. 2018’s rate hikes flattened the yield curve, but they didn’t invert it.” – Fisher Investments

They are. It is just a function of timing between the first rate hike and when something eventually breaks the “bullish psychology.” As we discussed previously:

“In the short term, the economy and the markets (due to the current momentum) can  DEFY the laws of financial gravity as interest rates rise. However, as interest rates increase, they act as a “brake” on economic activity. Such is because higher rates NEGATIVELY impact a highly levered economy:”

Fisher is correct that rates may not impact the financial markets in the short term. However, most of the gains got forfeited in every instance as interest rates slowed economic growth, reduced earnings, or created some crisis.

Fed funds 10-year rates and crisis events

Most importantly, a much higher degree of reversion occurs when the Fed tightens monetary policy during elevated valuations. For example, beginning in 1960, with valuations over 20x earnings, the Fed started a long-term rate-hiking campaign that resulted in three bear markets, two recessions, and a debt crisis. The following three times when the Fed hiked rates with valuations above 20x, outcomes ranged from bear markets to some credit crisis needing bailouts.

stock market valuation and Fed funds

Yes, rate hikes matter, and they matter more when there are elevated valuations.

I Fought The Fed, And The Fed Won

The primary bullish argument for owning stocks over the last decade is that low-interest rates support high valuations.

The assumption is the present value of future cash flows from equities rises, and subsequently, so should their valuation. Assuming all else is equal, a falling discount rate does suggest a higher valuation. However, as Cliff Asness noted previously, that argument has little validity.

“Instead of regarding stocks as a fixed-rate bond with known nominal coupons, one must think of stocks as a floating-rate bond whose coupons will float with nominal earnings growth. In this analogy, the stock market’s P/E is like the price of a floating-rate bond. In most cases, despite moves in interest rates, the price of a floating-rate bond changes little, and likewise the rational P/E for the stock market moves little.” – Cliff Asness

The problem for the bulls is simple:

“You can’t have it both ways.”

Either low-interest rates are bullish, or high rates are bullish. Unfortunately, they can’t be both.

As noted, rising interest rates correlate to rising equity prices due to market participants’ “risk-on” psychology. However, that correlation cuts both ways. When rising rates reduce earnings, economic growth, and investor sentiment, the “risk-off” trade (bonds) is where money flows.

With exceptionally high market valuations, the market can remain correlated to rising rates for a while longer. However, at some point, rates will matter.

This time will not be different. Only the catalyst, magnitude, and duration will be.

Investors would do well to remember the words of the then-chairman of the Securities and Exchange Commission Arthur Levitt in a 1998 speech entitled “The Numbers Game:”

“While the temptations are great, and the pressures strong, illusions in numbers are only that—ephemeral, and ultimately self-destructive.”

You can fight the Fed, but eventually, the Fed will win.

Portfolio Trade Alert – 01-13-22

Trade Alert For Equity & ETF Models Only

After having previously reduced our holdings in TLT, the recent decline in bond prices has now pushed TLT to more extreme oversold levels. Importantly, when the Fed begins its rate hikes and tapering program, historically rates fall as the markets enter into a “risk-off” mode. To capitalize on that trade we are using the recent decline in bond prices to increase our duration in the portfolio as a hedge against our long-equity positions.

  • Add 1% of the portfolio to TLT increasing total weighting to 8%.

7-Percent Inflation, What Will The Fed Do?

Inflation is now running at 7-percent, well above the Fed 2% objective. Following the CPI report, Cleveland Fed President Mester mentioned the Fed should sell some of their bond holdings and not merely let them roll off as they mature. This new hawkish wrinkle would greatly speed up balance sheet normalization. Despite the bearish implications for market liquidity, investors not need not worry. Ms. Mester also said they should reduce the balance sheet “as fast as it can without disrupting financial markets.” The Fed’s vocal concern for the stock market helps explain why stocks were relatively calm on the day inflation reached 7-percent, a 40 year high.

consumer price index
Daily Market Commnetary

What To Watch Today


Economy

  • 8:30 a.m. ET: Producer Price Index (PPI), month-over-month, December (0.4% expected, 0.8% in November)
  • 8:30 a.m. ET: PPI excluding food and energy, month-over-month, December (0.5% expected, 0.7% in November)
  • 8:30 a.m. ET: PPI year-over-year, December (9.8% expected, 9.6% in November)
  • 8:30 a.m. ET: PPI excluding food and energy, year-over-year, December (8.0% expected, 7.7% in November)
  • 8:30 a.m. ET: Initial jobless claims, week ended Jan. 8 (200,000 expected, 207,000 during prior week)
  • 8:30 a.m. ET: Continuing claims, week ended Jan. 1 (1.733 million during prior week)

Earnings

7:25 a.m. ET: Delta Air Lines (DAL) to report adjusted earnings of $0.225 on revenue of $8.452 billion

Market Trading Update

Despite a much more hawkish Fed in recent testimony, 7-percent inflation, and a lot of hand-wringing over the recent decline, the market has done “nothing” wrong. The uptrend channel that began in early December remains intact, the current “sell-signals” are starting to turn towards “buys,” and the market pushed above resistance with yesterday’s rally.

Currently, market action remains well contained and there remains little need to get overly concerned, for now. However, as always, things can, and will, change so it remains prudent to be slightly more cautious as we head into 2022.

SP500-Market Update

Value Versus Growth

For the first time in a while, value stocks seem to be gaining momentum versus growth stocks. Is it lasting or just another false breakout for value? We have developed a tool to help us better monitor value versus growth.

The graph below is a weekly scatter plot comparing value’s (IVE) momentum versus its relative strength as compared to growth (IVW). When dots appear in the top right corner it signals that value stocks have strong momentum and relative strength. We should expect the best returns as it heads toward that corner. Conversely, the bottom left corner is the worst area for value stocks. The current level is denoted in orange and the line shows us the path it has traveled over the last 10 weeks. As shown, IVE’s momentum improved over the last four weeks and its relative strength versus IVW slightly improved as well. Based solely on this graph it appears the value trade is still on. Note, the axes are represented in standard deviations. A level of 2 or more is strong but may warn a trend is nearing a possible reversal.

value growth rrg

CPI

The BLS CPI report came in largely as expected. Monthly CPI rose half a percent, which is a slight reprieve from last month’s .8% increase. The annual inflation rate is now 7-percent, the highest since March of 1982. The core inflation rate, the Fed’s preferred inflation gauge, rose to 5.5% annually. This level excludes food and energy prices. The breadth of the report remains troubling. Over half of the 251 subcomponents rose by more than 5-percent and a fifth of them rose by more than 10-percent. On an annual basis, the only major component increasing less than the Fed’s 2-percent inflation objective is medical care.

cpi core inflation

The Math Behind CPI

Why did the annual inflation rate increase despite the monthly rate falling from the previous month? The chart below from the BLS helps us answer the question. As we see below, the monthly rate fell from .8% to .5%. However, when we compute the annual inflation rate, the latest figure, 0.5%, replaces last December’s 0.2%. Next month, we need to see monthly inflation of 0.2% or lower to see a decline in the annual inflation rate. It will probably not be until March or April until the annual rate declines. At those points in time, it becomes more likely the monthly inflation rates are lower than those of a year ago.

cpi inflation

Mortgage Rates Matter

Since August, mortgage rates have been risen by 0.75% as shown below. While the rate increase may seem small it can have a big effect on mortgage payments and how much house a prospective homebuyer can afford. The second graph from our 2018 article The Headwinds Facing Housing demonstrates this.

The sensitivity of mortgage payments to changes in mortgage rates is about 9%, meaning that each 1% increase or decrease in the mortgage rate results in a payment increase or decrease of 9%. From a home buyer’s perspective, this means that each 1% change in rates makes the house more or less affordable by about 9%.”

Needless to say, the recent increase in mortgage rates is certain to restrain further house price appreciation and may actually cause them to decline. A continuation of the trend upwards in mortgage rates further increases the odds that home prices fall.

mortgage rates 30yr
house mortgage real estate

Chasing AMC? Buy Video Games Instead

Over the past year, one of the more famous “meme” stocks was AMC Theaters. Individuals ran the stock price “to the moon” on the assumption that somehow a return from the pandemic would mean a surge in theater profitability. It was a faulty premise, to begin with, but with 7-percent inflation, the return to profitability will become even more challenging.

However, as noted by Chartr, gaming revenues are where it’s at. To wit:

“The chart below gives some context on just how big the video game biz is. Last year the video game industry was pegged at somewhere around $180bn by Newzoo. That’s roughly ten times what the global movie industry brought in at the box office last year. Ten times. Admittedly last year the movie industry was still dealing with a pandemic hangover, but even in its best ever year the box office only brought in $39bn.

Video games may not carry the cultural impact of movies yet, but as a market they are in a completely different league.

Video games vs box office AMC

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Want Double-Digit Returns? Hold Cash.

So, you want double-digit returns in 2022? Hold cash. Sounds crazy, I know.

Especially today with the mainstream financial media headlines and big shots like Ray Dalio, who laments how ravaged cash is due to inflation. While that is indeed true for a long-term investment portfolio to a degree, maintaining a decent cash emergency reserve and going a step further with a financial vulnerability cushion can get you to double-digit returns.

Want to see how? I’ll show you.

First, let me share a broad perspective concerning the state of household cash coffers. According to a 2021 survey from Bankrate, only 39% of Americans say they could cover an unexpected expense of $1,000. Moreover, the Personal Saving Rate, which skyrocketed to 13.1% in 2020, has retreated to 6.9% as of September 2021. Moreover, real wages, which account for inflation, have declined by 1%. Consequently, the overall state of most Americans is cash poor.

Keep in mind, the decision to hold cash is a conscious tradeoff. The reasons to have cash are as diverse as people are. For some, it’s an emotional Snuggie to smooth out portfolio volatility or ‘dry powder’ for future purchases. Perhaps, you’re an investor dependent on portfolio cash to recreate a retirement paycheck.

Regardless of your motivations, maintaining a cash position is the ultimate protection against unforeseen events, and we seem to have quite a few of them over the last decade or so. Wall Street seeks to grab every dollar we possess, so they employ entire marketing departments to pick your pockets.

Even better, they’re persuasive enough for us to pick our own pockets because they disseminate scary stories about cash vs. the inflation monster. And while cash indeed can succumb to the inflation beast, it depends entirely upon the arena in which cash fights your financial battles. In many cases, cash rises victorious.

Cash is fungible – it channels through every financial category and keeps your household functioning – Sort of like oil in an engine. Therefore, breaking down the mental accounting barriers around cash Wall Street built in your head is crucial. In many cases, cash can provide attractive returns just because it’s available, ready for the taking because you need it!

How valuable are liquidity and preservation to robust financial health? Crucial.

One: Cash provides an attractive alternative in case of emergencies.

The Personal Savings Rate has dropped precipitously since March 2020. Household cash accumulated during the pandemic is dwindling. As a result, credit card usage to service daily needs is increasing. In the case of a financial emergency, would I want cash eroded by inflation or maintain a credit card balance?

Per Bankrate.com, the current three-month trend for credit card interest rates is 16.3%, and with the Federal Funds Rate forecasted to increase at least three times this year, interest rates on credit cards will inevitably go higher as well. So isn’t it worth maintaining six months of living expenses in cash instead of turning to high-interest alternatives?

It seems like a rudimentary question, but it’s common for our brains to categorize financial decisions and make them in a vacuum. For example, some consumers maintain a credit card balance yet have cash in reserves to pay it off. Unfortunately, mental walls prevent the flow of cash to its highest and best use in some instances! One small move and double-digit returns come from holding cash and parting with it at an opportune time.

Financial planning appointment

Two: Cash is an asset class and a respected addition to your portfolio.

In a portfolio strategy for retirees in the distribution stage, it makes sense to hold cash, perhaps a year’s worth. After all, periodic distribution of cash, cash flow in general, is the life’s blood of retirement.

However, what about younger investors with over a decade left to retirement? Cash is still worth a place in an accumulation portfolio. Here’s why:.’

Brokers lament – “Cash isn’t working for you! Cash will lose to inflation!” Well, there are times when cash will do just that. However, it’s the responsibility of your money manager to make portfolio adjustments. The ebb and flow of portfolios to adjust for risk is a responsibility most brokers will not undertake; therefore, they must trash cash regardless of valuations and the market’s overall health.

REMEMBER – It’s not cash forever; it’s cash for now. Can you imagine telling your broker that double-digit returns can come from holding cash?

Here, RIA’s Chief Investment Strategist Lance Roberts outlines the inflation-adjusted return of $100 invested in the S&P 500 (capital appreciation only using data provided by Dr. Robert Shiller). The chart also shows Dr. Shiller’s CAPE ratio. Lance caps the CAPE ratio at 23x earnings which has historically been the peak of secular bull markets. He then conducts a simple cash/stock switching model which buys stocks at a CAPE ratio of 6x or less and moves back to cash at a ratio of 23x.

During the significant inflation of the 1970s in the United States, the value of cash experienced downward pressure. In other words, although the CAPE ratio in 1970 was roughly 23x, a switch to cash didn’t work so well, which validates the erosion of returns on cash. However, the sentiment of this chart validates the fact that holding an allocation to cash during a period of nose-bleed valuation levels is a formidable risk management tactic. As of this writing, the Shiller P/E is 39X.

An idea for a do-it-yourself investor is to maintain a minimum of 5% cash to add to opportunities slowly; I expect significant volatility in 2022 as the Fed clumsily severs its love affair with risk assets by pulling liquidity and increasing short term rates.

As Lance so eloquently states –

“While no individual could effectively manage money this way, the importance of “cash” as an asset class is revealed. While cash did lose relative purchasing power, due to inflation, the benefits of having capital to invest at lower valuations produced substantial outperformance over waiting for previously destroyed investment capital to recover.

Time frames are crucial in the discussion of cash as an asset class. If an individual is “literally” burying cash in their backyard, then the discussion of the loss of purchasing power is appropriate.

However, if cash is a “tactical” holding to avoid short-term destruction of capital, then the protection afforded outweighs the loss of purchasing power in the distant future.”

Much of the mainstream media will quickly disagree with the concept of holding cash and tout long-term returns as the reason to remain invested in both good times and bad. The problem is it is YOUR money at risk. Furthermore, most individuals lack the “time” necessary to capture 30 to 60-year return averages truly.

So, if you want double-digit returns, hold cash because it allows you to pounce on opportunities. Again, cash is an emotional salve since it smooths the overall portfolio ride. Thus cash may prevent a novice investor from bailing out of markets entirely at the absolute worst time.

Market updates

Three: Cash can magnify your purchasing power.

Mark Cuban recently shared with Vanity Fair magazine that having cash can save money. In the article, he mentions how “negotiating with cash is a far better way to get a return on your investment.” A valid point. Ironically, cash provides leverage. Yet, leverage or debt places a borrower below a creditor in the financial pecking order of things.

For example, I worked with clients through the financial crisis who possessed tremendous leverage and deployed cash for real estate property offered at distressed prices because of overindebted owners. One client specifically headed to Florida and purchased four Naples and Fort Myers properties for 60 cents on the dollar because he held cash and waited for an opportunity. Today, those houses, townhomes provide robust rental income and have appreciated tremendously since early 2010.

Cash is boring; cash is not a riveting topic for cocktail party fodder.

But double-digit returns can come from holding cash.

Are you smart and patient enough to know when to release it?

The CPI Report Is Coming, Prepare For Volatility

At 8:30 am ET, the BLS will release the December CPI Report. Expectations are for an annual increase from 6.8% to 7.1%. Analysts expect the monthly inflation rate to slow from 0.8% to 0.4%. With the release of the CPI report, we are likely to see volatility in the stock and bond markets. The Fed is making it very clear that fighting inflation is their number one priority. The tools to fight inflation are ending QE, higher interest rates, and reducing the Fed’s balance sheet. QE and lower interest rates provided massive liquidity to markets. How will the markets fare without the excess liquidity?

Daily Market Commnetary

What To Watch Today

Economy

  • 7:00 a.m. ET: MBA Mortgage Applications, week ended January 7 (-5.6% during prior week)
  • 8:30 a.m. ET: Consumer Price Index (CPI), month-over-month, December (0.4% expected, 0.8% in November)
  • 8:30 a.m. ET: CPI excluding food and energy, month-over-month, December (0.5% expected, 0.5% in November)
  • 8:30 a.m. ET: CPI year-over-year, December (7.0% expected, 6.8% in November)
  • 8:30 a.m. ET: CPI excluding food and energy, year-over-year, December (5.4% expected, 4.9% in November)
  • 2:00 p.m. ET: Monthly budget statement, December (-$191.3 billion in November)
  • 2:00 p.m. ET: U.S. Federal Reserve Releases Beige Book

Earnings

  • Post-market: Jefferies Financial Corp. (JEF) to report adjusted earnings of $1.34 on revenue of $1.82 billion 

QT Is Top of Mind At The Fed

The following headlines hit the tape on Tuesday. Jerome Powell and two other Fed members are heavily hinting that not only is balance sheet reduction (QT) likely, but the Fed may do so at a much faster pace than market participants are expecting.

  • BOSTIC SAYS FED COULD EASILY PULL $1.5 TRILLION OF “EXCESS LIQUIDITY” FROM FINANCIAL SYSTEM, THEN WATCH MARKET REACTION FOR FURTHER BALANCE SHEET REDUCTIONS.
  • MESTER: ABLE TO LET BAL SHEET TO RUN DOWN FASTER THAN LAST TIME.
  • POWELL: WE EXPECT TO ALLOW BALANCE-SHEET RUNOFF LATER IN 2022.
  • POWELL: BALANCE SHEET IS FAR ABOVE WHERE IT NEEDS TO BE.
Fed funds rate vs CPI

Real Yields Drive Gold Prices

It is not inflation, runaway fiscal deficits, or the Fed that are the primary driver of gold prices. Believe it or not, real yields or the difference between nominal yields and expected inflation has a strong relationship with gold prices. As real yields fall, gold prices rise. The scatter plot below shows the statistically strong inverse correlation (r-squared .8321) between the two. The chart also provides an equation to model gold versus real yields. The second graph shows that gold is currently about $40 overvalued.

As a rule, every one basis point increase in real yields should result in a $2.5 decline in gold prices and vice versa. Since December 1, 2021, inflation expectations rose by .07% and nominal yields by .35%, resulting in real yields rising by .28%. Over the same period, gold inched higher by $5. Based on the model, gold should have fallen by $69. These dynamics help explain why gold went from undervalued to its current overvaluation.

gold real yields model

Used Car Prices Drive CPI

Since March 2020, used vehicle prices have skyrocketed. While they only account for about 2.5% of the CPI index, they added approximately .60% to CPI annually in each of the last two years. The graph below compares the Manheim and CPI used car price changes since March 2020. As shown, the CPI index is lagging Manheim by about 20%. If CPI catches up to Manheim in tomorrow’s CPI report, used cars will add .40% CPI. That is a significant contribution for such a small component.

cpi used cars

Earnings Season Set To Kick Off

As we enter earnings season, expectations have only softened mildly despite surging inflation, wages, and the subsequent risk to profit margins.

S&P 500 quarterly EPS

Importantly, as we have discussed previously, it is quite likely we will see substantial reversions in estimates later this year, which doesn’t bode well for the broader market.

The Quits Rate is Driving The Fed’s Inflation Concerns

The graph below from the Daily Shot shows why workers are quitting jobs at a record pace. As it shows, higher wages and benefits account for half the workers. The “quits rate” is at 4.527 million, almost a million above where it stood pre-Covid and about 2 million above the average of the last 20 years. The combination of record job openings and record quits rate puts leverage in the hands of employees and prospective employees. The Fed’s concern is that as wages rise, prices will follow, creating a wage-price spiral. We expect to hear more about the risks of a wage-price spiral at its next meeting.

quits rate wages

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2022 Investment Outlook Part 2 – Stocks & Bonds

Stocks are priced for perfection. Bonds trade at historically low yields despite 7% inflation. What could go wrong?

As fiscal and monetary support for the economy and markets wane, valuation extremes are in the crosshairs. While the setup for 2022 is not looking as friendly as 2021, we must realize the environment can change quickly.

For more on the macroeconomic drivers supporting this forecast, please read Part 1 of our 2022 Investment Outlook – Tailwinds Shift To Headwinds.

2022 Investment Outlook for Stocks

Valuations

As shown below, as we have highlighted in many articles, valuations are at or near record levels. While nothing limits valuations from rising further, we must consider a reversion to the mean in many cases can result in losses of greater than 40%.

shiller p/e valuations
pe valuations

Complicating the valuation story is inflation. The graph below shows that historically periods of low inflation or deflation or inflation running greater than 5% are accompanied by CAPE readings of 25 or less. The current reading is 40.

inflation cape valuations

The graph below uses three popular valuation techniques to quantify longer-term future returns. Based on the data, the ten-year outlook is for low single-digit returns at best. The second graph uses CAPE in a similar fashion to show the 20-year outlook is not much better. While our analysis may seem bearish, we reiterate that nothing says valuations cannot continue to stretch further.

tobin cape market cap to gdp
20 year returns valuations

Profit Margins

Corporate profit margins rose to record levels in 2021. Many companies were able to push higher costs onto consumers. At the same time, they were the ultimate beneficiaries of excessive government spending.

As we show below, corporate profits as a percentage of GDP are at the peak of the last decade and well above the 60-year trend leading to the financial crisis. A reversion back to the trend line would result in a 3% decline in profit margins. It is worth considering profit margins tend to revert to and through the trend line. A reversion back to the lows of 2009 and 2002 portends a 50% cut into profit margins. With valuations already at extremes, profit weakness would not support lofty expectations.

corporate profit margins
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The Tail Wagging The Dog- Stock Options

This is where the analysis gets tricky. The graph below from Goldman Sachs shows more volume trading in stock options than the underlying stocks. Options are inherently highly leveraged and volatile. As the amount of options grows versus the shares outstanding, options become the tail wagging the dog.

stock options volumes

As we learned over the last two years, dealer hedging of options positions can result in great rallies. Conversely, as we watched in the second half of 2021, the options expiration period was not an investor’s best friend.

Forecasting how options trading might affect stock prices is nearly impossible for a 2022 investment outlook. That said, options have and will continue to influence the market significantly.

One way to track potential volatility is with Gamma flip levels. Gamma helps us understand how dealers hedge options and react by buying or selling the underlying stocks to maintain hedges. SimpleVisor subscribers receive Viking Analytics weekly Gamma Band Update to help them with this task. The graph below from a recent edition shows recommended allocations based on the Gamma of S&P 500 options.

gamma viking analytics
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2022 Investment Outlook for Bonds 

The outlook for bonds is equally tricky. If you had asked most bond traders a year ago where they thought bond yields would be if inflation approached 7%, most would have said much higher than current levels.

Inflation and Growth Drive Bond Yields

The graph below from Longview Economics show bond yields are abnormally low given the level of inflation. Per the historical relationship between 10-year UST yields and inflation, the 10-year yield should be 4-7%.

inflation and yields

To help explain this anomaly, we must consider that bond traders tend to look at inflation beyond a year or two when determining value. Low expected inflation or deflation helps justify negative real yields today. Currently, TIPs markets imply 2.48% inflation for the next ten years.    Bond traders must be confident inflation is transitory. If persistently high inflation becomes more likely, bond yields could rise quickly.  

Economic growth over the next ten years is likely to be 2% or lower based on productivity and demographic trends. The Fed’s long-range forecast is 1.6-2.2%. The graph below shows the trends for GDP, and yields have been lower for the last 40 years. Note the declining yield trend is steeper than GDP. Some of this is due to the Fed’s influence on rates.  

gdp and yields

The Fed

As noted in Part 1 of the 2022 Investment outlook, the Fed has been buying nearly 100% of what the Treasury is issuing. To wit- “the Fed has bought nearly $5 trillion of bonds since the pandemic began. In doing so, it came close to absorbing 100% of the net new debt issuance from the government.”

Banks Are Flush With Cash

The graphs below help explain a third important factor keeping yields low. The bottom chart shows deposits at commercial banks are growing much faster than banks are lending money. The banks need to invest deposits, and since they are not lending them out, they frequently invest in U.S. Treasury securities. The upper graph shows the statistically strong correlation (R-squared .76) between the ratio of loans and leases to deposits versus ten-year Treasury yields.  Unless the banks are going to start significantly ramping up lending, which we doubt, expect current trends to continue, thus supporting low yields.

fed banks loans leases deposits

Lower Yields

We think inflation is in the process of peaking. Shortages and supply line problems are slowly diminishing. At the same time, demand is normalizing, and there is little fiscal stimulus on the horizon to boost demand further. We offer a big disclaimer. The current environment is anything but typical. While we think inflation will ease, we are mindful that factors, such as rising wages may keep it elevated.

Yields have trended lower for the past 30 years, following economic growth. We think those trends continue in the year ahead.

Some will counter that if the Fed is not buying bonds who will? We do not know, but as we conclude in Taper is Coming: Got Bonds?: “Currently, yields are close to their cycle highs. If we believe the Fed is nearing tapering, yields could be peaking. Based on prior QE taper experiences, a yield decline of 1% or even more may be in store for the next six months to a year if the Fed is, in fact, on the doorsteps of tapering.”

The graph below from the article shows yields tend to fall after periods of QE and when they are reducing their balance sheet (QT) as circled. QT is currently being discussed by Fed members per the two headlines below.

  • BOSTIC SAYS FED COULD EASILY PULL $1.5 TRILLION OF “EXCESS LIQUIDITY” FROM FINANCIAL SYSTEM, THEN WATCH MARKET REACTION FOR FURTHER BALANCE SHEET REDUCTIONS
  • MESTER: ABLE TO LET BAL SHEET TO RUN DOWN FASTER THAN LAST TIME
fed taper qe qt
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An ISM Reading That May Make You Rethink Your Stock/Bond Allocations

In a recent daily Commentary we wrote the following. This quick note provides another reason yields may fall in the coming months.

The ISM Manufacturing Index was below expectations at 58.7, an 11-month low. Notably, the prices paid index fell sharply from 82.4 to 68.2, and supplier delivery times fell to a four-month low. The data provide signals that inflationary pressures are fading, at least for the time being.

The first graph below, from Stouff Capital, shows the strong correlation between the difference of new orders and inventories compared to the ISM Index. The differential leads the ISM index by three months. If the correlation holds up, we should see a steep decline in ISM in the coming three months.

ism manufacturing

The following two graphs show how ISM’s decline may affect bond yields. The first graph below, courtesy of Brett Freeze, shows a statistically strong correlation between nominal ISM (inflation-adjusted) and ten-year UST yields. If the nominal ISM is reversing as it appears, we should expect lower yields. The second graph, courtesy of Mott Capital, charts the correlation of the ISM Prices paid index and inflation expectations. Assuming manufacturing inflation is finally cooling off, inflation expectations should follow. Lower inflation expectations will help reduce bond yields.

ism and yields
ism and tips

Rotations Matter

In 2021, the key to success was understanding when inflationary narratives would dictate market conditions and when deflation narratives drove investors. We do not think 2022 will be as simple.

It is quite possible that value versus growth and low beta versus high beta may be the rotations to key on. As we wrote in An Investment Playbook for Thriving During the Next Market Crash:

“We think it’s likely that value stocks will significantly outperform growth stocks in the event of a sizeable drawdown. Timing the transition from growth to value will be difficult, but such a rotation will likely prove invaluable. You may want to keep the 2000 investment playbook handy.”

Summary

If we learned anything from 2020, the future is far from certain. Not only should we expect the unexpected, but the market reactions to the unexpected may be vastly different than what many assume.

What we discuss above is our best guess as of today. We may be right in some areas and wrong in others. More importantly, we must adjust our expectations as political, economic, and monetary conditions and investor sentiment change.

Navigating 2021 in hindsight was easy. However, a year ago, the outlook was daunting. No doubt 2022 will offer us both risk and rewards. Limiting risks and reaping the rewards will help traverse what offers to be another tricky year.

Maybe, more importantly, relying on trusted economic and market models and not letting psychological biases hinder investment decisions may prove to be the best advice we can offer.

Portfolio Trade Alert – 01-11-22

Trade Alert For Macro Momentum Model Only

We are still in the process of building out the Macro Momentum Model. However, since performance is judged on an annual basis, we are allocating the cash to the market in bulk today until we are ready to buy individual securities. As we begin buying individual positions we will sell off the index holdings until the model is complete. Such should, in theory, keep the model aligned with the benchmark index during the buildout phase.

This is not a recommended trade. We are in the process of building a model which will take some time. While the model is live, it is a “project in the works,” so treat it accordingly.

  • Buy 30% of the portfolio in each of the following: RSP, QQQ, SPY
  • Leave 10% in cash for initial individual equity purchases.

Small-Cap Stocks Are On Thin Ice

While the large-cap indexes trended higher throughout 2021, small-cap stocks (IWM) spent most of the year in a trading range. The recent market downdraft is pushing the Russell 2000 small-cap stocks index to the bottom end of the 2021 range. Given how long the index has consolidated and how many times technical support has held, a close below the range would be troubling for small-cap stocks and potentially the broader larger-cap indexes. Our proprietary cash flow model is close to signaling a buy for IWM, so small-cap stocks may not break through the thin ice this time.

small-cap stocks russell 2000 iwm
Daily Market Commnetary

What To Watch Today

Economy

  • 6:00 a.m. ET: NFIB Small Business Optimism, December (98.7 expected, 98.4 in November)

Earnings

  • No notable reports scheduled for release

Time To Buy The Dip?

While it may not be time to buy small-cap stocks, it could be time for the Nasdaq names that have come under selling pressure since the beginning of the year.

“Nobody has missed the latest squeeze higher in NASDAQ volatility, absolutely, as well as relatively speaking. Note that the VXN vs VIX ratio is actually reversing lower today. Last time the ratio rose and then suddenly reversed, NASDAQ decided putting in a local low and ripped higher. Imagine that pain, especially given the fact we are in deep short gamma territory.” – @themarketear

Nasdaq vs Vix

More On ARKK

In last week’s Commentary, we discussed the recent downfall of ARKK. The Financial Times piles on with bearish information on ARKK’s holdings. To wit:

Company insiders sold $13.5bn of stock — and bought just $11m — in the six months to December

ARKK insider transactions.

Such insider selling is surprising given the underlying companies have such a high return potential. With the most knowledge of their companies’ operations, it appears insiders realize valuations are too extreme. Per the article- If the smart people are not buying, why should anyone else?

“Company insiders tend to be quite contrarian in their actions. They buy after a big drop. We have had a big drop and we have seen a lot of selling and not much buying. If the smart people are not buying, why should anyone else? Bubbles are always and everywhere a transfer of wealth from the public to insiders.”

ARKK shareholder value creation

Why Foreign Stocks Have Been Weak

Since January 2006, the S&P 500 is up 275%, while the global equity MSCI World (excluding the USA) is up 40%. The graph below, courtesy of @Mrblonde_macro, shows that S&P earnings are up approximately 185% over the same period while the MSCI earnings are relatively flat. While the S&P 500 index has risen in part due to increasing valuations, with P/E ratios in the upper 20s, the graph also makes it clear that investors are willing to pay up for earnings growth.

foreign stocks

With The Fed Ending QE, Who Will Buy Bonds?

The two graphs below provide one reason for low bond yields. The bottom graph shows that deposits at commercial banks are growing while bank lending is relatively flat. The banks need to invest the deposits, and since they are not lending them out, they frequently invest in U.S. Treasury securities. The upper graph shows the statistically strong correlation (R-squared .76) between the ratio of loans and leases to deposits versus ten-year Treasury yields. Unless the banks significantly ramp up lending, we should continue to expect current trends to continue, thus supporting low yields.

loans leases bonds yields qe

Taper Tantrum

The Bloomberg chart below shows five-day changes in the 10-year real yield, going back 20 years. Excluding March 2020, when the bond market was illiquid due to the onset of Covid, the rise in yields over the last week was the greatest since the original taper tantrum in 2013. TLT, the long bond ETF, is now trading nearly 3-standard deviations below its 20-day moving average.

taper tantrum bonds qe

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“Passive ETFs” Are Hiding The Bear Market

Passive ETFs are hiding a bear market in stocks. That may sound like a strange statement when you look at major stock market indexes hovering near all-time highs. However, much like an iceberg, what we see on the surface hides much of what lies beneath.

Such was a point we discussed in more detail in “Wipe Out:”

One of the problems with the financial markets currently is the illusion of performance. That illusion gets created by the largest market capitalization-weighted stocks. (Market capitalization is calculated by taking the price of a company multiplied by its number of shares outstanding.)

Notably, except for the Dow Jones Industrial Average, the major market indexes are weighted by market capitalization. Therefore, as a company’s stock price appreciates, it becomes a more significant index constituent. Such means that prices changes in the largest stocks have an outsized influence on the index.

You will recognize the names of the top-10 stocks in the index.”

Wipe Out, “Wipe Out” Below The Calm Surface Of The Bull Market

Currently, the top-10 stocks in the S&P 500 index comprise more than 1/3rd of the entire index. In other words, a 1% gain in the top-10 stocks is the same as a 1% gain in the bottom 90%.

Wipe Out, “Wipe Out” Below The Calm Surface Of The Bull Market

Such is the story of 2021. Had it not been for the enormous returns in companies like Apple (AAPL), Google (GOOG), Microsoft (MSFT), Tesla (TSLA), and Nvidia (NVDA), the return for the year would be much different.

The Nasdaq Bear Market

The same story holds for the Nasdaq, which is also heavily dominated by the same stocks as the S&P 500. As noted, without the support of the top-10 holdings, the year-to-date returns and overall volatility would be very different.

If we look at a sampling of the more “popular” trading stocks, you can understand current retail traders’ frustration. A vast majority of 2020 and early 2021’s high-flying stocks are down significantly from their respective 52-week highs.

Wipe Out, “Wipe Out” Below The Calm Surface Of The Bull Market

Of course, probably one of the best representations of the disparity between what you see “above” and “below” the surface is the ARKK Innovation Fund (ARKK). While the S&P 500 index was up roughly 27% in 2021, ARKK is down more than 20%. That is quite a performance differential but shows the disparity between the mega-cap companies and everyone else.

Wipe Out, “Wipe Out” Below The Calm Surface Of The Bull Market

As discussed in this past weekend’s newsletter, such is a phenomenon.

“After Wednesday’s post-FOMC selloff, more than 38% of stocks trading on the Nasdaq are now down 50% from their 52-week highs. Only 13% of days since 1999 have seen more stocks cut in half.

At no other point since at least 1999 have so many stocks been cut in half while the Nasdaq Composite index was so close to its peak. When at least 35% of stocks are down by half, the Composite has been down by an average of 47%. – Sentiment Trader

Fed Minutes, Fed Minutes Spook Markets Into Selloff

The last sentence is critical. There is no precedent for when so many stocks were in a bear market, yet the index was near its historical highs.

It’s A Passive Indexing Mirage

So, how is it that despite the destruction below the surface, so many indexes hold near highs? Not surprisingly, it is a mirage caused by passive indexing.

Currently, more than 1750 ETFs are trading in the U.S., with each of those ETFs owning many of the same underlying companies. For example, how many passive ETFs own the same stocks comprising the top-10 companies in the S&P 500? According to ETF.com:

  • 363 own Apple
  • 532 own Microsoft
  • 322 own Google (GOOG)
  • 213 own Google (GOOGL)
  • 424 own Amazon
  • 330 own Netflix
  • 445 own Nvidia
  • 339 own Tesla
  • 271 own Bershire Hathaway
  • 350 own JPM

In other words, out of roughly 1750 ETF’s, the top-10 stocks in the index comprise approximately 25% of all issued ETFs. Such makes sense, given that for an ETF issuer to “sell” you a product, they need good performance. Moreover, in a late-stage market cycle driven by momentum, it is not uncommon to find the same “best performing” stocks proliferating many ETFs.

Therefore, as investors buy shares of a passive ETF, the shares of all the underlying companies must get purchased. Given the massive inflows into ETFs over the last year and subsequent inflows into the top-10 stocks, the mirage of market stability is not surprising.

The following chart shows the mirage of the stability of the index from Sentiment Trader. Despite the most significant damage below the surface since 1999, the reason that most of the large-capitalization passive ETFs don’t own the majority of the smaller capitalization stocks in the index. Therefore, the continuous buying of ETFs keeps the largest capitalization, and hence the index themselves, elevated.

Of course, that will change if, and when, investors who are “passive investing” become “active sellers.”

The Liquidity Problem

The “stability” provided by passive index buying will also ultimately be the source of “instability.” When so many ETFs own the same company, the “liquidity” problem becomes evident during a market rout. The head of the BOE, Mark Carney, warned about the risk of “disorderly unwinding of portfolios” due to the lack of market liquidity.

“Market adjustments to date have occurred without significant stress. However, the risk of a sharp and disorderly reversal remains given the compressed credit and liquidity risk premia. As a result, market participants need to be mindful of the risks of diminished market liquidity, asset price discontinuities and contagion across asset markets.”

Howard Marks also noted in ‘”Liquidity:”

“ETFs have become popular because they’re generally believed to be ‘better than mutual funds,’ in that they’re traded all day. Thus an ETF investor can get in or out anytime during trading hours. But do the investors in ETFs wonder about the source of their liquidity?’”

Let me explain.

There is a true statement about how markets work.

“For every buyer, there is a seller.” 

Market participants believe if an individual wants to sell, there will always be a buyer available to “sell to.”

Such equates to the “greater fool theory.”

However, such is not the case.

A Lack Of Buyers

The correct statement is:

“For every buyer, there is a seller….at a specific price.”

In other words, when the selling begins, those wanting to “sell” overrun those willing to “buy,” so prices have to drop until a “buyer” is willing to execute a trade.

The “Apple” problem, using our example above, is that while investors who are long Apple shares directly are trying to find buyers, the 363 ETF’s that also own Apple shares are vying for the same buyers to meet redemption requests.

This surge in selling pressure creates a “liquidity vacuum” between the current price and a “buyer” willing to execute. Therefore, as we saw last week, Apple shares fell faster than the SPDR S&P 500 ETF, of which Apple is one of the most significant holdings.

Secondly, as noted, the ETF market is not a PASSIVE MARKET. Today, advisors are actively migrating portfolio management to passive ETFs for either some, if not all, of the asset allocation equation. Importantly, they are NOT doing it “passively.” The rise of index funds has turned everyone into “asset class pickers” instead of stock pickers. However, just because individuals are choosing to “buy baskets” of stocks rather than individual securities, it is not a “passive” choice but rather “active management” in a different form.  

While “passive indexing” sounds like a winning approach to “pace” the markets during the late stages of an advance, it is worth remembering it will also “pace” just as well during the subsequent decline.

Conclusion

Despite the best intentions, individual investors are NOT passive even though they invest in “passive” vehicles. Eventually, some exogenous, unexpected event will change investors’ “speculative” psychology. When the psychology changes from “bullish” to “bearish,” the rush to liquidate entire baskets of stocks will accelerate the decline making sell-offs more violent than what we saw in the past.

This concentration of risk, lack of liquidity, and a market increasingly driven by “robot trading algorithms,” reversals are no longer a slow and methodical process but rather a stampede with little regard to price, valuation, or fundamental measures as the exit becomes very narrow.

March 2020 was just a “sampling” of what will happen to the markets when the next bear market begins.

Viking Analytics: Weekly Gamma Band Update 1/10/2022

We share the Weekly Gamma Bands Update by Viking Analytics. The report uses options gamma to help you better manage risk and your equity allocations.

Gamma Band Update

The S&P 500 (SPX) touched all-time highs last week before selling off meaningfully on Fed rate hike fears.  The gamma flip ended the week near 4,740 and our model allocation has 50% exposure to SPX. The delta hedge programs will be selling the dips and buying the rips as long as the market remains below the gamma flip level. 

The Gamma Band model[1] is a simplified trend following model that is designed to show the effectiveness of tracking various “gamma” levels. This can be viewed conceptually as a risk management tool. When the daily price closes below Gamma Flip level, the model will reduce exposure to avoid price volatility and sell-off risk. If the market closes below what we call the “lower gamma level” (currently near 4,570), the model will reduce the SPX allocation to zero.

The main premise of this model is to maintain high allocations to stocks when risk and corresponding volatility are expected to be low.  For investors who have been conditioned to “buy low and sell high,” it is counter-intuitive to increase allocations when the market rises, but this approach has shown to increase risk-adjusted returns in the back-test.  

The Gamma Band model is one of several indicators that we publish daily in our SPX Report (click here for a sample report).  

With stocks climbing to obscenely high relative valuations, risk management tools have become more important than ever to manage the next big drawdown. We incorporate many options-based signals into our daily stock market algorithms. Please visit our website to learn more about our trading and investing tools.

The Gamma Flip – Background

Many market analysts have noted that daily volatility in the S&P 500 will change when the value of the SPX moves from one gamma regime to another.   Some analysts call this level the “gamma flip.”  The scatterplot below shows how price volatility (on the y-axis) is increasingly lower as the value of SPX rises higher above the Gamma Neutral level (on the right side of the chart).  When the value of the S&P closes lower than Gamma Neutral (to the left of the chart), volatility increases. 

Gamma Band Model – Background

The purpose of the Gamma Band model is to show how tail risk can be reduced by following a few simple rules.  The daily Gamma Band model has improved risk-adjusted returns by over 60% since 2007.  The graph below demonstrates how this approach can limit drawdowns while maintaining good returns.  A quick video introduction of the Gamma Band model can be seen by following this link

Disclaimer

[1] The Gamma Band model in our SPX Market Report adjusts position size DAILY based upon the daily closing levels of SPX value and calculated Gamma Neutral.  The Weekly Gamma Band model is shown for illustrative purposes only.

This is for informational purposes only and is not trading advice.  The information contained in this article is subject to our full disclaimer on our website.

Authors

Erik Lytikainen, the founder of Viking Analytics, has over twenty-five years of experience as a financial analyst, entrepreneur, business developer, and commodity trader. Erik holds an MBA from the University of Maryland and a BS in Mechanical Engineering from Virginia Tech.

Rob McBride has 15+ years of experience in the systematic investment space and is a former Managing Director at a multi-billion dollar hedge fund. Rob has deep experience with market data, software and model building in financial markets.  Rob has a M.S. in Computer Science from the South Dakota School of Mines and Technology.

 


GameStop Dumps As Speculative Fever Fades

Investor exuberance for speculative investments is increasingly waning. For instance, GameStop (GME) surged 25% in after-hours trading Thursday night after they announced plans to build an NFT marketplace. This is just another step as they morph into a cryptocurrency company. Earlier in 2021, when the speculative fever was rampant, Gamestop would have continued higher.

On Friday, GameStop dumped, giving up almost all of its gains. Speaking of speculative investments, Bitcoin is trading at 42,000, down about 33% over the last few months. These and other instances tell us investors are becoming more risk-averse. We are watching to see if the change in behavior filters to larger and well-tracked stocks and indexes.

gme gamestop bitcoin
Daily Market Commnetary

What To Watch Today

Economy

  • 10:00 a.m. ET: Wholesale inventories, month-over-month, November final (1.2% expected, 1.2% in previous print)

Earnings

  • No notable reports scheduled for release

Politics

The Week Ahead

This will be an important week with CPI on Wednesday and PPI the following day. The Fed is clearly basing policy decisions on inflation. As such, investors are likely to be sensitive to these critical reports. Current expectations are for CPI to rise to 7.1% and core (excluding food and energy) to jump from 4.9% to 5.4%. This is the last set of BLS inflation data before the Fed meets on January 26th.

Retail sales will be released on Friday. A small but growing concern of the market is stagflation. A negative retail sales number might further fuel such worries. The University of Michigan Consumer Sentiment and Inflation Expectations report will also come out on Friday.

The banks lead off Q4 earnings reporting this week. JPM, Citi, Wells Fargo, and Blackrock announce on Friday.

High Risk Stocks Have Taken A Beating – Time To Buy?

Higher risk stocks have underperformed significantly over the past 6 months, which is quite unusual considering that the drawdown in SPX has been very limited. – @TheMarketEar

Risky stocks and market drawdowns

A Good and Bad Employment Report

The BLS jobs report fell short of the ADP report for the second month in a row. 199k jobs were added in December, half of the expected amount. The BLS revised October and November up by 141k. Despite the weaker number, the unemployment rate fell appreciably from 4.2% to 3.9%. Of concern for the Fed, monthly hourly earnings doubled to .6% from .3% last month. The current monthly rate indicates wage growth of 7.2%, which is more or less in line with inflation. That said, the year-over-year rate is 4.7%, down .1% from last month and below the inflation rate. While the monthly boost in earnings is welcome news for workers, the Fed must grapple with whether companies raise prices to offset higher wages. The potential for wage-price spiral inflation is undoubtedly on their minds. The graph below shows how various sectors contributed to the BLS jobs number.

labor jobs bls

Got Bonds?

The key takeaway from last week’s Fed minutes was the increasing desire of Fed members to end QE rapidly but, more importantly, reduce the size of the Fed’s balance sheet, aka Quantitative Tightening (QT). Does this mean we should sell our bonds and maintain low-duration bond holdings? The graph below argues otherwise. It shows that bond yields tend to fall when QE ends. The circled area shows the one instance the Fed reduced the size of their balance sheet (QT). In late 2018 and 2019, yields initially rose slightly and then fell precipitously. You can read about the graph and on how bonds react to tapering and QT in our article- Taper is Coming: Got Bonds.

bonds fed QE QT

Chipotle Wants To Eat Taco Bell’s Lunch

Chipotle may be no Gamestop, but they are “in it to win it.”

Fast Mexican (or Tex-Mex) food is a really hot market — and Chipotle Mexican Grill is slowly catching up to Taco Bell, the biggest Mexican-based fast-food chain in the US. Last year Taco Bell’s system-wide sales were flat year-on-year, Chipotle grew 7%.

So it’s interesting that this week Taco Bell announced its latest innovation to re-invigorate growth: the Taco Lover’s Pass subscription, which gives you one taco a day for a whole month for $10. The idea is that you might stop by Taco Bell for your free taco, and decide that you were hungry and thirsty after all, and end up adding to your order. 

Taco Bell isn’t the first restaurant to experiment with subscriptions. Panera has one for drinks, and Sweetgreen just launched a loyalty subscription for its salads.

So far the jury’s out on whether these subscriptions actually work, or if they’re more of a short-term gimmick, but Taco Bell did say that its test of the subscription in Arizona grew its rewards program by 20%. – Chartr

Chipotle vs Taco Bell

IPOs Out of Favor

Over the last week, we reviewed a few speculative sectors that started 2021 on solid footing but lagged significantly as the year went on. In addition to GameStop, as discussed above, we can add newly issued IPOs to the list. As the SimpleVisor graph shows, the IPO ETF (IPO) has fallen well behind the S&P500. Since January 1, 2021, IPO has lost 23% compared to a 23% gain for the S&P 500.

IPOs out of favor.

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Technical Value Scorecard Report – Week Ending 1/7/2022

This report will now be released on Mondays so we can capture the full trading week (Monday through Friday). The scorecard report uses a series of technical studies to quantify how various sectors, factors, and indexes score on a technical basis versus the S&P 500 (relative value) and versus an appropriate benchmark, as well as on an absolute stand alone basis (absolute value).

Relative Value Graphs

  • The theme permeating this past week’s and the previous few week’s trading is that of value handily beating growth. Since the end of the year, S&P 500 large-cap value (IVE) is up 1.1%, while the large-cap growth ETF (IVW) is down 4.5%. The price action is evident when looking at the sector and factor/index graphs and the third graph below comparing value and growth.
  • The energy sector (XLE) score rose sharply from slightly oversold to well overbought. Its score of 75% signals a reversal or consolidation is in store. XLE rose over 10% last week, while the S&P retreated 2%.
  • The other leading sectors, consumer staples, and financials, are heavily dominated by value stocks. Conversely, note that technology and communications are the most oversold sectors. Communications have a good dose of value stocks such as T and VZ, but GOOGL and FB comprise about 45% of the ETF. Without the likes of the more traditional communications companies, the score would likely be much worse.
  • Value/Growth, Equal weighted S&P 500 (RSP), and the Dow are the most overbought factors/indexes pointing again toward the strong demand for value.
  • The hunt for value occurs as bond yields rise quickly and inflationary concerns are surfacing again. Note that TLT, upper right graph, has a score of -50%. We deem such a score very oversold in the fixed income sectors. TLT will likely bounce, perhaps after this coming week’s inflation data.
  • Market breadth improved this past week again as the S&P retreated. Note the relatively even number of sectors spread out between overbought and oversold.

Absolute Value Graphs

  • The absolute charts tell the same story. Note the highest scores belong to energy, financials, and staples. The only oversold sectors are technology and communications.
  • While the scores of financials and energy have some room to rise, they are both trading at least two standard deviations above their respective 20, 50, and 200dmas. Conversely, Technology and the NASDAQ are trading below their 20 and 50 dmas. A reversal of fortunes favoring growth may likely occur this week. Of more importance, though, will it be short-lived, or are we witnessing a lasting rotation toward value stocks?
S&P 500 relative sector
S&P 500 absolute sector
value vs growth S&P 500 ive ivw

Users Guide

The technical value scorecard report is one of many tools we use to manage our portfolios. This report may send a strong buy or sell signal, but we may not take action if other research and models do not affirm it.

The score is a percentage of the maximum score based on a series of weighted technical indicators for the last 200 trading days. Assets with scores over or under +/-70% are likely to either consolidate or change the trend. When the scatter plot in the sector graphs has an R-squared greater than .60, the signals are more reliable.

The first set of four graphs below are relative value-based, meaning the technical analysis is based on the ratio of the asset to its benchmark. The second set of graphs is computed solely on the price of the asset. At times we present “Sector spaghetti graphs,” which compare momentum and our score over time to provide further current and historical indications of strength or weakness. The square at the end of each squiggle is the current reading. The top right corner is the most bullish, while the bottom left corner is the most bearish.

The ETFs used in the model are as follows:

  • Staples XLP
  • Utilities XLU
  • Health Care XLV
  • Real Estate XLRE
  • Materials XLB
  • Industrials XLI
  • Communications XLC
  • Banking XLF
  • Transportation XTN
  • Energy XLE
  • Discretionary XLY
  • S&P 500 SPY
  • Value IVE
  • Growth IVW
  • Small Cap SLY
  • Mid Cap MDY
  • Momentum MTUM
  • Equal Weighted S&P 500 RSP
  • NASDAQ QQQ
  • Dow Jones DIA
  • Emerg. Markets EEM
  • Foreign Markets EFA
  • IG Corp Bonds LQD
  • High Yield Bonds HYG
  • Long Tsy Bonds TLT
  • Med Term Tsy IEI
  • Mortgages MBB
  • Inflation TIP
  • Inflation Index- XLB, XLE, XLF, and Value (IVE)
  • Deflation Index- XLP, XLU, XLK, and Growth (IWE)

Speculative Mania – Was 2021 The Peak?

“Speculative” is a word that aptly sums up the year 2021. The question that remains, however, is whether we have seen the peak in that speculative behavior, or will 2022 continue the trend?

From the mainstream media’s view, expectations are high that 2022 will be a continuation of 2021. Maybe such will be the case. However, as we laid out just recently, many of the headwinds that supported the ramp in speculative behaviors have, or will, reverse in the months ahead. To wit:

  • Tighter monetary policy, and high valuations.
  • Less liquidity globally as Central Banks slow accommodation.
  • Less liquidity in the economy the previous monetary injections fade.
  • Higher inflation reduces consumption
  • Weaker economic growth
  • Weak consumer confidence due to inflation
  • Flattening yield curve
  • Weaker earnings growth
  • Profit margin compression
  • Weaker year-over-year comparisons of most economic data.

I am sure I have forgotten a couple of things.

As is always the case, the event that changes the “bullish psychology” is always unknown. However, the eventual market reversion is almost always a function of changes in liquidity or a contraction in earnings.

Heading into 2022, a review of 2021 can undoubtedly provide some clues as to what potentially happens next. Notably, “record levels” of anything are records for a reason as it denotes the last period before the eventual reversion.

Peak Buybacks

While not a direct measure of speculative activity, share buybacks hit a record last year as companies rushed to improve bottom-line EPS reports. As we noted previously, more than 40% of the index’s total return since 2011 came from share buybacks. Over the last few years, in particular, they have accounted for nearly 100% of the net buying in the market.

Share buybacks

So, the question for 2022 is this:

“If buybacks accounted for a large portion of the net purchases in the equity market, what happens if those buybacks reverse?”

While it may seem like an unlikely event now, there are many reasons companies could rethink using cash for uneconomic benefits. For example, higher interest rates, slower economic growth, or declining share values could cause companies to hoard cash rather than spend it.

There is also the risk of legislative action due to the problem of “wealth inequality” in America. Over the last couple of years, CEO’s have gotten pushed into the spotlight for their excess wealth. While Congress may not lift taxes on the wealthy, an easy fix is making share buybacks illegal once again. Via Vox:

“Buybacks were illegal throughout most of the 20th century because they were considered a form of stock market manipulation. But in 1982, the Securities and Exchange Commission passed rule 10b-18, which created a legal process for buybacks and opened the floodgates for companies to start repurchasing their stock en masse.”

Everyone Is In The Pool

Another sign of excess speculation has been a record flood of liquidity into global equity funds over the last 18-months. Since the 2020 pandemic-driven economic shutdown, roughly $1.3 trillion in capital flowed into equity funds globally.

global equity fund flows

The massive floods of Central Bank liquidity and fiscal policy interventions by global governments swamped the financial system. So naturally, those funds found their way into equity funds to chase surging asset prices.

As we head into 2022, as noted above, the global government and central bank liquidity spigots are getting turned down. Interest rates are rising, and inflation is starting to affect policy decision-making. The result may well be a reversal of those flows into equity funds as witnessed in 2015-2016 and 2018-2019 as the Fed tightened monetary policy and tapered their balance sheet.

However, for now, everyone is still in the pool. When it comes to a speculative market, you don’t want to be the last one out.

IPO’s & SPAC’s

The actual image of speculation came in the form of Wall Street rushing to dump their private equity investments onto the unsuspecting public. It is always worth remembering that Wall Street is a huge business. Their job is to fill investor demand with supply.

In 2021, demand for products was exceedingly strong, from ESG funds to electric vehicles, disruptive technologies, and cryptocurrencies. So, if Wall Street could not get the company to market using a traditional IPO (initial public offering) process, a SPAC (Special Purpose Acquisition Company) was a quick way to get it done.

IPO's brought to market by year.

As shown below, investors were eager to buy the IPOs of companies even though most of them generated no profits. But in a “speculative market,” such is not surprising.

Non-profitable technology index

There was also a record number of private companies to reach $1 billion in market capitalization. In total, with private equity funds flush with capital, there were more than 800 “Unicorns” in 2021 alone.

Global unicorns in 2021

If Unicorns are supposed to be a rare and magical sighting, 2021 was truly unique in that it generated 30 companies that reached $10 billion in market capitalization.

Global decacorn count by year.

In the end, only Wall Street will benefit from the rush to supply speculative products to retail investors armed with a stimulus check and a trading app. But, as shown, by the end of 2021, most IPOs and SPACs failed to work as well as hoped.

IPOs profitable and non-profitable

Will 2022 see a recovery?

All Levered Up

Seth Klarman’s famous book, “A Margin Of Safety,” discussed the 1980’s bond mania before it imploded. At that time, many companies issued bonds despite little ability to pay the interest expenses. Today, we call such companies “zombies.” Such is because they must feed on cheap debt to stay alive. Currently, the market capitalization of these zombie firms is at a record.

Number of companies with EBIT less than interest expense. Zombie firms.
Chart courtesy of Kailash Concepts

The obvious problem is what happens when they cannot refinance their debt. Unfortunately, as Kailash Concepts explains, debt itself is a significant risk.

Currently, the world is awash in financial alchemy. There are a record number of companies unable to cover their interest expense from profits.

Since 2007, a big part of America’s debt crisis has moved from the financial sector to non-financial stocks with too much debt. We believe the mix of record debt and equity valuations is likely a side effect of real rates approaching lows last seen in 1973. Whether we are right or wrong on the causality, the facts are intimidating in our view.

Our research has documented the world has never been less prepared or equipped to deal with a possible outbreak of inflation or pull-back in Federal largesse.

However, it isn’t just a corporate leverage bubble. There is also a bubble in investor leverage.

margin debt balances

Not only did retail investors take on margin debt to leverage their bets in the markets, but they also took on a record level of speculative single stock options. Such is the purest form of speculation in the market.

Ratio of single stock options trading volume

The problem with options and margin debt is that individuals have little control over the outcome. If asset prices fall, for any reason, investors speculating with leverage and options get wiped out from margin calls and contract expiration.

It’s not a pretty thing.

Price To Sales Rocketship

The best measure of speculation in the market, in my opinion, is the number of people willing to pay more than 10x price-to-sales for an investment. But what about 20x? Kailash Capital recently showed an increase in the market capitalization of stocks with price-to-sales ratios greater than 20x.

“While we’ve seen an increase in the number of companies coming public via IPO’s / SPAC’s the number of investable companies hasn’t kept pace with the degree of inflows, resulting in re-ratings. Looking at the total market cap of stocks with P/S in excess of 20x we’ve surpassed the tech bubble high by nearly ~$1.0T.” – Kailash

Stocks with price to sales greater than 20x

If you don’t understand why this is so essential, let me remind you what Scott McNealy, then CEO of Sun Microsystems, told investors paying 10x Price-to-Sales for his company in a 1999 Bloomberg interview. 

“At 10-times revenues, to give you a 10-year payback, I must pay you 100% of revenues for 10-straight years in dividends. That assumes I can get that by my shareholders. It also assumes I have zero cost of goods sold, which is very hard for a computer company.

That assumes zero expenses, which is hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that expects you pay no taxes on your dividends, which is kind of illegal. And that assumes with zero R&D for the next 10-years, I can maintain the current revenue run rate.

Now, having done that, would any of you like to buy my stock at $64? Do you realize how ridiculous those underlying assumptions are? You don’t need any transparency. You don’t need any footnotes.

What were you thinking?”

Investors have forgotten the most crucial point of investing.

“The price you pay is the value you get.” – Warren Buffett

Speculation Always Ends Badly

The amount of speculation in the market currently is rampant. There have only been a couple of times in history when we saw similar investors’ actions, and both ended poorly.

The three most significant market risks heading into 2022 are a reversal of the things that supported the speculative attitude of investors over the last year: buybacks, liquidity, and earnings growth. Notably, the reversal of liquidity impacts every facet of the economy and markets, and earnings are the “bullish support” for overvaluation.

As Ray Dalio once quipped:

“The biggest mistake investors make is to believe that what happened in the recent past is likely to persist. They assume that something that was a good investment in the recent past is still a good investment. Typically, high past returns simply imply that an asset has become more expensive and is a poorer, not better, investment.”

As an investor, it is simply your job to step away from your “emotions” and look objectively at the market around you. Is it currently dominated by “greed” or “fear?” Your long-term returns will depend greatly not only on how you answer that question but to manage the inherent risk.

“The investor’s chief problem – and even his worst enemy – is likely to be himself.” – Benjamin Graham

Five ARKK Favorites

The ARKK ETF

Per the ARK Invest website:

“ARKK is an actively managed Exchange Traded Fund (ETF) that seeks long-term growth of capital by investing under normal circumstances primarily (at least 65% of its assets) in domestic and foreign equity securities of companies that are relevant to the Fund’s investment theme of disruptive innovation.”

“ARK defines ‘‘disruptive innovation’’ as the introduction of a technologically enabled new product or service that potentially changes the way the world works.” Please go to the ARK Invest website for more information about the ARKK fund and its holdings.

Over the past few years, ARKK’s popularity has grown wildly. Its AUM has risen sharply to $15.44 billion, ranking it in the top 100 of ETFs. The Ark Invest family of ETF’s founder Cathie Wood is highly sought after by the media. Readers and viewers are anxious to hear her views on technology, innovation, and the companies she follows  

Given the fund’s popularity, we thought it would be helpful to scan ARKK holdings for established companies with high growth opportunities. The stocks we selected and the ARKK ETF are highly volatile. Given the high level of market speculation, this has been even more true over the last 18 months.

ARKK struggled last year and in the first few days of 2022, but since 2018 is still handily beating the S&P 500. Four of the five stocks in this report are down significantly over the past couple of months.

arkk s&P500

Screening Criteria

The scan seeks larger companies with proven track records. We are looking for companies that are currently profitable and offer high future growth rates. Only seven of the 41 companies the ETF held at year-end showed up in our initial scans. Two stocks, ZM and DDD, met many of our conditions but lacked high enough expected growth levels. Included in this report, COIN is a recent IPO and therefore lacks data for the last five years. We decided to include it as it ranks high in the other categories and is the only stock trading with a reasonable current valuation.

High valuations are common in high-growth companies. Investors are betting the stocks will “grow into” their valuations. 

coin roku shop sq tsla

Company Summaries (all descriptions courtesy Zacks)

COIN

Coinbase is the largest U.S. cryptocurrency exchange, trading some 50 different digital assets.

Unfortunately, COIN lacks financial history since its IPO was in April of 2021. However, it is apparent with the limited data that COIN is the only stock in the list without a sky-high valuation. Although, it’s not for lack of growth prospects since analysts expect EPS to grow more than 66% annually over the next 5-years.

coinbase coin

ROKU

Roku is the leading TV streaming platform provider in the United States based on hours streamed.

Following a blowout year in 2020, ROKU struggled in 2021 as it formed a double top technical pattern throughout the better part of the year. Since the 2nd peak in July 2021, the stock has lost roughly 59% of its value and remains severely beaten up.

roku

SHOP

Ottawa, Canada-based Shopify Inc. provides a multi-tenant, cloud-based, multi-channel commerce platform for small and medium-sized businesses (SMBs). Merchants use the company’s software to run business across various sales channels, including web and mobile storefronts, physical retail locations, social media storefronts, and marketplaces.

SHOP has held on to its pandemic gains better than most stocks in this list. Still, it is a high-growth stock and thus remains vulnerable to expectations of higher interest rates. The stock is in deeply oversold territory after bouncing off the upper Bollinger Band in November.

shop shopify

SQ

Headquartered in San Francisco, CA, Block, formerly known as Square, was incorporated in 2015. The company offers financial and marketing services through its comprehensive commerce ecosystem that helps sellers to start, run and grow their businesses. SQ provides payment and point-of-sale (POS) services, including hardware and software to accept payments, streamline operations, and analyze business information.

SQ was largely range-bound in 2021 after surging with other high-growth names in 2020. The stock’s price began breaking down in November 2021 and has since fallen 42%. SQ remains deeply oversold and appears due for a reflexive bounce.

sq square

TSLA

Over the years, EV maker Tesla has evolved into a dynamic technology innovator. It has transformed the EV market much the same way as Amazon changed the retail landscape and Netflix revolutionized entertainment. Tesla is the market leader in battery-powered electric car sales in the United States, owning around 60% of the market share.

TSLA has been one of the pandemic favorites since Biden was elected in 2020, and the stock joined the S&P 500. TSLA’s price exploded higher on surging expectations for future growth and speculation alike. Despite widespread carnage in other high-growth names, the stock has been performing well recently. It recently bounced off its 50-week moving average and is making a run towards new highs.

tesla tsla

Five for Friday

Five for Friday uses stock screens to produce five stocks that we expect will outperform if a particular investment theme plays out in the future. Investment themes may be relevant to the current or expected market, industry and/or economic trends. Investment themes may not always represent our current forecast. 

Disclosure

This report is not a recommendation to buy or sell the named securities. We intend to elicit ideas about stocks meeting specific criteria and investment themes. Please read our disclosures carefully and do your own research before investing.

Is A Value Rotation Afoot?

As we enter 2022, we wonder if this is the year we finally see a rotation to value stocks? The graph below shows how value has lagged growth tremendously over the last four years. The chart plots the price ratio of the iShares Value ETF (IVE) to their growth ETF (IVW). Since early December, the ratio has risen by about 10%. Is this another head fake? Could be. Stay tuned, as this is one area we are closely watching as we consider how to approach the markets given the incoming fiscal and monetary headwinds.

growth vs value
Daily Market Commnetary

What To Watch Today


Economy

  • 8:30 a.m. ET: Non-farm payrollsDecember (447,000 expected, 210,000 in November) 
  • 8:30 a.m. ET: Unemployment Rate, December (4.1% expected, 4.2% prior)
  • 8:30. a.m. ET: Average Hourly Earnings, month over month, December (0.4% expected, 0.3% prior month)
  • 8:30 a.m. ET: Average Hourly Earnings, year over year (4.2% expected, 4.8% prior month)
  • 8:30 a.m. ET: Labor Force Participation Rate, December (61.9% expected, 61.8% prior month)
  • 3:00 p.m. ET: Consumer Credit, November ($20 billion expected, $16.897 billion during prior month)

Earnings

  • No notable reports scheduled for release

Fox Business Interview

ARKK Is Taking On Water

The Ark Disruptive Innovation fund (ARKK) has fallen on hard times lately. ARKK rode the Reddit/meme craze and became a market darling. As we show below, its 2020 performance was spectacular. Cathie Woods, founder and portfolio manager, fuels investor speculation by discussing the potentially outsized returns of investing in disruptive companies. She has thus far been right on Tesla, her top holding, but many of her other picks have fallen significantly. Her top five holdings and their respective 6-month changes are as follows: TSLA +62%, ROKU -55.1%, TDOC -48.9%, ZM -56%, and COIN -1.8%.

ARKK stock ETF

Meme Stocks Falling Out of Favor

The graph below, courtesy of Goldman Sachs, shows that the stocks most favored by retail traders on the popular investment chat forum Reddit are down almost 40% over the last six months. Not only are many of these stocks highly volatile but many lack solid fundamentals and are built on questionable narratives. Gamestop (GME) and AMC, two meme stocks are good examples. Looking at the graph you will notice a similar loss from highs between January and May last year. That five-month decline was erased in a month. With the Fed turning aggressively hawkish and the monetary and economic environments very different than last year, investors may want to carefully consider if a repeat is possible.

meme stocks Reddit

Gamestop Throws A Hail Mary

“In a desperate attempt to recreate the short squeeze from a year ago, GameStop stock is surging after hours after a report from the WSJ that the company which once was a video game retailer and now nobody really knows what it does, is launching a division to develop a marketplace for nonfungible tokens and establish cryptocurrency partnerships – in short throwing all possible catchy buzzwords at the wall and hoping something sticks – pushing the company into much-hyped areas as it tries to turn around its core videogame business.” – Zerohedge

GME Spike

Interestingly, one of the “meme stock” companies that have an opportunity to sell “movie memorabilia” as NFT’s is AMC movie theatres. Let’s see if they pick up on the trend.

Out Of Speculative Stocks and Into ??

If ARKK, Meme stocks, SPACs, and yesterday’s winners are out of vogue, where might the crowd rotate to? The graph below from Topdown Charts shows that the defensive value stocks have been grossly lagging the S&P 500 for the last five years. The last time it was at such a discount to the S&P 500 was on the eve of the tech bust.

defense value speculative stocks

As we have noted in our SimpleVisor Technical Value Scorecard, the defensive sectors have been leading the market as of late. To wit in our last report-

The value-oriented, higher dividend, and lower beta sectors continue to perform well. Over the last 35 trading days, real estate, utilities, healthcare, and staples were the top four performers. Last week utilities, real estate, and staples led the market.

It’s way too early to claim a major value rotation is afoot. However, value rotation is a theme we are watching closely and will position our portfolio accordingly.


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New Year “Investor” Resolutions For 2022

Here are my New Year “investor” resolutions for 2022. Like all resolutions made at the beginning of a new year, they can be hard to adhere to.

Early in my career, I built health and fitness facilities. But have you ever wondered why you couldn’t just go into a gym and pay a fee to use it? It’s because the entire fitness industry gets built around a simple premise – you will sign up for a membership and never use it. So, every month, the membership fee continues to hit your credit card. Yet, you don’t cancel the membership because you feel guilty about not starting your diet and workout program.

But you promise yourself you will start tomorrow.

Fitness facilities can continually oversell their gym capacity because of the many members that sign up but never show up. Just like going to the gym, resolutions to eat better, sleep more, work out, etc., all sound great. However, while we know we should do them, we simply don’t.

Such is why America is the most obese country on the planet.

Why am I telling you this? Because investor resolutions are just as hard to follow.

We know we should, but there are many psychological reasons we don’t.

Why We Continue To Repeat Our Mistakes

Every year, Dalbar Research publishes an extensive study that repeatedly shows three primary reasons for investor failure over time.

Investor psychology 3-reasons for shortfalls.

The key issues are a lack of capital to invest and psychology. Dalbar defined nine of the irrational investment behavioral biases specifically:

  • Loss Aversion – The fear of loss leads to a withdrawal of capital at the worst possible time.  Also known as “panic selling.”
  • Narrow Framing – Making decisions about on part of the portfolio without considering the effects on the total.
  • Anchoring – The process of remaining focused on what happened previously and not adapting to a changing market.
  • Mental Accounting – Separating performance of investments mentally to justify success and failure.
  • Lack of Diversification – Believing a portfolio is diversified when in fact it is a highly correlated pool of assets.
  • Herding– Following what everyone else is doing. Leads to “buy high/sell low.”
  • Regret – Not performing a necessary action due to the regret of a previous failure.
  • Media Response – The media has a bias to optimism to sell products from advertisers and attract view/readership.
  • Optimism – Overly optimistic assumptions tend to lead to rather dramatic reversions when met with reality.

The “herding effect” and “loss aversion” are the most significant behaviors that compound the issues of investor mistakes over time. As markets rise, individuals believe the current price trend will continue indefinitely. The longer the rising trend lasts, the more ingrained the belief becomes. Eventually, the last of “holdouts” finally “buy-in” as the market evolves into a “euphoric state.”

As markets decline, there is a slow realization “this decline” is not a “buy the dip” opportunity. As losses mount, the need to “avert loss” begins to mount until individuals seek to “avert further loss” by selling.

Investor psychology cycle

This behavioral trend runs counter-intuitive to the “buy low/sell high” investment rule.

Investor Resolutions For 2022

So, with the understanding that our emotions tend to get the better of us, I have put together a set of resolutions to help me be a better investor and portfolio manager.

In 2022, I will (or attempt to):

  • Do more of what is working and less of what isn’t. 
  • Remember that the “Trend Is My Friend.”
  • Be either bullish or bearish, but not “hoggish.” (Hogs get slaughtered)
  • Remember it is “Okay” to pay taxes.
  • Maximize profits by staging my buys, working my orders, and getting the best price.
  • Look to buy damaged opportunities, not damaged investments.
  • Diversify to control my risk.
  • Control my risk by always having pre-determined sell levels and stop-losses.
  • Do my homework. I will do my homework. I will do my homework.
  • Not allow panic to influence my buy/sell decisions.
  • Remember that “cash” is for winners.
  • Expect, but not fear, corrections.
  • Expect to be wrong, and I will correct errors quickly. 
  • Check “hope” at the door.
  • Be flexible.
  • Have the patience to allow my discipline and strategy to work.
  • Turn off the television, put down the newspaper, and focus on my analysis.

These are the same resolutions I attempt to follow every year.

In investing, just as in life, I won’t get into shape because I bought a gym membership. I won’t lose weight because I subscribed to a “diet app” on my phone. I have to go to the gym and stick to my diet.

There is no shortcut to being a successful investor. There are only the basic rules, discipline, and focus required to succeed long-term.

If I want to be a better investor, I have to follow my resolutions.

A Year Of Challenges

As I discussed on Tuesday, every analyst is optimistic about the new year. Expectations are high for explosive economic growth, more stimulus, debt-driven infrastructure spending, and 5000-5500 on the S&P by year-end.

Maybe that will be the case. However, as valuations have become more extreme, the consistently bullish media continue to invent rationals for higher stock prices.

  • Low interest rates justify high valuations.
  • There is no alternative (T.I.N.A.)
  • Monetary policy supports higher prices.
  • Low inflation supports higher prices

Notably, those rationalizations appeared correct due to the massive flood of monetary and fiscal policy during that period.

However, things are now changing with a Federal Reserve set to remove those accommodative policies. As a result, any shortfall in earnings growth, economic recovery, or a rise in interest rates could immediately and negatively impact investors.

The biggest problem for investors is the bull market itself.

When the “bull is running,” we believe we are smarter and better than we are. As a result, we take on substantially more risk than we realize as we continue to chase market returns and allow “greed” to displace our rational logic. Like gambling, success breeds overconfidence as the rising tide disguises our investment mistakes. 

Unfortunately, during the subsequent completion of the full-market cycle, our errors return to haunt us. Always too painfully and tragically as the loss of capital exceeds our capability to “hold on for the long-term.” 

Conclusion

While most financial media and blogosphere suggest that investors should only “buy and hold” for the long-term, the reality of capital destruction during significant market declines is a far more pernicious issue.

With market valuations elevated, leverage high, economic weakness pervasive, and profit margins coming under pressure, investors should consider their set of investor resolutions for 2022. The weight of evidence suggests that despite ongoing “bullish calls” for the markets in the year ahead, there is a risk of disappointment

Of course, the biggest mistake we all make is “waiting to start our resolutions” in the first place.

The Hawkish Fed Scares Investors

The Fed minutes from their December 14-15th meeting, released yesterday, show a heightened concern with inflation. There is little doubt after reading the minutes the Fed is growing increasingly hawkish. They seem intent on raising rates more aggressively than previously thought and shrinking their balance sheet at the same time. This week’s labor data, as we discuss below, will only intensify their concerns.

Markets are not happy with the Fed growing more hawkish. The Fed is slowly being put into a corner where they must weigh their desire to fight inflation with the negative effects of removing liquidity from markets. The graph below shows December Fed Fund Futures fell 7.5bps yesterday and are now implying a 50/50 chance of a fourth rate hike by the end of 2022.

fed funds
Daily Market Commnetary

What To Watch Today

Economy

  • 7:30 a.m. ET: Challenger Job Cuts, year over year, December (-77% prior)
  • 8:30 a.m. ET: Trade Balance, November (-$81 billion expected, -$67 billion)
  • 8:30 a.m. ET: Initial Jobless Claims, week ended January 1 (195,000 expected, 198,000 during prior week)
  • 8:30 a.m. ET: Continuing Claims, week ended January 1 (1,680,000 expected, 1,716,000 prior week)
  • 10:00 a.m. ET: ISM Services Index, December (67.0 expected, 69.1 prior)
  • 10:00 a.m. ET: Factory Orders, November (1.5% expected, 1.0% prior)
  • 10:00 a.m. ET: Factory Orders excluding transportation, November (1.1% expected, 1.6% prior)
  • 10:00 a.m. ET: Durable Goods Orders, November final (2.5% expected, 2.5% prior)
  • 10:00 a.m. ET: Durable Goods Excluding Transportation, November final (0.8% prior)
  • 10:00 a.m. ET: Capital Goods Orders Non-defense Excluding Aircrafts, November final (-0.1%)
  • 10:00 a.m. ET: Capital Goods Shipments Non-defense Excluding Aircrafts, November final (0.3%)

Earnings

  • Constellation Brands Inc. (STZ) to report earnings of $2.73 on revenue of $2.28 billion
  • 7:00 a.m. ET: Walgreens Boots Alliance (WBA) to report earnings of $1.36 on revenue of $33.014 billion
  • 8:15 a.m. ET: Bed Bath & Beyond Inc. (BBBY) to report earnings of $0.00 on revenue of $1.949 billion

Check Out Our 2022 Outlooks

Speaking of a more hawkish Fed, we review that risk and more in our outlooks for 2022.

Corporate Profit Margins and Our Outlook

The graph below, courtesy of @JosephPolitano, shows that pre and post-tax profit margins are at the highest levels since the 1970s. Given the tendency of margins to oscillate, we should expect profit margins to normalize over the next year or two. Given valuations are at extremes, any pressure on profits will push valuations to further extremes barring lower prices. Rising profit margins were a tailwind in 2021 that may likely become a headwind in 2022.

profit margins

ADP Fires a Warning Shot Over the Fed’s Bow

The ADP private-sector jobs report shows there 807k jobs added in December, more than two times expectations. This and Tuesday’s JOLTs data point to a red-hot labor market. It is worth noting that the labor market is still 4 million jobs short of pre-pandemic levels. However, based on the number of job openings and the quits rate, many of the people who left the workforce are doing so voluntarily. If the BLS confirms the ADP print, the market may begin to price in a more aggressive Fed in terms of rate hikes. They should be concerned that growing wage pressures will result in companies raising prices to offset the higher wages.

adp employment labor

Corporations Keep Buybacks Going

Corporations keep doing what they do best, buying back their own shares. As noted previously, stock buybacks have accounted for nearly 40% of the market’s rally since 2011. While that doesn’t seem to be changing anytime soon, higher interest rates and tighter Fed policy could change attitudes. Such is certainly something worth watching. With a more hawkish Fed looming, will corporations rethink their repurchase programs?

Corporate share buybacks.

Is the Semi Shortage Ending?

The first graph below provides a hopeful sign that the shortage of semiconductors is finally peaking. The deficit of chips has most notably affected the auto industry, which has greatly limited production. The side effect of their collective actions has been a shortage of new cars, resulting in more demand for used vehicles. At the same time, fewer trade-ins are crimping the supply of used cars. As a result, used car prices have risen appreciably, as shown in the second graph. We are hopeful the first graph is another sign inflationary pressures, especially concerning automobiles, may finally be abating.

Semiconductors semi shortages
used car prices manheim index

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Portfolio Trade Alert – 01-05-22

Trade Alert For Equity & ETF Models

As noted in this morning’s 3-Minutes video, the market is returning to its familiar pattern of a correction to the 50-dma and then a rally to all-time highs, a sideways consolidation, and decline back to support. That correction back to support, as discussed, has previously occurred right around options expiration week.

With that consideration, we sold the remainder of our SPY trading positions.

Equity & ETF Models

  • Sell 100% of the remaining SPY position.

Ford Is Starting To Trade Like Tesla

Ford (F) is following Tesla’s path. Tesla shares surged on Monday after they released strong delivery numbers over the weekend. Following in Tesla’s footsteps, Ford is up over 10% on Tuesday after they announced it would nearly double the annual production of the all-electric F-150 Lightning truck. Ford currently has a market cap of about 1/10th that of Tesla despite almost 4x the revenue. It does, however, have significantly more debt than Tesla. Ford has a P/B ratio of 2.61 and P/S of .71. In contrast, Tesla has a P/B of 42.11 and a P/S of 24.33. If Ford can become an EV powerhouse, the valuations of the other pure EV automakers argue F has a lot more upside.

ford tesla f tsla
SimpleVIsor
Daily Market Commnetary

What To Watch Today

Economy

  • 7:00 a.m. ET: MBA Mortgage Applications, week ended Dec. 31 (-0.6% during prior week)
  • 8:15 a.m. ET: ADP Employment Change, December (410,000 expected, 534,000 during prior month)
  • 9:45 a.m. ET: Markit US Composite PMI, December final (56.9 prior month)
  • 9:45 a.m. ET: Markit US Services PMI, December final (57.5 expected, 57.5 prior month)
  • 2:00 p.m. ET: FOMC Meeting Minutes, December 15

Earnings

  • No notable reports scheduled for release

Speaking Of Tesla

Yesterday commentators and the analyst community waxed enthusiastically about Tesla’s delivery beat in the quarter ended December 31, 2021. 

Tesla sold about 30k more cars than expected. At $50k/unit and assuming the company made 10% net after tax this would result in about $150 million in “extra” after tax profits in the fourth quarter. 

For a rough perspective on how absurd the $150 billion rise in Tesla’s market cap was yesterday – it represented 1000x the gain of $150 million of “extra” profits relative to consensus.” – Doug Kass

TSLA chart

JOLTs

The JOLTs data for November shows the jobs market may be finally cooling off. The number of job openings fell from 11.033 million to 10.562 million. Conversely, the number of quits rose to a new record of 4.5 million. Over half of the 370k increase in quits from the prior month came from the accommodation and food services industries. A high quit rate is due to workers believing they can quit and get a new higher-paying job. Such activity pressures wage expenses and will likely weigh to some degree of corporate profit margins.

An ISM Reading That May Make You Rethink Your Stock/Bond Allocations

The ISM Manufacturing Index was below expectations at 58.7, an 11 month low. Notably, the prices paid index fell sharply from 82.4 to 68.2, and supplier delivery times fell to a four-month low. The data provide signals that inflationary pressures are fading, at least for the time being.

The first graph below, from Stouff Capital, shows the strong correlation between the difference of new orders and inventories compared to the ISM Index. The differential leads the ISM index by three months. If the correlation holds up, we should see a steep decline in ISM in the coming three months.

ism

The following two graphs show us how ISM’s decline may affect bond yields. The first graph below, courtesy of Brett Freeze, shows a statistically strong correlation between nominal ISM (inflation-adjusted) and ten-year UST yields. If the nominal ISM is reversing as it appears, we should expect lower yields. The second graph, courtesy of Mott Capital, charts the correlation of the ISM Prices paid index and inflation expectations. Assuming manufacturing inflation is finally cooling off, inflation expectations should follow. Lower inflation expectations will help reduce bond yields.

ism  treasury yields
ism and inflation

ISM and Stocks

Not to beat a dead horse, but as we show below, a weak ISM Index is not good for stock prices.

ism s&P 500

Is The Fed Hinting At QT?

Nick Timiraos, who covers the Fed for the Wall Street Journal, is often the source of trial balloons from the Fed. Often, when the Fed is considering a new program or changes to a program, they will leak it to the press. The purpose is to gauge the market response. On Tuesday morning, the WSJ published Fed Weighs Proposals for Eventual Reduction in Bond Holdings. The article broaches what the Fed will do when they finish tapering bond purchases. Per the article:

Federal Reserve officials are beginning to map out how and when they could shrink their $8.76 trillion portfolio of Treasury and mortgage securities, which more than doubled amid efforts to stabilize the economy over the past two years.”

Tapering QE provides less liquidity to the market. Quantitative tightening (QT) removes liquidity. Given the financial market’s heavy reliance on Fed liquidity, the topic will prove to be sensitive. If the Fed is genuinely considering QT as a way to quell inflation further, we suspect we will hear more about it in upcoming speeches.

Apple

“Apple is worth $3 trillion — more than Walmart, Disney, Netflix, Nike, Exxon Mobil, Coca-Cola, McDonald’s, AT&T, Goldman Sachs, Boeing, IBM and Ford combined.” – New York Times

apple aapl stock

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2022 Outlook Part 1 – Tailwinds Shift To Headwinds

The first part of our 2022 outlook looks through the front windshield and contrasts 2021s tailwinds with 2022s growing headwinds. While no one knows what 2022 holds in store for investors, our concern is that it should not foster the same optimism as 2021. The economic and financial environments are shifting rapidly making the 2022 outlook much more difficult than this past year.

Part 2 of the 2022 outlook, coming out next week, will cover our thoughts on the stock and bond markets.

“The more extended the advance, and the higher valuations become, the more stable and promising the investment can appear to be, when judged through the rearview mirror.” John Hussman

It’s All About Growth

Before looking forward, it’s worth explaining how economists assess economic activity.

Most economic activity is measured in percentage growth terms and not nominal terms. To stress the importance of this nuance, consider the following:

If the government gives consumers $1 trillion to spend, it will boost GDP by at least $1 trillion. In our example, the stimulus will boost GDP to $21 trillion from $20 trillion, equating to 5% growth. Without government stimulus and excluding any new economic activity, GDP will retreat to $20 trillion in the following year. As a result, GDP will decline by 5%. While nothing changed with the economy, the 5% decline will be considered a recession. To avoid zero or declining economic growth, again assuming no other activity, the government will need to provide at least $1.01 trillion of stimulus.

As we show above, stimulus boosts economic activity. However, it detracts from economic growth rates unless it grows each year. This fact will become important in our 2022 outlook as the government will not likely replicate the massive amount of stimulus doled out over the prior two years. Can the economy make up for it?

Covid TailWinds

In hindsight, the rearview mirror showing the period from March 2020 to the present paints an unusual picture. What started so poorly ended up being one of the greatest periods for investors. The S&P 500 total return since the March 2020 lows is +115%.

In March 2020, the sky was falling, and investors aggressively sold stocks. It turns out buying stocks in the face of such a unique calamity was the right thing to do. The justification was not a coming cure or vaccine for Covid or an imminent return to normal, but the government with their fiscal guns blazing.

tailwinds federal deficit

Since March 2020, the government has run a $5.6 trillion deficit, dwarfing any prior instance. Such massive spending was only possible with the Treasury’s trusty sidekick, the Federal Reserve. 

federal reserve fed balance sheet

As we show, the Fed has bought nearly $5 trillion of bonds since the pandemic began. In doing so, it came close to absorbing 100% of the net new debt issuance from the government.

While the government was doling out money to boost economic activity, the Fed spewed liquidity, supported asset prices, and kept interest rates low. Despite Covid shutting down large segments of the economy, economic data quickly recovered to pre-Covid levels.

Record low interest rates, massive consumer and corporate stimulus, and enormous liquidity gusted at investors’ backs producing double- and triple-digit gains. Not only did most asset prices regain March 2020 levels, but many have well surpassed those levels.

In the latter half of 2021, vaccines, increased consumer demand, and a record amount of savings added further oomph to the tailwinds. However, the ominous winds of inflation began picking up at that point.

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2022 Headwinds

The perfect fiscal and monetary storms are petering out. As a result, headwinds for 2022 are mounting. Let consider how that weighs on our 2022 outlook.

Fiscal Spending

Over the last 3 months, the federal deficit grew at a $1.6 trillion annualized rate. That is historically high but well below 2020 and 2021 levels. Further, Joe Biden and the Democrats are struggling to pass the Build Back Better (BBB) social infrastructure program. We think it will pass in time, but the fiscal stimulus and spending related to it will not be as immediate or significant as initially planned.

The coming election in November poses more hurdles for spending bills. West Virginia Senator Joe Manchin and other Senators and Representatives from red and purple states face a growing risk of losing their seats. Some may take a page from Manchin’s playbook and voice deep concern for growing budget deficits to appease their voting bases.

Throughout later 2021 and even into 2022, Covid related stimulus programs ended or will end shortly. The closure of these programs will further reduce the flow of stimulus to consumers. For example, the recently extended student loan deferment program ends in a few months. In this case, many student debtors consume goods and services with money that should be servicing student debt. Once the deferment period ends, spending, in many cases, will decline. The child tax credit will also end shortly, resulting in a shortfall of funds for those receiving the benefit. Likewise, those that did not pay rent are now left with back payments or higher rents to make their landlords whole.

The graph below from Goldman Sachs helps quantify the sharp decline in fiscal spending related to the pandemic.

fiscal deficits

As we discuss later, the savings rate has fallen back to normal levels, meaning many of those affected will have to reduce consumption.

Monetary Stimulus

The Fed is tapering QE, expecting to end new purchases by March 2021. QE provides vast amounts of liquidity to the financial markets. As the Fed backs away, not only will it reduce liquidity to markets, but reduce the power of the world’s largest holder of U.S. Treasury debt. Someone will take the Fed’s place but must shed other assets to do so.

To help better understand this concept, we suggest reading The Fed Is Juicing Stocks. In particular, the section titled “Draining the Asset Pool.”

The Fed is also hinting at raising interest rates. Higher interest rates will increase interest expenses for debt-laden companies, consumers, and the government. Additionally, those using loans to leverage assets will have to pay more for the leverage. This will undoubtedly cause some investors to reduce or remove leverage as the potential returns diminish. 

The graphs below highlight that margin debt has proliferated and sits at or near record levels. The last two times margin debt grew this rapidly was in 1999 and 2007.

leverage fed
leverage
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Elections and the Fed

Further pressuring the Fed is politicians. Consider the following from the Financial Times:


The Fed needs to start tapering immediately and then they need to raise interest rates. Both those things can be done by March,” Jake Auchincloss, a Democrat from Massachusetts and member of the House of Representatives financial services committee, which oversees monetary policy, told the Financial Times. “I think chair [Jay] Powell would do well to end the decade of easy money,” he added.

Political pressure from the President and legislators may force the Fed to remove liquidity too quickly or raise rates too fast. Both are likely to be problematic for asset prices and economic recovery.

Savings Rate

The combination of direct government stimulus and the inability to spend money during the lockdowns resulted in unprecedented savings rates. As we show below, the savings rate jumped to levels that were twice as high as any previous level since at least 1959. Note that the two recent peaks result from the two rounds of personal stimulus checks.

savings rate

The following graph, courtesy of Brett Freeze, shows how government stimulus to consumers (transfer receipts) and credit provided a bonanza of spending power for consumers. Like the bloated savings rate above, that too has normalized.

stimulus savings

The savings rate is back to pre-Covid levels. Most consumers, especially those in the middle to lower-income classes, have fully exhausted extra savings and must either reduce spending or increase their use of debt.

Credit card debt and home equity withdraws are both increasing. While such funds can propel additional spending, it will not be nearly the same as the enlarged savings rates. Further, higher interest rates will make debt less appealing. Inevitably credit card and home equity are limited based on wage growth and the ability to service their debt.

Inflation

Prices are on the rise. Higher prices mean consumers spend more to get the same amount of goods. If wages keep up with inflation, the consumer is indifferent.  

Inflation is running at 6.9%, over three times higher than the Fed’s stated 2% objective. At the same time, wages are growing but at a lesser rate than inflation. Average hourly earnings are up 4.8%. While historically robust, real wages, factoring in inflation, are down 2%.

As we note earlier inflation is pressuring the Fed to prioritize their fight against inflation. Might the Fed have to choose between inflation and asset prices? Ohio Democrat Sherrod Brown recently shared thoughts on that- “The Fed should make sure our economy works for workers and their families, not Wall Street.”

Also, consider inflation is highly responsible for the recent string of poor consumer sentiment. People usually spend more when they have a positive outlook. As the graph below shows, the University of Michigan’s current and expected consumer sentiment indexes are at or near ten-year lows. The current index sits at 70.6. In April 2020, during the peak of Covid lockdowns, it was 71.8. In September 2008, when Lehman and others were failing, it was 70.3.

sentiment university of michigan
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Pent up Demand and Mid-Life Crisis

Having been deprived of vacations, eating out, and a host of other activities, people were hungry to return to normal. Vaccines further raised comfort levels and allowed many stores and venues to return to normal.

Consumers splurged as they bought those things they couldn’t buy during lockdowns. Not only did they travel and go out to dinner, but some bought cars and houses and other big-ticket items. It was as if many consumers had a mid-life crisis simultaneously.

Most of that pent-up demand is quickly diminishing. The bills from those spending sprees are mounting, and life is slowly becoming more normal by the day. This additional source of spending is fading quickly.

Summary

Prepare for the unknown by studying how others in the past have coped with the unforeseeable and the unpredictable.” -George S. Patton

As you just read in part one of our 2022 outlook, this year’s monetary and economic environment will not be as friendly for asset prices as last year. While that may seem problematic for investors, if we learned anything in 2020 and 2021, it is that stock prices can climb a wall of worry efficiently.

In part two of our 2022 outlook, coming next week, we share our thoughts on how stocks and bonds might perform in the new year.

Portfolio Trade Alert – 01-04-22

Trade Alert For Equity & ETF Models

As noted in this morning’s 3-Minutes video, and in our Daily Commentary, bond yields have risen back to more overbought levels. After we previously reduced our duration in our bond portfolios by selling TLT and adding TFLO (floating rate), we are now starting to reverse that trade to increase duration. We are also starting to reduce our SPY trading position on this rally.

As such, this morning we added 1% of TLT and sold 2% of SPY. We also sold 2% of FLOT to make room for TLT. We are nibbling on TLT as it is now oversold, at key support, and turning on a buy signal. We will likely continue to remove SPY over the coming days and get back to equal weight with the benchmark.

Equity & ETF Models

  • Add 1% of the portfolio to TLT
  • Sell 2% of the portfolio in TFLO
  • Reduce the SPY trading position by 2% of the portfolio.

Bonds Struggle On The First Day of 2022

Bonds struggled Monday following a couple of solid days to close out 2021. Ten-Year UST yields rose 14 bps to 1.64%. We caution reading too much into yesterday’s price action as window dressing before the new year often results in reversal trades after the new year. That said, the technical outlook for bonds shows it may be on the precipice of a significant move. TLT is now sitting on a critical support trend line. Breaking below that line and the 200dma (red) may likely signal bonds may struggle ahead. That said, the line has proven to be good support and may once again offer a buying opportunity. If so, a sustainable break above the horizontal blue might result in a run to new highs. As we watch bonds struggle, realize the wedge pattern is shrinking, likely signaling a big move is coming.

bonds struggle yields tlt
Daily Market Commnetary

What To Watch Today

Economy

  • 10:00 a.m. ET: ISM Manufacturing, December (60.0 expected, 61.1) prior month)
  • 10:00 a.m. ET: ISM Prices Paid, December (79.3 expected, 82.4 prior month)
  • 10:00 a.m. ET: ISM New Orders, December (60.4 expected, 61.5 prior month)
  • 10:00 a.m. ET: JOLTS job openings, November (11.1 million expected, 11.033 million prior month)
  • WARDS Total Vehicle Sales, December (13.1 million expected, 12.86 million prior month)

Earnings

  • MillerKnoll (MLKN) to report earnings of $0.56 on revenue of $1.043 billion

2022 Investor Resolutions

Here are my annual resolutions for the coming year to be a better investor/portfolio manager:

I will:

  • do more of what is working and less of what isn’t. 
  • remember that the “Trend Is My Friend.”
  • be either bullish or bearish, but not “piggish.” (Pigs get slaughtered)
  • remember it is “Okay” to pay taxes.
  • maximize profits by staging my buys, working my orders and getting the best price.
  • look to buy damaged opportunities, not damaged investments.
  • diversify to control my risk.
  • control my risk by always having pre-determined sell levels and stop-losses.
  • do my homework. I will do my homework. I will do my homework.
  • not allow panic to influence my buy/sell decisions.
  • remember that “cash” is for winners.
  • expect, but not fear, corrections.
  • expect to be wrong and I will correct errors quickly. 
  • check “hope” at the door.
  • be flexible.
  • have the patience to allow my discipline and strategy to work.
  • turn off the television, put down the newspaper, and focus on my own analysis.

Large Cap Value (LV) Is the Winner Last Year

The Fidelity table below ranks asset classes by their Sharpe ratios. The Sharpe ratio measures the return of an asset per unit of risk. If you notice, the boxes tend to shift year to year. As we discuss in our upcoming outlooks for the new year, look forward and not in the rearview mirror for those assets that may outperform.

periodic table of returns, sharpe ratio

Apple Is The First $3 Trillion Company

While bonds struggled yesterday, Apple briefly hit a market cap of $3 trillion during intraday trading on Monday. The milestone is mostly symbolic but it shows investors remain bullish on Apple stock and its ability to grow. At a market value of $3 trillion, Apple tripled its valuation in under four years. Yet, this is a fully mature company that has grown sales at just 11% annualized over the last decade. Is Apple really worth $3 Trillion or is it just another sign of an extremely overvalued market.

Apple stock chart

Is 2022 Finally The Time for Value To Shine?

Bloomberg surveyed 106 asset managers to see what type of stocks are likely to do best in 2022. Value took the cake accounting for the top choice for about 25% of those surveyed. Growth which led the way last year and has grossly outperformed value over the previous five years, is in fourth place with about 10% of the votes. Over the last month, we have seen value stocks lead the S&P 500 higher, with utilities, healthcare, real estate, and staples outperforming every other sector.

S&P 500 value growth

Fact of the Day

Since 1950, when the S&P 500 has risen in the first full week of the year, it’s had an 87% success rate of gaining for the full calendar year. -@callieabost

Top 10 Buys & Sells From TPA Research

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Sector Performance Since the Pandemic

The bar chart below plots the relative performance of each S&P 500 sector versus the S&P 500. In addition to spotting the winners and losers of the last two years, it also may also provide insight into which sectors may benefit from economic and monetary policy normalization. Of interest, utilities have given up nearly 50% versus the S&P 500 since the pandemic started. XLU is up 15% compared to 60% for the S&P 500. On the other side, the technology sector is beating the S&P 500 by over 35%.

S&p 500 sectors

May the Santa Rally Linger?

The following graph and commentary from David Robertson provide insight into a bullish factor that may drive returns in January.

“The following graph, posted by themarketear.com on Dec 27, 2021, illustrates the seasonal effect of money flows. Obviously January is a big one and that makes sense since year-end bonuses can be slogged away and annual limits for retirement programs are reset. These are valid reasons to expect above average flows of cash to enter the stock market – and therefore for the bias on stocks to be upward, all else being equal. By the same token, look out for the period of May through August.

money flows equities

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