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Hi all,

In our previous post, we mentioned remaining cautious in the short-term even though the market showed no real signs of slowing down.  As it happens, the final trading day of March marked the intraday all-time high in the S&P 500 (5264), and as of last week, the S&P was almost 6% lower.  The technology-heavy Nasdaq 100 found itself 7.5% lower and the representation of small business in America, the Russell 2000, was 9.5% lower.

It is likely we are nearing some sort of short-term bounce, but the $10,000 question remains: Will this be a buying opportunity on our way back to all-time highs, or do we still have more work to do on the downside before stocks find their footing?

“The work of a pullback in a bull market is to unwind over-aggressive positioning, drain excess optimism, reset expectations and take prices down to meet fundamental buyers’ conviction.” – Michael Santoli

This is precisely what has happened.  Less than a month ago, 82% of stocks were above their 20-day moving averages.  Last week, that number sat below 8% (got as low as 6% in October of 2022, which happened to be a fantastic buying opportunity).

We are believers that history remains a guide.  Over the last 100 years, when the S&P 500 had been up more than 10% by the end of March, it had closed the following nine months of the year green 12 out of 13 times.

Assuming this still holds true for 2024, that would portend a gain of at least 5-6% from current levels.  But with short-term interest rates holding very steady, a 9-month treasury bill can earn roughly 4% over the balance of 2024 with zero risk.  Herein lies the dilemma.  When will market participants decide to start moving out of very attractive risk-adjusted returns, and back into the stock market?

Our guess is that this happens sooner rather than later, but we believe that in order to justify moving out of high-yield savings accounts and short-term treasury bills, investors will start to go bargain hunting rather than choosing the darlings of the past year.  We’re looking for stocks and sectors that are well-off recent highs, still providing quality business models which have stood the test of time, and potentially pay an attractive dividend yield (as a nice transition from treasuries).  For a decent portion of our client base, we have been waiting for a better market entry point and been quite content to sit and collect interest.  We believe that time is coming to an end, and for those of you with the appropriate risk tolerance and time horizon, we put additional capital to work last week.

We have some supportive price levels a few percentage points lower than here, but the entire market is looking at these.  For instance, the Jan 2022 high for the S&P 500 is around 4800.  This would be the first test of the breakout from the levels in late January, but all tests are not passed.  The problem with focusing only on levels is that it disregards the most important indicator of all: price.  Are the majority of stocks going up? No.  Has there been a change in market sentiment? Yes, but not enough to consider it a major buy signal, in our opinion.

For those of you with additional cash on the sidelines, you will likely hear from us in the coming weeks in order to prepare to get those dollars to work in the short-term.  We have no idea whether or not the pullback extends to 4800 or 4500 or 4200.  Picking a number, while disregarding the current market environment is a terrible way to manage allocations, but we need to be prepared for all eventualities, including positive ones (gasp).

The Federal Reserve is meeting today and tomorrow, and tomorrow’s press conference should provide a little more clarity into the market’s patience level as it grips with the possibility of a “higher for longer” interest rate environment.

– Adam

Hi Everyone,

This month will be brief as we are moving offices (more to come on this next month).

Last week, the market extended its winning streak on the S&P 500 to five months, and looking back in history, the future looks pretty promising.

When the S&P 500 is positive for December, January, and February (the DJF Barometer), one year later the index is higher 25 out of 25 times.  According to Wayne Whaley, the signal is the only 25+ case study in his domain that is perfect back to 1930.  If you want to bet on something that’s never happened before, that’s fine.  It’s just not something that we do around here.

While we tend to agree that stocks will be higher one year from now, for those clients who have fresh capital right now (or those clients sitting in 5% yielding T-Bills) we remain cautious in the short-term.  Valuations remain elevated, speculative investments have started to come back into vogue (crypto, SPACs, etc.), the interest rate outlook remains muddled, and the first real signs of a stressed consumer have started to pop up as well.  Nike, Lululemon, and Walmart have all guided for a weaker first quarter than what they were seeing just several months ago.  This leads us to believe that the market is due for a traditional pullback (5-10%).  At that point we would feel much more comfortable allocating additional capital, although when the times comes to buy, you probably won’t want to.  Until then, sitting in a 5% money market doesn’t feel too terrible.

I’ll leave you with a passage from Berkshire Hathaway’s annual report, published early in 1987.  Keeping this information in the back of our minds has proven itself quite useful over our last two decades in the business.

– Adam

“Occasional outbreaks of those two super-contagious diseases, fear and greed, will forever occur in the investment community. The timing of these epidemics will be unpredictable. And the market aberrations produced by them will be equally unpredictable, both as to duration and degree. Therefore, we never try to anticipate the arrival or departure of either disease. Our goal is more modest: we simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.”

– Warren Buffett

“Some people are so poor, all they have is money” – Bob Marley

Hi all,

I read a short piece from Morgan Housel earlier this month and wanted to pass along a few points from his latest post, A Few Thoughts on Spending Money.

• There are two ways to use money. One is as a tool to live a better life.  The other is as yardstick of status to measure yourself against others.  Many aspire for the the former but get caught up chasing the latter.
• Everyone can spend money in a way that will make them happier, but there is no universal formula on how to do it.  The nice stuff that makes me happy might seem crazy to you, and vice versa.  Like many things in finance, debates over what kind of lifestyle you should live are often just people with different personalities talking over each other.
• Unspent money buys something intangible but valuable: freedom, independence, autonomy, and control over your time.  Every dollar of savings buys a claim check on the future.
• Some wealthy people struggle to spend money on things that would make them happy because “I’m a saver” becomes such an ingrained part of their identity. What you intended to be a strategy to achieve a better life turns into an ideology you are beholden to.
• The more money you have, the harder it becomes to know how to spend it in a way that will make you happy.  And that confusion sets in at fairly low levels of income. Luke Burgis writes: “After meeting our basic needs as creatures, we enter into the human universe of desire.  And knowing what to want is much harder than knowing what to need.”

Like everyone else, there’s always a push and pull from life’s expenses on what we want vs. what we need.  This was most apparent on my most recent hockey-related adventure to Madison, WI.  Buying souvenirs and eating out more often than you normally would is part of the fun on these “mini-vacations”.  I’m usually the one who is more conscious of the spending (curse of the job), but in more recent years I’ve softened my stance a bit.  Maybe it’s seeing the kids getting a little older and realizing it’s all moving too fast.  Maybe it’s becoming more financially comfortable as we start to earn more later in life.  But to be honest, the real catalyst for this post was the recent passing of a neighbor and parent at my son’s school.  46 years old and leaves behind a wife and two young boys.  He’d known about the terminal nature of his diagnosis for sometime and was lucky enough to be able to quit work and focus on his bucket list, which was not filled with regret about his mortgage rate being .5% too high, or his 401k’s relative performance with the S&P 500.

Just a reminder to hug everyone a little tighter this month and remember to try and create future nostalgia when we all hopefully look back at a life well lived.

– Adam

Hi all,

As I sit at the computer right now, the equal weight S&P 500 (if you owned one share of each company) is currently down one quarter of one percent (-.25%).  The market has continued to be inundated with Q4 earnings, election primaries, and geopolitical tensions.  The market has responded with a resounding opinion: meh.

Let’s get a better idea of the push and pull playing out in the hearts and minds of the bulls and bears.

1. The S&P 500 is statistically expensive.  On almost every metric, we are above long-term averages.  Whether or not the S&P gets cheaper or more expensive  from here is truly anyone’s guess.

   

2. The S&P 500 is at an all-time high.  The chart below from Callie Cox at eToro attempts to dispel the myth of investing at all-time highs. Counter-intuitively, in the financial markets, strength begets strength.

   

3. Different than what we saw to end last year, leadership in the market has started to narrow (large-cap Tech and AI names have once again been the engine pushing the markets to all-time highs).  But while narrow leadership is a certainly cause for pause, history tells us that when small caps (Russell 2000) start a year with a decline of at least 4%, the median performance for the remainder of the year was 26.1%, increasing 6 out of the 7 times since 1979.  20%+ rallies like we saw at the end of last year, tend to lead to further strength in the weeks and months ahead.  Again, strength begets strength.

   

4. We continue to recommend overweighting small caps (Russell 2000) and biotechnology for longer-term client portfolios.  Small caps remain cheap relative to the S&P 500, and the pharmaceutical industry is coming up to a patent cliff over the next five years that is 2.5 times greater than the previous five years.  We believe smaller companies with promise will likely start to get gobbled up by the larger firms looking to restock their pipelines.

   

   

In short, this is about as strong of an economy that anyone could expect after the Federal Reserve raised rates substantially over the past two years, but for some reason we (including us) are paranoid about the next shoe to drop.  There’s certainly a bit of froth that can be taken away from the stock market in the short-term (we’re counting on it), but perhaps we should start seeing the market for what it is: an overall reflection of things getting a bit better.

– Adam

Hi all,

As the page turns into 2024, we here at Second Level Capital are mostly filled with gratitude.  Gratitude for those clients who came to us in late 2021 and early 2022, and stuck with us through the roller coaster of the last few years.  Pride for our long-term clients seeing their portfolios near all-time highs.  Excitement for our business that continues to grow, and readiness to help more people in the coming year.

As for the market commentary, there isn’t much to glean just yet about how 2024 will shape up, but the transition we made for most clients in the fourth quarter of last year proved to be very profitable as the Russell 2000 went from a 52-week low on October 27th to a 52-week high on December 20th (one of the fastest moves on record).  Whether or not this value/growth rotation can be sustained is another question, but in terms of sectors, we continue to see opportunity in energy and biotech (to name a couple). Outside of those smaller areas, our conviction beyond a month or two remains pretty low. In similar times like these in the past, it has usually meant the market needs a bit of a breather to present more attractive buying spots.

As a heads up, we are likely moving office space this year (not quite The Jefferson’s), but more to come on that during future posts.

We hope that everyone had a safe and happy holiday season, and couldn’t be more ready to argue about markets with most of you in 2024 🙂

– Adam

“This is investing, where the smart money isn’t so smart, and the dumb money isn’t really as dumb as it thinks. Dumb money is only dumb when it listens to the smart money.” – Peter Lynch

Media outlets love to sell fear.  Imminent recessions.  Spiking inflation.  The impending doom of commercial real estate.  But let me give you a little snapshot of what’s happening in the stock market (which is NOT the economy, please don’t get these two confused).

During the 18 trading days to start the month of November, the S&P 500 was +10.8%.  To paraphrase Steve Deppe, chief investment officer at Nerad + Deppe Wealth Management, there have been lots of 18-day stretches where the stock market has gained 10.8% or more (some of them during very difficult times in the stock market and the US economy).  But there were no 18-day stretches that closed 10.8% higher AND closed higher 15 out of those 18 days…until last week.  One could argue that we are currently in the midst of the strongest, most persistent advance we’ve seen in the past 30 years.

Obviously, a huge factor in the index gain has been the outperformance of the largest companies (the magnificent seven).  You might be asking yourself, “Then why don’t we have all our money in the best and biggest companies in the world?”.  Because in the last 65 full calendar years (1958-2022), market cap weighting beats equal weighting only 25 of the last 65 years.  Almost a full 2/3rds of the time, the average stock beats the big guys.  We anticipate 2024 could be a great year for mean reversion, in what I have seen referred to as “Team 493” (for all the other companies in the S&P 500 that no one cares to talk about these days).  We continue to recommend building a position in “the others” to capture some gains if/when people start to realize the lofty valuations of the stocks that have run up, and the relative value investing in quality businesses that have been unloved.

I’ve had several conversations with clients about how this year has been a real roller coaster.  Then I casually mention this year has been extremely typical.  This is usually followed by a period of silence where they wonder if I’ve been staring at my stock charts too long.  Well, see for yourself…doesn’t get any more typical than this when it comes to seasonal pivots and trends.

With the Federal Reserve pausing for three straight meetings, the market has sniffed out that as long as inflation continues to moderate toward its 2% target, unemployment remains low, and growth remains strong, it’s quite possible they will CUT interest rates in 2024 as the restrictive policy meant to temper the US economy will no longer be needed.  This still remains to be seen, but given the amount of cash that has flown into money markets over the past year, it’s possible the amount of interest you’ll receive over the next 12 months becomes a lot less attractive (reinvestment risk).  At that point, savers could be driven back into the stock market to get competitive returns.  Even if we end up going back toward January 2022 money market levels, that’s over $1 trillion dollars flowing back toward stocks over the next 12-24 months.  Will those dollars buy the “expensive” magnificent seven stocks, or will they go bargain hunting for additional current income to supplement portfolios?  We’re betting on the latter.

While the stock market feels like it’s had an incredible advance this year (and it has), the highest price target on the S&P 500 for year-end 2024 is 5100.  An S&P 500 over 5000 feels like a pipe dream, but it would only be a 2% annual gain over the previous three years.

This is all to say that we remain bullish in the near-term, as we have since January 12th, 2023 when we got our breakaway momentum signal.  Hope everyone had a great Thanksgiving!

– Adam

“It’s no wonder that truth is stranger than fiction.  Fiction has to make sense” – Mark Twain

For this month’s commentary, let’s try and unpack some of what’s going on.

Market participants are all asking three questions.

1. Will inflation/prices come down?
2. How high will the Federal Reserve raise rates?
3. Will there be a recession?

Respectfully, these are not the things that matter.  We can’t know the answers to these questions, and even if we knew the answers to these questions, do we think we would be able to use that knowledge to build a portfolio that has stronger staying power than what we’ve built now?  Once you start to get past the idea that if you had tomorrow’s news, we’d be a step ahead, you start to realize we can only focus on the market that’s in front of us.  So let’s dig in a bit more on some charts (my favorite).

• Our largest single individual holding across our entire client base just so happens to be the best-performing major fixed-income asset class in the world: T-Bills.

As long as the market is going to give us a 5.5% annualized return with virtually no risk, it’s going to remain a healthy portion of diversified portfolios.  An upside down world has given us the opportunity to have one of the safest and also one of the best returns from the same investment.  That doesn’t happen very often.  And won’t last forever.

• The 10-year Treasury Yield is above 5% for the first time in 16 years.

  

“The bond market shows that we have exited what once was considered ‘the new normal’ and considering economic forces that could keep yields high for years: global warming, the transition to green energy, deglobalization, demographic shifts and, of course, the ever-growing supply of government bonds – the free money experiment is over.” – Bank of America (h/t to Kyla Scanlon and her presentation at MIT).

“The surge in yields is the ideal excuse to crystallize fears over everything: the durability of the economic expansion, equity valuations, the size of federal deficits, the health of banks and whatever else gets the butterflies fluttering in the gut.” – Michael Santoli, CNBC senior market commentator (and one of the few you should be listening to on financial TV).

• Are we going into a recession?  Not as long as people continue to spend like this.

According to Liz Ann Sonders, chief investment strategist at Charles Schwab, retail sales have been up for six consecutive months…a streak not seen since early-mid 2019.  Consumer stays strong…for now.

Yet certain parts of the stock market is already priced like we’re in a recession.  Small caps are trading at the same relative valuation as they were during the depths of the global financial crisis in 2008.  We continue to look to build larger positions in small caps over the coming months, but so far, we’ve been early (read: we’ve been wrong).

• What’s working in the stock market today?  Semiconductors (AI) and energy.

The chart above from Nautilus Research, shows that over the last 14 years, the semiconductor index was higher all 14 times from the months of November to May.

• Are there any historical periods that mimic the period we’re in now?

In the last 100 years (by the way, interest rates went up and down through these periods, too), when the first half of the year was very strong (up more than 10%) and we had a summer lull (Aug and Sep were lower), the fourth quarter of the year was up 12 times out of the last 12.

• Yeah, but energy is only up because of the war in the Middle East.  Well…

Perhaps the largest population center on the planet may be coming back in a bigger way than anyone is talking about right now.  Something to watch.

We have no idea “why” these things happen.  All we know is that they DID happen.  Once we start refocusing our attention on what we know vs. what we think vs. what we can prove, only then can we start to match our short-term stock market thesis with each person’s individual goals.

May we live in interesting times,

Adam

“But I come from out there, and everybody out there knows, everybody lies: cops lie, newspapers lie, parents lie. The one thing you can count on – word on the street… yeah, that’s solid.” – Christopher Walken, Suicide Kings

For this month’s blog, I thought I would give you a glimpse into the conversations we’ve been having with clients lately.

1. 1. “It feels like my account really hasn’t gone much of anywhere.”

That’s because it’s true.  To be honest, the average stock hasn’t gone much anywhere.  The equal-weighted S&P 500 is trading at the exact same price as March of 2021.  Year-to-date, it’s up 1%.

“But, Adam, the actual S&P 500 is up more than 11% this year.”

Thanks to the Magnificent Seven.

Diversification means always having to say you’re sorry.

2. “Should I be worried about another government shutdown?”

Sure.  I worry about a myriad of potential risks to client portfolios each day.  Most of them don’t make to the level of “actionable”, but I’m always happy to go down the rabbit hole.  Let’s take a look at how the S&P 500 has done in previous government shutdowns (which happens on average about every 2.5 years).

Looks to me like the average return during shutdowns is slightly positive, and looking 12 months out, it’s about 12% higher (again, on average).

The reason we pay attention to the stock market on a day-to-day basis isn’t to inundate ourselves with the noise of short-term price fluctuations, but rather to glean additional insights about the human condition and how crowds react.  In short, we love learning.

3.  “Is there any better opportunities out there than 5.5% Treasury Bills?”

Of course.  In hindsight they will be easy to see (and easy to convince yourself that you could have seen them).  But chasing the flavor of the quarter is not sustainable.

Said brilliantly recently by Sam Ro of TKer, “If only 20% of large-cap equity fund managers beat the S&P 500 over the past three years, then being in an S&P 500 index fund means you would’ve beaten 80% of the professional money managers during the period.”  This reminds me of the story where a 6-foot tall man drowned in a lake that was on average, 4-feet deep.

We have more than enough potential headwinds on the horizon (interest rates, degloballization, government dysfunction, striking union workers, etc.).  Try not to make this harder than it needs to be.  Sometimes, boring is sexy.

– Adam

Hi all,

As we wrote last month, we remained cautious on the overall market outlook, mostly due to rising valuations as well as concentration of the largest stocks in the market (now coined the Magnificent Seven, great movie, btw).   Well, with Apple down 8%, Netflix down 4%, and Microsoft down 3.5%, we’ve seen very traditional seasonal weakness from the large cap leaders.  The current consensus continues to suggest that higher interest rates will continue to work its way through the system and keep a lid on the economy as a whole.  While we believe this generally, a strong and resilient economy should be taken as a positive, not a negative.

Looking at some historical context, we turn to some research from Callie Cox, investment analyst at eToro, for our first monthly dose of reality.

As you can see from the scatter plot above, when the 10-year yield climbs more than .5% in a month, returns over the next 12 months are mixed, but, on average, still higher.

So, we’ve been expecting a pullback and we got one.  Now what?  As long term readers of our monthly posts will know, here at Second Level Capital, while we discourage continuous market timing (overtrading), we do feel it is possible for longer-term investors to find better entry points into the market to get their target allocations and certainly see the merit in periodic rebalancing.  In order to do this, we focus mostly on the behavioral side of the market.  When others are fearful, we become more interested.  When others are talking about generational opportunities to speed up the compounding process (*cough* artificial intelligence *cough*), we become more skeptical and try to insert some rationality and see if it passes the smell test.

The tough part about this is quantifying how investors FEEL.  While the overall S&P fell about 6% from peak to trough over the last month, confidence has fallen off a cliff.  As seen below, the weekly survey figures from the North American Asset Managers has gone from 100 earlier this month, to now just above 30.  For context, the last time we saw readings this low was last October (just after the market made its low).

As it stands right now, it’s just about as textbook of a pullback as you would want if you believe we are in the early stages of another bull market (as we do).  When price doesn’t drop that much, but sentiment falls off a cliff, it sets the stage for the next advance.

We continue to emphasize value sectors over growth (energy and healthcare, specifically) and smaller companies over larger ones (valuation remains reasonable in the smallcaps), we are anticipating a rally into year-end that could feasibly take the S&P 500 to new highs.

In the back of our mind, there is some doubt that remains, so as Cormac McCarthy wrote, “if trouble comes when you least expect it then maybe the thing to do is to always expect it”.  We’re keeping our eyes open for anything that may change our tune, but until then, let the market show us the way.

Sincerely,
Adam

 

Hi Everyone,

I spent a decent portion of my early career (and my own money) trying to fight the prevailing trend.  The seduction of catching a bottom, or calling a top was just too much for my young mind to pass up.  Sometimes, the market just didn’t make sense.  In 2009, as the market attempted to bounce in March, the global economy was in ruins.  The banks had started to fail, recession was the talk of the town, and commercial real estate was the next shoe to drop (sound familiar?).  As the market continued higher, I was certain the trap door was going to fall out of the bottom once again, just as it had done twice in 2008.  But it didn’t.  It continued to climb the proverbial wall of worry, closing higher by 23% for the year, and almost 70% higher than the intraday low in March 2009.  The experience of trying to trade a market I wanted, instead of the one that was in front of my face was invaluable, sowing the seeds for our playbook in 2020, which helped us navigate the COVID crisis.

That early experience set the stage for everything that came after (including Second Level Capital).  Learning how to take emotion out of analysis.  Trading the market as it is.  Being less concerned about missing out on the next move, knowing there will always be another entry.  Ebbs and flows in the business cycle are always for different reasons, but the human nature embedded in our own fear and greed remain the same.  Learning how to quantify these emotions to produce potential opportunities is likely to be our main focus for the foreseeable future.

While we remain cautious there will be a pullback in the next month or two, there is ZERO evidence it is imminent.  Could be today, could be next week, could be after the S&P 500 makes a new all-time high.  No one knows.  No one.  There are a few pieces of data that have caught our eyes, suggesting this may not be the greatest time to put new capital to work, but we will continue monitoring and if anything presents itself, we will reach out.

That’s it for this month, and a special happy birthday shout out to Second Level Capital.  It’s been 5 years, this month.  Can’t believe it, and we can’t thank all of you enough.

Stay Cool,

Adam